Dark liquidity

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In finance, a dark pool (also black pool) is a private forum for trading securities that is not openly available to the public. Liquidity on these markets is called dark pool liquidity.[1] The bulk of dark pool trades represent large trades by financial institutions that are offered away from public exchanges like the New York Stock Exchange and the NASDAQ, so that such trades remain confidential and outside the purview of the general investing public. The fragmentation of financial trading venues and electronic trading has allowed dark pools to be created, and they are normally accessed through crossing networks or directly among market participants via private contractual arrangements.

One of the main advantages for institutional investors in using dark pools is for buying or selling large blocks of securities without showing their hand to others and thus avoiding market impact as neither the size of the trade nor the identity are revealed until the trade is filled. However, it also means that some market participants are disadvantaged as they cannot see the trades before they are executed; prices are agreed upon by participants in the dark pools, so the market becomes no longer transparent.[2]

There are three major types of dark pools. The first type is an independent company set up to offer a unique differentiated basis for trading. The second type is a broker-owned dark pool where clients of the broker interact, most commonly with other clients of the broker (possibly including its own proprietary traders) in conditions of anonymity. Finally, some public exchanges are creating their own dark pools to allow their clients the benefits of anonymity and non-display of orders while offering an exchange "infrastructure". Depending on the precise way in which a "dark" pool operates and interacts with other venues it may be considered, and indeed referred to by some vendors as a "grey" pool.[3]

These systems and strategies typically seek liquidity among open and closed trading venues, such as other alternative trading systems. As such, they are particularly useful for computerized and quantitative strategies. Dark pools have been growing in importance since 2007, with dozens of different pools garnering a substantial portion of U.S. equity trading.[4] Dark pools are of various types and can execute trades in multiple ways, such as through negotiation or automatically (e.g., midpoint crosses, staggered crosses, VWAP, etc.), throughout the day or at scheduled times.[4]

Iceberg orders[edit]

Some markets allow dark liquidity to be posted inside the existing limit order book alongside public liquidity, usually through the use of iceberg orders.[5] Iceberg orders generally specify an additional "display quantity"—i.e., smaller than the overall order quantity. The order is queued along with other orders but only the display quantity is printed to the market depth. When the order reaches the front of its price queue, only the display quantity is filled before the order is automatically put at the back of the queue and must wait for its next chance to get a fill. Such orders will, therefore, get filled less quickly than the fully public equivalent, and they often carry an explicit cost penalty in the form of a larger execution cost charged by the market. Iceberg orders are not truly dark either, as the trade is usually visible after the fact in the market's public trade feed.

Dark pools[edit]

Truly dark liquidity can be collected off-market in dark pools. Dark pools are generally very similar to standard markets with similar order types, pricing rules and prioritization rules. However, the liquidity is deliberately not advertised—there is no market depth feed. Such markets have no need of an iceberg-order type. In addition, they prefer not to print the trades to any public data feed, or if legally required to do so, will do so with as large a delay as legally possible—all to reduce the market impact of any trade. Dark pools are often formed from brokers' order books and other off-market liquidity. When comparing pools, careful checks should be made as to how liquidity numbers were calculated—some venues count both sides of the trade, or even count liquidity that was posted but not filled.

Dark liquidity pools offer institutional investors many of the efficiencies associated with trading on the exchanges' public limit order books but without showing their actions to others. Dark liquidity pools avoid this risk because neither the price nor the identity of the trading company is displayed.[6]

Dark pools are recorded to the national consolidated tape. However, they are recorded as over-the-counter transactions. Therefore, detailed information about the volumes and types of transactions is left to the crossing network to report to clients if they desire and are contractually obligated.[7]

Dark pools allow funds to line up and move large blocks of equities without tipping their hands as to what they are up to. Modern electronic trading platforms and the lack of human interaction have reduced the time scale on market movements. This increased responsiveness of the price of an equity to market pressures has made it more difficult to move large blocks of stock without affecting the price.[8]

Dark pools are run by private brokerages which operate under fewer regulatory and public disclosure requirements than public exchanges.[9] Tabb Group estimates trading on the dark pools accounts for 32% of trades in 2012 vs 26% in 2008.[9]

Price discovery[edit]

For an asset that can be only publicly traded, the standard price discovery process is generally assumed to ensure that at any given time the price is approximately "correct" or "fair". However, very few assets are in this category since most can be traded off market without printing the trade to a publicly accessible data source. As the proportion of the daily volume of the asset that is traded in such a hidden manner increases, the public price might still be considered fair. However, if public trading continues to decrease as hidden trading increases, it can be seen that the public price does not take into account all information about the asset (in particular, it does not take into account what was traded but hidden) and thus the public price may no longer be "fair".

Yet when trades executed in dark pools are incorporated into a post-trade transparency regime, investors have access to them as a part of a consolidated tape. This can aid price discovery because institutional investors who are reluctant to tip their hands in lit market still have to trade and thus a dark pool with post-trade transparency improves price discovery by increasing the amount of trading taking place.[10]

Market impact[edit]

Whilst it is safe to say that trading on a dark venue will reduce market impact, it is very unlikely to reduce it to zero. In particular the liquidity that crosses when there is a transaction has to come from somewhere—and at least some of it is likely to come from the public market, as automated broker systems intercept market-bound orders and instead cross them with the buyer/seller. This disappearance of the opposite side liquidity as it trades with the buyer/seller and leaves the market will cause impact. In addition, the order will slow down the market movement in the direction favorable to the buyer/seller and speed it up in the unfavourable direction. The market impact of the hidden liquidity is greatest when all of the public liquidity has a chance to cross with the user and least when the user is able to cross with ONLY other hidden liquidity that is also not represented on the market. In other words, the user has a tradeoff: reduce the speed of execution by crossing with only dark liquidity or increase it and increase his market impact.

Adverse selection[edit]

One potential problem with crossing networks is the so-called winner's curse. Fulfillment of an order implies that the seller actually had more liquidity behind their order than the buyer. If the seller was making many small orders across a long period of time, this would not be relevant. However, when large volumes are being traded, it can be assumed that the other side—being even larger—has the power to cause market impact and thus push the price against the buyer. Paradoxically, the fulfillment of a large order is actually an indicator that the buyer would have benefitted from not placing the order to begin with—he or she would have been better off waiting for the seller's market impact, and then purchasing at the new price.[11]

Another type of adverse selection is caused on a very short-term basis by the economics of dark pools versus displayed markets. If a buy-side institution adds liquidity in the open market, a prop desk at a bank may want to take that liquidity because they have a short-term need. The prop desk would have to pay an Exchange/ECN access fee to take the liquidity in the displayed market. On the other hand, if the buy-side institution were floating their order in the prop desk's broker dark pool, then the economics make it very favorable to the prop desk: They pay little or no access fee to access their own dark pool, and the parent broker gets tape revenue for printing the trade on an exchange. For this reason, it is recommended that when entities transact in smaller sizes and do not have short-term alpha, do not add liquidity to dark pools; rather, go to the open market where the short-term adverse selection is likely to be less severe.

Pipeline LLC controversy[edit]

The use of dark pools for trading has also attracted controversy. In one case, Pipeline LLC, a company offering its services as a dark pool, had contracted an affiliate that transacted the trades.[12] In the Pipeline case, the firm began in an attempt to provide a trading system that would protect investors from the open, public electronic marketplace. In that system, investors' orders would be made public on the consolidated tape as soon as they were announced, which traders characterized as "playing poker with your cards face up". The service Pipeline offered was to find counterparties for various trades in a private manner.

Flash Boys and allegations of front running via dark pools[edit]

Michael Lewis, in his non-fiction work, Flash Boys: A Wall Street Revolt, attacks dark pools as a way that Wall Street banks sell to high frequency trading firms ("HFTs") the ability to front-run their customers' orders. The HFTs, using their own "broker-dealer" subsidiaries, buy access to investment banks' dark pools. They then systematically hunt for large block stock orders by blindly sending a series of small 100 share orders for various listed stocks into the dark pools and seeing which orders get executed. If a 100 lot share order gets executed, they are able to use the information, via their superior speed of access to other exchanges, to front-run the balance of the order, which often is of a much greater size. In return, the HFTs pay large fees to these Wall Street banks. [13]

Critical to this strategy is that the HFTs establish licensed broker-dealer subsidiaries so that the Wall Street banks can claim, for example, that they protect their customers' order flow from HFTs while allowing ordinary broker-dealers to access the dark pools.[13] According to sources in the book, dark pools represent one of the best "hunting grounds" for HFTs to gain market advantage because the outcome of each execution in a dark pool is not released to the public.[13]

Regulatory statements[edit]

In 2009 the U.S. Securities and Exchange Commission (SEC) announced that it was proposing measures to increase the transparency of dark pools, "so investors get a clearer view of stock prices and liquidity". These requirements would involve that information about investor interest in buying or selling stock be made available to the public, instead of to only the members of a dark pools.[14] FINRA announced in January 2013 that it will expand its monitoring of dark pools.

Barclays lawsuit[edit]

In June 2014 the U.S. state of New York filed a lawsuit against Barclays alleging the bank defrauded and deceived investors over its dark pool. The state, in its complaint, said it was being assisted by former Barclays executives and it was seeking unspecified damages. The bank's shares dropped 5% on news of the lawsuit, prompting an announcement to the London Stock Exchange by the bank saying it was taking the allegations seriously, and was cooperating with the New York attorney general.[15]

List of dark pools[edit]

Independent dark pools[edit]

Broker-dealer-owned dark pools[edit]

Consortium-owned dark pools[edit]

Exchange-owned dark pools[edit]

Other dark pools[edit]

Dark pool aggregators[edit]

  • Fidessa - Spotlight
  • Bloomberg Tradebook
  • SuperX+ – Deutsche Bank
  • ASOR – Quod Financial
  • Progress Apama
  • ONEPIPE – Weeden & Co. & Pragma Financial
  • Xasax Corporation
  • Crossfire – Credit Agricole Cheuvreux

See also[edit]

References[edit]

  1. ^ "Glossary - Dark Pools". Investopedia. Retrieved 2011-06-20. 
  2. ^ "Glossary - Dark Pools". AT Monitor. Retrieved June 18, 2011. 
  3. ^ http://www.atmonitor.co.uk/glossary.aspx?id=146
  4. ^ a b Lemke and Lins, Soft Dollars and Other Trading Activities, §2:28 (Thomson West, 2013-2014 ed.).
  5. ^ www.tsx.com
  6. ^ http://fixglobal.com/home/control-and-flexibility-how-trading-can-add-value-to-the-investment-process/ FIXGlobal. Control and Flexibility: How Trading Can Add Value to the Investment Process. Retrieved 12 October 2012.
  7. ^ http://www.quantprinciple.com/invest/index.php/docs/realworld/darkpools/#tape Consolidated tape and DARK Pools
  8. ^ "http://www.quantprinciple.com/invest/index.php/docs/realworld/darkpools/ Dark Pools: Some Reasons"
  9. ^ a b Philips, Matthew (May 10, 2012). "Where Has All the Stock Trading Gone?". Bloomberg Businessweek. 
  10. ^ FIXGlobal, "The Impact of Dark Pools on Access to Desirable Liquidity" Retrieved 12 October 2012.
  11. ^ http://fixglobal.com/content/dark-pools-what-lies-beneath FIXGlobal. Dark Pools: What Lies Beneath. Retrieved 12 October 2012.
  12. ^ Scott Patterson and Jenny Strasburg, "Traders Navigate a Murky New World", Wall Street Journal, April 9, 2012.
  13. ^ a b c Lewis, Michael (31 March 2014). Flash Boys: A Wall Street Revolt. W. W. Norton & Company; 1st edition. pp. 122–124. ISBN 0393244660. 
  14. ^ U.S. Securities and Exchange Commission, "SEC Issues Proposals to Shed Greater Light on Dark Pools", 21 October 2009, accessed 25 May 2012.
  15. ^ "Dark pool fraud lawsuit filed against Barclays in US". New York Telegraph. Retrieved 27 June 2014. 
  16. ^ http://www.etfone.com/

External links[edit]