My first baby steps to understand dark pools and high frequency trading

I’m blogging to learn. Writing means you need to understand, which means you need to read and think, which means you learn and then you can write.

One item on a really long list of things I don’t get is dark pools and high-speed trading. I understand the basic concept, but know there is a lot I’m missing. If you don’t get it either, join me for a few steps in the journey to get a clue.

Here’s an article that tells me there is a problem:

1/15 – Wall Street Journal – UBS to Pay $14.5 Million in S.E.C. Settlement Over Dark Pool – SEC fined UBS $12M and forced a disgorgement of $2.5M of profits. Issues are obscure but forking over fifteen million bucks for hosting traders is tipoff of bad behavior.

Here are a few pieces of information that register in my little brain.  First, this is ‘dark pool’ trading so it is off the radar screen of regulation and much disclosure. Second, traders were allowed to price deals in fractions of a cent instead of whole cents like the rest of the investment world. Third, this fractional pricing is a super big deal for rapid fire traders that execute massive trades in a fraction of a second.

Apparently this combination could allow high-frequency traders to outmaneuver the overall market and make good money by breaking the rules really fast. I don’t get how that could be, but that seems to be why UBS agreed to fork over $14.5M.

That exhausts my understanding. I sense there are some rather severe issues involved, but I can’t quite see what they are.

If you are curious along with me, let’s check out the Figuring Financial Forensics blog by Rumbi Bwerinofa:

5/31/14 – Hold on! –

Article explains a bit about High Frequency Trading (HFT). There are 16 regulated exchanges and around 45 dark pools.

A few key tidbits. Extreme speed allows traders to move faster than the market and thus make money.

Putting orders into the trading systems starts to get reactions from other traders (I don’t know how). Watching the reactions gives a feel for where the market is going (how, I don’t understand). Pulling your orders a few hundredths of a second later removes you from the market (that I get). Analyze the information you just gained in the last several hundredths of a second (huh?) and you can read what is about to happen (how?). Then, you jump in a tiny fraction of a second ahead of the market and can make a few pennies on the trade. Do that a lot, I suppose maybe thousands of times a day, and you can make money no matter what happens in the market or on a particular stock.

Am I vaguely on the right path?

For more info on the UBS settlement, check out:

1/18/15 – More Equal than Others

Title of the article is the line from Animal Farm: some animals (traders) are more equal that others.

The analogy used is that while most UBS customers were groping their way around the dark pool in the dark, UBS gave some preferred customers flashlights.

Combine super fast trades, calculated guesses on where the market is going in the next second, with the ability to undercut or outbid by fractions of a penny. Then you can grab a trade from one person and flip the position to someone coming along in half a second, thus pocketing a fraction of a penny gain.

Am I catching on?

I read the Wikipedia article on Dark Liquidity. Unfortunately, what I understood reinforced what I already knew. Article also confirmed there is much I still don’t get and reminded me there is something either really cool or quite unsettling here.

Check out both articles from Ms. Bwerinofa if you want to gain a bit of knowledge about dark pools and HFT.