Equity Research & Strategy

January 2010

BEWARE: DARK POOLS ARE ON THE MOVE

SOARing through the changing global market structure
In the final scene of the classic
movie Animal House (1978), as
John Belushi and the Deltas
reign chaos on the home
coming parade, Kevin Bacon,
amid a stampede of panicking
parade goers, tries to tell the
crowd to “remain calm – all is
well.” We fear that many
market participants are taking
the recent UK Financial
Services Authority (FSA)
estimates that dark pools
represent only 1.6% of total
volume, and the recent
estimates from the Tabb Group
that 4% of executions are
occurring in the dark, as
indications that there is nothing
to worry about regarding dark
pools – all is well. The current
belief is that the market is
essentially unchanged and
traders just have to focus on
hitting the lit markets because
they have the most market
share. Bloomberg Tradebook,
however, is finding that
Europe’s market structure is
again rapidly changing; dark
pools are on the move. The
changes to the pre-
transparency rules are making
smaller size orders eligible in
dark pools. Although the FSA
Figure 1 – Venue Transparency on Tradebook’s GTTA<Go>
data suggests that at a
composite level it appears that extracted from the dark (Figure done on demand using the
only a small percentage of 1) using our innovative Global Tradebook Trade
stock is executed in the dark, technology in Smart Order Analytic (GTTA<Go>).
we are finding that on a stock- Algorithmic Routing (SOAR) –
by-stock basis, the story can be dark aggregator. Europe’s Dark Landscape
quite different. As much as There are four types of dark
20% of the liquidity of our You can monitor pools in the European Market
clients orders are being where your orders are getting structure:
 • Exchange integrated – liquidity while doing it in a way already occurred – the damage
these are exchanges or that seeks to limit adverse price to the customer’s orders was
MTFs (LSE, Nasdaq OMX and information impact by already done.
integrated book, Chi-X proactively outsmarting the
integrated book, BATS, gamers. Outsmart the Gamers
Xetra, etc) that have lit or To prevent your order from
displayed orders with Anti-gaming – It’s Too Late being “mugged”, you have to
Icebergs or hidden order Some brokers will use post- take pro-active, preventative
types; trade statistical analysis to action to stop gaming before it
• Exchange segregated – measure toxic activity in a dark starts. The post-trade mean-
these are exchanges or pool. Mean reversion analysis reversion analysis should be
MTFs that operate takes a time and price stamp used to confirm that the
independent pools that do each instance that an order proactive anti-gaming
not have any lit components interacted with a dark pool. It techniques are working, or that
(Nasdaq OMX, Chi-X, then looks at the price of the more analysis thought, and
BATS and Turquoise Dark stock at 1, 5, 10, 30-seconds design needs to be done.
Books) and 1,5,10 minute intervals
• Block Trading – these are after the trade to see if there is Being proactive in the dark
MTFs that seek to have a statistically significant pattern space requires a certain
block sized orders find and of price behavior. An example methodology backed by
execute with each other; of such behavior would be if sophisticated implementation
• Broker Internalizers – these orders are sent to (or got an algorithms that take into
are broker books that pair execution from) “dark pool A” consideration, in part:
contra customer orders and statistically, 1 minute later 1. A true unconflicted
the stock consistently goes 10 business model
Asia’s Dark Pools basis points higher – this would 2. Techniques to finding
Although there have been many suggest toxic or gaming hidden liquidity and
announcements of alternative behavior occurring in the “dark statistics to create real
trading systems seeking to pool A.” Although this analysis time liquidity profiles, or
create dark pools, currently is extremely important, some Heat Maps
Asia’s dark landscape is less brokers rely exclusively on this 3. Real-time
mature - dominated mostly with analysis to determine if they allocation/ranking of
private broker dark pools. should continue their dark venues
relationship with such a dark 4. Order Distribution and
Dark Pools are a challenging pool. The problem with using representation
and potentially dangerous place this analysis as the sole anti- strategies
to play. High frequency traders, gaming prevention technique is 5. Price predictors
prop desks and predatory that it is reactive. The gaming 6. Ping detection
algorithms will use statistical
trading techniques to detect the Institutional Investor broker league
presence of large orders and
use that information to their tables 2009. Bloomberg Tradebook:
advantage. Dark pools,
however, may have significant #1 Global Equity Trading
liquidity so they cannot be #1 NYSE Equity Trading
ignored. Successful dark
interaction is not simply an #2 NASDAQ Equity Trading
issue of access and Ranking is out of 2,000 brokers with best results vs. interval VWAP
aggregation. Sophisticated benchmark.
algorithms that manage orders
to efficiently find and extract Figure 2
These six considerations are bias passive orders toward their (This is known as “Where’s
just some of the many complex own pool of liquidity and venues Waldo” in North America).
issues that need to be explored that offer high rebates or zero Because liquidity is
for effective dark aggregation. cost to post. If the broker fluid/transient we seek to create
selects venues based on cost heat-maps of market liquidity.
SOARing through Dark Pools and only represents the order in With the lit pools, we can look
Bloomberg Tradebook has one venue, the buy side client at the public trade history (the
sophisticated and innovative may incur an opportunity cost - tape). With the dark pools,
smart algorithmic order routing increased potential for an order Tradebook looks at our
(SOAR) that efficiently finds to be traded around – liquidity execution history in the stock to
and extracts the markets missed - thus increasing the answer the question, over the
unseen liquidity. We have been (potential) for inferior average past 30-days and in real-time
protecting our orders in both the prices and potential information (over the last 10 seconds), what
dark and lit pools, and from leakage. Some (not all) brokers venue has the stock tended to
potentially predatory high will search for additional trade in? This enables us to
frequency traders in the U.S. liquidity in dark pools. When create an allocation table of the
equity market, for years. We searching for liquidity, brokers statistically most likely liquidity
adapted and customized many may first search in venues with venues. We simultaneously
of these techniques for the the lowest access fees rather represent orders in several of
global equity markets. These than first going to venues where those dark pools at the same
algorithms are, in part, a reason they have had success and time and in a heat-map
for Bloomberg Tradebook’s top large size executions. determined priority order and as
ranking in the November 2009 executions occur, move orders
Institutional Investor best Tradebook has comprehensive around. Real-time success
execution league tables connectivity with all of the rates are given higher weights
(Figure 2). established exchange/MTF in the heat-map and will
pools. The trade analytic rebalance the dark pool
It all begins with a business GTTA<Go> (Figure 1), we rankings in real-time.
model that may result in higher show you where orders were
costs to the broker, but is pro- executed. In addition to the Protection
client. You have to treat orders exchange pools, we also have There are many predatory
by balancing the needs of many relationships with our algorithms out there, but they
liquidity aggregation and order customers that have their own really focus on two general
protection to seek the best private dark pools. Tradebook categories: large order
possible average price on an is an anonymous trading identification and momentum
order. platform. When we interact with surfing. To outsmart these
our client’s private dark pool, predatory algorithms, protection
Business Model the GTTA trade analytic uses a techniques need to focus on
Controlling the cost of mnemonic code to both show limiting information give-up
execution directly impacts that the order was executed in AND momentum determination.
broker’s profitability. An the dark and also to preserve Information leakage can be
unconflicted business model the liquidity-source client’s limited by order representation.
would select dark venues anonymity. The allocation table that is
based on the quality and created from the heat-map
quantity of liquidity they Where’s Wally? creates an initial representation,
provide, rather than rebates or One daunting challenge with and the subsequent rotation of,
cost of trading. To increase dark pools is finding and the orders in the dark. To seek
broker profitability on the extracting the liquidity. In some to limit information give up and
execution (commission less respects, finding dark liquidity is make detection more difficult,
trading fees), many brokers a little like the children’s books Tradebook uses many
(even those that provide by British illustrator Martin techniques including varying
agency-only execution) may Handford - Where’s Wally? the order sizes in the pools and
explicit limits. Orders are taking liquidity from the very Similar to how sonar is used to
disbursed into different pools, algorithms that are seeking to find submarines, in electronic
sometimes simultaneously, learn more about them and trading, algorithms will “ping” by
sometimes rotated. For game them. To do this, you sending thousands of small
example, on a buy order, we have to know when to be orders into the dark venues with
may divide the order into three aggressive and Tradebook’s limits at the mid or the contra
dark pools at the same time; Price Predictor Models (PPM) side to try and determine if
the limit may be the bid or the use a variety of inputs to there is such a contra order out
midpoint price of the stock. It all determine and take advantage there.
varies depending upon specific of short term price trends (for a
market conditions, success more detailed description of the In this case, protecting your
rates and other PPM, see Research and order from information leakage
regulatory/operational Strategy July, 2009. On the also means that you also have
considerations. Note, however, Bloomberg terminal, type to read your executions and
that strict limits are always used DOCS R&S_JULY_09 <GO>) surmise if someone is
and overt re-pricing is used for repeatedly “pinging”. If you are
modification in order for Let’s assume that you are a getting repeatedly pinged,
Tradebook to keep maximum buyer of a stock. If the price many times it forewarns that
control over the order. Many predictor indicates that the odds someone may be sizing you up.
brokers will use non-aggressive are that prices may move
limits with floating mid-point higher, then the dark If your order is represented in
pegs so the order can float in aggregator portion SOAR will the dark pool as a mid-point
the dark pool. That order move into an aggressive phase: peg with a non-aggressive limit,
representation strategy Depending on the strength of your order is exposed. An
exposes the order to gaming – conviction from the PPM, the algorithm that detects or thinks
which we will soon highlight. algorithm will either improve the you may have size, can try and
dark limits to the mid, or take the lit market higher
Since gamers use repeated immediately cross the spread (“walking you up”), hold it there
small sized executions for and seek to aggressively sweep and then sell those shares to
“order anticipation” strategies, dark liquidity. In this aggressive you at the higher price in the
all passive and aggressive phase, if an entire order in a dark pool. Then they would
orders on Tradebook use a particular dark pool is fully fade their bid and the market
variety of minimum fill sizes to executed, another order will be would fall back to the old level.
increase the cost of the moved in using the same strict
information to a gamer and at limit. If there is no subsequent So, how do you prevent this
the same time decrease our execution, then limits are from happening? Tradebook’s
information leakage exposure moved back to a passive use of strict limits means that
by completing the order. In stance and sizes are any price change in the stock
addition, a variety of time in rebalanced. Conversely, if the has to be analyzed by our dark
force techniques are used (IOC, PPM indicates that prices may algorithm. Tradebook has to
Synthetic IOCs, Day, 1 min, 2 fall, then sizes may be modified send a cancel/replace or an
min, etc) to avoid becoming a (reduced) still at the same limit order modification message to
“sitting duck”. in order to continue to take the dark pool. We determine
some liquidity, while new orders when limits should be changed
Algorithms with Attitude will be added in a ladder at based on the analysis of the
Order representation is one lower prices or the bid will be PPM. Predatory algorithms that
aspect of order protection. pulled altogether. seek to pull prices higher in
What you also want to try and order to "walk-up" the dark
do is beat the gamers at their Ping Detection and Toxicity order's bid, typically this occurs
own game. Algorithms need to You also have to be proactive only in that specific stock. Our
have an attitude – know when and try to determine if there is PPM seeks to prevent
to go on the offensive and start an algorithm out there hunting. Tradebook from chasing such
price changes because the The dark can be a dangerous
PPM may see those stock place to play. With some of our Bloomberg Tradebook
specific price movements as clients, orders reaching 20% of
anomalies – because they are liquidity being found in the dark, Gary Stone, Director Trading
not supported by corresponding it cannot be ignored. Research & Strategy
price action in the sector or Aggregating liquidity alone is
other the stocks in the peer inadequate. It is the Ron Taur, Manager Algorithm
group. In other words, the PPM responsibility of the broker to Trading Strategies
will think that such price protect client orders. We
movements in that specific believe that this can be
Jim White, Head of Equity
stock are probably achieved with the right business
unsustainable because they model, algorithms that seek to
Trading Development
may statistically deviate from control the order and price
the price action of other stocks predictors that game the Shireen Uttam, Manager
in sector or group. gamers. Tradebook seeks to Global Equity Trading
ensure that you get the liquidity Development
At times, Tradebook will employ while limiting information
the use of other market center leakage and adverse price Sabrina Rovelli, Manager U.S.
mid-point peg order types in impact. Equity Trading Development
order to capitalize on
opportunities for price
improvement. Rather than
being walked-up, the mid-point
peg with a strict limit enables
the order to float lower if the
market weakens.

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