Streetwise Professor

Scott Patterson, WSJ reporter and the author of Dark Pools, has a piece in today’s journal about the Barclays LX story. He finds, lo and behold, that several users of the pool had determined that they were getting poor executions:

Trading firms and employees raised concerns about high-speed traders at Barclays PLC’s dark pool months before the New York attorney general alleged in June that the firm lied to clients about the extent of predatory trading activity on the electronic trading venue, according to people familiar with the firms.

Some big trading outfits noticed their orders weren’t getting the best treatment on the dark pool, said people familiar with the trading. The firms began to grow concerned that the poor results resulted from high-frequency trading, the people said.

In response, at least two firms—RBC Capital Markets and T. Rowe Price Group Inc —boosted the minimum number of shares they would trade on the dark pool, letting them dodge high-speed traders, who often trade in small chunks of 100 or 200 shares, the people said.

This relates directly to a point that I made in my post on the Barclays story. Trading is an experience good. Dark pool customers can evaluate the quality of their executions. If a pool is not screening out opportunistic traders, execution costs will be high relative to other venues who do a better job of screening, and users who monitor their execution costs will detect this. Regardless of what a dark pool operator says about what it is doing, the proof of the pudding is in the trading, as it were.

The Patterson article shows that at least some buy side firms do the necessary analysis, and can detect a pool that does not exclude toxic flows.

This long FT piece relies extensively on quotes from Hisander Misra, one of the founders of Chi-X, to argue that many fund managers have been ignorant of the quality of executions they get on dark pools. The article talked to two anonymous fund managers who say they don’t know how dark pools work.

The stated implication here is that regulation is needed to protect the buy side from unscrupulous pool operators.

A couple of comments. First, not knowing how a pool works doesn’t really matter. Measures of execution quality are what matter, and these can be measured. I don’t know all of the technical details of the operation of my car or the computer I am using, but I can evaluate their performances, and that’s what matters.

Second, this is really a cost-benefit issue. Monitoring of performance is costly. But so is regulation and litigation. Given that market participants have the biggest stake in measuring pool performance properly, and can develop more sophisticated metrics, there are strong arguments in favor of relying on monitoring.  Regulators can, perhaps, see whether a dark pool does what it advertises it will do, but this is often irrelevant because it does not necessarily correspond closely to pool execution costs, which is what really matters.

Interestingly, one of the things that got a major dark pool (Liquidnet) in trouble was that it shared information about the identities of existing clients with prospective clients. This presents interesting issues. Sharing such information could economize on monitoring costs. If a a big firm (like a T. Rowe) trades in a pool, this can signal to other potential users that the pool does a good job of screening out the opportunistic. This allows them to free ride off the monitoring efforts of the big firm, which economizes on monitoring costs.

Another illustration of how things are never simple and straightforward when analyzing market structure.

One last point. Some of the commentary I’ve read recently uses the prevalence of HFT volume in a dark pool as a proxy for how much opportunistic trading goes on in the pool. This is a very dangerous shortcut, because as I (and others) have written repeatedly, there is all different kinds of HFT. Some adds to liquidity, some consumes it, and some may be outright toxic/predatory. Market-making HFT can enhance dark pool liquidity, which is probably why dark pools encourage HFT participation. Indeed, it is hard to understand how a pool could benefit from encouraging the participation of predatory HFT, especially if it lets such firms trade for free. This drives away the paying customers, particularly when the paying customers evaluate the quality of their executions.

Evaluating execution quality and cost could be considered a form of institutional trader due diligence. Firms that do so can protect themselves-and their investor-clients-from opportunistic counterparties. Even though the executions are done in the dark, it is possible to shine a light on the results. The WSJ piece shows that many firms do just that. The question of whether additional regulation is needed boils down to the question of whether the cost and efficacy of these self-help efforts is superior to that of regulation.