Scared of the dark

Buy-side traders must get to grips with the variety of dark pool models that are now available, or risk giving away valuable information that could impair execution performance.
By None

Non-displayed liquidity pools were created to help institutions minimise market impact, so why are buy-side traders worried about information leakage in the dark?

Dark pools have been marketed as a haven for buy-side firms that wish to limit the information they reveal to the market when trading. But the concept of the dark pool has evolved and diversified. Each model poses a different risk.

In Europe, many dark multilateral trading facilities (MTFs) court algorithmic flow through low-cost pricing tariffs and immediate-or-cancel order types, which raises the possibility that a portion of flow within the pool is derived from high-frequency trading (HFT).

For those wary of exposure to predatory HFT strategies, this is arguably more of a concern than interacting with HFT in displayed environment, as the buy-side trader is typically trading in the dark to protect a particularly sensitive order.

Brokers now promote connectivity to dark MTFs as an additional source of liquidity, rather than a means of protecting clients' order information.

Many brokers are also spending more time and resource measuring the quality of liquidity in dark MTFs, e.g. by monitoring a stock's behaviour after an execution, to help the buy-side understand the differences between dark pool outcomes.

How does this differ to the dark pools operated by brokers?

Unlike dark MTFs, brokers have discretion over who trades in their crossing networks and how orders are matched.

In theory, this is supposed to offer a greater level of protection to buy-side investors but some broker crossing networks (BCNs) allow proprietary market making or internal DMA flow to interact with client orders. This creates ambiguity on the extent to which BCNs are adding alpha to client or proprietary orders.

A handful of brokers have launched dark MTFs that operate separately from their BCNs to provide a clear division between internalisation-style crossing services and the non-discriminatory matching function provided by MTFs.

Regulators are keen to ensure this distinction is maintained, so that order information from a broker's MTF is not exploited by its trading desks. However, brokers point out that the nature of dark pools means that no pre-trade order information is published and therefore cannot be easily be taken advantage of by sales traders.

How can buy-side traders protect themselves from being gamed in dark pools?

In short: understand your options. Some dark pools such as Pipeline, ITG POSIT Alert or Liquidnet offer the buy-side the opportunity to cross large blocks with each other, with greater control over how their orders are handled.

ITG POSIT Alert, for example, does not allow immediate-or-cancel order types and runs on technology that has a higher latency than other trading venues, which means it is not conducive to HFT flow. Other systems like Liquidnet allow buy-side traders to negotiate the price of execution with each other, instead of depending on the mid-point price of a stock on the relevant primary market like dark MTFs.

Furthermore, almost all dark pools now offer users the chance to specify a minimum acceptable quantity, i.e. a minimum fill that they are willing to accept for their orders.

Planned revisions to MiFID could also shape a more secure dark trading environment. Final proposals expected from the European Commission in October could include a minimum size for all dark orders, a clearer distinction between BCNs, dark MTFs and systematic internalisers and more granular post-trade BCN data.

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