What Is an Upstairs Market?

The term upstairs market refers to a network that exists between large firms and institutional investors. This network involves large trades or block orders. Trades in these transactions are not submitted through a stock exchange, which means they are not visible to other market participants. These orders are carried out directly between buyers and sellers, with professional brokers acting as intermediaries. The size of the order made in the upstairs market accounts for a big portion of the market's trading volume.

Understanding Upstairs Markets

Upstairs markets involve networks of trading desks that conduct large volumes of trades. These trades are often called upstairs trades. Because of the sheer volume involved, these trades are normally done by institutional investors, such as mutual funds, banks, pension funds, insurance companies, and brokerage companies.

As noted above, these trades take place off the trading floor and are normally done electronically or over the phone. The way these upstairs trades are conducted means there are no large swings or disruptions to securities prices in the market.

Routing trades through professional intermediaries (i.e. away from the eyes of retail investors) can help prevent activities like front-running or trading that takes place by a broker who has inside information that will affect the price of a stock. Front-running may negatively impact the price or execution of a trade. 

Special Considerations

These markets are sometimes described as dark pools, hence the phrase “dark pools of liquidity”. Dark pools are financial exchanges, networks, or forums where the trading activity takes place, and are organized privately between the parties involved. Dark pools, like upstairs markets, allow investors to make large trades without having to disclose the details publicly. Although they may seem shady, dark pools—and upstairs trades—they are completely legal.

This doesn't mean that regulators aren't paying attention. As of 2014, trades executed in the upstairs market represented 15% of all trading activity in the United States, and there's a very good likelihood that that figure continues to grow.

• Canada introduced regulations in October 2012 that placed stricter limits on the conditions under which upstairs market transactions can take place
• Australian regulators introduced similar restrictions in May 2013, which caused the volume of upstairs-market transactions to decline significantly in both countries

Regulators in the United States are also questioning whether this method of trading hurts retail investors and undermines trading activity, and have taken some steps to make the market fair for all participants. For instance, the Financial Industry Regulatory Authority (FINRA) introduced an initiative that requires the weekly publication of trades that occur on an alternative trading system (ATS). It was approved by the U.S. Securities and Exchange Commission (SEC) in 2014.

Upstairs Market vs. Downstairs Market

If there's an upstairs market, then there's bound to be a downstairs market, right? The answer is yes. Since the upstairs market is a (private) network involving institutional investors, brokerage firms, and intermediaries, it's safe to assume that the downstairs markets are stock exchanges.

Downstairs markets, or stock exchanges, create liquidity in the market with trades that are executed by small investors, market makers, and traders who are actually on the floor. Unlike the upstairs market, which involves large trading volumes, trades that are conducted in the downstairs market are usually smaller. Trade details are also available, including prices and the amount of stock traded.

Advantages of an Upstairs Market

If a hedge fund wishes to unload its position in a security and submits a large sell order to the stock exchange accordingly, that sell order may be interpreted by other market participants as a bearish signal on that particular security. This, in turn, may lead other investors to bid down the price of the security, causing the hedge fund to obtain a less favorable sale price.

The upstairs market can also be beneficial for institutional investors because of the reduced transaction fees. By carrying out a large block order with just one or a small number of institutional counterparties, the firms involved could pay substantially lower overall commissions or other fees as compared to trading with a much larger number of smaller counterparts. 

In some cases, such as when executing program trades that require several transactions to be executed simultaneously, using professional intermediaries in the upstairs market may in fact be the only way to effectively carry out the strategy.