The poison goblet duel, like Dark Pools, if played fairly, gives no advantage to either player, superior intellect, high-speed technology or not...

Whenever I think about the debate over "Dark Pools," I can't help but compare it to the scene from The Princess Bride, where "The Man in BLACK" challenges "Vizzini" and his "superior intellect" to a battle of wits, in an effort to rescue the Princess Buttercup. The duel premise is simple; one goblet has been poisoned, choose one. Vizzini switches glasses, when the hero turns his back, thinking he has out-witted him. The funny part about this scene is that the man in black has tainted both goblets with poison, because he is immune to it. The villain dies and the hero rescues the princess...

Why does this remind me of Dark Pools? Well, first of all, ironically, the man in Black is the hero and in market structure, being dark, while portrayed as such, is not evil. Since the early days of the New York Stock Exchange, investors and their brokers have found ways to disguise their intentions when attempting to trade large amounts of stock. Instead of posting large orders for all to see, brokerage firms would often negotiate privately with clients, other brokers, or the specialist without disclosing the full order publically. As automation has changed the markets, Dark Pools have evolved to replace such negotiations in a manner that is more efficient and often more fair, as well.

The other reason The Princess Bride reminds me of the Dark Pool debate is that the poison goblet duel, if played fairly, gives no advantage to either player, superior intellect or not. In the movie, the villain prattles on for multiple reasons about how he "surely cannot choose the glass in front of me." But the reality is that he has no clue as to which goblet has been poisoned." Inconceivable!"

Similarly, many people complain about how all Dark Pools allow market makers to profit effortlessly, but it's just not true. In a well-run Dark Pool, there is no "free money" to be made by market makers. To profit from trading in the dark, market makers must trade based on price predictions and risk management. In that sense, trading in Dark Pools is not different than trading in any other venue. While there are differences between lit and dark venues, they both have plusses and minuses. On the plus side, Dark venues allow their users to choose the categories of orders and participants that they will interact with, they "leak" less information to the market about their participants trading interests, and they typically charge smaller fees to remove liquidity than exchanges. On the minus side, Dark Pools provide no quote protection for posted orders, so those orders can be ignored; rendering it is harder for routers to find their liquidity and they do not provide as large a rebate for liquidity provision as most exchanges.

In the movie, the good guy outsmarts the bad guy and then rolls down the hill with the princess. In the case of dark pools, like other venues, there is always the risk of villains, but most pool operators (as well as FINRA) are vigilant about attempting to uncover them. Despite being called "dark" both the regulators (via OATS) and the operators themselves have access to very detailed order information, along with the market data history to identify rogue behaviors. That said, regulators should require improvements in both best execution reporting and routing disclosures, in order to improve confidence in both the venues themselves, as well as the market as a whole.

As discussed previously, most of today's order flow routed to dark pools is not subject to the routing disclosure rule (Rule 606). Despite some industry efforts to improve the situation, only a well-designed public disclosure rule would really be sufficient to overcome the current distrust and ignorance of how dark pools are utilized. While it is certainly a good idea to enable large institutions to gain access to routing disclosure, there are thousands of large investors without the resources to analyze private disclosures from individual brokers. If a goal of the SEC is to eliminate the perception of "two tiered markets", then mandating public disclosure is the best option. However, changing rule 606 is not enough. It is also important to improve Rule 605, which is designed to require public reporting on execution quality by market centers, but is riddled with exemptions and lacks proper categorization of orders.

We recently delivered a presentation to the SEC that advocates for them to close the exemptions and modernize rule 605, in order to enable, statistically, valid comparisons of dark pools, market makers and exchanges. We articulated the notion that 100% of all immediately executable orders should be subject to the rule. This is a substantial change from the current rule that allows market centers to exclude all orders that are associated with large or discretionary orders. That exemption is utilized by the vast majority of Dark Pool orders, with the result that there is no public reporting on the fill rates, price improvement or adverse selection associated with most dark venues. In addition to closing this loophole, orders should be grouped together based on their broad characteristics. For example, we suggest that individual "held" orders (which are the focus of the current rule) be segregated from the child orders of institutional orders. This would allow exchanges to be measured against dark pools that handle such orders. We also suggest that "immediate or cancel" orders be segregated, for reporting purposes, from fully held orders and that limit orders be grouped by their level of aggressiveness, in addition, to their marketability. The purpose of these groupings is to help investors and trading firms gain an understanding of how each market center operates. Our belief is that such transparency would improve confidence and would also spur competition. Perhaps most importantly, these changes would be relatively inexpensive for the industry to implement and would have virtually no risk of impacting the ability of the market to trade efficiently. Other proposals, such as "trade-at" would be both expensive to implement and would carry substantial risks that transaction costs for investors would go up.

Despite such risks, Exchanges and other critics of Dark Pools keep repeating the mantra that regulation is needed because of the claim that dark pools impede price discovery. Sadly, this idea is as true as Vizzini's use of the word "Inconceivable" in the movie. He says this every time the man in black defeats an obstacle placed before him. The story that Dark Pools "historic" market share is impeding price discovery, is similarly misleading for two reasons.

1. History demonstrates it to be false. Dark pool volume used to represent a higher percentage than it does today for NASDAQ trading, even if it dipped first in the early days of electronic trading.
2. The focus on price discovery as the goal of market structure is also wrong; minimizing the total cost of trading should be the most important goal.

The past 15 years of market history shows that at the current share (which is roughly 40% of volume), Dark Pools are not an overly high percentage of market volume. At the turn of the millennium, on NASDAQ stocks, the percentage of trading volume that was "internalized" by brokers, was routinely over 50% (as determined by reporting to ACT, the precursor to today's TRF or Trade Reporting Facility). This percentage included wholesale market making, block sales trading, as well as, the initial generation of automated "Dark Pools." At that time, NASDAQ dominated the listings business for technology and high growth companies, so it is reasonable to assume that having over 50% of stock trading "dark," was not an issue for the capital markets.

When critics of Dark Pools look at that historical period, they always look at the overall percentage of off-Exchange trading, which was much lower. But, that was a function of a restrictive NYSE market structure; Rule 390 prevented members from the majority of off floor transactions and allowed for "arranged" trades on the floor. The result was that block trading of NYSE stocks often involved negotiations directly with the specialist and floor brokers holding orders in the stock in question. These transactions, however, were aggregated with the rest of the exchange's volume. The result is misleading in that the percentage of Dark Pool trading is at a historic high. In actuality, it was due to the inability to measure what arranged trading was done on the NYSE, before it became truly electronic.

The argument that crossing orders in the dark does not contribute to price discovery and should, therefore, be deemphasized, is also wrong; Displayed orders can signal to proprietary traders that large orders are being worked. While Dark Pools are no panacea, they have become an important tool for institutional traders, for managing their transaction costs.

This is a critical point, since lower transaction costs lead to more profitable investing, higher volumes and broader trader participation. This, in turn helps issuers to raise money, as more volume raises the liquidity premium of the public markets. All of these benefits are more important than the academic notion of price discovery, which is important long term, but is not really critical immediately.

Despite the sinister name, Dark Pools are a valuable part of the US equity market structure. They facilitate investor's desire to lower or eliminate transaction costs or help institutional investors to trade large orders with less market impact. Dark Pools are essentially an automated method of accomplishing what sales-traders and brokers used to do for clients. To the extent that the regulators are concerned about potential bad behavior, the best answer is to require more disclosure. As we have noted, Rule 605 could substantially improve our ability to evaluate dark liquidity, by ensuring orders are covered by the rule and that comparable orders can be grouped together. Such changes would facilitate the development of execution analytics by our firm and others, which would demonstrate the utility and fairness (or the lack thereof) for all such trading venues.

-Inigo Montoya

David Weisberger, Managing Director, Trading Services at Markit
Posted 30 April 2015

S&P Global provides industry-leading data, software and technology platforms and managed services to tackle some of the most difficult challenges in financial markets. We help our customers better understand complicated markets, reduce risk, operate more efficiently and comply with financial regulation.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.