The Concept of Dark Pool - Case Study Example

? Dark Pools Table of Contents Introduction 3 Dark Pools 4 Main aim of Dark Pool 5 Trading in Dark Pools 6 Effect of Dark Pool on Price Discovery 7 Improvement in price discovery by the dark pool 9 Dark Pool – Bad or Good 9 Name of Student: Name of Professor: Course Number: Date of Paper: Dark Pools Introduction The overall picture of the financial market has encountered much turmoil which has forced the traders or the investors to land in a depressing position, thereby losing their money. The strange trading activities in the world’s financial market have brought in violent swings in the performance of the stock prices, which have compelled people to scratch their head and worry for their loss. The investors are not aware of the cause behind these price fluctuations and for the firms or financial institutions to engage themselves in such activities. They are known to be trading in a dark pool. Thus, the concept of Dark Pool was introduced much back in 1980. This was initiated when many few of the institutional investors and traders got involved in trade in a secure place, away from the interfering eyes of the brokers or public exchanges. Their main aim was to sell or buy large amount of the stocks without being affected by the market fluctuations and achieve a better price than that provided by the public exchanges (“Definition of Dark Pools”). It was noticed that around 2005, the dark pools was successful in capturing 3-5% of the total market activity. After that, the situation had started to improve when the Security and Exchange Commission (SEC) passed a new regulation, called the Reg NMS (Regulation National Market System). In this regulation, there were provisions which had increased the level of competition among the exchanges. However, it got rid of the rules that confined manual quotations which are generated by the stock exchanges. It allowed the investors the option to avoid the exchanges, if they are unsatisfied with the price and receives better price and convenience elsewhere. Dark Pools The dark pools can be defined as the name that is given to the networks which enables the traders to sell or buy huge orders without bearing the risk of other traders and their price of selling the orders. Thus, they are criticized for the lack of transparency that the later possesses. The unavoidable fragmentation of trading can lead to less competent pricing in the conventional open stock exchanges. In the dark pools, the pre-trade prices of the shares that are open for sale are not detectable to the public. The participants are also not aware of the prices at which the shares are traded. The prices are revealed only when the trade is done (“What the Heck is a Dark Pool and Why are People Trading in Them?”). The Reg NMS gave an opportunity to the brokers and the dealers to start their own automated trading, thereby creating dark pools. The institutional investors and the banks which generate huge money, started to head towards these dark pools in order to save their trading costs. The recent statistics indentify that there has been 12% trading in the dark pool accounts in United States (“What are dark pools?”). The main benefit of trading in dark pool can be recognized as the price improvement. The benefit can be explained through an example. Suppose the bid price of a stock on an exchange is $10.00 and the asking price is $10.10. The dark pool will set the price at $10.05 which is in the midpoint of ask and bid price. The investors like the activity of the dark pool and thus, prefer to invest there. The equity markets in United States and worldwide are prospering at an increasing rate. The participants work on a certain model which allows the people, interested to trade display the sell or buy price and ask or bid price. In the exchanges, the displayed prices by the brokers are seen in the Tier II quotes (“What the Heck is a Dark Pool and Why are People Trading in Them?”). The opposite of the displayed prices are the dark pools. It refers to the place where the trading liquidity exists. However, the liquidity is not displayed to (“What the Heck is a Dark Pool and Why are People Trading in them?). The dark pools provide good benefits to the public and the participants in the equity markets. They allow large institutional members to mobilize huge amount of liquidity without facing the trading intermediaries, which misrepresent the stock prices. Some bear the opinion that the dark pools themselves have corrupted the pricing mechanisms and have presented the danger of two-tiered market in between the dark and displayed liquidity. However, all the markets are generally two-tiered. There are wholesale and retail channels for any products and same in the case of stocks. There are retail and wholesale brokers and floor and upstairs trading. Dark pool is basically the response to the regulatory efforts that creates a unique market for all the participants of varying nature. It serves the odd with miscellaneous purposes and with time horizons that symbolize the transactions in trading (“European Investors are Diving into Dark Pools”). Main aim of Dark Pool The main goal of dark pools is minimizing the impact of the market. They provide restrictions to the undesirable market participants and do not reveal the quotes. Thus, the dark pools permit the institutional investors to reduce information seepage and comprehend further proficient executions. It thus provides facilities for the advantage of price improvement and reduces the transaction costs by simply crossing the orders at midpoint of the best quoted offer and bid prices. Therefore, it helps in saving the bid-offer spread and the fees that is required for the exchange. The dark pools are recognized to be more popular in executing large orders. There has been rapid growth in the services of the dark pools in United States, Europe and many other countries. There has been a rise in 50% of the trade in United States in the last three years. While in Europe, the trading volume of dark pool has doubled from the previous year’s trading. The dark pools had become famous over the years with the help of the technological developments. These developments have lowered cost and permitted the dealers or brokers to create a roadway for bigger orders into their private pools, rather than sending unnecessary orders to public exchanges (“European Investors are Diving into Dark Pools”). Trading in Dark Pools It is very important to know the investors who are in dark and how the orders are sent to them by the dealers or the brokers. The brokers or dealers decide to send order in the dark pool only when they are not sure of the market prices. It depends upon their activity which will drive the investors to either make a gain or loss. Few brokers cut down the payments for the flow of orders and make the deals. Another method that is applied by them is the indication of interest (IOI) from dark pools. It contains the ticker for stocks, the interest for buy or sell and even, the price range at which the stock is high or low. However, it is not a price quote. The IOI is not a quote and is not disclosed in the public before the trade. However, the SEC has projected to make them as quotes, but it was not successful (“European Investors are Diving into Dark Pools”). The main downside of the dark pool is the hindrance in the way of understanding the need of the seller or buyer. The limitation of the dark pools can be identified as the slow operation of the whole system, which is not as efficient as the open exchanges. Effect of Dark Pool on Price Discovery Dark pools had increased the regulatory concerns which are observed to have harmed the price discovery. The European mechanism have stated that the raised use of dark pool have affected the price discovery mechanism in the markets. The International Organization of Securities Commissions has expressed similar worries for the development of dark pools and the increasing use of the services. They are suspecting that it could slow down the price discovery mechanism, provided the orders which are publicly displayed fall within the area of the dark pool services. According to the surveys conducted by CFA Institute in 2009, 71% of the respondents had believed that functioning of the dark pools is problematic for the price discovery mechanism. The Securities and Exchange Commission has considered that the effect of the liquidity which is not displayed is a very important issue for the price discovery, thereby criticizing the activities of the dark pool. It has been quoted by the SEC Commissioner that there should be some truth behind the crossing of the shares in the dark. Also, it does not ensure determining the right price for the share in the market (“Dark Pools Need Clampdown”). The traders, who are well informed about the market details, hope to make profit from the proprietary information, which shows the value of the assets that are being traded. However, the liquidity traders aim at meeting their individual liquidity needs. The traders actually select between the dark pool and exchange. The exchange, however, displays ask and bid price and thus, executes all the submitted orders at that ask or bid price. So, the dark pools ride free on the exchange prices, after matching orders within the bid and ask prices of the exchange. After comparing with the exchange, it can be seen that the dark pool does not have any market makers where it would absorb the excess order, which is owned and not guaranteed for execution. Thus, sending an order request to the dark pool brings in trade off between the potential price improvement and no execution risk. The execution risk in a dark pool drives the result of price discovery. The dark pool matching is dependent on the accessibility of the counterparties. Some of the orders are, however, heavier on the side of the market which consists of huge number of orders and often fails to be executed. The unexecuted orders are subject to costly delays (“Dark Pools Need Clampdown”). As the executed orders are positively correlated with the asset value, they are most likely to cluster around the heavy side of market. They are even subject to lower execution probabilities. Comparing the executed orders with the liquidity orders, they are seen to be less correlated with each other. They are even lesser likely to form clusters on heavy side of market. Thus, the liquidity orders possess higher probabilities for execution in the dark pool. The difference in the risk execution shoves the highly informed traders into exchange, unlike the uninformed traders in the dark pool (“Do “Dark Pools” Threaten the Health of America’s Financial Markets?). It is observed that under the natural circumstances, the self selection will decrease the noisiness of supply and demand in the exchange, thereby improving the price discovery. The effect of price-discovery on the dark pools has complemented the size discovery function through which the huge orders from the institutions are being executed without being revealed to the market at large. The size-discovery has helped the dark trading, which is highly acknowledged by the regulators and participants of the market. Thus, now only few dark pools are exercising huge orders (“U.S. Securities Watchdog Proposes New Rules for "Dark Pools"”). Improvement in price discovery by the dark pool From the above explanations, it can be identified that the services of dark pool has negative effect on the price discovery. However, the prospective improvement in the price discovery by the dark pools can be balanced with the help of few considerations which are enumerated below: 1) It is noticed that the dark pools is inclined to improve the price discovery on an average, but they may worsen due to the misleading facts about the value of the assets. Thus, it must be considered important to rectify the dark pool in this area. 2) It is known that improved price discovery does not correspond with the higher liquidity. However, more information about the orders may worsen the adverse selection on the exchanges, which can lead to higher price and wider spreads. 3) It is also observed that when the time horizons of the private information are longer, the dark pools are less effective in developing the price discovery (Zhu 2). Dark Pool – Bad or Good Dark pools have been working hard in convincing the investors with their services. However, there are also cases where they have faced restrictions from the authorities which serve the stock exchanges. In Europe, the condition of the financial market is such that the stock trading has shifted from the public exchanges to the private venues, known as the dark pools, where the trades are not made public and the prices are not revealed until the trade is over. It is surveyed that, on an average, about € 3.8 billion has been handed over daily to the 19 dark pools in Europe. However, about 12% of the trading in United States is done through 40 dark pools (“Europe Deal Will Cap ‘Dark Pools’ Trading”). Though dark pools have been performing well in United States, yet the three large stock exchanges in United States have delivered new limits to the dark pools by arguing that there have been too much non-transparency by the private venues, which have earned a lot of money and also, encountered volatility in the public markets (“Stock Exchanges Seek Curbs on Dark Pools to Fight Exodus”). They have come across the following complaints against the dark pools: 1) Dark pools do not publish the offer or bid price of the shares before hand. They are set up to allow investors to invest in big blocks. However, these investors do not have the information about the order and their prices. Thus, New York Stock Exchange (NYSE) have challenged that the original foundation is no longer been applied to trade and therefore, the average trade size in the dark pools has declined to 200 shares. The operators and brokers of dark pools have tried to ignore the lobbying campaign by the stock exchanges and have stated that there is no evidence for the occurrence of off-exchange trading, which are supposed to be negatively affecting the investors (“Threats to Financial Markets Lurk in Dark Pools”). 2) The wholesalers, who fill up the orders, provide with the price which is “one-tenth of a penny per share than the public quotes” (“Threats to Financial Markets Lurk in Dark Pools”). The exchanges have stated that the practice, which is known as the payment for order flow, have created conflicts of interest between the brokers and have burdened the exchanges with leftovers. The orders from the better informed investors and traders have prepared price directions for the short term. The increase in business from the small investors will help to balance the flow of order and will also result in appropriate prices with less volatility (“U.S. Securities Watchdog Proposes New Rules for "Dark Pools"”). 3) SEC has also exclaimed that the increased dark trading has been lowering the efficiency and quality of the public markets. The market share of the exchanges is decreasing, which is further affecting the stock prices (“U.S. Securities Watchdog Proposes New Rules for "Dark Pools"”). 4) There was a fierce battle which had taken place between the policy makers, exchanges and banks of Europe regarding the future operation of dark pools. The banks and the exchanges were highly interested to defend their own interest and raised voices against the operation of the dark pools, which were threatening their operations, as the investors were getting pulled into the dark pools. There was a debate in the Brussels Centre regarding the growing popularity of the off-exchange venues. They were concerned about the fact that the investors were not informed about the deal and the order price. They are informed once the deal is over. These had made price discovery difficult. (“Fierce Battle Erupts Over ‘Dark Pools’”) 5) The world of dark pool had become darker when the Credit Suisse (CS) was announced. In CS, it was mentioned that the investment banks will not make any data public through Crossfinder platform and had are ordered to not send any data to Rosenblatt Securities or Tabb Group, which are the two research firms. Thus, this had made difficult for the dark pools to acquire data. It can be derived that dark pools are creating obstacles for the investment banks and the exchanges and thus, they do not want their operations to be prevalent in the market (“Credit Suisse Is Making Dark Pools Even Darker”). 6) The Australian Securities and Investments Commission (ASIC) have prepared a report regarding the restrictions against the dark pools, which will be later published by them in the year 2013 (“ASIC Moves to Curb Growth of Dark Pools and High-Frequency Trading”). They have found out that the dark pools have actually hurt the investors by allowing the spread to widen to an extent which has increased the cost of transaction. Thus, the report will put forward few restrictions which are to be imposed on these venues, so that they are not hurting the investment decisions of the investors and also, the operations of the exchanges (“ASIC Moves to Curb Growth of Dark Pools and High-Frequency Trading”). Conclusion It can be concluded that the operations of the dark pools in United States, Europe and other countries, are not whole heartedly welcomed by the public exchanges and the investment banks. They have raised their voice as it has threatened their own existence and also, has harmed the price discovery mechanism. The stock prices were not revealed to the investors until the trade was over. Thus, it was also non-transparent to the investors. The transaction cost had also been increasing, which is surveyed to have affected the investors. However, it was seen that there was a rapid growth in dark pool operations, which have definitely harmed the open exchanges. Works Cited “ASIC Moves to Curb Growth of Dark Pools and High-Frequency Trading.” Business with Wall Street Journal. The Australian, 2013. Web. 28 Nov. 2013. “Credit Suisse Is Making Dark Pools Even Darker.” Bloomberg. Bloomberg L.P., 2013. Web. 28 Nov. 2013. “Dark Pools Need Clampdown.” Financial Times Lexicon. The Financial Times Ltd, 2013. Web. 28 Nov. 2013. “Definition of Dark Pools.” Financial Times Lexicon. The Financial Times Ltd, 2013. Web. 28 Nov. 2013. “Do “Dark Pools” Threaten the Health of America’s Financial Markets?.” Time Business and Money. Time Inc., 2013. Web. 28 Nov. 2013. “Europe Deal Will Cap ‘Dark Pools’ Trading.” Financial Times Lexicon. The Financial Times Ltd, 2013. Web. 28 Nov. 2013. “European Investors are Diving into Dark Pools.” Bloomberg. Bloomberg L.P., 2013. Web. 28 Nov. 2013. “Fierce Battle Erupts Over ‘Dark Pools’.” Financial Times Lexicon. The Financial Times Ltd, 2013. Web. 28 Nov. 2013. “Stock Exchanges Seek Curbs on Dark Pools to Fight Exodus.” Bloomberg. Bloomberg L.P., 2013. Web. 28 Nov. 2013. “Threats to Financial Markets Lurk in Dark Pools.” Bloomberg. Bloomberg L.P., 2013. Web. 28 Nov. 2013. “U.S. Securities Watchdog Proposes New Rules for "Dark Pools".” Reuters. Thomson Reuter, 2013. Web. 28 Nov. 2013. “What are dark pools?.” Modern IR. ModernIR LLC., 2013. Web. 28 Nov. 2013. “What The Heck Is A Dark Pool And Why Are People Trading In Them?.” Business Insider. Business Insider, Inc., 2013. Web. 28 Nov. 2013. Zhu, Haoxiang. “Do Dark Pools Harm Price Discovery?.” SEC Commissioner: Opening Remarks Regarding Dark Pools (2010): 1-63. Print. Read More