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The threebie that isn't

Published in Automated Trader Magazine Issue 19 Q4 2010

There’s a Rule of Three in dark-pools. One of the three types of counterparty match you meet there could cost you money. But which? Many dark pools and electronic liquidity providers now provide a matching service that allows users to potentially trade at a price that is equal to or better than the price on the primary exchange or corresponding MTF. Whilst this service seems instantly appealing, end users do not always question why somebody would be the counterparty to this trade. Dr Paul Lynch, CEO of Switzerland-based PE Lynch Global AG, takes a look at the desire to meet in the middle and why ending up on the end of the wrong type of mid price match could be to your disadvantage.

Dr Paul Lynch

Dr Paul Lynch

What is a dark pool?

Whilst there is no formal definition of a dark pool it is generally accepted that they are sources of liquidity that are not present on the visible order books (the lit books). Although many market participants assume that dark pools are automated market venues, one could contend that the largest dark pool is still a form of open outcry: every day, sales traders verbally seek out liquidity that is not on the lit order books on behalf of their clients and this method of order matching is still the lion's share of the 'over the counter' market in equities.

Apart from the open outcry dark pool the rest of these liquidity sources can be condensed into three categories:

Independent dark pools: These liquidity pools are often mechanisms for the buyside to facilitate a block trade. This gives the users the advantage of reducing market impact by not having to fill the trade on an illiquid lit book. However there is a well known risk associated with these pools; there is no guarantee you will be filled, as the price on the lit book could be moving unfavourably whilst you are waiting (hoping) for a fill.

Broker Dealer dark pools and electronic liquidity providers (ELP): These liquidity pools aim to match both large and small trades, typically at the mid price, to the lit books. As small orders can be facilitated these pools are often part of an executing broker's smart order routing policy as these pools operate high frequency order matching. Conversely, if no match is found then the user can quickly look to fill the order on the lit book.

Exchange and MTF owned dark pools: These pools are similar to the above but the trades are conducted on a regulated exchange/MTF. These pools are also an important part of an executing broker's SOR policy.

Interestingly, both broker dealers and exchanges offer a best of breed dark pool whereby an incoming order will first look for a match in the owner's dark pool. If the order cannot be executed then the best of breed dark pool will then sweep all the competing dark pools. All of this can be done at very high frequency and it is for this reason that we focus our attention at the Broker Dealer, ELPs and exchange owned high frequency dark pools that typically match trades at the reference mid price.choir

What are lit books doing?

All lit books and exchange based open cry markets simply match buyers with sellers. Prices will rise if there are more buyers than sellers. At higher price levels new sellers are attracted by the high price and trade occurs. If supply is greater than demand at this new price level then the price will start to drift lower (more sellers than buyers). This mechanism is formally known as the 'continuous double auction' and has been the basis of price formation and trade facilitation for hundreds of years (both in open outcry and electronically). The continuous double auction comes with a well know cost, the bid ask spread. If a buyer wants to instantly fill their order then they have to pay at least the ask price (and visa versa for a seller on the bid price). Thus the bid ask spread can be considered a market friction cost. However, this cost does come with a convenient by-product in the form of reference prices that will facilitate two way trade.

What are mid books doing?

As the lit books have a well known cost, the mid price dark pools have to offer an attractive alternative in order to capture flow from the lit books. As previously stated they give a buyer or seller the possibility (but not the certainty) of executing the trade at the mid price of the lit book and thus reduce the market friction caused by the bid ask spread. Furthermore, sometimes the trade is executed with volume in excess of what is offered on the lit book.

There are different situations where you would choose to look to execute at the mid price. If the bid ask spread is large then the attraction is obvious. However, even if the bid ask spread is small the mid price can still be desirable if one's order flow is aggressive and is constantly looking to cross the spread. (However, if the order is very passive then using the power of patience and queuing up on the lit books could give you greater reward.)

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Why would anybody give you the mid price?

As you can potentially slash your market friction costs by crossing at the mid then it sounds like a free lunch. So why should anybody give you that 'free' option? We now present three categories of reasons for why somebody might give you the fill at the mid price:

Natural Match - this happens with natural agency flow by the happy double coincidence of an impatient buyer and an impatient seller both signalling their intention to trade at the observed mid price at a given point in time. This is a natural reason for a mid price trade and both counter parties should reduce market friction, risk and hopefully exchange transaction costs.

Covered Match - Put simply this reason for somebody offering you the chance to trade at the mid is because they already have the other side of the trade. For example a market maker may have just been filled at the bid on a MTF. If the bid/ask spread on the lit order books has not moved, then quickly unwinding this position at the mid price locks in a profit and reduces the inventory risk. Another example of a covered match would be where derivative traders have underlying delta/gamma positions that need to be hedged. Therefore they might want to trade at mid to get the derivatives portfolio delta neutral. There are many other examples of a covered match and if this is the reason for your fill at mid then it is possibly a convenient coincidence that could reduce costs and risk for both counterparties.

Market Maker Match - This is where a market maker will give you a fill at mid because they believe the price will soon move in their favour. Hence they are putting up capital and the potential reward is half of the bid ask spread. These opportunities can arise when there is a difference between the observed mid price on the lit book and the effective mid price. For example, there could be a volume imbalance with a large volume on the ask price and a small volume on the bid price due to successive lit book trades occurring at the bid price. As a result, there is a good chance that the current bid price could become the new ask price, hence the effective mid price is closer to the current bid price and the difference between the observed mid price and the effective mid price presents a potential market making opportunity. If the reason for your fill at the observed mid price is due to a market maker match, then statistically you would have been better queuing up at the bid price on the lit books. Moreover, you may have even captured a rebate from the MTFs for your patience.

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What should I look at if I get a fill at the mid price?

It is unlikely that you will know immediately from your Broker Dealer/MTF/ ELP the reason for the "free" lunch. Obviously you would be happy to interact with Natural mid price matches and potentially Covered mid price matches (provided that Covered Match is not a Market Maker match in disguise). In the long run Market Maker mid price matches (such as the one outlined above) should be avoided, as statistically you would be better off queuing on the lit order book.

Hence, metrics are required to show what happened to the price of the stock just after the mid price match. Over a very large sample if there is little difference between the mid price match and the subsequent price on a particular dark pool, then it is likely that you are interacting with natural matches and harmless covered matches. There is therefore no need to be too paranoid about routing your flow to this mid price dark pool.

If however, over this large sample the subsequent price tends to go against where you have been filled at the mid price then it is highly likely that you are interacting with market maker matches. If this is so, it is also highly likely that this dark pool should be avoided and that you should queue on the lit books instead.

Obviously care needs to be taken regarding the length of the period after the mid price match that needs to be monitored to obtain a meaningful reference point. For example, if you get filled on 10,000 shares at mid, what is the average fill price on the lit books for the next 50,000 shares that trade?

A quick word of caution is appropriate. It may also be worth monitoring what happens to the price when you go to mid price but do not get a fill. If the price always tends to drift away, then there could be information leakage from your trade. However, this problem can be difficult to detect, because if you are not being filled at mid you may possibly look to pay the spread on the lit books - thus creating your own subsequent market impact.

Are dark pools going to replace lit books?

By definition, crossing at mid cannot exist without lit books that provide a reference bid price and ask price. Hence the mid price dark pools are parasitic in nature as they feed off the price formation process of the continuous double auction going on in the lit books. Therefore, if there was no lit book there would be no dark book. Furthermore, lit books provide a very useful reference price that can facilitate two way trade for market participants. For these reasons alone they should continue to prosper. Nevertheless, dark pools appear here to stay - but if you want to match at the mid price you need to be highly selective about your choice of meeting place...