According to Putnins and Comerton-Forde (2012), regulators and stock exchanges around the world have expressed concerns that growth in the share of equities volume executed in venues with little or no pre-trade transparency, so called ‘dark pools’, may harm market quality. Orders are hidden primarily in an attempt to reduce information leakage as well as price movements and order flows caused by substantial changes in a stock’s supply (market impact). Although off-exchange trading and internalization of order flow by brokers has been occurring for decades, recent years have seen a large number of organized dark trading venues emerge around the world and acquire a considerable share of trading volume (Putnins and Comerton Forde, 2012).
This evolution to dark trading, Bloomfield, O’Hara and Saar assert, has gained momentum in recent years driven by competitive pressures from new exchanges and trading platforms, resulting in an overall increase in fragmentation. Degryse, Jong and Kervel (2011) distinguish between two types of fragmentation: That between visible order books (aptly designated ‘visible fragmentation’ by the authors) and that between visible order books and those with no pre-trade transparency. They find that the effect of fragmentation on liquidity (measured by depth levels), a key component of market quality, is negative, but only for the fragmentation between visible and dark order books. Specifically, they find that an increase in dark trading of one standard deviation lowers liquidity by 9%.
If orders are hidden to prevent information leakage, then dark pool liquidity may be predictive of future price moves. Therefore knowledge of dark pool liquidity is valuable. An interesting aspect behind hidden orders is that they can be placed inside of the bid-ask spread (aggressive orders are orders that are placed within the spread) without affecting visible best ask and bid quotes. This mechanism creates enormous order activities in markets as market participants try to “ping” for hidden liquidity inside of the spread. Essentially, traders attempt to “light up” the dark pool by placing small orders in the pool for information gathering purposes.
An interesting aspect behind hidden orders is that they can be placed inside of the bid-ask spread (aggressive orders are orders that are placed within the spread) without affecting visible best ask and bid quotes. This mechanism creates enormous order activities in markets as market participants try to “ping” for hidden liquidity inside of the spread. Some market participants, particularly high frequency algorithms actively “ping” venues to determine whether or not there is hidden liquidity. Multiple small probing orders can be sent to a venue (dark pool), and if executed, convey information back to the participant that sent the ping order that there was hidden liquidity at that venue. The information can then be used to game the hidden order by trading ahead of the order in anticipation that the order will continue to be worked and will later switch to more aggressive orders that incur market impact to ensure completion. It is also possible for a participant that has discerned the presence of hidden liquidity to game that liquidity directly by either 1) trading in a manner that causes the NBBO to change in the trader’s favour (quote manipulation) or 2) by passively waiting for a favourable quote move and then selectively executing.
An analysis of the effects of pinging is important for regulators and investors alike. For the former, the question of whether strategies that involve pinging are manipulating the market is important in terms of market integrity. For the latter, importance is derived from an analysis of whether liquidity detection strategies (i.e. pinging) degrade execution quality. The two questions are, however, inextricably linked. If manipulation is detected then, by...