Dark pools of liquidity, or the secret stock market
May 20, 2008 10:14 AM   Subscribe

The rapid growth of electronic trading since 1976 has benefited equity market participants by improving competition, reducing cost and increasing liquidity while insuring better pricing.

One unexpected side effect has been the recent emergence of "dark pools of liquidity", or the secret stock market.

The New York Stock Exchange (NYSE) is arguably the world's single largest cash equity market: roughly 2,700 companies with a market capitalisation exceeding $25 trillion dollars are listed on the NYSE, Every day some 1.67 billion shares or over $63 billion dollars changes hands (data as of 2006).

But not all shares for NYSE listed companies are traded on this exchange.

Many institutional investors use electronic trading services called "Crossing Networks" to match buy and sell orders. Such networks are known in the buiness as "dark pools of liquidity", and while their emergence is a fascinating, competitive story, it is the possible ending that interests equity market researchers the most.

Crossing Networks provide two services critical to the institutional investor - anonymity and liquidity. Such networks allow participants to anonymously buy or sell large blocks of securities, without using listed stock exchanges or impacting publicly quoted prices on those exchanges.

The attraction of such networks to institutional investors is easy to understand: if competitors learn about your market activities they are in a position to disrupt your trades. Disrupting trades may be as simple as front running orders, or attempting to trade mispriced securities before you do. In other words, public activities may lead to price disruption, with risk of trading losses.

There are many such networks, each operating in specific niches or providing specialised services. For example, SIGMA X claims to offer "the largest pool of non-displayed liquidity in the United States", while BATS has taken the lead on aggressively reducing trading costs year after year. Merrill Lynch and ITG's joint offering, Block-Alert, allows institutional investors access to a large standing pool of liquidity, capable of absorbing buy or sell orders without matching.

At present crossing networks account for over 10% of all equity market trading, with business growing in excess of 40% per annum. Considering the vast sums of money attracted to dark pools of liquidity, their numbers are certain to continue growing. But precise data about crossing networks is difficult to come by, due to their international scope and the fact they serve the needs of private, institutional class investors.

However the dark pools of liquidity are converging, and, in some cases, emerging into the public eye.

Today Goldman, UBS and Morgan Stanley agreed to provide shared access to their own dark pools, creating, in a virtual sense, a single, large Crossing Network. As economies of scale are critical to equity trading, other dark pools will be certain to follow. And how might this story end?

As dark pools continue to converge, enlarging their liquidity base while doing so, they are beginning to compete for business with traditional, organised exchanges such as NYSE / Euronext.

BATS has already applied to the SEC for registration as "national securities exchange", an action that existing organised exchanges aren't welcoming. One of BATS competitors, DirectEdge, has indicated it also intends to apply for exchange status as well.

It will be fascinating to watch as dark pools of liquidity converge, growing larger as they do so, in many cases emerging from the shadows to threaten entrenched competitors such as NYSE / Euronext. This is a scenario that played out to its endgame, can only benefit all equity market participants.
posted by Mutant (21 comments total) 28 users marked this as a favorite
While discussing dark pools of liquidity, it's important to keep in mind these services are "non quoting"; in other words, while they provide liquidity they do so at the public price. No firm using these services is getting a better price than traders using public, organised exchanges. Indeed, crossing networks simply match buyers to sellers, who reference public prices to arrive at fair value.

Also, as several firms offer advanced routing services which automatically break up large block trades to suit the limited liquidity each pool can offer, many institutional class investors find that on aggregate, they are paying higher transaction costs than if they had used existing exchanges. But that's the price they are willing to pay for anonymity in the harshly competitive world of trading.

And what about the firms offering dark pools of liquidity? How do they make their money? Well, in many cases they are matching orders between buyers and sellers, thus earning commissions based on trading volumes.

Other firms which offer standing pools of liquidity are effectively accepting risk from market participants. Such organisations either utilise active risk management practices, thus rendering their trading books market neutral, or seek to offload such assets as rapidly as possible.

The most interesting thing about the story of dark pools of liquidity is circularity; while NYSE was busy acquiring any and all competitors, crossing networks operating in the shadows, were slowly building a client base, providing much needed, missing services. This fragmentation, in retrospect, actually was a good thing. Had new exchanges sought to compete from the outset with the established exchanges, they most certainly would have been driven from business.

Now pools of dark liquidity are emerging from the shadows, seeking to obtain full fledged exchange status and in doing so, completing a circle from secretive organisation to public entity.

A fascinating story.
posted by Mutant at 10:14 AM on May 20, 2008 [3 favorites]

Such networks allow participants to anonymously buy or sell large blocks of securities, without using listed stock exchanges or impacting publicly quoted prices on those exchanges.
It seems to me that this would imply that both systems cannot influence each other, or that at least NYSE et al don't reflect the financial impact that these anonymous transaction have on companies, regardless of the system on which these have happened.
posted by elpapacito at 10:29 AM on May 20, 2008

Wouldn't this invite shady activities such as insider trading, evading the requirement to notify the SEC when you acquire a certain % of a company's shares, etc?
posted by msalt at 10:47 AM on May 20, 2008

tl;but I read it anyway. Good post. Interesting topic.
posted by GuyZero at 11:28 AM on May 20, 2008

Msalt, that's the first thing my criminal mind went to.
I smell a zaibatsu.
posted by eclectist at 11:29 AM on May 20, 2008

I think the most interesting example of these type of private exchanges is the rise of excahnges for unregistered equity, like Nasdaq Portal, Opus, GS TRuE, etc. The distinction between being privately and publicly held starts becoming the number of owners and how much paperwork you have to file.

the requirement to notify the SEC when you acquire a certain % of a company's shares, etc?

Carl Icahn and Nelson Peltz know how to play that game.
posted by milkrate at 11:34 AM on May 20, 2008

Wouldn't this invite shady activities such as insider trading, evading the requirement to notify the SEC when you acquire a certain % of a company's shares, etc?

On insider trading: no, because the trades are still reported to the regulators.

On 13(d,f,g) style reporting: No, because section 13 has to do with ownership, which is based on the positions you hold, rather than the trades that it took to get your positions; and your accounting system is used to provide those reports to the regulators.

Disclaimer: I work in a financial institution on compliance activities.
posted by felix at 11:59 AM on May 20, 2008

I have to say that I have tried, and failed, to understand exactly what is going on here...My brain cannot seem to cope with high finance. If someone could dumb it down a notch, that would be helpful.

However, "Dark Pools of Liquidity" would appear to be an excellent name for a horror movie, a video game (or their potential sequels), and/or a rockband. For example:

Metafilter II: Dark Pools of Liquidity. In cyberspace, the information won't overload you - just drown you!
posted by never used baby shoes at 12:37 PM on May 20, 2008

No discussion on this topic is complete without a reference to LiquidNet.
posted by sfts2 at 12:38 PM on May 20, 2008

Didn't Queensr├┐che have a song about this?
posted by seanmpuckett at 1:03 PM on May 20, 2008

Public markets depend on the signals of both price and volume to function efficiently. If I were to simultaneously execute buy and sell transactions of a stock in order to artificially pump up the reported volume of trading and increase the apparent interest in a stock, the SEC would be all over me for manipulating reported market volume. The SEC has prosecuted traders for doing exactly that. The same should apply to traders that conceal their transactions to artificially depress the reported volume of trades. Transparency and disclosure of information is essential to efficient markets. These are publicly traded stocks and the SEC has the obligation to insist on transparency.
posted by JackFlash at 1:37 PM on May 20, 2008

"If someone could dumb it down a notch, that would be helpful."

If you want to buy or sell stock in Company A, for instance, you would go to your broker and place an order. The broker would take your order to the trading floor (these days its mostly electronic) and then buy or sell the shares as per your order. The trade would be public information, including how much you paid or accepted and how many shares you bought or sold.

The Dark Pools of Liquidity, however, are like if your broker takes your order and instead of going to the trading floor, s/he goes out back into the alley at night when the lights are off and wears all black with a mask on. A few hands are shaken, money is exchanged, your broker returns with your money or shares and only you and your broker know what just happened. Its like buying merchandise off the back of a truck -- you don't know where it came from and you don't care. Not that I'm implying there's anything illegal about this, just that its not transparent. The intention is to hide what you're doing, not expose it.

Anyway, that's my guess, please feel free to correct me.
posted by PigAlien at 3:49 PM on May 20, 2008

Oh good grief. That's not it at all.

To fix you analogy, you call your broker. You want to sell 100 shares of X. The broker takes your order and hangs up the phone. before calling the trading floor he hollers out "Anyone want 100 shares of X?" Broker 2 looks up and says "Sure!" They make the trade at the current price of X on the trading floor. But they never involve the stock exchange directly.

It's dark in that it never sees the trading floor where everyone knows what's going on. But as others have noted, the market is still setting the price. FOR NOW.
posted by GuyZero at 4:35 PM on May 20, 2008 [1 favorite]

I understood off-market trades were not that uncommon, and one of the criteria when choosing a broker in the old days was how good their (people) network was for getting these done.
I suppose the proliferation of electronic equivalents is a little surprising, and a little concerning from a risk management point of view - it would be tempting to try to go around trading curbs on market at times of high volatility.
posted by bystander at 5:16 PM on May 20, 2008

Although I suppose if Wall st is suspended there is no accurate market price to execute the trades at.
posted by bystander at 5:17 PM on May 20, 2008

Mutant, I've been wondering what "dark pools" are since I started delving into FIX protocol structure a few months ago; thanks for the best explanation I have seen yet.

As always, your posts and comments are some of the best of teh intarweb. Much appreciated.
posted by EricGjerde at 8:05 PM on May 20, 2008

Isn't this how oil is traded? the New York and London markets create the price, then Iran sells oil to China at that price, without going through markets.

I'm not understanding why this is bad.
posted by rakish_yet_centered at 7:35 AM on May 21, 2008

Here's a hypothetical scenario on why I think "dark pools" are bad for smaller market participants who don't have access to them:

XYZ Regional Savings & Loan (Ticker XYZ) has been having trouble - they wrote too many option ARM mortgages in a bubbly real estate market, and now a parabolically increasing % of their loans are defaulting.

Big Instutional Holders Alpha, Beta, Charlie and Delta each own 20% of XYZ's stock, with the remaining 20% in the hands of retail (individual) investors.

Alpha, Beta, Charlie & Delta all participate in a dark pool. Retail investors aren't invited - they can only buy and sell on the public exchanges.

The FDIC decides XYZ is in enough trouble that it needs to be taken over to protect XYZ's depositors. Typically in this situation, the common stockholders get almost nothing after the FDIC seizes assets. Although normally FDIC decisions such as these are carefully guarded secrets, the decision is leaked and Alpha learns of it.

Alpha goes to the dark pool and liquidates their holdings of XYZ to Beta, Charlie & Delta.

XYZ's listed stock price is materially unchanged at this point, since none of this sell volume has hit the public exchange.

Beta subsequently get the leak, and liquidates its holdings of ABC via the dark pool to Charlie & Delta.

XYZ's stock price is still unchanged.

Pattern continues until Delta is left holding 80% of XYZ's stock. Finally, Delta learns of the leak, but guess what, there are no participants left in the dark pool who will buy XYZ.

Delta is panicked and unsure of when the leak will become a widespread rumor. They put 80% of XYZ's stock up for the bid on the public exchange. Within minutes the price of XYZ drops by 50% and trading is halted. When trading resumes, XYZ trades for 5% of its former price. Delta sustains an enormous loss, but uses it as a tax write off. Retail investors in XYZ, however, are absolutely crushed in literally minutes.

If the dark pool didn't exist then the increasing volume of sells would have ramped over hours to perhaps days as Alpha, Beta, Charlie and Delta tried to break up their sells into smaller pieces so as to not rattle the market.

The SEC would have the public bids/offers by the big holders as evidence to investigate the source of the leak.

Retail investors would have had much more time to evaluate the price action and make a decision regarding their holdings of XYZ.
posted by de void at 10:02 AM on May 21, 2008

Some Thoughts on Dark Pools of Liquidity from Zero Beta.
posted by chunking express at 12:56 PM on May 21, 2008


OK, I'll buy that
posted by rakish_yet_centered at 12:35 AM on May 22, 2008

When holders are selling and buying large quantities of stock like this, what does this say for the stock exchange's role as clearinghouse of information regarding stocks. How do the Crossing Networks of big banks not use the insider knowledge of large movements of sales that they are given access to?

posted by stratastar at 6:37 AM on May 22, 2008

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