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Charts & Analysis

Dark Pools and Algorithmic Trading


From Economic Times: Dark pools threaten the existence of LSE, NYSE and Euronext:

Dark pools, to put it simply, are essentially trading platforms and exchanges that match block institutional orders, bypassing the main exchanges completely in off-market deals, and don’t publish stock quotes. The geeky jargon in the circuit is primarily because it’s been made possible by increasingly sophisticated technology like algorithmic trading tools. Algorithmic trading, says one study, will account for more than 50 % of all shares that change hands in the US by 2010.

Why dark pools? Since most bids and offers on say, LSE, NYSE or Nasdaq are shown publicly, trading on these exchanges is like, as one report says, “playing poker with an open hand.”

Dark pools, by contrast, guarantee absolute anonymity and secrecy to buy-side traders worried about revealing their strategies, accesses available liquidity outside the exchanges, and is only reported to the light side post-trade. It is, of course, all intensely regulated and painstakingly legal – dark pools have taken off in Europe only after the introduction of MiFID, which discourages internalisation of trades, and Regulation NMS in the US.

India has anonymous exchange systems anyhow at the retail end, and members of the exchange are disallowed from squaring off trades themselves – i.e. matching orders without sending them to the exchanges. With DMA, even institutional orders may become anonymous. Of course the knowledge of the order flow may exist with the broker (who needs to account for margining etc.) but that’s only postdictive i.e. only after the order is sent to the exchanges.

Indian tax laws discourage off market trades too – you pay more tax on non-exchange-traded transactions so you are likely to trade on the exchange as much as possible.

The need for a dark pool isn’t apparent here yet, given that the order matching systems even allow masking of trade volumes (you can see a different quantity than is actually asked for). Also, algorithmic trading isn’t very popular (thank goodness for that, it’s our future business model).

But there is need for it in the stock lending system for short selling. That bit currently reveals too much – needs to get pared down.

I have no doubt that should SEBI be lax about it, dark pools will start in India eventually. It already exists in most OTC derivatives like forex, where banks have trading desks that match order flow. When the stock markets get heavily liquid and full of algo traders, there will be a need to hide information. The future is bright. Or dark, whichever way you see it.


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