by Liam J Kelly
Initially introduced in the 1980s, a dark pool refers to the confidential trading of large swaths of financial instruments. Items like equities, securities, and simple shares were the typical exchange medium. Fast forward to 2018, and the emergence of crypto millionaires also means the growing interest in the same non-exchange trading.
Old Business, New Currency
To be more precise, a dark pool provides a medium for large bag holders to buy and sell large portions of their portfolio without affecting the market price of any holding. The transactions made between agents are technically “off the books.” So how does this level of privacy work in the crypto world?
Well, it’s not technically private. This is in part due to transparent characteristics of blockchain technology. As such, a transaction of 1,000 bitcoin (BTC), for instance, will still be visible to on the network’s distributed ledger. Any interested parties are still able to witness transactions made between cryptocurrencies (excluding privacy centric-coins, i.e., Monero, Zcash, AEON, etc.), but this doesn’t necessarily mean that it needs to affect the prices posted on Kraken, Bitrex, Bitstamp and other exchanges.
In speaking of their newest venture, Taiyang Zhang of Republic Protocol explained to The Wall Street Journal, “If I have 1,000 bitcoin and I want to trade it for another cryptocurrency, everyone can see that, and it puts downward pressure on the price. [But we] can’t hide orders on the Bitcoin blockchain.”
Following Republic’s announcement to generate a cryptocurrency dark pool, the firm accumulated 35,000 ether (ETH). Contributors were principally hedge funds interested in melding old-hand financial practices with the burgeoning digital currency sector. As evidenced by the Singapore-based firm’s recent ICO figures, there is a growing demand for dark pools.
In 2015, Kraken also introduced investors to their dark pool in 2015, stating that:
“The Kraken dark pool is an order book not visible to the rest of the market. Each trader only knows their own orders. Traders can anonymously place large buy or sell orders without revealing their interest to other traders. Typically, outsized orders, when seen by other traders will cause the market to move unfavorably, making it more difficult to fill the order at the desired price. This unfavorable price movement may be avoided in a dark pool.”
Downside of Crypto Dark Pools
From this perspective, we can already hear the celebrations from whales in the ecosystem, but what about the rest of the market?
The rise of crypto millionaires, especially those still interested in trading their holdings, has now created an incentive that runs completely counter to Satoshi’s whitepaper from 2008. The response to the global collusion by traditional financial institutions seems entirely undercut by the dark pools of Kraken and Republic. But, it may not be all bad.
In standard dark pool trading schemes, a single firm assigns an algorithm that anonymously connects buyers and sellers. Republic Protocol executes this task slightly differently, however.
In keeping face among the wave of “decentralize everything” pundits, Zhang’s proposed exchange will leverage atomic swaps of ether, ERC20 tokens, and bitcoin pairs.
In order to avoid concentrated or single massive trades Republic offers the following:
“Miners within the protocol run equation solving nodes to earn REN tokens and match orders without revealing the underlying trade until execution. This system creates a trustless trading system for large block orders enabling ERC20, Ethereum and Bitcoin pairs to be executed with minimal price slippage and provides protection from front-running.”
This method of buying and selling works in two ways, both of which are actually a great help to the crypto sector. The first, by parceling out large transactions into smaller packets, big orders don’t generate boat-rocking volatility. This process is called “Shamir’s Secret Sharing,” and in the case of Republic, it is leveraged via Ethereum’s smart contracts:
“[Partitioned] orders cannot be reconstructed unless a majority of the order fragments are recombined. To prevent this from happening, the Republic Protocol defines an Ethereum smart contract called the Registrar that organizes nodes into a network topology that makes it unreasonably difficult for an adversary to acquire the enough of the order fragments to reconstruct an order.“
Second, these partitioned orders are anonymous to exchanges, meaning prices remain relatively untouched. To ensure anonymity, the transaction is verified with a zero-knowledge proof all of which coalesces to a relatively novel form of dark pool trading. Or at least one that is distinct from what we’ve seen pre-Bitcoin.
Unfortunately, the exchange has yet to establish best off-boarding practices. Moving from crypto to fiat, especially regarding large orders, has always been a headache for exchanges. All of this will hopefully be resolved when their mainnet launches in Q3 2018.