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Saturday 19 June 2010

Dark Pools and Adverse Selection

Friendly Highwaymen

Scientists believe that a great deal of the universe is in hiding, being made up of dark matter which, rather inconveniently, refuses to interact with anything else and is therefore almost undetectable. In a similar fashion many stockmarket trades are now being carried out in so called dark pools, where they're supposed to be similarly undetectable. Unfortunately, despite what many users of them think, you don't need to construct a super-collider to detect trades in dark pools.

These dark pools are one way for investors to move large blocks of stock without alerting others to what they’re doing. They’re anonymous trades of indeterminate volume carried out in murky corners of the securities industry. As usual the industry argues that it’s doing investors a favour. That’s “favour” in the same way that a highwayman saved his victims from having to carry heavy bags of money about .

Off Market Mechanisms

Now you might think that the very act of trading large volumes without moving the market is a somewhat dubious practice given that the very idea of a market is to ensure transparency through price discovery. However markets don’t so much frown on this practice as positively welcome it. Yet even though dark pools, where private investors are excluded, are expanding rapidly they’re not quite so dark as many users imagine.

In essence dark pools are trading platforms which circumvent the normal stock exchanges. Everything happens off-market and everyone goes to great trouble to avoid publishing trading volumes – it’s not possible to know in real-time, and sometimes not ever, how much stock is being traded (although most trades are published after the event). The rationale behind this is for participants is to stop prices moving against them. Typically, in an open market if you attempt to buy or sell a large block of shares then the price will move up or down in response to this. Much effort is devoted to trying to prevent this happening, dark pools being only one method.

Price Setting on the Dark Side

However, if you don’t have open market price setting there’s got to be some other way of figuring out how to price a trade. Neatly dark pools parasitize open markets by using the mid-price of openly traded stocks. In theory this means that dark pools are truly dark, with no way of extracting information from them. After all, if buying and selling in dark pools only effects a change of ownership without any change of price then these trades should be neutral as far as retail investors are concerned. The dark pool participants are simply shuffling ownership around.

Only this can’t be quite true, even if the trades and participants in dark pools are genuinely kept secret. An instant’s consideration shows that there’s one simple and obvious way in which information can leak from the darkest of trading platforms – open market prices. After all, if you suspect there’s stock available via a dark pool then there’s always an option to manipulate the open market mid-price to change the price available.

Gaming and Adverse Selection

So, of course, people try to game the system by manipulating prices in the open markets and then making trades on the dark side. People will always game systems if you give them an opportunity and one way of doing so is by “fishing” – using a series of small orders to determine if there’s a seller on the dark side, then buying on the open market to move up the price and then selling on the new mid-price in the dark pool. You can also game on the mid-price by moving this on the open market and then selling in the dark pool if there’s someone who wants the stock.

There’s also a secondary behavioural issue known as adverse selection. This is the same problem that health insurers face: only the people that know they need health insurance will want to take it out so, logically, you should only offer health insurance to people who don’t want it. In dark pools the problem is if you submit a large order and get it filled you can reasonably assume that the seller or buyer either has or wants more stock and will cause the price to move against you: it's a neat behavioral paradox that you should only want to trade on the dark side if you know you'll fail to get all the stock you want.

Information Leakage

It’s tricky stuff and Hitesh Mittal gives a good overview in Are You Playing In A Toxic Dark Pool? where he goes over the wide proliferation of types of dark pool and the various opportunities to exploit information leakage from these supposedly informationless black holes. However, they’ll continue to be used because they offer institutions, in particular, the possibility of executing trades at lower cost.

The issue is, really, is this fair? After all the point of an open market is that if someone buys or sells the market price changes to reflect this and, in so doing, a fair price for the security is established. By conducting trades behind closed doors and denying the markets access to valid pricing information there’s a case that we’re seeing price manipulation rather than some kind of zero sum, no information trading situation. Yet if no information is being passed from the dark side to the light how can this be? How can dark pool transactions make any difference, information leakage aside, to the real market?

Well one way is though the removal of liquidity from open markets. If someone or some institution decides they want to trade and decide to do so in the informationless vacuum of a dark pool this means that liquidity is being removed from the real markets. In an extreme case you could see massive dark side volumes resulting in virtually no price change.

Jedi Knights Need Not Apply

This loss of liquidity from open markets is a genuine issue and regulators are starting to worry about it even as the number of dark pools available multiplies. Ironically as the number of dark side options increases and liquidity fragments the opportunities for algorithmic trading routines to expose dark side trades also goes up. It’s an arms race in which we, the punter in the street, is a mere bystander.

Yet although it’s possible to imagine many mispricing scenarios arising through the use of dark pools, another way in which the power and financial muscle of institutions can be used against smaller investors in the short-term, this shouldn't really be an issue for most private investors. The answer is, as ever, to not worry about short-term voting and instead concern ourselves about longer term weighing of the investment opportunities inherent in any stock. Because, for the long term and patient investor, the stockmarket is a game on a field slanted in our direction: we don’t need Jedi knights to tell us that.

Related articles: The Rise of the Machines, Quibbles With Quants, You Can't Trust the Experts With Your Investments

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