By Sam Barry, CEO, LittlefishFX
Why Dark Pools Matter for FX Traders
With the debate flying around on the subject of Dark Pools, why should I, as an FX trader care? Well, apart from it being an interesting subject for anyone involved in finance, dark pools aren’t actually too dissimilar to how FX brokers’ order books work.
Think of the concept: your orders go into a broker, which are then matched at the other end. You aren’t sure how it is matched or who your counter party is, and you don’t typically have line of sight to the order book in order to view what orders are coming in. Even if you did, how could you tell if it is transparent?
Potentially, in the equities world where there can be multiple prices across exchanges, this could lead to front running in the market if you could react quickly enough to a new order. In FX this is a lot harder to do, partly because the matching engines are based all over the world and not at a central exchange, but also due to the fine margins in FX.
Sam Barry
How Dark Pools Exploit Price Changes
So how do the dark pools systems exploit price changes? Firstly, it would look for a large order at a specific price, then shoot across to all the other exchanges and snap up all the orders at the price of the large order, then up the price by a tiny amount and sell it to the large order.
Interestingly though, if the large order was placed on the open market, all the smaller investors would remove their orders That is to say if I bought 100,000 units and there were only blocks of 1,000 to sell me, these would get removed until the point that my 100,000 is almost filled – thus driving my price higher.
This was partly the reason dark pools were set up, to essentially allow the 100,000 order to get filled with lots of smaller, cheaper orders without people discovering the large buy order.
Regulatory Challenges and Potential Solutions
What is the solution? The challenge is how to fix this situation without causing more harm than good.
Over recent years we have seen a lot of potential regulatory change, but a lot of it has been watered down given the complexity of the situation. This has resulted in very few substantial changes being made within the whole financial industry even though we are now six years on from the financial crisis.
So if nothing is going to happen, then why should we be worried?
Well, this time seems a little different. The challenge here is that the legal action being pursued across the world is putting more pressure on regulators and they are more likely to react hard – we have already heard ideas for centralised forex exchanges and randomised order books. In my view, this has the potential to cause a lot of trouble, not only logistically, but also politically and financially.
Problems with Complete Market Transparency
There are two main problems with jamming all of Forex, or Equities, or anything into one exchange – or even providing complete transparency to them. Firstly, it creates the problems we were trying to fix in the first place and secondly, it doesn’t actually build a level playing field.
Where am I going with this? Well, there are several points to note here.
- There is a reason why people are cagey about HFT and Dark Pools, and it’s not just because they seem shady. It’s because they are worried about what happens if you kill them off.
- This is a much bigger beast than just the equities market and whatever happens next is going to have a massive impact not just on markets but on companies, and global economies.
- The current system isn’t horrific, it’s just not ideal. But we can amend it to make it ideal and focusing on specific issues may be better than trying to overhaul a system which has evolved as quickly as it can to meet increasing demands
- Sometimes the better option is to provide choice and then let the market players and customers vote with their feet/money and accounts
My view is that we should focus on where this is heading and how we make that journey quicker and better.
The Future of FX Markets and Dark Pools
I think the future of many of these markets will see a merging of brokers and exchanges into global ones which compete for price and quality, .As technology advances, the limits to speed and cost will also be reduced.
The resultant offering will be differing levels of access on true dark pools or fully open order books. What we need to work on now is getting us there and helping people understand the full story.
Focusing on core components can make a larger impact in less time, and will motivate and incentivise people to build that new future state quicker.
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