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May 1, 2012

Cover Story: Keeping Watch

Bulge bracket brokers scrutinize trading behavior in their dark pools

By Peter Chapman

Big brother is watching.

Using sophisticated monitoring and analysis techniques, bulge bracket brokers are starting to build profiles of the traders in their dark pools. They know who’s naughty and who’s nice, and they are using their newfound information to police the naughty and shore up the integrity of their trading systems.

In the U.S., Morgan Stanley, Barclays Capital, Deutsche Bank, and Bank of America Merrill Lynch
have all developed tools to track trader behavior. Credit Suisse is doing the same in Europe.

Behind the initiatives is an attempt to appease buyside clients, many of whom worry they are getting gamed by their dark pool counterparties.

“We have built an analytical framework and reporting infrastructure around MS Pool that allows us to be proactive in monitoring how the participants are behaving,” Brad Johmann, head of research in Morgan Stanley’s electronic trading group, said of the broker’s pool. “If we do see a participant exhibiting certain behaviors, then we can take appropriate action.”

The behavior in question is using information gleaned in dark pools to turn a short-term profit. Often times, traders are able to discern price trends by trading against orders in these anonymous matching systems. They can then use this information to their advantage, which, in turn, works to the disadvantage of the original counterparty.

Many of these well-informed traders are professionals such as high-frequency market makers and statistical arbitrage shops. The HFT is the favorite bogeyman of the buyside, but, brokers say, well-armed institutional investors should also be feared. 

Enrico Cacciatore

Armed with this new intelligence, the brokers are using it in any or all of three ways. First, they are confronting their “toxic” participants and asking them to change their behavior, or else face expulsion.

Second, they are presenting the information to their customers—without disclosing identities—and allowing them to decide whether they want to trade with the sharp shooters. And, finally, they are incorporating the information into their algorithms, and letting the technology make the decision of which counterparty to trade with.

Taking a hard look at the trading practices of their dark pool participants is a relatively new step for the bulge bracket. Executives at Bank of America Merrill Lynch say they’ve been monitoring trader behavior for about three years, but others say they began just last year.

Previously, dark pool operators categorized their participants into various groups, allowing their customers to avoid those they considered harmful. But tracking every trade is a significant step forward.

To a certain extent, the bulge is catching up to the smaller agency brokers such as Liquidnet and BIDS Trading. These firms have always policed their members’ behavior, typically to make sure they are actually completing trades they started.

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