The decision for Société Générale to launch a dark pool trading platform, AlphaY, in April 2012 arose from a desire to access liquidity in a safe environment that the firm felt was not readily available externally.
Prior to launching AlphaY, SocGen’s analysis of dark pools led to it developing a series of measures to analyse liquidity toxicity. Each trading venue’s liquidity was profiled to create a liquidity spectrum ranging from safe to toxic. These measures convinced SocGen that there was a gap in the quality of dark pool liquidity and as Mark Goodman (pictured), head of quantitative electronic services, explains:
“We have a lot of hedging flow from our derivatives and Delta One business. By its very nature, this is very safe liquidity so we decided we wanted to fill that gap by creating a dark pool using this flow. That was something that our clients wanted to interact with.”
AlphaY gives clients access to over 4,500 securities and is run using technology provided by NYSE Technologies. Unlike multilateral trading facilities (MTFs), which are obliged to allow all participants to access the pool, AlphaY is run as a Broker Crossing Network (BCN). “By having discretion over who can participate in the pool and who cannot, we’ve been able to construct what we feel is a very safe environment with high quality and large-scale liquidity,” confirms Goodman.
At the outset, SocGen were determined not to bring another “Me too” solution to the dark pool market. As one of Europe’s leading quant-driven brokerages the scale of hedging and Delta One flow put SocGen in a unique position for institutions to tap into a unique liquidity source. The aim, says Goodman, was not only to offer a solution where clients can cross with each other – as they had access to venues which could do that – but to “deliver incremental liquidity from our other activities that’s not available to the same extent elsewhere”.
Being a quant-driven house, SocGen has a strong research team involved in building and refining the algorithms used to source the right liquidity for clients. For institutions that use dark pools, their primary concern is liquidity but not all dark pools represent the same type of liquidity. This can lead to different results when accessing them. Rather than cutting off certain venues altogether, thereby reducing available liquidity, SocGen’s approach is to help clients recognise that “all liquidity is useful some of the time but not all liquidity is useful all of the time”.
This ties back to the liquidity measures it developed pre-AlphaY and as Goodman explains, by being able to measure the quality of liquidity it enables clients to decide which venues to choose depending on the type of trade they’re looking to initiate.
“Consider two types of orders,” says Goodman. “If a client is trading a passive order on both dark and lit venues over a period of time, most algos will allocate some portion of that trade to dark pools. This may save on the spread but it could have an impact on the residual of the order if their trade is signalled to a dark pool participant; in this case the spread saving of the dark pool is not enough to offset the increased cost of adverse selection. If you compare that to a trader who has a lot of short-term alpha in their trades, they need to execute quickly and minimise time risk.
“Their signalling costs (as a result of information leakage) in a dark pool might be 20 basis points but their time risk might be 2 or 3 per cent. They just want to get the orders filled as fast as possible and require access to as wide a range of venues as possible.”
What SocGen is essentially doing is providing a network of liquidity to suit different trading needs at different times, thereby allowing its clients to take a more nuanced approach.
In terms of how SocGen define the quality of liquidity at other trading venues, the first measure is the immediate cost of liquidity. This involves looking at the price just before a trade is executed and just afterwards to ascertain whether or not the other counterparty had better timing.
This measure is then overlain with two factors.
“The first is information leakage, which we measure by looking at the stock volatility after the trade i.e. if the stocks get more volatile after we trade then what we’re seeing is a market reaction to our trade despite it being done in a dark pool. Our execution gave somebody information to react to.
“The second is market impact; this measures the absolute stock direction after we trade.”
What this means is that SocGen does not merely look at the immediate cost of liquidity, but rather it tracks the lifecycle of the order in order to understand the full cost benefit of using the dark pool. In a dark pool the institution may be saving half the spread as they are executing at the mid-point and instinctively this should be borne out in improved performance.
However if the broker doesn’t take into account the impact on the entire order then they are only looking at part of the story.
“I might think I’ve saved 4 basis points because I executed at mid-point but then, because I’m leaking information and having market impact, the stock might move against me by 12 basis points over the course of the next five minutes. If you’re not looking at that you might think you’re saving in the dark pool when in fact you’re not because it’s having an impact on the rest of your order.”
Unsurprisingly, the majority of SocGen’s clients who use AlphaY rely on the trading algos its team develops. This allows for a more customised approach. By understanding what each client is trying to achieve from a trading perspective the parameters are adjusted accordingly, particularly with respect to venue selection.
“Good or bad liquidity is a relative term depending on what you’re trying to do. Because it’s a quantifiable measure the algorithm can use it to determine how much impact it’s going to have on a trade, it knows what the time risk of each trade is, and hence knows which pools to access,” comments Goodman.
All BCNs operated by broker/dealers have the ability to match orders internally (“internalisation”) between clients or with their own proprietary books. This avoids having to access other dark pools. Nevertheless, in addition to AlphaY SocGen accesses a network of around 10 dark pools in Europe. This has enabled it to build out a range of liquidity sources, all of which are different from each other, using the liquidity measures already described.
Again, the emphasis here is to avoid connecting to multiple venues, all of which have the same participants.
“We’re always trying to find the next venue that has a liquidity profile we can’t currently access. We’ve got a fairly broad coverage right now but we’re interested in different crossing rules that are being introduced into different dark pools, which attract different types of liquidity.
“For us, that’s interesting because it might open up new sources of liquidity that we’re not currently accessing,” says Goodman.
Innovation and the ability to cross with new venues will help the liquidity network grow.
