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World Federation of Exchanges Annual Meeting,
Vancouver October 5-7, 2009
Dark Pools and Fragmented Markets
Bob Schwartz Zicklin School of Business Baruch
College, CUNY
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Plenty To Think About

• Dark Pools, Dark Orders, and IOIs
• Internalization
• Smart Order Routers and Databasing
• Private Markets
• Sub-micro second precision
• Co-location
• Trade through trade at rules

To name a few
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What a Title!
Dark Pools

and
Fragmented Markets

Lets start with the dark pools
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Dark Pools in The Past

• Dealer markets
• The NYSEs trading floor
• Plus ça change, plus cest la meme chose

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Dark PoolsSome Good Things Can Be Said

• Large orders require opacity
• Any order that has been sent to a trading venue
  has been revealed
• Can facilitate price discovery
• Post trade transparency
• Non-disruptive pricing

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A Problem With Dark Pools
sss
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We Are All in Favor of
Competition(but there is a tradeoff)

• Competition in the market-for-markets

• Competition within the order flow

One of these has received insufficient attention
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Competition Within the Order Flow

• Strict Price Time priority
• Two-sided markets
• The production of two public goods
• Liquidity creation
• Price discovery

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Price Discovery
The Multiple Purposes to Which Price is Put

• Marking-to-market
• Derivative pricing
• Mutual funds cash flow

• Estate valuations
• Dark pool pricing
• Etc.

An Exchange Produced Price is a Public Good
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Can Pre-Trade Connectivity and Smart Order
Routing Do It?
I Do Not Think So

• Cost
• Time priorities
• Proper integration of market information

Post-trade connectivity in a competitive dealer
market
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Temporal Fragmentation(Order Flow Fracturing)

• Slicing and dicing of orders
• Sub-milliseconds matter

06 Indianapolis 500 After 500 miles
What is accomplished by being able to distinguish
the sequence of order arrivals when only a
millisecond separates them?
Statistically Significant? Economically important?
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Two Papers, One Thought
Market Sidedness Insights into Motives for
Trade Initiation, Sarkar Schwartz Journal of
Finance, 2009
Liquidity Begets Liquidity Implications for a
Dark Pool Environment, Sarkar, Schwartz
Klagge, Institutional Investors Guide to Global
Liquidity, Winter 2009
Liquidity does not just happen, it does not
simply appear. Liquidity is generated in a
dynamic environment that may be thought of as an
ecology Diversity is required for markets to be
two-sided, and it is the two-sidedness of
markets that underlies liquidity creation.
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Definition of Two-Sided

• In the same, brief interval of time, some
  participants are actively looking to buy shares
  while others are actively looking to sell shares
• In short time intervals, the arrivals of
  buyer-initiated and seller-initiated trades are
  positively correlated

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Good News

• Markets are generally two-sided
• Nasdaq and NYSE stocks
• Market openings, mid-day and closings
• Large and small orders
• For individual stocks and all stocks in aggregate

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CorrelationsEarnings Report Events

• Correlation generally greater for
• Before Large vs small dispersion
• After Large vs small surprise

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Correlations 830 am Macro Announcement Events

• Correlation greater for
• Before Large vs small dispersion
• After Large vs small surprise

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Correlations Corporate Restructuring News Events
Correlation greater After vs before
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Dont Undermine Natural 2-Sidedness
Fagmenting one large pool into multiple
smaller pools can undercut the natural
two-sidedness. One small pool, by chance, may
receive orders predominantly from sellers, while
another small pool, also by chance, is receiving
orders predominantly from buyers. Together, the
pools would be two-sided separately, they are
not. This is a law of large numbers result
flip a fair coin many times and the proportions
of heads will be very close to 0.5 flip it just
a few times and either heads or tails may, by
chance, predominate. Sarkar, Schwartz and Klagge
(2009)
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Key Findings on ½ Hour Volatility
Ozenbas, Pagano Schwartz, Accentuated
Intra-Day Stock Price Volatility What is the
Cause? Journal of Portfolio Management, Spring
2010, forthcoming

• Accentuated Volatility at NYSE, Nasdaq, LSE is
• Greater at open close relative to mid-day
• Greater at the open than close
• At the open is greater for big caps than small
  caps
• At the close is not related to cap size

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Elevated Levels of Volatility in the Opening and
Closing Minutes
From Pagano, Peng and Schwartz, working paper
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10-Second Volatility Nasdaqs Opening/Closing
Crosses Feb 2004 And Feb 2005
40 bps Feb 2005 (Post-Calls)
40 bps Feb 2004 (Pre-Calls)
5 Min After Opening
5 Min Before Close
5 Min Before Close
5 Min After Opening
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Two Conclusions from Volatility Studies
All fingers point to Price Discovery
Market Structure Matters
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The Big Picture

• A securities market is a complex ecology
• Competition within the order flow is highly
  important
• Order flow attracts order flow
• But there is also free riding
• Today, our markets are inordinately fragmented

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Lawrence LeibowitzTraders Magazine, August 2009
Our market structure has gone astray. Over the
past 15 years the order-handling rules,
decimalization and Reg NMS were all designed to
increase transparency, level the playing field
and encourage limit-order display. We now live
in a completely fragmented market, with 50 or so
dark pools, 10 or so exchanges and liquidity
displayed to privileged participants.
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My Thought
This is not a pretty picture It is time that we
allow our markets to reconsolidate
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One Last Comment