Gaming is a significant concern for buy-side traders when executing orders in both displayed and non-displayed pools of liquidity. However, gaming is notoriously difficult to separate from genuine trading activity. And the increasing complexity of Europe’s equity market structure is only making the task harder.
In essence, gaming is the use of small orders to either manipulate a market in the gamer’s favour or discover another trader’s intentions. While gaming takes place on displayed markets, it is particularly prevalent in dark pools, as gamers try to find out what type of liquidity is available and use that information to their advantage. The practice is usually associated with high-frequency traders, because they are the most likely to have the high-speed technology capable of firing tiny orders into multiple pools, analysing the results and acting on their findings quickly enough to achieve an advantage.
The risk of leaking information and effectively being front-run makes the buy-side uneasy and eager to glean any information they can about other players in a pool.
“The buy-side wants to know if high-frequency market-makers are operating as liquidity providers either in brokers’ own pools or the pools brokers route to,” says Toby Bayliss, head of algorithmic and program trading, Europe, at agency broker Sanford C. Bernstein. “There is a nervousness about trading in some pools, which comes down to a fear of trading with someone who is able to leverage lower latency, higher prioritisation or improved short-term alpha modelling.”
Venues can prevent gaming. Some methods are simple, for example requiring that limit prices or size restrictions are applied. This can be particularly effective at stopping so-called pinging orders, as a high-frequency trader is unlikely to send a multi-thousand-share order into a dark pool to try to guess another party’s intentions. Another method is to set an order duration limit that requires orders to rest for a minimum length of time, which prevents high-speed pinging orders being sent to a pool.
“SmartPool’s built-in order size thresholds prevent any gaming,” claims Roland Bellegarde, head of European cash markets at NYSE Euronext, which launched the non-displayed multilateral trading facility (MTF) in February. “Unlike some other MTFs, you cannot enter SmartPool with one share. Small orders is where gaming starts.”
Some venues employ sophisticated surveillance techniques to spot evidence of abusive behaviour, such as rapidly amending orders after posting, or trading in both directions.
However, such signals can also be produced by perfectly benign trading strategies. “Gaming can be exceptionally difficult to spot,” says Bayliss. “Brokers executing on behalf of clients or market-makers are likely to move in and out of a name in a very short time frame and potentially have some impact. That is legitimate trading activity, and trying to differentiate between standard market practice and gaming is very difficult.”
Analysing trading data after the event may not be the most effective way of tackling gaming. “Many venues take the trade data and look for abusive patterns offline and then take action. However, by then it can be too late,” notes Giles Nelson, senior director of strategy at Progress Apama, the algorithmic trading and complex event processing division of Progress Software. “There is a need to look for abusive patterns in real-time.”
Although venues are well placed to monitor gaming because of the visibility they have over their order books, there could be tension between the need to police the pool and the desire to maximise revenue from it. Bayliss adds, “If you are looking purely for the pool to protect your order, you have to then think about whether there are any conflicts of interest for the owner of the pool.”
The increasingly complex European market structure, with its diverse multiple displayed and non-displayed trading venues, has expanded opportunities for market abuse. “Every time you have two pools of liquidity trading the same securities simultaneously, and one pool is bigger than the other, it is open for manipulation – people will try to game the larger pool through the smaller pool,” says Bellegarde. “You will find this in every market.”
The tools created to ease the effects of fragmentation can also introduce gaming risks, as clients’ flow could end up in venues they had wanted to avoid. “A lot of venues and algorithms are onward routing orders and it is important the users understand exactly where their order flow resides, how it is being treated and what priority they have in any given venue,” said Bayliss.
The cross-border trading opportunities brought about by MiFID also make abusive practices harder to police. “This is particularly true in Europe, where there is pan-European trading but no pan-European regulator,” says Nelson. “How does a regulator piece together all the information required to come down on an abusive operator?”
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