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Dark pools didn't start off as a bad idea. Their purpose was to allow big institutions to "hide" their block orders. Previously if an institution wanted to tr

Dark pools didn't start off as a bad idea. Their purpose was to allow big institutions to "hide" their block orders. Previously if an institution wanted to trade a big block, it had to break it up via a VWAP or POV algo and trade it over the day or to go to a sell side institution to find a buyer, in which case the broker would take a commission that is often 10x what the regular DMA commission would be. To be fair, this is still what most buy side firms do these days. Dark pools really haven't helped much in this regard as many funds now just bypass them when they can. > Meanwhile, Barclays was advertising LX to high-frequency traders by offering them more information, lower fees, and faster connections than it gave to institutional investors. This is the basis of problem here. A dark pool doesn't publish a bid/ask like other exchanges do. The idea was that everyone would be on equal footing wrt the information present. It appears as though Barclay's has been giving HFTs additional information, including the bid/ask spread in some cases, which totally defeats the purpose of having a dark pool to begin with. The reason they did thsi is that there probably only needs to be one dark pool for the entire US, but each bank realized that it could make some serious money running their own, the only problem is that now you have the same problem as any web 2.0 market place startup does. "How do you get the buyers and sellers"? The HFTs started offering the banks boat loads of money to have access to the order flow in their dark pools if the bank reached certain thresholds of flow. To get to the required flow the banks started routing as many orders as the could, keeping RegNMS in mind, to their dark pools first before settling the orders on other exchanges. I've been told with a straight face by some sell side brokers that I could not tell their SMART order routers to skip dark pools when trying to send my order to the market, again RegNMS excepted. It wasn't until we stopped trading through them that they relented and allowed us to by pass their dark pool.

tptacek 12y ago
Wait, you had me until the last 2 paragraphs. The whole point of Levine's article is that HFTs did not offer the dark pool operators "boat loads of money". The dark pool operators gave the HFTs sweetheart deals to induce them to trade in their pools. They didn't do that because the HFTs paid them. They did it because without the automated traders, the dark pools wouldn't have worked at all. By the numbers, if the big institutional investors wanted HFTs out of the dark pools, Barclays should have kicked them to the curve. Not ethically, but simply from a practical business perspective. But Barclays couldn't do that... or, they could, but then the institutional clients would have stopped trading in the LX pool, because they'd never get filled.
- chollida1 12y ago
  Ok, a few points. 1) most institutional clients don't necessarily want to trade in a dark pool, their orders are just routed there by the broker's smart order routers. You would be very surprised how many huge funds don't do post trade analysis. 2) the dark pool operators make money from the HFT's not in terms of the commission, but in terms of collocating fees, market data fees, and the right to be one of only a few HFTs allowed in the dark pool via collocating, ie exclusivity. The boat loads of money was maybe an akward of stating it. To match a trade you need people on both sides of the trade. The HFTs were the missing piece the other side of the trade. WIthout them no trades, hence no money. With them, you trade more... alot more, which leads to the boat load of money that starts following when the HFTs come in. I may have a biased view as I'm on the buy side but not on the HFT end of things:)
  - tptacek 12y ago
    Are they getting routed there because the dark pool can provide better execution for those orders? Because that could be happening even if the way it's happening under the hood is contrary to how the pools are marketed.
    - hft_throwaway 12y ago
      It likely was happening. If I'm a market-maker, I want to trade with retail orders or slowly sliced institutional orders that are trying to rebalance a portfolio throughout the day. When I sell stock to them, the price doesn't move very much in the short-term and I have a chance to buy back on the bid to make a spread. I don't want to trade with aggressive arbitrage or stat-arb traders capturing short-term price inefficiencies, hedge funds that want to buy huge blocks of stock all at once, etc. If I sell stock to them, the price ends up moving up more than the spread very rapidly and I lose money. When trading on a public market, I have no way to control which of these groups I trade with. I have to employ countermeasures to predict whether it's likely that I'll trade with an informed or uninformed trader and adjust my market accordingly. This is why you see market-makers rapidly flash their quotes for seemingly pointless reasons (e.g. I may adjust my prices in an airline when oil futures move) or flip out of positions aggressively when their model believes they were hit by an informed trader. Now if I'm able to trade on a market where I know I'll only trade with long-term fundamental traders, I can quote much larger, tighter, and more stable markets. This is good for the institutions since their execution costs are lower than going to the exchanges. It's bad for arbitrage traders and hedge funds with short-term information since they effectively pay higher execution costs in a tiered market (if more "good" order flow goes to dark pools, less reaches displayed markets, and spreads on displayed markets will increase to compensate). When people want to end dark trading or internalization, they really want to have retail and institutional flow cross-subsidize fast speculators. Ironically, it's probably HFT market-making firms who were the most impacted by Barclays giving other high-alpha HFT firms manual overrides to put them in a lower tier. If anyone would be excited at the promise of removing high-alpha traders from the pool, it would be market-makers who want to avoid being "picked off", not institutions who have a much longer time horizon.

tptacek 12y ago

Wait, you had me until the last 2 paragraphs. The whole point of Levine's article is that HFTs did not offer the dark pool operators "boat loads of money". The dark pool operators gave the HFTs sweetheart deals to induce them to trade in their pools. They didn't do that because the HFTs paid them. They did it because without the automated traders, the dark pools wouldn't have worked at all. By the numbers, if the big institutional investors wanted HFTs out of the dark pools, Barclays should have kicked them to the curve. Not ethically, but simply from a practical business perspective. But Barclays couldn't do that... or, they could, but then the institutional clients would have stopped trading in the LX pool, because they'd never get filled.

chollida1 12y ago
Ok, a few points. 1) most institutional clients don't necessarily want to trade in a dark pool, their orders are just routed there by the broker's smart order routers. You would be very surprised how many huge funds don't do post trade analysis. 2) the dark pool operators make money from the HFT's not in terms of the commission, but in terms of collocating fees, market data fees, and the right to be one of only a few HFTs allowed in the dark pool via collocating, ie exclusivity. The boat loads of money was maybe an akward of stating it. To match a trade you need people on both sides of the trade. The HFTs were the missing piece the other side of the trade. WIthout them no trades, hence no money. With them, you trade more... alot more, which leads to the boat load of money that starts following when the HFTs come in. I may have a biased view as I'm on the buy side but not on the HFT end of things:)
- tptacek 12y ago
  Are they getting routed there because the dark pool can provide better execution for those orders? Because that could be happening even if the way it's happening under the hood is contrary to how the pools are marketed.
  - hft_throwaway 12y ago
    It likely was happening. If I'm a market-maker, I want to trade with retail orders or slowly sliced institutional orders that are trying to rebalance a portfolio throughout the day. When I sell stock to them, the price doesn't move very much in the short-term and I have a chance to buy back on the bid to make a spread. I don't want to trade with aggressive arbitrage or stat-arb traders capturing short-term price inefficiencies, hedge funds that want to buy huge blocks of stock all at once, etc. If I sell stock to them, the price ends up moving up more than the spread very rapidly and I lose money. When trading on a public market, I have no way to control which of these groups I trade with. I have to employ countermeasures to predict whether it's likely that I'll trade with an informed or uninformed trader and adjust my market accordingly. This is why you see market-makers rapidly flash their quotes for seemingly pointless reasons (e.g. I may adjust my prices in an airline when oil futures move) or flip out of positions aggressively when their model believes they were hit by an informed trader. Now if I'm able to trade on a market where I know I'll only trade with long-term fundamental traders, I can quote much larger, tighter, and more stable markets. This is good for the institutions since their execution costs are lower than going to the exchanges. It's bad for arbitrage traders and hedge funds with short-term information since they effectively pay higher execution costs in a tiered market (if more "good" order flow goes to dark pools, less reaches displayed markets, and spreads on displayed markets will increase to compensate). When people want to end dark trading or internalization, they really want to have retail and institutional flow cross-subsidize fast speculators. Ironically, it's probably HFT market-making firms who were the most impacted by Barclays giving other high-alpha HFT firms manual overrides to put them in a lower tier. If anyone would be excited at the promise of removing high-alpha traders from the pool, it would be market-makers who want to avoid being "picked off", not institutions who have a much longer time horizon.