Dark pool

Liquidity in standard financial markets is often openly advertised in order to attract additional liquidity to that venue and is usually done in real time by publishing market depth. However, dark pools of liquidity or dark liquidity by definition cannot be seen by any potential market participant and its existence can be imputed only ex post facto. Dark liquidity is generally used to try to reduce market impact when trading large orders and is useful for traders who wish to move large numbers of shares without revealing themselves to the open market.

Dark liquidity pools offer institutional investors many of the efficiencies associated with trading on the exchanges' public limit order books but without showing their hands to others. Dark liquidity pools avoid this risk because neither the price nor the identity of the trading company is displayed. There are now three main types of dark pools. First are independent companies set up to offer a unique differentiated basis for trading. Second are broker owned dark pools 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 by some vendors is referred to as a ‘grey’ pool.

Iceberg Orders

Some markets allow dark liquidity to be posted inside the existing limit order book alongside public liquidity, usually through the use of iceberg orders [1]. Iceberg orders generally specify an additional display quantity, 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

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.

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.

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 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.

Price Discovery

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".

Market Impact

Whilst it is safe to say that trading on a dark venue will reduce market impact it must be noted that it is very unlikely to reduce it to zero. In particular the liquidity that crosses with you 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 you. This disappearance of the opposite side liquidity as it trades with you and leaves the market will cause impact. In addition your order will slow down the market movement in the direction favourable to you and speed it up in the direction unfavourable to you. The market impact of your hidden liquidity is greatest when all of the public liquidity has a chance to cross with you and least when you are able to cross with only other hidden liquidity that is not also represented on the market. In other words you still have a trade-off: reduce your speed of execution by crossing with only dark liquidity or increase it and increase your market impact.

Imputing the Existence of Dark Liquidity

There are a few ways to guess at the existence of dark liquidity. If you are watching the market depth and see that both the bid and offer have decreased by the same amount, you might reasonably assume that the trade was in fact made, but at a venue not visible to you. However this is unreliable, since there is the chance that two orders were simply canceled at the same time.

If you are actively trading at a dark venue and choose to take liquidity at a given price then you obviously have a piece of information known only to one other participant (the counterparty in the trade!). Additionally if you were completely filled you may reasonably assume that some more liquidity exists at the same price.

Adverse Selection

One potential problem with crossing networks is Winner's curse. Generally if you are completely filled, it implies that the counterparty actually had more liquidity behind their order than you did in yours. If you are slicing many small orders across time, this would not be meaningful. However if you are trading large volumes then it can be assumed that the other side - being even larger - will be likely to cause market impact and thus push the price against you. So the fact that you got filled is an indicator that you actually didn't want to get filled - it would have been better to wait until the price had been pushed and then cross.

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 you are transacting 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.

Gaming

Dark pools are open to gaming, but it is a risky business, predicated on being able to guess both the existence of large liquidity and the pricing mechanism being used. As an example suppose that, by whatever means, you believe that there is a large amount of hidden liquidity, say a buyer pegged to the public bid price but who does not want to buy out in the public markets. If the public market has much less quantity than you suspect is hidden on the bid, you can buy a similar amount of the asset, pushing up the price. Once the price is high enough, you place a limit price buy order of sufficient quantity onto the public market and simultaneously place a limit price sell order on the dark venue for the total quantity you just bought. You now hope that the hidden order will cross with you at the current high price bringing the profit. This profit comes from you being able to buy the stock incrementally at prices lower than the current price which you helped raise. This is a dangerous game though: how do you know that the pegged order is really in the dark pool, and how do you know what the volume is? Finally there is also the chance that another market participant will see the anomalous move, decide the market is mispriced, and take it back to the original price without you being able to liquidate your position at a favourable price.

List of Dark Pools

Independent dark pools

• Instinet
• SmartPool
• Posit/MatchNow from Investment Technology Group (ITG)
• Liquidnet
• NYFIX Millennium
• Pulse Trading BlockCross
• RiverCross
• Pipeline Trading Systems

Broker-dealer-owned dark pools

• Barclays Capital - LX Liquidity Cross
• BNP Paribas
• BNY ConvergEx Group (an affiliate of Bank of New York Mellon)
• Citi - Citi Match
• Credit Suisse - CrossFinder
• Fidelity Capital Markets
• GETCO - GETCO Execution Services
• Goldman Sachs SIGMA X
• Knight Capital Group - Knight Link, Knight Match
• Deutsche Bank Global Markets - DBA
• Merrill Lynch
• Morgan Stanley
• Nomura - Nomura NX
• UBS Investment Bank
• Ballista ATS Ballista Securities LLC
• BlocSec
• Bloomberg Tradebook (an affiliate of Bloomberg L.P.)
• Daiwa - DRECT

Consortium-owned dark pools

• BIDS Trading - BIDS ATS
• LeveL ATS

Exchange-owned dark pools

• International Securities Exchange
• NYSE Euronext
• BATS Trading
• Direct Edge
• Swiss Block
• Nordic@Mid

Other dark pools

• Chi-X
• Turquoise

Dark Pool Aggregators

• SuperX - Deutsche Bank
• BASOR - Quod Financial
• Progress Apama
• ONEPIPE - Weeden & Co. & Pragma Financial
• Xasax Corporation
• Crossfire - Credit Agricole Cheuvreux

See also

• Algorithmic trading
• Electronic communication network

External links

• "Big Traders Dive Into Dark Pools"
• "Dark Pool Article On Quant Principle"
• http://www.atmonitor.co.uk/glossary.aspx?id=146