Table of Contents

1. Introduction ....................................................................................... 2 2. Dark pools: a description.................................................................. 2 3. The expansion of dark pools ............................................................ 3 4. The drawbacks of dark pools ........................................................... 4 5. The advantages of dark pools .......................................................... 5 6. An outlook for dark pools ................................................................. 6

7. Conclusion ......................................................................................... 7 8. Bibliography ...................................................................................... 8

[Dark Pools] 1. INTRODUCTION

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This essay will explore the arguments for and against the expanding utilization of so-called dark pools of liquidity henceforth simply referred to as dark pools. Over the past decade several traditional equity exchanges have experienced a loss in trading volume, whilst a wide variety of dark pools have grown globally to unprecedented sizes (Degryse, Achter, & Wuyts, 2008: 2). The escalation in the size of these dark pools have raised concerns over their impact on financial stability, which has prompted authorities to consider regulating dark pools in order to negate the risks they pose. Section 2 of this essay will provide a definition of dark pools and its various distinctions. Section 3 will explain the evolution of dark pools. Section 4 and 5 will elaborate on the disadvantages and advantages of dark pools respectively. In section 6 the future of dark pools with regards to their growth and the possibility that they may be regulated will be contemplated. Section 7 will offer some concluding remarks.

2. DARK POOLS: A DESCRIPTION

Dark pools are one type of alternative trading systems (ATS) (Degryse, Achter, & Wuyts, 2008: 3). According to Brown and Reilly (2009: 107) ATSs are nontraditional equity trading systems which compete with or complement traditional exchanges and dealer markets. In contrast to traditional exchanges bid and offer quotes in dark pools are not publicly disseminated (Caplan, Cohen, Lenz, & Pullano, 2009: 1). Dark pools are able to conceal the details of their trades because existing regulation does not require them to disclose these details (Degryse, Achter, & Wuyts, 2008: 2) (Hod, Harvey, & Fournier, 2007: 1). Institutional traders are attracted to dark pools because they have various advantages over traditional exchanges: the potential of better liquidity,lower submission and execution fees and the offer of complete anonymity. In addition, dark pools extract their prices from the market thereby limiting market impact (Caplan, Cohen, Lenz, & Pullano, 2009: 1). Dark pools in contrast to exchanges, have no market makers to absorb surplus order flow and as a consequence an orders execution can not be guaranteed. Traders that direct orders to dark pools therefore face a trade-off between a possible price improvement and the risk of an order not being executed (Zhu, 2012: 3).

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Caplan, Cohen, Lenz, & Pullano (2009: 1) state that dark pools have two principle ownership structures namely large broker-dealer dark pools and exchange-owned dark pools. Zhu (2008: 8-9) distinguishes between three types of dark pools, which for the purpose of this essay will be named type 1, type 2 and type 3. Type 1 dark pools match orders at exchange prices, are mostly owned by agency brokers and exchanges; and typically execute at the average of an exchange bid and offer. Examples of type 1 include ITG Posit and Liquidnet. Type 2 dark pools are non-displayed limit order books which are mostly broker-dealer dark pools and may offer some price discovery and contain proprietary order flow. Examples of type 2 include Credit Suisse Crossfinder and Goldman Sachs Sigma X. Type 3 dark pools are electronic market makers, which are high-speed systems that handle immediate-or-cancel orders and typically trade as a principal. Examples of type 3 include GETCO and Knight Capital (Zhu, 2012 8-9).

3. THE EXPANSION OF DARK POOLS

Pre-2000 dark pools were virtually non-existent, but today there are more than 40 dark pools operative in the US alone and their trading volume is expanding, on average, at an annual growth rate of approximately 40%. Furthermore, around 90% of all the large US investment management companies have disclosed that they use Crossing Networks (CNs), which is the primary type of dark pool (Degryse, Achter, & Wuyts, 2008: 2). It is estimated that 12% of the equity trading volume in the US as of mid-2011 could be attributed to dark pools. There are over 60 dark pools globally and although dark pools in Canada, Europe and Asia have small market shares they are rapidly expanding (Caplan, Cohen, Lenz, & Pullano, 2009: 2) (Degryse, Achter, & Wuyts, 2008: 2). The market share of dark pools in the US nearly doubled from 2008 to 2011, while at the same time traditional exchanges experienced significant declines in average trading volumes (Zhu, 2012: 5). As a result many exchanges perceive dark pools as a threat and have responded by creating their own dark pools in the shape of anonymous CNs (Caplan, Cohen, Lenz, & Pullano, 2009: 3). There seems to be a perception that the radical emergence of dark pools appeared abruptly from nowhere, which is not the case the first CNs started out in the early 1970s as private phone-based networks between buy-side traders. In the 1980s the network went electronic with the appearance of Instinet and POSIT. Dark pools seemed to have emerged from nowhere because their early years of existence was met with limited success and their market share in equity trading was negligible. 3

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Furthermore, the competition among CNs was low, but this was all about to change quite dramatically (Degryse, Achter, & Wuyts, 2008: 4). There are two developments that are responsible for the rapid expansion of dark pools particularly after 2005: namely technological progress and regulation amendments which jointly promoted competition and electronic trading (Caplan, Cohen, Lenz, & Pullano, 2009: 3). In the past the main purpose of dark pools was to allow institutional traders to trade large blocks of shares without exposing their trading strategy to the wider market. In 2005 the Regulation National Market System (Reg NMS) was adopted, which proved to be a defining moment in the US equity market. Reg NMS promoted the formation of a wide variety of new and faster Electronic Communications Network (ECNs) and Electronic Crossing System (ECSs) which compete with traditional exchanges (Zhu, 2012: 4). Reg NMS compels trading locations to ensure the best executions of trades, thus stimulating the formation of new trading locations and increasing the volume executed through dark pools. In 2004 the European parliament adopted the Markets in Financial Instruments Directive (MiFID), the European equivalent of Reg NMS which can be expected to similar outcomes (Degryse, Achter, & Wuyts, 2008: 12).

Apart from regulation, technological advancements have lead to an immense increase in the number of algorithmic trading programs (algos). These algos are programmed to automatically and optimally route orders to various trading locations after taking prices, liquidity and market impact into consideration, (Degryse, Achter, & Wuyts, 2008: 4). There has over the past decade or so been a shift in the purpose of dark pools from being the domain of big-block trading to one that supports highfrequency trading of smaller and medium-sized order. Dark pools are now commonly seen as part of an alpha protection strategy by asset management and alternative firms (Caplan, Cohen, Lenz, & Pullano, 2009: 1).

4. THE DRAWBACKS OF DARK POOLS

As dark pools have expanded the concerns that accompany them and the calls to have them regulated have grown as well. The European Commission has expressed its concerns regarding the increased use of dark pools, specifically with regards to the likelihood that dark pools harm price discovery which in turn exacerbates short-term volatility (Zhu, 2012: 5). It is argued that since dark pools typically extract their execution prices form the exchange market, they do not directly contribute to price discovery. 4

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This is the case for the type 1 dark pools mentioned earlier (Zhu, 2012: 8-9). Another avenue along which dark pools may harm price discovery is by attracting valuable order flow away from traditional exchanges which also decreases the liquidity of the traditional exchange (Buti, Barbara, & Werner, 2011: 3). In a 2009 study by the CFA Institute 71% of the respondents indicated that they thought that dark pools were either somewhat or very problematic for price discovery (Zhu, 2008: 5). Another percieved drawback of dark pools are that they reduce market quality (Buti, Barbara, & Werner, 2011: 3). According to Brown and Reilly (2009: 92) market quality refers to characteristics that make a good market. A good market is one which has timely and accurate information regarding past information and current buy and sell orders. A further requirement of a good market is liquidity which is the ability to buy or sell an asset quickly. Over the past decade there has been a shift in dark pools towards high-frequency trading. In displayed markets high-frequency trading firms can often play an important role in thighting spreads, but in dark pools they often are the cause of short-term adverse selection. Due to the increased level of highfrequency trading in dark pools, adverse selection is much more prevelant which is harmful to buy-side participants (Saraiya & Mittal, 2009: 1). Adverse selection happens, for example when a trader, lets call him Robinson Crusoe, has a sell order executed and immediately following this excution a similar order is executed at a much higher price. This is to the detriment of Robinson Crusoe who received the lower price. In the lit market a trader can choose a given time and price at which to execute, but in dark pools the time and price at which a order is executed is only determined when the other side of the order appears (Saraiya & Mittal, 2009: 2). Previously adverse selection in dark pools was limited because dark pool operators restricted access; high-frequency trading firms, statistical arbitrage firms and proprietary desks were for instance not allowed to partake (Saraiya & Mittal, 2009: 21). Dark pools are not always that dark. In actual fact dark pools often send an indication of interest (IOI) to possible counterparties that contains certain information regarding an order for example a ticker, as a means to facilitate a match (Zhu, 2012: 34).

5. THE ADVANTAGES OF DARK POOLS

Several advantages of dark pools were mentioned in the first section of this essay: anonymity for the trader, limited market impact or reduced information leakage, the potential for price improvement

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and greater liquidity. Buti, Barbara and Werner (2011:2) list the various motives institutional traders may have for wanting to hide their orders from the continuous limit order market. Firstly, displayed orders can invite imitation which may reduce the alpha of the underlying investment strategy. Secondly it can invite front running and quote matching by broker-dealers and opportunistic traders which increase trading costs. Thirdly, institutional traders are very cautious of counterparty risk, the risk of trading against informed order flow. Futhermore, over the past few years the average trade and order size have decreased dramatically which makes it near impossible to trade in bulk in the continuous limit order market (Buti, Barbara, & Werner, 2011: 2) Zhu (2008: 2) argues that the view of regulators and market participants that dark pools harm price discovery is misguided and that dark pools in fact improve price discovery on the exchange. Informed orders in a dark pool, which are positively correlated to the value of a stock, are less probable to be executed, because they are more likely to be concentrated on the side of the market with more orders. On the other hand liquidity orders, which are less correlated, have a greater chance of being executed in a dark pool because they are more likely to be on the side of the market with fewer orders. This disparity in execution risk forces informed traders into the traditional exchange and relatively more uninformed traders into dark pools. This self selection reduces noise on the traditional exchange and enhances price discovery (Zhu, 2012: 4).

6. AN OUTLOOK FOR DARK POOLS

Dark pools may continue to thrive due to advances in technology, trading strategy requirements and a regulatory environment that remains favourable. Dark pools seem to possess a successful business model that in the short run at least will ensure their success. It remains doubtful however, whether an overly fragmented equity market can be sustainable in the long run. As smaller players fight for survival market consolidation is inevitable. Crossing networks could either integrate with traditional exchanges or traditional exchanges could opt to further develop their own dark pools (Degryse, Achter, & Wuyts, 2008: 16). The continued growth in dark pool trading volumes has been met with increasing calls for stricter regulation of dark pools (Hod, Harvey, & Fournier, 2007:1). The principal concerns relate to nonstandardized reporting requirements and automated IOIs sent between dark pools. It is believed that IOIs could worsen market fragmentation and exclude the public investor. Furthermore, the deficient 6

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standards in reporting requirements of dark pools are thought to have led to inconsistent and unreliable volume statistics (Caplan, Cohen, Lenz, & Pullano, 2009:3-4).

7. CONCLUSION
We have seen that dark pools, venues were equities are traded hidden from the view of the general public, have grown tremendously over the past decade. New technology and a benign regulatory environment are to thank for this. Growing concerns have been raised over the potential for dark pools to impede price discovery and liquidity on traditional exchanges, which contributes to short term volatility. Other disadvantages of dark pools are the following: adverse selection, non-standardized reporting requirements and restricted access. However, dark pools have many positives as well. They limit market impact which is especially useful for bulk trades. They can also provide better liquidity and lower submission and execution fees. Contrary to the concerns, dark pools have been shown to reduce noise on traditional exchanges and enhance price discovery. In the future dark pools are likely to be subjected to stricter regulation and will most probably be integrated into traditional exchanges.

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Word Count: 2024 [Excluding abstract, headings and citations]

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8. BIBLIOGRAPHY
Brown, K.C. and Reilly F.K. 2009. Analysis of Investment and Management of Portfolios, 9th Edition. Canada: South-Western. Buti, S., Barbara, R. and Werner, I.M. 2011. Diving Into Dark Pools. Online [Available]: http://www.efa2012.org/papers/s1f2.pdf [2012, August 23].

Caplan, K., Cohen, P., Lenz, J. and Pullano, C. 2009. Dark pools of liquidity. Pricewaterhousecoopers. Online [Available]: http://www.pwc.com/us/en/alternativeinvestment/assets/NY-10-0105-PwC-alt-Caplan.pdf [2012, August 23]. Degryse, H., Van Achter, M. And Wuyts, G. 2008. Shedding Light on Dark Liquidity Pools. Online [Available]: http://ssrn.com/abstract=1303482 [2012, August 23]. Hod, Z., Harvey, C. and Fournier, L. 2007. Shining a light on dark liquidity: Managing liquidity, anonymity and transparency. Online [Available]: http://www-935.ibm.com/ services/ us/gbs/bus/pdf/dark_liquiditybcw01629-usen-00.pdf [2012, August 23]. Saraiya, N. and Mittal, H. 2009. Understanding and Avoiding Adverse Selection in Dark Pools. Investment Technology Group, Inc. Online [Available]: http://www.positalert.com/news_events/papers/AdverseSelectionDarkPools_113009F.pdf [2012, August 23]. Zhu, H. 2012. Do Dark Pools Harm Price Discovery? Online [Available]: http://www.mit.edu/~zhuh/Zhu_darkpool.pdf [2012, August 23].

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