Steve Wunsch’s Dark Pool Comment Letter from January 2010

An industry colleague pointed out this comment letter to us, that has been written six months ago by Steve Wunsch, principal investor and inventor of two stock exchanges (AZX and ISE). Joe and I remember watching the AZX carefully from a competitive standpoint while we worked at Instinet back in the 1990’s.  His ability to think through problems/needs in the marketplace gives him instant credibility when he speaks, in our view, whether our views coincide or not. His jist is that the mandating of transparency is of course what has created the lack of it in our market structure, so caution by regulators is warranted before they go further down that path.

We found this read fascinating, and his points will make you think. It is a must read in our view, and the entire piece is on the SEC’s site here :

I would like to highlight my three favorite passages:

“Today, no one is disclosing anything honestly to anyone and the anchoring blocks are disappearing. In fact, the main purpose of the algos is to mislead, and they work. The result is a wildly wandering thin stream of tiny prints executed at a multiplicity of dispersed venues of multifarious character, some of which print where they trade while others print somewhere else, sometimes after being routed and rerouted like hot potatoes to satisfy “best execution” regulations. None of the tiny trades mean anything by themselves and in aggregate are even more confusing, flashing by at a speed that only sophisticated computers can capture and decipher. Like strobe lights, they can be more blinding than illuminating and, thus, better suited to hiding activity than presenting it fairly to the public.”

“I won’t rehash here the benefits of calls, except as necessary to illustrate what I discovered about the hidden misconceptions that many have regarding the benefits of transparency. In a nutshell, they believe that transparent electronic trading, by itself, will automatically eliminate intermediation costs, even if applied in continuous trading, which they assume is the only way to trade. This is not because they have thought about it and come to this conclusion, but rather because they have not thought about it. They certainly have not realized that, when it comes to transparency, it is necessary to make the distinction between continuous and fixed time trading. In contrast, as I learned in designing AZX, it is difficult to even make transparency work in a fixed time call auction; many conditions need to be satisfied to produce the requisite competition that makes an auction work. But transparency never works in continuous trading, either as trading strategy or market structure. Without the fixed point in time on which to focus competition, it will always be dangerous to be the first discloser, i.e., the transparent one.”

And my favorite for last:

“The main event is in the lit market itself, where the furious interactions between algorithmic shredding and high frequency trading produce so much “transparency,” over a million messages per second and doubling every year, that no one sees anything anyway. That is why institutions are using the lit market as a giant dark pool to hide in. This is the big picture. This is the forest to the dark pool trees. Even if all those little dark pools could be wiped out completely, that would only hasten the full transformation of the lit market into a scary house of mirrors, where the public tape is always behind the private feeds, where high frequency traders know what’s about to happen and the public doesn’t, and where the co-lo box seats are unaffordable by normal investors. So what is the point of moving dark pool orders into it?”

We agree with Steve on some points, and are forced to think on all points. Enjoy the read!