Dark Pools and High Frequency Trading For Dummies - Vaananen Jay

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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,

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