Explainer: black markets, grey markets, and dark pools

By Richard Heaney, University of Western Australia

There are a range of markets available to buyers and sellers that allow them to exchange goods and services. But whereas some markets are highly regulated, others are not regulated at all.

The sale of tobacco and alcohol is fairly heavily regulated, while there is little regulation governing the exchange of a second hand car between two individuals.

While there are organised markets that we all know and understand, lesser known avenues of trade such as “the black market”, “grey markets” and “dark pools” are all being increasingly relied upon by investors when buying or selling large blocks of financial securities.

The Black Market

A black market is one which operates illegally within its particular country. Black markets develop quickly to fulfil unmet needs wherever there is demand for a product but restricted supply. The black market in drugs is an obvious example of illegal trade. There is also a black market in tobacco; a product which is heavily taxed and regulated in Australia.

Black markets usually arise where trading is restricted in some sense. For example a black market could arise in order to avoid taxes or price controls, or it could arise to meet unmet demand for illegal products or services.

Grey Markets

Grey markets differ in that they are not illegal, but they are not authorised or controlled in the usual way. Goods and services may be acquired in one country and then legally brought into another country and sold. There may be no legal restriction on this activity but it does affect the profitability of those trading in the normal manner in the country where the good or service is sold.

One example of a grey market is the growth in online shopping that has occurred in Australia. Australian retailers have expressed considerable concern over the burgeoning online retail market, which has attracted the attention of shoppers due to its ability to provide cheaper, sometimes tax-free products. The popularity of this particular grey market is so strong that some of the most trenchant critics of online trading when it was first established, are now working within this market. Recent estimates suggest online sales had reached $14.2 billion for the year ended August 2013.

Grey markets exist outside of the usual market structures we have come to know. As a result these markets are often able to offer goods and services at lower prices, or offer a greater range, than what existing local markets can achieve.

A more recent example of a grey market in financial derivatives concerns the trading of Contracts For Difference (CFDs) related to Twitter shares.Twitter’s Initial Public Offering has only recently been announced. The social media giant will float its shares on the NASDAQ, with a possible initial listed value of $10 billion. Many investors were surprised by the poor performance of Facebook when it listed, so there is some interest in CFDs relating to Twitter’s float. CFDs will provide a hedge against unforeseen price movements in Twitter’s IPO price as the IPO date approaches. While CFDs are banned in the US, it is possible for investors around the world to trade in these contracts via the web.

In terms of technology markets, a grey market for iPhones has recently emerged in China. This grey market is driven by the movement of iPhones from Hong Kong to mainland China, given that iPhones were generally made available in Hong Kong well before they were released in mainland China. Furthermore, Hong Kong sourced iPhones tended to be sold at lower prices than those that were available to regular consumers in mainland China. The result was a booming demand for iPhones in Hong Kong, followed by the resale of these iPhones into the mainland Chinese market. In fact, the iPhone grey market has become such a key player in China’s technology sector that Apple was forced to launch the iPhone 5 in the US and China simultaneously.

Dark Pools

In the case of dark pools buyers and sellers with large bundles of financial securities to trade are aligned with one another to complete their trades quickly and at low cost.

This option has always been available to Australian investors in the form of off market trades, though dark pools provide an alternative to the organised markets. This is particularly important for investors like large mutual funds or superannuation funds. Were these traders to push all their trades through organised securities exchanges, their trading costs would increase substantially because organised exchanges do not always have sufficient depth to deal with large trades. Prices can move dramatically when there are mismatches in supply and demand.

Dark pools are informal in the sense that buyers and sellers identify each other, either directly or through intermediaries, and execute large securities trades without going to an organised securities exchange like the Australian Securities Exchange or the Chi-X market.

Richard Heaney has received funding from ARC in the past.

This article was originally published at The Conversation.