Dark Pools and fragmented Markets

Author Name: 
Robert A. Schwartz

Dark Pools and Fragmented Markets: As far as I can recall, I have never come up with any title as foreboding as this one. The term “dark pools” conjures up some nasty images, like black holes and Darth Vader.  Fragmented markets sounds terrible, like Humpty Dumpty after he took his big fall. Dark and fragmented, what kind of shape are our markets in?  Let’s consider the dark pools first.

Dark Pools

Handling large orders always has, and always will, require some darkness. Every big market participant wants to know what others are doing but, for valid reasons that have to do with market impact, the big players do not want others to know what their own trading intensions are.  No large institutional investor would want the world to know that he or she is in the process of working a 250,000 share order for a stock that, on average, trades 500,000 share a day. 

The term “dark pool” is new; the reality is not. Dealer markets have always been opaque. Pre-trade, quotes are displayed but not much else, and the immediate post-trade reporting of large transactions is not in the best interest of the dealer firms. Market makers know that “shares sold to a dealer are still for sale,” and no dealer firm wants its trading intensions signaled any more than its customers do.

How about the floor based trading of not held orders? I have long thought of the New York Stock Exchange’s trading floor as being a pretty dark pool of liquidity. Roughly fifteen years ago I was on the NYSE’s trading floor standing next to a specialist. I noticed a tall, lanky man hovering off a bit in the crowd. Every now and then he would step forward and trade a couple of thousand shares or so with the specialist. We made eye contact. 

“Hey, there,” he said, beckoning me over to where he stood. “Are you a professor?” he asked when I got there. 

“Gosh, yes, how could you tell?” I answered. 

“Well, no matter,” he responded before adding, “Would you like to see the order that I am holding in my pocket?” 

“Sure,” I muttered, dying of curiosity. The order was for more than 100,000 shares. 

“Don’t tell anyone,” he cautioned. 

“Professors do not condone information leakage,” I replied. 

Thinking back on the incident, I realize that it was my first look into a dark pool. But the term “dark pool” did not exist at that earlier time. The NYSE’s trading floor was simply a good place to do business for orders that were too big to put on a specialist’s book, yet too small to work in the upstairs market. Today the floor is not what it once was, and many orders that in the past would have been worked on the floor are now being sent to an ATS that is a dark pool. And so, there you have it.  In Latin the thought is expressed as “mutatis mutandis.” In French the concept is “plus ça change, plus c’est la meme chose.”  In simple English, we would say “the more things change the more they stay the same.” And yet the term “dark pool” conjures up a dreadful image.

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About Robert A. Schwartz

Robert A. Schwartz is Marvin M. Speiser Professor of Finance and University Distinguished Professor in the Zicklin School of Business, Baruch College, CUNY. Before joining the Baruch faculty in 1997, he was Professor of Finance and Economics and Yamaichi Faculty Fellow at New York University's Leonard N. Stern School of Business, where he had been a member of the faculty since 1965. In 1966, Professor Schwartz received his Ph.D. in Economics from Columbia University. His research is in the area of financial economics, with a primary focus on the structure of securities markets. He has published over 60 refereed journal articles, twelve edited books, five authored books, including The Equity Trader Course (co-authored with Reto Francioni and Bruce Weber) Wiley & Sons, 2006, Equity Markets in Action: The Fundamentals of Liquidity, Market Structure and Trading (co-authored with Reto Francioni) Wiley & Sons, 2004, and Reshaping the Equity Markets: A Guide for the 1990s, Harper Business, 1991 (reissued by Business One Irwin, 1993). He has served as a consultant to various market centers including the New York Stock Exchange, the American Stock Exchange, Nasdaq, the London Stock Exchange, Instinet, the Arizona Stock Exchange, Deutsche Börse, and the Bolsa Mexicana. From April 1983 to April 1988, he was an associate editor of The Journal of Finance, and he is currently an associate editor of the Review of Quantitative Finance and Accounting and the Review of Pacific Basin Financial Markets and Policies, and is a member of the advisory boards of International Finance and The Journal of Trading. In December 1995, Professor Schwartz was named the first chairman of Nasdaq's Economic Advisory Board, and he served on the EAB until Spring 1999. He is developer, with Bruce Weber and Greg Sipress, of the trading and market structure simulation, TraderEx (http://www.etraderex.com/).