Exchanges

04:29 PM
Sugata Ray
Sugata Ray
Commentary
50%
50%

Differences Between Dark and Lit Trading

Distinguishing between "dark and lit" trading venues in strategy discussions must consider the order size because small trades parsed algorithmically across venues have a different impact on information leakage than block trades.

Nimalendran Mahendrarajah co-authored this article.

In a recent research article, we examined "Informational Linkages Between Dark and Lit Trading Venues" (Forthcoming in the Journal of Financial Markets; view the working paper version here). We found that the principal source of information leakage was from smaller trades initiated by algorithms that seemed to be spread across dark and lit platforms. We concluded this was a result of liquidity seeking algorithms parsing out orders over time and across venues.

The big block crosses did not show similar leakage. This makes sense because no one would be using an algorithm while leaving a sitting block order, for fear of leakage and getting gamed.

[HFT Debate: Two Experts Square Off On Market Structure ]

The upshot we took away from this was that execution traders can choose between gambling on an uncertain big block cross with minimal price impact or an algo suite parsing orders for a more certain fill at what would likely be a worse price. Perhaps a mixture of the two could also be used, but it was unlikely both would be used at the same time.

These different trading strategies suggests that the size of the order is strongly correlating with how truly "dark" the order was. In some senses, the small cross venues seem more like kiddy pools (shallow and without scope for large liquidity), and these were the pools that were more likely to be leaking.

Our paper documented a variety of other facts which were consistent with this story, but the differences in these types of trades remain one of the main findings. As such, there are concerns when we see articles regarding dark trading that do not make this distinction clear (or refer to dark pools without qualification), as the markets for the two types of dark trades have very different impacts on stock prices and cost of trading.

Sugata Ray is an Assistant Professor of Finance at the University of Florida. His research interests include hedge funds and market microstructure. Prior to joining the finance department at the University of Florida, he worked as a consultant for financial institutions with ... View Full Bio
Comment  | 
Print  | 
More Insights
More Commentary
Markets Looking Forward to Earnings
Geopolitical risks are increasing as the markets chug through the summer months, and investors are watching their risk profiles very closely.
5 Red Hot Summer Market Predictions
With the summer starting to heat up, here are five things we will see in the financial markets in the second half of 2014.
So Much Data, So Little Time
How fast does data need to be used in order to be beneficial?
Understanding the Value of Big Data
Winning investors are embracing new technologies to make better allocation decisions.
Catch Me if You Can: Risk Hidden in Plain Sight
The digital revolution hasn't yet reached all four corners of the enterprise. Paper-based data and manual workflows are hotspots for risk and are ripe for modernization.
Register for Wall Street & Technology Newsletters
White Papers
Current Issue
Wall Street & Technology - July 2014
In addition to regular audits, the SEC will start to scrutinize the cyber-security preparedness of market participants.
Video
Exclusive: Inside the GETCO Execution Services Trading Floor
Exclusive: Inside the GETCO Execution Services Trading Floor
Advanced Trading takes you on an exclusive tour of the New York trading floor of GETCO Execution Services, the solutions arm of GETCO.