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20 November 2012

Buy-Side Traders Aren’t Afraid of the Dark

With equities volumes vanishing, buy-side traders acknowledge that they can’t avoid dark pools even if they want to. To help traders navigate the dark, TABB’s Equities Liquidity Matrix identifies where liquidity lies and provides more transparency into dark venues.

Although equities volumes have been vanishing this year, the media attention focused on equity trading has been as intense as ever. Specifically, dark pools have felt the heat as a number of trading errors and regulatory investigations have turned up the scrutiny on the space and further damaged the reputations of alternative trading venues.

Pipeline Trading was ultimately forced to shut down earlier this year after the SEC found that many of the orders in its dark pool were matched against proprietary flow and filled at various times by a trading operation affiliated with the firm. Back in August, Knight Capital’s dark pool, Knight Match, saw a sharp decline in volume after a technology glitch caused a series of automatic orders to be mistakenly executed, resulting in massive losses for the firm. Fortunately, Knight’s volume quickly rebounded in the following months.

During the most recent incident, in October, the SEC revealed that eBX LLC (which operates the LeveL ATS) was in its sights. The SEC claims that the technology provider behind the LeveL ATS, Lava, leveraged the LeveL ATS book information in its routing decisions, routing only actionable orders to the ATS. While neither Lava or LeveL released any book or order information to the market, the LeveL ATS saw average volume that month tumble by 54 percent from September 2012 levels. [Ed. note: For more on the claims against LeveL ATS, see the SEC’s related release. For more on eBX’s response, see the company’s letter to customers.]

It is clear that participants are quick to pull back orders when the integrity of dark venues is called into question. In TABB’s most recent buy-side study, 44 percent of the 66 head traders interviewed said there were dark venues to which they would not connect at all. On the other hand, many participants in the study said they would disconnect from a dark pool for only a short time if there were an issue, such as an investigation, until they gained better insight into what may have been happening. If traders are confident that the venue is safe for trading, however, they said they would reconnect to a dark pool even if it has been questioned, because liquidity is simply too scarce to just cut off connectivity to certain pools.

A lack of liquidity in the equities markets is apparent. October average daily volume in U.S. equities totaled just 6.1 billion shares per day, down 6 percent from the month prior. And with the year coming to a close, November is not likely to fare much better. Hurricane Sandy’s assault on the East Coast in the first week of the month forced markets to close for two days, and judging by the Christmas music playing in department stores, the holiday season already is upon us, promising a quiet rest of the year.

Scarce liquidity, along with concerns regarding the safety hazards that can come with sending orders through an opaque trading structure, have forced the buy side to proactively monitor the performance of venues, and buy-side traders have called for greater transparency into dark pools, including information on volumes, participants and routing logic. Independent accounts of volume, such as TABB Group’s Equities Liquidity Matrix, which reports average shares traded on a monthly basis, can help traders navigate the fragmented market and make more well-informed trading decisions. (TABB directly sources details on volume from liquidity pools willing to publicly disclose such statistics. The data is reported after the fact so as not to jeopardize the value proposition of anonymous dark trading.)

Ultimately, though, traders admit that most decisions on which broker dark pools to connect to are based on an ongoing process of experimentation and elimination. And given the current scarcity of liquidity, the buy side’s exploration of the dark isn’t likely to end soon.

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3 Comments to "Buy-Side Traders Aren’t Afraid of the Dark":
  • Comment_230146_210851315613283_100000652474653_678322_2285980_n

    21 November 2012

    we now trade dark pools mainly due to exchanges allowing HFT  to dominate their markets and therefore provide little liquidity and volume ........ they were warned as were the regulators . How long dark pools survive is another issue but if exchanges govern HFT there be no issue ! 

  • Anon_avatar

    21 November 2012

    The proportion of HFT is bigger in the Dark than in the Lit. Does that mean that people can (should?) (shouldn't?) only be afraid of what they can see?

  • Comment_10x29_mackie_headshot

    21 November 2012

    To my mind, the emergence of dark pools and the phrase "HFT" are synchronous and derive from the same source: the democratization of markets caused by the advent of electronic trading.  

    In the case of dark pools, said democratization brought better price discovery but at the expense of size or, put another way, liquidity.  Dark pools are an attempt to recreate the old market structure where size could more readily find a market without creating price disruption.  

    In the case of HFT, this type of trading always existed but it became more apparent in the new market structure and it grew because the conditions in electronic trading were favorable to this type of activity.  

    If this is true then it is also true that dark pools are not a reaction to HFT and attempts to limit, constrain or change HFT behaviors are not likely to change the lit/dark market dynamics other than to reduce the toal level of liquidity.  In this environment, that is a very negative outcome.

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