missing the boat on dark pools

Maybe it’s the name, as some have suggested, but for whatever reason electronic crossing networks for stock trading are being portrayed in the press as insidious devices that need a large dose of sunlight shone on them.

That’s not right.  Electronic crossing networks exist for a good reason  …two, actually.

why use a dark pool?

Suppose you’re the manager of the Fidelity Magellan Fund and want to sell your entire holding in Bank of America (BAC).  As of its end of May disclosure, that amounted to 25.2 million shares.

Here’s the plan:

–average daily trading volume for BAC on the exchanges is 60.6 million shares.  Let’s say you don’t want to be more than 10% of daily volume, so that your selling doesn’t disturb the market too much.  That means it will take you four days to trade out of the position.

That’s pretty straightforward.  The real trick is to keep your identity and intentions secret for as long as possible, so that news of your selling doesn’t reach potential buyers and cause them to lower their bids.  This may be doubly important if you have a reputation as a shrewd investor.  Worse still if you bought BAC at the bottom when others thought you were crazy: your selling may be taken as a strong sign that the party is over for that stock.  So the exit door may get pretty crowded if others find out what you’re doing.

call a broker?

In my experience, if you’re Fidelity, calling one of the big brokerage houses and placing a sell order, even for a small amount of stock, is not the best idea.  Within minutes, that broker’s proprietary trading desk will likely know about your order.  Shortly after that, so too will other brokers.  Everyone’s sales desks will then begin to call the trading arms of institutional clients, spreading the information.  After all, these guys make their money by generating lots of trading commissions, not by taking the best care of you.

…and lose outperformance?

In my view, good trading + the ability to keep your actions below Wall Street’s radar, can be worth 100 basis points in annual performance.  This is like gold in keeping your money management clients happy …and getting new ones.

try a crossing network

Preserving this treasure is why crossing networks were invented and why professional money managers want to do business through them.

the second reason

The SEC mandates that managers it supervises obtain the lowest possible trading cost.  That’s crossing networks.  In other words, all other things being equal, professional money managers (ex hedge funds) have a positive obligation to use them.

the Barclays case

Most investors don’t want high-speed traders in their crossing networks.  The latter’s computers can quickly detect unusual trading activity, which allows them to trade against this movement, both in and out of the dark pool.  Put another way, the element of secrecy, the key feature of the crossing network, is lost.

Barclays is accused, among other things, of running a dark pool whose largest participant was a high-speed trader while telling other participants no such damaging influence was present.


The big brokers are now saying the solution to the Barclays problem is to abolish dark pools.  Of course, I’m sure they’d also like to get rid of discount brokers and no-load funds as well.  But the real issue is alleged deceptive business practices by one of the big brokers themselves.  Eliminating alternatives to their trading desks is no solution.  If you’re not a borker, it’s crazy.






the “dark pool” investigation

Someone with a Dungeons and Dragons background must have named them “dark pools.”  But they’re neither mysterious nor scary.  Dark pools are just off-exchange automated trading networks for stocks.

They exist for two reasons:

–the old school method of having a trader in a money management firm call up a broker and place a buy or sell order by phone is expensive.  And money managers have a legal obligation to obtain the lowest cost execution of their orders on behalf of clients.  So they have a positive obligation to seek out cheaper ways of doing business–which automated networks are.

–brokerage house traders won’t keep a money manager’s order secret unless the manager is exceptionally diligent.  This is a real hassle, and very time-consuming for the  money manager’s trading room.  But if you don’t pay extraordinary attention, your secret trading plans–which, after all, are your stock in trade–will be all over Wall Street in a nanosecond.

Automated trading networks have one–no, make that two–defects:

–they can be relatively illiquid, so that very large positions may not be able to be moved quickly, and

–many of the biggest of them are run by investment banks/brokerage houses.

This second characteristic is the reason for the current SEC investigation.

In a recent post, I wrote that Fidelity was exploring the possibility of forming its own automated trading network with other money managers, cutting out brokers altogether.  Its reason, I thought, was that computer=based high frequency traders were able to deduce Fidelity’s trading plans by analyzing dark pool data–and that Fidelity wanted to create a venue where they’d be banned.

It appears I may have been too high-tech in my approach.  The SEC investigation appears to focus on two possibilities, both of which are decidedly old-school brokerage behavior and both of which would violate the guarantees the automated network operators give to clients:

–the first is that the operators may have taken undisclosed fees from high-speed traders to allow their buys and sells to have priority over other order–essentially letting them front-run or scalp other participants

–the second is that operators may have taken the supposedly anonymous trading activity of high-profile participants and sold its details to others.  I say “sold” but in my experience, the compensation for such information would normally not be in cash but either in increased trading volume or higher per-trade fees.

Personally, I don’t think dark pools themselves are the issue.  I view them as part of the solution to a problem with how traditional brokerage/investment banks are run.  And the fact that the old system is breaking down makes these firms even less willing than normal to give clients an even shake.

It will be interesting to see how the SEC investigation progresses.



Fidelity’s dark pool proposal–why?

Recently, Fidelity, one of the largest money managers in the world, has been sending feelers out to its peers to form a private “dark pool” in which they could all trade anonymously.

What’s this all about?

I’m not sure who made up the name “dark pool.”  But it glamorizes a pretty mundane operation.  A dark pool is a computer-driven trading network where professional investors buy and sell securities with each other in a low-cost anonymous way.

They’re meant to solve two problems that every large investor like Fidelity who’s subject to SEC regulation in the US has:

–in trading securities for their clients,money managers are required to obtain the lowest cost in making any trade as well as the best execution of the order.  Best execution, which I take to mean the most favorable price, given the circumstances at the time of the trade, is a rather vague and contentious concept.  But lowest cost, meaning the lowest commission or bid/ask spread paid to get the trade accomplished, is relatively clear.

It’s also very clear that dealing with a third-party broker isn’t the lowest cost way of doing business.  Dealing directly with another institution through a computer trading network may cut commission/spread costs in half.  As a result, increasing amounts of trade is being done through dark pools so institutions can establish that they’re working to fulfil the lowest-cost legal mandate.

–any money manager wants to keep his trading activity as secret as possible.  After all, no one wants others to be freeriding on investment ideas that a manager has developed after long and expensive research efforts.

This is a particularly pressing issue for managers with large amounts of money under management, since such a manager will often have orders that are so big they can take, say, a month to execute–sometimes longer.  The trickiest part of such trading is keeping the manager’s activity secret for as long as possible.

Again, brokerage house trading operations for third parties are not a great way to go.  They tend to leak like sieves.  Part of this is a function of order size.  The broker may approach potentially interested parties.  As/when the size of the order becomes apparent, the other party may be able to guess the identity of the institution the broker represents.

There’s mre than that, however.  Information is also a valuable resource.  In my experience, most important clients of a broker–and the broker’s own proprietary trading desk–would know the general outlines of a Fidelity order within minutes of its being placed.  The broker might not use the Fidelity name, but the description ” a large institution in Boston” would leave little to the imagination.  The idea is that smaller clients will regard this as valuable information and will compensate the broker with increased trading commissions in return for continuing access.  (My tendency would be to do less business with a broker who acts this way, but apparently I’m in the minority.)

Dark pools, though sometimes illiquid, are one solution to this problem.

It turns out, though, that the dark pools also have their issues.  One that I find interesting is that to obtain liquidity dark pools may allow high frequency traders to participate.  And, it turns out, they have found “big data” ways to figure out which orders are Fidelity’s–and to use this information to trade against them.

Fidelity’s response is to try to form a dark pool that will consist only of institutional investors, without high frequency traders.  Such a setup might have issues of its own.  If there are only, say, four major members it may be that the trading intentions of the others will be obvious to all.  But, in Fidelity’s view at least, that would be better than the current situation.



dark pools and Pipeline Trading Systems

dark pools: what they are

the traditional brokerage system

Twenty years ago, virtually all trading between professional investors was conducted through stockbrokers as middlemen.  This traditional system had three big advantages:

–brokers are constantly in touch with a large number of potential buyers and sellers–including other brokers–of a wide variety of securities.  This means that orders can be executed quickly and in large size.

–in some cases, brokers may use their own capital to buy less liquid securities from a customer right away–securities that would otherwise be hard to sell–hoping to trade out of the positions at a profit over a period of time.

–because brokers see lots of orders from very many customers, they may be able to spot trends in the markets faster than an individual investor.  So they may be a source of market intelligence.

Using a broker has one big disadvantage and one smaller one:

–the smaller one is that they’re more expensive than dealing directly with another professional investor would be,

–the larger one is that your broker knows who you are and what securities you’re transacting in.  The more you deal with a given broker, the more insight he will gain about your plans and methods of operation.  In a sense, he gradually comes to “own” them.  He can use this information in his proprietary trading or pass it on to your rival investment managers.

The bigger the institution, the savvier the investment manager, the more valuable this information is–and therefore the more likely it is to be passed on to others.

anonymous trading networks…

Advances in computer technology, both software and hardware, allowed entrepreneurs to create the first anonymous computer trading networks, or “dark pools” for institutional investors about a decade ago.  Investors register with the network operator, but place all their buy and sell orders on the network without revealing their identity.  Nor can they find out who the other side of any transaction is.

The advantages of dark pools are:

–anonymity, and

–very low commission costs.

The main disadvantage is:

–liquidity in a given issue may be low, meaning that execution of a large order may take a considerable amount of time.  An institution can mitigate this problem somewhat by placing orders with a bunch of dark pools at the same time.

…have become very popular

As time has passed and investors have become more accustomed to the concept, the use of dark pools has increased to where some estimates have them accounting for more than one trade in four in the US.  Three reasons:

–more users means better liquidity

–SEC-regulated investors have a positive obligation to seek the lowest-cost executions in their trading.  Using electronic crossing networks demonstrates they’re doing so

–as brokers have deemphasized stock research as a way to cut costs, the need to do enough business with brokers to get full access to research information has diminished.

where Pipeline Trading Systems comes in

Pipeline (PTS) is a broker- dealer who decided to cash in on the dark pool trend by creating one of its own.  It intended to make money, as any dark pool operator would, by charging a fee to anyone using its service.  It opened for business in September 2004.

In its advertising, PTS touted its anonymity and its ability to provide “natural” buyers/sellers for the other side of any trade.  Although, as the SEC notes in its recent cease and desist order, natural doesn’t have a precise legal definition, its use is meant to convey that the other party is another institutional investor, and not a financial intermediary like a broker or short-term trader.

Despite this claim, even before opening, PTS created a wholly-owned trading affiliate to take the other side of trades.  Its idea appears to have been that liquidity in the dark pool would thereby appear bigger than it actually was.

PTS didn’t disclose this to clients.  Quite the opposite.  It continually assured them that this was not the case.

As it turns out, the PTS dark pool was a bust.  In the early years, PTS itself provided well over 90% of the other sides of institutional members’ trades.  And it lost a lot of money doing so.

So PTS decided to put its head trader in charge of the brokerage affiliate, with the task of whittling down the losses.  The in-house broker promptly began to act in a way I see as being against the interests of its institutional clients.  Contrary to what it was telling clients, PTS gave the broker privileged access to the dark pool’s trading data, so it could study customers’ trading patterns; traders were given bonuses for money-making trades; the broker gave suggestions to its parent on how to tweak the dark pool rules in the broker’s favor.

PTS continued to lose money, however, though at a lower rate.  And then it was caught by the SEC.

PTS and two principals were together fined $1.2 million.  They also agreed to stop their illegal behavior.

Although the PTS crew were a hapless bunch, the SEC administrative proceeding against them shows that the agency is finally beginning to examine the operation of dark pools.  At the same time, the case shows that an enterprise like PTS can operate for the better part of a decade without being detected.