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Look deep into my dark pools

It’s a line I’ve wanted to use in conversation for a long-time but never found the opportunity and now here it is: “look deep into my dark pools”.

No, I haven’t made a mess or done something socially unacceptable.  I’m just looking at the latest trading phenomena where buyers can place large trades into a market exchange and they sit there until sellers offer a good enough price for the volume.

Ker-ching, trade executes.

It works the same vice-versa and is well illustrated by Turquoise’s “How it Works” page.

Some people believe that dark pools are a worryingly new phenomena but it is not. As Chair of the TradeTech discussions, Andrew Silverman, Managing Director for Electronic Trading with Morgan Stanley, stated in a story about when he first joined the investment markets back in the 1980s.

Then, the head of the trading floor would receive a large block order that needed trading in the dark and so he would split the order.

So let’s say a large buy-side firm wants to trade a million IBM shares.  The order would be separated into two orders of 500,000 shares each across two of the firm’s trading desks. The head of those desks would allocate 250,000 shares to the lead technology traders in their team. Quite often those traders would then split the trade further to two of their technology analysts, who might then split the deal again to the junior traders recently joining the firm, such as Andrew back in those heady days.

Andrew would trade 62,500 IBM shares and have no idea that he and the other fifteen traders were all dealing at the same time on behalf of the same client for a total order of a million IBM shares.  In other words, on ly 62,500 shares in this trade are 'lit' whilst 937,500 shares were in the 'dark'.

So dark has been with us a long time.

It’s just that today, it’s a lot faster.

As Andrew stated when he opened the discussion: “I can remember in 1982 latency was three minutes. Now, it is a millionth of a second and getting faster.”

My, how far we’ve come and soon … real-time dark trading in a perfect market?

Not quite yet but we’re not far off.

To discuss such matters, Andrew introduced a panel comprising:

  • Yvette Roozenbeek, Executive Director, Strategic Development, NYSE Euronext for SmartPool;
  • Robert Boardman, Head of Algorithmic Trading, ITG; and
  • Daniel Keegan, Global Head of Electronic Execution Sales, Citi.

and various comments and quotes popped out of the woodwork.

For example, “it’s where you sit in the dark pool queue that is critical”.

Too right.

With today’s low latency systems if you’re not at the front of queue and other block orders are there ahead of you, you might be sitting for a while before any of the order is filled for your block trades.

To be honest, it isn’t supposed to work that way as, under best execution rules, dealers are meant to process orders in the sequence they arrive. However, with dark orders, this is not necessarily the case as a dark order can sit on the books for as long as it takes to be filled, whilst other orders pass through.

One panellist commented: “Although a dark order is filled, you have to ask where the prices comes from. The price is not in the dark, but the order fill can be from a price that is not of the moment because size is discovered in the dark whilst price is public.”

Sounds like some form of bedroom discussion, but it is much more to do with the dark orders being for large trading volumes of low frequency, where keeping a player’s hand close to their chest is key.

This means that dark pools are there to offer a method of trading where orders are not based upon the visible market price but on mid-point matching for example. Now mid-point matching – the difference between Bid and Offer – may be OK, but in a world of Best Bid-Offer, Best Execution and pre-trade transparency, this seems to fly a little in the face of MiFIDs aims.

Another panellist pointed out that: “although you may have the legal right to ask brokers where they trade and with which execution venues, the fact that the European press are different is the reason why pre-trade is so hard to deal with.”

This seemed to be getting at the idea that you may have pre-trade rules in the USA and Europe that strive to be the same … but that the European press are always looking for news and rumours, and hence will stir up market stories that may not even be true based upon access to full price transparency and visibility.

Citi’s Dan Keegan then jumped in with a comment that about 30 percent of Citi’s trading book is dark but that the numbers vary dependent upon how you define “off of primary”. This is based upon the fact that you have three books of business:

  1. A light book of business, which is visible to the markets for price discovery;
  2. A grey book of business, which has some lit areas such as price, and some dark areas such as block order trading volumes; and
  3. A dark book of business, which is invisible to the open market place (the primary market) in both price and size.

The whole point of this is that there is always a danger of information leakage, where transparency of trading, especially block order trading of size, can be leaked for both insider and press analysis.

That's the whole point of dark – to trade with the other investors being unaware of how and what you are trading, particularly if you are a market maker or market mover and shaker.

And, sorry to get into such detail but it is important, this brings in other areas of the trade order cycle, namely two pieces of information: Indication of Interest (IOI) and Immediate or Cancel Order (IOC).

IOI is an invitation to see if anyone can trade an order you are thinking about placing, and IOC moves markets as it uses IOIs to trade and then immediately negates the trade before it is filled.

Using such information allows traders, if they see a market mover trading, to buck the price without ever placing an order.  This is why it is so important to keep IOIs and IOCs secret, especially in dark pools where major players are placing high value orders in low volumes.

In fact, the misuse of IOIs and IOCs is a hot debate topic, as many dark pools use this information badly to allow leakage and hence ‘gaming’. 

For example, you receive 16 orders for 62,500 IBM shares from one fund manager or broker dealer and you know that a million shares are moving, probably on the basis of news or views of one player.

Using IOIs and IOCs, other traders can then game those IBM shares, moving prices using dark pools.  Then combine IOIs and IOCs with latency arbitrage and you can see how complicated this all gets.

For example, the US markets have about 45 dark pools and managing the complexity of all that liquidity across so many venues is proving incredibly difficult, as well as providing lots of opportunities for gaming.

Lots more chat about such stuff and, at the end of it, a question around how to deal with such pools and regulate them, if at all.

The answer?

It’s a trade-off between innovation and transparency, and you cannot have full transparency if it is at the expense of market innovation.

I’m not sure I concur with this point, as many say that our markets are in the mess they are in today thanks to innovation.

In fact, it’s interesting that if you combine the points made by others in the previous two panels about avoiding regulation at the expense of innovation, you do wonder what all of this means. I think it means something around the themes raised by Anthony Hilton, City Editor of the Evening Standard yesterday:

“Trade unions could not believe it when 30 years ago Prime Minister Margaret Thatcher said she would no longer listen to them, give them privileges or allow them a special place in the economic order.

“They had become so used to flexing their economic muscle and being listened to by government that they came to believe their own publicity. They thought they were so special, so irreplaceable, so essential to the functioning of the economy that no one would dare to try to run things without them. They seemed genuinely to believe they had a divine right to a disproportionate share of the country's economic output.

“It took a long time for them to realise the world had moved on, and the mass of the public had switched off. Their behavioural excesses had destroyed their mystique and provoked a backlash so severe that most of us were no longer interested in them or their ideas — still less their prosperity.

“Today's senior bankers have a lot in common with those unions. They too have spent a decade over-exploiting their economic and political muscle, straying well beyond their original purpose, pretending to a mystique and importance they do not possess and trying to extract unjustifiably large rewards for their labours. They too have ultimately been brought down by their arrogance.

“And they still don't seem to get it.”

In other words, like bank bonuses and OTC Credit Derivatives, I have a strong feeling that anything which creates additional risks in the future by being dark may become noticed by policymakers as unacceptable risk and lit-up.


About Chris M Skinner

Chris Skinner is best known as an independent commentator on the financial markets through his blog, TheFinanser.com, as author of the bestselling book Digital Bank, and Chair of the European networking forum the Financial Services Club. He has been voted one of the most influential people in banking by The Financial Brand (as well as one of the best blogs), a FinTech Titan (Next Bank), one of the Fintech Leaders you need to follow (City AM, Deluxe and Jax Finance), as well as one of the Top 40 most influential people in financial technology by the Wall Street Journal’s Financial News. To learn more click here...

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