Dark liquidity
Encyclopedia
In finance, dark pools of liquidity also referred to as dark liquidity or simply dark pools is trading volume or liquidity that is not openly available to the public. The bulk of these represent large trades by financial institutions that are offered away from public exchanges
so that trades are anonymous. The fragmentation of financial trading venues and electronic trading
has allowed dark pools to be created, and they are normally accessed through crossing networks or directly between market participants.
One of the main advantages for institutional investors in using dark pools is for buying or selling large blocks of securities
without showing their hand to others and thus avoiding market impact
as neither the size of the trade nor the identity are revealed. But it also means that some market participants are disadvantaged as they cannot see the trades executed and prices agreed by participants in the dark pools, and so there is no longer a transparent market.
The term comes from the fact that trades as well as buyers and sellers are concealed from the public, unlike in a traditional stock exchange
thus clouding the transactions, drawing obvious comparisons with murky water.
There are three major types of dark pools. The first type is independent companies set up to offer a unique differentiated basis for trading. The second type is broker-owned dark pools where clients of the broker interact, most commonly with other clients of the broker (possibly including its own proprietary traders) in conditions of anonymity. Finally, some public exchanges
are creating their own dark pools to allow their clients the benefits of anonymity and non-display of orders while offering an exchange ‘infrastructure’. Depending on the precise way in which a ‘dark’ pool operates and interacts with other venues it may be considered, and indeed referred to by some vendors as a ‘grey’ pool.
Dark liquidity pools offer institutional investors many of the efficiencies associated with trading on the exchanges' public limit order books but without showing their actions to others. Dark liquidity pools avoid this risk because neither the price nor the identity of the trading company is displayed.
Dark pools are recorded to the national consolidated tape
. However, they are recorded as over-the-counter transactions. Therefore, detailed information about the volumes and types of transactions is left to the crossing network to report to clients if they desire and are contractually obligated.
Dark pools allow funds to line up and move large blocks of equities without tipping their hands as to what they are up to. Modern trading platforms and the lack of human interaction have reduced the time scale on market movements. This increased responsiveness of the price of an equity to market pressures has made it more difficult to move large blocks of stock without affecting the price.
process is generally assumed to ensure that at any given time the price is approximately "correct" or "fair". However, very few assets are in this category since most can be traded off market without printing the trade to a publicly accessible data source. As the proportion of the daily volume of the asset that is traded in such a hidden manner increases, the public price might still be considered fair. However, if public trading continues to decrease as hidden trading increases, it can be seen that the public price does not take into account all information about the asset (in particular it does not take into account what was traded but hidden)—and thus the public price may no longer be "fair".
If you are actively trading at a dark venue and choose to take liquidity at a given price then you obviously have a piece of information known only to one other participant (the counterparty in the trade!). Additionally if you were completely filled you may reasonably assume that some more liquidity exists at the same price.
. Generally if you are completely filled, it implies that the counterparty actually had more liquidity behind their order than you did in yours. If you are slicing many small orders across time, this would not be meaningful. However if you are trading large volumes then it can be assumed that the other side - being even larger - will be likely to cause market impact and thus push the price against you. So the fact that you got filled is an indicator that you actually didn't want to get filled - it would have been better to wait until the price had been pushed and then cross.
Another type of adverse selection is caused on a very short-term basis by the economics of dark pools versus displayed markets. If a buy-side institution adds liquidity in the open market, a prop desk at a bank may want to take that liquidity because they have a short-term need. The prop desk would have to pay an Exchange/ECN
access fee to take the liquidity in the displayed market. On the other hand, if the buy-side institution were floating their order in the prop desk's broker dark pool, then the economics make it very favorable to the prop desk: They pay little or no access fee to access their own dark pool, and the parent broker gets tape revenue for printing the trade on an exchange. For this reason, it is recommended that when you are transacting in smaller sizes and do not have short-term alpha, do not add liquidity to dark pools; rather, go to the open market where the short-term adverse selection is likely to be less severe.
, but it is a risky business, predicated on being able to guess both the existence of large liquidity and the pricing mechanism being used. As an example suppose that, by whatever means, you believe that there is a large amount of hidden liquidity, say a buyer pegged to the public bid price but who does not want to buy out in the public markets. If the public market has much less quantity than you suspect is hidden on the bid, you can buy a similar amount of the asset, pushing up the price. Once the price is high enough, you place a limit price buy order of sufficient quantity onto the public market and simultaneously place a limit price sell order on the dark venue for the total quantity you just bought. You now hope that the hidden order will cross with you at the current high price bringing the profit. This profit comes from you being able to buy the stock incrementally at prices lower than the current price which you helped raise. This is a dangerous game though: how do you know that the pegged order is really in the dark pool, and how do you know what the volume is? Finally there is also the chance that another market participant will see the anomalous move, decide the market is mispriced, and take it back to the original price without you being able to liquidate your position at a favourable price.
Exchange (organized market)
An exchange is a highly organized market where tradable securities, commodities, foreign exchange, futures, and options contracts are sold and bought.-Description:...
so that trades are anonymous. The fragmentation of financial trading venues and electronic trading
Electronic trading
Electronic trading, sometimes called etrading, is a method of trading securities , foreign exchange or financial derivatives electronically...
has allowed dark pools to be created, and they are normally accessed through crossing networks or directly between market participants.
One of the main advantages for institutional investors in using dark pools is for buying or selling large blocks of securities
Block trade
A block trade is a permissible, noncompetitive, privately negotiated transaction either at or exceeding an exchange determined minimum threshold quantity of shares, which is executed apart and away from the open outcry or electronic markets...
without showing their hand to others and thus avoiding market impact
Market impact
In financial markets, market impact is the effect that a market participant has when it buys or sells an asset. It is the extent to which the buying or selling moves the price against the buyer or seller, i.e. upward when buying and downward when selling...
as neither the size of the trade nor the identity are revealed. But it also means that some market participants are disadvantaged as they cannot see the trades executed and prices agreed by participants in the dark pools, and so there is no longer a transparent market.
The term comes from the fact that trades as well as buyers and sellers are concealed from the public, unlike in a traditional stock exchange
Stock exchange
A stock exchange is an entity that provides services for stock brokers and traders to trade stocks, bonds, and other securities. Stock exchanges also provide facilities for issue and redemption of securities and other financial instruments, and capital events including the payment of income and...
thus clouding the transactions, drawing obvious comparisons with murky water.
There are three major types of dark pools. The first type is independent companies set up to offer a unique differentiated basis for trading. The second type is broker-owned dark pools where clients of the broker interact, most commonly with other clients of the broker (possibly including its own proprietary traders) in conditions of anonymity. Finally, some public exchanges
Exchange (organized market)
An exchange is a highly organized market where tradable securities, commodities, foreign exchange, futures, and options contracts are sold and bought.-Description:...
are creating their own dark pools to allow their clients the benefits of anonymity and non-display of orders while offering an exchange ‘infrastructure’. Depending on the precise way in which a ‘dark’ pool operates and interacts with other venues it may be considered, and indeed referred to by some vendors as a ‘grey’ pool.
Iceberg orders
Some markets allow dark liquidity to be posted inside the existing limit order book alongside public liquidity, usually through the use of iceberg orders. Iceberg orders generally specify an additional display quantity, smaller than the overall order quantity. The order is queued along with other orders but only the display quantity is printed to the market depth. When the order reaches the front of its price queue, only the display quantity is filled before the order is automatically put at the back of the queue and must wait for its next chance to get a fill. Such orders will, therefore, get filled less quickly than the fully public equivalent, and they often carry an explicit cost penalty in the form of a larger execution cost charged by the market. Iceberg orders are not truly dark either, as the trade is usually visible after the fact in the market's public trade feed.Dark pools
Truly dark liquidity can be collected off-market in dark pools. Dark pools are generally very similar to standard markets with similar order types, pricing rules and prioritization rules. However, the liquidity is deliberately not advertised—there is no market depth feed. Such markets have no need of an iceberg order type. In addition, they prefer not to print the trades to any public data feed, or if legally required to do so, will do so with as large a delay as legally possible—all to reduce the market impact of any trade. Dark pools are often formed from brokers' order books and other off-market liquidity. When comparing pools, careful checks should be made as to how liquidity numbers were calculated—some venues count both sides of the trade, or even count liquidity that was posted but not filled.Dark liquidity pools offer institutional investors many of the efficiencies associated with trading on the exchanges' public limit order books but without showing their actions to others. Dark liquidity pools avoid this risk because neither the price nor the identity of the trading company is displayed.
Dark pools are recorded to the national consolidated tape
Consolidated Tape System
The Consolidated Tape System is the electronic service, introduced in April 1976, that provides last sale and trade data for issues admitted to dealings on the American Stock Exchange, New York Stock Exchange, and U.S...
. However, they are recorded as over-the-counter transactions. Therefore, detailed information about the volumes and types of transactions is left to the crossing network to report to clients if they desire and are contractually obligated.
Dark pools allow funds to line up and move large blocks of equities without tipping their hands as to what they are up to. Modern trading platforms and the lack of human interaction have reduced the time scale on market movements. This increased responsiveness of the price of an equity to market pressures has made it more difficult to move large blocks of stock without affecting the price.
Price discovery
For an asset that can be only publicly traded, the standard price discoveryPrice discovery
The price discovery process is the process of determining the price of an asset in the marketplace through the interactions of buyers and sellers ....
process is generally assumed to ensure that at any given time the price is approximately "correct" or "fair". However, very few assets are in this category since most can be traded off market without printing the trade to a publicly accessible data source. As the proportion of the daily volume of the asset that is traded in such a hidden manner increases, the public price might still be considered fair. However, if public trading continues to decrease as hidden trading increases, it can be seen that the public price does not take into account all information about the asset (in particular it does not take into account what was traded but hidden)—and thus the public price may no longer be "fair".
Market impact
Whilst it is safe to say that trading on a dark venue will reduce market impact it must be noted that it is very unlikely to reduce it to zero. In particular the liquidity that crosses with you has to come from somewhere—and at least some of it is likely to come from the public market, as automated broker systems intercept market-bound orders and instead cross them with you. This disappearance of the opposite side liquidity as it trades with you and leaves the market will cause impact. In addition, your order will slow down the market movement in the direction favorable to you and speed it up in the direction unfavorable to you. The market impact of your hidden liquidity is greatest when all of the public liquidity has a chance to cross with you and least when you are able to cross with only other hidden liquidity that is not also represented on the market. In other words, you still have a trade-off: reduce your speed of execution by crossing with only dark liquidity or increase it and increase your market impact.Imputing the existence of dark liquidity
There are a few ways to guess at the existence of dark liquidity. If you are watching the market depth and see that both the bid and offer have decreased by the same amount, you might reasonably assume that the trade was in fact made, but at a venue not visible to you. However this is unreliable, since there is the chance that two orders were simply canceled at the same time.If you are actively trading at a dark venue and choose to take liquidity at a given price then you obviously have a piece of information known only to one other participant (the counterparty in the trade!). Additionally if you were completely filled you may reasonably assume that some more liquidity exists at the same price.
Adverse selection
One potential problem with crossing networks is winner's curseWinner's curse
The winner's curse is a phenomenon akin to a Pyrrhic victory that occurs in common value auctions with incomplete information. In short, the winner's curse says that in such an auction, the winner will tend to overpay...
. Generally if you are completely filled, it implies that the counterparty actually had more liquidity behind their order than you did in yours. If you are slicing many small orders across time, this would not be meaningful. However if you are trading large volumes then it can be assumed that the other side - being even larger - will be likely to cause market impact and thus push the price against you. So the fact that you got filled is an indicator that you actually didn't want to get filled - it would have been better to wait until the price had been pushed and then cross.
Another type of adverse selection is caused on a very short-term basis by the economics of dark pools versus displayed markets. If a buy-side institution adds liquidity in the open market, a prop desk at a bank may want to take that liquidity because they have a short-term need. The prop desk would have to pay an Exchange/ECN
Electronic communication network
An electronic communication network is the term used in financial circles for a type of computer system that facilitates trading of financial products outside of stock exchanges. The primary products that are traded on ECNs are stocks and currencies. The first ECN, Instinet, was created in 1969...
access fee to take the liquidity in the displayed market. On the other hand, if the buy-side institution were floating their order in the prop desk's broker dark pool, then the economics make it very favorable to the prop desk: They pay little or no access fee to access their own dark pool, and the parent broker gets tape revenue for printing the trade on an exchange. For this reason, it is recommended that when you are transacting in smaller sizes and do not have short-term alpha, do not add liquidity to dark pools; rather, go to the open market where the short-term adverse selection is likely to be less severe.
Gaming
Dark pools are open to gamingGaming the system
Gaming the system can be defined as "[using] the rules and procedures meant to protect a system in order, instead, to manipulate the system for [a] desired outcome".According to James Rieley, structures in organizations Gaming the system (or bending the rules, playing the system, abusing the...
, but it is a risky business, predicated on being able to guess both the existence of large liquidity and the pricing mechanism being used. As an example suppose that, by whatever means, you believe that there is a large amount of hidden liquidity, say a buyer pegged to the public bid price but who does not want to buy out in the public markets. If the public market has much less quantity than you suspect is hidden on the bid, you can buy a similar amount of the asset, pushing up the price. Once the price is high enough, you place a limit price buy order of sufficient quantity onto the public market and simultaneously place a limit price sell order on the dark venue for the total quantity you just bought. You now hope that the hidden order will cross with you at the current high price bringing the profit. This profit comes from you being able to buy the stock incrementally at prices lower than the current price which you helped raise. This is a dangerous game though: how do you know that the pegged order is really in the dark pool, and how do you know what the volume is? Finally there is also the chance that another market participant will see the anomalous move, decide the market is mispriced, and take it back to the original price without you being able to liquidate your position at a favourable price.
Independent dark pools
- InstinetInstinetInstinet is an institutional, agency-only broker. As such, it executes trades for roughly 1,500 “buyside” clients such as asset management firms, hedge funds, insurance companies, mutual funds and pension funds...
- SmartPool
- Posit/MatchNow from Investment Technology GroupInvestment Technology GroupInvestment Technology Group, Inc. is a United States-based multinational agency brokerage and financial markets technology firm aimed at a hedge fund and asset management clientele. One of the first suppliers of electronic trading services, ITG launched the industry’s second anonymous electronic...
(ITG) - Liquidnet
- NYFIX Millennium
- Pulse Trading BlockCross
- RiverCross
- Pipeline Trading Systems
Broker-dealer-owned dark pools
- Barclays CapitalBarclays CapitalBarclays Capital is a global British investment bank. It is the investment banking division of Barclays plc which has a balance sheet of over £1.2 trillion . Barclays Capital provides financing and risk management services to large companies, institutions and government clients. It is a primary...
- LX Liquidity Cross - BNP ParibasBNP ParibasBNP Paribas S.A. is a global banking group, headquartered in Paris, with its second global headquarters in London. In October 2010 BNP Paribas was ranked by Bloomberg and Forbes as the largest bank and largest company in the world by assets with over $3.1 trillion. It was formed through the merger...
- BNY ConvergEx Group (an affiliate of Bank of New York MellonBank of New York MellonThe Bank of New York Mellon Corporation is a global financial services company formed on July 1, 2007 as result of the merger of The Bank of New York and Mellon Financial Corporation...
) - CitiCitigroupCitigroup Inc. or Citi is an American multinational financial services corporation headquartered in Manhattan, New York City, New York, United States. Citigroup was formed from one of the world's largest mergers in history by combining the banking giant Citicorp and financial conglomerate...
- Citi Match - Credit SuisseCredit SuisseThe Credit Suisse Group AG is a Swiss multinational financial services company headquartered in Zurich, with more than 250 branches in Switzerland and operations in more than 50 countries.-History:...
- CrossFinder - FidelityFidelity InvestmentsFMR LLC or Fidelity Investments is an American multinational financial services corporation one of the largest mutual fund and financial services groups in the world. It was founded in 1946 and serves North American investors. Fidelity Ventures is its venture capital arm...
Capital Markets - GETCOGlobal Electronic Trading CompanyThe Global Electronic Trading Company , or Getco LLC, is a proprietary algorithmic trading and electronic market making firm based in Chicago, Illinois.-Description:...
- GETMatched - Goldman SachsGoldman SachsThe Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
SIGMA X - Knight Capital GroupKnight Capital GroupKnight Capital Group is a global financial services firm based in Jersey City, New Jersey that provides access to the capital markets across multiple asset classes to buy- and sell-side firms and corporations.Knight is a specialized firm with highly developed market-making and trading capabilities...
- Knight Link, Knight Match - Deutsche BankDeutsche BankDeutsche Bank AG is a global financial service company with its headquarters in Frankfurt, Germany. It employs more than 100,000 people in over 70 countries, and has a large presence in Europe, the Americas, Asia Pacific and the emerging markets...
Global Markets - DBA - Merrill LynchMerrill LynchMerrill Lynch is the wealth management division of Bank of America. With over 15,000 financial advisors and $2.2 trillion in client assets it is the world's largest brokerage. Formerly known as Merrill Lynch & Co., Inc., prior to 2009 the firm was publicly owned and traded on the New York...
- MLXN - Morgan StanleyMorgan StanleyMorgan Stanley is a global financial services firm headquartered in New York City serving a diversified group of corporations, governments, financial institutions, and individuals. Morgan Stanley also operates in 36 countries around the world, with over 600 offices and a workforce of over 60,000....
- NomuraNomura Securities Co.is a wholly owned subsidiary of Nomura Holdings, Inc. , which forms part of the Nomura Group. It plays a central role in the securities business, the Group's core business. Nomura is a financial services group and global investment bank. Based in Tokyo and with regional headquarters in Hong Kong,...
- Nomura NX - UBSUBS AGUBS AG is a Swiss global financial services company headquartered in Basel and Zürich, Switzerland, which provides investment banking, asset management, and wealth management services for private, corporate, and institutional clients worldwide, as well as retail clients in Switzerland...
Investment Bank - Ballista ATS Ballista Securities LLC
- BlocSec
- Bloomberg Tradebook (an affiliate of Bloomberg L.P.Bloomberg L.P.Bloomberg L.P. is an American privately held financial software, media, and data company. Bloomberg makes up one third of the $16 billion global financial data market with estimated revenue of $6.9 billion. Bloomberg L.P...
) - Daiwa - DRECT
Exchange-owned dark pools
- International Securities ExchangeInternational Securities ExchangeInternational Securities Exchange Holdings, Inc. is a wholly owned subsidiary of German derivatives exchange Eurex. It is a member of the Options Clearing Corporation and the Options Industry Council . Historically, responsibility for organizing the Options Industry Conference is rotated amongst...
- NYSE Euronext
- BATS TradingBats Exchange, IncBATS is a stock exchange based in Lenexa, Kansas, a satellite city of Kansas City, Missouri. BATS was founded in June 2005 as an ECN and its name stands for Better Alternative Trading System....
- Direct EdgeDirect EdgeDirect Edge is a Jersey City, NJ-based stock exchange operating two separate platforms, EDGA Exchange and EDGX Exchange. Since March 2009, Direct Edge has had a market share in the range of 9%-12% of U.S. equities trading volume, regularly trades 1 billion to 2 billion shares per day...
- Swiss Block
- Nordic@Mid
Dark pool aggregators
- Fidessa - Spotlight
- SuperX+ – Deutsche Bank
- ASOR – Quod FinancialQuod FinancialQuod Financial is a privately owned adaptive trading technology provider which specialises in software and services such as algorithmic trading, smart order routing and of liquidity. The firm provides electronic trading solutions to liquidity venues, exchanges, retail brokers, buy side and sell...
- Progress Apama
- ONEPIPE – Weeden & Co. & Pragma Financial
- Xasax Corporation
- Crossfire – Credit Agricole Cheuvreux