Not all alternative liquidity is created equal

Robert Dykes, ToraRobert Dykes, CEO, TORA, says toxicity analysis is a critical tool for shedding light on the value that dark pools can bring to the investment process.  

Buy-side trading desks are faced with the same challenges in the new electronic world as they were before the era of advanced trading technology tools. The search for liquidity, retaining anonymity and the hunt for best price remain at the heart of maximising trading performance. The advent of electronic trading has provided buy-side traders with a rapidly expanding set of electronic tools both to generate alpha and achieve best execution. Advanced execution management systems (EMSs) are now an integral part of maximising performance, and it is no surprise that the usage of alternative venues and smart order routers (SORs) have also become an essential part of the trading process through their promise of price improvement and anonymity.

Technology has assisted the rise in crossing offexchange liquidity, in both lit and dark venues, with SORs and crossing networks providing a low latency solution to access liquidity across multiple venues. Compared to the US and Europe, Asia has a small but growing percentage of volume accessing broker, exchange and a limited number of third party dark pools such as TORA Crosspoint™. These venues are vital in achieving best execution, but as usage of dark pools is incorporated into execution decisions in Asia, understanding how flow interacts with the pool and how to optimise their value can be a challenge.

Analysing pool quality  

While it is often assumed that dark pools will deliver a better trading performance, not all pools are created equal. Varied approaches to pricing, access, available order types, participants, monitoring and connectivity influence the performance that any given pool will deliver. Traders in Asia may wonder, as in the US and Europe, am I getting best execution for my trade through a dark pool and how do I ensure that I do?

Dark pools can tick several boxes which a buy-side desk is looking to fulfill. Liquidity may be available in dark pools that is not displayed in lit markets and is tradable anonymously, preventing information leakage and therefore limit or remove price impact on the market. Other considerations are price and size and whether the trade was filled at the best combination of price and size by going through a dark pool(s), rather than a traditional route to the primary market.

As knowledge and trading expertise build in Asia, so does the richness and depth of data to analyse dark pool execution. One common definition of toxicity analysis is an evaluation of whether execution in any given pool delivered a better or worse price than if the trade was matched in the lit market. Alpha windows, the immediate time pre- or post- the trade being posted in the pool, are often taken at intervals of between one to four minutes and the actual price is analysed against the price that could have been secured outside of the pool during the alpha window. Post-trade analysis is useful in all aspects of trading but it is essential to understanding the value a dark pool delivers.

Understanding toxicity  

Toxicity analysis is not often made publicly available, which creates a gap in understanding the true effectiveness of dark pools in achieving best execution. TORA recently undertook its own analysis of trades routed via TSOR™ (TORA’s smart order routing algo) to our own pool, TORA Crosspoint™, and other broker pools to better understand the differences in the quality of pools.

The study looked at varying alpha windows and trades were broken down into individual months. The toxicity analysis and results were generally consistent across all timeframes. While each pool has monthly variations in their toxicity levels, it was clear that pools were consistently toxic or non-toxic. In short, some pools need to be watched more than others and only accessed in limited circumstances where getting liquidity is paramount. The outcome of the toxicity analysis of TORA Crosspoint™ determined it to be a safe, non-toxic place to execute orders.

There are many variables as to why the quality of pools varies so greatly including the type of flow in the pool (institutional or retail), the types of trades being posted, market making or even the volatility and momentum of the stock. Deeper analysis to understand these variables and their impact on toxicity within individual pools is an important tool in evaluating performance and can therefore influence future trading decisions when executing through a dark pool.

Intelligent direction  

Toxicity analysis and understanding the factors that affect pool quality are used by TORA to make smart decisions on the operation and rules of engagement of its pool and how TSOR™ is calibrated to interact across pools. Ultimately the aim of any off-exchange venue is price improvement, reduced market impact and liquidity. The next generation of smart routers, such as TSOR™, are built to dynamically create any type of rule which help achieve best execution for the client. This includes toxicity-based rules to intelligently direct flow to quality pools and posting certain types of orders to pools where that order is likely to benefit. Even relatively toxic pools have a place especially when liquidity is thin or the most important criterion is executing the order.

One thing for certain is that alternative liquidity pools are here to stay. These venues will grow to be an even more important part of the process in enabling the buy-side to deliver price improvement and liquidity while protecting anonymity. Despite some participants being skeptical about the toxicity of dark pools, their benefits far outweigh any shortfalls on the whole. Rather than shy away from accessing dark liquidity, it is a matter of using analysis and liquidity tools smartly to aid execution decisions and empower the buy-side trader to make a positive impact on the bottom line.