Dark Pools and Alternative Trading Systems

Executive Summary

Alternative Trading Systems (ATSs) and dark pools represent a critical and controversial component of modern equity market structure. Regulated by the U.S. Securities and Exchange Commission (SEC) ¹, ATSs are electronic trading venues that are registered as broker-dealers but operate outside the traditional framework of national securities exchanges.² Functionally, all current US equity ATSs operate as "dark pools," systems that allow users to submit orders without publicly displaying size or price, primarily serving institutional investors seeking to mitigate market impact.¹

The landscape of US equity trading is now highly fragmented, with substantial volume executed off-exchange. In 2024, trading reported via the Trade Reporting Facility (TRF)—the measure of off-exchange activity—constituted 47% of Total Consolidated Volume (TCV).⁵ Critically, this off-exchange flow is dominated not by formal institutional ATS platforms, which account for only 17.0% of TRF volume, but by Principal Dealers and Internalizers, which execute 83.0% of TRF volume (equating to approximately 39% of TCV).⁵

This proliferation of non-transparent trading has intensified regulatory scrutiny globally. In the European Union, the Markets in Financial Instruments Directive II (MiFID II) introduced the stringent Double Volume Cap (DVC), successfully curtailing formal dark pool activity but inadvertently pushing volume into less regulated Over-The-Counter (OTC) markets.⁶ In the United States, the SEC has responded by adopting amendments to Regulation NMS to refine tick sizes and increase transparency ⁷, alongside proposing the transformative Order Competition Rule (OCR), designed to inject competition into the vast segment of segmented retail order flow currently channeled through internalizers.⁹ The central challenge remains balancing the efficiency needed for large-scale institutional risk transfer against the potential impairment of public price discovery and market fairness.

I. The Fragmented Landscape: Defining Dark Pools and Alternative Trading Systems (ATS)

1.1 The Genesis of Non-Displayed Liquidity: From Traditional Exchanges to Fragmentation

The structure of the US equity market was profoundly altered following the adoption of Regulation National Market System (Reg NMS) in 2007. Prior to this, trading was concentrated on a few major national exchanges.¹⁰ Reg NMS, by abolishing earlier rules that protected manually submitted quotes, fostered a highly competitive environment dominated by innovative electronic trading venues and High-Frequency Trading (HFT).¹⁰ This technological and regulatory shift accelerated market fragmentation, leading to a complex trading structure that includes over a dozen exchanges and roughly 40 dark pools competing for business.¹⁰

The primary catalyst for the development of dark pools was the institutional investor’s dilemma: executing large block trades on a public, or "lit," exchange inevitably results in market impact. This adverse price movement—where selling a large volume depresses the price, or buying a large volume drives it up—imposes significant, often prohibitive, transaction costs.⁴ Dark pools were specifically engineered to provide a venue where trading intentions could be concealed, allowing large buyers and sellers to find liquidity without signaling their presence to the broader market.¹³

1.2 Statutory and Regulatory Definitions: ATS under SEC Regulation ATS

An Alternative Trading System (ATS) is defined as an electronic system that matches buy and sell orders for securities.¹ While an ATS performs functions similar to a national securities exchange, it is not registered as one. Instead, it operates as a broker-dealer under the regulatory framework established by Regulation ATS.³

To operate under this exemption, an ATS must comply with Rules 300-303 of Regulation ATS, which requires the operator to register as a broker-dealer and file an initial operation report (Form ATS) with the SEC.³ This filing acts as a notice to the Commission rather than an application for formal approval.³ In the context of the U.S. equity market, the terms ATS and "dark pool" are essentially synonymous, as the SEC confirms that all current ATSs operate as dark pools—trading systems that withhold the display of order size and price from other participants.¹ Thus, the designation of ATS is a legal framework (Reg ATS), while "dark pool" is a functional description of a non-displayed order book. This regulatory structure effectively accommodates non-displayed trading, acknowledging the essential need for market impact mitigation for large, complex transactions.

1.3 Dark Pools vs. Lit Markets: Transparency, Price Formation, and Market Impact

The defining characteristic separating dark pools from lit markets (national exchanges) is pre-trade transparency. Lit markets publicly display their order books, showing all bids, offers, and associated prices, thus facilitating public price formation around the National Best Bid and Offer (NBBO).¹⁵

In stark contrast, dark pools offer complete opacity.¹⁵ Order information is hidden, allowing participants to transact discreetly.¹³ A critical incentive for using dark pools is the ability to achieve price improvement. While lit markets execute at the prevailing bid or offer, dark pools frequently execute trades closer to the mid-point of the quoted bid-ask spread.¹² Furthermore, dark pools often incur lower transaction fees compared to traditional exchanges.¹²

The tension between efficiency and transparency forms the central structural dilemma of fragmented markets. The ability to execute large trades efficiently protects institutional investors from adverse price movement. However, this increased efficiency for large participants introduces significant information asymmetry, disadvantaging the general public who rely on the integrity and depth of the publicly displayed order book to assess true supply and demand dynamics.¹³

II. Taxonomy of Alternative Trading Systems (ATS) and Non-Displayed Venues

The off-exchange trading landscape is highly heterogeneous, comprising several types of ATSs, each characterized by its operational model, clientele, and the use (or exclusion) of the operator's proprietary capital.

2.1 Overview of ATS Categories

Historically, ATSs encompass several formats ¹⁷:

• Electronic Communication Networks (ECNs): These are trading platforms that enable brokerages and traders to transact directly. While ECNs are a type of ATS, many operate with visible limit order books and thus are not strictly "dark."

• Crossing Networks: These systems match buyers and sellers outside the public eye. The first major example, Posit (1987), pioneered the method of executing trades at predetermined prices, typically the mid-point of the public spread, often via periodic matching "crosses".¹⁸

• Call Markets: These ATSs match orders at set times rather than continuously.¹⁷

2.2 Agency-Only Dark Pools (Public Crossing Networks)

Agency-only pools, or public crossing networks, represent the most traditional form of dark pool liquidity.¹⁹ These venues are often founded by agency-only brokerage firms whose primary objective is generating commission by matching client flow, strictly excluding the firm's proprietary flow from participating in the matching process.¹⁹

A prime example is Liquidnet, which operates as a global institutional trading network. It uses proprietary "blotter-scraping technology" to scan buy-side clients’ order management systems to find natural, peer-to-peer matches for large blocks of securities.²⁰ Liquidnet facilitates block trading not only in equities but also in complex, less liquid asset classes like corporate bonds and emerging market (EM) equities.²⁰ In these markets, where trading is typically "high-touch" and the ability to simply find a counterparty for a large size is crucial, the anonymity of the dark pool provides necessary scale and depth.²¹ The retention of the Large in Scale (LIS) waiver in regulations such as MiFID II confirms that global regulators view the efficient execution of large, institutional block trades as a structurally necessary component of the market.²²

2.3 Principal and Bank-Owned Dark Pools (Internalization Pools)

Internalization pools, often established by major investment banks, emerged more recently and are intended primarily to internalize the operator’s trade flow.¹⁹ The most successful example is Goldman Sachs’ Sigma X, a major bank-operated dark pool that has consistently ranked among the largest by volume.¹⁸

Internalization is the process where a broker-dealer executes client orders by matching them internally rather than sending them to external exchanges.²³ This process occurs in two primary ways: agency cross (matching two client orders against each other), or principal trading (the broker-dealer takes the opposite side of the client order using the firm's own inventory, thereby assuming market risk).²³ The firm benefits by capturing the bid-ask spread.²⁵

The incentive structure for operating these principal pools differs fundamentally from agency pools. While agency pools seek only to generate commission by connecting natural counterparties, internalization pools are driven by cost savings, commission generation, and the potential for proprietary alpha generation for the operating firm.¹⁹ Sigma X, for instance, maintains a fully internal and anonymous matching process, ensuring no pre-trade information is disseminated to internal trading desks.²⁶ However, this ability to restrict access and utilize proprietary flow creates potential conflicts of interest, leading to regulatory settlements in the past regarding inadequate conflict disclosure.¹⁸ The concentration of proprietary flow introduces the risk that the broker-dealer may prioritize maximizing the return on its inventory over obtaining the best execution price for the client, a conflict that forms the structural basis of the Payment for Order Flow debate.

Table 1: Operational Comparison of Major Equity Trading Venues

Feature	Lit Market (Exchange)	Agency Dark Pool (ATS)	Internalizer/Principal Pool
Pre-Trade Transparency	High (Public Order Book)	None (Dark)	None (Dark)
Primary Users	All Participants	Institutional Investors/Buy-Side	Broker-Dealers/Wholesalers
Execution Price	Best Bid/Offer (NBBO)	Mid-point or better	Mid-point or Price Improvement
Market Risk Assumed	None	None (Agency-Only)	High (Principal Trading)

III. Institutional Drivers: Market Impact Mitigation and Execution Quality

3.1 The Imperative of Block Trading: Managing Adverse Price Movement

For large institutional funds, the single greatest justification for utilizing dark pools is the management and mitigation of market impact. When trading large volumes of shares, revealing those intentions on a lit market guarantees an adverse price movement that significantly raises trading costs.⁴ The use of private trading venues allows institutions to execute these transfers without displaying the order size or intent, thereby protecting themselves from immediate market disruption and aggressive trading by High-Frequency Traders (HFTs).¹¹

While modern execution algorithms often split large orders into smaller ones executed over time (e.g., VWAP or TWAP strategies) ¹¹, dark pools offer the possibility of immediate block matching, reducing the risk of gradual information leakage that comes with time-based execution. Specialized order routing allows for optimization, such as Direct Orders which remain exclusively in the dark pool, or Sweep Orders which attempt a dark match first before forwarding the remaining volume to other available order books.⁴ To further protect these orders, sophisticated systems incorporate anti-gaming logic designed to shield the institutional flow from predatory HFT tactics.²⁷

3.2 Price Improvement Mechanisms: Mid-Point Execution and Spread Capture

A secondary, but powerful, incentive for using dark venues is obtaining superior execution quality. Trades executed in dark pools can achieve better pricing by filling closer to the mid-point of the quoted bid-ask spread.¹² This price improvement mechanism, coupled with typically lower exchange fees, contributes directly to reduced transaction costs.¹²

Some academic analysis posits that the existence of dark pools, particularly those executing at the midpoint, can paradoxically benefit the overall market structure. If uninformed traders are attracted to dark pools (due to the promise of mid-point execution and lower volatility), while highly informed traders continue to use lit exchanges to act on fresh information, the dark pool effectively filters out "noise." This segregation may concentrate price-relevant information onto the public exchange, theoretically improving the quality of the price discovery mechanism.²⁸ However, this theory relies on the premise that the public exchange retains sufficient trading volume to form a reliable price signal.

3.3 The Evolution of Dark Trading Beyond Equities

The utility of non-displayed liquidity is most pronounced in asset classes characterized by low liquidity and wide spreads, such as corporate bonds and emerging market (EM) equities. For hard-to-trade, illiquid securities, the priority shifts from spread optimization to simply finding a large counterparty.²⁰

Liquidnet, for example, extended its blotter-scraping P2P technology to launch a dark pool for corporate bonds in 2015, focusing on facilitating high-notional trades.²⁰ In these markets, augmented liquidity from dealers is often incorporated, allowing participants to target block axes for hard-to-trade bonds while minimizing information leakage.²⁰ Similarly, block matching in EM equities is seen as a consequential opportunity to provide the necessary scale for sustainable fund allocation in markets that suffer from fragmentation and liquidity concerns.²¹

IV. Quantitative Analysis of Off-Exchange Trading Volume

The fragmentation of the U.S. equity market, exacerbated by Reg NMS, has resulted in a substantial migration of volume away from traditional, lit exchanges. Understanding this migration requires differentiating between formal ATS platforms and the principal internalization performed by broker-dealers.

4.1 Off-Exchange Dominance in US Equities

U.S. equity markets have sustained elevated trading activity, with the Average Daily Volume (ADV) in 2024 reaching 12.2 billion shares.⁵ Data tracked through the Trade Reporting Facility (TRF) shows that nearly half of all equity trading occurs off-exchange.³⁰ In 2024, TRF volume accounted for 47% of Total Consolidated Volume (TCV), an increase of 300 basis points in market share.⁵

4.2 Deconstructing the Off-Exchange Flow

A granular analysis of this 47% off-exchange volume reveals the true drivers of market fragmentation. The off-exchange category is not monolithic; it consists of formalized ATS platforms and the activity of Principal Dealers/Internalizers.

For the period through November 2024, only 17.0% of TRF volume occurred on formal Alternative Trading System (ATS) platforms. In sharp contrast, the vast majority, 83.0% of TRF volume, was executed through Principal Dealers.⁵

This translates to the following distribution of TCV:

• National Securities Exchanges (Lit Markets): Approximately 53% of TCV.

• Off-Exchange Trading (47% TCV):

• Formal ATS (Dark Pools): Approximately 8.0% of TCV (17.0% of 47%).

• Principal Dealers/Internalizers: Approximately 39.0% of TCV (83.0% of 47%).

The data demonstrates unequivocally that the systemic shift of liquidity away from lit markets is predominantly driven by principal dealer internalization, not the institutional block trades handled by traditional ATS platforms.

Table 2: US Equity Trading Volume Distribution (2024 Analysis)

Venue Category	Share of Total Consolidated Volume (TCV)	Derived Share of TCV	Key Function
National Securities Exchanges (Lit Markets)	100% - 47%	~53%	Price Discovery, Public Liquidity
Trade Reporting Facility (TRF) Total	47%	47%	Off-Exchange Execution
ATS Platforms (Formal Dark Pools)	17.0% of TRF Volume 5	~8.0%	Institutional Block Execution
Principal Dealers (Internalization)	83.0% of TRF Volume 5	~39.0%	Retail Order Execution, PFOF Channel

4.3 Implications of Principal Dealer Dominance

The dominance of principal internalization volume (39% of TCV) means that a substantial portion of the market’s trading activity, often sourced from aggregated retail orders, is systematically diverted away from centralized, public exchanges where price competition establishes the NBBO. This diversion creates a structural risk: if a large proportion of flow bypasses the primary venue, the publicly displayed price may be based on a continuously shallower pool of liquidity. While internalization often provides small price improvements, this lack of volume on the exchange floor can impair price discovery, making it difficult to ascertain the true market value or existing supply and demand dynamics.¹³

Furthermore, off-exchange trading shows a significant concentration in low-priced stocks. In 2024, securities priced below $5 accounted for 33.1% of the total TRF volume.⁵ This high incidence suggests that internalizers specialize in capturing micro-profits from high-volume, low-margin instruments, where wider spreads allow for greater capture potential through mid-point execution.

V. Regulatory Intervention and Conflicts of Interest

The significant volume channeled through non-transparent venues, particularly via internalization, highlights critical conflicts of interest and regulatory concerns regarding best execution and market fairness.

5.1 Payment for Order Flow (PFOF) and Best Execution

Broker-dealers owe their clients a duty of best execution, requiring them to use reasonable diligence to ascertain the most favorable terms available for a customer's order.³¹ Internalization structurally challenges this duty. PFOF is the compensation broker-dealers receive from wholesale market makers for routing customer orders to them.³²

PFOF generates a direct conflict of interest: the broker-dealer may be incentivized to route the order to maximize PFOF revenue rather than prioritizing the customer's best execution price.³⁴ While some firms argue PFOF enables "zero-commission" trading, critics contend that the cost is simply internalized, leading to estimated execution losses for investors, particularly for larger retail orders.³³ The lack of pre-trade competition concentrates execution among a few large wholesalers, who may behave non-competitively, exploiting retail orders, especially in related markets like options, to generate substantial arbitrage profits.³⁵

5.2 US Regulatory Reforms (2024-2025): Targeting Competition and Price Quality

In response to the market fragmentation driven by PFOF and internalization, the SEC has pursued comprehensive reforms to Regulation NMS, shifting regulatory focus from mere disclosure toward mandating competition.

5.2.1 SEC Amendments to Regulation NMS (2024)

In September 2024, the SEC adopted amendments designed to enhance competition and reduce transaction costs.⁷ These changes include:

• New Tick Size Increment: A new, additional minimum pricing increment of $0.005 was established for quotations and orders in certain NMS stocks priced at or above $1.00.⁷ This change is intended to relieve pricing constraints on many NMS stocks, allowing exchanges to quote more competitively and potentially reduce the economic advantage internalizers gain from capturing the existing spread.

• Fee Adjustments: The maximum access fee cap for protected quotations was reduced, and exchanges are now required to disclose transaction fees at the time of execution.⁸

• Transparency: Rules mandating the accelerated display of odd-lot information will increase the transparency of better-priced, smaller-sized orders.⁷

5.2.2 The Proposed Order Competition Rule (OCR)

The most direct attack on the internalization model is the proposed Order Competition Rule (OCR).⁹ This rule is predicated on the idea that segmented retail orders must be exposed to open competition before being executed internally. The proposal would prohibit a restricted competition trading center (an internalizer) from executing certain individual investor orders unless those orders are first routed to a "qualified auction" operated by an "open competition trading center".⁹

The objective of the OCR is to force segmented orders to compete on an order-by-order basis, thereby minimizing transaction costs incurred by individual investors and providing the best prices.³⁶ The shift from a reactive, disclosure-based regime to one mandating pre-trade competition attempts to mitigate the non-competitive practices fostered by PFOF. However, if implemented, principal dealers who currently dominate off-exchange flow may respond by developing sophisticated HFT strategies within the auction format or by acquiring stakes in the required auction centers, potentially diminishing the intended competitive benefits.

VI. Global Regulatory Comparison: The MiFID II Experience

To understand the potential impact of structural regulation on dark pools, the experience of the European Union under the revised Markets in Financial Instruments Directive (MiFID II) is instructive. MiFID II, effective in 2018, aimed specifically to protect price formation integrity by limiting the amount of non-transparent trading.⁶

6.1 The Double Volume Cap (DVC) Mechanism

MiFID II introduced the Double Volume Cap (DVC) mechanism, detailed in Article 5 of MiFIR, which targeted dark trading executed under waivers from pre-trade transparency requirements.⁶ The DVC imposed two specific thresholds for any given financial instrument over a 12-month period:

1. First Cap (4%): Limits trading in a single dark pool venue under the waivers to 4% of the instrument's total EU volume.⁶

2. Second Cap (8%): Limits aggregate trading across all dark pools using the waivers to 8% of the instrument's total EU volume.⁶

If either cap was breached, the instrument would be suspended from dark pool execution.⁶ This measure led to the suspension of hundreds of instruments from dark trading shortly after implementation.⁶

6.2 Unintended Consequences and Regulatory Arbitrage

The DVC succeeded in its immediate goal: European dark pool volumes experienced a sharp contraction, shrinking from approximately 9% to a mere 0.15% by mid-2018.⁶ However, the ambitious goal of compelling this liquidity back onto lit exchanges failed. Liquidity is highly mobile and will migrate to the path of least regulatory friction.

Instead of returning to transparent venues, a significant portion of the restricted volume migrated to non-transparent, off-exchange Over-The-Counter (OTC) trading. OTC trading volumes consequently surged, reporting levels three times higher than pre-MiFID II figures in some months.⁶ This migration demonstrates regulatory arbitrage; by imposing severe constraints on regulated dark pools, the EU inadvertently fostered growth in unregulated, truly opaque OTC markets, leading to an ambiguous net outcome for overall market transparency.⁶

6.3 The Importance of the Large In Scale (LIS) Exemption

A crucial component of MiFID II was the preservation of the "Large in Scale" (LIS) waiver.²² This exemption allows sufficiently large transactions to be executed in the dark without contributing to or being restricted by the DVC.²² The retention of the LIS waiver confirmed the regulatory recognition that institutional block trades must be executed without transparency to reduce price impact, effectively pushing regulated dark trading back to its core purpose: the efficient matching of large institutional orders.²²

The contrasting focuses of US and EU regulatory reform reflect their unique market structure problems. The EU prioritized controlling high institutional volume (DVC), while the US is now focused on controlling the vast, segmented retail flow captured by internalizers (OCR), recognizing that the latter is the primary driver of market fragmentation in the US.

Table 3: Comparative Regulatory Limitations on Dark Trading

Regulatory Jurisdiction	Mechanism/Rule	Targeted Flow/Activity	Primary Limitation/Threshold
European Union (MiFID II)	Double Volume Cap (DVC)	Non-LIS reference price trades	4% single venue / 8% aggregate volume limit 6
United States (SEC Reg NMS)	Tick Size Amendments (2024)	Spread constrained stocks, competitive pricing	New minimum $0.005 increment for certain stocks 7
United States (SEC OCR) (Proposed)	Order Competition Rule	Principal execution of segmented retail orders	Mandated exposure to qualified auction 9

VII. Conclusion and Strategic Recommendations

7.1 Synthesis: Internalization as the Primary Structural Concern

The analysis confirms that the US equity market has reached a critical juncture, with nearly half of all share volume executed off-exchange. While formal ATS dark pools serve the essential function of minimizing market impact for large institutional block orders (around 8.0% of TCV), the overwhelming majority of non-displayed volume (39.0% of TCV) is managed by Principal Dealers/Internalizers.

This vast stream of internalized flow, often tied to retail orders and facilitated by Payment for Order Flow, introduces profound conflicts of interest. The structural profitability derived from capturing the bid-ask spread motivates brokers to prioritize PFOF revenue over achieving the theoretically optimal price for the customer, thereby systematically diverting volume that could otherwise contribute to price discovery on lit exchanges. The high proportion of total market volume diverted fundamentally risks eroding the reliability of the public price signal.

7.2 Outlook on Future Market Structure: Regulatory Response

The SEC’s recent and proposed reforms signal a focused effort to address the economics of internalization:

1. Tick Size Adjustments: The new $0.005 tick size is intended to narrow the profitability buffer currently exploited by internalizers on constrained stocks, making it easier for exchanges to compete for that same liquidity stream.

2. Order Competition Rule (OCR): The OCR represents a monumental structural shift. By mandating that segmented orders face auction competition, the rule attempts to eliminate the economic advantage wholesalers currently hold over obtaining order flow non-competitively. If successful, this could significantly re-route or restructure the 39% of TCV currently executed by principal dealers.

7.3 Strategic Recommendations

To navigate and influence this evolving market structure, institutional participants and regulators must adopt targeted strategies:

For Institutional Participants (Buy-Side):

• Demand Transparency and Auditability: Institutional investors must demand rigorous, enhanced disclosures regarding execution quality across all off-exchange venues. This requires demanding execution data from both lit and dark venues to distinguish between high-quality, agency-only crossing networks and potentially toxic broker-run internalizers that may introduce adverse selection risk.

• Prioritize Agency Models: Routing strategies should prioritize established agency-only ATSs for large block execution to ensure transactions are matched with natural, non-proprietary liquidity, thereby maximizing impact mitigation and execution quality.

• Prepare for OCR Impact: Institutions should prepare execution algorithms for a potential shift in the retail liquidity landscape, as the successful implementation of the OCR could redistribute significant amounts of flow, impacting liquidity sourcing strategies across all venues.

For Regulators (SEC/FINRA):

• Focus on Conflict Mitigation: Regulatory action must focus heavily on enforcing best execution duties and mitigating the conflicts of interest created by PFOF and principal internalization, rather than exclusively targeting institutional dark pools, which fulfill a specialized, necessary function (LIS).

• Prevent Regulatory Arbitrage: The SEC must carefully design the Order Competition Rule to prevent liquidity from migrating entirely outside the regulated TRF reporting system into unregulated bilateral OTC mechanisms, mirroring the unintended negative outcome observed following the implementation of MiFID II’s DVC in Europe.

• Strengthen Public Data: Finalizing and implementing rules related to displaying odd-lot quotes is crucial to ensure that the public NBBO reflects the best available prices and that fragmentation does not irreparably harm the quality and reliability of centralized price discovery.

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