The Dark Pool Rises

The dark markets have become so efficient that the costs of execution and market impact are lower than at the display markets, where take fees are highest and market impact is most significant.

“SEC Ponders Recent Jump in Off-Board Trading” was a headline in the October issue of this magazine, and it’s true that the issues surrounding dark pools and other alternative trading venues have become frequent topics of conversation among many market pundits. The implication in many discussions seems to be that increased dark pool trading is an unhealthy development for the markets and should somehow be curtailed. Such criticism underestimates the strength and depth of today’s electronic stock markets and the benefits of dark pools as alternatives to exchanges.

Why is more volume migrating away from display markets? One answer is that traders sending their flow to the dark are having a better experience there than on exchanges. It is hard to imagine a more competitive environment than in the U.S. financial markets today. Traders managing clients’ orders must compete on cost and best execution and are measured on every trade. It stands to follow that if these traders are sending their orders to dark pools, it’s because that is the best way to accomplish their clients’ goals. The dark markets have in fact become so efficient that the costs of execution and market impact are lower than at the display markets, where the take fees are the highest and market impact is the most significant.

There are two other factors contributing to more volume in the dark. The first factor is overall market volatility. In the last few years, since the worst of the financial crisis has passed, the average VIX level has been approximately 19, recently hovering around 12 to 13, compared with 32 and 31 in 2008 and 2009, respectively. Traders have more patience with a passive order in a dark pool when the market is less volatile, so it is easier now to find a fill away from the lit market than during volatile market conditions. In terms of the second factor, when lit markets fully display orders, it is easier for high-speed algorithms to penny and game the orders, particularly if the visible quote is multiple ticks wide with nominal display volume as in high-priced stocks like Google and Apple.

Tim Mahoney, CEO of BIDS Trading, shared a frequently overlooked fact at the Baruch College Financial Conference in New York this October. Mahoney emphasized the importance of the consolidated tape in informing the marketplace of the last sale and size of every transaction that takes place in the equity market. Traders and regulators find comfort in seeing a deep book of bids and asks when they are contemplating a trade, but any effective algorithm will give more weight to the last sale of a stock than the displayed prices on an electronic book.

In fact, when a trade takes place “in the dark,” it is immediately printed to the consolidated tape and the whole marketplace can see its price and quantity. This print is the actual price discovery and the “last sale” is the important information the marketplace needs for further price formation. One could easily argue that the only way to achieve price discovery is to make a trade, and the next price discovery event is actually the subsequent trade, not a bid or offer on a screen. While it is nice to see bids and offers displayed on terminals, in today’s world of high-speed electronic trading there is a reasonable question of whether a human can even access those quotes in a timely manner. As Blair Hull, founder of Hull Trading Company and an electronic trading pioneer, famously said, “If your hand is on the mouse, you are already too late.”

It is also very important to note that most other foreign trading venues do not have a consolidated tape or reporting requirement. This fact dramatically changes the function and impact of trading at dark pools, and when reports, both academic and anecdotal, reach conclusions about how dark pools should be regulated, the reader should be aware that it is typically an apples-and-oranges comparison if foreign-market analysis is being applied to U.S. venues.


Given these market conditions, a reasonable question might be: If a trader can see a quote but can’t access it due to the slow nature of human reflexes (when compared with high-speed computer processors), do larger display quantities on the lit exchanges result in a “better or fairer” market? Is it this appearance of liquidity that leads commentators to argue that exchange markets are better or more efficient than dark pools?

An excellent source for gauging market quality over the last 10 years is the paper released in June of this year titled “Equity Trading in the 21st Century: An Update” by James Angel, Lawrence E. Harris and Chester S. Spatt. The paper, an update to the initial report published in February 2010, reviews 22 metrics concerning the quality of the equity markets and concludes that the quality of the markets has improved significantly in the last 10 years and has never been better. Some quick highlights from 2003 to 2012: Average bid ask spread is down from 4 cents to 2 cents; average display depth (the market value of bids and offers at the lit exchanges) has increased from $40,000 to $120,000 for a median stock, with similar gains for large and small stocks; execution speeds (the time to execute a market order) have plummeted from 15 to 30 seconds (depending on the exchange) to 1 second or less; and institutional block trade costs have dropped from 70 basis points to 40 basis points. All signs of a healthy market and market structure.

These improvements become even more impressive when you consider that they have occurred while trading in dark pools, as a percentage of overall volume (excluding internalization) has risen from under 4 percent to more than 16 percent during the same time frame. The data presented in the paper indicate that while trading has migrated to dark pools, market quality has improved. Furthermore, these results have been created by today’s highly efficient computerized trading systems, which continue to innovate and improve the markets for the benefit of all investors.

Let’s play a “what if?” game. What if more than 50 perfect of the market volume migrated to the dark-or even worse, according to some, let’s suppose volume in dark pools became 60 to 70 percent of overall market volume. What would that mean for the market and price discovery? A concern might be that the display prices would not be as relevant and the price discovery mechanism would break down, but I would argue differently.

Think about it this way: If less volume is traded on the lit markets, the oversize rebate that is available to liquidity providers will become more significant and encourage them to post liquidity to capture the larger rebate more often, thus shifting volume back to the lit market. If traders and their clients realize it has become a disadvantage to use dark venues, they will migrate back to the display markets. Most important, if real price discovery is the result of an actual transaction, as long as the transaction is transparent and reported quickly and accurately to the whole market, whether the trade is sourced in a dark or a lit venue is not important.

The bigger question we should be asking is: How efficient are the equity markets at matching buyers and sellers and transferring risk? The data analysis from “Equity Trading in the 21st Century: An Update” portrays a very efficient market that continues to improve, even though dark pool trading has been increasing, by providing a much needed alternative.

D. Keith Ross is chief executive officer for PDQ ATS.

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