Jay Vaananen

Cheat Sheet / Updated 05-02-2022

Dark pools and high frequency trading (HFT) are contentious subjects in financial markets. Billions of dollars are traded through dark pools, and HFT algorithms with just small, incremental price differences make billions of dollars. And it all can happen in milliseconds. Most importantly, dark pools and HFT are part of the current market environment. Anyone who’s invested in the markets needs to know what they’re involved with and what they’re up against.

Article / Updated 07-06-2021

Dark pools have grown to be a major part of the global equity markets, and they’ve become a real competitor and alternative to traditional stock exchanges. Many investors are confused about dark pools because of rampant rumors, which isn’t surprising. Just the name is enough to put fear into anyone who takes an interest in them. When you take a dip in a dark pool, you’re swimming in murky waters. Whether you like it or not, if you’re buying or selling equities, the chances are you’ll be operating in a dark pool at some point. They’re as much a part of the global financial markets as the iconic New York Stock Exchange, the City of London, or Wall Street itself. Because there is so little knowledge of what happens in dark pools, these ten things about dark pools are important in helping you understand how they affect the markets and, more importantly, how they can affect you and your equity trades. Dark pools are dark, not transparent Trading in dark pools is all about visibility and, as the name implies, dark pools don’t have a lot of visibility. In a traditional stock exchange, when you send an order to the market with a price limit, that order shows up on the exchange’s trading book. It’s there for all to see in public. Only the price and the number of shares you want to trade are visible. You don’t have this type of transparency in dark pools. A dark pool doesn’t show how much of a stock you want to buy or at what price, which is what makes dark pools dark. To differentiate, traditional stock exchanges are sometimes referred to as lit or displayed markets. Dark Pools are for everyone Originally, dark pools were set up so that only big, institutional investors could buy and sell large orders of stocks with other big, institutional investors without making a big price impact on the market. When orders are displayed in a market, everyone can see the intentions of all the buyers and sellers. A big order could easily alert others to someone who was desperate to buy or sell, which could cause a change in the price. Without showing the size of the trade, big institutions were able to find matching orders without letting the market see the size of their order. That’s not the case anymore. Dark pools, just like stock exchanges, need people to trade in them; they need buy and sell orders. To attract more and more orders, many dark pools now let smaller orders, with smaller-sized trades, into their pools in order to create more liquidity (an abundance of orders at different prices from many different market participants). Executed orders in dark pools have been steadily decreasing over recent years, and dark pools are no longer the sole preserve of big institutions. Dark pools are more and more prevalent What began with a need for big institutions to get their trades executed with as little market impact as possible quickly turned into a great money-spinner for banks and brokers. If they could match client orders in their own dark pools, they wouldn’t have to pay the stock exchange’s fees and perhaps they could themselves do a bit of buying and selling in their own pools and profit even more. With this realization, banks and brokers began to promote and encourage the use of their own dark pools to a wider clientele, including retail investors. The spread of dark pools has made them an integral part of the current market structure, and there is now no escape from dark pools. Numerous dark pools exist all over the world. In fact, a large part of the overall volume in stock trading on the major markets is now conducted in the dark. In the United States alone, estimates suggest that 40 percent of all executed trades are completed in a dark pool and about 20 percent in Europe. In other markets across the world, dark pools aren’t as common, but in any market that sees growth in equity trading, dark pools are sure to show up. Dark pools need stock markets Dark pools need traditional displayed markets. That’s how they determine the price of a stock. Because the price and the number of shares that are to be traded aren’t shown in a dark pool, the dark pool has to get its price from somewhere, which is why dark pools look to the displayed markets for a price benchmark. The original matching of trades in a dark pool would be done based on the average price of the best bid and the best offer available on a displayed stock exchange. The best bid is the highest price a buyer is willing to pay for a stock, whereas the best offer is the lowest price a seller is willing to sell his stock. By matching a trade at the average of the best bid and best offer, both the buyer and the seller in a dark pool receive a better price than they would’ve received in the displayed market. This competitive edge of the dark pools is referred to as price improvement. Dark pools have grown because of HFT Originally, dark pools were designed for big institutions. Dark pools quickly grew, however, in part due to the growth of high-frequency trading (HFT) in the traditional displayed stock markets. Institutions now had an even stronger need to avoid what they felt was the predatory trading of high-frequency traders as the HFT crowd tried to sniff out large orders in the displayed markets. As a result, more and more institutions traded in the dark. It brought about a problem for the dark pools, though. Who would be trading with the big institutions? Who would take the other side of the institutional investors’ trades? To satisfy the demand for more liquidity, some dark pools began letting high-frequency traders into their pools so that more trades could be matched. Opening the door to high-frequency traders has resulted in exactly the same activity within dark pools that institutional investors tried to get away from in the displayed markets – predatory algorithms sniffing out big orders and trading against them. Dark pools are preferred by banks and brokers Banks and brokers are more than happy to execute trades in their own dark pool to improve on their own bottom line. As the size of the average executed trades on dark pools has decreased, more and more small orders are being routed to dark pools before being sent to the displayed markets. Brokers may possibly try to match your order in their own dark pool. Doing so is okay as long as you get price improvement and an overall saving in your trading costs. Be sure to ask your broker whether he routes your orders via a dark pool or not. Dark pools allow front running Front running is when another trader knows that you’re about to buy (or sell) a stock and that trader then buys (or sells) the same stock before you’re able to and then immediately sells the stock to you at a higher price. Front running isn’t fair and is banned, but unfortunately, front running still happens in dark pools. Some dark pool operators have been fined for such actions, and some are facing lawsuits. Some dark pools have been fined for breaking rules and facing the ire of regulators. Because of the way dark pools are set up and their lack of transparency, there is a real temptation to front-run orders. Be careful and know what dark pools your orders are being traded on. Dark pools aren’t all the same Dark pools come in many different guises. Their lack of transparency is the one unifying factor, but each one is a little different from the other because they all have their own specific rules on whom they allow to trade in their pools and under what conditions. Some dark pools have limits on trade sizes, only allowing large orders, also known as blocks, to be traded within them. Then others allow high-frequency traders to trade in their pools. Other dark pools even differentiate themselves with the way they match trades. Dark pools are regulated Dark pools aren’t a complete version of the Wild West in the financial world, as some market pundits would have you believe. Dark pools are actually regulated, with national financial authorities in the respective countries monitoring and policing their actions and the way that they conduct business. As dark pools have grown, regulators and legislators have taken a keener interest in the way that dark pools are run. As a result, dark pools are facing more and updated legislation to control how they operate. Dark pools aren’t going away Legislation will change and alter the way dark pools do business and how they operate, but dark pools are nothing new. The need to trade large blocks of shares with minimal market impact will always be part of the market. That’s why before the emergence of dark pools brokers discussed and agreed on block trades outside of stock market trading hours. Dark pools are simply the evolution from those times. When operated fairly with clear rules, dark pools can be beneficial for investors in search of both price improvement and minimal price impact. Investors will always need the option of having a dark pool to trade-in.

Article / Updated 03-26-2016

High frequency trading (HFT) requires speed quicker than the eye can see. With superior speeds, high frequency traders are able to react to news faster than market participants with inferior speed, because computer algorithms are able to analyse and produce trading instructions faster than a human can manually input an order. These are some of the ways they achieve these superfast speeds: Co-location is at the heart of HFT speed. Co-location basically means placing a high frequency trader's computers as close as physically possible to the exchange's trade-matching computers. Doing so reduces the time it takes for the HFT trader's computers to receive important market information. By placing their computers as close as possible to an exchange's matching engine, high frequency traders are able to have faster access to changes in price and the order book. News service providers get a look at important economic data prior to the official release. They then place the news in servers close to the exchanges so that when the news is released, it's available in different geographical locations at exactly the same time. High frequency traders with their computers located close to the news servers will be at an advantage because they can get the released news more quickly and then trade on the news faster than other market participants. Routing via a dark pool exposes you to the possibility of being front run and of information leakage. When an order is first routed through a dark pool or even several dark pools, it's leaking information all the time. The type of order, the price information and the amount of stocks in the order are all valuable information to other traders. This information is being sent electronically and is therefore at risk of being picked up or even given to other market participants, which is why it's called information leakage. Make sure that it's a dark pool you're happy to have your orders go through.

Article / Updated 03-26-2016

It’s a risky market out there, no doubt about it. Dark pools aren’t transparent (the clue is in the name), which raises many questions and concerns as to what is going on when an investor sends an order out to the market. Many dark pools have faced fines or are the targets of ongoing investigations and fines from regulators, which hasn’t helped the cause of dark pools. The continuing fines and lawsuits have caused a crisis of trust within the financial markets. Here are a couple of risks for trading in dark pools you need to be aware of: Front running: Front running basically means that someone gets to see your trade first and jumps in front of you, buying ahead of you when you want to buy, and then selling to you for a higher price. Being fodder for high frequency traders: High frequency traders can use tactics that make you pay more when you’re buying stocks and receive less when you’re selling stocks. Lack of transparency: Because dark pools don’t display their orders, knowing whether you have received the best possible price at the time when your order was executed is difficult. To mitigate these risks, know the dark pools your broker uses and then see whether those dark pools have been fined or are under investigation. If you find your broker using these dark pools, you can always ask her not to route through the dark pools that worry you the most. Asking your broker isn’t without risk, though, because it becomes a matter of trust. How much do you trust your broker? Verifying that your broker is routing exactly as you want can be difficult. Because trade entry is often automated, your broker may not have much control of the routing of the order, which means you still remain in the dark. The world of dark pools is a constantly changing market. If you’re investing via the markets, you need to pay close attention to the public discussion concerning dark pools. The rule today may change tomorrow. If you can keep up with the discussion, know the good guys from the bad guys and identify quickly any changes that are happening then you’ll be able to trade more safely in the markets.

Article / Updated 03-26-2016

If you're buying or selling shares then you'll inevitably be routed through a dark pool at some point and your trades may well be executed there. Your broker's expertise and the services that he provides are now one of the most important parts of your investment process. Figure out what you want to do with your investments and what type of relationship you need with a broker. Deciding on a broker depends on how hands-on you want to be and how much control you want to have over your orders. If you just want to push the button and execute your order then you need a broker you can trust. If, on the other hand, you prefer to do things yourself then you need a broker who offers you as much control and decision making as possible when it comes to the execution of your trade. When you talk with your broker, ask him these questions to ensure that he's working for your best interests: Do you know the different dark pools? Your broker should know the main dark pools. This question will tell you whether your broker is up to speed on the current market and has an understanding of who the major operators are. Stock trades are regularly routed through dark pools; if a broker hasn't got any idea about dark pools, it's a sign of incompetence. After asking your broker what he knows about the different dark pools, you can also do your own investigation. Know the biggest dark pools by name. Read recent news reports about them and find out how they execute their orders and who they allow to operate in their pools. Don't just believe their web pages and marketing materials. There have been lawsuits accusing dark pools of misleading clients, so make sure that you know the good guys from the bad guys. The good guys can become the bad guys overnight, so regularly follow any developments in the dark pool market via the media. If a dark pool operator is fined or is under investigation for offences that have negatively impacted its clients, you should discuss the matter with your broker and make sure that he doesn't route your trades through that particular dark pool until the issue with the dark pool is resolved. What markets do you trade in? Discuss with your broker what dark pools and what displayed markets he executes your trades on. Don't be afraid to ask straight and difficult questions and see what your broker says. If he can't give you clear answers then the broker serving you either doesn't know his job well enough or is hiding something from you. Does the dark pool operate a maker-taker fee? A maker-taker fee is when some traders (often high frequency traders) are paid a fee to post orders on the book, which adds liquidity (maker fee), or to trade against existing orders in the book, which takes away liquidity (taker fee). If the dark pools your broker uses operate a maker-taker fee then high frequency traders are likely to be operating in that dark pool. Exchanges make money when trades are executed; that's why sometimes they offer financial incentives to certain traders to either post orders or to execute against existing orders already in the order book. If you're dealing in small share lots then it may be fine for you to use the standard at-market orders, because they're unlikely to have an impact on the price. If you're trading large sizes then you may be better off trading in another dark pool because the chances are high that a high-frequency-trading algorithm will discover your larger order and trade against it. Do you offer direct market access? Direct market access means the ability to enter your orders directly into a market venue without having to go through a broker or intermediary. If you want to operate your trades yourself, you need direct market access. This gives you a choice of how and where to route your orders. What special order types do you have access to? If you manage your own orders then you'll need to know all the different special order types available and know exactly how they work in the market. Don't just take your broker's word; make sure that you research the different types of special order types and cross-reference with what your broker tells you. What is your trading portal? A trading portal is what you have in front of you on your computer screen to enter and follow your trades. Get to know the trading tools at your disposal and test to see how they work. Check to see whether the broker's trading portal is intuitive and easy to use. Will you answer my dark pool queries in writing? Don't be afraid to ask your broker for confirmation in writing on any issues you have with how he operates in dark pools and routes trades. Getting everything in writing is important because it gives you proof that you've discussed the matter of dark pools with your broker and made demands on the broker as to how he should act with your orders when dark pools are involved in one of your trades. If a situation arises in which a dark pool has acted unfairly to certain market participants (as has happened before) then you at least have the possibility of redress.

Article / Updated 03-26-2016

Much of what happens in the markets nowadays is automated, including the time when news is released and how orders are matched and reported. Many trades are now being transacted via computer algorithms and programs. Consider this development as market evolution, because the trend to automation is only natural. The markets have always been technology driven. As new technologies emerge, investors are keen to use that technology to get an edge on their competition. Through this desire for an edge automated trading evolved. Automation has a couple of main advantages: Computers and algorithms make fewer mistakes than humans. Computers and algorithms are much faster than humans. It takes a few hundred milliseconds for a person to blink his eyes. Nowadays, in that same time, an automated trading algorithm will have read, analysed, made a trading decision, and sent and executed an order. And not just one order, but thousands of orders! A human can’t compete with that kind of speed. Little wonder then that automated trading has become such a big part of the markets. Everyone is at it nowadays. Institutions automate their larger orders, and market makers run their orders via an algorithm. High frequency traders run their black boxes (computer algorithms that are programmed to trade stocks) that send out and cancel orders at a frenetic pace, trying to make small little profits from thousands upon thousands of trades a day. It won’t be long before the private investor can build and use his own algorithms. As technology has increased in the markets, so has complexity. Sending an order into the market used to be easy — buy or sell at the prevailing market price or set a limit. That was it. Not any more. Automated trading has brought about what can only be described as a baffling amount of special order types. There are hundreds of them, and each dark pool and stock exchange has its own. Often these orders have been specially designed according to the demands of high frequency traders so their algorithms can choose the most appropriate type of order for their trading strategy. Regulators and some market participants have noticed this proliferation of special order types. Many investors and traders argue that the special order types are only available to certain market participants and that they create an unfair market. Automated trading has come to stay; its availability will increase, but so will the debate about fairness. Following the markets is exciting, but for many it’s also scary. Much isn’t known about what automated algorithms are up to on the markets and those operating them don’t want to talk about their strategies. The battle for information continues.

Article / Updated 03-26-2016

Dark pools are simply venues or conduits where stocks are traded. Think of a dark pool as a platform where all sorts of players — or, as the pros like to say, market participants — come to trade stocks. Unlike traditional stock exchanges, those market participants trading in dark pools have little idea of whom it is they’re trading with. There’s always been a need to trade off exchange. And there’s nothing new or nefarious about doing so. After all, a buyer is always looking to buy at the lowest price possible, and a seller is looking to sell at the highest price possible. Often a big institution has a large block of shares to buy or sell. If that institution just put its order out on a stock exchange for all to see, the price might spike upward or crash downward. That doesn’t make much sense. So before the days of dark pools, brokers would get together with other brokers outside trading hours to try to match large orders. After they agreed on the deal, they would settle the trades on the exchange when it opened. As the markets and trading volumes grew, a need arose for alternate places to the traditional stock market, which explains in a nutshell how dark pools started. Nowadays the activity in a dark pool consists of everyone who trades, which may include the everyday investor as well as the large institutional investors. No matter how big or small the order is, dark pools are a part of the modern equity markets. Most major banks and brokers have their own dark pools where they try to match trade first without sending the order to a stock market. If they can’t match the trade in their own dark pool, they may route it to another dark pool or multiple dark pools. Only as a last option will the trade end up on the stock market. Often a trade never even reaches a stock market; it’ll be executed in one of the pools beforehand. All the investors who operate in a stock market are involved in a dark pool to some degree, either as a platform provider or a trader. A platform provider is simply the entity (most often a bank or a broker) that supplies and operates the dark pool, whereas a trader is the one who uses the dark pool to buy and sell stocks. Traders can include market makers, banks, institutional investors, high frequency traders and private investors. Some of the participants won’t even know their trade has been executed in a dark pool. The name dark pool hints at secrecy, which is exactly what the pools have been for a long time. But when something is as big as the global financial markets, trying to keep a growing business secret has become impossible, and more and more journalists, academics and regulators have become interested in the goings-on in dark pools.

Article / Updated 03-26-2016

Having a grasp of the fundamental traits of a high frequency trade helps you spot where the high frequency traders are operating and what tactics they're using. The more knowledge you have of the tactics and trading strategies used by high frequency traders, the better equipped you will be to avoid becoming their prey and receiving poor trade executions. Here are some suggestions: High frequency traders trade in small lots of 100 to 200 shares. They try to find out big orders hidden in the markets by using small orders to test the market. Watch for stock price slippage. Slippage is the difference between the price of a stock when you send an order into the market and the price your order actually gets executed at. Consistently seeing slippage in your trades is indicative of high frequency traders operating in that stock. Be careful: you don't want to be fodder for high frequency traders. Flash crashes can often be traced back to high frequency traders. Flash crashes happen fast. At their longest, a flash crash may take minutes; more often they are just seconds or milliseconds in length. Because of the speed at which a flash crash happens, it often involves high frequency traders pulling their orders out of the market and/or placing a large amount of sell orders. If the stock has had flash crashes then the order book may be the realm of high frequency traders. High frequency traders operate in dark pools. Be aware that high frequency traders have been allowed into some dark pools. The fact that there may be high frequency traders in a dark pool makes it impossible for you to spot whether you're trading against them. In such a situation, you're at risk of receiving an execution at an inferior price. High frequency traders use many different strategies. High frequency traders employ traditional market-making and trading strategies; contrary to popular belief, not all high frequency trading is predatory. High frequency trading follows regulatory changes. Laws and regulations are the foundation of how high frequency traders are able to ply their trade. Any changes in regulation will affect how the market works.