Why do we need hidden pools of liquidity (dark pools)
Thanks to the efforts of journalists and writers, a kind of aura of evil was created around hidden pools of liquidity (dark pools). Meanwhile, this institution of exchange trading solves a simple and important task.
In the early 80s, the growth of investment funds in the United States began. This was due to the adoption of the law on preferential taxation of 401(k) retirement savings, which allowed saving for old age without paying taxes on them and investing them in securities.
In this regard, the popularity of investment funds has increased against the background of a decrease in the activity of individual investors. It was easier to invest money in some index fund, entrusting asset management to a professional, than to monitor stocks every day and manage your portfolio in an amateur way.
Very soon, billions of dollars were managed by these funds.
What is the market impact?
However, the funds had a problem: if the manager needed to change the ratio of shares in his giant portfolio — some shares to sell and some to buy, he got very large orders — for hundreds of thousands or millions of shares.
At the same time, the existing exchanges were not designed for such order sizes. The average order size on the exchange was 200 shares. In order to execute an order to buy a million shares, you need to find 5,000 counter orders to sell 200 shares each. Making the first transactions will immediately be noticed by the market (information leak) and will cause the price to move up due to an imbalance of supply and demand. The execution of a giant order will take a lot of time and will end with an unfavorable result for the investor. He will have to pay a higher price than what he saw before placing his order.
This effect is called market impact. In fact, the investor with his large order seems to send an open text signal to the market: “I have a large amount for which I need to buy a lot of shares.” Or “I have a lot of stocks that I need to get rid of.” Investors had no choice but to accept this and assume that the price shift is an inevitable payment for the implementation of such a transaction, taking it as an inevitable given. To analyze the impact of a large order on prices, a whole section of financial mathematics Transaction Cost Analysis was even developed.
Of course, transaction cost deducted a significant amount from the fund’s profits in addition to other unavoidable deductions: commissions to brokers and fees to exchanges, and affected the financial performance of the fund. And the question arose, is it possible to somehow reduce this cost? After all, the lower the transaction cost, the more money will remain in the fund, the better the performance indicators of its manager will be—both the participants of the benefit fund and the manager.
It’s like playing poker. Only a complete moron plays poker with open cards. That’s why all market participants, not only large investors, hold their cards as close to their chest as possible. This is the difference between a professional and an amateur. In the exchange business, it is important to know not only what and when but also how so as not to overpay when buying and not to lose money when selling.
In order to reduce transaction costs caused by the size of the transaction, the investor needs to hide his intention from the market. And this is not a figure of speech. This is a real problem of a real business. Before the advent of electronic trading, the order was transferred to the stock exchange broker with the condition “not-held – it was an order to the broker to keep the order in his pocket. The broker literally put a ticket with an order in his pocket and kept his ears and eyes open in anticipation of a profitable deal at a bargain price. Until now, the FIX protocol has the tag 18 (ExecInst), one of the values of which 1 = Not Held is an echo of those “long ago” times.
Solutions to the problem
Life has offered a number of solutions to this problem:
- The upstairs market is the second floor of the exchange, wherein the quiet of the offices you can “negotiate” a deal face to face.
- Algorithmic trading.
- Open pools of liquidity (ECN).
- Hidden pools of liquidity (dark pools).
- Open pools.
This is practically the same as exchanges – electronic trading platforms where all bidders see the orders of other bidders. Their main difference from conventional exchanges was their electronic nature. After all, at all exchanges in those days, trades were conducted manually face to face on the trading floor. In open pools, the trading floor had a computer, and bidders connected to the trading floor only through terminals.
The very first open liquidity pool for institutional investors was the Instinet network, created in 1969. It cannot be said that this idea was unique, and only one person came up with it. As soon as the development of computer technology allowed this to be done, liquidity pools began to grow like mushrooms. They were created by everyone who could: brokerage companies, consortia, exchanges, private companies. And at first, all the liquidity pools were open.
Hidden liquidity pools are also a kind of exchange, and they work according to the same principles as open pools with one main distinguishing feature: they allow the investor to place a large order without showing it to other bidders. That’s why these pools are called hidden (dark), as everyone trades in the pool blindly, in complete darkness. There is no open order book in these pools, where everyone sees their own and others’ buy and sell orders. Without seeing other people’s orders in the book, participants cannot monitor the activity of orders in the book and monitor how many orders at what price are in the queue for sale, how many for purchase, and how this queue moves. All orders are visible only to the engine of this pool, which reduces orders if a transaction is possible between them. At the same time:
- Orders and their sizes are visible only to the owner of the orders;
- All participants see only their orders and cannot look at the cards of other participants;
- Since no one sees your orders, there is no market impact;
- The order has more chances to be executed quickly with large fills at once;
- If the order was executed, the owner of the order did not know who his counterpart was. Thus, disclosure of the investor’s intentions to his competitors who hung out in the same pool was excluded;
- The transaction price becomes known post factum after the transaction is completed.
Wikipedia provides an impressive list of currently existing pools of hidden liquidity. All their differences from each other are that,
- who owns the pool;
- who can be a member of the pool;
- how exactly transactions are made in the pool (for example, instant consolidation of the transaction or only indicative orders);
- how exactly are auctions conducted (for example, periodic auctions or continuous auctions);
- at what price (for example, mid-price, limit price, VWAP price, or close price) and
- how exactly does the pool disclose to the market the price of the transaction after it is completed and so on.
The main thing in the hidden pool business model is to attract as many investors as possible to create positive feedback. The more investors, the better their orders are executed, the more orders investors send to the pool, the better their orders are executed, and so on in an increasing spiral.
Many early attempts to create dark pools crashed against this wall – the lack of a sufficient critical mass of bidders. If an investor sent an order to a pool, and it was not executed there all day, he simply stopped sending his orders to this pool and then forgot about its existence altogether. According to approximately the same principle, various social networks and forums died on the Internet: the fewer participants there are on a forum or in a social network, the fewer visitors come, the fewer participants become, and so on.
The most famous hidden liquidity pools are Instinet (one of the pioneers of this business), ITG POSIT, Liquidnet, Chi-X. These are pools that, so to speak, “stood at the origins” of this business.
A large number of liquidity pools inevitably leads to the defragmentation of the stock market. The more pools there are, the more difficult it is for investors to make a choice where to send their orders. Of course, it would be easier if there were a few pools as possible so that all investors would know where the whole crowd is hanging out and where the chances of executing a large order are highest.
Similarly, a large number of social networks, websites, and forums on the same topic leads to a blurring of the audience. And in the end, there remains one network or one website or forum where the largest audience hangs out.
Monopoly and trust
But reducing defragmentation leads to monopoly. When there is only one pool left, the pool owner gains enormous power over the participants. In fact, as the owner of the system, as a judge in a poker tournament, he sees the cards of all players. And here, very weighty proofs of the pool owner’s honesty are required to convince the participants of the game that he does not use the information known only to him for selfish purposes. Reputation and trust in this business are very expensive.
Nevertheless, there have been scandalous cases when pool owners have been caught leaking information or playing a selfish game against pool participants. This resulted in investigations by financial regulators, large fines, and the closure of pools.
Why do dark pools have such a bad reputation?
Hidden pools of liquidity have freed institutional investors from the custody of brokers. Prior to their appearance, investors could only trade on the New York Stock Exchange, on NASDAQ, in Britain – only on the London Stock Exchange and only through brokers. This situation generated a lot of abuse on the part of brokers: accidental or intentional leakage of information, front-running, and so on.
Thanks to the pools, investors could trade with each other anonymously in compliance with all measures to prevent the leakage of sensitive information and without intermediaries.
This undermined the foundations of brokers’ power over investors, threatening their very privileged existence as an exclusive intermediary between the investor and the market. It is not surprising that the first hidden pools caused irritation among brokers and even active opposition through the political lobby and the press, books, interviews, and websites until the brokers themselves started creating exactly the same pools under their wing.
Open and hidden pools of liquidity are electronic platforms by definition. This means that they are a kind of information computer system, which requires an impressive staff of IT specialists to ensure its operation. We need programmers who will write an exchange engine, database administrators, networkers, support service.
As we can see, hidden liquidity pools fulfill an important and useful mission. They are not some kind of conspiracy of the rich against the poor, where under cover of darkness, they make some mysterious transactions to the detriment of ordinary humanity. On the contrary, pools help to reduce the costs of investors for large transactions and, therefore, increase the profits of investment funds in which moms and dads keep their money.