By James Williams – With dark pools appearing a lot more in media headlines this year, understanding some of the benefits, and risks, for institutions who have yet to fully engage with them, is vital.
Such has been the media coverage recently that last month Credit Suisse took the decision to stop publishing data on their CrossFinder dark pool to Rosenblatt Securities. In the context of whether dark pools are good or bad, the decision was perhaps understandable given that CrossFinder is the largest dark pool in the US.
And, staying out of the spotlight illustrates one of the core advantages of these venues: anonymity. This is especially important for institutions like mutual funds and pension funds who need to trade large blocks of stock away for the glare of the ‘lit’ markets.
“That’s what a small number of independent dark pools like Liquidnet are providing. The benefit to trading a big block with a fellow buy-side institution is that it’s going to reduce your market impact costs and information leakage to the marketplace,” explains Justin Schack, managing director at Rosenblatt Securities. However, Schack notes that as the dark pool space has evolved over time, block trading has actually become a small minority of dark pool activity.
He adds, “Mostly, now, those block trades are being sliced and diced by trading algorithms into smaller ‘child’ orders, and the pieces are executed over time at the exchanges and various dark pools. There’s still a measure of benefit to executing those in the orders in the dark. You might not want to be on an exchange with numerous types of counterparties. Staying in the dark allows you to interact with similar types of clients and doesn’t require you to quote out loud.”
Another advantage to the buy-side community using off-exchange venues is to avoid interacting with high frequency traders. Some argue that the toxicity of order flow in dark pools is less than it is on the exchanges right now. Firms like Barclays Capital have spent time putting measures in place to help their clients’ order flow avoid interacting with toxic liquidity. Barclays LX has what is referred to as a “toxicity framework”, which involves close monitoring of all end-users providing liquidity to its clients.
“Regardless of who you are, we’ll look at your flow in aggregate and if it shows up as being toxic we’ll benchmark it into five different groups. Clients can then look at what pools of liquidity they want to trade with.
“I call it the IRS Theory. When you’re watching behaviour to that degree, behaviour changes. If an end user has been delivering low rated flow we tell them, ‘Either change it, or don’t send it here’. We give them the ability to break up their low toxicity flow versus their high,” says Bill White, head of equities electronic trading at Barclays Capital.
Toxicity, says White, is defined in Barclays LX in terms of what the price of that order was when it arrived, which then gets assessed in multiple time sheets. “Generally if someone is coming in and taking liquidity aggressively the bid is going to change. So we look at it in time series.
“We have an algorithm and a scoring methodology that basically creates a liquidity spectrum. The far left being passive and low toxic liquidity, the far right being aggressive, high toxic liquidity. As we are able to restrict HFTs interacting with our clients we’re getting the better half of their order flow (i.e. higher quality liquidity) such as hedges or low impact positions.”
TORA trading is one of Asia’s leading dark pool venues providing liquidity between buy-side to buy-side institutions. Given the nature of Asia’s markets, and where the bulk of institutional trade flow originates, Japan and Hong Kong are two of its most important markets from a trade flow perspective. Crosspoint is TORA’s native liquidity dark pool, while TSOR is the smart router that sits on top; this is what conducts flow in and out of the pool.
Chris Jenkins, managing director sales and operations, says that TORA is different to other dark pools in that the institutions participating in the pool access it via it’s Compass OEMS product “so we know their profile and also work with them to understand what they want to achieve by participating in the pool”.
“When we allow clients orders to interact with other dark venues, that’s when the toxicity issue gets interesting,” says Jenkins.
“We’re connected to nine other dark pool venues for the Japan and Hong Kong market,” says Gerrit van Wingerden, managing director at TORA Trading, Japan.
“Each month, for every client we look at each fill that they’re getting in each of the venues that we’re routing to and compare how those fills do, on average, compared to the primary market in a two minute time window. If, on average, those fills are getting a similar or slightly better price the pool is “neutral”. If, on average, they are getting fills that are worse than the market, then it’s toxic. And obviously if they’re getting fills that better priced than the primary market then its less toxic.”
Like White, van Wingerden says that TORA works with the brokers running these other venues and gives them examples of situations where their clients are getting consistently bad fills.
“Typically they will say ‘By default we cross you with all sorts of flow and if you want to, we can turn off opportunistic flow’. Once that happens, the toxicity measures in these venues improves significantly.
“So my advice to anyone that is interacting with dark pools would be to assume that you’re going to get the worst possible settings by default. Ask the broker, or whoever it is operating the pool, what type of flow you are interacting with and whether you have the option to opt out of interacting with certain types of flow. That will make a material difference to the quality of fills that you’re getting.”
Another significant advantage to institutions that trade in the dark is price improvement. Liquidmetrix is an independent research company that, amongst other things, measures average improvement across various off-exchange platforms. Data shows that for March 2013, venues such as BATS Dark, BlockMatch, Turquoise Dark and UBS MTF delivered average price improvement of between 3.7 and 5.3 basis points. Liquidnet, which caters for institutional block trading, delivered average price improvement of 106 basis points.
“Large institutions need efficient ways to trade large blocks of stock. Using dark venues like Liquidnet, enables the end investors to enjoy significant price improvement and minimised market impact, directly affecting asset growth. One hundred basis points is a big improvement for institutions that trade hundreds of millions of euros in stocks each year.
“Obviously, institutions pay a commission for trading with us, but the implicit price improvement that you get by minimising market impact is clear,” says Per Lovén, Head of EMEA Corporate Strategy and Product at Liquidnet.
This ability to trade safely and anonymously in the dark, without showing your hand to the lit market, means that venues like Liquidnet ultimately help to reduce volatility in the market.
But not all dark pools are like Liquidnet. They come in a variety of flavours and cater for an increasingly wider client base. In the US alone it is estimated that there are around 45 dark venues. Add to that the 13 or so exchanges, and one gets a clear idea of just how fragmented, and complex, the marketplace has become.
It’s that inherent complexity that is seen by some buy-side institutions to be a major disadvantage. That there are now so many smart router options and dark venues to trade in means that liquidity is drying-up.
“Think about it: there are, say, 45 dark pool venues. What is the probability that someone on the other side is going to be executing the same size order to fill? It’s so low. It’s a very inefficient structure. A lot of buy-side firms will call their trading algorithm providers and say ‘Cut off this pool and that pool because there’s too much toxicity in there’. That creates an even more fragmented market structure. If it changed whereby we could execute more size, at more depth, that would help,” explains Anthony Godonis, senior equity trader at Aberdeen Asset Management.
Aside from the sheer proliferation of dark venues, the average order size is falling. This too is perceived as a disadvantage. As the broker-owned dark pools have an incentive to keep trade flow away from the lit markets, every order that comes through will either attempt to be matched up internally, or be sent out to third party venues. This all happens in a split second. The problem is, says Godonis, that orders are not being rested and being pinged to the dark pools with which each BCN interacts; and that means information leakage.
“If there’s a resting order on the sell side then it’ll get executed but if nobody is resting any orders it’s difficult, and perhaps explains why the average share size is falling. If more orders were forced to rest that would help. However, no matter what you trade, the high frequency aspect of the entire business means that there’s always signalling.
“These issues may seem trivial, but small execution sizes really give the higher frequency traders a window into what’s going on. If I buy 3,000 lots of a specific name, they are going to know about it. It gives them the information they need (to potentially move the market against you). It may be in a lot of smaller pieces, but it gives people an idea into what institutions are doing. It’s not hard to figure out. These pinged orders, right now, are just spraying everywhere and not resting anywhere. That’s information for someone else to trade on,” stresses Godonis.
When asked whether something like the proposed trade-at rule would help institutions like Aberdeen, Godonis adds: “Whether it’s a dark pool or a primary exchange, I don’t care where the order trades but more size needs to be available at a price. There’s no depth of execution anymore. What does it accomplish by trading 250 share lots in the dark? It the trade-at rule being talked about means that more volume gets executed then I’m all for it. It’s gotten so frustrating.”
Liquidnet’s Lovén says that the marketplace has become undoubtedly more complex and that buy-side traders today have to be execution specialists as well as market structure experts: “A lot of the brokerage firms have become more like execution consultants to large institutions. They need to understand what their clients are trying to achieve with their investment strategy and find the best solution to execute the trade within minimal market impact.”
On the signaling risk – information leakage – to using dark pools, Schack says it goes back to the fundamental conflict that brokers face i.e. the economic incentive to seek executions on behalf of clients on the lowest cost venues, with exchanges being the venue of last resort. Ironically, these are often the venues that offer the best liquidity.
“There is a danger that as a child order goes unexecuted at multiple venues, other traders learn about that order. There’s also a chance that the price might move against you while your broker is checking all these different venues to get a better deal for itself on the fee.
“So there’s information leakage risk, but also price risk. The best offer for a given stock might be USD16 on Nasdaq, for example. If your broker first checks a number of cheaper venues before eventually lifting the Nasdaq offer, the price may move and you might wind up buying at USD16.01.”
Godonis says that he’d like to see longer resting times for orders, or even a delay in the execution reporting back to the consolidated tape, so as to lessen information leakage.
And as for the proliferation of child orders being pinged all over the place, he adds: “There needs to be some sort of tool, electronically, either at the router level or the exchange level, that funnels these orders into one central place so that they can match up and trade."