Diary of a Financier

Bookshelf Update: Dark Pools

In Bookshelf on Mon 15 Oct 2012 at 08:05

Since 2008, I’ve gleaned a lot of exposure to literature regarding the evolution of trading in the US. Long after the electronic trading revolution was first documented in the quiet corners of the blogosphere, the mainstream media have undertaken their own witchhunt. The oddity of the MSM’s position in the debate is that the same constituency once heralded–and therefore enabled–the “capitalists” who were first movers in the electronic exchange/HFT/algo space. But, upon the practice’s proliferation, the same necessary evils always inherent in computer-based trading are suddenly referenced as if purportedly criminal offenses. In other words, [widespread] scandal sells.

Like drug enforcement officers in Le Tour de France, the MSM & market regulators always lag the marketplace’s innovations. They’re always fighting the last battle and reporting on yesteryear’s revelations. Like those officials in Le Tour, trading regulators don’t stand a chance against well capitalized, asymmetrically incentivized, intellectually endowed, programmed traders.

In that vein, I recently finished a Scott Patterson book called Dark Pools: High-Speed Traders, A.I. Bandits, and the Threat to the Global Financial System. In this work I noted four interventions that particularly enabled a technology-led degeneration in the market’ plumbing. These are the four progressive drips that leaked a malevolent potential energy now synonymous with electronic trading:

  1. Reg NMS- In 2007, the SEC implemented the National Market System rule that mandated any buy/sell order had to be executed by the exchange flashing the best price. This paved the way for a migration away from floor trading (market makers in pits who took 15-20 seconds to execute a trade) toward electronic trading (ECNs or dark pools that boast millisecond execution times). It was a big victory for the early proponents of electronic trading, many of whom lobbied against traditional market makers. Throughout history, market makers were humans on the floors of physical exchanges. They were easy to portray as careless profiteers, fat cats who’d collude to fix wide bid/ask spreads, siphoning dollars from Moms & Pops across the country… but unbeknownst to everyone, the seemingly benevolent innovators who developed an electronic infrastructure were arguing for a new normal, which really just swapped one evil for another.
  2. Rebates- So called “maker/taker” orders provided market participants with a rebate ($0.01/share or less), which essentially rewarded them for providing liquidity to a trading pool. The party crossing the bid/ask spread to execute a transaction (i.e. a price taker hitting the bid) pays a commission; the party making the market (usually specifying a price with a limit order) receives part of that commission; the balance of the commission goes to the ECN host or dark pool operator. This created a misincentive for traders to boost their trading activity–not having to achieve capital appreciation in securities transactions in order to make money. A byproduct of the new standard, speed became a renewed operative for traders, and ECNs encouraged the race by providing an order priority classification that bumped loyal “customer” orders to the top of queues. At this point, the market’s supposed caretakers were starting to foster a two-tiered market.
  3. Dark Pools Incorporate Dumb Money- The original dark pools like Island only welcomed institutional money, the smart money. The markets were incredibly efficient (tight spreads), so sharks were eating the sharks, and it left a lot of traders hungry. To appease its biggest institutional clients, Island began welcoming the dumb money (retail & buy/hold investors), who didn’t care about losing 1-2 pennies by executing market orders (as opposed to limit).  This act unwound all the progress that had been made in quashing the old market maker model: instead of human market makers skimming pennies away from the investing public, HFT tradebots were now the new profiteers.
  4. Colocation- Archipelago started a trend of locating order system servers as close as possible to exchanges’ servers (NYSE & NASDAQ) to pickup millisecond advantages in trade entry/execution. This marked a violent compromise in the stock market’s utilitarian objective–a sanctioned migration toward a two-tiered, asymmetrical marketplace.  It also redoubled the ongoing arms race within the marketplace.  Trading in a matter of seconds or milliseconds was not enough.  The status quo would never be enough, because eventually trading pools just filled with [faster] sharks eating sharks all over again.  So, the sharks had to get faster, faster than the rest of their species. No, the game’s now about who can trade in nanoseconds… picoseconds… on and on, racing to the bottom.

There’s something vastly different about security regulators’ situation compared to that of Le Tour’s drug enforcement body: the former can at least eradicate its irritant by tracing it to the origin and (to mix metaphors) nipping it in the bud.  These four items are a good place to start.

As mentioned above, it’s not so much the fractions of pennies that HFT bots are skimming from investors–because that’s actually a massive improvement over yesteryear’s floor traders taking 25 cent commissions–it’s the structural stability of our markets that’s troubling. The structural integrity of our financial markets has been weakened by certain misincentives. By the properties of the butterfly effect, flash crashes and elusive confidence can materially alter the course of history. In both cycling and financial markets, there will always be an incentive to cheat. The SEC/FINRA/SROs can quash one problem, but another will always lurk in the shadows. Yet, you don’t let Lance Armstrong walk because you’re overwhelmed with the multitude of offenders standing in line behind him. You don’t let doping persist if you can stop the flow of drug traffic.


I’ll leave you with a cautionary excerpt from Dark Pools. Mr. Patterson chose this quote as a parting note for the book itself. It draws upon comments made by Thomas Peterffy, an industry insider as the founder of Interactive Brokers and an original protagonist of electronic/computer-based trading. He delivered these words at an annual gala event for the World Federation of Exchanges in the company of such moguls as Bill Brodsky, chairman of the Chicago Board Options Exchange, the NYSE’s Duncan Niederauer, Christine Lagarde, French minister for the economy and future head of the International Monetary Fund, Nasdaq CEO Bob Greifeld, and Atsushi Saito, CEO of the Tokyo Stock Exchange. He issues a warning herein, a warning which he continues to broadcast (often through avenues such as CNBC) to this day:

“An exchange used to be a place, yes, a physical place, where people would come together to buy or sell, hoping to achieve the best price for themselves,” he said. “The more the exchange was able to attract all of the buy and sell interests in a product, the more the prices on the exchange would reflect the true state of supply and demand.”

It was the old mantra: liquidity breeds liquidity. But something had changed.

“In the last twenty years came computers, electronic communications, electronic exchanges, dark pools, flash orders, multiple exchanges, alternative trading venues, direct access brokers, OTC derivatives, high-frequency traders, Reg NMS in the U.S.–and what we have today is a complete mess…

It is not so much anymore that the public does not trust their brokers. They do not trust the markets, the exchanges, or the regulators either. And why should they, given our showing the past few years? To the public the financial markets may increasingly seem like a casino, except that the casino is more transparent and simpler to understand.”

Visible tension spread through the room. Did Thomas Peterffy just call the market a casino? That was an attack they might have expected from the likes of Arnuk and Saluzzi or Senator Ted Kaufman — but from the founder of Timber Hill and Interactive Brokers, the godfather of electronic trading?

Peterffy, of course, was fully aware that his words seemed to contradict his own history.

“I must confess to you that I was an ardent proponent of bringing technology to trading and brokerage. Unfortunately, I only saw the good sides. I saw how electronic trading and record-keeping could be used to force people to be more honest, to make the process more efficient, to lower transaction costs and to bring liquidity to the markets. I did not see the forces of fragmentation and the opportunity for people to use technology to keep to the letter but avoid the spirit of the rules–creating the current crisis.

He gazed out at his audience. Peterffy wasn’t shocked to see the stern faces, the shaking heads and averted eyes. He was certain that he’d become their enemy — and he had little hope that they would listen. The computer-trading elite would never admit that the markets they’d created were deeply flawed. Still, he kept hammering away.

“It is vitally important that we bring an end to this crisis of trust before it spreads any further. That we bring back order, fair dealing, and trust in the marketplace. The financial markets of … the world’s developed countries are at a turning point. Technology, market structure, and new products have evolved more quickly than our capacity to understand or control them. The result has been a series of crises over the past few years that have caused many investors to lose confidence or to think that the whole system is a rigged game.”


  1. […] mentioned Thomas Peterffy, IBKR’s founder & CEO, before.  The man is a legend, a trailblazer, […]

  2. […] Video documentary: “The Wall Street Code” | VPRO Haim Bodek, “The Algo Arms Dealer,” reveals High Frequency Trading (#HFT) as an almost criminal underground–a conflict of interest for the algorithms & stock/options exchanges. [Previously: Dark Pools: High-Speed Traders, A.I. Bandits, and the Threat to the Global Financial System] […]


Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s