The Titanic Battle between “Icebergs” and “Dark Pools”

(The use of Complex Event Processing in Algorithmic Trading)

Trading 101 – It’s the balance of sentiment between buyers and sellers that determines the price (of an instrument) in a market. More buyers, the market goes up, more sellers the market goes down. New market events will determine a new balance point (price) in the market. The market will always trend to a price that brings these opposing views back into balance.

So in order to achieve a true market (market transparency) everything that can be known about buyer and seller sentiment needs to be known. Indeed this concept of market transparency is the basis upon which exchanges have built their businesses over the past decades and have grown to dominate trading in global markets.

No problem with small orders that have little or no impact on market sentiment, but how do you execute large orders without adversely affecting the market. If you put the complete order in the market and “show your hand” the market could, and probably will, move against you.

One way is to execute an “Iceberg” trade (also known as Guerrilla, Sniper, Sniffer etc), where only a small percentage of the trade is ever shown to the market (the tip of the Iceberg). Once this has been executed, hopefully with minimal price impact, you can then release the next piece of the iceberg in to the market and so on. This process may take various “shapes” or models such as a Volume Profile, Lead (Aggressive), Lag (Conditioning) etc or any other model that your tick data analysis has shown to be effective. The end result - you succeed in trading the large order in the market at the best price (to you).

Another way is to participate in the much less visible “Dark Pools” of liquidity. These non-visible pools are trading venues outside of the traditional Trading Exchanges that provide liquidity that is not displayed on order books. Shares can be traded at a price on or better than the visible markets with minimal impact. This is useful for traders who wish to move large numbers of shares without revealing themselves to the open market. Significant order flows are executed through these venues and it is predicted that, under the new regulations (RegNMS and MiFID), significant amounts of the flow currently internalised by the top tier institutions will participate in this rapidly growing sector of the market.

So why not send all of your large orders to these dark pools of liquidity where they can be traded with minimal impact instead of having to execute them in the open market and run the real risk of the price moving against you?

Indeed significant levels of trading are done this way. However if the vast majority of large orders went exclusively to these dark pools then the overall sentiment of the market would become fragmented. The visible end of the market would cease to represent the overall market and would become biased towards small order sentiment with the dark pools being biased towards large order sentiment.

"So what?" – you might ask. Well the problem is that the dark pools get their reference prices from the visible market. Without the visible market having a true balance of market sentiment, prices would become much less transparent and there would be an increased risk of significant price volatility. All of which would impact the attractiveness of these dark pools. Markets would become more chaotic which, at the very least would result in the regulators insisting that these Dark Pools participate more fully in the open market (already under way as part of RegNMS and MiFID) and at worst, the whole rational behind these dark pools would be undermined.

So the more the icebergs play in these dark pools the more dangerous it becomes for the trading community as true transparency disappears and even the most robust trading strategies runs aground in an increasingly volatile market – truly a Titanic battle (all puns intended!!).  Traders need to manage their complex strategies in the visible markets, whilst taking advantage, where appropriate, of appropriate liquidity in the non-visible markets; balancing “iceberging” and “deep pool trawling” to provide their clients with the best possible outcome.

And this complex interplay of trading techniques all needs to be done in real time to ensure the most effective result. Traders need to access all of the relevant pools of liquidity all the time, they need to be able to respond quickly to changing market conditions and they need to be able to handle an increasing deluge of market data from an increasingly fragmented market.

These increasingly complex events need to be managed by a robust, enterprise-class, Complex Event Processing (CEP) Platform that can handle the high volumes and low latency of this rapidly developing sector of the capital markets.

Such a platform will enable you to access all of the relevant pools of liquidity and by consolidating the visible liquidity from these venues in to a single order book you will then be able to gain a much better picture of the depth of the market. Being able to probe the liquidity in each of the venues in the various market segments in real time and monitor how they each respond to your preliminary orders in terms of latency, orderbook reload times and speed of fills will enable you to gain a much better understanding of the true liquidity in the market. 

However, other players in the market may also be using similar trading techniques and may, in the future, be able to spot the “game-play” of other participants. Execution Management Systems (EMS), whilst able to cope well with current trading styles, will find it very difficult to adjust their trading strategies in real time to changing market conditions. CEP technology, on the other hand, offers the real promise of providing traders with the tools and techniques to develop intelligent solutions that can respond in real time to changing market events and help keep them ahead in the inevitable “arms race” that will come to dominate the world of trading.