Читать книгу Dark Pools and High Frequency Trading For Dummies - Vaananen Jay - Страница 4

In This Chapter

Looking at what makes a dark pool

Defining high frequency trading

Naming the cast of characters

Identifying the order types

Eyeing regulation

They’re the hot topic in financial markets now. You can’t open a newspaper or click on financial news without coming up against the terms dark pools or high frequency trading (HFT). It’s all happening in the world of dark pools – lawsuits, scandals and accusations of the market being rigged. One thing is certain: all the banks and brokers are involved in one way or another with dark pools. But whenever you mention dark pools, you also have to consider the subject of HFT. One came about because of the other, and then they came full circle and now both operate in the same environments.

Like the name implies, dark pools are dark and secretive and the banks, brokers and institutions that operate the dark pools would prefer them to remain that way. High frequency traders are no different; they’re even more secretive about their activities and would’ve liked nothing more than to have stayed hidden in the shadows, buying and selling stocks in milliseconds and making money.

The world has changed, though, and now there’s no hiding in the dark anymore. The light is being shone on dark pools and HFT. This chapter serves as your jumping-off point into that world.

HFT, dark pools and algorithms can be found anywhere where there’s a working stock exchange. There’s no place to hide from them if you want to invest in the markets. The United States remains the main market by far. With more than ten stock exchanges and dozens of dark pools, the venues are so fragmented that the US market remains the best type of market for high frequency traders to operate in. When it comes to changes and trends in the high frequency and dark pool market, look to the United States first – the rest of the world is sure to follow.

Defining Dark Pools: Why They’re an Investment Option

Dark pools have been around in one form or another since organised stock exchanges began. In their simplest form they’re a venue other than the stock exchange where stocks are traded. A stock market is one big, ongoing auction with investors and traders bidding and offering shares at different prices. Stock markets display their orders in an order book for all to see. When investors agree on a price, a trade happens and the process of agreeing on a price and making a trade repeats itself and continues all through the trading day as long as the stock exchange is open. But other times an investor may want to do a trade outside of an exchange.

That’s where a dark pool comes in. A dark pool is a private venue where investors can exchange large amounts of stock without tipping the market to their intentions and, most importantly, without overly moving the market price. The common attributes of a dark pool are as follows. You can also refer to Chapter 2 for more detailed information about dark pools.

✓ Little transparency of trade execution: The broker, bank or whatever entity that is running a dark pool has a huge responsibility of discretion towards its clients to keep the information private and to make sure that information about a large order doesn’t leak. Trying to find buyers without letting anyone know there are sellers and vice versa is challenging.

✓ Trades executed within the spread: The spread is the price difference on a stock exchange between a bid (a price someone is willing to buy a stock at) and an offer (a price someone is willing to sell at). A dark pool will benchmark the price it trades at to the prices on a stock exchange with the aim of doing the trade at a slightly better price for both the buyer and the seller. By settling a trade within the spread the price will be better than the price for both buyer and seller on the displayed stock market because the buyer receives a lower price than on the stock exchange and the seller gets a higher price than he would get on the stock exchange. Dark pools tend to be cheaper than a stock exchange because they don’t have the same fees.

✓ Owned by a bank or broker: Banks and brokers are keen to use dark pools because it saves them from having to pay the exchange’s fees. Although stock exchange fees seem small, just fractions of a cent, for a bank or broker they add up. It’s much more cost effective to be able to match a trade internally in a dark pool.

Thanks to superfast computers and the ability to route trades through many locations inside of a millisecond, for many banks and brokers dark pools have become the first point to try to execute a trade before routing it to a stock exchange.

There are now dozens of dark pools all over the world. Brokers often first try to settle a trade between their own clients (called internalising) in their own dark pool. If they can’t find a match, they will then route it to another dark pool, trying to find a match. Often the last port of call will be the traditional stock exchange.

On the darker side of the dark pool market, trading outside the displayed markets may give the broker an opportunity to take a small extra slice. Accusations have been made and even fines levied against some dark pools due to actions that haven’t been in the clients’ favour. Because of little transparency in the market, trading venue providers may be tempted to try to skim the little extra bit for themselves. Trading venue providers are those who operate a dark pool, most often banks and brokers. (Refer to Part IV for some risks associated with dark pools.) As a result of the suspect behaviour of some dark pools, legislators have stepped in to regulate and protect the investor. Head to the later section, ‘Regulating the Markets: Legislators Take Action’, for more information.

The growth in dark pools in recent years has been accelerated by the growth in HFT.

The evolution of dark pools and HFT

The modern dark pool market was created and has grown as large as it has because of high frequency traders. As HFT became better at detecting big orders, large institutions felt they were being used as fodder for the high frequency traders. They then wanted to hide from the high frequency traders and execute their trades out of sight of the algorithms. This is why dark pools were so attractive to big investors.

Now the situation has come full circle. The dark pools became successful businesses and therefore they wanted to grow. This meant they needed new traders in their pools and some opened the doors to high frequency traders and let them into the dark pools to trade. Now there are dark pools that allow high frequency traders in, the very group they were invented to keep out.

Explaining What High Frequency Trading Is

High frequency trading (HFT) is the use of algorithms to trade shares at a high velocity of turnover, sending orders to the market in large numbers and using computer algorithms at great speed. Thousands of trades are sent out and executed inside milliseconds, and it all happens at a pace faster than the human eye can detect.

Here are the defining parts of HFT:

✓ Run by fast algorithms: An HFT algorithm tries to catch tiny differences in the price of a stock – just a penny or even a fraction of a penny. It tries to repeat that thousands and thousands of times a day, so those pennies add up quickly into big money. Chapter 7 takes a closer look at algorithms.

✓ Fast computers are co-located with exchanges: High frequency traders are able to do what they do by using fast computer algorithms and placing their own computers close to the stock exchanges’ own computers. Refer to Chapter 10 for more information on co-location.

✓ Use of special order types: Special orders are complex buy/sell orders used by algorithmic trading programs that define how an order is placed in a market, how it’s shown on the order book and how it interacts with changes in the order book. Head to the later section ‘Eyeing the special order types’ for more.

✓ The sending out and cancellation of lots of small lot orders: High frequency traders send out small orders of 100 to 200 shares at a time, trying to find information about larger, hidden orders. They then trade against those orders to make a profit. Chapter 10 provides more information.

For a while HFT was touted as bringing down the cost of investing and trading in the markets, but as information about the nature of HFT started to leak out, cracks began to appear. Some players in the markets started criticising HFT as something that gave an unfair advantage to some, using predatory behaviour and taking advantage of other investors.

This debate split financial professionals into two camps. Some defended HFT as bringing down trading costs and providing liquidity, making the market a better, well-oiled machine. Then there were those who argued that HFT was akin to the market being rigged and should be outlawed. What’s clear is that some shenanigans have been going on, and often the retail investor and the large institutions have been on the receiving end of the antics of some high frequency traders.

My experience with dark pools and HFT

I first got interested in dark pools and HFT when, as a private banker, I started noticing funny (not funny ha-ha; I mean funny as in strange) things happening when placing trades on the markets for my clients. The price would suddenly move against me, only to immediately move back to the original price after my execution was done at a less favourable price. Then there were the times when I placed an order in the market and it wouldn’t appear on the order book. I’d call my trader, asking what was wrong. He’d call the broker (yep, we still used phones in the early days) who would confirm that the order was in the market, but still I couldn’t see it. Round and round we’d go. Like a Christmas pantomime. My trader and broker telling me, ‘Oh yes it is!’ about my assertion that the order wasn’t in the market, and me saying, ‘Oh no it isn’t!’

This situation started to get on my nerves, so I started looking into what was going on, asking questions and doing research. This led me to dark pools and HFT. At the time I had no idea how all-encompassing these two things had become for the market. The amazing thing was that so few top market participants, fund managers and CIOs had any idea of what was going on.

Through my research and the reach of my website, www.bankersumbrella.com, I’ve got to interact and discuss HFT and dark pools with many influential people on both sides of the HFT debate. I’ve learned a lot and continue to follow closely the changes in the market. I try to report on these matters and explain them in an easy-to-understand format, both on my website and on Twitter.

Knowing Who’s Involved When Investing in Dark Pools

All those involved in the financial markets are in some way involved with dark pools and HFT. Some swim deeper in the pools than others, and some investors actually having no idea that their trades are involved in the world of HFT and dark pools. To grasp how the world of dark pools works you need to know who’s involved, to what extent and how their activities might affect you. Chapter 5 looks at the cast of characters involved in dark pools and what their responsibilities are.

Brokers can make or break you

Brokers are the ones who match the trades. They find buyers for sellers and sellers for buyers. Without brokers there would be no market. In the world of dark pools and HFT, brokers operate their own dark pools and also run their own algorithms that execute trades and route orders to exchanges and dark pools.

The actions of brokers have a direct impact on you getting the best or worst out of your trade, so it’s important for you to know how brokers operate, particularly how your own broker operates.

The other important folk

Plenty of other important operators are involved in dark pools. Here are the main ones. Turn to Chapter 5 for information on what role they play in dark pools and HFT.

✓ Banks: Banks operate their own dark pools in which they match trades for investors. Originally, banks’ dark pools matched trades from their own clients, but their dark pools have grown to include high frequency traders and outside investors.

✓ High frequency traders: High frequency traders make up a large amount of the daily trading volume today, both in the displayed markets and now also in dark pools. They send out large amounts of small orders, trying to make a profit from tiny changes in the prices of stocks.

✓ Large, institutional investors: Investment fund managers and pension funds use dark pools and their own trading algorithms to try to disguise their large orders so their orders have as small a price impact on the market as possible.

✓ Regulators: Regulators monitor and enforce the laws regarding trading and markets.

Looking at the Order Types

To buy or sell stock in the markets, you need to send out an order that defines what it is you want to do with a stock (buy/sell), at what price and how many shares. Buy or sell orders used to be a rather simple affair, but in recent years order types have become more numerous and complex as HFT has evolved. Originally, only a handful of regular order types made trading in markets possible.

With the emergence of dark pools, multiple trading venues and algorithmic trading, special order types have been created that add a whole new level of complexity to trading. Knowing about both the regular and the special order types is important so that you can know which to use and how you can get the best of your trades. These sections give you a quick overview.

Considering the regular order types

The regular order types come in a few basic forms. Some orders execute immediately at the current price and others execute at a limit price. All orders include the amount of shares to be bought, sometimes with an additional caveat of only showing a certain amount of the order. Head to Chapter 8 for the ins and outs of these regular order types.

Eyeing the special order types

Special order types are complex and have many different criteria in addition to the regular order types. Literally hundreds of these special order types exist, with each market venue having its own. The one thing they all have in common is that they have been designed for use by algorithmic trading programs. Chapter 9 examines the most commonly used special orders in dark pools and explains what you need to know if they’re right for you.

Regulating the Markets: Legislators Take Action

Legislators have taken an interest in HFT and dark pools because it’s their job to set the rules that provide a fair market to all investors. HFT was born out of legislation, or perhaps a more apt description is to say that it was born out of legal loopholes.

As technological changes have outpaced legislative changes, new, superfast trading algorithms and computers have made it possible to execute trades faster than the eye can see. The speeds have become so fast that regulators haven’t had the tools or expertise to see what’s really going on in the markets. Regulators are now catching up with HFT and trying to crack down on those operators whom they suspect of trying to manipulate the market and take advantage of other investors.

Now legislators from all over the world are trying to block those loopholes. Doing so is a difficult task, but one thing is sure: more lawsuits and more legislation are sure to come that will change how both dark pools handle, route and execute their orders.

Legislation will also affect high frequency traders, and as a result the HFT market will also change, with some players unable to adjust to the new ways of doing business and new players taking their place. Refer to Chapter 6 for an in-depth discussion on how legislators are trying to regulate dark pools and HFT.

Information is a winner-takes-all race

HFT has become so fast that when news breaks that has an effect on market prices the price movement is over within a millisecond. There’s no way you can compete in this market without the same speed as the high frequency traders and the best algorithms. The speed has become so fast that it is in fact a winner-takes-all race, with the first one to make the trade on the news being the one who takes all the profits. Refer to Chapter 10 to see how the information game is important in HFT.