Dark Pools: Good or bad for the average trader?

Dark Pools recently have been subject of many headlines, mostly due to alleged illegal activities from the banks that operate them. For instance, Barclays is said have given High Frequency Traders (HFTs) unfair advantagesdarkpool over traders and investors in order to boost its trading activity and revenues.

In this article I’m going to explain what dark pools are, how they can be used by traders to reduce trading costs and when they should be avoided in order to achieve the same purpose.

First, what is a dark pool? The technical term for them are ATS (alternative trading system). They are essentially mini exchanges that match buy and sell orders without displaying them to the market. If you route a buy order (say, buy 50,000 shares of MSFT) to a dark pool, in theory, nobody knows your order is there. You have the possibility of getting filled for your entire order without “spooking” the market by displaying a large bid in the Level 2 Window. A lot of smart routers tend to go through Dark Pools first before they hit the displayed exchanges/ECNs, as a result your order would be exposed to that order flow before other participants. Another benefit of dark pools is that because the order is not displayed, sometimes you get the benefit of not having to hit the bid or ask in order to get your order executed. If you send a displayed order and have it appear in the Level 2, frequently, high frequency traders will jump ahead of you by one cent. This sort of “penny jumping” is done automatically by computers, while it has to be adjusted manually by us humans, this is annoying, time consuming and inefficient. By having that order in a dark pool, you can be in front of the HFT bids and asks without, in theory, they knowing about it and you can get the order flow of that dark pool to save you the spread.

Another benefit of dark pools is that when you send liquidity taking orders that go through them first, you tend to get access to additional liquidity not shown in the Level 2 that is inside the NBBO (National Best Bid and Offer). This tends to reduce your trading costs because it reduces the spread that you have to pay. Example: You try to buy 1,000 shares of PG at 80.02 in a market quoted at 80.01 x 80.02, your smart router hits a dark pool before the displayed market and gives back a fill for your entire order at 80.015. You just saved half a cent which comes out at $5. Over the course of a year, these savings add up.

Does that mean that dark pools are the Holy Grail for traders and investors to reduce their trading costs?

No. In addition to the unfair advantages that high frequency traders might be getting in dark pools, there are other issues even through legal means. For instance, Eric Hunsander from Nanex recently did an expose on how modern markets are rigged http://www.nanex.net/aqck2/4661.html

In it he demonstrated that a large order (in this case a buy order for 20,000 shares of Ford) alerted HFTs about his buying intentions because it hit dark pools first before the displayed markets. The HFTs then proceeded to cancel their orders from the displayed exchanges. The trader behind the order ended up only getting 12,133 shares (and 600 were from the dark pool). In this case, having the order go through the dark pool first was an extremely bad deal.

The question now is, if you are looking to decrease trading costs, when should a trader use dark pools and when he should avoid them?

It all depends on your order size. As a rule of thumb, if you are executing a small liquidity taking order (you are hitting the bid or ask), you want to go through as many dark pools as possible. The additional liquidity will give you fills inside the NBBO and reduce the spread that you pay. Some brokers allow you to expand the number of dark pools that your order will go through, being aware of this option can help you expose your order to dark pools when you think that is valuable. Ask your broker if they offer such option.

If you are sending a small liquidity providing order, you want to use a dark pool that has a lot of activity in that stock. This will enable you to not have to sit with a bid or offer for very long, get taken and save the spread. Not a lot of retail brokerages allow routing to dark pools. Ask your broker if they have such option.

On the order hand, if you are executing a liquidity taking large order, you want to go through as few dark pools as possible. As explained by Nanex and evidenced by a lot of frustrated traders, when HFTs notice dark pool activity a lot of the time, they tend to cancel their orders in the displayed market. HFTs know that dark pools are used by institutional traders looking for liquidity. Since institutions usually have a lot of stock to buy and sell, HFTs can make more by widening their spreads. In the case of large liquidity adding orders, it’s also problematic to use a dark pool. Barclays and Credit Suisse are both being  probed for potential wrongdoing when dealing with institutional orders. And these are just two banks, there are dozens of dark pools out there. Every time you send your larger orders to dark pools, you run the risk of being taken advantage of by executives looking to increase their market share. The benefit of you having your block trade executed is significant, but so is the cost of having your intentions exposed to HFTs. Choosing the right dark pool becomes crucial.

To summarize, I created the following table of how traders and investors can use dark pools to decrease trading costs. The definitions of small, medium and large orders have to do with how much of a market impact you expect to have. For instance, if you want to buy 400 shares of ABC and there are 5,000 shares bid and 6,000 offered, you have a small order as this is not expected to have much of a market impact. If you are trying to buy 5,000 shares, it’s a large order. A medium sized order would be somewhere in between. There is a forth category for huge orders (say 50,000, 100,000 or even 1 million shares), these are institutional orders that require more advanced techniques to conceal your intentions and require multiple executions over many hours/days. Those techniques are beyond the scope of this article.

Keep in mind that some larger spread stocks without a lot of liquidity (typical of small caps), sometimes even something as little as 200-300 shares is expected to have market impact. Also, when I say Dark Pool, I also mean Dark liquidity like orders that are sent to internalizers.


Two other variables you have to take into account are, how quickly you want to get in or out of a stock, and how fast is the stock moving.


Brokers: Retail brokers like CenterPoint Securities give access to a lot of dark liquidity through their special routes like CPCIT(Citadel), CPKCG (Knight), CSFBDESK (Credit Suisse), and others. That extra liquidity can help when traders are looking for price improvement or for fills when dealing with the Short Sell Restriction.

Interactive Brokers has an option called “Seek Price Improvement” that is turned off by default. If your order is small, turning the option on can decrease your trading costs and expose you to additional intra NBBO liquidity.

Conclusion: Dark pool orders definitely have a place in a trader’s toolbox. Don’t be scared by the headlines you read on the financial websites. If you understand them and know how to use them, you can use your judgment of when they are likely to decrease or increase your trading costs. Being aware of how much market impact you are likely to have and how your broker routes your orders can further help you in decreasing those costs.

Here is why HFTs hate IEX: How to use IEX to improve your order execution, prevent HFTs from gaming you and save money in the process


Katsuyama and the IEX team

Ever since Michael Lewis published his big best seller Flash Boys, an interesting exchange has gotten a lot of the public’s attention. IEX, or The Investors Exchange, was created by Brad Katsuyama and his colleagues from the Royal Bank of Canada(RBC) after they realized that the US stock market was severely lacking an exchange that would actually respect and be fair to the investors and traders who were bringing their business there. The main idea is that they will not allow special advantages to HFTs that are routing their orders to their exchange; the way they achieve that is through several methods:

  • Limited amount of order types. Unlike the main exchanges that allow almost any kind of order type (even if unfair) to be created.
  • No maker/taker rebates – a pricing system designed to give “kickbacks” to certain firms at the expense of other firms.
  • No collocated HFTs. They deny HFTs the privilege of being collocated inside their exchange.
  • A 350 microsecond latency for any order action taken by a participant (enter, cancel, revise an order), which ensures the IEX Matching Engine has sufficient time to receive and process changes to the NBBO (national best bid and offer) before a fast participant can receive and act upon the change on IEX.

This last point is a very important one. If you check out Eric Hunsader’s twitter feed and website (@nanexllc and nanex.net) he talks about all the time how HFTs can cancel orders faster than order routers can spread out their orders to different exchanges. This lets the HFTs widen out their spreads and make a little more on the transaction than otherwise would be the case.

How can a trader use IEX to its advantage and improve its order execution?

You see, the way IEX works, you can route an order, say buy 10,000 shares of PG, to IEX (which currently is an ATS, a dark pool, but soon it might become a displayed exchange) and if there are orders to sell PG there, you will get executed for whatever amount is resting there for up to 10,000 shares. If there isn’t the full amount that you want, they will re-route the balance of your order to the 11 registered displayed stock exchanges (3 from NYSE, 3 from NASDAQ, 4 from BATS and the Chicago Stock Exchange) plus the LavaFlow ECN. The thing is, Katsuyama and his colleagues are the folks who created Thor, the system that is used to combat HFTs games by getting orders to hit all the exchanges/ECNs at the same exact time to prevent them from cancelling or changing their orders after they discover your interest.

Because IEX is run by folks who know a lot about these HFT games and who were creative about how to work around it, you can expect that they will be intelligent about how IEX routes out your orders. This creates an interesting tool to traders: using IEX as a smart router. They have a proprietary method in which they re-route orders to other pools of liquidity (they have filed patent applications covering it). What they do disclose is the following:

  • After leaving IEX, the order does not go through dark pools or internalizers first (which is the case with quite a number of retail brokerages’ smart routers). Frequently orders that hit dark pools tip off HFTs and allow them to cancel their orders in other places. Because routing to a dark pool is a shot in the dark, you don’t know how many or if there are any shares of your stock bid or offered there at all, your upside can be limited and the downside of alerting HFTs is significant.
  • They have direct data feeds from the exchanges that they are trying to hit. This means that their order router is looking at the present rather than looking at the past which is the case with the SIP.
  • They will hit those 11 exchanges plus LavaFlow over a custom-built dark fibre network (which is proprietary) that is designed as to not allow the HFTs there to cancel or modify orders in other places when they see the buy or sell interest.
  • Their own 350 microsecond delay prevents HFTs from outracing IEX’s smart order router to the other displayed exchanges based on “signaling” from buy or sell interest on IEX.

IEX’s new order routing approach doesn’t use (or need) Thor for several reasons:

First because their technology is much better than it was at RBC. RBC, being a broker dealer, didn’t have much incentive to get the fastest connections to the exchanges or the best hardware. They weren’t in the “arms race” to zero latency, whereas IEX’s hardware and connections are as good or almost as good as the top HFT firms these days.

Secondly, because their router is centrally located among data centers in New Jersey, they don’t need to spread out orders in a Thor-like fashion because they are quite close to the other data centers (and the exchanges housed within).

At RBC, they were routing off lower Manhattan. Signals had to travel up the Hudson River, and across into New Jersey (NJ), before reaching each of the data centers sequentially: first Weekawken (BATS), then Secaucus (Direct Edge), then Cartaret (NASDAQ) and finally Mahwah (NYSE). The time it took to reach each data center was relatively consistent, and predictable. This enabled the HFTs to play their games.

By having their router close to the other data centers in NJ, there is no need for Thor anymore. Any difference in reaching different destinations will be so tiny that it won’t matter.

With this unique architecture, you can expect significant improvements over other routers. The results from their own statistics show that it is indeed the case. They have a 98% fill rate (data from June 2014). Where they route is tightly correlated to each exchange’s market share, and not to the exchange’s pricing schedules (like most routers). They also report a ~15% fill rate on their venue, where 70-80% of their trading is done at the midpoint.

What this means is that if you send an order for 10,000 PG, it has a real opportunity to first execute at the midpoint on IEX (and getting executed at midpoint is a “price improvement” compared to the NBBO, it puts a bit of money in your pocket through better priced fills), and in the case where IEX does not have all the offsetting liquidity, the balance is sent out to the displayed exchanges. If there are 10,000 shares (or whatever balance that wasn’t filled at IEX) in those displayed exchanges (at the NBBO), you are likely to get 98% of it filled. This resolves the problems that a lot of traders have experienced: the market disappears on you when you are trying to work out a big order.

Eric Hunsader from Nanex recently did an exposé on this issue. It should be a required reading to anyone trading US equities in any significant size. In it he showed a chart of the ideal results while routing a big order, the results from a regular router and the results from the IEX router. The different in performance in remarkable:


The cost of using the IEX smart router is also not significant, just $0.0001 per share (about $1 for a 10,000 share order), plus the exchange fee/rebate incurred when orders are routed out to other exchanges (that you will pay or receive anyway). When the orders are matched at IEX, the cost is $0.0009. Its low when you consider that occasionally getting at least part of your order filled at midpoint will save you a significant amount ($0.005 for a 1 cent spread stock, the savings are more than five times the cost).

Currently (as of August of 2014) there are three retail brokerage houses that allow order routing to IEX. They are Interactive Brokers, Tradestation Securities and Lightspeed. Having an account for bigger orders at those brokerages can decrease your costs dramatically. It’s also important to ask your brokerage (in case it’s not one of the three) to enable IEX routing: the more clients demand it, the more they will feel forced to do it. As a result, traders and investors won’t have to rely on the inefficient and frequently biased smart routers the some brokers offer.

As it will be the case with a lot of advice in this site, try it out and see if your results improve.

-Fernando Oliveira