Fair game?

Brokers’ invitations to enter into the dark world of non-displayed liquidity are being greeted with caution, as buy-side traders assess whether the rewards are worth the risk of information leakage. Richard McClure

With their promise of liquidity and low-impact trading, dark pools have become a mainstay of buy-side trading desks. Over the past five years, the anonymous off-exchange venues – where traders can match large orders while concealing price and volume – have been rapidly gaining market share. Central to their appeal is the ability of investors to place larger orders without showing their hand to the market and risking adverse price movements.

By recent estimates, dark pools now account for at least 10% of daily volume in the US equities market, up from 1% in 2003, and the figure looks likely to rise further as hedge funds and big institutional investors seek less transparent ways to trade large positions. In the US, the number of dark pools has mushroomed to more than 40 and volume is expected to grow to nearly 1.5 billion shares in 2010, an annual growth rate of 40%. Europe currently boasts around 20 dark pools, operated largely but not exclusively by major broker-dealers.

In May, the growing stature of dark pools was highlighted when Goldman Sachs – whose Sigma X is the largest broker-run dark pool, averaging 140 million shares a day – announced a US liquidity-sharing agreement with internalisation pools belonging to UBS and Morgan Stanley. With exchanges including NYSE Euronext, International Securities Exchange, and SWX Europe also beginning to get in on the act by setting up non-displayed platforms for trading large blocks of stock, volumes are expected to rise further as more and more broker algorithms execute institutional orders in dark pools.

The enemy within
In theory, trading in dark crossing venues should be relatively secure, with institutions able to place and exe-cute a large order in some privacy without moving the price or tipping off anyone who might want to profit from the information. Yet as more liquidity flows into dark pools, there is an increasing fear among buy-side firms that trade information can be obtained and used by another party for financial gain.

‘Gaming’ is the industry term for the unscrupulous means by which traders try to manipulate prices in dark pools, usually by sending a series of small orders to a dark pool to detect a large order. “Gaming is obviously some-thing I am concerned about,” says Timothy Olsen, head trader at Washington-based ICM Asset Management. “I have had suspicions in the past that I have been gamed in dark pools. I’ve been aware on occasions that something wasn’t quite right.”

With dark pools often representing large institutional orders, if a gamer gets a few fills from a pool, he can generally assume that there is going to be more behind it. Once the gamer locates those orders, he can manipulate the price in his favour in various ways. Most commonly, this involves the gamer buying the stock rapidly in the displayed market, thus moving the stock up. After moving the stock, the gamer sends a large sell order to the dark pool and sells at substantially higher prices than the price he started buying at in the displayed market.

“In the classic gaming technique, the predatory ‘pinger’ sends a small order, which then enables them to see if there is a participant in the pool who matches the other side,” says Alexandra Foster, head of sales, global execution services, BNP Paribas. “As the price of the transaction normally refers back to the main exchange, the pinger can manipulate the price of the stock, either by buying or selling stock, after which the pinger would complete the transaction in the dark pool.”

Whether or not gaming is illegal is a source of much industry debate, but if gamers succeed in finding standing orders on the venues and manipulating prices, they can dramatically undercut trading results.

Little wonder then that the buy-side is increasingly anxious about their expo-sure to ‘toxic’ flow.

Research conducted by financial markets advisory firm TABB Group in October 2007 found that 60% of head traders were concerned about the risks of trading in dark pools. Of that number, 82% said that their primary anxiety was gaming or information leakage. “It is an issue that the buy-side is concerned about,” remarks Laurie Berke, a senior consultant with TABB Group. “They are thinking about it and looking at it all the time.”

Reputation risk
So, who are these guilty par-ties carrying out gaming in dark pools? Berke identifies sell-side institutions’ proprietary trading desks, aggressive hedge funds and statisti-cal arbitrage traders as those most likely to participate in dark pools with ulterior motives. “However, brokers are walking a very delicate line if they dare to take a peek into the dark pool,” says Berke. “They stand to lose tremendous credibility and tremendous order flows. If a client finds out that’s what you are doing, that will be the last time they ever do business with you.”

ICM’s Olsen says he refuses to use dark pools that are open to liquidity sources he’s not comfortable with, i.e. pools that contain flow from proprietary trading desks and internal hedge funds that could potentially see the order flow and act on it in a way that is detrimental to his business. “Some firms state that their prop desks can’t see the flow, but there are enough alternative pools out there that I don’t want to take that risk,” he says.

Although the effects of dark pool gaming are difficult to quantify in terms of profit and loss, the buy-side is understandably unhappy that they could potentially be interacting with toxic counterparties. There is, however, some light in the dark. According to the TABB Group report, 46% of those buy-side traders worried about dark pool gaming were reassured by the presence of anti-gaming monitoring.

“The buy-side is looking for some indication from the brokers to give them confidence that there isn’t a significant amount of gamesmanship going on,” adds Berke. “To the extent that there is a potential for hedge fund flow or proprietary flow, they want to know if there is any mechanism in place to catch these guys if they are behaving badly.”

To reassure the buy-side and retain crucial business, both large and small dark pool operators are tackling the problem by putting anti-gaming measures in place to keep orders safe, prevent customers crossing at an adverse price, and thwart those predators seeking to manipulate the system. “When we talk to clients, really without exception, anti-gaming is number one on their list,” observes Douglas Rivelli, managing director at US broker Weeden & Co. “Clients tell us that if they feel there is not appropriate anti-gaming logic in a particular venue or a particular product they won’t use it, even at the expense of liquidity.”

One of the simplest strategies by which dark pool operators can prevent unwelcome activity is to require a minimum order size to pre-vent pinging, i.e. sending in small orders to sniff out others’ trades. Testing different dark pools with 100-share orders is a tried-and-tested method for identifying and taking advantage of institutional flow.

“Our system has a mini-mum order size of 5,000 shares,” says Wally Sullivan, managing partner, Pulse Trading, an agency broker-age based in Boston, which operates dark crossing net-work BlockCross. “If gamers send in a small order and get a hit, they could make the assumption that they are in front of an institutional order. By raising the minimum up to 5,000 shares you pretty much eliminate the overwhelming majority of predators.”

Barriers to entry

Aware that anti-gaming technology is a key selling point for prospective clients of their pools, a number of operators offer a range of safeguards to prevent gaming and leakage, including rules governing participation, setting up private client networks so traders know who they are dealing with, and even placing bans on broker algorithms.

Among the most secure venues are established dark crossing networks Liquidnet and ITG’s POSIT Now. Liquidnet constantly monitors its system and has a full-time member of staff to look for patterns of abuse and to notify members when a trader appears to be gaming. During its seven-year history, the 500-mem-ber venue has suspended approximately 100 members. “Liquidnet has very strict policies about trading behaviour,” says Berke of TABB Group. “They capture the data, they document it, they monitor it, and if they find people showing up but never trading they will kick them out.”

Likewise, ITG’s POSIT Now runs a ‘watchdog’ safety feature called Posit Watch that monitors and identifies potential manipulation. “If ever we have any instances where a client’s behaviour is suspect, we will ask them to no longer use the system,” says Chris Heckman, man-aging director, ITG. “We do everything we can to protect our integrity.”

Some long-only managers report that they get better results from trading in buy-side only crossing net-works than from a pool that allows brokers and their clients. “More than anything, we pride ourselves on the constituency of POSIT, which is 95% buy-side to buy-side,” says Heckman. “All POSIT participants are effectively passive in nature, searching for natural liquidity. There is not a lot of small order flow that passes through the system that has a short-term alpha component attached to it.”

As well as putting anti-gaming logic into the matching technology in the dark pools, it can also be coded into algorithms that tap dark pools. Some algos are able to restrict order size or type, while others provide a credibility rating that allows investors to see their counterparties’ track records for completing orders and opt out of interacting with certain investors.

Room to roam safely
Anti-gaming logic is also increasingly built into dark pool aggregators which offer institutional investors a one-stop shop linked to a number of dark pools. A recent launch in this space is OnePipe, an aggregator developed in a joint venture between brokerage firm Weeden & Co and Pragma Financial Systems, a New York-based financial technology provider, and which provides access to more than 25 dark pools.

“It is a little bit unnerving for the buy-side to know that they are only as protected as the weakest destination of all the dark pools that they go to,” says Peter Fraenkel, director of quantitative services at Pragma Financial Systems. “OnePipe provides anti-gaming measures at the aggregation level, and monitors every liquidity venue for execution quality, so we can give customers an overall higher degree of safety.”

Similar protection is offered by FAN, the neutral aggregator of displayed and non-displayed liquidity of US agency broker and trading software company EdgeTrade, recently acquired by Knight Capital. “As a buy-side firm using dark pools, your main concern is limiting yourself to only a number of dark pools that you go to all the time and not having an aggregation tool randomising that flow and mixing it up by using different minimum order quantities and different order types within those dark pools,” says Joseph Wald, managing director, Knight Capital, and co-founder, EdgeTrade.

Pragma’s Fraenkel believes it makes sense for anti-gaming to be present at the aggregation level, because “otherwise it becomes incumbent on the investor to check out the anti-gaming measures of every single place where his shares might be executed”. That, he suggests, is too onerous to be worth doing. However, Olsen of ICM believes there are also measures that the buy-side can take themselves to avoid being gamed. “Dark pools have their own randomisation, but I am constantly working them, moving orders, moving limits, adjusting my urgency levels, moving things around all the time,” he says. “By doing that I feel very comfortable on the executions I am doing on behalf of our clients in the small-cap market.”

Despite his concerns about being gamed, Olsen is quick to point out that the risk in dark pools is no different from exposing his order to a traditional broker. Moreover, he is less concerned about the risk associated with certain counterparties than the risk of not executing at all. “Gaming won’t inhibit the popularity of dark pools,” he insists. “The risk reward is there. There are enough systems in place to negate the negativity of dark pools and the potential for gaming. The liquidity there is growing much faster than the amount of corruption.”