End Game: Anti-Gaming Technology in Dark Pools Tops Buy-Side Agenda

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.

Jeff Albright,
Waddell & Reed

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</a>. 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.

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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