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In This Chapter

Knowing what dark pools are (and aren’t)

Comprehending how dark pools work

Identifying the rewards and risks

Figuring out whether dark pools are right for you

The term dark pools has been bandied around in the past few years in the financial world. What are they? What happens in them? Who runs them? The name is actually far more sinister than the real thing. Dark pools are simply places where stocks are traded ‘off exchange’. In other words, they’re an alternative to stock exchanges.

Stocks were traditionally traded in a stock exchange. Now, thanks to computer algorithms and increased volumes in stock trading, these new venues called dark pools have sprung up where stocks are traded. They pool together different investors’ orders and match them up. In fact, they do exactly what an exchange does; the only difference is that executed trades aren’t disclosed to the public immediately.

This chapter examines dark pools and explains what they are, how they operate and why they came about. This chapter tells you how they evolved and changed as the market changed and how they operate today. I also explain the pros and cons of dark pools and what you need to know to determine whether they’re right for you.

Taking a Snapshot of Dark Pools: What They Are and Aren’t

Dark pools have many similarities with a traditional stock exchange. Both are venues where stocks are bought and sold by traders and investors. There are, however, significant differences in how orders are priced and matched with each other in a dark pool and in a stock market. These sections show you exactly what dark pools are and what they aren’t, so you can decide whether and when they are a good place for you to execute your trades.

Settled outside the public eye

Trades that are settled (also often referred to as executed) in a dark pool aren’t immediately reported publicly. Usually, they’re reported to the exchange sometime after the trades have been done. The timeframe of reporting trades differs from venue to venue and can also be dependent on the local financial rules and regulations. When the trades are reported after the fact and not in real time, there is less likelihood of a significant price impact on the stock.

Need for secrecy: Dark versus lit

Dark pool trades are anonymous and they aren’t immediately reported, which is why they’re referred to as dark. Any market that isn’t a stock exchange quoting its trade data in real time is a form of dark pool.

On the flip side, traditional stock exchanges rely on transparency and openness. To exchanges, the very idea of a fair market is that all trading data regarding price and volume is open, which is why stock exchanges are referred to as lit markets. Today’s global market place is a combination of trading done in the dark or in the lit markets.

You may think that the anonymity and secrecy of dark pools sounds sinister. However, allowing trading and the settlement of trades to be done out of the public eye, and in real time, is important for a couple of reasons.

Getting orders matched without moving the market

Brokers and banks have some options at their disposal to match orders without moving the market, which means that the price of the stock doesn’t move while the order is being filled. Supply and demand affect market prices. Big sell orders increase the supply and can push prices down. Large buy orders increase demand and can therefore push up prices. Before the emergence of dark pools, a large institution could make a large order in only two ways:

✓ Try to settle it between brokers after trading hours. There are set hours when a stock exchange is open for trading. By agreeing to a price and amount of shares when the stock market is closed for trading, a large order will not move the market price.

✓ Put the order into the displayed market. If the whole order with it’s full volume is displayed, the price will likely move against the institution because its order is so big that it moves the price of the stock. To counteract this, the smart option is to break the order into several parts, drip-feeding it into the markets by sending in orders in smaller 100 or 200 share lots. When these orders are filled the process would be repeated. This process can be laborious, and in fact advanced standard order types (see Chapter 8 for advanced standard order types) were planned to address this issue by automatically slicing a big order into smaller parts.

Algorithmic computer trading was created to sniff out these types of orders and then trade against them. Institutions were then faced with a need to find an alternate solution to their larger orders being adversely affected by the algorithms.

Making more profit by avoiding exchange fees

Brokers and banks could make more profit because their trades wouldn’t be subject to exchange fees. The business of a stock exchange is to match trades. Each time a trade is executed, a stock exchange charges a fee, which is how stock exchanges make their money. Brokers liked the idea of dark pools because they could bypass the stock exchange and not pay any exchange fees and so increase their own profits. All the brokers needed to do was find buyers and sellers among their own clients and match those trades.

Improving price

Brokers have a duty to their clients of best execution, which is trying to find the best possible price for their clients. Part of the concept of best execution is price improvement, which means the opportunity, but not the guarantee, of getting a better price for their clients. If a broker has the opportunity of getting her client a better price in a dark pool as opposed to a displayed stock exchange, she can then route the client’s orders to a dark pool.

Because prices in a dark pool take their prices from the bid and offer of the displayed exchange it and are often executed at the midpoint (average price) of the best bid and offer available on the displayed markets this gives the opportunity for a better price. Because prices can move very quickly, the opportunity for price improvement can be lost while the trade is being routed and the client ends up with an inferior price.

The midpoint of a trade is the average price between the best bid and the best offer; this way both the buyer and seller are satisfied because they get a slightly better price. For example, if a stock’s best bid is $10.50 and the best offer is $11.00 and you’d like to sell your shares immediately, you’d receive the best bid of $10.50. If another buyer at the same time wanted to buy immediately, she’d have to pay $11.00. A dark pool would match these orders together at the midprice, which is $10.75. This way you, the seller, get $0.25 per share more for the stock and the buyer pays $0.25 less for her stock. Both of you get a better price than you’d have got in the stock exchange. This is a dark pool working at its best, delivering value to both sides of the market.

Examining How Dark Pools Work: Step by Step

Dark pools have become an important part of the global markets, and they’re used as a viable alternative to stock markets. Knowing how they work will help you in your investing and help you to decide whether you want your trades to be routed through a dark pool and, if so, which one. This section discusses the ins and outs of how a dark pool works, from sending an order to executing an order.

In the days before dark pools, when you entered a trade your broker would place it in the appropriate exchange and that would be that. If you placed a limit order, an order that stipulates an exact price at which you’re willing to trade a stock, it would be displayed in the order book. If you were watching the trading book in real time and the stock was one that was trading slowly enough, you could actually spot your order coming into the book. The number of shares and the price you instructed would pop up on the exchange’s book. Here is what happens when you invest in dark pools:

1. If your bank or broker has their own dark pool or has access to other dark pools, they may place your order there first before routing it to an exchange.

If you’re using a limit order and the stock you’re trading is one that moves slowly and isn’t very liquid, a telltale sign of orders being routed via a dark pool is if your order doesn’t show up on the order book.

With an at-market order, which is an order that says you will make a trade at the best price on offer at that moment, your trade should be executed at the mid-price of the bid or offer if your broker is using a dark pool. (Refer to Chapter 8 for additional information about limit orders and at-market orders.)

2. If the order is routed through a dark pool and there is an opposite matching order in the pool (a buy order to match your sell order or a sell order to match your buy order), your order will be executed there.

At worse the price you get should be equal to the bid or offer available on the displayed stock market. Ideally, though, the price you get will be the midpoint of the bid and offer available in the displayed stock market. (Check out the earlier section ‘Improving price’ for more about the midpoint.)

3. If there is no matching order in the dark pool, your broker may then route it to another dark pool and try to match the trade.

If a match still can’t be found then the order is routed to the stock market. If it’s an at-market order then it’s executed immediately. If it’s a limit order, it’s placed on the order book until the price of the stock matches the price in the limit order.

4. If the order is matched in a dark pool, it will then be reported to the exchange.

This doesn’t happen in real time. Different countries have different rules as to the timeframe in which a dark pool transaction must be reported.

Weighing the Rewards and the Risks

Trading through a dark pool has both risks and rewards. One thing dark pools have done is brought more complexity and more choice to the markets. Here you can find out about the risks and rewards involved in a dark pool transaction and how to prepare your trading strategy for the potential risks.

Identifying potential rewards

Trading in dark pools has two main rewards:

✓ Less price impact: If you’re trading in large orders or you’re trading in shares that are illiquid (not traded actively in the market) then any order you send into the displayed market has the risk of moving the price in the direction that you don’t want it to move. For example, when you send a sell order, you obviously want as high a price as possible for the stocks that you’re trying to sell. Sending in a large sell order when not as many buyers are visible in the stock market will move the price down.

Also, when the order is displayed it sends a signal to the market that there is a large seller and buyers will pull their orders out of the market, anticipating that they will soon be able to buy the stock at an even lower price. This pushes the price of the stock you’re selling down further.

But when it comes to sending the order to a dark pool, the size of the order isn’t displayed, so your order has less likelihood of moving the price adversely against you. So one of the rewards of dark pools is to be able to buy or sell stock without moving the price against you.

✓ Better price than the displayed markets: The standard way to match a trade in a dark pool is to do it in the mid-price of the spread, which means that the price at which a dark pool trade is settled is the halfway point between the best bid (the highest price someone is willing to buy the stock at) and the best offer (the lowest price someone is willing to sell at).

If you want to buy a stock immediately, you pay the best offer. If you want to sell, you receive the best bid. The bid is always lower than the offer. By trading within the midpoint of the spread, the seller will get a slightly higher price than the best bid, and a buyer will get a slightly lower price than the best offer. When you’re trading large orders in stock, or if you’re trading often, this ability offered by dark pools to match trades at the mid-price can save you a significant amount of money in the long run.

Recognising the risks and preparing for them

Trading in dark pools has two main risks. They basically come down to the following:

✓ Information leakage: Information leakage is when other traders are able to receive information about orders coming into the market and use that information to profit from their own trading. When a large order is sent to a dark pool, no volume is shown, but it does and can leak information. For example, if a buy order is sent into a dark pool and it comes back unfilled or only partially filled, that shows that there aren’t as many sellers in the market as there are buyers. This information has a tendency to leak and affect the price. Just as in a traditional exchange, when there are more buyers than sellers the price moves up. Whenever investors make an attempt to buy or sell, they’re sending a signal to the market regardless of whether it’s made in the dark or in the lit markets. Refer to Chapter 12 for more information about information leakage.

If you’re a retail investor investing in small share lots then you don’t need to worry about information leakage, because your trading won’t have a great effect on the price of the shares.

✓ Trust: Any investor who uses a dark pool places a great amount of trust in whoever is operating the pool. When you place an order into a dark pool, the operator of the pool will have knowledge of the order. With that knowledge, the operator could trade ahead of the client (known as front running; refer to Chapter 12 for more information), or the operator could sell the information to a third party who could then do the same. Both of these issues are widely discussed when it comes to dark pools.

If you’re concerned about trust, consider whether you trust your broker not to use predatory high frequency traders for liquidity. If your broker does, you could well find yourself often getting a worse price than what you expected. If you don’t trust your broker then you may need to find another broker. Refer to the later section ‘Asking your broker the right questions’ to make sure that your broker is providing you with the best service.

To develop trust with your broker, your broker needs to be open with you about how she routes your trades and what specific dark pools she uses. Your broker needs to show that she follows and is up to date on the debate and public discussion on dark pools and HFT. Doing so shows you that she is competent and is able to adapt to any possible changes in how dark pools work and are regulated.

Investigating Whether Your Trades Are Exchanged in Dark Pools

Brokers aren’t often upfront with their clients about how they route their clients’ trades. Sometimes you may notice that you enter an order into the market and it doesn’t show up on the exchange’s order book. This can be particularly apparent in a slow-moving and illiquid stock; it’s likely that your broker is trying to execute the trade in a dark pool.

Your broker may execute in a dark pool without asking you. Nothing is wrong with doing so if it helps you get a better price for your transaction. But dark pools do have some risks (which I discuss in the previous section), so you want to know if and when your trades are being executed in a dark pool and whether doing so is to your advantage or your broker’s advantage. These sections explain what to do to ensure that you get the best from your trades.

Asking your broker the right questions

In order to find out whether your trades are being executed in dark pools, the best thing to do is to discuss the matter with your broker. Remember that dark pools can be good for you because they give you the opportunity to get your trades matched inside the spread of the displayed market and therefore get a better price. There is nothing inherently sinister about your broker using a dark pool, so the more you know about how your order is routed, the more it increases the chances of you getting a good price for your trade.

To have that discussion with your broker (or bank), come right out and ask whether your broker uses dark pools and which dark pools she uses. Seek to have a phone or face-to-face conversation so that you can have an open dialogue. Be sure to follow up on that dialogue with a written letter or email outlining your discussion; you want to keep some form of proof about the matters you have addressed with your broker about dark pools. Here are some additional questions that you can ask to uncover important information:

✓ Do you have a default action regarding when orders are routed to a dark pool and when directly to an exchange? Or is it just at your discretion? This question can tell you what route your order is likely to take and what venues it will go through. If any dark pools have been fined or are under investigation then you’ll know which dark pools to avoid.

✓ Do you accept payment for order flow? If so, from whom? Some brokers accept payment from third parties, often high frequency traders, so that the brokers send their orders first to the entity that is paying for the order flow. Order flow can contain important, market impacting information and those whose orders are part of that order flow are at risk of predatory traders. In the United States, brokers are obligated to inform if they accept payment for order flow, but remember to ask, because it’s always in the fine print.

✓ Where have my executed orders been routed during the past six months? In the United States, a broker is obligated to supply this information to her clients. This information will show you if your broker has a preference for certain markets. If so, be sure to ask why.

Check out the Cheat Sheet at www.dummies.com/cheatsheet/darkpools for more questions to ask your broker.