Let There Be Light – Dark Pools Can Reveal A Lot and Impact Your Performance. Here’s How to See in the Dark.
All market participants want to know what the true liquidity is in the market. However, many cannot see dark and grey pools of liquidity – even though these pools are a substantial part of the price forming process.
Here are some easy (and affordable) ways to improve your view of liquidity…
First, it is important to understand that not all liquidity is created equal. Some pools of liquidity play a large role in the price forming process, while others not at all. When examining a pool of liquidity, you should consider its level of transparency, both pre- and post-trade. How much of its price information is readily available? For example, can you see the full level 3 depth of book quotes, or just the best bids & offers?
Also, you should determine whether the liquidity is addressable. That is, is the liquidity accessible to all market participants at the time of execution.
Let’s look at the various classifications of liquidity:
1. Lit Addressable – liquidity with transparency on a pre- and post-trade basis (e.g. stocks trading during the regular session on an exchange).
2. Dark/Grey Addressable – liquidity with full post-trade transparency but limited pre-trade transparency (e.g. dark pools, automated RFQ systems, large-in-scale pools, periodic auctions).
3. Bilateral Addressable – liquidity that is part of the price forming process but requires you to have a bilateral agreement with another party to get the information (e.g. Systematic Internalizer (SI) transactions, OTC trades).
4. Non-Addressable – liquidity that is NOT part of the price forming process (e.g. trades that are flagged as not price forming, out-of-hours OTC trades, swap unwinds, give-up/give-in trades).
Such classifications are very important when evaluating liquidity. For example, if you don’t have a bilateral trading agreement with Goldman Sachs, seeing their liquidity in a consolidated feed is not useful to you because it is not addressable to you. When calculating market metrics like VWAP, you probably don’t want to include liquidity that you can’t address yourself.
An Example of How to Use Dark/Grey Liquidity to Your Advantage.
DIH’s friends at BMLL Technologies recently observed that since the beginning of 2021, there has been a dramatic change in the way EU stocks trade in the United Kingdom versus how they trade on EU venues (see Exhibit 1). Dark pools in the United Kingdom saw a huge increase in volume, but the volume for EU-based dark pools remained unchanged – even though overall trading volumes on EU venues were significantly (145X) higher.
Why would EU stocks suddenly trade so differently in the United Kingdom than they do on EU venues?
One might think it is due to regulation changes in the United Kingdom. If you didn’t hear, late last year the Financial Conduct Authority (FCA) lowered the large-in-scale (LIS) thresholds that allow dark trading in transactions above a certain size in the UK to €15,000, significantly lower than the €650,000 threshold in the EU. This is part of the UK’s efforts to reclaim the roughly €6 billion of trading volumes that shifted from London to the EU post-Brexit.
However, the true answer lies deeper below the surface…
BMLL investigated further and examined the average spread for Lit venues during the same period (see Exhibit 2). Based on the stocks in the CAC-40 and DAX-30 traded on CHIX, CEUX, TRQX, TQEX, AQXE and AQEU, they examined the change in market fragmentation across Lit, Dark, Bilateral, and Non-Addressable venues. Again, it is worth noting that during the period in question, EU Dark venues traded 145x more volume than the corresponding UK venues for the same securities.
It appears that the volume shift to the UK Dark venues coincided with widening spreads on Lit venues, in particular, January to mid-March this year. Since spreads have settled down on Lit venues, the fraction moving to the Dark has also stabilized.
The trading landscape continues to evolve, whether it be driven by concerns over COVID or changes in regulations. You as a market participant can more quickly identify such changes by examining what is happening in the various classifications of liquidity (Lit, Bilateral, and Dark/Grey). This is especially true when underlying conditions are changing below the order book surface. Using the most granular level 3 data you can better understand the current state of liquidity and improve your performance accordingly.
What about you? Are you considering the various classifications of liquidity during your analysis? I’d love to hear your thoughts.
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Tom Myers is the founder of Data In Harmony (DIH), who offers complete & accurate financial data that is globally sourced, reliably delivered under user-friendly license terms, and for a price that fits your budget. DIH also provides a wide variety of alternative data, as well as data engineering tools.