Building a truly dark dark pool

Building a truly dark dark pool
Dark pool demo available at

At Sunscreen, we've recently been spending time on private double auctions where the operators only learn of an order's details after the order has been matched (details of unsuccessful orders are never revealed, even to the operators!). Building upon our last demo, we showcase a truly dark dark pool and how to build it using (threshold) fully homomorphic encryption.

Although our focus is on cryptocurrency in this post, dark pools trace their history back to equities. As "cryptocurrencies are not securities," there are a number of challenges or opportunities (depending on if you're a glass half empty or a glass half full kind of person) outside of privacy to grapple with when building trading venues in crypto. We touch upon some of these issues before presenting our demo.

A brief introduction to dark pools

Traditionally, orders are stored in order books where other parties can view existing bids/offers. However, placing a "large" order (volume-wise, relative to the item's market cap) will almost always cause the market to move against you (e.g. for a large buy order, price may move up once others see your order in the book; for a large sell order, price may go down once others see your order). Dark pools popped up as one solution to this problem within equities, allowing sophisticated (often institutional) investors to place large orders without alerting the market to their intention--thereby incurring minimal price impact/slippage. Dark pools also allow such investors to hide/obscure their trading strategy from others (i.e. protect their alpha).

Dark pools came into being in the 80s, after the SEC allowed securities to be traded off their listed exchange. However, they didn't truly take off until after the mid-2000s when the SEC allowed investors to bypass public markets if price improvement were possible. Nowadays, a significant portion of daily US equities volume passes through dark pools.

So what are dark pools and how do they work? You can think of a dark pool as an invite-only trading venue where only the operator can view the full order book. Assuming participants trust the dark pool operator, they can trade large blocks of securities with minimal to no slippage as other participants are unaware of outstanding orders. Unfortunately, dark pool operators have historically abused their privileged position for their own benefit (some examples include 1, 2, 3).

Make it dark dark

So we ask—can we build a truly dark dark pool where even the dark pool operators can't view the order book?

Specifically, we'd like to build a dark pool where the operator(s) can't view orders until they've been successfully matched. We refer to this as "blind matching" since we want to match orders together without knowing what the underlying order values are (e.g. volume, limit price).

Although there are a few different cryptographic solutions to this problem, we'll showcase how to build a dark dark pool using (threshold) fully homomorphic encryption (which minimizes communication between parties and is a purely software-based solution without the same attack vectors of hardware-based privacy solutions).[1]

At a high level, the following happens:

  • A committee generates a public-private key pair such that each committee member holds a portion of the private (i.e. decryption) key.
  • Dark pool participants submit encrypted orders.
  • Committee members run the matching algorithm directly on the encrypted orders to check for possible matches.
  • Upon knowing a successful match can be done between two orders (without knowing price or volume information for the orders), the committee members provide their respective piece of the private key to decrypt the final result (i.e. "Party A has sold a quantity of x items to Party B for y price").

By having the key split into shares, we construct a distributed trust model where no single party can view outstanding orders (which would violate traders' privacy). Furthermore, we can configure trust so that we require just a single honest operator within the pool to ensure order privacy (i.e. say we have 5 committee members; even if 4 out of 5 of them were corrupt, they would not be able to decrypt and view the traders' orders).

How does crypto fit into all of this?

If we were building a dark pool for a security, most of the decisions would be made for us with regards to price execution, auction design, settlement process, and system permissioning so we'd just move directly on to presenting a demo of what such a dark dark pool might look like.

Cryptocurrency currently operates in a regulatory grey zone. While the design space for crypto trading platforms is therefore much richer, there are also a number of challenges due to the lack of established infrastructure and regulations within the space.

Given the dearth of crypto dark pools, there is also a unique opportunity to rethink design to benefit a new class of participants. Below, we bring light to some of the challenges in designing a dark pool for cryptocurrencies, with the goal of sparking a broader conversation within the community and relevant experts.

(Non-)existence of NBBO

Most equities dark pools use midpoint price execution, minimizing the number of disputes between buyers and sellers, as well as allowing trading venues to ensure they provided "best execution" for their clients. What does best execution mean for crypto (especially when no NBBO equivalent is available for a given cryptocurrency)?

For securities, there are best execution requirements that require brokers to execute customers' orders with the most favorable terms possible. Although best execution is defined intentionally ambiguously, it tends to take into account price improvement as well as execution time. To understand price improvement, the NBBO (national best bid and offer) is used as reference. However, when trading larger blocks of securities where slippage is a serious problem, beating the national best bid and offer seems unlikely. Thus, equities dark pools often rely on midpoint price execution.

Given the lack of regulation, there is no centralized entity (like the SIP) that disseminates NBBO for a given cryptocurrency. Even if such a thing were to exist, would we consider best bids and offers with respect to only centralized exchanges or should we include decentralized venues as well? Should crypto dark pools, by default, mimic their equities equivalent providing midpoint price execution or should we allow for a more traditional order book model where buyers and sellers can specify price as well as volume?

Continuous vs. periodic auctions

While most equities dark pools perform matching on a continuous basis, there are a few options for clients who prefer a periodic model. Which option is best for the crypto space?

Continuous double auctions are prevalent within traditional finance, allowing buyers and sellers to submit orders whenever they want. Matching occurs on a continuous basis, meaning as soon as an order comes in the operators search for a counterparty/match. There are a few venues within traditional finance in which auctions are done "periodically," meaning buyers and sellers can submit orders during a specified time period and crossings are performed at a set time. However, by and large, continuous auctions dominate the landscape.

Opponents of continuous double auctions argue that such a model inherently favors those with a speed advantage like sophisticated high frequency trading firms, encouraging co-location and a latency arms race. To counter this speed and latency arms race within tradfi, some have suggested frequent batch auctions, a type of periodic auction in which orders from a specified time period are batched together and then executed at a uniform clearing price. Proponents of periodic auctions also argue that a discrete time model allows participants to compete on price (to the advantage of other system participants) rather than speed.

While the existing winners in tradfi have little incentive to push for periodic auctions, an open design space still exists for crypto markets. We can already see some of the continuous vs period auction debate playing out, with popular decentralized trading venues like dYdX, Cowswap, and Penumbra championing the use of frequent batch auctions to mitigate the negative effects of MEV.

Should crypto dark pools further entrench HFT firms' dominance or seek to level the playing field for the rest of us by adopting a new design?

Insider trading and toxic order flow

How does lack of insider trading laws impact order flow in crypto?

When it comes to startups, founders, early employees, as well as (venture capital) investors generally hold a substantial portion of the respective company's stock. When the company goes public, employees face restrictions on trading their company's stock to prevent "insider trading."

Similarly, for cryptocurrency startups, early employees and investors often control a substantial portion of the project's initial token supply. The equivalent situation of an IPO for a cryptocurrency startup might be having the token listed on a prominent centralized exchange like Coinbase. However, given the lack of regulation in the crypto space, there is very little to legally prevent early employees from acting on material non-public information that they strongly suspect will affect the token's price (e.g. employee Alice knows her company's token will be listed on xyz prominent exchange in 3 months, likely causing the price to go up once the news is announced).

Although early employees and investors are likely to trade in large blocks, it's not a great look for a founder or early employee to be seen selling off large portions of their own company's stock or cryptocurrency.

With a crypto dark pool, early employees could now hide their activity, acting on material non-public information whenever they wish without alerting the broader market about what they're doing. Furthermore, it's very possible (if not likely) that some of this order flow would be "toxic."

While a large number of crypto trading venues are decentralized and permissionless, they do not offer privacy which may affect how participants behave when using the system (knowing they can likely be de-anonymized and all their bids/offers viewed). So we must ask--will building a dark pool that supports trading large blocks of altcoins further encourage "insider" trading within crypto and allow toxic flow to proliferate?

Custody, settlement, and information leakage

With no DTC(C) available, how will settlement and clearing work for crypto dark pools?

For the vast majority of securities transactions within the US, the DTCC provides clearing and settlement services to ensure the successful handoff between buyers and sellers.

The goal of a dark pool is to allow participants to shield their activity from others. While FINRA requires some information regarding dark pools to be made public, it's fairly minimal, revealing high level info like total number of shares and trades done per instrument each week rather than details on individual trades and the participants' identities.

How would custody and settlement work for a crypto dark pool when there is no DTCC equivalent? The natural and obvious solution is to rely on the blockchain to handle these tasks. Unfortunately, if orders settle via a public blockchain, some information will almost certainly be revealed. It may be possible to hide transactions made within the dark pool (if it's properly set up as a rollup or L2) but how do participants get their cryptocurrency into the dark pool in the first place and what happens when they attempt to exit the dark pool? Surely there will be public transactions (on say Ethereum) showing that they've deposited (withdrawn) x number of tokens into (from) some contract.

Another option might involve relying on some semi-trusted third party to handle custody and settlement, as well as shielding participants' activity from the public (say via the use of wash accounts).

How much information leakage can we eliminate while still relying on a public blockchain? What amount of information leakage is acceptable to dark pool users?

Our demo (aka make it fast)

We've built a demo showcasing what such a truly dark dark pool might look like where operators cannot abuse their privileged role to view orders before they've been matched.

You can test out two different experiences:

  1. A continuous double auction where participants specify both price and volume, with matchings attempted as soon as a new order comes in (mimicking a traditional order book model).
  2. A periodic volume match where crossings are performed every 5 seconds and price is determined from an external source (akin to a frequent batch auction). We could just as well provide midpoint price execution if we collected price data across various centralized exchanges.

While our demo currently runs on a 64-core machine (c7g.16xlarge instance), much better performance can be achieved with beefier machines and hardware acceleration (e.g. GPU-accelerated implementation).

For simplicity, we provide partial fills by default as well as fill-or-kill orders. We could just as well allow for minimum fills but have chosen to omit them for an initial version. Quantity and price are currently restricted to a 216 bit range; larger ranges can be provided but come with a performance penalty. Other aspects that impact performance include number of orders to process and security level.

Our demo makes use of our own version of the TFHE fully homomorphic encryption scheme under the hood, allowing us to get better performance than existing FHE libraries. As dark pools are one example of double auctions, this work naturally builds upon our previous work for private verifiable auctions in which we showcased how to build a first-price sealed-bid auction in which losing bids were never revealed.

We imagine initial versions of dark pools will need to be permissioned to best optimize for user experience and protect against bad actors. When it comes to custody and settlement, there are many open questions that need to be answered before a dark pool can be deployed into the wild.

Looking forward

Can we build a future with private and fair financial systems? We believe the answer is yes and our work here is one step towards that.

We're at a potential crossroads in time as institutions and tradfi players start to move into crypto. Given how young the space is, there are opportunities to rethink market design and determine how the winners of the next financial systems will be chosen. What worked well for tradfi may not necessarily work as well for us in crypto.

As for our plans, we'll soon be open-sourcing our low-level implementation of the TFHE (fully homomorphic encryption) scheme. We'd love to hear your thoughts if you've been thinking about some of the issues here and, if you happen to be at ETHDenver, come say hi!

  1. Threshold FHE has the advantage of requiring little communication between parties and no communication during the computation itself (as FHE is compute-bound). MPC-based solutions (e.g. SPDZ) are communication-bound, on the other hand. In practice, this means that the various parties need to be co-located to get good performance. ↩︎