What Are Dark Pools? The Heart of High Frequency Trading

“The hidden passages and trapdoors that riddled the exchanges enabled a handful of players to exploit everyone else.”
– Michael Lewis, Flash Boys
High frequency trading has dominated the financial media for the last month, thanks to Michael Lewis’ latest bestselling book titled Flash Boys: A Wall Street Revolt.
While high frequency trading may be getting most of the attention, there is a far bigger problem plaguing the financial markets. I’m referring to “dark pools” that allow high frequency traders to pillage and plunder the investment world.

So what are dark pools?

Dark pools are off-exchange trading platforms that allow institutional investors to trade stocks anonymously. These dark pools arose in the late 1980s from a desire by these big players to conduct large block trades without tipping their hand. Essentially, the dark pools that were created by many of the big Wall Street banks allow them to secretly trade on behalf of their clients.
By design, there is an inherent lack of transparency in the dark pools. But today, high frequency traders use these trading platforms as a tool for front-running customers and profiting at the expense of real investors.
In the beginning, dark pools only made up a small percentage of the daily market volume. Today, the percentage stands at almost 50% of all volume traded in the market.
What’s behind the exponential increase in volume? High frequency trading.
High-frequency trading uses speed to discover a trade before it happens. It allows the HFT computer to execute a trade before the original buyer or seller can. When the original trade does get executed, there’s an HFT operator on the other end. That trader benefits from the price being changed by a penny or so. And the more trades the HFT operators can “see” – no matter where the trades happen – the better high-frequency traders can predict the direction of a stock.
This newfound access into the dark pools allows the HFT firms to detect what big institutional investors were doing. That inside information – combined with their view of conventional exchanges including the New York Stock Exchange and Nasdaq – gives them a true advantage over most investors. And that information advantage is what allows these trading firms to make so much money.
It’s not just high frequency trading firms who are turning a tidy profit from high frequency trading. The companies running the dark pools – including investment banks like Goldman Sachs (NYSE: GS) and Morgan Stanley (NYSE:MS) – also stand to turn a healthy profit. That’s because they charge the HFT firms exorbitant fees for access to the order flows coming through their trading platforms.
As Michael Lewis explains, it’s the real investors who are the losers. Every investor – from big institutional investors to the average individual – gets burned, losing a little bit on every trade.
In the wake of Flash Boys, some big Wall Street firms are changing their tune. Goldman Sachs – Wall Street’s preeminent investment bank – has endorsed a new stock exchange called The Investors Exchange or IEX.
When you read Flash Boys, you’ll hear all about Brad Katsuyama and a small team that set out to create a fair stock exchange. Their goal was simple: create an exchange where the investors came first. To accomplish this simple goal, they needed to build a new stock exchange that shut out high frequency traders.
As it stands IEX has already captured 1% of average daily market volume. That’s impressive for a stock exchange that’s only been around for a couple months.
Goldman Sachs recently endorsed IEX, saying “it would be best for the overall market if IEX achieved critical mass, even it that results in reduced volume on [our dark pool].”
It’s clear that big changes are happening on Wall Street. And that’s why it’s so important that you understand the scope of this scam known as high frequency trading.
To help get you up to speed, I’d like to send you a free hardcover copy of Michael Lewis’ latest bestseller. You can claim your free copy of Flash Boys: A Wall Street Revolt by clicking here now. The retail price of the book is $27.95. But I’d like to mail you a complimentary copy of the book right now.
I only have 500 copies of the book – and they’re going fast.