Advanced Trading
By Ivy Schmerken
Even as buy-side traders continue to send more and more order flow to dark liquidity pools as a way to avoid information leakage and moving the market, concerns about price manipulation, or gaming, in the opaque crossing networks are on the rise. While six months ago the main issue for buy-side institutions was navigating the fragmented markets -- which comprise more than 40 crossing networks, block trading systems and dark liquidity pools -- the hot topic now is protecting against gamers who ping non-displayed venues where large institutional orders rest.
A gamer, or predator, enters a dark pool with a small order to discover if there is more significant volume on the opposite side of the trade with the intention of exploiting the information to push up the price of the stock in the public markets. For example, a gamer might place a 100-share order in an illiquid stock into a crossing network. If the order executes immediately, then the gamer assumes there is more volume behind the buy order and quickly places a 1,000-share buy order in the public markets to push up the price. Then the gamer returns to place a 10,000-share sell order in the crossing network in order to trade with the institutional counterparty at a temporarily inflated midpoint price. While the anonymity afforded by dark pools prevents traders from definitively concluding that gaming is occurring, one telltale sign of the price manipulation, according to experts, is a sharp spike in the bid or offer side for a security that's trading at low volume.
The practice of gaming cuts at dark pools' core value proposition — the ability to trade anonymously with minimal market impact — and hinders buy-side traders' ability to ensure best execution for clients. Rather than trade at the volume-weighted average price (VWAP), for example, buy-side traders may end up executing buy orders at the highest prices of the day if a predator is able to sniff out their large standing orders in the dark pool.
"It's definitely a concern," says Jeff Albright, VP of equity trading at Waddell & Reed Asset Management Group in Overland Park, Kan. "Pools without anti-gaming logic can do more damage than good. It completely reverses the entire philosophy behind a dark pool because you're going in there to be anonymous, and if someone is not in there putting some constraints on their activity and monitoring their activity, it's a useless cause."
Anti-Gaming Logic as a Competitive Necessity
As a result, anti-gaming technology has become a hot topic in the industry. The independent operators of block trading systems — namely Liquidnet, Investment Technology Group and Pipeline Trading Systems — have been vocal about their anti-gaming practices for several years. Now, with the proliferation of broker-sponsored dark liquidity pools, the sell-side firms are putting stronger controls in place to deter price manipulation. Most Wall Street firms say they have automated tools as well as humans monitoring the systems and conducting historical analysis to catch gaming.
"Everyone is very concerned, " says Brian Fagen, U.S. head of electronic and program trading sales at Lehman Brothers, which recently invested in new anti-gaming technology. "It's a big topic. We all know there are certain types of traders who are looking to lever off of liquidity, and they do it in the open market — they do it on the NYSE and Nasdaq, and that's been around a long time," he adds.
"These new dark liquidity pools and ATSs [alternative trading systems] just offer a new venue to do that," Fagen continues. "The key is that your general institutional investor may not want its flow exposed to those types of counterparties. So our job when we build a pool is to build in anti-gaming logic to protect the quality of the venue."
Sell-side firms are even talking about anti-gaming technology as a competitive differentiator.
In early July, Weeden & Co. and Pragma Financial Systems announced the rollout of second-generation anti-gaming logic, known as OnePipe Lifeguard. Acting like a spam filter, according to Peter Fraenkel, director of quantitative services at New York-based Pragma Financial Systems, this extra layer of protection is designed to detect suspicious trades on the firms' joint trading network, the OnePipe Optimal Liquidity Management System, which aggregates liquidity from more than 30 dark pools. The capability, Fraenkel claims, alleviates buy-side firms of the burden of vetting each dark pool's anti-gaming logic.
Despite dark pools' efforts to eliminate gaming, buy-side traders are proceeding with caution.
"I wouldn't say for us that it's a noted concern," says Rob Adriaanse, head trader at Wilmington, Del.-based DuPont Capital Management Corp., which has $25.6 billion in assets under management from DuPont's corporate U.S. pension plan and external funds. "But I'm aware of [other] people's concerns that gaming is going on."
Like other buy-side traders, Adriaanse takes steps to protect his firm's orders. "We slice and dice [orders in] a lot of ways to protect information from going into the market," he relates. For example, Adriaanse may place just 10 percent of an order to see how the market reacts. "We monitor the impact of the orders we're sending into the market. If it's going in our favor, we may start releasing more and more," he explains. "But if there's a feeling that the stock is moving because of the market or gaming, we may hold back. There's a million different scenarios."
Gaming Isn't a New Play
But are dark pools more susceptible to predatory behavior and price manipulation than exchanges and ECNs? "There's limited visibility [in dark pools, so they have] the potential for it," says Adriaanse.
"Just the nature of how they are set up and how [participants] can be stealthy, it could lend itself to people trying to game it," Adriaanse adds. "I wouldn't doubt there is some [price manipulation]; to what extent, I have no idea."
According to Tony Huck, managing director at ITG, "In theory, the nature of dark pools makes them more susceptible to gaming because of the anonymity of the buyer and seller. Traders that use gaming techniques are able to conceal their actions at the expense of the firm on the other side of the trade."
On the other hand, some buy-side traders say similar tactics are used in the displayed venues as well. "I don't think the issues you would face in a dark pool are different than what you would face with an ECN or an exchange," asserts Drina Loncar, senior trader at Chicago-based Pentwater Capital Management, an event-driven hedge fund with $1.25 billion in assets.
"Someone is always trying to figure out or exploit information on flow. It is an issue, so you have to consistently monitor your orders," Loncar continues. "You don't reveal more in the dark pool than you would anywhere else. Orders should be actively managed, regardless of execution venue. You don't have to show your size in a dark pool, and you need to use limits."
Waddell & Reed's Albright, however, says gaming probably is more prevalent in dark pools and algorithmic trading because of the presence of institutional flow. "The [gamers likely are] more active in dark pools because of the institutions," he contends. "Gaming could have a bigger presence there."
Still, some question whether gaming is a real threat. According to Pragma's Fraenkel, however, there's no doubt it is a real concern. "Not only does it happen, but it's hair-raising," he contends, noting that he has studied millions of transactions.
Putting an End to Gaming
Fortunately, there are ways to limit gaming. Parameters in the broker-sponsored algos, for example, enable the buy side to put some "pretty tight parameters on movements of stocks," Waddell & Reed's Albright acknowledges. "What's especially helpful is percentage of volume movements — lowering your execution capacity," he says. "If the stock moves a certain percentage up or down, you lower your participation rate."
"[Gaming] depends on the gamer having some way of inferring that you have this position," adds Pragma's Fraenkel, noting that this is one key to stopping gaming. "If he has no reason to believe that you have a position, this could be an expensive shot in the dark. It also relies on there being sufficient light stock volume that the stock price can be pushed."
Sell-side firms are taking the responsibility of policing their dark liquidity pools very seriously. Lehman Brothers, for example, allows immediate or cancel (IOC) orders in parts of its LX order book, but it doesn't allow high-frequency IOC orders in the institutional tier of the order book, according to the firm's Fagen. "If you restrict people from using certain types of [potentially manipulative] orders, then you take away certain types of traders," he says, referring to predators. "They won't want to play there anymore."
At its simplest form, a buy-side firm posts an order in a dark pool, illustrates Fagen. "Someone else may ping the book with a small bid or offer in an attempt to discover that order, taking their information without being exposed to too much risk." he relates.
One way to combat this tactic is to give the institutions control over the minimum order size. "If anyone comes in for a lesser amount of shares, they can't see me — I won't trade with them," says Fagen. "Therefore, you raise the risk level — [the predator] has to take more risk to discover the order."
And there are other techniques that a sell-side firm can use to control or protect orders, Fagen adds. "Some of the tools involve order type, frequency, size, market cap, liquidity or price," he relates. "Additionally, how you allow orders to interact within the book is important."
According to Fagen, Lehman monitors every order that comes into the book. "We have sophisticated tools that allow us to detect any unfavorable behavior to the book," he claims. "All of the anti-gaming controls are performed through a series of automated tools and analysis that are then backed up by human review of the data to ascertain a bigger picture view."
To help combat gaming, LeveLATS allows buy-side participants to set minimum order sizes, relates Whit Conary, the broker-consortium-sponsored ATS's CEO. "Because we're an open platform, and people are going to come in and game any system, we have to be flexible enough so that if a customer wants to set a minimum execution size, they can use that," he explains.
Another anti-gaming feature of LeveL's system is the ability "to build a trading list of firms you would trade against," Conary adds. "Let's say firm XYZ is gaming your order — you build a list that doesn't have that firm on it," he says. "We will monitor if a customer believes they've been gamed. We can work with the customer to keep that from happening."
LeveL also avoids sending out indications of interest, or IOIs, to other dark pools, a practice intended to attract additional liquidity. "Sending IOIs out can increase your volume and your match rate but it does so at the expense of information leakage on your customers' orders," Conary explains, suggesting that IOIs can turn dark pools into gray pools. "We have sold ourselves as a dark pool — IOIs is one way for information to leak."
Gaining Insight Into Dark Pools
Meanwhile, buy-side firms are growing more and more vigilant about the potential for gaming and increasingly question sell-side firms about their anti-gaming measures. "Whenever I entertain doing business in broker-sponsored dark pools, the first thing I'm going to ask is what type of anti-gaming logic they have in place to detect the activity, and what actions they are taking after that detection as far as trying to track down who is doing the gaming," says Waddell & Reed's Albright. He adds that he would like to see brokers put in a grading system — along the lines of Liquidnet's system — under which participants are kicked out of the system if they receive three strikes against them.
But are the sell-side firms serious enough about preventing gaming to the point that they may turn away liquidity? DuPont's Adriaanse says he's a little skeptical of what the larger brokers are saying about their anti-gaming procedures.
"I place a lot of stock in what Liquidnet says," Adriaanse notes. "The types of flow that are coming in from Liquidnet are probably easier to police. [And] Liquidnet has more at stake. Their business is based on [executing institutional-size orders anonymously and without information leakage] — they said it early on, so they have to deliver on it," he comments.
"The whole notion of Liquidnet is based on real, actionable orders," Adriaanse continues. "That lends itself to having more real participants versus people who are just testing the waters, possibly gaming or possibly not becoming a real order."
Despite the concerns about gaming, the dark pools continue to attract more and more order flow. In July, both Lehman's LX and LeveLATS achieved milestones of more than 100 million shares traded in a single day, while on July 17, Goldman Sachs' Sigma X became the first U.S. dark pool to trade more than 400 million shares in a single day. For the month of July, Sigma X's average daily volume was 310 million shares.
"With increased volatility in the markets, people are looking for a safe, quiet, anonymous place where they can trade their more-volatile, less-liquid stocks," says Waddell & Reed's Albright. But while dark pools are helping the buy side find liquidity, he notes, "It comes with a lot more work on the traders' part because they have to watch the market activity after execution to see that there isn't gaming going on."
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