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Intelligent Investing Panel

Don't Be Afraid Of The Dark Pools

Alexandra Zendrian, 05.18.09, 04:00 PM EDT

While the term dark pool might sound mysterious, they can provide price improvement and better quality trades for retail investors.

Dark pools are venues where trading is done off of an exchange to obtain price improvement and not move the price if a large block of stocks is being traded. While the term dark pool conjures up visions of dark alleys and one broker passing another broker stocks in a silver suitcase, they can be helpful for moving tough-to-trade securities. Still, why should dark pools matter to you?

One reason is since dark pools trade off of the traditional exchanges and often execute at the midpoint between the bid and the ask price, they can be a way to save you money.

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"Although the term dark pool sounds very sinister, retail investors have nothing to fear," said Jamil Nazarali, head of Knight Capital Group’s dark pool, called Knight Link. "Although the term dark pool is relatively new, the concept of crossing off exchange liquidity has been with us since the beginning of stock trading. Institutions have always crossed large blocks off exchange and the large sell side firms have facilitated this."

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The executions done in dark pools are only hidden from the public and other brokers before and during trading. "I think it is important to remember that dark only refers to a pre-trade state. Once a trade occurs, regardless of the venue, it is reported to the consolidated tape," said Tim Mahoney, chief executive of BIDS Trading and co-developer of the New York Block Exchange, a joint venture between BIDS and the New York Stock Exchange.

Dark pools have been traditionally been used by institutional traders, who use them to execute large stock transactions without moving the market against themselves. But dark pools have evolved to give retail investors and smaller orders a crack at price improvement and better liquidity.

For example, some dark pools offer ways to trade portfolios of securities, such as Investment Technology Group’s POSIT Marketplace. This dark pool features sector balancing, cash constraints and other offerings that help money managers maintain the balance in customers' portfolios. Sometimes when portfolios are traded on standard exchanges they can lose their exposure to certain sectors, such as automobiles, when brokers try to get a cheaper execution in another sector. By using cash constraints and sector balancing, a portfolio that was supposed to be long on tech stocks, for example, is more likely to remain so.

Retail investors should tune into dark pools as they may help their brokers benefit from lower hidden trading costs, said James Ross, head of NYSE MatchPoint, which aggregates brokers together to trade in the dark. Ross said dark pools could offer price improvement for retail investors with mutual funds and 401 (k) programs, as compared with standard stock market trades. "Because these funds bundle these investment interests into single trading decisions, they are extremely focused on trading costs," he said. "The size of their orders and … and their visibility in the marketplace can incur massive trading costs which ultimately are negative performance for the fund."

Dark Pools have some risks too. When information is leaked out of a dark pool it can lead to gaming -- such as when a broker discovers what securities are within a pool and is then able to step ahead of dark pool participants. Because of this dark pool users have to be aware of when they are sending out information that could cause their order to be pre-empted by another trader.

So while the average retail investor may not typically use a dark pool for their own trades, their broker may. And since dark pools can lead to orders being gamed, traders working on behalf of retail investors should ask the dark pools they use what kind of safety measures are in place.

In The Dark?

Forbes: Many buy-side traders are concerned about gaming in dark pools. Is this a legitimate concern now, and what are dark pools doing to reduce gaming?

Jamil Nazarali: I think gaming is a legitimate concern in that is does sometimes happen and buy-side traders should take precautions to detect and stop it. However, I think dark pool operators are getting better and better at detecting and throwing out the gamers. I'm not saying that gaming doesn't exist, just that it is probably much less prevalent than people think. Let's also remember that gaming also happens in exchanges, ECNs and other liquidity venues, so a buy-side trader can't stop worrying about gaming just because they are not using dark pools.

Forbes: Do you think fears of gaming should increase or decrease depending on whether pools use indications of interest or immediate or cancel orders? And for readers who don't necessarily know what IOIs and IOCs are, can you explain that?

Jamil Nazarali: Sure, first an explanation, IOI stands for indications of interest, they are often used to determine if there is available liquidity that can be crossed with your order. For example, if you enter a buy order for 100,000 shares of Stock XYZ into Dark Pool A, Dark Pool A may send indications of interest to Dark Pools B and C to tell them it is interested is trading stock XYZ, if either pool has a crossable order. Typically Dark Pool A will not disclose whether it is a buyer or a seller or how many shares are available to buy or sell. IOI's are typically used for large non-marketable orders.

IOC's stand for Immediate or Cancel. IOCs are used for small marketable orders. So, for example, if you want to buy 1,000 shares of stock XYZ and you send the order to Dark Pool A, if there is not a crossable order in Dark Pool A, it may send an IOC to buy 1,000 shares of stock XYZ to Dark Pools B and C. If Dark Pools B or C have a crossable order, they will execute the IOC and the customer will get a fill, if not the order will be canceled back to Dark Pool A and it will route this order to a public market for a fill.

In terms of gaming, although the use of IOC's disseminates more information (stock, size and side), it is much less susceptible to gaming because one, the orders tend to be small so the information is less useful to any gamer, and two, within milliseconds of the dark pool rejecting the order, it will be routed to a public venue for execution and not much is going to happen in that time.

The IOI on the other hand lends itself more to gaming, if I am dark pool B or C and dark pool flashes me an IOI in stock XYZ, I have a pretty good idea that there is a large buyer or seller in the market and that their actions will move the price up or down over time. If I am nefarious I could pretend that I am a seller of 500 shares, if Dark Pool A fills me, then I will know there is a big buyer in the market and I could start buying in anticipation that the big buyer will push the price up. This will hurt the buyer because he will end up paying more for his purchases since my actions in and of themselves drive up the price. On the other hand, again if I am nefarious and pretend that I am a seller of 500 shares and Dark Pool A does not give me a fill, I have a pretty good idea there is a big seller out there and I can equally manipulate the situation to my advantage.

Of course there are protections to prevent this, but yes the use of IOIs does increase the risk of gaming. I don't think the IOCs increase the risk very much.

James Ross: Jamil's points are well made. I do think there are two elements to address gaming. The first starts at the dark pool design level … often times how a dark pool is designed can minimize or increase the risks of being gamed. Like Jamil said, it is the trader's responsibility [or best interest] to understand these risks. Second, there is the surveillance, oversight and enforcement layer that is also critical to identifying abuse not just within a single dark pool but across ATSs, ECNs and exchanges.

To be sure, the dark pools that are broker-owned have a vested business interest to make sure they surveil and address abuse. Otherwise traders would not go to them. Exchanges, though, do have a more robust and independent surveillance and oversight process. And the enforcement can be, well, career changing for those caught contravening Exchange rules and securities laws.

Forbes: So speaking of regulation, do you anticipate regulation regarding IOIs and IOCs? Would that be helpful? Is there a good reason to use IOIs or IOCs?

Jamil Nazarali: I don't anticipate any new regulation in the near term, regulators have their hands full right now with a number of more important things. I actually don't think that regulations would help in this area. It is in the best interest of Dark Pool operators to stamp out gaming in every form, and in general they are doing a great job, but it is very difficult to get rid of it completely. I don't think regulators are going to be able to find any magic bullet to stop this, and if they could the Dark Pools would gladly implement it without the need for regulation.

James Ross: Regulation of dark pools. This is a very important issue. There are two areas that I feel demand reform and they revolve around the ATS (Alternative Trading System) industry. As I said earlier, it is imperative for traders and investors to be able to understand the particular benefits and costs of a dark pool so that they can make an informed decision about participating in it.

Currently there is no regulatory requirement for an ATS to exactly disclose how it operates and processes its orders. There is no requirement for the public disclosure of how an ATS dark pool works. From an Exchange facility front, before a share is traded it must go through a rule-writing process with the Securities and Exchange Commission, which lays out how the system works. Once a "draft" version of the rules is agreed upon between the SEC staff and the exchange, the SEC posts these rules for public comment and response. Only after that can the exchange formally adopt the rules, publish them on their Web site and begin operations. This is the level of operational transparency that the ATS industry needs right now.

And then second and equally important … ATS dark pool trades are printed on FINRA "Trade Report Facilities" (TRF) sponsored by exchanges. Today over 35% of ALL U.S. equity trading prints on TRFs and all ATS dark pools print there. Problem is there is no way to distinguish one ATS dark pool trade from another! Millions of trades occur in over 50 different and unique dark pools, internalizers and ECNS (all of whom have different (undisclosed) operating and business models) and no one can determine which dark pool did the trade. For this reason alone, no one can do comparative analysis between dark pool trades, get a real understanding of dark pool volumes or even do their own trading cost analysis.

Anonymity and order opacity benefit all investors but not disclosing operational models and hiding ATS dark pool trades "in plain sight" on a TRF undermines our marketplace and impacts investors negatively and unnecessarily. Operational transparency and trade attribution are "must haves" for all ATS, ECN and Exchange markets!

Information has value. Dark pools are "dark" or non-displayed in order to not disclose information about the trader's identity or, in varying degrees, the order information. All dark pools do not disclose the identities, but after that there is a wide range of ways dark pools handle order information. NYSE MatchPoint, which is an NYSE exchange dark crossing facility, does not disclose any order information. Other dark pools may show symbol and side, send single or market-wide IOIs or set criteria such as minimum participation requirements so that when an IOI message is distributed either to a single contra-side or a marketplace, there are ways of "reading" into the order information.

I particularly like the fact that MatchPoint, as a point-in-time crossing network, aggregates multiple buyers and sellers in a single trading moment … so that even the users do not know if they traded against one or many contra-side users. Whether reading the tape, getting IOIs or seeing partial order information all of these have informational value and a COST to the trader but these "disclosures" can also bring needed liquidity when immediacy is critical … as long as the trader understands how these dark pools work and their associated costs for their value. That is very important.

Forbes: Do either of you think there is something to be gained from sending out IOIs or IOCs, namely that a trade that maybe couldn't be completed otherwise because a trader can't find the other side, can now be completed?

Jamil Nazarali: Absolutely IOIs and IOCs have value. If dark pools send an IOI out to multiple venues, they will often source liquidity that would otherwise be unavailable. Also, the trader always has the choice, typically dark pools give you the option of not having your IOI sent out or if they don't you can decide not to use that dark pool. So there are risks but also great benefits; it is really up to the trader to decide if the right trade-off between benefit and risk.

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