Dark pools smeared unfairly
Dark pools have faced unfair criticism as industry spin continues to fabricate untruths and distort reality about the
venues’ usefulness, a leading capital markets expert has claimed.
Matt Samelson, principal of research consultancy Woodbine
Associates, said the utility of dark trading venues has been muddied the barrage
of bad press they receive – often unfairly.
“If you took a general cross section of the world, of those who
knew about dark pools, most would regard them as sinister,” he said. “But a lot
of spin about dark pools is nonsense. We should be happy we have them and
make sure that we are informed users.”
One criticism levelled at dark pools is that they actively
route orders to other venues and/or expose orders to non-members, which leads
to information leakage.
“In fact, dark pools substantially curtail, but do not
eliminate, information leakage. The degree of potential exposure depends on the
operating model of the venue. From what we have seen, no one is wantonly
routing out flow to other brokers or high-frequency traders,” he said. “A handful of pools have features or integrated user tools that permit the sending of
indications of interests (IOIs), but in virtually all instances, IOI features
are used at the discretion of the dark pool client.”
Woodbine has just completed a 111-page in-depth study of US
dark pools, which examines the market venue-by-venue, providing traders with an
unbiased assessment of pool management and operational practices to enable
optimal stock execution.
“You can trade badly anywhere,” Samelson said. “Dark pools
are good places to execute but they are complex and participants need to have a
more comprehensive understanding of them.”
The report, entitled ‘Dark pools, characteristics, operations and liquidity’, asserts the presence of high frequency trading (HFT)
in dark pools is not grounds alone to say a venue is favourable or unfavourable.
As well as detailed assessments of 19 dark pools in the US,
the Woodbine report also covers key buy-side concerns about dark trading,
including gaming risk, price discovery impact, and block trading opportunities.
Know your dark pool
Critics assert that because dark pools admit HFT, they expose
counterparty orders to increased risk of gaming and abuse. But Samelson said the
interaction of high frequency traders with non-HFT liquidity varies
significantly among pools. The manner and degree to which HFT order flow interacts
with non-HFT order flow depends more on each venue’s philosophy on pool
operation and the tools and features made available to control interaction.
“We did not audit venue anti-gaming, but everyone we spoke
to said they keep an eye on activity,” said Samelson. “They have to; if people
have a bad user experience, that will trickle down.”
Samelson said US venues have varying ideas of oversight.
Some have tight controls and rigorous enforcement while others operate more
like free markets. Some look at liquidity more holistically while others are
focused on the type of participant they allow.
“Buy-side firms need to make themselves keenly aware of the
nature of the venues they use,” he said.
And while concern has also been expressed that increased
internalisation of flow in the US market will negatively impact price discovery,
Samelson argued that market share figures show little evidence price discovery has
been impacted, nor is it likely to be anytime soon.
“Dark pool market share of total internalisation might be
growing – from around 8% in 2008 to 13% today – but internal flow in the US is still
only around 27-34% and steady,” he said, adding this was not enough to affect
price discovery in the lit.
Samelson said the characterisation of dark pool liquidity as
particularly toxic was often a bias used by brokers and other providers of
aggregation tools and algorithms to describe dark pools in which adverse
post-execution price movement is continuously observed.
“It may simply be liquidity that is better managed by the
agent’s competitors through competing tools and algorithms,” he said,
suggesting the buy-side should try another broker’s tools before blocking
access to a particular pool.