What are ‘dark pools’ in share trading and why India has kept these at bay

How safe is trading in the Indian stock market for small investors? While many common Indians have taken to the stock market and market-based financial schemes and mutual funds over the years to boost their earnings, a lot of people still shy away from investing in the market because they are afraid of the risks involved.

However, the Indian trading regulations have put in place a fair degree of transparency that much of the Western world does not enjoy. One such peril of having lax regulations is the “dark pool” — something that allows large institutional traders to make hay as small retail investors remain in the dark. The transparency of the Indian trading regulations has ensured a safety net from dark pools, a National Stock Exchange (NSE) official said recently.

So, what are dark pools and why can these hurt small retail investors?

What is a dark pool?

To put it very simply, dark pools are private marketplaces where a large number of stocks are bought and sold bypassing the main stock exchanges, without the details of such transactions being made public.

While these have been common in the US and certain European Union countries — with regulations — Asia has been largely sceptical of these, even though dark pools have been trying to gain a foothold in Japan and Hong Kong, for instance, over the past 15 years or so.

How dark pools work

Taking the example of India, all stocks in the country are bought or sold on either of the two stock exchanges, BSE or NSE. When investors want to sell stocks, all players in the market, big or small, get to see it on either of the two and take a decision on whether to buy and how much.

A lot of demand can push up the prices, affecting the business of a big trader who wants to invest in those stocks, unless they make an early move. Therefore, what would be in the interest of such big investors? To make a quiet deal without anyone knowing about it, right? That is where dark pools come in. The bulk trader can quietly buy all the shares it wants without making a ripple in the market.

The seller submits the details of sale to a dark pool, which matches it to a willing buyer. The dark pool transfers the shares from the seller to the buyer at the agreed-upon price without disclosing the identities of either party in public.

Advantages of dark pools

These are very often used to make bulk transactions that would spark chaos if done openly. Suppose an entity is offering a large number of shares on sale, and a big investment company wants to buy the bulk of those shares. In India, they would have to do it openly, but in that case, others might also start buying those shares, pushing up the prices before the bulk buyer can finish buying all the shares it wants.

In India, such large exchanges are carried out through block deal windows of BSE or NSE. All information about the buyer, seller, price, and quantity of shares that changed hands is made public. But then, when such a large trade takes place, the stock prices react sharply. The seller may have to perform several trades to push all the stocks, and the bulk buyer may have to cough up a bigger price than they intended to.

Disadvantages of dark pools

So, who owns and operates these dark pools? Usually, private brokerage firms. Even though Europe and the US regulate these dark pools in varying degrees, there is always the fear that some player may manipulate the market by secretly buying or selling a lot of shares in a dark pool, thus pushing the market up or down drastically, hurting small retail investors beyond repair.

The popularity of dark pools in the West can be gauged from the fact that almost 40 per cent of the US trade in 2019 happened in dark pools, beyond the reach or knowledge of the small investor. That is why dark pools have never been made legal in India, where the SEBI has always believed in providing a level playing field to all market players.