February 3, 2014

The Dark Pool Rises

The dark markets have become so efficient that the costs of execution and market impact are lower than at the display markets, where take fees are highest and market impact is most significant.

By Keith Ross

"SEC Ponders Recent Jump in Off-Board Trading" was a headline in the October issue of this magazine, and it's true that the issues surrounding dark pools and other alternative trading venues have become frequent topics of conversation among many market pundits. The implication in many discussions seems to be that increased dark pool trading is an unhealthy development for the markets and should somehow be curtailed. Such criticism underestimates the strength and depth of today's electronic stock markets and the benefits of dark pools as alternatives to exchanges.

Why is more volume migrating away from display markets? One answer is that traders sending their flow to the dark are having a better experience there than on exchanges. It is hard to imagine a more competitive environment than in the U.S. financial markets today. Traders managing clients' orders must compete on cost and best execution and are measured on every trade. It stands to follow that if these traders are sending their orders to dark pools, it's because that is the best way to accomplish their clients' goals. The dark markets have in fact become so efficient that the costs of execution and market impact are lower than at the display markets, where the take fees are the highest and market impact is the most significant.

Keith Ross

There are two other factors contributing to more volume in the dark. The first factor is overall market volatility. In the last few years, since the worst of the financial crisis has passed, the average VIX level has been approximately 19, recently hovering around 12 to 13, compared with 32 and 31 in 2008 and 2009, respectively. Traders have more patience with a passive order in a dark pool when the market is less volatile, so it is easier now to find a fill away from the lit market than during volatile market conditions. In terms of the second factor, when lit markets fully display orders, it is easier for high-speed algorithms to penny and game the orders, particularly if the visible quote is multiple ticks wide with nominal display volume as in high-priced stocks like Google and Apple.

Tim Mahoney, CEO of BIDS Trading, shared a frequently overlooked fact at the Baruch College Financial Conference in New York this October. Mahoney emphasized the importance of the consolidated tape in informing the marketplace of the last sale and size of every transaction that takes place in the equity market. Traders and regulators find comfort in seeing a deep book of bids and asks when they are contemplating a trade, but any effective algorithm will give more weight to the last sale of a stock than the displayed prices on an electronic book.