LITMIR.BIZ

      ✓ 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.

      ✓ 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.