Exchanges v dark pools and liquidity fragmentation

Exchanges v dark pools and liquidity fragmentation

Sep 4, 2012. | By: Fil

You get who you are, not what you wanted

What we've ended up with is a market where the informed investors efficiently pick-up profits from the uninformed investors. Given this environment it is no surprise that the market has responded with a complex array of execution alternatives. The explosion in the choice of execution venues has been swift - both additional exchanges and dark pools, MTF, ECN. These options create complexity, additional cost and fragment the liquidity that is available - so there must be some perceived threat that is causing participants to leave the transparent public order books for the uncertain world of alternatives. Of course the objective of avoiding more informed investors is only one reason why people opt for dark pools - information leakage probably being the primary reason. But as the available technology increases (both in speed and smarts), the disparity between you and the Usain Bolt of traders widens, thereby making you increasingly uninformed on a relative basis.

The structure of the market today is a result of the battle between uninformed and informed investors. Uninformed traders have the temptation to leave the exchanges for the safety of a dark pool in order to achieve protection - but at what cost? There is certainly a cost paid by the market as a whole, so is it worth it?

Dark pools can be like a canary in the cage - if they're significant, it indicates there is a problem. The problem is not that dark pools exist, it is the fact that anyone wants to use them. It should be noted that there is not a trend away from the public order book towards dark pools in Australia. Contrary to popular commentary, traders are not moving from the public order book into dark pools. They are moving from other off-market trading schemes (like broker crossings).

Solving the problem of the informed-imbalance is one I want to tackle (next), but prior I want to make the point that it is one that should be solved in the public order book. Everyone should have equal access to the order book, and be able to give and take liquidity.


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