Thursday, November 05, 2009

Dark Pools in Equity Markets

I had written up a discussion of Dark Pools in equity markets at see Dark Pools. I am entering the main text here.

Dark Pools in the Equity Markets

What are dark pools? Dark pools are large blocks of equities traded off the exchange floor. In order to understand dark pools, and how they arose, we first must look at why they would even arise in the first place. As Mutual Funds, Hedge Funds, Pension Funds, Insurance Funds and other large blocks of equity increased in size, it became much more challenging for these entities to move their money in and out of a stock. Funds started to look at strategies for how to move money into and out of stocks. These strategies would get quite complex, and would have Quants (typically Ph.D.s in Mathematics or Quantitative Finance) develop them. The strategies were typically assembled by a team of quants, and carried out by a team of traders. However, as soon as a fund's "hat was tipped" other traders would start to take advantage of that knowledge, thus moving the price of the underlying in a disadvantageous direction. Therefore, the Quants would develop strategies that were unpredictable. These could include buying or selling options or other derivative type contracts to allow for protection as the funds tried to move large amounts of equity in or out of an underlying stock.

This worked well while trading was done mostly on the floor. Times changed. Trading moved to electronic systems which are far more analytical and far more sophisticated. Possibly the most significant aspect of the electronic trading and clearing is that the time scales decreased. An equity's price can move much more rapidly today than it could in an open call system. Digital computers are far less forgiving than market makers standing on the floor of the stock exchange.

All these factors lead to the natural desire for a third party to find a more efficient way to move large blocks of equities, without forcing the price up or down in the process. Dark pools allow funds to quietly trade large blocks of stock in the same manner that smaller players can trade. This is really very important for the liquidity of the market because the large player and the small players are really two different equity pools. Therefore, making the large funds play in the small pool of equity would mean that every move they make drives the price in that direction.

Consolidated Tape

Dark pools are recorded to the national consolidated tape. However, they are recorded as over-the-counter transactions. Therefore detailed information about the volumes and types of transactions is left to the crossing network to report to clients if they desire and are contractually obligated.

Dark Pool transactions are recorded on the exchange's consolidated tape. The SEC, and anyone else that wants to purchase the consolidated tape, has some limited visibility into those transactions.

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