How Dark Pools Are Quietly Affecting Crypto Markets

In 2021, crypto investors heralded market movements, such as MicroStrategy and Tesla, as champions of the bull market. They represented the tip of an institutional iceberg of growing interest in digital assets.

While the spotlight may not be kind during a crypto winter, the bottom half of the iceberg is still there – all of which wouldn’t exist without dark pools. These sometimes controversial backdoor entries into the crypto market function similarly to dark pools in traditional markets – often moving markets in mysterious ways.

We met with sFOX, a full-service crypto-prime dealer, to learn more about dark pools and their relationship with crypto markets.

What is a dark pool?

A dark pool allows oversized market players to trade large blocks of digital assets without the trade being visible to a wider public. Their origins in traditional markets go back decades, made possible by SEC regulation, which allowed investors to trade securities over the counter.

According to the SEC, dark pool trading accounts for 18% of trades in US stocks. More recent data from Nasdaq puts it at 40%.

SFOX explains in their new dark pool report that the main point of difference with crypto dark pools is the settlement process and trade execution. All digital asset transactions must ultimately be settled on the blockchain. Dark pools pass these transaction costs on to customers. Trade execution differs in that crypto dark pools use a multiparty computation protocol (MPC) to split the trade into multiple orders. This approach maintains privacy and security for the client.

Their use has created some controversy. On the one hand, the lack of transparency means that dark pool trades do not move the market at the time of the trade. However, on post-trade disclosure to the regulator, the most important trades tend to drive the market in a general direction.

Greater market participation

Dark pools played an important role in the run-up to the 2021 crypto market. SFOX shared a report from Finoa to illustrate the impact of accelerated institutional interest:

Source: Finoa

While 2021 started the first wave of institutional interest, we have yet to witness the second. This lack of movement is largely due to regulatory uncertainty and price volatility.

The larger institutions, which wait on the sidelines, are slow-moving and risk-averse. They are not going to enter a market until the rules of engagement are crystal clear. And these rules are not as simple as approving or banning certain digital assets. In our conversation with sFOX, they explained that these larger, more established players need full compliance standards to ensure their ability to meet fiduciary obligations.

Since 2018, we have seen parts of the institutional jigsaw being put into place — bit by bit. From digital asset managers to prime brokers, lending, credit and risk management facilities. A jurisdictional battle between regulatory agencies may be one of the remaining points in need of clarity.

Reduced volatility

In our conversation with sFOX, they listed price volatility and illiquidity as the second barrier to institutional buyouts. Crypto dark pools offer a necessary solution, but they have their trade-offs. Because liquidity is fragmented across a 24-hour global market, many institutions must go through intermediaries before executing a trade through the pool.

Another option for an institution is to engage with digital asset infrastructure firms such as Fireblocks. They can provide plumbing to access different pools of liquidity, although the shortcoming of this approach is that it is not seamless. It will be necessary for the market participant to have separate accounts with the various liquidity providers.

A senior representative at sFOX stated that their dark pool solves this problem by routing trades through a “single order.” This approach keeps the trade private while offering route transparency to the market maker. Working with a specialist and having one account for a collection of liquidity providers is likely to be a robust option for institutions in the future. Institutions will find better price discovery as more incorporate this aggregated liquidity model into crypto dark pools.

The representative clarified that dark pools are not the final solution to market volatility and fragmentation. As dark pools improve price discovery for larger trades, it will attract more institutional capital across the market. It has a “rising tide” effect on the industry, and consequently improves price stability to some extent.

But he states that liquidity fragmentation will still need to be addressed. If the price continues to fluctuate differently across markets, arbitrageurs will take advantage of and maintain volatility. He believes that sFOX’s approach to pooling liquidity into a single order can offer the stability institutions want for increased participation.

A better result for institutions

The possibility of limited market influence for an institution using a dark pool essentially means that the entire order is filled without the asset price increasing/decreasing disproportionately. In this way, the trade should not get ahead, and producer orders can occur without slippage.

In fact, it means the best trade execution for that institution. It also means the ability to execute trades at lower fees. Reduced reporting and information requirements, absence of exchange fees and fewer intermediaries lead to significant savings.

Diminishing arbitrage returns

Considering all of the above, between an expansion of the digital asset market partly due to the availability of dark pools (as a prerequisite for the entry of institutions), the improved market liquidity and greater efficiency still with an aggregate liquidity approach, the opportunities for arbitrage will decrease, especially in the case of less sophisticated investors.

Hedge funds are likely to cannibalize any arbitrage opportunities that arise. Their quants will formulate algorithms as part of sophisticated trading strategies designed to remove the residual inefficiencies that exist in the market at that stage.

Dark pools are likely to pose a perennial point of controversy in crypto, just as they have in TradFi. But increasing liquidity in dark pools can invite the capital needed to calm the waters in an industry characterized by fear and uncertainty.

This content is sponsored by sFOX.

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