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May 3, 2010

Word For Word

By Editorial Staff

Marie Konstance, an electronic trading sales executive at Nomura Securities International, recently offered her views on misconceptions the buyside has about dark pools. In her piece from tradersmagazine.com, Konstance addressed a number of myths surrounding dark pools. Here are some excerpts.

 

Myth: Pinging is bad--

A "blind ping," defined as an immediate-or-cancel (IOC) order for a small quantity to find liquidity, is a term of derision. Pinging is reputed to be a sign of nefarious activity on the part of high-frequency traders trying to sniff out liquidity and manipulate prices. Well ... maybe, and maybe not. Actually many brokers' algorithms use blind pings to find liquidity and increase the liquidity capture for their buyside clients. (These algorithms attempt to find hidden orders on lit markets as well).

 

Myth: Comparing crossing rates is the best way to analyze dark pool liquidity--

It is meaningless to compare dark pools by using crossing rates provided by different brokers, and not just because of normal marketing spin. The problem is that while the numerator--the execution quantity--is known, the denominator--order quantity--is actually a pretty nebulous concept, and brokers can calculate this in different ways. Some clients put in new orders every time they change a limit; some use a cancel-replace in which many variations of an order are part of the same order. Does the broker count each new order, or try to link orders that just have limit changes?

 

Myth: You must avoid dark pools used by high-frequency traders--

Again, ask yourself if you want dark liquidity. Some of the biggest pools have lots of high-frequency traders. And who are these guys? People from market makers to stat arbs to some fairly unfriendly folks play in dark pools. It is not at all clear that you will be disadvantaged by trading with high-frequency traders--the issue is muddied, as toxicity in dark pools can be very hard to measure or prove. What looks like a bad trade can be caused by many factors.

 

Myth: You use dark pools only for price improvement--

Midpoint pegs are nice, but if you are looking to trade a stock with high adverse momentum, consider pricing aggressively. Many traders cause their own adverse selection, missing opportunities to trade quickly when needed, in their attempt to capture spread savings. And don't forget that another advantage of dark pools is potential size improvement by getting filled at a larger size than the quote. Many algorithms and smart routers send oversize IOC orders to seek attractive liquidity.

Marie Konstance, Nomura

 

Conclusion--

Please don't misunderstand: Dark pools are not without their dangers. (Neither are lit venues, for that matter.) However, dark pool providers want to ensure that investors come back and trade tomorrow. This gives them an incentive to police their membership. The bottom line is to put your trading objective first when using dark pools.

 

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