The Prop Trader's Chronicles: Short-Term Proprietary Trading Strategies for Both Bull and Bear Markets

CHAPTER 5

Dark Pool Liquidity and Alternative Trading Systems

To publicly display liquidity (the bids and offers posted by liquidity providers and shown on a Level 2 quote) is, naturally, to show one's hand to every other market participant. While there are situations in which some institutions may feel free to do this for one reason or another, it's typically not a good idea for an institution or hedge fund to display a large block since every other participant in the market can take advantage of the situation.

It would be disadvantageous to the large seller, as well as to others with long positions on the same asset, to show that they intend to unload a large amount of the asset as the rest of the market will immediately react and all or part of the seller's shares will end up transacting at a much lower price.

This is the primary reason for the existence of dark pools (alternative trading systems for hidden liquidity). Dark pool transactions (after a transaction has been completed) must be reported just as any other transaction must be. However, prior to execution, they are not publicly displayed. Their function is similar to hidden orders on the ECN systems except the actual order matching algorithms tend to be a completely different beast. Each dark pool is designed to offer big institutional traders, such as large hedge funds, unique benefits but is typically not time-price priority like the majority of ECN systems.