Morgan Stanley is taking steps to ferret out the bad actors in its dark pool.
In response to customer concerns over trading counterparties, the big broker is tracking the behavior of the participants in its MS Pool and the performance of the stocks they trade.
The goal is to improve the quality of executions for all participants by eliminating what the firm considers abusive behavior. The oversight is not biased toward any single group, executives say. They are scrutinizing all traders, including money managers, broker-dealers and market making firms.
Still, the initiatives stem from concerns on the buyside that trades done in dark pools can result in information leakage that negatively impacts the final price at which they trade. The buyside often blames its problems in dark pools on professional traders, particularly the high-frequency variety.
Many of the major dark pool operators have taken steps in the past couple of years to categorize the players in their pools and allow their customers to bypass those they believe are dangerous. But monitoring traders’ behavior is a relatively new trend. Besides Morgan Stanley, Barclays is also tracking trader behavior. Both bulge brackets have been doing so since last year.
“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.”
Morgan Stanley started tracking behavior in its dark pool last April shortly after Johmann rejoined the broker’s electronic trading group. Johmann had previously worked in equities at Morgan Stanley but left briefly for a stint in the firm’s foreign exchange department.
“The marketplace has been inundated with discussions about toxicity and venue performance,” Johmann said. “We are providing a level of transparency as to how we monitor behaviors that exists within our pool.”
Morgan Stanley is looking at a number of variables in order to determine what is good behavior and what is not. Chief among them is monitoring the prices in the marketplace after a participant completes a trade in MS Pool. If the firm determines that prices consistently move in the trader’s behavior after it completes a trade–and to the detriment of its counterparties –Morgan Stanley will have a chat with that firm.
It will also consult with participants it considers aggressive takers of liquidity. A not unusual occurrence is for a trading firm to hit bids or lift offers in a dark pool and then do the same in the public markets with such speed and in such quantities that they move the price. Contra-parties in a dark pool could suffer an immediate loss from this type of behavior. Morgan Stanley focuses on a pattern of this behavior to maintain the integrity of MS POOL. “Certain types of activity are not healthy for our pool or our clients,” Johmann said.
Consistency is a key factor when judging the behavior of a particular participant, Morgan Stanley execs say. A trader that consistently provides “good” liquidity will score high in the firm’s monthly surveys. One that consistently provides “bad” liquidity will score low.
Take firms in the business of providing liquidity, for example. Morgan Stanley prefers them to make markets across several names and not just trade when they want to. “We would prefer to see someone make a market in 100 names throughout the day, over someone who makes a market in one name and only trades in brief stretches of the day,” Johmann said.
Buysiders contacted by Traders Magazine spoke favorably of the new practice, but some indicated they weren’t relying on their brokers to do the monitoring. Some buysiders, including Franklin Templeton, a money manager with about $400 billion in stocks, are doing it themselves.
About two months ago, Franklin Templeton informed its brokers it wanted them to deliver certain information about the venues to which the money manager’s orders were exposed if they wanted to continue getting its business.
The big buysider wants to know where its orders have been sent; where they were and were not filled; the behavior of the quotes before and after their trades; and other pertinent data.
“Ultimately, it could be better for the brokers because their performance numbers should improve,” said David Lewis, who heads U.S. stock trading at Franklin Templeton.. “We would be able to point out to them a venue that looks toxic and they can consider removing it from our list of destinations.”
Franklin Templeton isn’t the only buysider taking its own measures to protect itself against bad actors. Chicago Equity Partners, with about $3 billion in equities under management, contends more effective deterrents are to specify a minimum trade size as well as establishing contra-party blacklists.
“We’ve imposed minimums for a very long time now,” said Tereck Fares, CFA, director of Equity Trading at Chicago Equity Partners, “because the toxic players don’t want to risk capital in amounts greater than 100 shares. So, that way, you’re already bypassing a lot of the junk. You don’t need to monitor. You need to recognize that some of the players bring nothing to the table except the illusion of liquidity.”
Fares builds the minimum trade levels into all of its connections with dark pools as well as contra-party blacklists for the obvious offenders. Amounts are typically between three hundred and five hundred shares. Given the large blocks he trades, Fares says he doesn’t mind missing out on the small fills that could prove detrimental to the rest of his order.
