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01:43 PM
Dan Mathisson, Credit Suisse
Dan Mathisson, Credit Suisse
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Hidden Orders and Dark pools Are Taking Order Secrecy on Wall Street to a New Level

The continued growth of electronic trading may mean a decrease in the hidden costs of actively traded funds.

There is a strange phenomenon occurring in the U.S. stock markets: No one knows what's going on anymore, and the markets are better for it.

Traditionally, professional trading largely has been a game of sniffing out the supply and demand in a particular stock to determine if the price is likely to go up or down in the short term. The game involved talking to other players in the markets, getting "looks" from the floor of the NYSE, and intently watching the publicly displayed bids and offers. Similar to expert poker players sitting at a table with novices, short-term traders who could read the signals and detect the presence of buy or sell orders were able to consistently collect a toll from the institutional investors.

Partly as a result of all the order information available to the Street, there has always been a consistent, measurable loss from the price when a money manager starts to buy a stock versus the average price at which it eventually is bought. This loss is known in industry parlance as "slippage," "market impact" or the fancier "implementation shortfall," and historically it has been a major hidden cost for actively traded funds.

Look on the Bright Side
But the good news is that with the continued growth of electronic trading, signals are drying up and, as a result, slippage will likely decrease. Money managers now routinely send large orders directly into walled-off computer servers that use advanced execution algorithms to slice orders into tiny pieces, which then blend in with the regular order flow. Sophisticated institutional brokers increasingly work orders for their clients using electronic venues that silently match orders with no chance for information to leak out.

And now, "hidden orders" and "dark pools" are taking order secrecy on Wall Street to a new level. Hidden orders are the name on the Street for electronic orders that do not display on any quote feed. Enter a standard displayed order to sell 5,000 shares on the NYSE at 25.75 and the entire market sees it within seconds, often resulting in a short-term trader stepping a penny ahead of it and offering to sell the stock at 25.74. Enter the same order on NYSE Arca as a hidden order and nothing gets displayed to the world. The order sits in the dark, having transmitted no information to competitors, quietly waiting for a match against another silent electronic buy order.

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