From Flash Orders to Dark Pools

Much has been written lately around two controversial trading approaches known as flash orders and dark pools. For the uninitiated, the recent focus on these practices may lead one to believe they only recently arrived on the scene, but in fact, they have been in use for several years. Both concepts rely heavily on the use of sophisticated computer systems and dedicated software and for this reason, are often lumped into the larger category of High Frequency Trading (HFT). On the surface, this may be an accurate categorization, but whereas HFT seeks to use computers and technology to send many trades to the market to take advantage of miniscule price changes, flash orders and dark pools use technology – and a little help from certain exchanges – to try to take advantage of other market participants.

How Flash Orders Damage Market Integrity

Flash orders hit the airwaves again in early August when Senator Charles Schumer pronounced they were unfair and were a threat that “seriously compromises the integrity of our markets and creates a two-tiered system where a privileged group of insiders receives preferential treatment, depriving others of a fair price for their transactions.”

So adamant was Schumer, that he basically threatened Securities and Exchange Commission (SEC) officials to either outlaw the practice willingly, or he would introduce legislation himself to mandate the change. Within days, word came from SEC head Mary Shapiro that the SEC would see that flash orders were banned from all U.S. exchanges.

Flash orders were first developed by Direct Edge, a financial electronic communication network (ECN) providing an electronic exchange for equity trading. In order to take order flow from older, more established exchanges, Direct Edge pioneered the concept of the flash order which provides a “sneak peak” at prices ahead of the general market. It works like this.

Smaller exchanges are forced to pass parts of large orders to the major exchanges including the New York Stock Exchange and Nasdaq if they cannot fill them with their own market participants. Naturally, they lose much of the revenue the trade would generate, so in order to encourage greater participation within their own exchange, orders are flashed to the ECN’s biggest customers for up to half a second before the order is released to the market.

Armed with an advanced look at the market price, and by using computers to quickly look at the total depth of the market for the security across all exchanges together with all outstanding orders, these automated systems can quickly determine if there is a profit opportunity by entering into a trade – even if they take a position for only a fraction of a second. For instance, if the price for a particular stock is increasing, and the preferred customer receiving the early look sees that the availability is limited yet demand is relatively high, the broker’s automated trading system will buy up the stock ahead of the rest of the market. The system can then turn around and sell the stock back at a profit and while the difference may not be that great, the volumes involved ensure significant profits.

Proponents of flash orders argue that flashing orders makes it more likely that a transaction will be completed, thus ensuring sufficient liquidity for the stock, but this is at best, a weak defense. The reality is that flash orders give preferred customers a chance to – at the very least – influence prices in their favor. At worst, it actually leads to outright price manipulation. Either way, flash orders make a mockery out of the notion that all market participants are equal.

Using Dark Pools to Hide Market Activity

Not to be outdone by Schumer, Senator Edward Kaufman has set his sights on “dark pools”. On the surface, dark pools are not as sinister perhaps as flash orders but ultimately, their purpose is to deceive the market with respect to the positions being traded. Perhaps “deceive” is a bit harsh – let’s say they are used to hide the size of positions being traded in an attempt to reduce price volatility.

Yes, I can hear you saying that this sounds like a simple iceberg order where large trades are broken into smaller orders. This is a well-used tactic designed to obscure the actions of a single broker, and is so common-place that most trading platforms can be configured to “slice” large orders into a series of smaller orders automatically. Each slice is then submitted as an individual order to camouflage the fact that all these orders are coming from one source. This practice is often defended using the logic that if a broker were to submit one massive sell order for example, the price would be pushed downwards, and because it is usually hedge funds or mutual funds dealing in this size of order, individual investors could suffer.

There is merit to that argument, but dark pools have an important distinction from iceberg orders. Dark pools – like flash orders – incorporate “early looks” for dark pool participants providing advance knowledge not only with respect to bid and offer prices, but also the total size of the order and not just each individual slice. This information is not available to the general market, thus calling into question the idea of true transparency of the market.

As testament to how effective dark pools can be, one of the largest dark pools in operation is known as “Sigma X”. It is managed by Goldman Sachs and is thought to be largely responsible for Goldman Sachs’s tremendously profitable trading program earlier this year.

This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.