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Complex Order Types, Fragmentation And Dark Pools, Oh My!

Traders agree that market structure and some complex order types are not benefiting investors.

Dark Pools: Are they A Bigger Problem?

“Flash Boys” is also lifting the covers on the lack of transparency in dark pools. Investors learn that retail firms –including Charles Schwab and TD Ameritrade, ship their retail orders off to the likes of UBS, Citi and Citadel and receive payment for order flow in return.

Investors are only getting part of the volume picture because a significant amount of volume is executed off-exchange in dark pools or through brokers’ internal networks.

With about 40 percent of all U.S. stock trades occurring of-exchange, up from about 16 percent six years ago, there are concerns that this reduces price formation and price transparency in the public exchanges.

“Orders going into the dark pool don’t have pre-trade transparency,” says Jennifer Liu, a principal consultant in Capco Capital Markets practice. A dark pool doesn't display quotes and doesn't provide any information about the orders received by the pool prior to execution. “So, we don’t know the price that takes place in the dark pools. Usually that is reported in the post-trade,” she says. In a recent Reuters article, former Head of the SEC’s Trading and Markets division John Ramsay, points to academic data that suggests there’s a point where dark trading erodes market quality.” Liu contends that dark pools pose a systemic risk given their growth over the past two decades. Dark pool share has grown from about 2% in 2004 to about 12% in 2012,” notes Liu. Recent figures show that dark pools are as high as 14%. But as much as 30% of volume is sent to brokers that internally match flows from retail brokers against their own orders or those of institutional customers.

Liu also points out that retail investors don’t have [direct] access to dark pools, which leads to the question of “fair access.” One of the concerns in “Flash Boys” is that dark pools are fertile ground for HFT who are submitting small orders so they can sniff out a large institution. They then go into another venue, buy the stock for a few pennies more and sell the stock back to the institution for a higher price.

“If you’re trading a small order on a dark pool, there’s a good chance your contra is a market maker, trying to scalp the flow for something, “ commented a buy-side trader in Tabb Group’s US Institutional Equity Trading 2014 study. As a sign that HFT firms are in dark pools, institutions use algorithms to break up their order to avoid leaking information about a large trade to a predator. Thus, the trade size on dark pools is now 200 to 300 shares, which is about the same as on exchanges, suggesting that dark pools are not fulfilling their original mission.

However, the most economical way for brokers to execute orders is against internal flow. When they receive an institutional order, “they will first check to see if there is a contra in their internal pool. Everybody is conscious of costs,” said Larson, noting this includes connectivity costs and costs to colocate. When the buy side should see that 20, 30 or 40 percent of their order flow is internalized, that is a time to ask questions, he said.

However, IEX, the new dark pool launched by Brad Katsuyama and his team, shows that some transparency can work for dark pools. While dark pools are known for their opaqueness, IEX is publishing volume statistics on its web site.

On Wednesday, April 8, IEX recorded a record volume of 67 million shares (double counted), or 33 million (single counted). The average trade size 868 shares, according to its web site, as compared to 368 for the five largest ATSs and 374 across all venues. IEX is simplifying its order types down to three and is transparent about naming its participants on its web site. It’s interesting that five of the largest ATS operators Credit Suisse, Goldman Sachs, Barclays, Morgan Stanley, are routing order flow to IEX.

While the debate over HFT continues to rage, Larson, like others, doesn’t necessarily think HFT is bad. He says, “it’s just replacing electronic market making on the floor and that’s what makes the markets.” They use a lot of order types and strategies that provide liquidity, he adds. Some strategies such as stat arb have existed, but because they use algorithms, they are lumped under HFT. While some order types are useful, others are probably detrimental, he says.

Since it’s so difficult for professionals to figure out these strategies to decide when HFT constitutes liquidity and when it’s harmful, what’s puzzling is how the regulators are going to figure it out. Even though several regulators are now investigating high frequency trading for allegations of insider trading, it’s not clear that much is going to happen anytime soon. SEC Chairman Mary Jo White has said that her agency is going to take a data-driven approach and use analytics. Traders such as Larson feel that is the right way to go. Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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