Calculating Dark Pool Volume: The Players And Problems

The Financial News is reporting how the current methodologies for non-exchange dark pools may be resulting in volumes being reported higher than they should be. Guidelines exist for reporting volume, but there is not a standard way for calculating them. Currently, both the buyer and seller volume are being counted, resulting in a form of double counting. This has been standard practice, but now smart-order routing is causing many sellside brokers and independent pools to count routed volume as well. For instance, by using smart-order routing, an order sent to a dark pool could be matched in the pool, or routed to another dark pool, causing volume to be counted two or three times. When it is match in the second dark pool, it is counted once again, possibly even two more times.

Double counting is often used as a standard practice, many times for no other reason than for marketing purposes in order to show the liquidity offered by a particular dark pool. Nonetheless, not everyone is following the same rules-of-thumb, making it difficult to compare dark pools, and more importantly, get a good read on the real level of trading volume. Some brokerages, such as Merrill Lynch, are choosing to not publish volume data given the industry-wide inconsistencies. To correct the problems, some are reporting both "volume" and "pass through." While using "pass through" to measure routing volume would seem to be an easy fix, it is not quite as simple as it seems given that some pass through trades are "not matched," some or "not eligible for matching," and some are just "touched."

To complicate matters, the exchanges are not free and clear when it comes to dark pools. While the exchanges have seen some trade volume move to the dark pools, and the non-exchange dark pools have generated criticism for their secretive nature, the exchanges are also involved in similar activities. In fact, exchange dark pools not only exist, but have been increasing as the exchanges try to fend off threats from non-exchange dark pools. Approximately 10-20% of consolidated volume occurs on Bats Trading, Nasdaq OMX, and the NYSE Arca exchange-based dark pools. As mentioned by Brian Hyndman, senior vice-president of Nasdaq transaction services: "We have the ability to break our non-displayed liquidity from our displayed liquidity. We are the largest exchange in terms of volume in the US and the largest for non-displayed volume." Such a badge of courage may make Nasdaq investors happy in the short-term, but may also cause problems in the future as regulators begin to look into dark pools and their affects on liquidity and price discovery. Given the recent talk of speculation in the commodities markets, in particular the crude oil markets, any discussion of lack of price discovery, even in a different non-commodity market such as the equity exchanges, may generate un-welcomed attention. The uncovering of increased dark pool activity may be something that not only results in embarrassment, but also causes investors to increase selling volume and execute their own method of price discovery.