What lurks in those dark pools?

Regulatory developments have been very much on the side of the retail
investor, but what about technological evolution in the way securities markets
operate? Thanks to books such as Michael Lewis’s Flash Boys, the activities of
high-frequency traders (HFTs) and the operation of multilateral trading
facilities have become the subject of suspicion by investors and regulators
alike.

It is difficult to quantify what the exact impact of HFTs has been on retail
investors, but that’s probably because brokers and market makers themselves
don’t know. With sophisticated algorithms and super-fast execution effectively
enabling them to front-run orders, HFT teams are creaming profits ahead of
other investors, although they would argue they are adding liquidity. The
question is what proportion of their profits comes at the expense of the market
makers on the spread and what is at the expense of investors by moving the
price?

Another innovation that has been helpful to institutions as well as fast traders
is the introduction of dark pools of liquidity. These enable big players to work
large orders into the market without showing their hand. A large order can get
filled without the offer price moving too much against the bidder. As
destinations that compete for business and order flow, stock exchanges have
been keen to keep pace with demand for these innovations. The LSE has
partnered with large market participants to introduce the Turquoise exchange,
which facilitates demand from institutional investors for dark pool liquidity.

Regulators are generally suspicious of dark pools and worry that too much
order flow is being directed through them. While some participants benefit
from the cloak of anonymity, many buyers and sellers prefer transparency and
measures have been taken by ESMA to limit volume leaving the main order
books. Only 4 per cent of the market capitalisation of a stock can be traded in
any one dark pool and there is a limit of 8 per cent being traded in all dark
pools.

Retail investors won’t have their orders executed via dark pools as the trades
are just too small, so the impact would be limited to any knock-on effect to
liquidity and pricing on main order books such as SETS. Broker Hargreaves
Lansdown (HL) says the average size of trades by its clients is £6,000, so there
is no instance where a dark pool would be used. When asked whether high-
frequency trading has had an impact on the prices private investors can get,
HL’s spokesperson told us: “Market makers have improved their systems and
this has reduced the quote window time, but [there is] still plenty of time and
competition to get clients best prices.”