Peter Levin’s Rethinking Markets

November 6, 2007

prices and baselines, part 2

Filed under: Prices, Technology — Peter @ 11:02 am

In an earlier attempt to think through pricing, I was trying to understand the importance of public, baseline prices from which traders, investors, potential buyers and sellers could determine commodity prices. This leads me to discussions of ‘dark pools’ of liquidity..

When an equity is traded, unlike a future which needs to be executed on an exchange, it can be traded in a number of ways. We normally think about things like NASDAQ or NYSE, stock exchanges where prices are registered, public, and printed (or online) in newspapers. When you read that the Dow, or NASDAQ is up or down, this is what we’re talking about.

Stocks can also be traded through a whole series of alternative trading systems (ATS), chief among them ECNs (electronic communication networks). Instinet and Archipelago are two of the larger ones - the former platform now owned by NASDAQ and the latter by the NYSE. In 2005 about 1/3 of the volume of NASDAQ stocks goes through these ECNs. BATS Trading has emerged over the last year or so as another alternative trading system, now conducting about 10% of NASDAQ stock trades.

But these are still pretty public. More interesting are the so-called ‘dark pools’ of liquidity, privately traded, often anonymous electronic crossing networks. These are things like Liquidnet, Pipeline, Posit, Sigma X. They anonymously match buyers and sellers, but they: a) do not display orders; and b) do not first publish quotes to a public market. The aim of dark pools is to allow large institutional orders to trade without overly affecting prices.

Dark pools are fascinating, sociologically. There were, and are, dark pools in public arenas - people trading 50 lots in futures, 10 times in a row, instead of trading 500 at once. But, significantly, dark pools require price discovery but do not contribute to it. And, dark pools encourage market fragmentation, since different orders trade in different places, with different prices. Currently, the big push is to find and get access to these dark pools (Goldman Sachs owns Sigma X; won’t they please let me in, and the like).

But the interesting question to think about is, what if individuals and small traders are providing the price discovery, and large institutions are feeding off that price discovery while not providing any liquidity or discovery of their own? In other works, there is a sense that dark pools are derivative of public, exchange-traded prices. I’ve not seen much at all on what this might mean.

In the late 19th century and early 20th century, the justification for futures exchanges was that their products were prices - they provided a national marketplace not for corn or wheat, but for centralization of prices and the transfer of risk.

I realize that equities are not futures. But still, dark pools are unravelling this long-held justification. They are an odd combination of over-the-counter negotiated agreements of exchange-traded instruments. I’m curious to see what happens when you remove the baselines from this equation - will trading quotes be individually-negotiated and largely theoretically-based? Or will they continue to look to published prices on ECNs or NYSE/NASDAQ?

3 Responses to “prices and baselines, part 2”

1. Yuval Says:
   January 18th, 2008 at 6:06 am

   Hi Peter,
   Happy New Year. Haven’t been at the ‘blogging scene’ in a while, but had a peak at your newly-designed blog and from a quick reading through things, it looks like it’s great stuff, as ever. This particular discussion, about ‘dark’ or ‘hidden’ liquidity is extremely interesting for quite a number of reasons. For example, (and I think that this is the 500 lb. gorilla in the middle of the living room that people tend to ignore), the institutional market-fragmentation that anonymous trading platforms remind us, once again, that underpinning the standardization as a condition for liquidity is a sheer political force: the ability to determine on whose exchange product X will be traded. Liquidity, in this sense, is a function of the ability to suppress competing trading platforms.
   Best,
   Yuval

2. Peter Says:
   January 18th, 2008 at 12:05 pm

   underpinning the standardization as a condition for liquidity is a sheer political force

   Hi Yuval! Yes, this was behind the early NYSE kicking out curb trading I think. I wonder, though, if the problem is something like the fetishism of liquidity itself. The notion that individual traders should theoretically have no effect on the market has far-reaching consequences, beyond just market manipulation, including the cognitive beliefs that markets are external to, rather than constitutive of, individual action. Large institutional (in the bank/pension fund/hedge fund sense) actors are making the gap between the theory of liquidity and its reality more vivid.

   The dark pools are a wholly untapped area to think about, from scholar point of view - clearly banks are working overtime to tap into and manage them.

3. Yuval Says:
   January 20th, 2008 at 3:29 pm

   “The notion that individual traders should theoretically have no effect on the market… ”
   Yes. This is a very funny notion. Of course, you spent enough time on a trading floor that traders don’t care that much for such ideas. In fact, they make their living by proving that they can change the market prices. However, when it comes to institutional systems (and especially techno-social ones), such ideas about liquidity are embedded into the infrastructure of the system. So, a clash of civilisations? You bet. The markets frequently ‘work against’ their traders. Again, a fairly common notion among traders.

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