05.05.22 | Dark Pools Intermediation


Dark pools were originally intended to be disintermediation devices: that is, digital mechanisms by which fund managers could trade directly with each other.   They required fund managers to disentangle themselves from their structural dependency on investment banks.

Take, for example, Island ECN … one of the first electronic communication networks and the first ECN to represent orders for all Nasdaq stocks.   As disintermediation devices, dark pools failed almost completely.

Today, off-exchange transactions are held (“owned”) by broker-dealers (B-Ds).   B-Ds act as both agents and principles.   In other words, functioning as dealers, as they act on behalf of the brokerage firm, initiating transactions for the firm’s own account.   As brokers, they handle transactions, buying and selling securities on behalf of their clients.

Whether trades are executed within the B-D or are matched through a B-D-owned Alternative Trading System (ATS) … the goal is the same: eliminate the exchange as a costly middle-man.   (That diversion of order flow has been viewed as a threat to the exchanges’ bottom lines.)

Filling discretionary investor orders has moved from disintermediation (1997) to intermediation in modern markets, as a result of advances in technology and forces of competition.

Intermediation refers to the services offered by market professionals to execute the buy and sell orders of investors.   Exchanges provide facilities that bring together purchasers and sellers of securities, generally for a specified fee.   Brokers are agents – they engage in the business of effecting transactions in securities for the account of others, generally for an explicit commission.   And dealers are principals – they engage in the business of buying and selling securities for their own account, and generally are compensated implicitly through trading profits.   And some of these dealers are high-frequency traders. SEC [1]

Bottom Line

Under normal market conditions when liquidity is abundant, intermediation is at its greatest.   Investor orders are filled, cheaply, by brokers and market makers at mid (bid-ask).

Under conditions of market stress, liquidity is less available … and that, which is … is more expensive.   Under conditions of stress, discretionary traders move to lit venues, a process referred to as “flight to transparency.”

Note:   For the past few weeks … during a period of rate fear, volatility, and relative illiquidity, I have been tweeting about the reduced TRF volume recorded as a share of total market volume … seen, again, in today’s market data.. (Refer to earlier Tweets.)


[1] SEC on Intermediation

Twitter thread at https://twitter.com/stephenharlinmd/status/1522310447378087936