10/29/12

Is it doing the breast stroke in the dark? If it were only that simple but in today's complex trading world there exists a mysterious and illiquid private market called, Dark Pools. Even though they only account for 12% of activity, when combined with wholesale brokers they suck up almost one-third of U.S. stock trading order flow away from public exchanges. Yet the controversy is that the public doesn't know what's being transacted and how much, hence the name. Even with only about 50 operators, MIT Sloan's Professor Haoxiang Zhu has studied how they're having a significant impact on investors and exchanges. Read on to learn more about what he uncovered on this shadowy market...



HISTORY
Dating back to the era of big hair and high tops of the 1980's, dark pools were established to avoid large block orders from influencing financial markets and ensure privacy. For almost 25 years all was well as pool activity was a mere three to five percent but then in 2007 the SEC passed Regulation NMS (National Market System), which allowed investors to bypass public exchanges to gain price improvements.

Since then broker-dealers began to setup their own pools in concert with algorithmic trading and decimalization and as a result, bid-ask spreads shriveled and trading costs declined with institutional investors and BB following suite. Instead, now a public exchange quote at $10.00-$10.05 can be beaten by the pool at a fractional mid-point spread of say $10.025 bypassing the NMS sub-penny rule..."And trader's like that", says Linette Lopez in her article, What The Heck Is A Dark Pool And Why Are People Trading In Them?


MECHANICS
Essentially, there are two types of order routing to dark pools:
1. Indications of Interest - in which pool information only on ticker symbol, price, and buy/sell interest goes to brokers.
2. Payment for Order Flow - where a broker favors a specific pool in sending orders.

However, once the actual order is received it's either an IOC (immediate or cancel) or an FOK (fill or kill), both synonymous with HFT activity on quote stuffing and pinging. To clarify how this works, I've provided a flow chart of a typical order routing decision tree.

Dark Pool Trading

In Professor Zhu's paper, Do Dark Pools Harm Price Discovery he argues that even if an investor gains a price improvement, the delay in execution may be harmful and that it entails greater risk and volatility. First, information traders entail a greater risk as their information becomes stale and a possible herd movement begins due to transaction delays. Second, the longer the delay in execution, the greater the odds that the price could move against them once the herd gains momentum, hence the volatility.

He also finds that these information traders are self-selecting and go back to the exchanges where market-makers price-in these price improvements and as such spreads widen as they protect themselves while uninformed traders, such as hedgers, remain in the pool and subtract liquidity.

Thus, if Zhu is correct then dark pools are widening spreads on public exchanges!


Lastly, keep an eye out for DARK POOLS PART II, where I will discuss their advantages and how the exchanges are trying to compete against them otherwise this topic is wide open, so any comments, concerns, or questions you monkeys have, let 'em rip!

Comments (41)

10/28/12

I know a guy that worked for a company that does software for dark pools. Kind of fucked up because people can use it for insider trading. If you know a company is gonna get acquired, thus bringing up the stock price, then you can buy up a ton of shares in the dark pool so that your buying doesn't push up the price prior to the acquisition so you don't create suspicion of wrong-doing. Also, the government can't track who bought the block of shares so you get off scott-free.

I asked him why this isn't illegal and he was like "regulators and Congress don't understand it."

10/28/12

Thanks! very interesting article! learned a lot this summer about Stigma X. Was pretty interesting.
http://www.stocktrading.com/sigmax.pdf

10/29/12

thanks. ive always wanted to learn more about dark pools but didnt know where to find info (read: lazy)
but now that it's out there, does anybody know where one can further expand their knowledge on the matter?

11/1/12

Newspeak
It would have to depend on what size the trade is besides the information itself. If the person is block trading on the company who's expected to rise in price, then yes I believe you painted an accurate picture otherwise if it's just tens of round lots, they're not going to affect the price unless the market is shallow (i.e. low volume stock). However, your friend's explanation sounds correct as I think regulators don't tackle what they don't understand until it's already a problem, like MBS and CDO dealings in the last financial crises.

NikitaN
Thank you! I'm glad it was helpful. You may also want to look at Credit Suisse's CrossFinder, the second largest brokerage dark pool operator. Also, here's an extended List of Dark Pools.

Fundamentally Undervalued
You're welcome! I don't off-hand but if you stay tuned for part two, next week (not this coming weekend) I will cover a bit more and if I find anything good along the way, I'll be sure to insert it at the bottom as a further reading link. Thanks for asking!

Who Am I? | See what GMngmt is all about at About.Me

11/1/12

Great posts

11/1/12

wait dark pools are not related to dark matter?

11/1/12

you quoted Sal Arnuk, who believes HFT is the next skynet, and may, just may, be hacking into his profit margins. I never understood this discussion, noone is forcing you to trade on a dark pool! Trade where you get the better price....

11/1/12

I'd like to thank all three of you for your comments and I'll address each one...


cakepie:
Great posts"

Thank you and I'm glad you enjoyed them.


airball:
Wait, dark pools are not related to dark matter?"

Kind of. A trade goes into a public order system but gets executed by some unknown but measurable force that we suspect to be "dark pools". So yeah, same thing!


trazer985:
You quoted Sal Arnuk, who believes HFT is the next Skynet and maybe, just may be hacking into his profit margins. I never understood this discussion. No one is forcing you to trade on a dark pool! Trade where you get the better price...."

Believe me, I think Sal Arnuk is a disgruntled antiquated broker who's upset by being displaced by technology and new methods but in this case his statement is correct.

Force no, but larger transactions are being taken to these dark markets for reasons stated above and like the CFA Institute study suggests, there are likely an optimum number of operators otherwise equity exchange will start to go private while gauging liquidity and matching price will be difficult especially among fragmented networks. Think of it as the NYSE but fragmented by brokers, investors, and banks. How hard would that be to trade?

Who Am I? | See what GMngmt is all about at About.Me

11/1/12

Just read both your posts, very interesting. Thanks a ton.

"When you stop striving for perfection, you might as well be dead."

11/1/12

Did you have a question or just find the topic interesting. Pretty good article, I think anonymity in a mature market like equities where the information flow is so quick especially for the more active stocks dark pools will play an increasing role in the future.

"Oh - the ladies ever tell you that you look like a fucking optical illusion?"

"Oh the ladies ever tell you that you look like a fucking optical illusion" - Frank Slaughtery 25th Hour.

11/1/12

i found the topic interesting. i don't understand why they would do that. aren't there arbitrage opportunities if there were two or more markets available quoteing different prices?

11/1/12

Traders arent using dark pools for abitrage. Dark pools are used when you want to move size and anonymity is key.
Im not sure what market you are addressing looking for arbitrage but if your talking about equities where dark pools are prevalent then arbitrage is nearly non exitant.

Your using dark pools to build or unwind a big position with tipping your hand thats essentially what they are there for.

Im not sure what your question is so its tough to answer.

"Oh - the ladies ever tell you that you look like a fucking optical illusion?"

"Oh the ladies ever tell you that you look like a fucking optical illusion" - Frank Slaughtery 25th Hour.

11/1/12

from what i understand, dark pools are used for large block orders. if yhoo was trading @ 25, i can just put in an order to dark pools to buy at 24 or sell at 26 right? or if we have a real volatile stock, i can just put in a fairly low bid.

11/1/12

Yes but what you should realize is how they differ from the regular order book.

On a regular order book you typically have your bids on the left and offers on the right. In addition each bid shows what market maker ID is giving that bid along with the quantity.

In a dark pool when you put your order in to buy at 24 basically its a order thats hidden to the public. No one can see you have an order in to buy X shares at 24.

This is really as best as I can explain it. I dont know the further intricacies of it. If you read the article you will see that only 5% of orders are executed in dark pools but it has grown rapidly.

"Oh - the ladies ever tell you that you look like a fucking optical illusion?"

"Oh the ladies ever tell you that you look like a fucking optical illusion" - Frank Slaughtery 25th Hour.

11/1/12

i understand that the bid doesn't show. but i can put the order in, and once it executes, i can immediately go to the public markets and cover my position for an arbitrage profit... no?

11/1/12

though i'm also not particularly familiar with the darkpools, i'd venture to say that if you were to execute an order in a darkpool then instantly cover yourself in the open market, you'd lose your arb profit pretty quick since the sheer size of the position you're trying to arb will cause the open-market price to quickly rally or drop against you.

my $.02

hodeez:

i understand that the bid doesn't show. but i can put the order in, and once it executes, i can immediately go to the public markets and cover my position for an arbitrage profit... no?

------

"its the running joke now, we now have fair trade with china so they send us poisoned sea food and we send them fraudulent securities."

------

"its the running joke now, we now have fair trade with china so they send us poisoned sea food and we send them fraudulent securities."

11/1/12
EE:

though i'm also not particularly familiar with the darkpools, i'd venture to say that if you were to execute an order in a darkpool then instantly cover yourself in the open market, you'd lose your arb profit pretty quick since the sheer size of the position you're trying to arb will cause the open-market price to quickly rally or drop against you.

my $.02

hodeez:

i understand that the bid doesn't show. but i can put the order in, and once it executes, i can immediately go to the public markets and cover my position for an arbitrage profit... no?

------

"its the running joke now, we now have fair trade with china so they send us poisoned sea food and we send them fraudulent securities."

though dark pools were initially built for large blocks to trade, there are orders that are quite small. under 1,000 shares...food for thought.

11/1/12
hodeez:

i understand that the bid doesn't show. but i can put the order in, and once it executes, i can immediately go to the public markets and cover my position for an arbitrage profit... no?

Dark pools have nothing to do with arbitrage! They're simply used to cover tracks and avoid moving the market. This analogy isn't perfect, but think of them as 'private' placements. Even if you saw an arbitrage opportunity, though I can't image any situations in which that would happen, the B/A spread would be wide enough to protect the dealer. More importantly though, if you're asking about shorting a dark pool, then covering in open market, why would a buyer in the pool agree to buy your securities if you were selling them for more than the ask price on the public markets?

11/1/12

Sorry i cant really answer anything about arbing the underlying b/c your being executed in a dark pool. I dont think the market is going to be that inefficient to pull that type of arb off.

"Oh - the ladies ever tell you that you look like a fucking optical illusion?"

"Oh the ladies ever tell you that you look like a fucking optical illusion" - Frank Slaughtery 25th Hour.

11/1/12

Wouldn't the prices on these platforms be identical? I think they are simply ways for OTC transactions to occur without institutional investors exposing their strategies...

11/1/12

in addition, in some dark pool exchanges, you can set certain requirements for you to match up. For example, I could say someone can only lift my offer if their own bid is greater or equal to my block size.

The filters are key. I wonder what this will do to OTC brokers.

11/1/12

I have been over this time and again. Equity trading will never be completely automated. Rather the skills that used to be required before are changing. The need for solid coverage will always be desired by the buy side. As long as the buy side feels a need for information there will be a sell side there to service them.

"Oh - the ladies ever tell you that you look like a fucking optical illusion?"

"Oh the ladies ever tell you that you look like a fucking optical illusion" - Frank Slaughtery 25th Hour.

Best Response
11/1/12

SEC Clampdown on Dark Pools? (Originally Posted: 10/23/2009)

The SEC is proposing more aggressive regulation of "dark pools", outside stock trading systems that allow institutions to make large trades without public disclosure.

The changes would require pool operators to provide public displays of stock transactions and quotes. The use of dark pools has exploded over the past 8 years, and it is estimated that they currently make up 7.2% of all trading volume.

"Given the growth of dark pools, this lack of transparency could create a two-tiered market that deprives the public of information about stock prices," SEC chairman Mary Schapiro said at the agency's public meeting Wednesday.

Like the brouhaha that ensued over high-frequency trading this summer, Sen. Chuck Schumer (D-NY) is behind this push for regulating the more esoteric markets. It will be interesting to see if the SEC can actually get it done. There are powerful players on the other side of the table that would prefer to keep things quiet.

11/1/12

Barney Frank suggests the solution is in desalinizing the chlorine, making the pools less dark...i.e. "more transparent".

11/1/12

Thanks for posting--John Thain is an absolute boss and I found his perspective on dark pools particularly interesting.

11/1/12

I'd work for him too if I could put my bum on a 30k toilet after eating chipotle everday

If the glove don't fit, you must acquit!

11/1/12

I can't watch the video at work, but I call BS

"I'd work with this guy tomorrow if I had the chance"

This would require you to go into an office and work 10 hours a day. I just don't imagine you doing this at this point. Hell, the hurdle of putting on pants might be too high for you

11/1/12

LOL. Fair point.

I'd probably go back to work if I got to work with a solid crew doing something I gave a shit about, though. But yeah, the bar is pretty high on that at this point. Pants are a drag.

11/1/12

Decent interview...seems like a level-headed guy, but probably partly because he is running a small business lender and not an ibank chock full of old boy networks and frat bros. Also, Stephanie Ruhle is kind of cute.

11/1/12

Is it me, or is that cute lady really aggressive?

11/1/12

.

11/1/12

Marker:

Is it me, or is that cute lady really aggressive?

*annoying

The man's taking time out of his schedule to do this...at least let the man finish his thoughts.

I'd still smash doe.

11/1/12

Haha I saw her grabbing schatzkers arm. She wants to jump one of their guns

11/1/12

Great video...Thain just might be Superman.

11/1/12

Now that's someone who loves what they do. Engaged as fuck in the convo; when it's ending he just has that look in his eyes like he sees prey lol.

But ya, total boss. Deserves a few #rozaygrunts. I'd love for him to do an hour q&a.

11/1/12

PE is the new black.

11/1/12

"I keep my eyes on him. Then once I see a chink in his armor, boom, one of his eyes may move, and then I know I have him." - Mike Tyson

11/1/12
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