Tuesday, May 27, 2008

Dark pools under your eyes

Well, here he goes again: Guambat diving deep beyond his comprehension into the magical phantasmagoria of finance.

Dark pools of liquidity have just bubbled up to the surface before Guambat's eyes. Evidently, they've been around for a while, but have had to take second or third or nth billing to the alphabet soup cooked up by the financial wizzes of late. But the financial culinary arts have been busy in the outdoor kitchen, cooking up another, so it smells to Guambat, who tends to follow his nose in these matters, deliciously indigestible pot of toil and trouble.

Dark liquidity pools, as a concept, were today introduced to Guambat via FT Alphaville:

Ft Alhpaville: "Guambat, please meet Dark Liquidity Pool".

Guambat: "Pleased to meetcha, I'm surely hopefully sure."

Dark Liquidity Pool: "Piss off, ya moron."

It seemed to Guambat, upon first reading of the FT Aphaville news that Lehman Bros. was adding Japanese stocks to its dark liquidity pool, that these things were sort of the speakeasy of off-market, back-room, beyond regulation, corruptible if not corrupt market trading in securities and all the other things that hum along over the financial wires that constitute the strings connecting the puppets and puppeteers.

Now, bear in mind, that such shenanigans wouldn't bother Guambat in the least if he was in any way assured that, first, none of his hard earned and saved wasn't being wisked off into these dark dank spots by "funds" and "managers" and others who play with his money under the rubric of financial intermediation. Nor if there was any certainty that this undisclosed and incalculable devise was something other than the same kin of algorithm that brought down CPDO and R2D2.

But Guambat, being the silly old fudge that he is, just lacks the je ne sais quoi to quoi what's going on here. Regardless whether it is ET or Alien, Guambat retreats at the mere hint of this sort of out-of-this-world gimmickry. He'll sneak out of his burrow later to see what all the fuss is really about.

And what are dark liquidity pools all about? Guambat couldn't begin to guess, let alone translate, so this is what he's found, so far:

Will Dark Pools Swallow Wall Street? by Kit R. Roane Jul 9 2007
In search of lower prices, less scrutiny, and fewer rules, some of the biggest securities traders are turning to private exchanges called dark pools to make their biggest deals.

These pools are basically internal systems for trading stocks privately, off of public exchanges and out of the public eye. They are growing rapidly, both in number and in volume of trades.

Behind the boom in dark pools are large hedge funds and institutional clients that want to build and liquidate large stock positions at lower costs, while also being shielded from those who might profit by knowing their intentions.

The mainstream exchanges see the pools as yet another group attempting to steal revenue-producing trades and liquidity from their markets. That's in addition to a welter of new electronic-trading platforms that offer faster execution and lower transaction costs. These platforms alone have triggered a wave of consolidation among traditional exchanges.

Exchanges are at a disadvantage as they try to compete with dark pools. The S.E.C. regulates traditional exchanges, and new rules being phased in over the next few months will require them to share information fairly and mandate that trades be routed to whichever exchange gives the best and fastest price.

Dark pools, by contrast, can largely avoid regulation if they keep their trading volumes under a set threshold. This makes them attractive to big institutional traders seeking to avoid being so transparent about their trading patterns that competitors can anticipate their actions or otherwise gain an edge.

The S.E.C., meanwhile, is worried that the fundamental lack of transparency in these pools might lead to price manipulation or other abuses.

The idea behind dark pools isn't exactly new. Brokerages have long tried to cross (or satisfy) trades internally, by matching one customer's sale with another customer's purchase. The first true dark pool is believed to be Investment Technology Group's two-decade-old Portfolio System for Institutional Trading, or Posit.

But now new technologies have combined with market changes to make these alternative, private exchanges a hotter place to invest.

Shedding light on the dark liquidity pools May 2007
Fragmentation in the market has formed a lot of ‘dark pools’ of liquidity, which can only be accessible through electronic means.

Paul Scott, director of trading solutions specialist FIXCITY, explains that increased electronic trading means financial institutions can execute trades and secure liquidity from many different venues. “Automated platforms offer the opportunity to match ‘off exchange’ with other buyers and sellers, without showing the available liquidity to the market,” he says.

“Dark pools refer to the non-displayed or hidden nature of the buy and sell orders that reside in a crossing platform. The term dark liquidity can also be applied to all forms of non-displayed liquidity such as the order blotters of buy-side dealing desks.”

According to Mr Palmer, fragmentation of the market is responsible for the growth in these pools – “because there are so many venues to execute trades on”. Mr Scott adds: “In the US, the influx of crossing networks and alternative venues, and the rapid adoption of electronic trading technologies, has driven the growth of dark pools.”

Crossing networks, he explains, “allow dealers to match orders off-market and access ‘hidden’ natural liquidity. Trades can be processed anonymously, without impacting the price.”

Currently, dark pools are primarily a US phenomenon, although Mr Scott expects the use of alternative trading venues, which has driven their growth in the US, to catch up in Europe “as traders integrate electronic trading strategies and streamline their execution facilities”. According to Jerry Lees, head of alternative execution at CA Chevreux, there are 30-40 dark pools of liquidity in the US, but “not many in the European or other markets”.

Richard Balarkas, head of Advanced Execution Services sales at Credit Suisse, adds: “There are only two crossing networks outside of the exchanges in Europe – ITG and Liquidnet. But there is dark liquidity. One area is through the exchanges having iceberg orders – people may have a lot more to trade than is displayed on the screen at any time. The biggest sources of dark liquidity are within the investment banks and major brokers.

Says Mr Balarkas: “One of the biggest problems for any sizable money manager wishing to trade is lack of liquidity and signalling risk. A dark pool is a very simple way you can hopefully capture lots of liquidity and achieve a large proportion of your order being executed without displaying anything to the market.

Algorithms Sweep Dark Books By Ivy Schmerken October 24, 2005
Several brokers are designing algorithms that sweep crossing networks and so-called dark books - liquidity pools that match buy and sell orders without publishing a quote. Similar to crossing networks, dark books are an alternative to the public equity markets that brokers are exploring for their algorithmic trades.

For example, in October, Piper Jaffray was set to launch Fusion, an algorithm that works within the public equity markets and simultaneously searches multiple crossing networks and dark books for hidden liquidity. "We can either send larger orders to the block-crossing networks or send smaller orders to the dark books, and, in every case, we're searching for liquidity," says David Mortimer, head of product development, Piper Jaffray Algorithmic & Program Trading Group (APT). Mortimer explains that Piper is in a position to have relationships with large crossing networks because the broker represents institutional flow, as opposed to statistical arbitrage flow, and doesn't trade for its own proprietary account.

Additionally, in July, Investment Technology Group released Dark Server - an algorithm that scans multiple alternative trading systems (ATSs), including ITG's own POSIT, NYFIX Millennium and Pipeline Trading, simultaneously. "What all of our clients want to do is have access to a lot of the ATSs through one source," says Tony Huck, managing director at ITG. Further, institutions want to soak up as much natural liquidity as possible without leaving a footprint in the market, he adds.

Meanwhile, Credit Suisse First Boston has had the capability to scan multiple ATSs with its Guerilla algorithm for about a year and a half. Manny Santayana, managing director and head of advanced execution services sales and marketing, Americas, for CSFB, says Guerilla is a stealth algorithm that provides a trading solution for the small cap and mid cap environment.

"It hides in the electronic bushes, and it waits for liquidity to appear," Santayana describes. "When liquidity shows itself, the guerilla comes out firing orders into the electronic marketplace, taking out liquidity and capturing price improvement for you in small cap and mid cap names."

Dark Is Hot. But Is It Good? By Larry Tabb August 07, 2006
Dark pools are all the rage. Those opaque matching venues where large blocks meet seem to be on everyone's hit parade. Whether it is Liquidnet's valuation (which seems to have occurred eons ago), the preponderance of announced sell-side internal crossing engines, the development of dark algorithms, the buy side's desire to participate with hidden flow, or just the loss of NYSE market share causing firms to hunt more judiciously for an execution, dark is hot.

But while dark is hot, is dark good? External crossing networks now execute approximately 5 percent to 8 percent of buy-side flow, while the largest sell-side firms cross approximately 6 percent to 10 percent of their institutional flow. Are we getting to a point where we should be concerned that the dark liquidity pools are beginning to impact the price discovery process of traditional markets?

Certainly the exchanges think so. At the SIA Market Structure Conference a few months ago, Catherine Kinney, president of the NYSE, had a few not-so-nice words to say about crossing - particularly broker internal crossing networks. She posited that dark books impair price discovery, and that every share that is crossed in the dark is a share that doesn't assist the market in determining an accurate price. Now, Ms. Kinney certainly has a vested interest in keeping flow on the exchange, but she isn't completely off base.

At what point should the market be concerned that limited amounts of retail order flow could adversely impact the price of very large blocks? Even if institutions are happy with their price discovery, are we as an industry comfortable with retail flow being matched against sophisticated flow and never making it to the market for all to see?

While all is fair in love and war, and what goes on in a dark room between consenting institutions and hedge funds is fine with me, when it comes to retail fiduciary responsibility, we should act as an industry before the regulators step in and mandate something that everyone will hate. So while dark pools are great for finding liquidity, let's be sure that these dark pools are honest fair, and provide best execution. While I am all for dark pools, it's black eyes I'm against.

At least one financial website with a bit more paranoia conspiracy predisposition than Guambat (but only a bit)asks, and posits some tentative answers to, the question, "Don’t all these ‘dark vehicles’ greatly increase the risks in the market? "

Links to nothing much:
Dark liquidity

Optimizing Dark Pool Liquidity 2007 and 2008

Dark Pools of Liquidity

AND SINCE we started this post with a story about Lehman Bros. and Japanese stocks, we return to the theme to finish it off:

Japan Fraud Lawsuit: Should Lehman Have Known Better? (WSJ DealJournal)
A Tokyo court will hear opening remarks Wednesday in a high-profile lawsuit filed by New York investment bank Lehman Brothers Inc., which is seeking reimbursement for $350 million it says was swindled from it by employees of Japanese trading giant Marubeni Corp.

Lehman says a pair of Marubeni employees, as well as executives at two smaller companies, presented bogus documents, fake corporate seals and an impostor to convince Lehman officials that a partnership it was joining was a legitimate business. The purported partnership was supposed to provide short-term financing–at annualized rates as high as 25%–to hospitals buying sophisticated medical equipment through a one-time Marubeni subagent.

Lehman committed more than $300 million to the partnership, only to be told the enterprise was a fraud at a repayment deadline.

The apparent scam captured headlines in Japan, where people marveled that a sophisticated Wall Street firm could be duped and that a blue-chip member of Japan Inc. might be involved. Both companies have cooperated with police.

The trial will likely hinge on whether the court finds that Lehman was justified in believing the two Marubeni employees were in positions responsible enough to enter into the purported deal on the company’s behalf.

Marubeni will argue that Lehman failed to conduct thorough due diligence, according to a senior Marubeni executive familiar with the company’s legal case. The deal was so big, it would have required the approval of Marubeni’s board of directors, the executive said.

Guambat fears Lehman Bros. and others will have the dark pools pulled over their eyes, too. That Marubeni case just goes to show, as do many other anecdotes, that the big money hotshots may be the smartest guys in the room, but then again, they might'n't.


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