How Wall Street Plays the Dark Pool Game

27 | By Shah Gilani

Most people who are just “in the market” don’t understand high-frequency trading and dark pools. And that’s OK.

However, as I’ve been writing about over the past couple of years, apparently that unknowledgeable also includes people whose job it is to understand these things, including institutional money managers, brokers, investors and apparently most regulators… though I don’t buy their ignorance one bit.

My knowledge of high-frequency trading (HFT) and dark pools dates back to the late 1990s, when I was trying to figure out how to get better executions on the large trades my hedge fund was generating. I consider myself as a bit of an expert, and I got to show that off a little last week on the radio.

So, for all of you who want to know a bit more about what’s going on in the shadows, I’m going to get a little technical on you and share some of that expertise.

This won’t be boring – I can promise you that.

A lightbulb will go on inside your brains, and you’ll understand what’s really going on and how dark pools and HFT – which the Securities Exchange Commission and other regulators allow to happen – undermine markets.

Now, I’m going to flip the switch and turn that lightbulb on …

The New Math

My hedge fund was generating large amounts of mathematically driven (algorithms) trades. These kinds of trades are very precise. They aren’t “fundamentally” driven, where there’s some allowable swing in terms of getting in at this price or that price and not caring about pennies, nickels, dimes and quarters on a per-share basis.

This is the argument high-frequency traders make: So what if your execution costs you a penny or two more per share and you’re holding the position for months or years?

That’s rubbish, and I’ll debunk that. For us, every penny counted.

The problem was that competition had created multiple trading venues. In the old days, if you wanted to trade IBM Corp. (NYSE: IBM), for example, you sent all buy and sell orders to the New York Stock Exchange – the only place where IBM traded.

Today you have a choice between 11 exchanges and some 50 dark pools – including ones run by Barclays and Credit Suisse.

Not that you, the average investor, can get into a dark pool or that you get to pick where your order goes if you’re executing through a broker or a discount brokerage trading platform. Suffice it to say, there are many paces that match up buyers’ and sellers’ orders, which is how trades are consummated.

We had direct access to the NYSE, the American Stock Exchange (Amex), to virtually every market maker on the Street – and to all the electronic communications networks (ECNs). We could see all the bids and offers that each venue was posting for every stock we traded. Needless to say, not all the quotes were the same at all the venues.

The problem with all that competition is that markets get “fragmented.” There’ no central place where a stock is traded. And because competition spreads the “order flow” around, there aren’t as many shares being traded at any one location as there would be if there was only one trading location. Instead, “liquidity” at each venue is less, sometimes considerably less, than what it would be if there was only one exchange.

We had to go looking for the best prices. Which venue had the highest bid price? Which had the lowest offer price?

More importantly: How many shares could we execute at those best prices before we’d taken or hit all those shares and had to go to the next venue, then the next venue, to try and execute the rest of our usually large orders?

The SEC recognized that all this competition, which it allowed, was causing problems. To fix the problem of having to look all over the place (which not a lot of average traders had the ability to do) to see where the best bids and offers were, the SEC came up with the NBBO – that’s national best bid and offer.

The NBBO is posed every second of every day stocks are trading as a consolidated quote. That means every market maker and exchange posting bids and offers (for the same stock) has to send them all to a central location, where the best bid and best offer are shown for all the world to see. Theoretically, if you’re fast enough and see that 1,000 shares of IBM are offered at $181.50, you can buy them if you’re first to get there.

From here, it’s easy to see how dark pools came about. Big institutions were having problems chasing all the stock they wanted to trade.

So, big banks and big trading outfits said, “Send us your big orders. You’re not alone: Other big traders like you will come to us, too, and we’ll match up your big orders in a blind pool. We’ll call it a dark pool, because no one on the outside or on the inside will know who is selling or buying big blocks. We’ll do it all at a great price, and we’ll do it anonymously.”

That made sense. But the net result was a lot more trading venues.

And in April 2001, onto this highway where unintended consequences eventually all collided, the SEC unleashed “decimilization.” From then on, stocks could be traded in increments of one penny, not the eighths of a dollar, or even sixteenths of a dollar in some places, that had been the minimum increment stocks could trade under.

Now, imagine the “unintended consequences” of that market change.

Instead of market makers or NYSE specialists making quotes in eighths, quarters, etc., the spreads between bids and offers got narrower. And everyone could bid a penny higher than the person in front of them, or offer to sell their shares at a penny lower than everyone in line ahead of them trying to sell their shares.

And the pundits all said: It is good. Spreads will be narrower and transaction costs cheaper. It’s time to rest and let the world turn.

But there were devils in the details.

Enter the Dragons

I’m not a dragon – what I like to call high-frequency traders – I thought about becoming one. Back in the day, I had to execute at the prices my trading models dictated. I looked at the fragmented world and quickly figured out that if I could create a computerized system to look at every quote on every venue and how many shares were being bid and offered everywhere at the same time, I could figure out what prices I could buy and sell at and at what volume of shares.

And I could do all that and still trade pretty accurately, as long as I could transact instantaneously. It was going to be an HFT program. Not to pick off anybody, but to get the best execution on my trades for my hedge-fund clients.

I spent millions of dollars setting the systems up, only to realize it would be a forever game, always spending millions every few months, year after year, to have the best, fastest access to everywhere. That wasn’t my business model. I was just trying to create an execution engine.

So, I abandoned the game.

Because I’m honest, I’ll tell you, I wish I hadn’t. Because that’s how HFT came into being.

It started out for a lot of traders as a way to get better executions. And as they spent and spent, they realized they could beat everyone at the game.

So, the unintended consequences of competition and fragmentation, when they merged with decimilization, spawned HFT.

Here’s how far it’s gone.

Remember that NBBO consolidated quote requirement? That’s where everybody has to send in their quotes to a central location. Well, the HFT boys get into the wires and see those quotes heading to the consolidated quote room before everyone’s quotes get there, before they end up creating the NBBO that the world sees. By intercepting everybody’s quotes, HFT shops can construct the NBBO before the consolidated quote machinery gets all the quotes and establishes the NBBO.

They know what it will be… and they act on it.

By the time the NBBO is posted, usually a nanosecond before (because of a thing called “lag”), high-frequency traders take the offer that’s posted or hit the bid that’s posted, long before anyone else can get there to grab those shares.

What happens then? The NBBO might change, and guess who knows what it’s going to change to next? This happens all day, every day. HFT shops are in picking off trades and causing other traders to change their quotes or chase shares up or down.

And those HFT boys? They’re in the dark pools too. They’re reading what’s supposed to be blind as if they had X-ray vision. They pay dark-pool operators to let them peer in and construct internal engine quotes (internal NBBOs) and then trade ahead of other blind participants.

Who are some of those HFT guys in those dark pools? They are the trading desks of the dark-pool operators themselves.

Nice game, isn’t it?

None of this was planned. Opportunities arose. Unintended consequences have had monumental consequences.

Believe it or not, the exchanges are all in on it. So is the SEC. It’s now in the rigging of the market’s sails. It’s how it all floats today.

What’s the problem?

The Rise of Rodents

The ship is full of rats. And they’re eating away at the hull of our capital markets.

Intermediaries are exacting excessive tolls that most people can’t even feel, let alone see. Intermediaries are doing nothing for the market, nothing, except gnawing away at its foundation.

Yes, they trade a lot. About half of all the volume every day is the result of HFT trading. Imagine what volume numbers would be if there was no HFT in and out trading.

Volume does not equal liquidity. Just because there is more volume because HFT boys are active 24-7 doesn’t mean markets are more liquid. The truth is that they are less liquid.

Liquidity refers to the ability to get in and out of stocks with minimal impact on prices.

The incorrect assumption is that if there’s a lot of volume, there’s good liquidity. But the volume we’re seeing is nothing but toll takers inserting themselves in between real buyers and sellers. It’s fluff volume that adds zero liquidity.

It masks the lack of liquidity… which we will come to suffer from in the not too distant future.

You’ve been warned.

Are HFT players investors? No.

Are they adding anything?

Yes, according to some duped “professionals.”

Some proponents say because they’re there, because they’re paying for data feeds and access to quote information so they can pick everybody off, their payments offset the cost of executions for discount brokers, allowing them to charge mom-and-pop investors next to nothing to do a trade.

Isn’t life great! The public gets cheap executions, spreads are narrower, we can trade in increments of a penny, all to aid and abet HFT shops making billions as institutionalized toll takers that add NOTHING to the safety, transparency or legitimacy of America’s (and the world’s) capital markets.

Now do you get it?

Any questions?

Related Reports:

Wall Street Insights & Indictments: “Dark Pools Pervade Wall Street”

Wall Street Insights & Indictments: “The Truth About ‘Dark Pool’ Trading”

Wall Street Insights & Indictments: “Fight Club: Shah battles ‘Dark Pools’ apologist on NPR today”

27 Responses to How Wall Street Plays the Dark Pool Game

  1. Richard says:

    When will they come out with program that gets ahead of the HFT Group….. Someone will figure it out if not done now, I bet it is soon coming to help level the playing field.

    • mart says:

      To do HFT you have to just be faster – it’s not rocket science. It takes a lot of money not a smart invention

  2. Edouard D'Orange says:

    Sorry, I have a question, but not about what you have succinctly and brilliantly explained. What would happen if somebody (SEC, Congress, etc.) was to expose the dark pools for what they are and rein in the HFT (though it’s not likely)? Would it be devastating, as you ominously state: “You’ve been warned”? If the markets are cleaned up, can it be done without causing a severe panic?

    • Rumpole says:

      Didn’t you read that the SEC, etc., are in on the scam?? How likely do you think that they’re gonna blow the whistle?? Highly, highly unlikely because they’ve got their hands in the cash register too!

    • mart says:

      HFT trading is not illegal. The only issue is if you fraudulently present one condition to one trader vs another. In the case of some dark pools that is the case but those are the dark pool operators not the HFT traders.

  3. Veronica says:

    Thanks so much for this overview of the HFT situation – trouble is now that everybody in this game is making money hand over fist, no-one will do anything to kill it. I believe the only way to stop this is that Tobin tax that they have introduced in Europe (I think?) so they will generate oodles of dollars for the country and MAYBE this will actually hold them back (tamp it down?).
    It makes us ordinary folks just shrug our shoulders in disgust. This is really criminal behavior.
    Does no-one do anything for the right reasons any more ?
    As I was explaining to a Scottrade person who called me to check on why I was no longer actively investing and in fact I am slowly taking my money out of my account – I no longer trust the setup at all !!!!!
    Not the fault of Scottrade or any other ‘family’ broker – the system stinks now and everyone needs to get out.

    • mart says:

      so why are you not trusting it? if you are an investor HFTs have no impact on you – in fact you trade at cheaper prices because of them

    • Ian S says:

      Tobin Tax? No thank you! This tax is nothing to do with regulation, it is all to do with a bankrupt EU seeking anything it can tax. Because the EU is in fact a rats nest of competing nations each primarily interested in doing down one of the others. The Tobin tax is directly aimed by France at Britain. A reverse of the situation would see a hike in the tax on soft cheese but not hard cheese and sparkling wine but not flat wine. In other words you single out an activity that your country does not participate in but your neighbour does for a tax hike.

      In fact HFT is not a problem, before electronic platforms a market in a stock was made by a jobber who charged half a per cent in and out. The public is better off with the current high volume of trades partially caused by HFT because Joe Public trades in and out today at less of a margin than the stock jobber charged him.

  4. Thomas Nelson Smith says:

    Shah, Bless you, you are right on most everything you write about, say, and when you are on live TV. This is appreciated by many more than you realize. I am on a fact finding mission over here in China at the moment, but even though everything is censored, because of people like you word still gets through. The Chinese government is hard to figure out. They have become the largest capitalist in the history of the world, they are wise alright, I just hope that they can realize that there is a lot more that America that they can use together, instead of trying to do everything themselves. I have always thought of Russia as a loose cannon, but with China I think there is hope for world peace eventually. Your cohort, is on to the latest things as well, the Zero Line is a big problem and dealing with the Taliban and the many radical nutcases are more than decent people should have to put up with. Keep up the good work Shah!
    Cheers, Tom

    • mart says:

      russia is a loose cannon? really? how many wars did the US start recently vs how many did Russia start?

      • guest says:

        Tell us – how many wars did the U.S. start?

        Now, be sure to tell us how many wars Russia started. Be sure to include the wars Russia started with Japan, Afghanistan, Ukraine, Poland, and Czechoslovakia, all the countries they forced to join the USSR, the Russo-Turkish Wars, the Crimean War, etc, etc, etc.

  5. Seegar SwansonJr says:

    So wouldn’t all this HFT halt if everyone was taxed a penny per share for every trade made?

    Thank you for explaining all this.

  6. Maxwell says:


    Handle it! Give the detailed explanation and break it down for “us” and them. Let people know about the pools full of sharks. The sharks will be coming to refute and expound on competition and capitalism. If you do not want to see beyond the profit…how can you see the “patriotism”…

    The fear mongering is getting built up and we all know fear is expensive…and we have all seen the price of “safety”.

    Help to educate us Shah…keep up the light!

  7. Rumpole says:

    On the enema analogy, well said! I’d add that it’s followed by a colonoscopy performed by a crooked doctor who says there’s nothing wrong but your butt is full of polyps! No wonder you don’t feel better!

  8. Arem says:

    Such a conundrum! Let’s see. Brokers send online “feeds” to a “central location”, which then calculates and posts NBBO prices. Brokers are then supposed to (be able to) “execute” client trades (theoretically) based on NBBO posted prices. But HFT traders “intercept” those inbound feeds, enabling them to “front-run” participating broker trades (for clients) – and thereby “profit” from essentially manipulating the NBBO prices. Gosh! HMMM! How about “disconnecting” the connections that enable the HFT boyz to “intercept” the inbound online feeds from all these NBBO-participating brokers? – and making the existence of such a connection by any person or entity a Class A felony, conviction to carry such penalties as loss-of-license (if any), mandatory “dissolution” of the offending (employing) entity, a (sliding-scale) personal “ban” on investing/trading activity for an individual, hefty fines (all around), significant prison time, reimbursement of all litigation costs pertaining to investigation, trial, and imprisonment, preclusion of post-conviction “gain” arising from the crime — and, aw heck, let’s just also altogether eliminate this “no admission of guilt” thingy. Hey! – by golly, let’s also think about all those participating brokers submitting their (client) orders ONLINE using (ah, what’s it called? – oh) “secure encryption technology”! – and insisting that any person or entity found to POSSESS (never mind use) its counter-part “decryption technology” to be similarly guilty (to the foregoing Class A felony), ipso facto. Hell, let’s even explicitly “authorize” the NSA to (um) perform the requisite (ah) “online monitoring” activity!? . . . ENDING this crap is, of course, more a matter of “will” than “ability”. Obviously the powers-that-be ain’t interested (yet.) And why would THAT be? Hmmmm . . .

  9. mart says:

    Let’s face it.
    HFT actually has NO detriment to investors which virtually all of us small guys are. They actually benefit us by reducing transaction costs.
    The only players they harm are other high frequency traders. Well if you want to get in and out in seconds then you need to invest more to beat them – that is your problem. For the rest of us they are beneficial as we pay less to get in and out and their impact on the direction of our longer term trades is 0.
    Thank you

  10. Ron says:

    It’s hard to escape the conclusion that everything is crooked- the banks, the accountants, the markets, the courts, the government-everything you are required to trust.
    At least, some degree of trust is necessary in every transaction, and you can’t help but wonder how this house of cards continues to stand.

    • guest says:

      No, Buffett is not remotely a high frequency trader. Quite the opposite. He is a super slow frequency trader. His preferred holding period for every purchase is “forever.”

  11. Teddy says:

    1. I like Arem’s ideas.
    2. How does Goldman Sachs consistently make a profit every day (well, maybe except for one or two days) of the year doing this? What advantage do they have and who then are the losers? I know from a lifetime of experience that there are those who would sell their grandma (customers?) down the river for a penny for themselves if they thought they could get away with it without anyone else knowing.
    3. I think there have been abuses to the HFT system that have been allowed, such as errors by traders who have been allowed to reverse their mistakes while others have not been allowed the same privilege. I think that if a trade was made you should be stuck with it, error or not but that there should be controls or limits to avoid gross errors in the first place so as not to disrupt the market.
    4. I am just a little guy; a retired accountant.

    • John says:

      wouldn’t you LOVE to get paid to do their taxes on thousands/millions of transactions?

      Is this irrelevant to me on MY investiong (only) if i just put in lowball orders and wait? And high limit orders and wait?? And stoploss orders 10-25% below where they are now?

  12. MachineGhost says:

    Interesting analysis, but flawed conclusion. I see no difference between floor traders and specialists who have inside information about order flow and front-run customer orders, etc. and HFT’s doing the same. They all serve a liquidity-provider role and if there are ethical considerations or lines being crossed, then implement regulations. Throwing the whole baby out with the bathwater is just hyperbole.

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