Summary of key points
In traditional financial markets, large-scale transactions by institutional investors can have a significant impact on market prices, which may cause other market participants to face losses. To mitigate these effects, Dark Pools were introduced as an alternative trading system in which transaction details remain confidential until the trade is executed.
While dark pools have continued to grow since their inception, trust has been eroded by leaks and misuse by operators. To this end, regulators in several countries have taken action to strengthen oversight of these platforms. In light of this, blockchain-based dark pools emerged as a potential solution.
On-chain dark pools provide traders with privacy protections while eliminating the need for centralized intermediaries. This solves several problems faced by traditional financial systems. Furthermore, the growing demand for private transactions is expected to drive the development of the on-chain dark pool market in the near future.
Shenchao Note: In traditional financial markets, dark pools are private trading platforms that allow institutional investors to conduct large-amount securities transactions without disclosing transaction information. Transactions conducted in dark pools are not immediately publicly displayed on the open market, and transaction information is usually released with a delay or only partial information.
1. Introduction
Volatility in traditional financial markets continues to rise, driven primarily by technological advances and a variety of market factors. Large-scale trading by institutional investors, particularly block trading and the evolution of high-frequency trading (HFT) techniques, are the main causes of this volatility. ㄖㄦYou can't touch the screen, you can't translate it manually, and you have to use your hands to see what's going on. Take your eyes a little closer so that you can see clearly. Can you also see the distance?
This heightened market volatility poses significant risks to ordinary investors. As a result, institutional investors seek alternatives that enable them to execute large trades while minimizing market disruption. A solution that is gaining traction is dark pools, which are alternative trading systems designed to conduct private transactions.
There are several key differences between dark pools and traditional exchanges. First, transaction details such as order price and volume are not disclosed until the trade is executed. Secondly, dark pools mainly support large orders, and some platforms set minimum order sizes to filter out smaller transactions. Finally, they employ unique execution methods that include focused matching of large orders and execution of trades at midpoints in market spreads. These features allow institutional investors to execute large-scale transactions at favorable prices without leaking strategic information to competitors, thereby reducing the impact on market prices.
Source: Nasdaq
Dark pools are mainly developed in the United States and Europe. In the United States, dark pools once accounted for about 15% of total trading volume, peaking at 40% of average daily trading volume. Currently, more than 50 dark pools are registered with the Securities and Exchange Commission (SEC), and the number continues to grow. In Europe, the introduction of the Markets in Financial Instruments Directive (MiFID) in 2007 gave a boost to the development of dark pools.
This trend is also expanding capabilities in Asia. Hong Kong and Singapore have adopted dark pool systems since 2010, while Japan and South Korea have introduced these platforms within their respective regulatory frameworks.
Source: JPX Japanese dark pool trading trends
While dark pools were originally designed for institutional investors to handle large trades, recent data shows a shift toward smaller trades. According to FINRA (Financial Industry Regulatory Authority), the average trade size of the top five U.S. dark pools is just 187 shares. This shift comes down to two factors:
The emergence of platforms targeting ordinary investors has diversified the types of transactions in dark pools.
Institutions are increasingly looking to split large orders into smaller trades to reduce market impact, changing trading patterns within these platforms.
2. Challenges faced by dark pools in traditional financial markets
Dark pools offer distinct advantages by not disclosing transaction details until the trade is executed, thereby reducing market impact and lowering the cost of large trades. However, criticism surrounding dark pools persists, leading some countries to either avoid their adoption or limit their use. This is mainly due to the following major concerns.
First, while dark pools enable cost-effective large-scale transactions, they do so at the expense of transparency. In public markets, information about transactions that occur in dark pools is hidden until the transaction is completed. This lack of transparency makes monitoring and regulation more difficult, raising concerns about potential negative impacts on financial markets. Second, the concentration of liquidity in dark pools reduces liquidity on public exchanges. This increases transaction costs for ordinary investors and may reduce market efficiency.
Source: Tiger Research Reports
Third, although dark pool transactions remain confidential, platform operators are known to intentionally leak information. Documented cases show the harmful impact of these leaks, fueling suspicion about dark pools.
3. The inevitable rise of on-chain dark pools
Some believe that decentralized finance (DeFi) systems offer solutions to the problems faced by traditional dark pools. As mentioned previously, the operation of dark pools relies heavily on the assumption that the operators will not exploit customer information. This is a key factor in ensuring transaction confidentiality. However, in the traditional dark pool industry, it is not uncommon for operators to leak information in order to obtain compensation.
Consider a scenario involving a dark pool named "BlackTiger" and a stock named "Tiger". Suppose Institution A intends to purchase 5 million shares of Tiger from Institution B. The operators of BlackTiger leaked this information to Investor C in exchange for compensation. Since dark pool trades can take time to execute, Investor C waits for the price of Tiger to drop and then purchases a large number of shares. After the dark pool trade was publicly revealed, stock prices rose, allowing Investor C to sell those shares at a profit, thereby exploiting information asymmetries
This approach erodes trust in centralized dark pools in traditional finance. One reason this problem persists is that operators can make substantial profits by exploiting this information asymmetry, and these profits often outweigh the possible risk of penalties. Although some countries have attempted to address these issues with stricter regulations, suspicion of dark pool operators remains strong.
4. Implementation of on-chain dark pools
Source: Delphi Digital
In the decentralized finance (DeFi) industry, some platforms have partially implemented dark pool functions. Decentralized exchanges (DEXs), such as Uniswap, provide traders with a level of anonymity by leveraging automated market makers (AMMs), which allow token trades to be matched without revealing the identities of participants. DEX operates using a blockchain network and smart contracts, eliminating the need for intermediaries or centralized control. This effectively eliminates the trust issues that often exist in traditional dark pools, where operators can misuse customer information.
Source: Renegade
However, due to the inherent transparency of blockchain technology, it is difficult for decentralized exchanges (DEX) to fully replicate the confidentiality of traditional dark pools. Wallet addresses associated with certain institutions or large traders are often tagged and traceable, with transaction details visible to everyone on the blockchain. Services like block explorers and trackers make both completed and pending transactions easily accessible. Traders and platforms often take advantage of this transparency. This can lead to increased market instability, as well as issues such as transaction copying and Maximum Extractable Value (MEV) attacks, creating a less conducive environment.
In order to solve these challenges, on-chain dark pools have introduced technologies such as Zero-Knowledge Proofs (ZKP), Multi-Party Computation (MPC) and Fully Homomorphic Encryption (FHE) to achieve privacy. trading mechanism. ZKP ensures that participants can prove the validity of a transaction without revealing the actual inputs, thereby maintaining the confidentiality of the transaction. For example, traders can prove that they have sufficient token balances to complete transactions without exposing their entire balance.
Source: Renegade
One notable on-chain dark pool is Renegade, which uses Multi-Party Computation (MPC) for order matching and Zero-Knowledge Proofs (ZKP) to execute matching transactions. This ensures that no information about the order or balance is revealed until the transaction is completed. Even after the transaction is completed, only the traded tokens are visible. Smart contracts validate ZKP, thereby reducing the risk of malicious behavior by block producers or orderers. Other protocols, such as Panther, also leverage ZKP and cryptography to facilitate private on-chain transactions.
Image source: ETH Online 2024
At the same time, automated market makers (AMM)-based decentralized exchanges (DEX) such as Uniswap and Curve are vulnerable to front- and back-trading attacks. This is when a trade is copied or manipulated by a third party monitoring the trading mempool, resulting in adverse price results for the original trader.
In response, projects like Fugazi gained recognition on Ethereum Online, introducing mechanisms such as batch transaction processing and noise orders to prevent MEV attacks. Fugazi bundles user transactions with random noise orders and then performs Fully Homomorphic Encryption (FHE). This prevents third parties from identifying specific transaction details and performing transaction fronting attacks. While many on-chain dark pools employ peer-to-peer (P2P) systems to reduce slippage, Fugazi’s approach of combining AMMs with measures to mitigate MEV attacks is a promising advance in protecting participants.
5. The dilemma of on-chain dark pools: transparency
One of the major concerns surrounding on-chain dark pools is whether they will impact the transparency of the blockchain network. Since the birth of blockchain technology, it has faced a series of challenges such as the "blockchain trilemma" (balancing scalable functionality, decentralization and security). Similarly, the transparency issue posed by on-chain dark pools is another challenge that will require extensive research and experimentation to resolve.
Source: vitalik buterin's blog
Inherently, there may be certain trade-offs between transparency and security in blockchain systems. On-chain dark pools are developed to minimize security risks and market impact and are a response to the inherent transparency of blockchain. Even Ethereum founder Vitalik Buterin proposed the concept of stealth addresses to alleviate privacy concerns arising from publicly available information such as wallet addresses and Ethereum Name Service (ENS) records. This suggests that while transparency is a major benefit of blockchain, achieving mass adoption may require a balance between transparency and user privacy without compromising user experience.
6. The prospect of on-chain dark pools
Image source: blocknative
The growth potential of on-chain dark pools is expected to grow significantly. This is evidenced by the rapid growth of private transactions within the Ethereum network. While private transactions accounted for only 4.5% of total Ethereum transactions in 2022, they have recently surged to over 50% of total gas fees. This shows that people are trying to avoid bots that affect trading results.
Users can use private mempools to conduct private transactions, but this still relies on trusting a small group of operators who control these mempools. Although private mempools offer greater resistance to censorship than public mempools, the fundamental problem remains: block producers can still monitor and potentially exploit transaction information. Given these challenges, the market for on-chain dark pools—where transactions can be securely hidden while remaining transparently accessible—is poised to continue to grow.
7. Can on-chain dark pools revolutionize financial markets?
Dark pools in traditional financial markets are facing a serious crisis of trust due to incidents such as money laundering, hacking attacks, and information leaks. As a result, regions such as the United States and Europe, once leaders in dark pool adoption, have unveiled regulations to increase transparency and set clear conditions for private trading to take place. In contrast, in markets like Hong Kong, the use of dark pools is restricted, participation is limited, and ordinary investors are prohibited from participating in dark pool trading.
Despite these challenges, on-chain dark pools with strong anti-censorship capabilities and security could be transformative for the financial industry. However, in order to achieve widespread adoption of on-chain dark pools, two key issues must be addressed. First, the platforms and entities operating these pools must be thoroughly vetted to ensure their stability and reliability, as they rely on blockchain networks and smart contracts. Secondly, on-chain dark pools currently lack a clear regulatory structure. Institutional investors must participate with caution and ensure they review all relevant regulatory requirements before participating in such markets.
[Disclaimer] There are risks in the market, so investment needs to be cautious. This article does not constitute investment advice, and users should consider whether any opinions, views or conclusions contained in this article are appropriate for their particular circumstances. Invest accordingly and do so at your own risk.
This article is reproduced with permission from: (Shenchao TechFlow)
Original author: Tiger Research Reports
