It is good that Goldman at least acknowledges the issue of perceived "dark pool"/Sigma X impropriety. I hope Mr. Ed Canaday can now respond in a comparable fashion to the Zero Hedge queries about Program Trading/SLP issues presented here over the past 2 months: after all such disclosures would go a long way toward increasing "transparency, confidence in our industry, and the understanding of our complex market structure."
Emphasis mine.
Valued Clients:
We live in a complex world where technology is driving the evolution of market structure at an exponentially increasing pace. Improved technology has fostered greater competition, lowered barriers to entry for new participants, and increased the total amount of liquidity available in the market. However, this evolution has come at the cost of much greater complexity in our markets.
Recently, much has been written about the need for greater transparency in our securities markets broadly and, of late, this topic has been connected to the dialogue about non-displayed liquidity (so called “dark pools”), and certain order routing practices. However, today, U.S. cash equities operate in one of the more transparent market environments. Trades are reported to the Consolidated Tape, and regulations applicable to this market, such as Regulation NMS, are quite prescriptive with regard to the manner in which orders are executed.
I actually view the current discussion on transparency in U.S. cash equities as an attempt to understand an increasingly complex market structure and set of order routing practices. Currently, it may be difficult for all market participants to clearly understand what transactions have taken place in which liquidity pool, how each pool chooses to disclose its volumes, and, furthermore, how those volumes are accounted for.
To that end, we support the recent suggestion of more disclosure with regards to where transactions have taken place, as well as a move to a standardized volume reporting regime. This will make it easier to compare market venues and understand the true relative size of each liquidity pool. More specifically, we support the reporting of “single-counted” and “matched only” volume as a standard, similar to what exchanges have followed for some time. We believe these suggestions will go a long way to increase transparency, confidence in our industry, and the understanding of our complex market structure.
Accordingly, starting in June, 2009, all SIGMA X volumes will be reported on the basis of a single-count of customer-to-customer shares executed in the SIGMA X AT S. It is our hope that the industry will adopt a similar reporting practice as soon as practically possible.
The last time I discussed dark pools, it was in the context of SEC regulation due to the increasing sense of opacity of what happens in this subset of the stock market. A new Reuters article adds fuel to the fire, indicating that not only are dark pools aggressively taking away from exchange trading action, but it is in fact bank-run dark pools that are the primary culprit.
"Dark pools," where orders are anonymously matched so that traders do not alert the wider market to their intentions, have triggered concerns that stock pricing may not be transparent.
But the growth of those run by broker-dealers such as Goldman Sachs and Credit Suisse are squeezing other "dark" electronic trading venues, as well as exchanges, resulting in lower fees.
"The dark pools are definitely going to grow; the wild card is any new regulation," said Dmitri Galinov, director and head of liquidity strategy at Credit Suisse's advanced execution services, running the bank's CrossFinder dark pool.
Overall, dark market share rose last year, but in the last eight months hit a ceiling near 9 percent of the U.S. market.
And while dark pools controlled by independent private ventures such as ITG would be a perfectly normal response to market demand for liquidity facilitation, it is surprising to discover that a vast majority of the pools are in fact controlled by the very same recipients of TARP funding (who are now doing all they can to issue stock so they can repay their TARP bonus burden).
Dark pools owned by brokers and large market makers accounted for 70 percent of all dark U.S. equity volume in April, up from 64 percent in December and from 58 percent a year earlier, according to Rosenblatt Securities, a widely referenced agency broker that tracks 18 dark pools.
Dark pools, which usually publish trades to the consolidated tape with little detail well after they are executed, have been around for decades, but their brands have gained more exposure in the last few years.
As frequent Zero Hedge readers know, when it comes to program trading on a traditional exchange such the NYSE, Goldman Sachs is by far the most dominant force. It is by Goldman's own admission that the primary reason for this monopoly is to facilitate high-frequency trading in the open market. It would only be fitting that Goldman would be the dominant market player in the dark pool high-frequency market as well. And, as it turns out, it is.
Goldman's Sigma X was the largest in April, followed by market maker GETCO's Execution Services, and Credit Suisse's CrossFinder -- the winners benefiting from the collapse of other investment banks such as Lehman Brothers.
Justin Schack, vice president of market structure analysis at Rosenblatt, said broker-run dark pools had grown because they're faster, cheaper and open to algorithms -- the computerized trading programs that dominate the market, especially during volatile periods such as last year's crash.
"Market structure has changed over the last five or six years in ways that favor small size, rapid-fire trading," Schack said. [SPY IOI anyone?]
The most successful bank-run dark pools have steady participation from individuals, or retailers, whose standing trade orders are gobbled up by high-frequency players who use algorithms and account for about 65 percent of the market.
Why is Goldman Sachs so obsessed with high frequency trading, be it in the open market or in dark pools? Would it have something to do with traditional liquidity providers getting cremated in the current market as a function of usual mean reversion factors getting obliterated.
As was previously noted, the ample room for manipulating this shadow market has been the reason why none other than the SEC has started taking a much more cautious look at what goes on under the surface.
[R]egulators, exchanges and others have raised concerns that dark pools do not publicize their quotes, that there is a general lack of comprehensive data on them, and that some provide early messages, or "looks," to specific market players about upcoming orders.
"I am concerned that (undisplayed quotes) may not promote public confidence in the equity markets," James Brigagliano, co-acting director of the U.S. Securities and Exchange Commission's trading and markets division, told a major market structure conference in New York last month.
Most amusing is the response by Bank of Monetreal's Doug Clark, managing director of quantitative execution services, on whether Canadian banks could launch dark pools: "There would be instant vilification from the rest of the public. So I don't think they're going to do it." So apparently even the "backward national park" to the north is sufficiently advanced to know not to dabble in a form of exchange which is essentially a platform for shady dealing to occur under the public's radar.
And yet, here in America, the investing public not only does not care about these underground exchanges but also welcomes them happily, because they "lower trading fees." But all is well - let's just leave all the dark pool regulation to the SEC. They have proven beyond a reasonable doubt that when it comes to issues such as market manipulation, be it by individuals or semi-nationalized corporations, they are a phenomenal first line of response. And in the meantime the general public will happily keep on buying stocks, unaware of what is really happening on the margin.
For those interested in more data on dark pools, attached is a dated piece by Rosenblatt Securities discussing some of the major aspects of this market, and also validating Goldman's Sigma X market dominance in significant detail.
Also, a good representation of how certain funds take advantage of micro block trading (which may or may not have been done on a dark pool), I refer readers to the following 13-G filed recently by Millennium Partner in Composite Technology Corp: amusingly Izzy Englander's firm discloses the stock offloading pattern in the Schedule A in vivid detail. It is a stunner.
The same "liquidity providers" that have been discussed previously in Zero Hedge, are also in dark pools to make sure trading costs are shifted from observable to less observable or not directly observable. Observable trading costs are the difference from VWAP, open price or arrival price + commission and spread costs. Less observable are bid/ask drift before a dark pool print. For example if I put an order to buy 100k shares of IBM to POSIT, UBS, or GS (especially the latter two where prop traders are more than happy to get right of first refusal on the bid/offer if they so desire) the stock might move up about 10 cents (not an actual observation) and than print my block. Within 15 minutes after the print, the stock is back to being 10 to 15 cents lower. Example of non-observable cost is P&L reversion. In the IBM example, I put an order to buy 100k shares to POSIT. The stock does whatever it would have done anyway and within 30 minutes my block is printed during regular crossing session. In the next trading day, the first 30 minute VWAP will be about 10 to 15 cents lower. So if I buy IBM on POSIT on a regular basis, on average, I can pay 10-15 cents less just by buying the next day on open market. If we factor in higher crossing networks commissions (mostly invisible, charged via net markups), the promise of a free lunch become the reality of very expensive lunch.
Obviously, mutual and pension fund traders have high alpha, they need access to expensive liquidity provided by GS principal bids desk, crossing networks and other means where trading costs are allocated via the "back door" and do not affect buy side traders' bonus scheme payouts. And obviously, teachers, firefighters and the police along with 401(k) investors are on the receiving end. What's new?
In essence, dark pools do not facilitate liquidity provisions over and above what the high-vol players provide, and one can argue, do not lower transaction costs at all - these are merely contraptions that are designed to fool naive traders that immediate vol spikes can be avoided on large block trades, however the cost in the long run is prohibitive enough to where the entire model start cannibalizing itself. Potentially the only benefit from the pools is as an opaque conduit for "not so legitimate" transactions.
Sphere: Related Content
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.
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.
Gaming
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 TMCLLC 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.
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.
