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Dark Pool: How the Markets Work

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August 31, 2012 – Comments (3) | RELATED TICKERS: KCG

Board: Macro Economics

Author: yodaorange

After a typical investor makes the decision to buy or sell a stock/ETF, he logs into his brokerage account, makes a few clicks and VOILA! the trade is executed. This presumes that the order was entered to buy/sell at the “market” price. If it was a “limit” order, the order will presumably execute when/if the stock trades at the limit price. For most investors, this is the end of their journey to buy a stock. The investor implicitly understands that many actions occur behind the scenes to complete the trade, but rarely delves into the “plumbing” that makes it all work.

I just finished reading an excellent new book that goes into semi-infinite detail about the behind the scenes plumbing. The book is “Dark Pools: High-Speed Traders, A.I. Bandits and the Threat to the Global Financial System” by Wall Street Journal reporter Scott Patterson. [1] You might remember Scott’s first book “The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It.” [2] Scott has broad access to a long list of movers and shakers in the US markets. Dark Pools details the history of modern stock trading through extensive interviews with a long list of characters, 99% of whom are unknown to average main street investors.

I have previously posted about High Frequency Trading (HFT) and how it has transformed the markets. [3] My post was limited to HFT and was timed to the anniversary of the 5/6/10 “Flash Crash.” Scott’s book is FAR more extensive and covers the equity markets from about 1995 through 2012. There are so many significant points covered in the book, I do not want to attempt to put them all into a single post. Also, while I loved the book and learned many things, the book is mostly directed at apprentice plumbers. I would NOT recommend it to typical, mainstream investors, it would seem too bizarre.

Here are three simple points that I think are pertinent to METARites:

1.”Internalizers” A few months ago Knight Trading (KT) made headline when they lost $440 million in about 30 minutes. I posted about it at the time [4] and we still do not know the definitive answer as to what happened. I am willing to bet that 99.9% of the average investors never heard of KT before they had this problem.

While the average investor had never heard of KT, they were likely using them anytime they bought a stock. KT is an “internalizer.” When you enter a stock order through Vanguard, Fidelity, TD Waterhouse, etc. chances are very good that it was “routed” to KT. KT “filled” the order one way or the other. KT was a “designated market maker” on the NYSE, so the order might be matched up with a seller from a different firm. What was news to me was that KT also ran a “Dark Pool” where your order might be matched up. KT’s goal is to have a wide range of open buy and sell orders for all issues inside their Dark Pool. If they can match up your order in the Dark Pool, they can generally pocket a few cents extra spread for completing the trade.

The book also disclosed that KT and the other internalizers PAY the brokerage firms for your order! This was also news to me. Your brokerage firm gets to keep the $5 or $10 or $20 commission all to themselves PLUS pick up a small amount from the internalizer. Obviously, KT is making money on the trade somehow. They are NOT operating as a charity. You have to assume they are pocketing an adequate spread of pennies per share to make a profit. I do NOT see anything nefarious about this business model. In the old days, small investors typically paid a spread of 12.5 or 25 cents per share to a NYSE specialist or a NASDAQ market maker. You can argue that paying a hidden few cents per share to an internalizer is a better deal for the small investor

2. “Maker-Taker” makes the markets work. This is incredibly obscure to the average investor. I knew about this before the book, but I did NOT understand the history or significance of it. All of the electronic US exchanges currently operate on a Maker-Taker model. Here is how it works:

a) Stock XYZ has a bid price of 10.00 and an ask price of 10.01
b) A trade will only occur if a seller agrees to lower his price to 10.00 or a buyer agrees to raise his price to 10.01
c) When someone agrees to “cross the line” to make the trade, his is classified as a “taker”
d) In this case, a seller that agrees to 10.00 is the taker. The taker PAYS a small fee to the stock exchange for “taking the liquidity”
e) The buyer that paid 10.00 is the “maker” and is PAID a small fee by the stock exchange for “providing liquidity”
f) Typical NYSE maker fees are 0.23 cents per share. Taker fees are 0.28 cents per share [5] The exchange pockets the difference between the maker and taker fees

The maker-taker model is setup to incentivize traders to “provide liquidity” which is how they justify paying makers. Most of the HFT trades are designed to be makers and receive this fee. You might think that a firm cannot be very profitable receiving 0.23 cents per share. To paraphrase Everett Dirksen, a sub penny here and a sub penny there and pretty soon you are talking real money. In 2008, the NYSE and NASDAQ paid out $2 billion in maker fees. The overall payout is much larger since there are many other exchanges that do trades.

The goal of all HFT’s is to earn the maker fee. If you wanted to instantly put the HFT’s out of business, you would stop offering the maker fees. The HFT’s would be shut down in about a nanosecond. At the same time, the liquidity of the market would disappear. Spreads would widen and you might not have any willing buyers/sellers for many issues. So be careful what you ask for.

Once again, I do not think this is a horribly nefarious practice. It is a tradeoff that likely ends up costing small investors a few cents per share, but once again it is less than we used to pay the specialists in the old days.

3. HFT’s rule the day, small traders are sheep waiting to be fleeced. We all kind of knew this intuitively, but the book clarifies that ALL of the exchanges exist for the HFT’s. The exchanges do anything and everything to make their life better and more profitable. Small investors are sheep. Small investors in this context can and do mean mutual and pension funds. The HFT’s prey on investors that have to buy/sell as opposed to having the time to wait. Exchanges have added the maker-taker fees, added “co-location” sites and added special order types specifically for the benefit of the HFT’s.

BOTTOM LINE is that small investors are and will continue to pay a few cents per share of vigorish in order to trade. In the grand scheme of things, this is less than they used to pay in the days of NYSE specialists and NASDAQ market makers. Also, the book re-iterates a point that I already believed in: Another computer driven meltdown is very likely. It is only a matter of time, not a matter of certainty.

If there is any interest, I will post a few more highlights from the book.

Thanks,

Yodaorange

[1] Dark Pools book by Scott Patterson
http://www.amazon.com/Dark-Pools-High-Speed-Traders-Financia...

[2] The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It by Scott Patterson
http://www.amazon.com/The-Quants-Whizzes-Conquered-Destroyed...

[3] Yodaorange post: High Frequency Trading: Winners and Losers
http://boards.fool.com/high-frequency-trading-winners-and-lo...

[4] Yodaorange post: Why Knight COULDN’T hit the red kill switch
http://boards.fool.com/why-knight-couldn8217t-hit-the-red-ki...

[5] NYSE-ARCA Maker-Taker fees
http://www.nyse.com/pdfs/NYSEArca_Equities_Fees.pdf

3 Comments – Post Your Own

#1) On August 31, 2012 at 1:08 PM, vriguy (78.46) wrote:

I was reassured when I read your post. I trade once a week, on average, and use limit orders for the most part, so my contribution to the HFT bottom line is maybe a cup of coffee each quarter. 

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#2) On September 01, 2012 at 10:57 AM, VExplorer (30.48) wrote:

I see HFT as good for me even if my contribution is couple of cups of coffee each quarter. :)

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#3) On September 04, 2012 at 6:54 PM, ChrisGraley (30.25) wrote:

Would like to know your reasoning on why the market takers aren't just as guilty. I can envision seeing HFT taking advantage of the other side of the equation as well with a slightly higher profit and slightly less opportunity.

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