Question

Discuss the role played in modern financial markets by dark pools and high frequency traders, and comment on the lessons to be learned by the risk manager.

Answer 1

Dark Pools are private forums for trading financial instruments. The trades in the Dark pools will be done away from the public exchanges, so that they remain confidential and outside the purview of the general investing public. Dark Pools are mainly used by institutional investors for buying or selling large blocks of securities without displaying the order to the general public. Because Dark Pools lacks transparency, trades executed in do not impact price discovery.

High Frequency Traders are program trading platforms that use supercomputers to transact large number of orders in fractional seconds.

Informed traders who is taking a bet on the direction of a price move, whereas liquidity trader profits from the spread between the buying and selling price without gambling on the direction of a price move. Informed traders with the strongest signals trade in public exchanges, where traders with weaker signals trade in dark pool. The uninformed liquidity traders, those with high liquidity demand trade in public exchange and those with lower liquidity demand trade in the dark pool. Dark pools provide better prices that exchanges but this is offset by a higher probability of non-execution or inability to trade.

Dark pools account for around 14% of the overall trading volume in the US and around 4.5% of European volumes. Dark pools operated by investment banks account for the largest share of dark pool volumes. Notable examples are UBS ATS by UBS, LX by Barclays and Crossfinder by Credit Suisse. Market maker pools are operated by a manager which is the sole provider of liquidity while Independent pools are operated by agency brokers with periodic executions. Finally, Consortium pools are jointly owned by banks which use them as trading venues of last resort.

There are some cases which are lessons to risk managers:

Pipeline Trading Systems LLC, UBS Dark Pool, Barclays, Deutsche Bank and Credit Suisse are the main cases where the companies promised that the venue is transparent and free from HFTs, despite advertising otherwise. Risk managers should be very careful and need to understand that there is no venue that is absolutely free from malpractice. It always recommended to observe all the price changes and avoid participating these Dead Pools for benefits.