With more institutions entering the market, the industry may witness increased trading volume and larger transactions, however, these institutions don’t want these transactions to be public as it might induce market panic or cause them to lose a competitive edge. In traditional financial markets, dark pools were introduced to tackle this problem. These trading avenues enable institutional investors to execute significant financial transactions without disclosing them to the general market.
So, unlike public exchanges like the New York Stock Exchange, where pricing is centralized and traders trade against each other. These trades in dark pools are over-the-counter traders through which prices are negotiated. So in essence, it's a private trade, where participants outside the dark pool can’t see the trade price or the number of shares.
Like other financial instruments in digital assets, developers started implementing dark pools, with the first being launched in 2018 by Republic Protocol. However, these trading avenues have yet to gain significant traction. Nevertheless, if institutional investors decide to become active on public blockchains where everything is transparent, these institutional trading avenues might start gaining momentum. But how do these dark pools work in a decentralized environment?
There are various methods but this method is quite a common practice. When a trader executes a large transaction, it sends the details to the dark pool platform. When the platform receives the transaction, it breaks it into hundreds of fragments and sends these to nodes within the dark pool platform. These nodes operate on a cryptographic technique called secure multi-party computation (sMPC) and zero-knowledge proofs.
sMPC allows these nodes to submit and match buy and sell orders without revealing their details to any single party. Furthermore, it allows them to cooperate while not sharing any data. This allows the dark pool to match the over-the-counter deals while maintaining the confidentiality of order sizes, prices, and participant identities.
The Zero-knowledge proofs allow the nodes to verify the validity of transactions without revealing any details about the trade itself. Furthermore, these nodes compete against each other to match the most orders and are rewarded with a portion of the overall fee for each match.
While dark pools may not be interesting to the average digital assets user, they could become a vital industry component. This will only happen if institutions decide to operate on public blockchains. Although it is intriguing for these institutions to explore the public realm, a private blockchain where they can set the rules likely suits them better.
However, not all institutional operations will likely be on private blockchains. Therefore, we see a plausible chance that dark pools will become increasingly popular, which is good. The digital assets market is still quite volatile and tends to react strongly to positive and negative news. If an institution decides to sell 100,000 Bitcoin and is visible in an order book, the price will likely tank. Thus, it is better for the average investor if these large-scale transactions occur outside the public eye.
Although this may go against the transparent ethos of industry, to welcome institutions and their capital, this might be one of the best solutions.