Dark matters
11 November 2015
Turquoise’s Robert Barnes suggests that the answer to more efficient trading functions in Europe could lie in the differences between light and dark
Image: Shutterstock
Trading of stocks can take place on either an exchange or via multilateral trading facility (MTF). While the exchange remains the listing venue for corporates, trading can happen on either venue. Turquoise is an MTF, a trading platform majority-owned by London Stock Exchange Group, in partnership with users. It allows the trading of thousands of equities and exchange-traded funds (ETF) from 19 European countries, through a single connection.
The system differs from London Stock Exchange and Borsa Italiana; each of these operates a primary market, on which companies can list securities, and a secondary market, on which investors can trade these securities via respective UK and Italian lit order books. Turquoise, however, is designed for trading a wider European stock universe—including UK and Italian stocks—offering a choice of ‘lit’ or ‘dark’ order books.
While many people understand the concept of ‘lit’ order books, which show the price and size of orders available to trade, an increasing number of investors are now discovering how to access order books using complementary trading mechanisms called ‘dark pools’. The term refers to an electronic order book where the price and size of an order is not displayed to the market before the trade. After a match, however, the trade is reported to the public domain.
Order book prices offer a good proxy for prices of shares listed on European exchanges, and if post-trade data offers dark as well as lit real-time prices, the result is a more accurate portrayal of the market. In an automated world, post-trade transparency enhances pre-trade transparency for the next trade.
Consider the analogy of buying a house. The real estate agent might provide a ‘pre-trade’ price, but it also helps to know the actual price of the house next door ‘post-trade’ before making an offer to buy or sell the house.
Dark pools complement lit order books as an extra knob on the dial that helps investors to get their business done; dark pools match approximately 10 percent of all order book trading of UK and European shares. While lit order books conform to an agreed regime on tick sizes—the increments by which prices rise and fall—dark pools can match at midpoint. This means a participant can place orders inside the tick and midway between the best bid and best offer price available on the primary exchange.
Investors that use dark pools could therefore benefit from potential price improvement, meaning better investment performance. Like any tool, however, it is important to understand how each works.
Modern equity investor trends include global passive indexation and the desire to outperform benchmarks by trading block liquidity, increasingly in mid and small caps, diversified by geography. The bigger prize of block trading is to match size at a price, while avoiding market impact. As buy-side dealers often explain, there are a number of channels through which they may direct an order.
Channel one might be the high-touch sales trader, channel two might be the algorithmic smart order router, slicing up and dicing small sizes into multiple order books. But there is a new channel appearing, the anonymous order book mechanism that can rest larger orders until finding another side to match in block size, without informing the market until after the trade.
There is a call for innovation. While the Turquoise Lit order book is a market for price, the Turquoise Midpoint dark order book is a market with a priority of size, and specialist functions.
Turquoise Uncross allows buyers and sellers to rest anonymously with potential to match at a time determined by randomised functions. The key feature here, in addition to size priority, is the randomised function. Having a series of auction uncrossings with a randomised feature means the likelihood of matching at a fair price is higher.
LiquidMetrix, the independent analytics firm that specialises in venue performance metrics, repeatedly reviewed transaction data of European dark pools, and confirmed that participants could benefit from placing larger orders in a function like this for longer, and many firms are opting for this functionality.
The order book mechanism mitigates the natural electronic trend of shrinking trade size. If the average trade size within midpoint trading is approximately €10,000 per trade, the average size for trades matched in an order book mechanism like Turquoise Uncross would likely be double that at €20,000.
Turquoise’s Block Discovery function facilitates larger block orders by matching undisclosed block indications and interacting with existing liquidity in the Turquoise Uncross mechanism.
The result is a working order book mechanism that serves investors wishing to trade larger blocks in blue chips or mid- and small-cap stocks, plus the operational benefits of straight-through processing associated with traditional order book trades.
When facilitated in this way, it is estimated that the average trade size could be even higher, reaching €200,000, or 20 times the average midpoint trade size.
There are also several single trade examples that exceed €1 million, and many are above the European Securities and Market Authority’s large-in-scale threshold. However, Turquoise is also ready to fulfil the needs of long-term investors, and Turquoise Uncross and Turquoise Block Discovery are just the beginning.
The system differs from London Stock Exchange and Borsa Italiana; each of these operates a primary market, on which companies can list securities, and a secondary market, on which investors can trade these securities via respective UK and Italian lit order books. Turquoise, however, is designed for trading a wider European stock universe—including UK and Italian stocks—offering a choice of ‘lit’ or ‘dark’ order books.
While many people understand the concept of ‘lit’ order books, which show the price and size of orders available to trade, an increasing number of investors are now discovering how to access order books using complementary trading mechanisms called ‘dark pools’. The term refers to an electronic order book where the price and size of an order is not displayed to the market before the trade. After a match, however, the trade is reported to the public domain.
Order book prices offer a good proxy for prices of shares listed on European exchanges, and if post-trade data offers dark as well as lit real-time prices, the result is a more accurate portrayal of the market. In an automated world, post-trade transparency enhances pre-trade transparency for the next trade.
Consider the analogy of buying a house. The real estate agent might provide a ‘pre-trade’ price, but it also helps to know the actual price of the house next door ‘post-trade’ before making an offer to buy or sell the house.
Dark pools complement lit order books as an extra knob on the dial that helps investors to get their business done; dark pools match approximately 10 percent of all order book trading of UK and European shares. While lit order books conform to an agreed regime on tick sizes—the increments by which prices rise and fall—dark pools can match at midpoint. This means a participant can place orders inside the tick and midway between the best bid and best offer price available on the primary exchange.
Investors that use dark pools could therefore benefit from potential price improvement, meaning better investment performance. Like any tool, however, it is important to understand how each works.
Modern equity investor trends include global passive indexation and the desire to outperform benchmarks by trading block liquidity, increasingly in mid and small caps, diversified by geography. The bigger prize of block trading is to match size at a price, while avoiding market impact. As buy-side dealers often explain, there are a number of channels through which they may direct an order.
Channel one might be the high-touch sales trader, channel two might be the algorithmic smart order router, slicing up and dicing small sizes into multiple order books. But there is a new channel appearing, the anonymous order book mechanism that can rest larger orders until finding another side to match in block size, without informing the market until after the trade.
There is a call for innovation. While the Turquoise Lit order book is a market for price, the Turquoise Midpoint dark order book is a market with a priority of size, and specialist functions.
Turquoise Uncross allows buyers and sellers to rest anonymously with potential to match at a time determined by randomised functions. The key feature here, in addition to size priority, is the randomised function. Having a series of auction uncrossings with a randomised feature means the likelihood of matching at a fair price is higher.
LiquidMetrix, the independent analytics firm that specialises in venue performance metrics, repeatedly reviewed transaction data of European dark pools, and confirmed that participants could benefit from placing larger orders in a function like this for longer, and many firms are opting for this functionality.
The order book mechanism mitigates the natural electronic trend of shrinking trade size. If the average trade size within midpoint trading is approximately €10,000 per trade, the average size for trades matched in an order book mechanism like Turquoise Uncross would likely be double that at €20,000.
Turquoise’s Block Discovery function facilitates larger block orders by matching undisclosed block indications and interacting with existing liquidity in the Turquoise Uncross mechanism.
The result is a working order book mechanism that serves investors wishing to trade larger blocks in blue chips or mid- and small-cap stocks, plus the operational benefits of straight-through processing associated with traditional order book trades.
When facilitated in this way, it is estimated that the average trade size could be even higher, reaching €200,000, or 20 times the average midpoint trade size.
There are also several single trade examples that exceed €1 million, and many are above the European Securities and Market Authority’s large-in-scale threshold. However, Turquoise is also ready to fulfil the needs of long-term investors, and Turquoise Uncross and Turquoise Block Discovery are just the beginning.
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