Dark Pools – how much will regulations really impact their existence and what is the way forward

Dark Pools – how much will regulations really impact their existence and what is the way forward?




Johns J. Mangattu

Abstract



Dark pools are a recent type of stock exchange in which information about outstanding orders is deliberately hidden in order to minimize the market impact of large-volume trades. The success and proliferation of dark pools have created challenging problems to the regulator as the trades in the exchanges took a downward swing as the institutional investors turned to dark pools for fast, undisclosed trading and better price discovery. An SEC proposal for increasing transparency into dark liquidity pools has sparked debate in the industry over whether disclosure of trades on a real-time basis could play into the strategies of gamers and high-frequency traders. This paper focuses on the dark pool market size, trends, opportunities and the way forward for this new type of stock exchange. This paper also discusses the dark pool market players, their market share, regulatory concerns, expected regulatory interventions and the fragmentation caused by them in the market.

Introduction



Dark pools are a relatively new type of exchange designed to address the problems that arise from the transparent nature of a typical stock exchange—namely, the difficulty of minimizing the impact of large-volume trades. In a typical exchange, the revelation that there is a large-volume buyer (seller) in the market can cause prices to rise (fall) at the buyer’s (seller’s) expense. If the volume is sufficiently large, and the trading period sufficiently short, such market impacts remain even if one attempts to fragment the trade over time into smaller transactions. As a result, there has been increasing interest in recent years in execution mechanisms that allow full or partial concealment of large trades.Dark pools are a private or alternative trading system that allows participants to transact without displaying quotes publicly.



In a typical dark pool, buyers and sellers submit orders that simply specify the total volume of shares they wish to buy or sell, with the price of the transaction determined by the market. Upon submitting an order to buy (or sell) X shares, a trader is put in a queue of buyers (or sellers) awaiting transaction. Matching between buyers and sellers occurs in sequential arrival of orders, similar to a normal stock exchange. However, unlike a stock exchange, no information is provided to traders about how many parties or shares might be available in the pool at any given moment. Thus in a given time period, a submission of X shares results only in a report of how many shares up to X were executed.



While presenting their own trading challenges, dark pools have become tremendously popular exchanges, responsible for executing 12% (Source: Rosenblatt Securities Inc.) of the overall US equity volume. In fact, they have been so successful that there are now approximately 40+ dark pools for the US Equity market alone.The rapid growth of trades now conducted in dark pools presents significant challenges for regulators and their increased emphasis on transparency. This makes a mockery of efficient-market hypothesis, which has already been damaged by the near-collapse of the financial system. The idea that prices are determined by all relevant information being known in the market at the same time, and reflected in the intentions of buyers and sellers, is the theoretical underpinning of markets. Furthermore, the same large institutions that brought about the 'structured credit derivatives meltdown' dominate dark pools, which could be cause for concern.



The implications for price discovery mean that regulators are beginning to take a closer look at the increasing share of trading volumes now being conducted in the 'dark'. However, the question is whether regulators are too busy with a fundamental rewrite of financial rules to address the issue at present.

Key Trends and Market Size



Dark pools are becoming more popular all over the world and the volume of trades is on an upswing. Recently, more than12 percent of all trading volume in US equities was done through dark pools, up from just 3 percent a few years ago. Currently, an estimated 1% of trades in Hong Kong are conducted through dark pools, compared with 3.5%-4% in Japan and 4%-4.5% in Europe.



Pic 1: Growth of Dark Pool from 2001 to 2008



The Dark Pool trading volume increased after 2008. From 3% in 2008, the dark pool share of transactions reached a high of 12% in 2010. Among the dark pools, GoldmanSachs Sigma X and Credit Suisse CrossFinder are the market leaders in USA. In Europe, SmartPool, a dark pool created by NYSE Euronext in association with JP Morgan, HSBC and BNP Paribas is a strong competitor along with CrossFinder, Chi-X and BATS.









Pic 2: Dark Pool Trade Volume as of January 2010



GoldmanSachs Sigma X used to be the market leader in USA with a market share of 22% among dark pools till the end of 2008. Credit Suisse's CrossFinder has grown rapidly in the past few months, becoming the largest dark pool by average daily matched volume in January 2010.



The number of dark pools operating in each country is on the upswing. The popularity of these exchanges has left large-volume traders and brokerages facing a novel problem: How should one optimally distribute a large trade over the many independent dark pools? Due to this large number of 40+ dark pools, the dark pool market place is highly fragmented. This natural competition could lead many dark pools to go out of business.





Pic 3 : Dark Pools Market Share in Millions of Shares for the month of January 2010.





So volume has become the first and foremost success factor of the dark pools. TABB Group's Tabb adds that the ultimate success of a dark pool will be based on buy-side traffic due to the pricing power they can achieve.



Regulation of Dark Pools



An SEC proposal for increasing transparency into dark liquidity pools has sparked debate in the industry over whether disclosure of trades on a real-time basis could play into the strategies of gamers and high-frequency traders. In October 2009 the SEC issued a concept release detailing rules that would require real-time disclosure of the identity of dark pools and other alternative trading systems (ATSs) on the reports of their respective executed trades. The proposal would mandate that dark pools and ATSs attain specific market participant identifiers (MPIDs).



Currently, dark pools, which are members of the Financial Industry Regulatory Authority (FINRA), report their trades to a trade reporting facility, or TRF, operated by either NYSE Euronext or Nasdaq, or to FINRA's Alternative Display Facility (ADF). But these trades are identified as over-the-counter trades, so the identity of the dark pool that executed each trade is not publicly disclosed.



Currently, all dark pools must report their trades within 90 seconds to the TRF operated by either NYSE Euronext or by Nasdaq or to FINRA's ADF. Market centers (i.e., exchanges) are required to report their trade activity within 90 seconds to the Consolidated Trade System (CTS), but unlike dark pools, regulated exchanges are required to publish the name of the venue on which the trade took place. The large institutional firms can see an awful lot of risk if there is real-time disclosure. The SEC realizes, however, that disclosing the identity of ATSs could cause information leakage that would be damaging to institutions executing large block trades. Hence, the agency's proposal would protect the identity of an ATS executing a large trade with a market value of at least $200,000. Brokers that operate dark pools also are concerned that disclosing trades in real time with a unique identifier could provide gamers with an edge. In a letter commenting on the SEC's proposals, ITG, an agency broker that develops algorithmic trading strategies and operates the ITG Posit dark pool, expressed concern that including the identity of an ATS on trade reports on a real-time basis may allow traders to take advantage of large orders being executed on an ATS.



Considering these circumstances, it is expected that the SEC cannot force the dark pools to give real time reporting to the public. There is a high probability for a ruling which gives real time reporting to regulators and delayed reporting to the market to avoid traders taking advantage of the information.



Product & Service Opportunities



With multiple, imperfectly integrated dark pools, the collective information content of the order flow is impaired, liquidity creation is impaired, and it is more difficult for willing counterparties to find one another. Consolidation of dark pools is a must for the survival of these numerous exchanges. Financial institutions can integrate the various dark pools to achieve better liquidity for their trades.



Buy-side firms are choosing to have their orders crossed first, before trading through brokers. This has added more slicing and dicing of orders, where the buy-side splits orders across multiple execution venues (including their brokers) with the aim of matching with the liquidity present in each.



The sell-side is also seeking to take advantage of dark pools, in an effort to get back order flow lost to alternative venues. Brokers are investing in the creation of their own internal crossing platforms and the development of more advanced algorithms. Moreover, crossing networks are opening up, allowing brokers to trade through them and so linking liquidity to maximise trading opportunities.



Option trading has exploded in recent years, with more than 3.5 billion contracts changing hands in 2009, according to the Options Industry Council. But trading options in the dark isn't like dark equities trading. Currently, options trades cannot execute away from exchanges. So while counterparties can come together and settle trade details on a dark pool platform, they have to route out to an exchange for execution. Option trading is going to be the next driver of growth for the dark pools.



Potential for dark pools in even more asset classes is very much a reality. Whenever there is a highly liquid market that is fragmented and people are looking for a better way of providing execution services, there is going to be a market for dark pool types of platforms.

Summary



Dark pools and other alternative trading systems bring certain benefits to institutional investors. These trading systems enables institutional investors who want to trade promptly, anonymously and in bulk, the opportunity to carry out their transactions:

• With reduced market impact

• At improved execution prices, through the mid-point matching algorithm

• With access to most of the institutional investors who trade in bulk

At the same time, not displaying orders also leads to concerns for the structure of the securities markets. Regulators are trying to bring in controls to make sure that the dark pools are not taking advantage of their anonymity. Due to the increased number of dark pools, the market is fragmented and consolidation or cooperation between the dark pools is necessary to ensure liquidity and their survival. While regulating the dark pools is necessary, hard regulations may affect the exchanges itself by helping the gamers in the market. So the dark pool regulations can be made with a dual reporting system. The dark pool exchanges are here to stay, and they may start participating in other asset classes too in the future.



Key Words/Glossary

ADF : Alternative Display Facility

ATS : Alternative Trading System

CTS : Consolidated Trading System

Dark Pool : A recent type of stock exchange in which information about outstanding orders is deliberately hidden in order to minimize the market impact of large-volume trades.

FINRA : Financial Industry Regulatory Authority

MPID : Market Participant Identifier

SEC : Securities and Exchange Commision

TRF : Trade Reporting Facility

References

1. Ganchev, K. Censored exploration and the dark pool problem, Communications of the ACM, Vol. 53, May 2010, p 99.

2. Mehta, N. Dark pools under the gun, Traders magazine, December 2009, p 16, 22.

3. Sripathma, V. Dark pools : Option trading goes dark, Global Derivatives Magazine, Issue 443, July 2008, p 25.

4. Mathisson, D. Exchanges take on dark pools with new order types, Traders Magazine, April 2007, p. 20.

5. Anonymous, Regulators to shine light on dark pools, Data Monitor, September 2009, p 133-134.

6. Fiacco, D. Accessing liquidity: Sigma and Sigma X, Goldman Sachs presentation to Bright Trading, September, 2008.

7. Trading Talk, Market Structure Analysis and Trading Strategy, Rosenblatt Securities Inc., February, 2010.

8. Bayliss, T. Speed and aggression to hit the dark pools, FTMandate interview, available at: http://ftmandate.com/news/fullstory.php/aid/1444/Speed_and_aggression_to_hit_the_dark_pools.html

9. Willmer, S. Credit Suisse vies for top dark pool slot, AllBusiness article, available at: http://www.allbusiness.com/banking-finance/financial-markets-investing/, 2009.

10. B ogoslaw, D. Big traders dive into dark pools. Business Week article, available at: http://www.businessweek.com/investor/content/oct2007/pi2007102_394204.htm, 2007.

11. Credit Suisse CrossFinder, available at:

https://www.credit-suisse.com/news/en/media_release.jsp?ns=41337

12. GoldmanSachs Sigma X, available at: https://gset.gs.com/gset/offering/execution.asp

13. NYSE Euronext SmartPool, available at : http://www.tradeonsmartpool.com/

14. Dark pool section in Advanced Trading Website, available at:

http://www.advancedtrading.com/crossingnetworks/

Long long ago, my pretty fat friend @ simsr wrote a poem. That came to my mind today, so sharing it with everyone : I need to check it out in the future too

no body loves me
everybody hates me
i'm going to the garden to eat worms
long thin slimy ones
big fat furry ones
gooly gooly gooly worms
long thin slimy ones
slip down easily
big fat furry ones stick
stick to the teeth they wriggle and wriggle
and their juice goes slurp slurp slurp
bite off their heads
and cut off their tails
and throw all the juice away
(nobody knows how)
(i survive on)
(1000 worms a day)
(C) Kshama Singhania :) :)