Sunday, December 27, 2009

Dark liquidity pools

Real integrity is doing the right thing, knowing that nobody’s going to know whether you did it or not. -  Oprah Winfrey

What are Dark Pools:
Dark pools are internal crossing networks wherein, typically large orders from traders are crossed internally without routing them to the exchange. The prime feature of dark pools is the anonymity they provide with respect to the identity of the trader, the trading price as well as the liquidity.

What is the need for them:
Large institutional investors generally follow sohisticated strategies which may require them to buy/sell large proportions of a stock at short notices. These investors are vary of trading such large quantities because of the market impact they bring about whihc may shift the prices against them. Tradionally, Quants were employeed to come up with complicated strategies of loading/unloading such large quantites by buying and selling in equity as well as derivative markets for that security. However, these methods were soon found not to be sustainable for a long time. This need for an alternate trading facility other than the exchange gave rise to the concept of "dark pools". This allows traders to trade large quantites without having these trades shown up on the exchange side order books. This in turn guarantees no market impact of such trades.

These pools are owned by private brokers like Morgan  Stanley, Goldman Sachs etc. They may also be shared across multiple brokerage houses.
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 Pool transactions are recorded on the exchanges' consolidated tape. The SEC, and anyone else that wants to purchase the consolidated tape, has some limited visibility into those transactions.

  1. Alternate trading systems (ATS), as they are refered by, provide internal crossing of client orders without having to route them to the exchange. This saves execution and routing time. Further, it provides anonymity by not having these orders shown up in the exchange order books.
  2. Unlike exchange, where such large orders might  be sliced and routed to different destinations, and executed are possibly different prices, these dark pools can provide a fixed execution price (often midpoint of ap and bp) since they dont need to slice the order, entire chunk can be executed at same price often.
  3. They offer high levels of liquidity for trading stocks. Sometimes, traders might find it difficult to trade less liquid stocks in open exchanges. So they may opt for dark pools in such cases.
  4. Low transaction fees. This is because, unlike exchanges wherein these costs might be incurred on each slice, the costs for dark pools is much lesser.
  1. These dark pools are only accessible via electronic trading.
  2. There is a limitation on the total volume of trading done  on a particular stock that can pass through dark pools.
  3. Since they hide the order level information from outside world, one cannot guarantee that the prices one sees on the exchange are indeed the real prices of that stock. Now, although this might not affect retail investors because they can still trade at the price available in exchange relative to the price they expect, as long as both of them are in sync. However, the regulators who are looking to keep the prices of a stock as close to its fundamentals as possible would have problems with this. 
Dark algorithms:
Given thast algorithmic trading is only a sub partt of electronic trading, algorithms will eventually become an integral part of managing liquidity in the markets. Brokers often try to find best possible pools for execution of client order to ensure best prices. For this, they slice and route the orders to different pools based on their availability. Any leftover volume is broken up and placed back across the pools, with the result that the buy-side firm’s order is executed efficiently with minimised risk of overexposure or missed opportunities, and without the firm having to manage the multiple venues itself. As such, traders these days are trying to cook algorithms which expose minimum information of the trade to the external world. Then there are algorithms who try to  find hidden liquidity by tracking such dark pools and efficiently manage the order execution by routing the  orders to the best pool. Credit Suisse's Guerilla and Sniper are two such dark algorithms. This is a snippet of an interview of Toby Bayliss, Citi posted on about the use of algorithms in dark pool trading -

FTM: The need for gaining access to the growing number of dark pools of liquidity has resulted in the development of new liquidity-seeking algorithms. How do they work?
TB: Smart order routers work by having an understanding of each of the liquidity pools and how they work and interact with flow. Each venue differentiates itself by having its own methodology for interacting with the actual flow that is there. Negotiation takes place in different ways. A smart order router needs to understand each and have access to all of them.
Depending on the aggressiveness of your liquidity-seeking algorithm, it may seek only to interact with dark liquidity –sending in hidden order types to see if they are matched on the other side. To get more aggressive, you can interact with order book flow or you can post liquidity on certain venues.

FTM: And what are the challenges for sell-side firms trying to differentiate themselves in this area?
TB: It really comes down to speed, which is crucial; knowledge of where things are trading; and building up that knowledge over time. Because speed is important, you want to target venues where you have seen liquidity in the past or where liquidity exists at the moment. Because there are so many venues you can only ping so many at a time before you have to prioritise which will target. Pinging is sending the minimum size order for that venue and seeing if you get a fill. The actual knowledge side is also crucial. At Citigroup we own Lava, which has the concept of a dark book. This effectively allows clients to enter the full order size even if they only send a small part to market. Lava has the knowledge that a large order exists so it can match large buyers and sellers of large blocks. It gives you a higher probability of finding the other side for your whole order size.

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