The name of the game!
George Andreadis, head of AES liquidity strategy, Europe at Credit Suisse, examines the role of advanced execution tools in limiting the potential for gaming and maximising the efficient execution of orders across light and dark venues.
How do buy-side traders protect themselves against savvy and informed players in the market who are actively looking for trading information? On the face of it this is not an easy question to answer, especially in a trading environment with increasing fragmentation and speed of trading coupled with decreased average order sizes.
Navigating light venues
Protection against gaming on visible venues has by and large already been solved. The key to sourcing liquidity and achieving best execution in visible order books lies in the quality of the execution tools at your disposal and the access they can provide to the available liquidity pools. Algorithms such as AES Guerrilla and Sniper have consistently proved that you can have a high participation rate in visible order books without chasing or pushing prices. Combined with a smart order router (SOR) such as AES Pathfinder, these execution tools not only reduce signaling risk but they can also take advantage of better prices available on alternative execution venues. They do this by dynamically routing orders to where the best prices and the most volume reside.
Navigating dark venues
Unlike visible order books, which seek to maximise pre- and post-trade transparency, dark pools aim to minimise market impact, often for large trades, by hiding all orders on a pre- but not post-trade basis.
Dark pools exist in several different forms and can be gamed in different ways. Negotiated models usually work by alerting a human trader to another trader’s intention to trade the other side of the same stock. Both traders can choose to enter into a negotiation at this stage. These models can be prone to information leakage if one of the traders pulls out of the negotiation and subsequently uses the information they have acquired to their advantage. Negotiated venues often adopt a closed buy-side membership base, which they claim limits the amount of gaming on their systems. They often monitor the use of the system and can exclude participants that they deem to be mistreating or exploiting their rules.
Other dark pools such as AES CrossFinder and NYFIX Euro Millennium operate similarly to public limit order books with the exception that they are dark on a pre-trade basis. Orders can be pegged to the mid, bid or offer of the main exchange, depending on the aggression level of the dealer’s strategy. Once executed, a trade is immediately printed to the market and becomes visible on a post-trade basis. These types of models often have a wide user base and can include buy-side firms typically using algorithms and /or DMA, program trading desks, cash desks, proprietary trading desks and sometimes high-frequency players.
Trading simplistically or simply sending orders into these types of pools can leave a dealer open to exploitation by more sophisticated market participants. Fortunately, access to the right execution tools, such as AES Guerrilla and AES Crossfinder+, Credit Suisse’s dark smart order router, can help buy-side dealers to achieve the level of protection they need when posting orders into single or multiple dark pools. They do this by incorporating sophisticated logic within the algorithm, which dynamically monitors order sizes, price levels, execution venues etc, to ensure fair play.
Pinging
‘Pinging’ or ‘fishing’ is one of the more common concerns associated with using dark pools and can often be misinterpreted as an abusive activity. There is a difference between genuine liquidity sourcing and principal price discovery. The former being part of a SOR strategy designed to find liquidity amongst multiple dark pools. The latter is where a participant trading on its own account sends very small orders to a dark book for the sole purpose of finding the price point of a large hidden order and using the information to its own advantage.
In order to combat this issue, many dark pools sup-port minimum acceptable quantity (MAQ), where a user sends an order into the pool specifying the mini-mum size that it is willing to interact with. This eliminates the issue of being pinged but can have the drawback that the higher the MAQ the lower the chances of being filled, because the order is unable to interact with genuine order flow that may be smaller in size. AES CrossFinder uses a combination of MAQ and drip-feeding orders into the market depending on the prevailing market conditions to solve this issue.
Asymmetric trend risk
By far the biggest concern for buy-side traders using dark pools is not actually to do with being gamed but rather the risk of not getting filled. The more time a large order spends in a dark pool with-out getting filled, the greater the risk that the price will trend away from them. Subsequently, the dealer is forced to trade in the visible market much more aggressively than otherwise, thereby increasing market impact. Many buy-side traders have had to manage this risk by entering orders into dark pools and then manually removing them if they are not happy with the fill rate. They then typically use a broker to source liquidity elsewhere, which can lead to a poorer execution result inherent with delayed market participation. However, this issue can be addressed by using a combination of dark smart order routing and intelligent liquidity sourcing. This ensures that orders are dynamically rebalanced into dark venues with the highest probability of execution.
With an increasing number of dark pools planning to enter the European equity market, smart order routing and liquidity seeking algorithms are becoming ever more important to fulfilling firms’ obligation to achieve best execution. Gaming and low fill rates do not have to be an issue if you are accessing dark pools using sophisticated execution tools.
