Friday, March 6, 2009

Wall Street's Secretive and Dangerous Dark Pools

Few things on Wall Street are as secretive and mysterious as "Dark Pools" - stock crossing networks that provide liquidity not displayed in market order books. The biggest implication of this is that an outsized bid can be matched up with an offer in a private transaction without disclosing the transaction at all. Traditional financial markets generate liquidity by openly advertising buy and sell interest in a given venue, with real time liquidity data provided by publishing market depth (think Level 2). Dark Pools, or Dark Liquidity, as they are sometimes known, have been used more and more by brokers and funds in transacting off market in increasingly greater volume.

Dark Pool background

Wikipedia does a good overview of some of the dark pool basics:

Iceberg Orders

Some markets allow dark liquidity to be posted inside the existing limit order book alongside public liquidity, usually through the use of iceberg orders. Iceberg orders generally specify an additional display quantity, smaller than the overall order quantity. The order is queued along with other orders but only the display quantity is printed to the market depth. When the order reaches the front of its price queue, only the display quantity is filled before the order is automatically put at the back of the queue and must wait for its next chance to get a fill. Such orders will therefore get filled less quickly than the fully public equivalent, and they often carry an explicit cost penalty in the form of a larger execution cost charged by the market. Iceberg orders are not truly dark either, as the trade is usually visible after the fact in the
market's public trade feed.

Dark Pools

Truly dark liquidity can be collected off-market in dark pools. Dark pools are generally very similar to standard markets with similar order types, pricing rules and prioritization rules. However the liquidity is deliberately not advertised - there is no market depth feed. Such markets have no need of an iceberg order type. In addition they prefer not to print the trades to any public data feed, or if legally required to do so, will do so with as large a delay as legally possible - all to reduce the market impact of any trade. Dark pools are often formed from brokers' order books and other off-market liquidity. When comparing pools careful checks should be made as to how liquidity numbers were calculated - some venues count both sides of the trade, or even count liquidity that was posted but not filled.

Market Impact

Whilst it is safe to say that trading on a dark venue will reduce market impact it must be noted that it is very unlikely to reduce it to zero. In particular the liquidity that crosses with you has to come from somewhere - and at least some of it is likely to come from the public market, as automated broker systems intercept market-bound orders and instead cross them with you. This disappearance of the opposite side liquidity as it trades with you and leaves the market will cause impact. In addition your order will slow down the market movement in the direction favourable to you and speed it up in the direction unfavourable to you. The market impact of your hidden liquidity is greatest when all of the public liquidity has a chance to cross
with you and least when you are only able to cross with other hidden liquidity that isn't also represented on the market. In other words you still have a trade-off: reduce your speed of execution by only crossing with dark liquidity or increase it and increase your market impact

Imputing the Existence of Dark Liquidity

There are a few ways to guess at the existence of dark liquidity. If you are watching the market depth and see that both the bid and offer have decreased by the same amount, you might reasonably assume that the trade was in fact made, but at a venue not visible to you. However this is unreliable, since there is the chance that two orders were simply canceled at the same time.

If you are actively trading at a dark venue and choose to take liquidity at a given price then you obviously have a piece of information known only to one other participant (the counterparty in the trade!). Additionally if you were completely filled you may reasonably assume that some more liquidity exists at the same price.


Dark pools are open to gaming, but it is a risky business, predicated on being able to guess both the existence of large liquidity and the pricing mechanism being used. As an example suppose that, by whatever means, you believe that there is a large amount of hidden liquidity, say a buyer pegged to the public bid price. If the public market has much less quantity than you suspect is hidden on the bid, you can buy a similar amount of the asset, pushing up the price. Once the price is high enough, you place a limit price buy order of sufficient quantity onto the public market and
simultaneously place a limit price sell order for the total quantity you just bought on the dark venue. You now hope that the hidden order will cross with you at the current high price bringing the profit. This is a dangerous game though: how do you know that the pegged order is really in the dark pool, and how do you know what the volume is? Finally there is also the chance that another market participant will see the anomalous move, decide the market is mispriced, and take it back to the original price without you being able to liquidate your position at a favourable price.

A side effect of the bull market was that more and more broker dealers and independent firms ploughed their way into dark pool creation and management as there was a boom in stock volume over the past 5 years. Some of the most notable market participants are Instinet, ITG, Knight Capital, Liquidnet, NYFIX Millennium, and most of the bulge brackets. Lately, companies have jumped into fixed income dark pools as well, with TMC LLC being an early adopter of the idea of providing off-market corporate bond transactions, having over $1 billion in bond inventory.

We are very surprised that this market hasn't attracted much closer administrative scrutiny. In a testament to how well Wall Street guards one of its best secrets it is shocking that the Democratic congressman from Massachusetts hasn't swooped in on this like white on rice, even more so since it has the word "dark" in its title.

A curious disclosure from Morgan Stanley pitching its second dark pool product MS Pool today highlights some of potential aberrations of order flow within dark pools:

Unlike many other dark pools operating in the United States, MS POOL does not solicit order flow from external parties by leaking information regarding current client order flow. MS POOL also prevents the potential for gaming and manipulative trading behavior by not accepting immediate or cancel (IOC) orders.
Highlighting the inherent flaws in the entire dark pool product is quite a novel way to differentiate yourself from the competition. Also, as the Wikipedia disclosure points out, substantial dark pool usage is a terrific way for parties who may have "semi-legal" information about a company (and have access to a dark pool) to transact in its stock without alerting regulators or the general public, as dumping 100 million shares ahead of a major M&A transaction without alerting L2 at all is likely the most effective way to front run any material public disclosure.

We, of course, are not accusing anyone of abusing the system, just pointing out some of the structural variations in dark pool order flow versus regular markets. And as MS points out, it currently trades over 100 million shares per day in just one of its dark liquidity pools. Multiply this by the over 30 providers of such markets and you approach a number that could be more than half the total share volume trades on the NYSE! We hope MS is successful in signing up more clients for MS POOL ahead of what will likely be a substantial crack down on this market, which in this author's belief, is significantly more prone to abuse than the much maligned CDS OTC product.
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Thomas said...

Thank you for an excellent post. As a former NYSE floor broker, I have always been amazed at the lack of scrutiny of many of the electronic platforms. I find it hard to believe that the buy-side community views this as progress.

dvolatility said...

This is the shadyest sh* I've ever seen.

Anonymous said...

even shadier than hiring an execution trader whose only job is to hide big orders by breaking them in pieces and only showing them in piecemeal?

S said...

Great post. WS is all about creating opacity and this screams the bvery same probelme as CDS. It is absolutely astounding that while the siren calls for CDS onto an exchange grow daily, MS/GS etc are launching new products like this. This is nothign more than a private privalaged market. Unbeliveable. It is sad that Gillian Tett who had it so right on CDOs etc.. has all but disappeared. Would it be novel if someone in the MSm starting writing about this. MAybe this is why GS is down $5 bucks today.

Anonymous said...

Really, Tyler, Wikipedia is your source these days?

Dark pool trades must be 'printed' to the tape within 90 seconds of execution. These transactions are usually recorded in the NASDAQ ADF tape and are visible to anyone with access to time and sales data (hint: it's often a mid penny price since most trade at the midpoint of Nat'l best bid/offer). Dark pool trades clear and settle via the normal equity clearing routes, i.e. thru DTC. Anyone 'dumping 100 million shares of a company' will be cought (hopefully) by the same market surveillance that catches someone who does the same thing on their Etrade account.

Morgan Stanley's claim of 100 mil shares is also of dubious value. When was the last time that a broker was honest about the size of it's business. "We have no need for additional capital sound familiar?"

I appreciate the fact that calling something a 'dark' pool is not a great PR move but your comparison to the CDS market is way off.

Tracy Jordan said...

the reality of dark pools is a lot more mundane.

i'd love to see your writeup on the former advantages held by NYSE specialists.

keep in mind it took a decade of regulation to level the playing field with customers, and we're still not all the way there (close).

Thomas said...

While you may believe that specialists had an "advantage", the old floor-based trading model allowed for transparency and price discovery. Don't forget that the floor was the end of the trade. There was( and is )far more information leakage from the upstairs dealers than ever happened on the floor. The bottom line is that the buyside community has been forced onto the execution platforms of the dealers. These dealers have no obligation to the marketplace and in fact are competing for liquidity along with their customers. The pure buyers and sellers of equities are now clueless and have no way to explore depth or liquidity.