How Dark Pools Quietly Influence Crypto Markets

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

While the spotlight may not be kind during a crypto winter, the bottom half of that iceberg is still there – all of which wouldn’t exist without dark pools. These sometimes controversial back door entrances into the crypto market serve the same function as 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 to 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 the broader public. Their origins in traditional markets go back several decades, enabled by SEC regulation, which allowed investors to trade securities off-exchange.

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

SFOX explains in their new dark pool report that the main point in difference with crypto dark pools is the settlement process and trade execution. All digital asset transactions eventually need to settle on the blockchain. Dark pools pass those transaction costs on to the clients. Trade execution differs in that crypto dark pools use a multiparty computation protocol (MPC) to break the trade into multiple orders. This approach maintains privacy and security for the client. 

Their use has courted some controversy. On the one hand, the lack of transparency means that dark pool trades don’t move the market at the time of trading. However, upon disclosure to the regulator post-trade, the most significant trades tend to drive the market in a general direction.

Greater market participation

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

Source: Finoa

While 2021 initiated the first wave of institutional interest, we have yet to witness the second one. This lack of movement, in large part, is due to regulatory uncertainty and price volatility.  

The larger Institutions, waiting on the sidelines, are slow moving and risk averse. They’re not going to enter a market until the rules of engagement are crystal clear. And these rules aren’t as simple as approving or banning particular digital assets. In our conversation with sFOX, they explained that these larger, more established players need complete compliance standards to ensure their ability to fulfill fiduciary obligations. 

Since 2018, we have seen parts of the institutional-grade jigsaw being put in place — piece by piece. From digital asset custodians to prime brokers, lending, credit and risk management facilities. A jurisdictional battle between regulatory agencies may be one of the remaining items needing clarity. 

Decreased volatility

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

Another option for an institution is to engage with digital assets infrastructure firms such as Fireblocks. They can provide the plumbing to access different liquidity pools, although the shortcoming with this approach is that it’s not seamless. There will be a need for the market player to have separate accounts with the various liquidity providers.

A senior representative at sFOX stated that their dark pool addresses this problem by routing the trade through a ‘single order.’ This approach keeps the trade private while offering routing transparency to the market maker. Collaborating with a specialist and having one account to an aggregation 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 end 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, consequently improving price stability to a degree. 

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

A better outcome for institutions

The opportunity for limited market impact for an institution utilizing a dark pool essentially means that the entire order gets filled without the asset price increasing/decreasing disproportionately. In this way, the trade shouldn’t get front-run, and maker orders can occur without slippage. 

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

Diminishing arbitrage returns

In considering all of the above, between an expansion of the digital asset market due in part to dark pools being made available (as a prerequisite to the entry of the institutions), the improved market liquidity and greater efficiencies still with an aggregated liquidity approach, arbitrage opportunities will diminish, especially in the case of less sophisticated investors.

Hedge funds will likely cannibalize any arbitrage opportunities that arise. Their quants will formulate algorithms as part of sophisticated trading strategies developed to mop up whatever remaining inefficiencies exist in the market at that stage.

Dark pools will likely make for a perennial point of controversy in crypto, just as they have done in TradFi. But increasing dark pool liquidity may invite the capital needed to calm the waters of an industry plagued with fear and uncertainty.

This content is sponsored by sFOX.

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