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"Dark Pools": An Exciting Thriller That Will Teach You About Trading


Scott Patterson has written a book that's not only a great summer beach read, but a useful trading manual for winter study as well.

MINYANVILLE ORIGINAL Scott Patterson's new Dark Pools: High-Speed Traders, A.I. Bandits, and the Threat to the Global Financial System does to the back office what Michael Lewis' The Big Short did to subprime CDOs. It puts you in the room with high-frequency traders, conveying the excitement of that business, then follows the execution trail through the complex and murky system of exchanges. Along the way you meet all the players and the institutions that employ, regulate, or fight that system. It gives you a pretty fair education in how modern markets work, including a history of the democratization and fragmentation of equity execution. And it packages it in a thriller worthy of Michael Crichton.

You should care about this book, but not for the obvious reason. There is small reason for most traders to notice the nuts and bolts of execution-quality, cost, and speed (generally in that order) are what matter. If you buy a beach towel at Wal-Mart (WMT), you don't need to know how the company's inventory management system works, nor how many distributors, wholesalers, and other intermediaries bought and sold the towel between the manufacturer and you. If someone told you that 50% (or 80% or any other number) of beach towel transactions were between intermediaries you would have no opinion about whether that number should be higher or lower. If you trade enough to care how things work, you need boring professional accounts, not any popular account, even one as accurate as this one.

This book matters because trade execution is too important to the economy to be left to insiders and regulators. We need broad public education on the subject. Trading execution affects both the efficiency and fairness of capital markets, which means it affects the efficiency and fairness of the economy. But it's a complicated issue that is ill-suited to partisan sound bites (not that there are a lot of issues well served by partisan sound bites).

Suppose you were in charge of organizing the global stock market. You'd probably start by having anyone who wanted to trade send orders to your computer system. The system would match up the orders so that if I sent in a limit order to buy 100 shares of Microsoft (MSFT) at up to $30.05 per share and someone else sent in a limit order to sell 100 shares of Microsoft at $29.95 or more, and there were no other orders for Microsoft, your system would let me buy the 100 shares at $30.00 (in exchange speak, the system would cross the orders at the mid).

Now there's the question of whether you would make the orders public, that is, whether to run a "light" or a "dark" pool. If you choose light, it would provide useful information for people thinking of buying or selling the stock, and also to third parties interested in the economy. But it would also cause people to think twice about sending the orders in for fear they would give information to others that could be used against them. If I send in my limit buy order at $30.05, no one is going to send in a limit sell order at $29.95; they'll hit my bid and I'll pay $30.05 instead of $30.00 for the shares.

Exposing all orders also can make it profitable to send in misleading orders. I might put in a limit order to sell one million shares at $30.10, knowing it will not be executed, but it might spook people into offering shares for sale at lower prices, as well as chase potential buyers away from the stock. As soon as I buy my hundred shares, I cancel my million share order.

Thinking about questions like this, you'll probably decide on a compromise. Maybe you'll publish the best bid and offer, but not the size available at those prices. Maybe you'll publish the size as well, but not the orders behind those or the identities of the traders making bids and offers. Or maybe you'll set rules to discipline traders who play games like making and canceling large orders that are unlikely to be executed.

This illustrates two points. First, exchange design is not simple. It's not that light pools are good and dark pools are bad; there are pros and cons to each. Second, any exchange design is a game. You have to set rules that lead to a good outcome assuming everyone extracts every advantage possible. This leads to complicated rules that do not have immediately obvious purpose. Think about offsides in soccer, lane violations in basketball, the infield fly rule in baseball, icing in hockey-every major sport has a thick rule book to make sure play follows the simple patterns everyone understands and wants. You only have to know a few major principles to enjoy the game, but you need to know a lot of technical minutiae to officiate one.

Scott Patterson's book doesn't actually discuss dark pools much; he concentrates on other choices. Do you want to have one exchange or many? A single exchange is the fairest in the sense that everyone has a chance at the same liquidity. But it may strike some investors as unfair. For example, institutional investors who want to trade large blocks may not be happy exposing their order so that a few retail investors can take 100 share pieces of it. They might want an exchange limited to other institutions.

Do you want to pay traders for liquidity? The New York Stock Exchange (NYX) pays specialists in the form of order book information (the exchange is a lighter pool to specialists than to everyone else) in exchange for market-making obligations. Many pools charge a lower commission to a trader who puts a limit order on the exchange, and a higher commission to a trader who hits that bid or lifts that offer. The logic is the limit order adds liquidity to the market. Without it, traders on both sides will wait for someone else to put in an order. If I want to buy at up to $30.05 and you want to sell at $29.95 or more, if I place my order first you'll hit at $30.05 and I'll pay $0.10 more than if you place your order first. If the order placer gets a $0.05 commission rebate and the other party pays $0.05 extra, then it doesn't matter who places the order. Instead of waiting around for others to act, people send in orders and trading gets done.

There are dozens of other details about organizing an exchange. No decisions about them are fair or unfair considered in isolation; you have to ask what kind of game the overall design creates. Does it give fast, cheap, fair execution to everyone, and also throw off lots of useful information (and no misleading information), and is it always stable? I can tell you right now, the answer will never be "yes" for all these questions in everyone's eyes. The best you can hope for is a pretty good compromise that is acceptable or better for everyone.

Dark Pools takes us on an exciting tour through the more than 70 venues that choose different combinations of rules. It may not seem possible that these nuances are exciting, but a dull rule book can generate exciting action on the field. We meet all kinds of people competing to make money, or to design exchanges to offer investors better options. A lot of them think someone else is doing something unfair, but you won't find many games without that kind of controversy. None of them makes a compelling case for any specific rule change, but you do get the idea that no one has yet found the best balance among competing considerations. The race is still on.

Scott Patterson has done the world a service by making it fun to learn about the plumbing of the financial system. At the least, you'll come away with the idea that this is both important and complicated. You may do a bit better and hit on a high-frequency trading algorithm that mints money, or an exchange design that grabs a healthy market share. You'll meet some interesting people doing some interesting things. This is one of those rare books that is a great summer beach read and a useful trading manual for winter study.
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