Dark pools have faced unfair criticism as industry spin continues to fabricate untruths and distort reality about the venues’ usefulness, a leading capital markets expert has claimed.
Matt Samelson, principal of research consultancy Woodbine Associates, said the utility of dark trading venues has been muddied the barrage of bad press they receive – often unfairly.
“If you took a general cross section of the world, of those who knew about dark pools, most would regard them as sinister,” he said. “But a lot of spin about dark pools is nonsense. We should be happy we have them and make sure that we are informed users.”
One criticism levelled at dark pools is that they actively route orders to other venues and/or expose orders to non-members, which leads to information leakage.
“In fact, dark pools substantially curtail, but do not eliminate, information leakage. The degree of potential exposure depends on the operating model of the venue. From what we have seen, no one is wantonly routing out flow to other brokers or high-frequency traders,” he said. “A handful of pools have features or integrated user tools that permit the sending of indications of interests (IOIs), but in virtually all instances, IOI features are used at the discretion of the dark pool client.”
Woodbine has just completed a 111-page in-depth study of US dark pools, which examines the market venue-by-venue, providing traders with an unbiased assessment of pool management and operational practices to enable optimal stock execution.
“You can trade badly anywhere,” Samelson said. “Dark pools are good places to execute but they are complex and participants need to have a more comprehensive understanding of them.”
The report, entitled ‘Dark pools, characteristics, operations and liquidity’, asserts the presence of high frequency trading (HFT) in dark pools is not grounds alone to say a venue is favourable or unfavourable.
As well as detailed assessments of 19 dark pools in the US, the Woodbine report also covers key buy-side concerns about dark trading, including gaming risk, price discovery impact, and block trading opportunities.
Know your dark pool
Critics assert that because dark pools admit HFT, they expose counterparty orders to increased risk of gaming and abuse. But Samelson said the interaction of high frequency traders with non-HFT liquidity varies significantly among pools. The manner and degree to which HFT order flow interacts with non-HFT order flow depends more on each venue’s philosophy on pool operation and the tools and features made available to control interaction.
“We did not audit venue anti-gaming, but everyone we spoke to said they keep an eye on activity,” said Samelson. “They have to; if people have a bad user experience, that will trickle down.”
Samelson said US venues have varying ideas of oversight. Some have tight controls and rigorous enforcement while others operate more like free markets. Some look at liquidity more holistically while others are focused on the type of participant they allow.
“Buy-side firms need to make themselves keenly aware of the nature of the venues they use,” he said.
And while concern has also been expressed that increased internalisation of flow in the US market will negatively impact price discovery, Samelson argued that market share figures show little evidence price discovery has been impacted, nor is it likely to be anytime soon.
“Dark pool market share of total internalisation might be growing – from around 8% in 2008 to 13% today – but internal flow in the US is still only around 27-34% and steady,” he said, adding this was not enough to affect price discovery in the lit.
Samelson said the characterisation of dark pool liquidity as particularly toxic was often a bias used by brokers and other providers of aggregation tools and algorithms to describe dark pools in which adverse post-execution price movement is continuously observed.
“It may simply be liquidity that is better managed by the agent’s competitors through competing tools and algorithms,” he said, suggesting the buy-side should try another broker’s tools before blocking access to a particular pool.