Commentary: Dispelling Dark Pool Myths
Don't fear the dark
Traders Magazine Online News, April 8, 2010
Among buy side traders, there are misconceptions about how to evaluate and use dark pools. This article is an attempt to challenge some of these beliefs and offer some guidance on their use. In my prior experience managing and analyzing dark pool performance, there is a big difference between the myths and the reality of dark liquidity.
Marie Konstance, Nomura Securities
Myths:
1. Pinging is Bad
A ping, or a "blind ping", defined as an Immediate or Cancel (IOC) order for a small quantity to find liquidity, has acquired a negative connotation. Pinging has been cited by some articles as a sign of nefarious activity by high-frequency traders trying to sniff out liquidity and even to manipulate prices. Actually many brokers' algorithms use blind pings to find liquidity and increase the liquidity capture for their buy side clients. (These algorithms also attempt to find hidden orders on lit markets as well.) They do it, but they don't talk about it too loudly because of common misperceptions. This leads to the second point:
2. You should prevent pinging with high minimum share constraints on your algorithms.
This applies only if you are not terribly interested in getting orders filled. If you curtail pinging you may eliminate the chance of crossing with some very respectable counterparties. The average execution size in most dark pools is only a few hundred shares. If you impose a minimum share constraint of 1,000 shares, for example, you would miss many crossing opportunities.
3. You can rely on studies to determine whether a pool is a good place for resting orders.
Actually, some studies may not have enough data to draw meaningful conclusions. You need hundreds of observations to determine trends and most orders resting in a dark pool don't rest terribly long. Even resting orders are usually of short duration, sometimes so short that they are essentially synonymous with IOC's. The orders that do rest for a long time may not be worth studying, as they might have very tight minimum share and/ or price constraints that make them trade too slowly (or not complete) often missing attractive liquidity.
4. The best way to compare dark pool liquidity is to compare crossing rates.
It is meaningless to compare dark pools by using crossing rates provided by different brokers. The problem is that while the numerator-the execution quantity-is known, the denominator-order quantity-is actually unclear. Brokers calculate it 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? IOCs present another problem. If the pool has many IOCs, it may appear to have many orders and a very low fill rate compared to a pool with more resting orders. Liquidity analysis by a broker on their algorithms is somewhat better, but the fill rates are affected by how they send the orders and the sequence in which they send them. For example, orders are often sent to the broker's pool first and other large pools next so smaller pools get orders later, after most of the liquidity has been sopped up. Overall liquidity statistics from a third party often show a clearer picture.
For more information on related topics, visit the following channels:
