Chapter 1
Focusing on Dark Pools and High Frequency Trading, Just the Basics
In This Chapter
Looking at what makes a dark pool
Defining high frequency trading
Naming the cast of characters
Identifying the order types
Theyâre the hot topic in financial markets now. You canât open a newspaper or click on financial news without coming up against the terms dark pools or high frequency trading (HFT). Itâs all happening in the world of dark pools â lawsuits, scandals and accusations of the market being rigged. One thing is certain: all the banks and brokers are involved in one way or another with dark pools. But whenever you mention dark pools, you also have to consider the subject of HFT. One came about because of the other, and then they came full circle and now both operate in the same environments.
Like the name implies, dark pools are dark and secretive and the banks, brokers and institutions that operate the dark pools would prefer them to remain that way. High frequency traders are no different; theyâre even more secretive about their activities and wouldâve liked nothing more than to have stayed hidden in the shadows, buying and selling stocks in milliseconds and making money.
The world has changed, though, and now thereâs no hiding in the dark anymore. The light is being shone on dark pools and HFT. This chapter serves as your jumping-off point into that world.
HFT, dark pools and algorithms can be found anywhere where thereâs a working stock exchange. Thereâs no place to hide from them if you want to invest in the markets. The United States remains the main market by far. With more than ten stock exchanges and dozens of dark pools, the venues are so fragmented that the US market remains the best type of market for high frequency traders to operate in. When it comes to changes and trends in the high frequency and dark pool market, look to the United States first â the rest of the world is sure to follow.
Defining Dark Pools: Why Theyâre an Investment Option
Dark pools have been around in one form or another since organised stock exchanges began. In their simplest form theyâre a venue other than the stock exchange where stocks are traded. A stock market is one big, ongoing auction with investors and traders bidding and offering shares at different prices. Stock markets display their orders in an order book for all to see. When investors agree on a price, a trade happens and the process of agreeing on a price and making a trade repeats itself and continues all through the trading day as long as the stock exchange is open. But other times an investor may want to do a trade outside of an exchange.
Thatâs where a dark pool comes in. A
dark pool is a private venue where investors can exchange large amounts of stock without tipping the market to their intentions and, most importantly, without overly moving the market price. The common attributes of a dark pool are as follows. You can also refer to Chapter
2 for more detailed information about dark pools.
There are now dozens of dark pools all over the world. Brokers often first try to settle a trade between their own clients (called internalising) in their own dark pool. If they canât find a match, they will then route it to another dark pool, trying to find a match. Often the last port of call will be the traditional stock exchange.
On the darker side of the dark pool market, trading outside the displayed markets may give the broker an opportunity to take a small extra slice. Accusations have been made and even fines levied against some dark pools due to actions that havenât been in the clientsâ favour. Because of little transparency in the market, trading venue providers may be tempted to try to skim the little extra bit for themselves.
Trading venue providers are those who operate a dark pool, most often banks and brokers. (Refer to Part
IV for some risks associated with dark pools.) As a result of the suspect behaviour of some dark pools, legislators have stepped in to regulate and protect the investor. Head to the later section, â
Regulating the Markets: Legislators Take Actionâ, for more information.
The growth in dark pools in recent years has been accelerated by the growth in HFT.
Explaining What High Frequency Trading Is
High frequency trading (HFT) is the use of algorithms to trade shares at a high velocity of turnover, sending orders to the market in large numbers and using computer algorithms at great speed. Thousands of trades are sent out and executed inside milliseconds, and it all happens at a pace faster than the human eye can detect.
Here are the defining parts of HFT:
- Run by fast algorithms: An HFT algorithm tries to catch tiny differences in the price of a stock â just a penny or even a fraction of a penny. It tries to repeat that thousands and thousands of times a day, so those pennies add up quickly into big money. Chapter 7 takes a closer look at algorithms.
- Fast computers are co-located with exchanges: High frequency traders are able to do what they do by using fast computer algorithms and placing their own computers close to the stock exchangesâ own computers. Refer to Chapter 10 for more information on co-location.
- Use of special order types: Special orders are complex buy/sell orders used by algorithmic trading programs that define how an order is placed in a market, how itâs shown on the order book and how it interacts with changes in the order book. Head to the later section âEyeing the special order typesâ for more.
- The sending out and cancellation of lots of small lot orders: High frequency traders send out small orders of 100 to 200 shares at a time, trying to find information about larger, hidden orders. They then trade against those orders to make a profit. Chapter 10 provides more information.
For a while HFT was touted as bringing down the cost of investing and trading in the markets, but as information about the nature of HFT started to leak out, cracks began to appear. Some players in the markets started criticising HFT as something that gave an unfair advantage to some, using predatory behaviour and taking advantage of other investors.
This debate split financial professionals into two camps. Some defended HFT as bringing down trading costs and providing liquidity, making the market a better, well-oiled machine. Then there were those who argued that HFT was akin to the market being rigged and should be outlawed. Whatâs clear is that some shenanigans have been going on, and often the retail investor and the large institutions have been on the receiving end of the antics of some high frequency traders.
