40% Of Stock Trades Are Done Outside the Prying Eye Of Regulators

Most stock trades are conducted on public exchanges and are in full view of regulators. Dark pools, by contrast, are exchanges where the trading is done outside of public view and the prying eye of regulators. Here's you insider's look into how these dark pools of money function.

Dark pools are trading venues that, in contrast to traditional exchanges, do not publicly display bid and offer quotes. In practice, a wide variety of dark pools exists, distinguishable based on a number of institutional properties. A first distinct difference is their market model (e.g., continuous vs. periodic crossing, blind vs. advertisement-based pools …). A second distinction is ownership: is a dark pool owned by a traditional exchange or by a (group of) broker-dealer(s). A third distinction is related to which traders have access to the dark pool: are these only clients of the owner can both buy and sell-side traders connect, can both retail and institutional clients submit orders? Based on these properties, Mittal (2008) distinguishes five different types of Dark Pools. The first, “Public Crossing Networks”, are agency-only, broker-owned and set up to generate commissions. These independent dark pool operators submit no proprietary orders. Buy-side traders in general have a direct connection to them. Examples include ITG POSIT, Instinet, and Liquidnet. A second category is the so-called “Internalization Pools.” These aim to internalize the operator’s trade flows. Next to retail orders, these pools could include proprietary order flow from the operator. Buy-side traders usually have access, while the operator can decide to ban sell-siders. A third category is “Ping Destinations.” As they only accept “immediate or cancel” orders and their customers’ order flow only interacts with the operator’s flow, these systems could be seen as outliers compared to the other dark pools. A fourth dark pool type is “Exchanged-Based Pools.” These are systems that are actually registered ATSs by exchanges, e.g., Deutsche Börse Xetra. A final category is “Consortium-Based Pools”. A number of brokers jointly operate these. Examples include LeveL or BIDS. Typically, partners first try to cross orders in their own dark pool and only send unexecuted orders to the consortium pool. In general, sell-side traders can access them.

The emergence of dark pools seems to be a recent phenomenon. The reasoning behind this perception is that this type of trading venue only managed to obtain a significant market share in equity trading in recent years. However, their history dates back much further. CNs originated in the early 1970s as private phone-based networks in between buy-side traders. Later on, in the 1980s, they went electronic with the introduction of Instinet and POSIT (Plexusgroup, 2004). In these early years, their success was very limited though. Moreover, competition between CNs was low, since almost no CNs were set up. This situation has radically changed over the last few years. There are around 50 dark pools in the United States and 13 public exchanges. Some of the largest U.S. dark pools are run by banks that are also some of the exchanges' largest customers. They include Credit Suisse Group AG's CrossFinder, Morgan Stanley's MS Pool, and Citigroup Inc's Citi Match.  Moreover, the growth in the volume executed via dark pools has increased enormously over the last few years. In 2003, their market share in equity trading was negligible. By the end of 2006, CNs and dark pools obtained a share of nearly 10% of the total equity market and were executing on average 420 million shares a day (Johnson and Tabb, 2007). Today, they account for 40% of all equity trading in the US. One possible explanation for this explosive growth is the emergence of algorithmic trading programs (“algo’s”). These algo’s optimally and automatically route orders to various trading venues, taking into account prices, liquidity and market impact. Another explanation is Regulation NMS, the new security regulation in the US. This regulation requires that trading venues ensure the best execution of trades, thus spurring the creation of new trading venues. In Europe, MIFID could be expected to have similar consequences.

Essentially, the most common type of dark pool is the Crossing Network (CN). A Crossing Network is a system that allows buyers and sellers to transfer publicly traded securities without using a public market. The primary purpose of these trades is to move large amounts of a specific type of security without affecting the price through the large sale. Over the years, the trend in CNs has been growing due to large institutional investors not moms and pops. This is mostly because the block trades sizes are beyond their reach. A block trade is technically an order of at least 10,000 shares, or an amount of stock that has a value of at least $200,000. Consider this, whatever you want to call it, CN, Dark Pool, Dark Liquidity; they are financial weapons of mass destruction. It was through their use that the Credit Default Swaps machinations flew under the SEC’s radar and ruined many an investor. It was using Dark Pools, that Bruno Iksil, the JPM trader since labeled rogue, did the Machiavellian deeds that wound up biting Jamie Dimon in the ass. In the final analysis, these Pools are just another tool for banksters to rip off ordinary investors. As such, they ought to be outlawed and shut down, otherwise hang on for a roller-coaster ride.