Hidden Orders and Dark pools Are Taking Order Secrecy on Wall Street to a New Level

It's a Different World
Trading in the old days was trench warfare - you would try to hide your order. But to actually trade, you still needed to have the guts to eventually pop your head out of the trench and publicly expose your order to the markets. Trading today has become more like submarine warfare in a Tom Clancy novel - huge orders lurk beneath the surface, waiting for their opposing target to reveal itself, unseen and unknown to the short-term traders trolling the surface.

The result of all of this secrecy is that no one really knows what's going on in a stock anymore. Ironically, this state of confusion is likely to reduce transaction costs throughout the Street.

When an employee pension fund begins buying Hormel Foods through a signal-reducing algorithm, the stock doesn't begin shooting up because no traders are getting "the call" anymore. When a mutual fund sells U.S. Steel through dark pools, the investors don't pay a toll to a floor broker that repeatedly steps a penny in front of the mutual fund's order. The new confidential electronic order types do not feed the experienced insiders, and, as a result, the playing field has become more level than ever before.

Despite their benefits in reducing slippage, stand-alone dark pools have been controversial primarily because access to them is not universal. There is a fear that the owners of prominent dark pools will be capricious in deciding who can have access to their liquidity, and, indeed, we have seen some of this behavior in the marketplace. But this is not a long-term problem - with the recent introduction of hidden order types on the major exchanges and ECNs, stand-alone dark pools likely will shrink in volume. Most exchanges and ECNs now offer essentially the same "dark" product as dark pools, but with much greater liquidity and lower fees.

The second point of controversy regarding dark orders is that they damage "price discovery." But when traders have access to hidden orders, much larger aggregate size tends to build up in limit orders near the last price. In the traditional displayed world, there is a huge signaling disincentive to leaving limit orders on the book, which is why we see markets that are 200 shares by 400 shares, even in stocks that trade millions of shares per day. What good is discovering the price of 200 shares at a time?

When traders post to dark books instead, they tend to put out much larger sizes, since no one will see their order or be able to penny it. So the market may appear to be .32 by .38, 300 up, but it's really .35 by .36, 100,000 up. Dark markets fluctuate less around the last price, with greater liquidity for all players, making meaningful price discovery easier rather than harder. This current proliferation of confidential electronic orders may be confusing to yesterday's insiders on the Street, but that's precisely the goal, and the markets are better for it.

Dan Mathisson is Managing Director and Head of Advanced Execution Services at Credit Suisse in New York.

2 of 2