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October 14, 2009

Joint Study Tackles Dark Aggregators

By James Ramage

Also in this article

  • Joint Study Tackles Dark Aggregators
  • Page 2

Tools that help traders reach many dark pools at once can be a detriment to best execution, according to a recent study.

Using "dark pool aggregators" can actually work against you. In fact, they can increase your chances of incurring adverse selection on a trade, where the trade is about to move against you or already has. The institutional electronic brokerage Pipeline Trading Systems and the buyside firm AllianceBernstein reached these conclusions recently after conducting a study on the subject. It's titled: "Adverse Selection vs. Opportunistic Savings in Dark Aggregators."

Adverse selection means selecting the wrong counterparty. Market makers prefer to deal with "uninformed" traders, such as retail customers. They don't want to buy stocks from "informed" traders, such as sophisticated day traders or hedge funds, who know everything about where a stock is going. For example, a dealer does not want to pay $40 per share to accommodate a well-informed seller for fear that the stock will then drop to $30.

Brokerages have been building algos that access multiple dark pools over the past couple of years as solutions to the market fragmentation that so many of the pools have helped create. Different aggregators would let traders access an ever-increasing number of pools at once.

And as dark pool volume climbs, aggregator use becomes more significant. Average daily volume traded in dark pools stands at roughly 8 to 10 percent of the overall market, according to many estimates. But as a percent of the total market volume, participation rates in the dark aggregators--where one trades consistently using them--commonly range between 15 and 25 percent, depending on the aggregator, according to Henri Waelbroeck, vice president and director of research at Pipeline.

Henri Waelbroeck, Pipeline Trading

More than dark pool volume trends, problems of adverse selection can develop from the company you keep. As traders get more of their volume done in dark pools that provide small fills, they interact more frequently with high-frequency trading firms, Waelbroeck said. Trouble arises when high-frequency traders--which represent around 70 percent of overall volume today--use their short-term alpha models to trade at advantageous prices, he added.

"So, as you interact with these guys, if you don't have any kind of control for participations rates [in aggregators], you're exposing yourself to the natural adverse selection," Waelbroeck said, "in that, when you are putting out buy orders, then they tend to execute faster as the stock is about to go down, and more slowly as the stock is about to go up."

But the study also reported that it's possible to both measure and mitigate the severity of adverse selection incurred from using dark pool aggregators. And it said there are tactics traders can apply to use aggregators and reduce adverse selection costs, Waelbroeck said.