Woodbine Report Hits Back at Dark Pool Critics

Dark pools, venues that enable participants to execute block trades without moving the lit markets, ultimately benefit long-term and institutional investors, and have been unfairly targeted by critics amid unprecedented competition among trading venues, a report by advisory firm Woodbine Associates says.

In conducting its research, Woodbine said it studied the key features of 19 non-displayed trading venues. The 111-page report , which provides an in-depth view of every dark pool in existence today, contends that institutional traders benefit from dark pools because such venues restrict information leakage, minimize market impact and facilitate price improvement.

"There is distinct value in their ability to help institutional traders improve their execution quality, no question about it," says Matt Samelson, principal of Woodbine Associates. "A lot of the negative stuff you hear is either patently false or largely distorted."

Among the criticisms that are often lobbed at dark pools is that they route orders to other venues, exposing orders to non-members. However Woodbine counters that dark pools function as destinations and that a handful of them have features that permit the sending of indications of interest (IOI). "In virtually all instances, IOI features are used at the discretion of the dark pool client," the report says.

Another charge often thrown dark pools' way is venues that admit high-frequency traders expose counterparty orders to the same risk of gaming and abuse that's seen in the lit markets. But Woodbine argues that from what it's observed, dark pool operators step in to stop such things from occurring in their venues.

"The manner and degree to which HFT order flow interacts with non-HFT order flow depends upon management's philosophy on pool operation and tools/features made available by the pools to control interaction," the report said. "In almost all instances, pool operators inform us they oversee pool operations and curtail activity adverse to the institutional trader."

The report also notes that there's a segment of the broker community who believes that dark liquidity is toxic. But this charge is usually being hurled by brokers - and other providers of aggregation tools and algorithms - to describe dark pools where adverse post-execution price movement is continuously observed, the report says.

"It may simply be liquidity that is better managed by the agent's competitors through competing tools and algorithms," the report says. "Try another broker's tools before blocking access to a particular pool."

In June, Advanced Trading reported that a mathematical model designed by Alex Frino, head of the Sydney-based Capital Markets Co-operative Research Center, found that price discovery could be hampered when too much liquidity is allowed to flow into the dark. But Samelson says this is unlikely to happen anytime soon in the U.S. marketplace given how much volume is being traded in dark pools, and how those volumes are expected to grow over the near and medium-term.

"There is some number hypothetically out there where we think price discovery could be impacted," Samelson says. "But for the time being you don't hear traders complaining that their trades in the market are going off away from fair value. So I don't think the market as a whole believes there is a price discovery issue right now. And I don't see there being one because things aren't increasing."

As the Senior Editor of Advanced Trading, Justin Grant plays a key role in steering the magazine's coverage of the latest issues affecting the buy-side trading community. Since joining Advanced Trading in 2010, Grant's news analysis has touched on everything from the latest ... View Full Bio