Dark pools

19 August 2014


I was recently interviewed on CNBC about high frequency trading and dark pools in Europe. Steve Sedgwick raised some interesting questions during the interview, which I wanted to address further here.

To start with the basics, dark pools are alternative trading venues (i.e. not exchanges) where different participants can place bids and offers (also known as resting orders) without the details being made available to the public until the trade has been completed. Those involved in the trade (called the counterparties) remain anonymous throughout: only the price and quantity of the equity traded are publicized. Similarly, the price at which shares are offered for sale is not made known to any participants until after a sale has been completed. This means that you make your offer to buy or sell based on your own assessment of the price at the time (e.g. based on public price data from exchanges), but without knowing the other prices being offered on the dark pool itself. Your order will only be filled if the conditions of your offer can be met by another participant. 

The primary reason these venues were created was to help institutional investors execute large trades more cost-effectively. As they tend to have very large order sizes, institutional investors trading on the lit markets could have a market impact (move the price considerably), which is undesirable for the investor. Before executing a trade on a lit market, investors will often check to see whether there’s liquidity on dark pools, where the restricted price information allows them to execute these orders with less price impact.

Many different sorts of market participants run their own dark pools including brokers, exchanges and banks: like exchanges they charge fees on each individual transaction. As with exchanges, the fees vary, sometimes the fees charged by dark pools are more competitive than those of the exchanges.

The idea has arisen more recently, that dark pools were created so that investors could only trade with each other (e.g. through internal order-crossing) and thereby avoid trading with high frequency traders. The origin of this myth is hard to determine, but it is important to understand that like every other trading venue, dark pools need liquidity providers to keep transactions moving at a competitive speed. Many dark pool operators invite electronic market makers (EMMs, often referred to in the media as 'HFT' firms) to provide liquidity on their dark pools. EMMs are also invited to provide liquidity on regulated exchanges and MTFs (lit markets). 

EMMs are invited to operate in dark pools because their presence is needed: if an institutional investor goes to a dark pool to buy or sell a number of shares, the probability that the dark pool can fill the whole of that order through ‘natural’ liquidity (other investors buying and selling) is quite small. 

What the institution (and the dark pool) needs for the order to be filled is participants trading on a different timescale. High frequency traders trade on intraday volatility (fractional price fluctuations occurring during a single day’s trading) and therefore are likely to be unconcerned by the long term price trend. High frequency traders (particularly electronic market makers) also tend to have a very broad portfolio, trading on hundreds of different equities simultaneously, rather than confining themselves to a particular specialism. The presence of high frequency traders in dark pools (as on exchanges) therefore means that institutional investors are able to trade when they want to, and often at the price they want. 

There are concerns about dark pools due to the lack of price transparency and also regarding the share of some markets’ trading currently being conducted ‘in the dark’. While high frequency trading is one of the most heavily-regulated aspects of the financial markets (particularly in Europe); dark pools are one of the more lightly regulated. As MiFID II aims to make the markets more accountable and transparent, regulations for dark pools in Europe will increase, although the impact of this is yet to be seen.  

There are those who lose out because of the presence of HFT in the markets – they are the traditional market makers who have chosen not to adopt the new technology (you can read more about this in our blog ). Institutional investors (as has been widely covered of late) have benefited from the reduction in transaction costs that have resulted from the practice of electronic market making. 

The views expressed in this blog post are the personal opinions of the author and do not necessarily reflect the official policies or positions of the FIA European Principal Traders Association or the Futures Industry Association.

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