Finding your way in the dark
With the proliferation of European dark
pools, finding the right venue to reduce market impact and provide price
improvement can be a difficult task for buy-side institutions. But the answers
could be closer than you think, according to Darren Toulson, head of research
at financial research firm LiquidMetrix.
"You need information to check whether
the execution was actually better on one venue versus another,” he says. “Be
scientific. Is your opinion of a venue supported by the facts? You don't have
to wonder – you can check the data."
Data compiled by LiquidMetrix for the month
of March revealed some of the differences between European dark pools –
including the average order size, the matching systems used and the kind of
liquidity they contain.
According to LiquidMetrix, Liquidnet has
the largest average trade size at €429,366, while Nomura’s NX dark pool registered
an average of just €3,734. This contrasts with an estimated UK average in all
lit markets of €7,351. UBS MTF’s average trade size was €10,354, while POSIT
Marketplace saw €17,704 average trade size.
"The differences between dark pools
are so enormous, it's almost unfair to group them together under the same
term," says Toulson.
Most dark pools offer mid-point matching systems,
which essentially exist to provide price improvement for buy-side institutions.
In recent months, some venues, such as UBS MTF and Instinet’s BlockMatch, have
added the ability to trade at the bid and the offer, adding to the array of
choices available to buy-side market participants. Nomura’s NX is also in the
process of rolling out bid and offer order books. But working out which pool
offers the best price requires a reference point.
Traditionally, best price has often been
measured by the prices available on the primary exchange. But with a larger
proportion of trading taking place on multilateral trading facilities and dark
pools, the primary market may no longer serve as an accurate representation of
the best price that a market participant could have achieved with a given
order. Measuring performance against consolidated European best bid and offer
(EBBO) incorporates pricing information for all lit venues, providing a better
picture of whether a trade actually performed well against the market,
according to Toulson.
"Using the primary exchanges as a
reference point doesn't always conclusively show whether you have achieved best
price,” he says. “But using the EBBO gives you that certainty."
Even if a dark pool does secure price
improvement, some market participants have expressed fears that trading in
large size in the dark could still expose them to signalling risk, revealing to
the market their intention to buy or sell a large block of stock. Other
observers have even suggested that trading in a dark pool might actually
produce more information leakage than trading on a lit venue. But Toulson
suggests that that would depend on the stock that is being traded, the market
conditions and a host of other variables.
For some stocks, for example a mid-cap, a
dark trade could create signalling risk, just because any movement in that
stock at all would be relatively noteworthy to the market. But that risk is
relatively small, says Toulson, when compared to trading in the lit markets.
"The difference is that in the dark,
you can't tell with certainty whether you're seeing a buy or sell order,” he
says. “That helps mitigate the market impact – in many cases, you will find
that the market impact to execute on a lit venue would have been far
The opportunity cost of trading in
different dark pools is another factor that market participants should watch
out for, according to Toulson. Different pools are used for different things –
for example, ITG’s POSIT is a marketplace that sees a fair amount of activity
in mid-cap stocks. Trading for a specific kind of flow produces a distinctive
volume curve through the day.
Other venues such as Turquoise, BATS Dark
and Chi-Delta produce a different kind of volume curve – but the three venues
are very similar to each other through the day, according to the LiquidMetrix
Therefore, waiting for liquidity in each of
the three correlated venues in succession may not be a sound strategy, since
each is likely to contain similar flow. Instead, it might be better to develop
strategies that ping different kinds of dark pools, to ensure that an order is
being exposed to a variety of flow that will increase the overall chance of
getting a fill.