Dark Pools and Hidden Liquidity

What Dark Pools Are

A dark pool is an electronic venue at an exchange used by investment brokers to provide hidden liquidity, i.e. allow trading out-of the public’s eye in an anonymous and private manner.
Currently it is estimated that in the US around 10 to 15% of equity transactions are executed via dark pools.

Dark pools are provided by investment brokers, e.g. Goldman Sachs, JP Morgan, UBS, Morgan Stanley, etc.
They are also increasingly provided by traditional stock exchanges, like NYSE Euronext, NASDAQ OMX, LSE, SWX. This is mostly to counter the growth of new exchanges like Chi-X, BATS, Turquoise, whose business model relies on dark pools.

Here are some dark pool providers (what I could find so far):

Dark pool providers

Dark pool providers

Why Dark Pools are Attractive

One reason that they are attractive, is that they allow larger blocks being traded than do the public order books. Most traditional exchanges have the size of blocks that can be traded limited. This in an attempt to counter-act the effect of the algorithms used by the brokers.

Another reason is, that dark pools are anonymous and private. At least that’s the claim, but we, can we not, can assume that at least the party managing the dark pool knows everything about the activity inside the pool.

Dark pools are also serviced by the (quantitative) trading algorithms. Those are in essence computer trading programs that, given certain parameters, automatically trade in the open and the hidden market.
For example, Deutsche Bank’s Stealth algorithm provides access to 30 dark pools world-wide, Credit Suisse to 26, it is said.
Now, we no longer need to wonder, why the global exchanges as NYSE, LSE, etc seem to work in sync. They actually do work in sync, linked together by the same providers.

In addition, the insanity of this approach becomes obvious now. There is algorithm A talking to algorithm B – no humans involved – duking out amongst them who will profit more in an exchange. Something that can be tuned by typing in the right parameters. The result is that, you can not only program your profit, but can make it entirely independent of anything that happens in the real world. That’s what we are currently witnessing: Algorithms run amok bidding eachother ever higher, while the world around them – and the people with it – go down the drain. And all with a hefty bonus for Dimon, Blankfein and their ilk.

Recent Dark Pool Developments

There were some interesting developments over the last two years. It is notable and interesting to see that there already has been a consolidation in the dark pool world right up to the time of the crash in 2008.

On September 9, 2008 it was announced that Credit Suisse and Lehman Brothers were to link their dark pools, i.e. provide each other access to the other ones dark pool. More here.

This move followed an earlier one by Goldman Sachs, Morgan Stanley and UBS who linked together their pools in May 2008. More here.

So, obviously, there has a consolidation and a shake-out been going on among large brokers and exchanges at the time of the beginning of the financial crisis.

We also not that Turquoise, a relatively new exchange that has started operating in August 2008, was and is pushed and financed by Deutsche Bank, BNP Paribas, Credit Suisse, Goldman Sachs, Merril Lynch, Morgan Stanley, Societe Generale and UBS.

Please note the absence of both Bank of America and Lehman Brothers from this list. BofA was not in the dark pool business before it was forced to acquire Merril Lynch by Paulson, and Lehman is now gone, because Paulson, former Goldman Sachs CEO, said so.

Lehman not only had a partnership with Credit Suisse to link their dark pools together as noted above, it also had a partnership with LSE to establish a common dark pool named Baikal.
However, with the collapse of Lehman, this attempt has run into difficulties and LSE now intends to sell up to half of it’s stake in Baikal dark pool. Who has acquired Lehman’s stake in Baikal anyway? I think it’s still up for grabs, at least I couldn’t find information on it.

The major competitors of LSE are Turquoise, BATS and Chi-X. Their business model is strongly based on dark pools. Certainly, Turqoise (and its backers) doesn’t mind that Lehman disappeared and that the LSE is in trouble.

The Problem with Dark Pools

Dark pools, in addition to motiviations given above, have another benefit for the one who controls them. It gives the large participants total control of access to liquidity. The dark pool provider can make the rules and rig the game as he pleases. They can admit whomever they want to their pools and make the rules as they see fit.
That fair access is indeed an issue, can be seen from the attempts of Credit Suisse who lobbied for fairer access to these pools.

The trades made in dark pools (hidden book) are all anonymous and private, i.e. they are not visible to the participants in the public part of the exchange (open book). There is no way of knowing at what price, how many and by whom a security was traded and most importantly who did what.
So, in the future you can just give those large brokers your money, hoping that they will make a profit for you. However, if something goes wrong, you won’t have any way of knowing what has gone wrong and why.
In short, you are at their complete mercy. This has nothing to do with a fair market or efficient market. The quotations and indices on the exchanges are thus becoming completly insignificant as an indicatior of anything, they are devoid of any useful informational content.

I might be wrong, but I thought the purpose of exchanges and regulation was to provide transparency and had as a purpose to avoid excatly this kind of situation.
Again, we notice once more that regulators are either completly clueless as of what is going on or do not really have an interest in doing something about this situation.

[Hat tip: Zero Hedge who has been writing about the problems with dark pools for months]

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