Dark Pools Are Not Scary Damp Places Where Investors Get Ripped Off

The next step in the discussion about high frequency trading leads logically to the topic of dark pools. I'm constantly mind-boggled to see the same people who were railing against high frequency trading proceed to dark pools as their next target. Why is this so surprising to me? It's simple: dark pools are the antidote to high frequency trading. They're where you go to hide from the computer algorithms that are making lightening fast trades in reaction to the bids and offers you post in the marketplace.

Let's take a quick step back. One component of high frequency trading is what I'll call "pattern mappers" - algorithms that try to deduce how stock prices are going to move based on the bids and offers that are lining up in the marketplace on open books. For example, if XYZ normally trades one million shares a day, and there is a bid posted for 100,000 shares, it might be reasonable for a high frequency trading algorithm, or any other market participant for that matter, to assume that there is more demand for shares than there is supply, and that the price of XYZ will go higher. Of course, there is no guarantee that this will happen, and the person buying 100,000 XYZ may not ever change his limit. So, the algorithm, we'll call her Patty Pattern Mapper, buys stock in XYZ hoping to sell it to the buyer at a higher price. The big buyer, we'll call him Donnie Dark Pool, has other options though. Instead of exposing his bid to Patty's pattern mapping algo on the NYSE, he can enter his order in a dark pool, where no one can see the order. If, and only if, there is someone on the other side of his trade willing to sell shares to Donnie, the stock will trade.

Now, there are some key facts about dark pool trades that lots of people either ignore or fail to understand. First, all dark pool trades, like any other trades, are required to be reported to the tape within 90 seconds. Second, all dark pool trades, like any other trades, in accordance with Reg NMS, are required to take place within the inside market - the NBBO - national best bid/offer. So, no matter how much Karl Denninger would like to construct an example where a stock is trading at $10 on the "open exchange" and there is a seller in a dark pool willing to sell shares at 9.90, which are instantly snatched up by Goldman Sachs (GS) for $9.90 to resell to the open market at $10 - that simply does not happen. The dark pool either routs the seller's order to the open $10 bid, the stock trades at $10 or better in the dark pool, or no trade takes place.

Third, and most importantly, trades in a dark pool, or in any other marketplace, only happen when there are matching supply and demand for shares at a given price. One misconception is that dark pools somehow unfairly allow buyers to buy large blocks of stock without moving the price. Huh? Yeah - they can buy large blocks of stock if there is someone willing to sell large blocks of stock. Otherwise, they can either raise their bid in the dark pool until they find liquidity, or not buy shares. It's impossible to buy "large volumes of shares" at "small volume prices."

An erroneous critique related to this third point is that "large supply of stock should make prices go lower in an open market." David Weidner's column on Marketwatch gives an example of this common thought error:

The problem, of course, is that bulky trades move markets. If I'm at Merrill Lynch and I need to unload 500,000 shares of XYZ, I can place the order in dribs and drabs -- through the multiple public markets out there including the Nasdaq, EDGE and Arca. But that order still is going to pressure XYZ's share price. Also, I'm going to be giving myself away. It also means that XYZ's share price should be lower because there are more shares for sale than buyers. That's how free markets are supposed to work, right?

Is that how free markets are supposed to work? If I want to sell stock at $15, large amounts of it, then the stock should trade lower? No - I don't think that's a requirement of good, free, efficient markets at all. Although, it is one area of market inefficiencies that the high frequency pattern mappers are experts at implementing. The truth is that if I want to sell 1mm shares of stock at $15, the price need not go down at all. The price goes down only when there is no one willing to pay $15 and I lower my limit to $14.95. Then, when I exhaust the demand at $14.95, the price goes down again when I lower my price to $14.90. Supply of stock at a given price (say $15) does not make a stock go lower. Supply of stock at increasingly lower prices without a corresponding match in demand makes a stock go lower - this is a key point, and is not semantic nitpicking. We're so accustomed to trading off of what we think other traders are going to do that it requires some philosophical forethought to understand this concept.

In the ideal market, I believe that the entire marketplace would be dark - we need not even see bid and ask prices - just one last price. Everyone can enter their bids and offers - their supply and demand - into this one big dark pool, and trades would print as matches were made, with no one worrying about being out-traded by Patty Pattern Mapper.

I believe it's totally consistent to have the view that both dark pools and high frequency trading algorithms which exploit the bids and offers they see on open exchanges are ok. However, I think it's logically impossible to be against both these pattern mappers and the dark pools which enable other traders to hide from them. Furthermore, I believe its clear that individual investors are not disadvantaged by dark pools, and elimination of dark pools would result in higher execution costs.

Comments

[athena:]

I believe that what you meant to say is that the liquidity HFT provides is really worth much more in better executions than the extra few cents per trade that we pay..
I believe that is true.

Oct 27 03:38 PM

[Mr MarkToMa...:]

Exactly.

Oct 27 04:26 PM

[dcb:]

There are times in life when you know things are wrong. Dark pools are one of them. Just the idea that we have exchanges offf the book is unamerican. I can assure you banks wouldn't be in such a huff about them if they didn't benefit their bottom line. Please once the banks start telling me how I benefit from something I don't want I know the thing is wrong. All market transactions on open exchanges. If HFT does not allow for trading large blocks of shares then HFT should be done away with. trading stratagies adopt to the exchange, you don't open new exchanges so banks/hedge funds can more easily maintain a trading strategy.

If it cost society more to have an open system where all players receive the same information it is worth the price. god knows what can happen in these pools, and it is simply something I don't want to worry about. seeing order flows, etc. It just opens a can of worms.

Please excuse me if I just decide not to trust banks at their word in this regard.

As for HFT, you should know that there really is no comprehennsive study on the subject. My intuitive gut is that they increase magnify a concept called resonance, meaning when I trade O try to find out what algorhythm the other person is using and follow it. this amplifies highs and lows. I am also sick of see what I think is a run and the HFT trader sells out. it turns the usual signals into useless mush. Very simply there should be a transaction tax. Think about it. the exchanges are paying people to trade on them. No wonder they want HFt. No paying for trading, and transaction tax. if you want to do HFT then do so, but by adding some kind of tax it means one would have to think about things like cash flow and valuation before trading. the idea that you get paid from the system for trading doesn't help anyone.

wth HFT, just mean those who have access to the discount window , and are the exclusive supplemental liquidy providers to and exchange have unlimited fire power in 2000 unit trades to do what ever they want with the market.

Big trades that would move the market and upset those delicate computer algos have to be kept off the system. that's why they don't want it.

Example from Jan to march indexes dropped but vix decreased. Because on lower trading volumes quants can tailor the drop to keep vix down. Big sell orders screw up the quants and that's what happened after Lehman. the systems couldn't cope and algo trading becomes useless. that is why dark pools are wanted. It just makes it easier for them to manipulate the market.

I have sold lots of vix options. I want to drop the market but not pay, I use my HFT quant fund to do it. See Jan to March this year. Means I can be short but not trigger those expensive options I have sold!!!

You think the market going down have anything to do with the call/put ratio being high. Now that the wall street players have sold so many calls they drop it in order not to pay off. they can buy puts, sell vix options, etc. control the movement with high speed computers that move like lightning. You can tailor your program to look at your entire portfolio and max your profits, shorts, call, etc.
Big trades fuck up the program so they have to be taken into dark pools. That is what this is about!!!

Oct 27 05:49 PM

[Moon Kil Woong:]

The author fails to mention the fact that dark pools preclude people like me and you from knowing or executing on such trades before HFT and institutions get to (often they are the same especially with Goldman Sacs the market). If time = money we lose. If time = price advantage we lose. If time = asymmetric information we lose. Please tell me where this arranged system functionally benefits me asides from my broker saving money on execution costs (even though usually they bill customers the same transaction fees).

Increasingly what they trade in dark pools is real supply and demand. What you see on the exchange is HFT games and what you trade on the exchange is arbitrators picking you off on the spread after HFT traders have lulled you into thinking a given price is actually real market demand.

Oct 28 01:00 AM

[Kid Dynamite:]

@MKW - your comment is a common one, and really misses the point: 1) individuals (retail) do not need dark pools when they are trading 100, 500 or 1000 shares lots. 2) the people trading in the dark pools: mutual funds, pension funds, etc, trading large size, are trading ON BEHALF OF INDIVIDUALS! this benefits you greatly if your fund doesn't have the sophistication to compete with HFT algo's on the "open" exchanges.

by the way, when you say that HFT traders have "lulled you into thinking a given price is actually real market demand" you are proving two points in one: 1) that you are trying to trade of your impression of other traders' supply and demand for shares, not your impression of the VALUE of shares - (which is exactly why people hate HFT algo's!!!) and 2) that dark pools have a purpose.


On Oct 28 01:00 AM Moon Kil Woong wrote:

> The author fails to mention the fact that dark pools preclude people
> like me and you from knowing or executing on such trades before HFT
> and institutions get to (often they are the same especially with
> Goldman Sacs the market). If time = money we lose. If time = price
> advantage we lose. If time = asymmetric information we lose. Please
> tell me where this arranged system functionally benefits me asides
> from my broker saving money on execution costs (even though usually
> they bill customers the same transaction fees).
>
> Increasingly what they trade in dark pools is real supply and demand.
> What you see on the exchange is HFT games and what you trade on the
> exchange is arbitrators picking you off on the spread after HFT traders
> have lulled you into thinking a given price is actually real market
> demand.

Oct 28 08:35 AM