Introduction Dark pools are a complex topic subject to misunderstanding amongst the broad public, media, and government regulators. To help provide a better perspective, we discuss the evolution of equity markets that led to the development of electronic trading, dark pools, and current market structure. We move on to analyze dark pools and their overall impact on trading. We then discuss further aspects of dark pools in particular, and consider regulation and global trends in market structure.
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Historical Perspective on Equity Markets The first modern equity market was established in the Netherlands in 1610 with the biblically traded shares of the Dutch East India Company. Financial transactions had taken place since the dawn of civilization, but 1610 was a milestone towards the development of the equity markets we know today. Because equity securities represent transferable ownership interests in corporations, dividing business organizations into small, affordable pieces made it easier for entrepreneurs to raise capital from multiple sources.
At the same time, limited liability allowed investors to diversify their investments without fear of incurring risk of personal accountability. Enhanced liquidity also eased transfer of ownership. Secondary markets for the securities of public firms quickly developed as the number of companies increased. Merchants and traders bought and sold securities Just like other commodities, and specialization soon flourished. Stock exchanges were developed to enhance liquidity, transaction settlement, and protect broker commissions.
The New York Stock Exchange(NYSE) originated out of the famous Buttonwood Agreement of 1792, in which a group of 24 brokers agreed to exclusively trade amongst themselves and fix commissions at a minimum of 0. 25%; this system of fixed commissions lasted until 975. Technology has always played a prominent role in driving the evolution of financial markets. The invention of the telegraph and stock ticker, for example, in the nineteenth century made it possible to transmit price and order information quickly and over large distances.
Indeed, it was the skillful use of the stock ticker to efficiently disseminate pricing information that led the NYSE to become the dominant stock exchange in the United States. Years later, the rise of computertechnology would fundamentally change the economics and future development of markets. The sass dinettes the creation of NASDAQ (National Association of Securities Dealers Automated Quotation) and Instinct, an electronic quotation system. Traditionally, non-exchange listed stocks (ETC securities) required brokers to request prices and trade over the phone.
Page 2 Dark Pools – Investment Banking Essay
NASDAQ and Instinctallowed brokers and dealers to electronically publish quotes (bid/ask prices) on a consolidated display, which encouraged information efficiency, reduced spreads and improved liquidity. NASDAQ and Instinct gradually established a network effect to attain a critical mass of brokers and built the necessary operational and regulatory infrastructure to become formal electronic stock exchanges. A major scandal erupted in 1994, when NASDAQ dealers (e. G. Arrest makers) were accused of colluding to maintain wide bid/ask spreads, Commission (SEC) responded in 1996 by imposing order handling rules that required brokers and dealers to publish customer limit orders in their quotes (which were previously hidden at their discretion) and execute client orders at the best published price. Further regulatory and political pressure on exchanges and Wall Street decreased the minimum quote variation (I. E. The minimum price interval between bid/ask) from 18th of a dollar ($0. 125) to 1/16th ($0. 0625) in 1997, and to generalization ($0. 1) in 2001 to encourage competition. Finally, in 2005, the SEC established Regulation National Market System (Erg MS) which required exchanges to honor the best quotes of other exchanges and established regulations for sub-penny pricing increments (< $0. 01). The combination of regulatory change and advancements in technological capabilities led to a proliferation of change within the markets industry. Bid/ask spreads and average trade sizes fell dramatically, while total trading volume increased (Figure 1 and 2). Computers replaced human market makers, and trading profits shifted from the club world of
Wall Street trading firms to proprietary technology firms that could execute faster trades and arbitrage prices across exchanges. Exchanges around the world adopted fully automated trading systems, closed their trading floors, and converted from membership organizations into publicly traded Joint stock companies to raise capital in order to respond to increasing competition and a new wave of alternative exchange venues such as electronic communication networks and dark pools (Figure 3 and 4). Figure 1, Market share of NYSE listings 2006-2010 Figure 2, Market share U.
S Equities June 2010 Figure 3, Average trade size in U. S. Markets percentage of total 2002 – 2010 What are DARK pools? Figure 4, Electronic trading as U. S Equity Trading The evolution of equity markets has created additional options to execute trades outside the primary listing exchange. Dark pools are one of these alternatives and its popularity continues to propagate, gaining market share over the traditional exchanges. Institutional traders, defined as those who represent large pools of capital, have always faced challenges with buying and selling large positions of securities.
Typically, trading large positions involves breaking the large order into mailer ones and participating in the daily trading of a security (I. E. Trying to disguise your order), and at the same time searching for an institutional buyer or seller on the opposite side who would be willing to transact a large amount in a negotiated transaction. A particular concern for institutional traders is information leakage about their position and trading intentions. If word got out that a large investor was buying a stock, traders would quickly buy the stock with the expectation that they would be able to resell it later at a higher price.
In the past, this conflict created an opportunity for sell-side brokers to create value for their institutional clients by with their book of clients to see if anyone was interested in a large cross transaction (I. E. Trading a big block of securities directly between two clients and avoiding the stock exchange altogether). An expert broker was said to “know where the bodies were buried” (I. E. Know which institutional traders were interested in which stocks) and be able to trade large amounts of securities with minimal information leakage.
With the advent of electronic markets and advancements in technology, many banks plopped trading algorithms that could take a large order and trade it in an intelligent manner to minimize trading impact, essentially replacing the Job formerly done by human brokers and floor traders. Banks soon rolled out the algorithmic trading products directly to institutional clients. New electronic products were also being developed to assist with the second liquidity challenge for institutional traders – that of finding a large counterpart with whom they could directly transact outside of the exchange.
Liquidate, an independent technology company founded in 2001, as a pioneer by creating a trading venue in which an institutional trader could directly, electronically, and anonymously, cross large blocks of shares with other institutional traders off of the exchange. Liquidate is considered one of the first dark pools. Institutional traders were keen to transition to the use of dark pools because one of the inherent risks of using human brokers was exposing orders and trading intentions to counterparts.
Even the use of skilled and trusted brokers required disclosing information to counterparts to gauge trading interest, let alone the risk f information leakage along the way, I. E. Overheard on the phone, to bank traders, and floor traders. The operational workflow of sending or communicating an order to a broker was prone to information leakage at all stages. Dark pools capitalized on this opportunity, yet faced the challenge of acquiring enough institutional clients to generate trading volume.
This concept of “network effect,” wherein those pools that create a critical mass of volume offer the most value for clients as well as create barriers to entry for competitors, is important to understand because efforts to attract trading flow could possibly contradict the best interests of its clients (e. G. Providing incentives to predatory hedge funds or high frequency trading firms to provide trading volume). Global investment banks also realized the benefits of dark pools for their clients, and created proprietary dark pools in which clients could cross shares internally, these types of dark pools are known as broker operated dark pools.
Credit Guise’s Crossfire and Goldman Cash’ Sigma X are the largest of approximately 19 dark pools in the US, with a combined market share of aggregate traded volume around 3. %. Broker dark pool executions are particularly beneficial for investment banks because it reduces the costs of sending an order to an exchange (which typically charges a per-share fee for execution) and incentives clients to use their trading services. Broker dark pool market share as a proportion of total traded volume was about 13% as of 2012.
The definition of dark pool executions is debatable in professional circles, but can be interpreted as executions without being made biblically available via an exchange limit-order book nor executed against a published limit order. As such, dark execution also includes what the SFA Institute describes as “Initialization/Retail Market Making” which involves broker/ dealers “internally executing client order flow against their own accounts on a banks and proprietary firms that execute against client orders before they are sent to the market.
These executions are subject to best execution regulation and offer slight improvements to the National Best Bid/Offer (N.B. – the published bid/ask quote). The brokers/dealers attempt to create enough liquidity within their own order book to make markets (I. E. Eying and selling stocks in their inventory and profiting from the spread), replacing the prior era of human market makers. The SFA Institute estimates this category to include over 200 broker/dealers and market making firms, composing 18% of consolidated market volume.
Although dark pools may seem complicated, understanding that dark pools are electronic evolutions of tasks formerly carried out by people will help place them in context. About half of dark pool volume occurs in institutional client dark pools, where large traders can trade big blocks of stock without revealing to the market their trading intentions. The other Alfa of dark pool volume originates from electronic market makers, who execute client orders with slight price improvements to the best bid or offer.
After a trade is executed in a dark pool, the trade information (price and number of shares, but not the venue) is reported to the consolidated tape, the real-time electronic information feed that disseminates all trade execution information. Figure 5, market share for US market constituents Dark Pools Impact on Trading There is a lot of debate in the media and investment community over the advantages and disadvantages of dark pools, and what should be the likely future path of regulation. On the positive side, dark pools provide a venue for institutional traders to discreetly transact large trades without adverse market impact.
These traders often speak in favor of dark pools and because they typically represent money invested by the public (I. E. Other people’s savings), their interests are thought to be aligned with the broader investment community as a whole. On the negative side, dark pools may hinder the price setting mechanism of equity markets because of the potential distortion of real supply and demand. Proponents of lit markets (I. E. Exchanges) are often, unsurprisingly, the exchanges themselves who have lost significant market share to dark pools and alternative venues.
Evidence points to the US as the most efficient equity market in the world with high liquidity, low spreads, and low costs (see figures 6 and 7 below). Dark pools and other market fragmentation trends create the need for institutional traders to stay informed about the complexities of market structure and order routing. Dark pools are essentially technological evolutions from older broker-mediated transactions. As such, the often quoted growth in dark pool market share in the media can be misleading – these types of transactions have always occurred.
It is also intuitive that because of the increased efficiency of trading in general, due in some part to dark pools, that more trading occurs. Because of increase in trading, the price discovery mechanism becomes more efficient. In any case, there are tangible benefits of dark pools for institutional investors such as savings on spreads (dark pool executions typically occur at the midpoint of the bid/ask spread), transactions costs (electronic dark pool information discretion. The same benefits have accrued in many ways to the retail investor as well, who benefit from historically low commissions (Charles Schwab hares a flat $8. 5 per trade fee) and spreads. Figure 6, Institutional commission per share Figure 7, Bid/ask spread in the U. S. Market 1995-2009 versus other developed markets: 2010 There comes a point, however, that too much trading away from the exchanges could negatively impact the market’s price-setting mechanism. At the extreme, 100% of trading volume in dark venues would completely inhibit the price discovery process. The SFA Institute performed a regression on several variables in an attempt to calculate the optimal proportion of dark executions as a percentage of consolidated volume (see Figure 8 below).
Although the calculations likely involve several debatable assumptions, an important takeaway is that today’s proportion of dark liquidity, approximately 31%, is well within the probable range of contribution to efficient markets (as defined by bid/ask spreads). Figure 8, Estimated relationship between aggregate underplayed trading and bid- offer spreads An indisputable aspect of today’s equity markets is the increased complexity of market structure, and the need for institutional investors to be progressively vigilant regarding order routing.
Traders rely on electronic trading algorithms (often supplied y the sell-side) to break up a large order and route smaller pieces to various venues for execution. This routing logic has become increasingly important, especially as several dark pool scandals have been revealed (covered later in this essay) and venues continue to differentiate by the “quality’ of their trading constituents.
Because dark pools are less regulated than official exchanges, they are able to exclude specific participants such as hedge funds or high frequency trading firms who may be able to “sniff out” a larger order and trade accordingly to the detriment of the institutional trader. Institutional traders must balance the tradeoff of accessing liquidity across a variety of venues and keeping their trade information confidential – much like they used to with human broker counterparts, but now facilitated by electronic innovation and tools.
Figure 9, graphic display of hypothetical order routing of an institutional trader to sell 15,000 shares. Keep in mind there are over 13 exchanges, 19 dark pools, and over 200 broker/market makers! In conclusion, the increased competition in equity markets, due to deregulation and technological innovation that have led to developments such as dark pools, appears o have contributed greatly to market efficiency, as measured by liquidity, trading commissions, and bid/ask spreads.
However, the resulting complexity of market structure creates challenges for institutional traders to efficiently route orders and oversight and transparency over dark pools and alternative trade venue structure and operations, which are subject to relatively lax requirements in comparison to traditional exchanges. Hot Topic: 2010 Flash Crash An example that shows the need for a better understanding on new technology developments and market structure, as well as the call for increasing regulation on OTF from certain politicians, the media, and exchanges, is the 2010 Flash Crash.
Within a short 5-minute period the DEJA was down 9. 2% after which the indices recovered much of the loss in a short period of time. Executions in various prominent individual stocks such as Proctor & Gamble, Accentuate, and Apple were recorded at prices as low as $0. 01 and as high as $100,000 as liquidity completely vanished from the market. At the nadir of the day, it was the biggest single-day point decline in the DEJA history. (Figure 10) Figure 10, The Flash Crash Popular press, often misunderstanding these highly complex topics, blamed High-
Frequency Traders (HFTP), algorithmic trading glitches, and even human error for the incident. The US Congress took the opportunity to call for increasing regulation on markets, including the ominous-sounding “dark pools”. Five months later, the SEC and CUFF (U. S. Commodity Futures Trading Commission) published a report absolving dark pools of any wrong doing. However, the inability of regulators to point to any one cause for the crash allowed the press, politicians, and the NYSE, which had lost market share to new exchanges and dark pools, to continue blaming various aspects of the financial industry for the crash.
Dark pools were increasingly scrutinized and proposals were put forth to ban them outright, subject them to “price-improvement” regulations that would hinder their operations, or other measures that often appealed to an uninformed public but were continually opposed by those in the industry, especially the buy-side traders whose interests are aligned with retail investors and the general public.
The Flash Crash acts as an important reminder of unforeseen events that often serve as catalysts for regulatory officials to play off of public reaction, and push through reforms that create unforeseen consequences that eave driven the evolution of equity markets that we know today. Although dark pool regulation continues to be discussed in the news, albeit under increasingly balanced perspectives, regulators have delayed implementing any recommendations. The Flash Crash highlighted the need for regulators and investment public to understand recent innovations in technology and market structure.
Regulating dark pools Regulators legalized the operation of dark pools through regulations like Miffed in Euro area and Regulation TATS in the US, both of which came into force in 2007. Regulators from Japan, Australia, Canada, Hong Kong and Singapore also have pacific requirements with regards to operating dark pools. Some of the common regulatory features involve licensing from the regulator and sharing all trade related information with the national stock exchange. Efforts have been made to restrict the trade volume or mandating that dark pools offer meaningful price improvement over displayed best bid/ask available on the exchanges.
Support for further regulation against dark pools has been prompted by concerns about price discovery on stock exchanges as well as toxicity of dark pools and charges of information leakage. Toxicity refers to interaction of the buy side investor with High Frequency Trading firms (HFTP). Some of these Hafts use a momentum strategy which allows them to detect large orders from buy side institutions before the orders are executed thereby allowing the HFTP to trade ahead of the order.
Institutional investors, who are major contributors to trading fees on stock exchanges, are finding it increasingly attractive to trade on dark pools due to their depth of liquidity. As off-exchange volume has increased and trading revenues have dropped, stock exchanges have been expressing concern about the effect on price discovery due to these alternate trading platforms. Dark pools have been subject to two recent scandals raising concerns about order routing and information leakage.
Pipeline Trading Systems and LeveL TATS were both independently operated dark pools that advertised themselves along the traditional lines of offering a dark venue for client orders to interact. More than 100 broker-dealers routed orders to these trading venues. In October 2011, the SEC fined Pipeline $1 million for operating an undisclosed proprietary trading subsidiary that executed against client orders resting in its dark venue. The trading subsidiary allegedly traded ahead of client orders (I. E. Rant running) and executed against resting client orders at adverse prices. In October 2012, the SEC fined ibex- operator of dark pool, Level TATS – $0. 8 million for failing to protect customer’s confidential information. ibex was charged with sharing unexpected client order information with a third party technology firm, without informing participants. Both scandals demonstrated a blatant disregard for the confidentiality of client orders and have raised concern amongst buy side institutions about information leakage transparency, and toxicity of dark pools.
In the US, regulators are reviewing whether maximum average trading volume could be set up at 0. 25% of consolidated volume, beyond which dark pools would have to display bid and offer data. Real time disclosure of executions by all venues might also be made mandatory. In the Euro area, the Markets in Financial Instruments Directive 2 (Miffed 2), which is set to be tentatively implemented by 201 5, is proposing regulations that could effectively end the working of Broker Crossing Networks (BCC) as dark pools in Europe.
Miffed 2 proposes introduction of Organized Trading Facility (OTF) as a new category of jugulate trading venue to capture all the alternative trading venues that are currently unregulated. The definition of OTF includes “broker-crossing networks”. OTF have to comply with the same transparency rules as regulated markets and Multi-lateral Trading facilities (MAT – the European equivalent of the US Alternative Trading Facility). Miffed 2 also proposes to slow down Hafts by imposing a 500 millisecond minimum resting time for orders.
Australian Securities and Investments Commission (ASIA) has proposed minimum order thresholds of $50,000 and $20,000, depending on the size or class of the company’s shares being traded. It has also reposed reducing the tick size, which is a measure of price improvement used to determine whether shares must be traded in the dark or lit markets. For HFTP trades, market before they can be withdrawn, to reduce the impact of small and fleeting orders on the market.
There are several important takeaways from these events. Market regulators such as the SEC are behind the curve in terms of effective regulations of recent technological advancement, yet must strive to ensure sufficient transparency of dark pool operations and integrity. Broker-dealers and buy-side institutional traders must increasingly understand the intricacies of order routing ND perform quantitative and qualitative evaluation to study potentially adverse executions.
Credit Issue, for example, evaluates short term alpha generation (unexplained, statistically significant short term trading profits) of dark pools and shuts off order flow to venues that exhibit consistent alpha against its client orders. Global trends in market structure As described in the previous section, certain market participants have been pushing to restrict the volume of orders executed through alternative trading venues. Nonetheless, there are initiatives in the global market to boost competition and increase the use of alternative trading venues such as dark pools.
Using the US equity marketplace as a template for increasing liquidity, decreasing costs, and improving market efficiencies, investment banks have worked closely with market regulators around the world to deregulate equity market structures. European regulators have been most adaptive as increasing financial integration within the Euro region coincided with the increasing competition and deregulation of national markets towards international exchanges, cross-listing, and alternative trading venues including dark pools. Dark pools now compose about 10% of pan-European consolidated volume.
However, the current state of affairs in Europe is extremely disorganized due in no small part to competing interests across international and national regulatory bodies. There are many different and sometimes contradictory classifications and requirements for exchanges and venues, which can create additional complexities for institutional traders. For example, a broker who conducts a guaranteed MAP (volume-weighted average price – a price benchmark for trading) transaction with an institutional client must report the volume to the exchange twice once for the MAP transaction, and again for the underlying trades.See More on Stock Market