Dark liquidity pools may sound like something out of science fiction, but they're real. And they're already spreading throughout Wall Street.

These pools are basically internal systems for trading stocks privately, off of public exchanges and out of the public eye. They are growing rapidly, both in number and in volume of trades.

Behind the boom in dark pools are large hedge funds and institutional clients that want to build and liquidate large stock positions at lower costs, while also being shielded from those who might profit by knowing their intentions.

An activist hedge fund, for instance, may not want to reveal that it is buying up large blocks of stock in a company it is about to attack, or a mutual fund might want to sell a large amount of stock without causing a downdraft that would hurt any shares it still holds.

But these alternative trading systems have also raised concerns as they have multiplied over the last two years. Poking fun at some of the hand-wringing over these secretive pools, the Securities and Exchange Commission's libertarian-leaning commissioner, Paul Atkins, joked recently that someone should make a horror movie about them, perhaps called The Dark Pool That Swallowed Manhattan!.

Jokes aside, major stock exchanges have some reasons to be nervous about the dark pools' proliferation. The mainstream exchanges see the pools as yet another group attempting to steal revenue-producing trades and liquidity from their markets. That's in addition to a welter of new electronic-trading platforms that offer faster execution and lower transaction costs. These platforms alone have triggered a wave of consolidation among traditional exchanges.

Exchanges are at a disadvantage as they try to compete with dark pools. The S.E.C. regulates traditional exchanges, and new rules being phased in over the next few months will require them to share information fairly and mandate that trades be routed to whichever exchange gives the best and fastest price.

Dark pools, by contrast, can largely avoid regulation if they keep their trading volumes under a set threshold. This makes them attractive to big institutional traders seeking to avoid being so transparent about their trading patterns that competitors can anticipate their actions or otherwise gain an edge.

The S.E.C., meanwhile, is worried that the fundamental lack of transparency in these pools might lead to price manipulation or other abuses.

The idea behind dark pools isn't exactly new. Brokerages have long tried to cross (or satisfy) trades internally, by matching one customer's sale with another customer's purchase. The first true dark pool is believed to be Investment Technology Group's two-decade-old Portfolio System for Institutional Trading, or Posit.

But now new technologies have combined with market changes to make these alternative, private exchanges a hotter place to invest.

The consolidation of public stock exchanges, the rise of slice-and-dice algorithmic trading, and new regulations—including order-handling rules—have had the effect of reducing liquidity, or ease of trading, in the public markets.

They have also led to a shrinkage of order size, so it has become increasingly difficult to buy or sell a large block of stock without being noticed—and thereby, often, moving the price of the underlying security.

Meanwhile, sophisticated electronic-trading systems have made buying and selling away from public markets both easier and more efficient. There are even new systems aimed at providing access to large numbers of dark pools.

For hedge funds, pension funds, and other big traders, the beauty of the system is that it can often allow these institutional investors to use the public markets to set stock prices while they buy and sell stock discreetly and at set terms in a private market.

"The public exchange is mandated to be equal and fair and open," says Jeromee Johnson, a senior analyst at Tabb Group, a firm that conducts research into and provides advice about financial markets. "The dark pools don't have to provide equal and fair access or, necessarily, a level playing field."

"And for institutions," he adds, "it can mean a better execution because they are able to protect the information about the size and type of their order and negotiate with the other counterparties."

It can also be cheaper than having a broker-dealer route the order onto the public market.

As an example, Johnson uses a simple scenario in which a relatively illiquid—that is, infrequently traded—stock has a three-cent spread between the bid and the ask price. An institution wanting to buy or sell a quarter-million shares would save several thousand dollars (the difference between the public bid and ask prices) by making the trade in a dark pool.

Of even greater importance would be the additional value of eliminating the spike in supply or demand caused by its big order, which would lead to a swing in the stock's price. "The potential value of savings on the transaction could be in the 80 or 90 percent range," Johnson says. "These are significant savings."

The hunger for anonymous block trading has caused the field to explode. There are about 40 active pools, double the number just last year. New pools and services to aggregate them are announced almost every month.

Nearly every major Wall Street institution seems to have a system in place, from Goldman Sachs' Sigma X and Merrill Lynch's Block Alert to the consortium-owned BIDS network, whose principals include Bank of America, Bear Stearns, and Deutsche Bank.

Each system has its own character, with some allowing negotiated prices and others setting prices based on the quotes in the public markets. Some systems only allow large orders, while others will mix small orders in the trades. A few—worried about manipulation—won't let hedge funds in the door. But others welcome them because they bring liquidity.

Hedge funds were early adopters of the computer algorithms used to find and exploit price discrepancies in dark pools. These algorithms are now so important to the business that Citigroup recently developed a new one, called I.S. Shadow, just to assuage the concerns of two funds that weren't able to complete enough of the profitable trades they had found.

Backers of the pools are attracted to the game because it is lucrative. By satisfying orders internally, they not only avoid stock exchange trading fees but also get paid to make the trades.

Liquidnet, for instance, reported an average daily volume of nearly 57 million shares in the U.S. during the first quarter of 2007, a 28 percent increase from the same quarter in 2006. This seven-year-old company has become the ninth-largest broker on the New York Stock Exchange and is estimated to be worth more than $2 billion.

The Tabb Group predicts that these internal crossing networks and internal markets will continue to eat into the market share of the public exchanges, trading nearly 1.5 billion shares per day by 2010, an annual growth rate of more than 40 percent. That would equal about 15 percent of all equity shares traded in the United States.

By comparison, the N.Y.S.E.'s market share is expected to fall to 32 percent in 2010, from about 40 percent this year, while the Nasdaq is expected to lose just over six percentage points of its current market share over that period, falling to 34 percent.

Public exchanges have been fighting back with plans for their own anonymous-trading systems.

At the same time, Catherine Kinney, the N.Y.S.E.'s president, has attempted to rally opposition to dark pools. She has argued in conferences that private exchanges are already hurting investors by reducing the information that public markets use to set stock prices.

Charles Schwab,

UBS.

The Tabb Group's Johnson explains: "So the institutions are able to take a large order and park it in the pool, then let the non-educated retail flow pass through," nibbling away at it but without being able to see the large block aching to be filled or being able to affect the price being paid for the shares.

These are just niggling concerns compared with the problems such pools might bring if they continue to scarf up market share at their current rapid pace. Something ugly could be around the bend.

"As these dark pools grow, then the public—you and I—will get less liquidity in the sense of price," says Boston University Law professor Tamar Frankel, a securities and regulation expert.

"There will come a point," she adds, "where the price on the open exchanges will not be sufficiently informative, and that will hurt everybody, even the parties that trade on these dark exchanges, because the price may no longer be representative of the true value of the shares."