Dark pool interaction – managing the risk of gaming

The potential for gaming in dark pools can only be assessed by understanding the liquidity in each pool and an individual’s investment objectives, says Phil Allison, head of client trading and execution, UBS.

The scepticism around dark pools that was once prevalent is rapidly diminishing as the benefits of accessing their liquidity is acknowledged. Nevertheless, the lack of transparency can make traders cautious about how and when to tap into hid-den volume.

A fear of gaming is at the heart of this unease, yet interaction with dark pools requires similar techniques to those used in any efficient execution. Traders have always tried to buy a stock as cheaply as they can by understanding the market supply and demand, and these principles are at the heart of how we interact with any dark pool. In a ‘lit’ book a trader may try and take a small offer to see if more liquidity appears or the stock gaps up – equally trying to understand the dynamic of a dark pool supply of liquidity is central to any interaction.

At the heart of all inter-actions is the aim to disguise your intentions to others, by sending appropriately sized orders in a randomised manner for execution at fair prices. The two key risks are someone detecting that you have a large order or obtaining executions at a disadvantageous price.

Whilst similar techniques can be used to access various pools, two components are central to defining the optimal interaction. The first is the nature of the pool with which you are interacting, and the second is the investment objective behind the order.

Dark pool characteristics
Every pool is uniquely defined by the participants that access it and the rules and fee structure that govern that interaction.

For example, when developing our internal pool in Europe, we have always focused on ensuring the ‘quality’ of the liquidity. As such, the only access available to internal or external users is through our algorithms. Crosses only happen at the mid-point, and only when analysis of the recent movements of the stock price suggests that this is a fair price.

If we allowed all DMA and prop trading into the pool, and crossing at price points other than the mid, we could clearly substantially increase the amount of client flow we cross from the current 15%. But doing so would change the nature of the existing pool.

There is nothing inherently wrong with other pools that attract a large amount of high frequency stat-arb participation. Exchanges, after all, allow all participants to trade on an equal basis. It is not a bad pool of liquidity; it is simply a different pool. Exposing a large block may well be foolish, but small, randomised orders may allow substantial amounts of liquidity to be sourced over time. Equally, a pool with a large minimum crossing size, high fee structure and restricted participant access would require an entirely different order entry strategy in order to effectively access the potential volume.

Diversity of dark pools, and competition amongst them, is generally a positive for investors – creating greater price competition and introducing diverse liquidity to the market.

Investment objectives
The second key part of working any order using dark pools is to understand the investment objective. Typically, clients are simultaneously aiming to find volume and minimise adverse price movement. The relative importance of these two criteria depends on a number of factors such as the size of the order and the short-term alpha of their investment process.

For example, a client with a large order may wait until good size natural liquidity can be found before starting to trade. Others may set a low participation rate and take dark liquidity opportunistically. Those who feel they have a lot of short-term alpha may be much more aggressive, seeking liquidity from all possible venues simultaneously.

As we understand the objective, we can advise on the best execution strategy and algorithmic options (including customisation) to enable effective access to all liquidity sources. In doing so, we are recreating in electronic form the trading interactions that have always been core to the business – understanding at what price levels and at what points in time finding liquidity will improve the overall execution, and when holding off is the best solution.

In summary, dark pools are neither something to be feared, nor a venue in which to assume every fill will be desirable. Whenever an execution takes place some information is given to the market. As markets continue to fragment and new dark pools are created it is crucial to understand their nature and have clear strategies to find liquidity in the optimal manner. Accessing all viable liquidity pools in a manner appropriate to their characteristics and your investment objectives is the ultimate aim