Global Financial Markets series

Global Financial Markets series Global Financial Markets is a series of practical guides to the latest financial market tools, techniques and strategies. Written for practitioners across a range of disciplines it provides comprehensive but practical coverage of key topics in finance covering strategy, markets, financial products, tools and techniques and their implementation. This series will appeal to a broad readership, from new entrants to experienced practitioners across the financial services industry, including areas such as institutional investment; financial derivatives; investment strategy; private banking; risk management; corporate finance and M&A, financial accounting and governance, and many more. Titles include: Erik Banks DARK POOLS, 2nd Edition Off-Exchange Liquidity in an Era of High Frequency, Program, and Algorithmic Trading Erik Banks LIQUIDITY RISK, 2nd Edition Managing Funding and Asset Risk Daniel Capocci THE COMPLETE GUIDE TO HEDGE FUNDS AND HEDGE FUND STRATEGIES Sandy Chen INTEGRATED BANK ANALYSIS AND VALUATION A Practical Guide to the ROIC Methodology Frances Cowell RISK-BASED INVESTMENT MANAGEMENT IN PRACTICE, 2nd Edition Jawwad Farid MODELS AT WORK A Practitioner s Guide to Risk Management Guy Fraser-Sampson INTELLIGENT INVESTING A Guide to the Practical and Behavioural Aspects of Investment Strategy Michael Hünseler CREDIT PORTFOLIO MANAGEMENT A Practitioner s Guide to the Active Management of Credit Risks Felix Lessambo THE INTERNATIONAL CORPORATE GOVERNANCE SYSTEM Audit Roles and Board Oversight Ross K. McGill US WITHHOLDING TAX Practical Implications of QI and FATCA David Murphy OTC DERIVATIVES, BILATERAL TRADING AND CENTRAL CLEARING An Introduction to Regulatory Policy, Trading Impact and Systemic Risk Gianluca Oricchio PRIVATE COMPANY VALUATION How Credit Risk Reshaped Equity Markets and Corporate Finance Valuation Tools

Andrew Sutherland and Jason Court THE FRONT OFFICE MANUAL The Definitive Guide to Trading, Structuring and Sales Michael C. S. Wong and Wilson F. C. Chan ( editors) INVESTING IN ASIAN OFFSHORE CURRENCY MARKETS The Shift from Dollars to Renminbi Global Financial Markets series Series Standing Order ISBN: 978 1137 32734 5 You can receive future titles in this series as they are published by placing a standing order. Please contact your bookseller or, in case of difficulty, write to us at the address below with your name and address, the title of the series and the ISBN quoted above. Customer Services Department, Macmillan Distribution Ltd, Houndmills, Basingstoke, Hampshire RG21 6XS, England Also by Erik Banks: LIQUIDITY RISK, 2nd Edition RISK CULTURE SEE NO EVIL: UNCOVERING THE TRUTH BEHIND THE FINANCIAL CRISIS FINANCE : THE BASICS, SECOND EDITION DICTIONARY OF FINANCE, INVESTMENT AND BANKING RISK AND FINANCIAL CATASTROPHE SYNTHETIC AND STRUCTURED ASSETS CATASTROPHIC RISK LIQUIDITY RISK THE FINANCIAL LEXICON THE FAILURE OF WALL STREET ALTERNATIVE RISK TRANSFER WORKING THE STREET CREDIT RISK OF COMPLEX DERIVATIVES, 3rd Edition CORPORATE GOVERNANCE EXCHANGE-TRADED DERIVATIVES THE SIMPLE RULES OF RISK E-FINANCE THE RISE AND FALL OF THE MERCHANT BANKS ASIA PACIFIC DERIVATIVE MARKETS EMERGING ASIAN FIXED INCOME MARKETS CREDIT RISK OF FINANCIAL INSTRUMENTS OPTIONS APPLICATIONS ( Co-authored with P. Siegel ) CREDIT DERIVATIVES ( Co-authored with M. Glantz and P. Siegel ) PRACTICAL RISK MANAGEMENT ( Co-authored with R. Dunn ) WEATHER RISK MANAGEMENT ( Edited and co-authored with XL Financial )

Dark Pools Off-Exchange Liquidity in an Era of High Frequency, Program, and Algorithmic Trading 2nd edition E r i k B an ks

Erik Banks 2010, 2014 Softcover reprint of the hardcover 2nd edition 2014 978-1-137-44953-5 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6 10 Kirby Street, London EC1N 8TS. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2014 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan in the US is a division of St Martin s Press LLC, 175 Fifth Avenue, New York, NY 10010. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave and Macmillan are registered trademarks in the United States, the United Kingdom, Europe and other countries ISBN 978-1-349-49682-2 ISBN 978-1-137-44957-3 (ebook) DOI 10.1057/9781137449573 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Banks, Erik. Dark pools: off-exchange liquidity in an era of high frequency, program and algorithmic trading / Erik Banks. pages cm. (Global financial markets) Second edition Preface. Revised edition of the author s Dark pools: the structure and future of off-exchange trading and liquidity, published in 2010. Includes bibliographical references and index. 1. Capital market. 2. Liquidity (Economics) 3. Risk. I. Title. HG4523.B364 2014 332.6492 dc23 2014024789

Contents List of Illustrations... Pools in Practice Vignettes... Preface to the Second Edition... About the Author... vi viii ix xi PART I MARKET STRUCTURE 1 Introduction to Dark Pools... 3 2 Market Liquidity and Structure... 33 3 Dark Pool Structure... 64 PART II MICRO ISSUES 4 Topics in Pricing and Execution... 103 5 Trading in Dark Pools... 127 6 Aspects of Technology and Architecture... 153 PART III ENVIRONMENT OF THE FUTURE 7 Regulation, Control, and Transparency... 177 8 The Future of Dark Pools... 204 Appendix 1 Listing of Dark Pool Sites... 221 App endix 2 Listing of MiFID Regulated Markets, Systematic Internalizers, and Multilateral Trading Facilities... 223 Notes... 230 Gloss ar y... 239 S elec ted Bibliog raphy... 255 Index... 259 v

Illustrations FIGURES 1.1 Orders coming into various price points... 15 1.2 Sources of dark liquidity... 19 2.1 Twilight pools in the lit/dark market... 38 2.2 Limit bids and offers... 42 2.3 Reserve order execution in Stock XYZ... 49 2.4 Hidden order execution in Stock XYZ... 50 2.5 Order types... 52 2.6 Market structures... 59 2.7 Liquidity spectrum... 63 3.1 Types of alternative trading systems/multilateral trading facilities... 71 3.2 Key types of crossing networks... 80 3.3 Broker/dealer desk model... 82 3.4 Examples of dark pool venues and mechanisms... 93 4.1(a) Limit order book: Stock XYZ... 109 4.1(b) Limit order book: Stock ABC... 109 4.2 Supply, demand, and market clearing price... 111 4.3 Crossing at best bid offer... 114 4.4 Order entry into a crossing network... 118 5.1 Implementation shortfall routine... 144 5.2 Data feeds in HFT/ULLT ventures... 149 6.1 Trade lifecycle... 159 6.2 Routing process... 163 6.3 The matching flow... 168 TABLES 2.1 Major classes of orders and primary motivations... 53 2.2 Stock EFG order book example 1... 53 2.3 Stock EFG order book example 2... 54 2.4 Stock EFG order book example 1, without illustrating the dark trade.. 54 3.1 Major global exchanges with hidden/reserve orders... 67 4.1 Stock ABC order book, pre-call... 111 vi

Illustrations vii 4.2 Stock ABC order matching... 111 4.3 Stock ABC order book, post-call... 112 4.4 Stock ABC, continuous-order market... 113 6.1 Share blocks on various dark pools... 165 6.2 Order fill against various dark pools... 165 6.3(a) FOK buy limit order at $50.00, 1000 shares... 172 6.3(b) Dark sell peg order at the midpoint of the NBBO, 2000 shares and minimum quantity 1000 shares, valid market open tomorrow (T + 1)... 173

Pools in Practice Vignettes A typical dark trade (Chapter 1) Traderspeak... (Chapter 2) Twilight pools (Chapter 2) The midpoint match (Chapter 2) The slow death of flash trading? (Chapter 2) The rise of the conditional order (Chapter 2) Dark aggregation (Chapter 3) Different degrees of direct market access (Chapter 3) Dipping into a toxic pool (Chapter 3) Bond trading in the dark (Chapter 3) Creating a synthetic NBBO (Chapter 4) The robustness of the best bid-offer (Chapter 4) Touch price crossing (Chapter 4) Measuring dark market variables (Chapter 4) Cash neutrality (Chapter 5) Real life algo orders... (Chapter 5) Looking in the dark with algos (Chapter 5) Ultra-low latency trading (Chapter 5) The Flash Crash (Chapter 7) Not every pool makes it... (Chapter 8) viii

Preface to the Second Edition The marketplace for securities trading has continued evolving and growing since the first edition of Dark Pools was published in 2010. Specifically, following the devastating market crisis of 2007 2009, which sidelined many participants, an accelerating market recovery began to appear in 2011 and 2012, bringing retail and institutional investors back to the developed and emerging equity and fixed income markets. Their return has heralded growth in volume and liquidity, essential ingredients for dark market expansion. In addition, new technologies have been introduced in the programming, hardware, and networking sectors which have led to a new generation of increasingly sophisticated, and rapidly executed, trading strategies including high frequency/low latency trading and algorithmic trading. Furthermore, a growing focus on cost reduction and profit maximization has caused the largest investors to find ways of employing cost-saving solutions, like low market impact trading and direct market access. These forces, combined with consolidation and restructuring in the exchange and off-exchange sector and a redrafting of market regulations, have led to a reshaping of the dark pool sector. Against this background, dark trading remains an important financial market growth sector. By all available statistics which are still challenging to derive in a market that, by definition, remains opaque dark trading now accounts for approximately 40% of all U.S. turnover; the European share ranges from 8 to 15% at any point in time, while countries such as Canada and Australia have breached the 10% mark. Collectively, these are significant market shares which have helped solidify the function and legitimacy of the dark market. Given the changes and growth in this important segment of the financial markets, it seems timely and appropriate to bring the original material in Dark Pools up to date and to further expand its scope. The new edition reflects current ideas on micro and macrostructure and regulations. More specifically, this new edition incorporates the following features: Updates and new examples throughout the book to reflect growth and change in national markets and asset classes. Expanded sections on algorithms, high frequency and low latency trading, aggregators, and market structures and their interaction with dark liquidity. Enhancements and updates on regulatory matters, focusing on efforts in the U.S. (via the SEC and FINRA), Europe (via MiFID II and MiFIR), Canada, and Australia. New Pools in Practice vignettes which give a practical treatment of some of the topics traders, exchanges, and other market participants are dealing with. ix

x Preface to the Second Edition New concluding remarks on the future of dark pools. Updated appendixes featuring the latest listings of dark pool sites and authorized MTFs. An expanded glossary that features new and important terminology. This new volume should prove a ready reference to those interested in one of the most interesting and important segments of the traded financial markets.

About the Author Erik Banks is a risk management specialist who has held executive positions at Citibank, Merrill Lynch, UniCredit and in the hedge fund sector, in New York, Tokyo, Hong Kong, London, and Munich. He is the author of more than 20 books on risk, derivatives, emerging markets, and governance. xi