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Dark Pools
Off-Exchange Liquidity in an Era of High Frequency, Program, and Algorithmic Trading
E. Banks
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eBook - ePub
Dark Pools
Off-Exchange Liquidity in an Era of High Frequency, Program, and Algorithmic Trading
E. Banks
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About This Book
This book deals with the topic of dark trading, or non-displayed, off-exchange trading execution. It discusses the development, importance and practice of dark equity trading in an environment dominated by high frequency, program, block and algorithmic trading, and considers its future prospects in a world of mobile capital and changing regulation.
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PART I
Market Structure
1 |  | Introduction to Dark Pools |
A Definition
The ādark poolā ā a somewhat mysterious, even ominous, term ā is the name given to a market structure that has become an integral part of the traded financial markets of the twenty-first century. While on the surface the concept of a dark pool might sound threatening, reality is fortunately rather different: such pools convey a range of benefits to both buy-side investors/traders and sell-side brokers and dealers, contributing to rapid growth in a relatively short period.
Before embarking on a more detailed discussion of the subject, let us begin by removing the shroud from the term. We can do so through a simple definition:
A dark pool is a venue or mechanism containing anonymous, nondisplayed trading liquidity that is available for execution.
We can clarify this even further by parsing the definition.
Anonymous, nondisplayed trading liquidity is order flow that is submitted confidentially and is not visible to the market at large, that is, it does not appear in public order books, like those operated by exchanges. The fact that the flow is not visible has given rise to the term ādarkā liquidity. Note that by extension visible trades are commonly referred to as ālitā liquidity.
A venue is any electronic platform that is involved either solely or partly in housing nondisplayed liquidity.
A mechanism is any structure within an exchange or any venue/participant in the market that houses nondisplayed liquidity.
Execution is the ability to buy or sell an asset through the submission of an order.
Therefore, we may summarize by saying that a dark pool is an accumulation of orders to buy or sell assets, but whose existence is not publicly known or advertised. This is but one way of defining the dark pool sector, but it is useful and workable for our purposes.
To put this definition in perspective, let us consider the instance of Asset Manager QRS, which owns a large position in Stock XYZ that it wishes to sell as quietly as possible ā discretion, rather than speed, is QRSās priority. While it can place an order with its broker to sell XYZ on a regulated āvisibleā exchange in the normal manner (i.e., setting a limit or market order and having it crossed against a visible contra-trade in the market), this might attract too much attention and result in an adverse sale price. To minimize this potentially negative outcome, QRS may choose instead to place an order to āsell the block darkā, meaning the broker will route the order to one or more dark pools to seek execution. This strategy of āgoing darkā gives QRS certain critical advantages related to anonymity and market impact, as we shall note later in the chapter.
A dark pool is actually quite similar to a conventional visible market in terms of structure and function, executing orders according to certain rules, but it features no pre-trade transparency, that is, it posts no visible prices or volume (market depth). It can thus be seen as a form of exchange or exchange mechanism that supports discreet execution of trades. Indeed, many of the worldās major exchanges operate dark pools or feature dark liquidity of their own. They are joined by hundreds of major financial institutions that have also created specific dark mechanisms or ventures. Knowing this, we can take comfort that the dark sector is not negative or in some way anticompetitive or prejudicial. The dark sector is not a āwild westā marketplace, operating without rules or structure, where investors and traders can be unwittingly fleeced. In fact, the benefits it conveys are significant, and certainly a key reason why dark pools have very quickly become an important dimension of the financial markets.
* * *
Pools in Practice: A typical dark trade
Letās consider a typical trade example and how it touches the investor, broker, and dark venue as it evolves through the process. We begin by assuming that an investor is interested in submitting an order to a broker-dealer that runs a proprietary operation that is used to support its client business. In the first instance, the investor must decide whether to send the order to the lit markets, the dark markets, or both; assuming it prefers a ādark onlyā execution it selects the correct flag on the order entry screen of the interface provided by the broker-dealer. Since the broker-dealer is essentially operating an internal matching engine where it accumulates all of its client orders, it receives the client order and routes it directly to its engine. Assuming a match can be made against the proprietary book or other incoming client flow, the engine crosses the trade and sends a confirmation back to the investor. The dark trade is thus complete. Note that it is common within the logic of the broker-dealerās engine to rank order the matching sequence of incoming client orders, that is, match against the broker-dealerās proprietary positions or other incoming client flow first, then route to other designated dark pools if no internal match is possible, and then route to the lit markets if no dark liquidity is available at all. Whilst broker-dealers, particularly large ones, generally opt to build their own engines in accordance with their own business, operational, and governance requirements, third party solutions are also available for purchase; this tends to be attractive to smaller broker-dealers.
Naturally, if the investor wants to take greater control of the execution, it could use a smart order router (SOR) instead of directing the trade to the broker-dealer. In this instance, the SOR could be set up to look for dark liquidity by sending indications of interest (IOIs) or immediate or cancel orders (IOCs) to various dark pools; it would continue the process in a sequential iteration until all pools had been exhausted. At that point, if the order were to remain totally or partially unfilled, the SOR logic could be instructed to take another pass through the population of pools, or it could route the remaining order straight to the lit markets. We will discuss IOIs, IOCs, and SORs later in the book.
* * *
In the rest of this chapter we shall consider the reasons why dark pools exist, some of the advantages they convey, the catalysts that have led to their creation and expansion, and the evolutionary path they have taken. This will be followed by a brief picture of the regional status quo and the changing face of trading execution. We shall conclude with a brief overview of the text to set the stage for the material that follows.
It is worth noting at this early point that most of what we consider in the book relates to the global stock markets. Although the dark pool phenomenon is making its way into various nonequity asset classes, the driving force has been, and remains, the equity sector. Where relevant we shall broaden our discussion to these alternate asset classes (e.g., fixed income), but will remain primarily focused on the equity markets.
Rationale, Catalysts, and Evolution
To kick off our discussion, let us begin by exploring why dark liquidity exists and why it has given rise to myriad dark pool venues and mechanisms in recent years ā which, in total, continue to gain important market share in global equity trading.
Rationale
A new financial market/product is developed by intermediaries to provide participants with advantages that might otherwise not be realizable. These advantages, which are basically drivers, can come in various forms: reduced costs, higher returns, more efficient processing, faster execution, more accurate risk management, and so forth. In the case of dark pools the primary drivers include the following:
ā¢Confidentiality
ā¢Reduced market impact
ā¢Cost savings
ā¢Profit opportunities/price improvement.
To explore these drivers, let us consider the case of an institutional investor that is thinking about buying a large block of stock, say 100,000 shares of Stock ABC. It seems reasonable to assume that if this information becomes public, other investors might try and jump ahead of the investor to buy the same stock ā effectively pushing up the price of the stock in the process, and creating a market impact ā or unfavorable price movement ā for the investor. If, however, the investor very quietly and confidentially attempts to purchase the stock before anyone is aware, they may be able to do so without moving the price of the stock ā thus avoiding a market impact. Note that this same market impact would not occur if the investor were trying to buy 100 shares of ABC, because the order would be too small to generate interest in the market. Thus, large trades, or block trades ā which we may define as those in excess of several thousand shares per trade1 ā are central to the dark liquidity thesis.2 The number of block trades in the marketplace may be small in absolute number but they account for the largest amount of volume, and often absorb more liquidity than is available on an exchange or through a dealer network.
There is arguably no benefit to be obtained from āshowing oneās cardsā when it comes to block trades, as any such disclosure may reveal to the market a specific investment posture, the search for a certain kind of stock, a preference for a particular kind of return, and so forth. We may refer to this unwanted disclosure as information leakage, and it may seep into the market either obviously or discreetly. Preserving confidentiality can protect sensitive information from falling into the hands of competitors or others who might have an interest in such details. Once the information is leaked, confidentiality is lost and some degree of market impact will invariably follow.
Let us also consider the issue of cost savings. If any economic benefits can be derived from dealing through an alternative mechanism or venue that effectively serves as a competitor to traditional, well-established exchanges, the investor is again in a position to benefit. In fact, clients executing away from an exchange can avoid paying exchange fees ā any trade that is executed off-exchange creates a savings on fees, meaning that brokers can preserve more of the spread for themselves and split the savings with their clients; alternatively, large clients that access markets directly can keep the savings all to themselves. Use of direct market access (DMA), which is an increasingly popular mechanism that links electronic trading platforms on the desks of institutional clients directly to multiple exchanges, can result in even greater savings (we shall discuss DMA later in the book). Electronic trading generally, and dark trading specifically, can generate true cost savings.
In addition, there is the potential for a profit opportunity or price improvement. Active sell-side and sophisticated buy-side institutions have at their disposal advanced technologies and analytics that they apply to a range of strategies (including high frequency trading, statistical arbitrage, algorithmic trading, and so forth) ā many of which are designed to take advantage of electronic trading and pockets of displayed and nondisplayed liquidity to generate short-term alpha, or excess returns. Venues that can be used to take or provide liquidity alongside, or away from, conventional exchanges emerge as important participants in this process, and can attract a great deal of buy-side and sell-side interest. Separately, traders or investors that submit orders into a dark pool on the basis of a reference price (which we discuss below) may benefit from some degree of price improvement, which is formally defined as the savings obtained when a trade is executed at a price that is superior to the base reference price at the time the order reaches the market (typically measured in terms of ticks or fractions of ticks). Again, a venue that can interact with dark liquidity to routinely deliver price improvement will attract client and dealer interest.
We may therefore consider that any mechanism or venue that (1) brings together buyers and sellers in a confidential manner,3 (2) reduces or eliminates market impact, (3) saves on fees, and (4) creates the possibility for alpha generation or price improvement would appear to be compelling. In fact, dark pools provide all four of these advantages, which helps explain why their market share as a percentage of total turnover has risen dramatically in recent years.
Measuring activity in dark pools is not yet an exact science, as standardized reporting is only starting to become the norm (as we shall note in more detail in our discussion on regulatory matters). Accordingly, gauging market share is based on a variety of research studies and estimates. And, while estimates vary based on definition, consensus research appears to indicate that in the U.S., up to 40% of all trades were executed through a dark pool in 2013, up from some 15% in 2010.4 Average daily trading volume at the largest U.S. platforms ranged from 100 to 300 million shares (single counted, matched trades). Although Europe, Canada, Australia, and Asia trail the U.S., with 5% to 15% trading dark in 2013 (depending on country), all have seen significant growth over the past few years. If we assume, therefore, that 30% to 50% of the global equity markets trade on a dark basis at any point in time, then we are clearly dealing with a very important market mechanism. This becomes even more obvious when we consider projections suggesting that at least half of the U.S. market, up to 30% of the European market (depending on regulation), and between 10% and 20% of the Asian market, will trade dark within the next five years.
Catalysts
Nondisplayed liquidity has been available in some form for many years through exchange mechanisms such as reserve orders and worked orders in specialist books, and via the so-called upstairs market, effectively an off-exchange gathering of buyers and sellers of large blocks operating under the auspices of broker/dealers.5 In recent years, various catalysts have led to the development of new venues/mechanisms to supplement the original ones. The most powerful of these forces include the following:
ā¢Technological innovation
ā¢Regulatory changes
ā¢Decimalization
ā¢Capital accumulation and mobility
Success of new dark venues has been reinforced by the willingness of buy-side investors and other clients to embrace new technologies and new business models. In fact, the benefits buy-side firms have derived from these advances have been significant enough to persuade them to direct increasing amounts of activity into the dark sector and have helped dispel the notion that a central exchange marketplace is the only, or even best, way to trade in securities. Sell-side firms and established exchanges have taken up the challenge, redesigning their technology platforms and business models in order to offer clients new exe...