Fred and Ethel Go Dancing In The Dark!



You all may remember Fred and Ethel. They have a lot of free time ever since they retired – Ethel from the library and Fred from Maury Sills Clothing Emporium. With that extra free time they have taken to managing their own investing, and occasionally even trading. They frequently call on us and ask us to explain facets of modern markets to them; frankly we love talking with them, except when Ethel gets agitated, which she sometimes does.

In the past year we have spoken to them about the NYSE RLP Program, sub-penny prints, and even inter-market sweep (ISO) orders!

Yesterday they called again. They wanted to understand how dark pools work, and specifically wanted to understand something called the conditional order.

Ethel:               We were at a Springsteen concert last night! Boy that brought back memories. “You can’t start a fire – you can’t start a fire without a spark; this gun’s for hire, even if we’re just dancing in the dark.” Makes me want to shake it backstage all over again!

Fred:                Ethel. Really? Listen boys – we heard an awful lot about these dark pools over the last few years.  So let me get this straight – you are saying that nearly 40% of the volume takes place not even on the stock exchanges?

Us:                   Yup. Can you blame all the mutual funds and managed 401k money? I mean with all the queue-jumping and colo and private data feed leaky stuff… remember our past talks? It’s no surprise that dark pool volumes have skyrocketed.

Fred:                Yeah. I guess. And I guess the dark pools are so much more simple and cleaner too – they are anonymous right? And they are used to trade bigger chunks of stock at bid-ask midpoints. I mean you can’t just trade 50,000 shares like that on stock exchanges. Dark pools do that all the time. Not that I can heave blocks around mind you – it’s just that this stuff is good to know.

Ethel:               The only thing Fred heaves around nowadays is a hernia.

Us:                   Funny Ethel…  Fred – to answer your questions…  yes and no. Are they really anonymous? Are they really for trading blocks? Do you know the average trade size in dark pools is the same as on the exchanges – 200 shares? And regarding simple… you have to do your homework. We have found that they have gotten quite complex indeed; they may not have 2,000, or even 253 order types, but nobody truly knows all the secrets of how the pools match buyers and sellers.

Ethel:               Wait. Back up sonny.  Investopedia says that the bulk of dark pool liquidity is “represented by block trades facilitated away from the central exchanges.” Weren’t the dark pools supposed to be used to trade size for institutions, without impact, and complement the smaller-size trading on the exchanges?

Us:                   Ethel, yes. But you know that when Wall Street tells you that an innovation was created for one reason, it usually is the case that it was created for another reason. We wrote about this in our book Broken Markets. The concept of dark pools has been perverted. Today, dark pools want to have all the volume and order flow just like the exchanges do, so they in fact court the same players.

Fred:                Including the HFT guys?

Us:                   Oh yes. Especially the HFT guys. Think about it – why would the average trade size be the same in both exchanges and dark pools if they didn’t? Actually given that dark pools are “kind of dark”, with in general much larger order sizes entered, for a dark pool to still have a 200 share average trade size means they must really love the HFT guys. In fact some HFT firms have developed “dark pool teams” to perfect their dark pool strategies.

Fred:                This is disconcerting. So how do stocks trade in a dark pool? And what is this thing called a conditional order?

Themis:            Well the dark pools – and there are like fifty of them – have a matching engine which kind of decides which buy order get matched with which sell orders. And orders get entered into the pools in so many different ways. They can be entered:

–          Directly in the pool by the prop trading arm of the owner of the pool (the bank’s HFT algo buying 100 shares at $185.50).

–          Directly in the pools in a resting manner, if you are a client of the pool (buy 10,000 shares of IBM at $185.50).

–          Streamed through in pieces, via dark pool aggregators (buy 300 shares IBM at $185.50 for only a sub second as the aggregator passes through like a high speed train).

–          IOI’d into the pool (Indication of interest to maybe buy some IBM at $185.50). Perhaps they are even IOI’d in after an SOI – solicitation of interest.

–          Market makers can enter orders to buy at $185.50 in different sizes depending on what kind of player the dark pool has as a seller (they will buy 3,000 shares if retail (dumb) is on the other side, 900 shares if it is an institutional VWAP execution algo, or maybe just 100 shares if someone smart and informed is the seller… say like a large mutual fund)

–          Entered at offset prices from the public bid and ask – i.e. floating.

–          And to answer your conditional order question – they can be entered into the dark pool as a conditional order (I think I want to buy 1,000 shares of IBM at $185.50. If you are a seller of stock at $185.50 let me know, and then I will enter my firm order to buy at $185.50. But definitely let me know, and be quick about it, because I am indicating my intention to buy this 1,000 shares in 19 other places too). And the conditional orders can be direct conditional orders, or algorithmic conditional orders.

Ethel:               Is this a joke? I thought dark pools were simple –  like a Secret Santa, where anonymous stuff is entered into a shoebox, with a simple outcome or crossing trade.  How do market makers know if the other side is retail, an institutional algo, or a smart guy? This is insane.

Fred:                Hush Ethel – I am writing this stuff down. Who determines which kind of order is first in line?

Themis:            Well Fred, we are glad you are writing it down, because you may be the only market player who will have it written down. And that is the problem. How the dark pools prioritize the above order depends on the dark pool. And it is not written down somewhere like in an exchange rule book filed with the SEC. And Ethel – excellent question. Dark pools are not truly anonymous at all, the only thing Secret-Santa like about them is that like only 1% truly understand how they work – they are “secret” indeed.  The dark pool operators are indeed labeling the orders and letting lots of stuff about them be known to some clients. HFT market makers get to pick pre-trade how big their order will be depending on who is on the other side. And Big Institutions who do not want to trade with HFT people can actually ask the dark pool operator to make sure a certain firm is not on the other side of their trades.

Ethel:               And do the dark pool owners comply?

Themis:            We guess so. But I mean who is to truly know?

Ethel:               And the dark pools owners have to match according to which order gets there first. Right?

Themis:            No. It depends on the dark pool. Resting order are higher than streaming which is higher than direct conditional, which is higher than algorithmic conditional, and all are below the owners own orders… maybe. Again who is to know? And each pool can treat the orders as they see fit. To quote Lonnergan from The Sting, “Ya folla?”

Fred:                How can the regulators in Washington allow this to operate in this way? How is it policed?

Themis:            It isn’t policed. Well, there are hints that in the future they will police a little bit more, but it is still at the talk stage. And dark pools have evolved into these opaque and complex mechanisms because the regulators refused to act on something called Flash Orders on the stock exchanges. Think about it… if something so blatantly wrong as the Flash Order – the free-look-for-a-fill, was allowed to flourish unchallenged, with the cops looking the other way and refusing to act, and you owned a dark pool, wouldn’t you feel you had carte blanche to “innovate” away with flash-order-like mechanisms?


Fred:                If the institutions sort of know this, why do they allow for their orders to go to these pools?

Themis:            Well – a few reasons. First of all low volume environments make traders feel like they need liquidity – wherever it is, and what better way to get all the liquidity than to try to be everywhere. Secondly the algos that feed into the pools are really low cost explicitly – a fraction of a penny. And explicit costs are focused on the most – especially when commission budget time comes around.

Ethel:               Boys, this dark pool talk is really enlightening.

Fred:                Screw that. It is the last thing in the world from enlightening. First I am more confused than I ever was, and second it is en-darkening!

Ethel:               Is that your joke of the day Fred? Go eat some prunes and have a Fresca.