What is a Lit Pool? What is a Dark Pool – LIT TRADING VS DARK TRADING
Lit pools are the opposite of dark pools. A lit pool refers to a public stock exchange where
the order book is openly displayed and available for all participants. This means that traders
using a lit pool are able to see the amount of liquidity on the bid and offer for a security
through the order book, which can be used to gauge the short-term direction of a stock.
Dark pools are private exchanges only available to institutional investors. These private
exchanges (also called Alternative Trading Systems) are known as “dark pools” due to their
complete lack of transparency.
The main difference is dark pools don’t have public order books or show the prices a buyer
or selling is willing to pay while, in contrast, lit pools publicly display the various bids and
offers for stocks listed on the exchange.
According to the CFA Institute, dark pools are continuing to rise in popularity with an
estimated 40% of all stock trades being executed in dark pools in 2017 compared to an
estimated 16% in 2010.
When Do Institutional Investors Use Dark Pools Over Lit Pools?
Institutional investors trade in dark pools over lit pools for two primary reasons:
1. Find buyers and sellers for large orders without publicly revealing intentions
2. Obtain better pricing for executed trades
Dark pools allow institutional investors to quietly find buyers and sellers for large orders
without causing large swings in the market (typically against them). How is this possible?
Dark pools are not required to make the order book available to the public. Instead,
transactions executed through dark pools are released to the consolidated tape after a
delay.
For example, let’s say an investment bank is trying to sell 400,000 shares on a public
exchange like the New York Stock Exchange. As soon as institutional investors or high-
frequency traders see a large sell block hit the order book on a lit pool, the markets react,
and the security likely would have decreased in value by the time the investment bank was
able to find enough buyers to fill the entire order. However, if the trade is disclosed only
after it has been executed, the news has a much smaller impact on the market.
Another reason to fill large equity orders in dark pools is to obtain better pricing. Trades
made on dark pools can have lower transaction costs in two ways:
1. Dark pools typically offer lower exchange fees
2. The lack of price transparency may result in trades filled closer to the mid-point of the
quoted bid-ask spread
A common criticism of dark pools is that enough volume traded through dark pools could
result in stock prices on public exchanges not reflecting the actual market value. While the
above scenario may work out well for the investment bank selling the shares, consider a
retail investor who just purchased shares of the company the investment bank just sold
400,000 shares of on a dark pool. Once the sale of those 400,000 shares becomes public
, knowledge, the stock price could tank, and the retail investor who just bought shares paid
too much.
What Is an American Depositary Receipt (ADR)?
The term American depositary receipt (ADR) refers to a negotiable certificate issued by a U.S.
depositary bank representing a specified number of shares—usually one share—of a foreign
company's stock. The ADR trades on U.S. stock markets as any domestic shares would. ADRs
offer U.S. investors a way to purchase stock in overseas companies that would not otherwise
be available. Foreign firms also benefit, as ADRs enable them to attract American investors
and capital without the hassle and expense of listing on U.S. stock exchanges.
KEY TAKEAWAYS
An American depositary receipt is a certificate issued by a U.S. bank, represents
shares in foreign stock. These certificates trade on American stock exchanges.
ADRs and their dividends are priced in U.S. dollars.
ADRs represent an easy, liquid way for U.S. investors to own foreign stocks.
These investments may open investors up to double taxation and there are a limited
number of options available.
How American Depositary Receipts (ADRs) Work
American depositary receipts are denominated in U.S. dollars. The underlying security is
held by a U.S. financial institution, often by an overseas branch. ADR holders do not have to
transact the trade in the foreign currency or worry about exchanging currency on the forex
market. These securities are priced and traded in dollars and cleared through U.S.
settlement systems.
In order to begin offering ADRs, a U.S. bank must purchase shares on a foreign exchange.
The bank holds the stock as inventory and issues an ADR for domestic trading. ADRs list on
either the New York Stock Exchange (NYSE) or the Nasdaq, but they are also sold over-the-
counter (OTC).
U.S. banks require that foreign companies provide them with detailed financial information.
This requirement makes it easier for American investors to assess a company's financial
health.
Types of American Depositary Receipts
American depositary receipts come in two basic categories:
- A bank issues a sponsored ADR on behalf of the foreign company. The bank and the
business enter into a legal arrangement. The foreign company usually pays the costs of
issuing an ADR and retains control over it, while the bank handles the transactions with
investors. Sponsored ADRs are categorized by what degree the foreign company
complies with Securities and Exchange Commission (SEC) regulations and American
accounting procedures.
- A bank also issues an unsponsored ADR. However, this certificate has no direct
involvement, participation, or even permission from the foreign company. Theoretically,
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