Securities Services: Welcome to the dark side
Traders seeking maximum liquidity with minimum impact on the markets are turning to the dark arts, says Simmy Grewal
The goal of any trader is liquidity. Portfolio managers may spend many hours analysing balance sheets and doing due diligence, but the trader's only thought is how to complete those orders with the least amount of market impact. Technology has transformed the equity markets; there has been increased adoption of algorithms and automated systems, and the average trade size on the FTSE has fallen over the last 10 years.
The smaller trade sizes are a result not just of the use of technology but of increased active trading and market fragmentation. With this reduction in trade sizes, traders have turned to alternative execution venues to source all-important liquidity - one of which is dark pools.
Dark pools are defined as execution venues that do not provide displayed quotes, whose core value is in providing access to liquidity while minimizing market impact. While there are nearly 20 dark venues in the European markets, the non-displayed market lacks homogeneity. Broadly speaking, there are four different types of dark pool within the European landscape: block trading dark pools, agency dark pools, multi-lateral trading facilities (MTFs) and exchange-operated dark pools, and internalisation dark pools.
Led by industry pioneers like Liquidnet and ITG's POSIT, block-trading dark pools provide an environment in which large orders can be crossed with minimum market impact. Off-exchange block-trading has always existed, and block-trading dark pools have flourished in recent years due to diminishing order size in the public market and the continuous need from the buy-side to execute large blocks of stock.
Dark pool business models vary. Liquidnet developed the passive trading model in which blotters of buy-side clients are constantly monitored to initiate negotiation-based execution. Here buy-side traders merely commit their uncommitted orders and wait for the contra to emerge. Under the more traditional active trading model, clients must actively enter orders or indications of interest to seek out contra.
Typically operated by independent agency brokers, agency dark pools attempt to cross various client orders that flow through the broker. The key difference between agency dark pools and internalisation dark pools is the fact that agency dark pools lack principal interest in any of the executions. Because of this lack of principal trading, attracting client liquidity into these dark pools can be difficult. Larger agency brokers, such as Instinet and ConvergEx, heavily involve their algorithms to ensure that extensive liquidity flows through crossing platforms.
MTFs have leveraged the success of their displayed order books to create accessible dark books, including Chi-Delta and the BATS dark order book, which have had similar levels of success. Incumbent exchanges have been the unfortunate victims of the increase in volumes across alternative execution venues, and have themselves wandered down the dark pool road as a result, with NYSE Euronext introducing SmartPool alongside the LSE's Baikal project. The partnership between displayed and non-displayed pools of liquidity has proved fruitful, with those orders not completed in the dark being filled in the ‘lit' books.
The largest in the dark pool category, internalisation, encompasses those broker-operated dark pools that can utilise their own account to execute against client order flow. Most of these platforms require clients to opt into involvement of the dealer side. Those dark pools that involve market-making flow (eg, Knight Link and GETCO) are in this category. This specific area is currently under regulatory focus, as most are not registered as Systematic Internalisers or MTFs. Banning or restrictions around broker crossing networks may have a marked negative impact on buy-side firms. Internal crossing of trades has been in effect since brokers first began operating; indeed, it is a foundation of the broker/dealer model. Broker crossing networks are just an electronic version of this pivotal function. Internal crossing is actually more transparent than it was as clients are alerted when their trades are internally crossed and then receive the price improvement. But it remains vital that regulators consider providing standardised reporting, which will help the buy-side understand where essential liquidity is located within the markets.
Dark pools have made the life of the average buy-side trader extremely difficult, as real-time decisions must still be made in terms of where the order should be routed to get the best possible execution, while market fragmentation adds another layer of complexity.
The birth of dark pools in post-MiFID Europe has caused a stir; they are misunderstood by some and downright distrusted by others. Given the lack of a requirement to report and no standardisation among those that do choose to report, many traders remain largely unsure about how much liquidity is actually being executed and how dark they really are. However, dark pool growth in Europe continues.
Combined with uncertainty of executed volume within dark pools, awareness of alternative venues has led to a rise in demand of dark-only, liquidity-aggregating strategies. Algorithms provide a solution for traders who are uncertain about dark execution venues, but who need to access them in case there is a significant amount of volume executing in these destinations.
Institutions considering using dark pools should ask the following questions to those venues:
• What type of order flow will I be interacting with? Investigate the type of order flow (ie, institutional, retail, proprietary, etc) you can interact with in the crossing platform, and ask if periodic performance measurement can be provided per type of order flow that you ultimately interact with. Make sure that you can opt out of interacting with specific order flows.
• Do you use IOIs (indications of interest) and IOCs (immediate or cancel orders)? If so, how? While you might risk a certain degree of information leakage in using them, use of these tools might also increase your chances of getting a fill. Examine each dark pool's policy toward IOIs and IOCs; ask for detailed workflow to ensure that information leakage is minimised.
• Do you link with other dark pools? If so, how? Ask questions about the exact workflow behind how orders or trading intentions are conveyed to other dark pools. Most brokers currently provide access to other dark pools via their dark pool algos and not necessarily directly from their dark pools. Also ask about the type of liquidity mapping expertise that the broker has developed to ensure that your order is being routed to other dark pools properly and not randomly.
• What kind of anti-gaming functionality have you built into the dark pool? The potential for abuse in the dark pools has increased as the market share of dark pools has grown. Make sure that the dark pool is taking an active approach; this will help ensure that information leakage does not lead to opportunities for predatory traders.
Having started out as an island touting diversity of unique internal and customer flow and cost-effective, low-market-impact execution service, dark pools have evolved into something much larger and connected. Given the large number of venues, finding liquidity in them will be impossible so long as information remains in silo. Traders seeking the greatest depth of liquidity need to understand how venues interact.
Simmy Grewal is a senior analyst with Aite Group