High-Frequency Trading and Dark Pools: The Complexity of Financial Markets

By William Troyaux

You will find in this book exclusive interviews of renowned specialists about market microstructure and high-frequency trading strategies on lit markets and Dark Pools.
This book was developed following extensive research to democratize as many aspects as possible on US and European market microstructure, high-frequency trading strategies and Dark Pools.

Today, financial markets have become extremely complex. Market automation and new regulations have encouraged the emergence of new market players: high-frequency traders. These new players hold intraday positions. They deploy their specific orders and arbitrage strategies across multiple markets at close to the speed of light to get the best prices and to trade ahead of other market participants.

Dark Pools, whose operations are also difficult to understand for most professionals, have been created, adding complexity to financial markets. Dark Pools seems a little bit scary. However, we will see that Dark Pools are advantageous in terms of price compared to regulated markets.

“Fantastic job explaining some tough to understand topics.” – Joe Saluzzi, Partner and co-founder of Themis Trading and co-author of the book Broken Markets.

William’s message: “High-frequency trading is a small world that is difficult to access. I have spent a large part of this last year writing this book, taking into account the interviews I have been able to carry out in order to democratize as many aspects as possible. Many thanks to Joe Saluzzi, Alexandre Laumonier, Dave Lauer, Benoît Lallemand, Jean-Philippe Bouchaud and Donald MacKenzie. This book will help you to better understand the winning strategies of high-frequency trading firms.”

• Language: English
• Publisher: Publishroom
• Release date: Jul 4, 2023
• ISBN: 9782384547753

Book preview

CouverturePage de titre

Book written with the help of professionals in market microstructure and high-frequency trading.

Speakers

General Introduction

I chose to write this book on the subject of high-frequency trading and dark pools because many market participants use the financial markets without really knowing what is going on there. Moreover, these topics are difficult to address and require a lot of research.

Today, financial markets have become extremely complex. On one hand, due to the progressive automation of the markets which has considerably increased the speed at which an order can be sent and executed on a trading venue. On the other hand, due to the implementation of new stock market regulations in the United States and in Europe. Market automation and new regulations have also favored market competition and the emergence of new market players: high-frequency traders. These new players hold intraday positions. They deploy their arbitrage strategies across multiple markets at a speed close to the speed of light to get the best prices.

Market competition has become so important and complex that it is difficult to give the exact number of platforms available. At the end of 2022, in the United States, there were 16 regulated stock markets and 32 electronic platforms with the status of Alternative Trading System. This high number illustrates how incomprehensible financial markets have become. High-frequency traders exploit this complexity by deploying several types of strategies.

The first high-frequency trading companies, such as Getco or Tradebot, appeared in the early 2000s. The main objective of these companies was to make daily gains while remaining in the shadows.

However, the subject of high-frequency trading has been highlighted and has been the subject of many media debates following the flash crash of May 6, 2010 in the United States. Many specialists introduced high-frequency trading as a new risk for financial markets. Some went so far as to qualify this risk as systemic.

To add some complexity, new markets that are little known and whose operations are also difficult to understand for most financial professionals, have been created to protect institutional investors from the strategies deployed by high-frequency traders on regulated markets. These new markets are identified as Dark Pools. This term seems a bit scary. However, we will see that dark pools are price advantageous compared to regulated markets.

The objective of this book is not to question the current functioning of financial markets nor to criticize high-frequency trading activities but to maintain an objective point of view in order to present the complexity of the current markets and certain aspects of the financial markets that are little known by investors.

Thus, I will first present the main developments in the US and European financial markets, both in terms of automation and competition. I will then present the advantages and disadvantages of high-frequency trading for the financial markets as well as the main strategies implemented, some of which can be characterized as market abuse. Finally, I will end with the role and main characteristics of Dark Pools, these new opaque markets whose functioning remains unknown to a large part of market participants.

Acknowledgments

I started my investigations on high-frequency trading and Dark Pools more than one year ago. This book was developed following extensive research and interviews with specialists in market microstructure and high-frequency trading.

This work was very long, very difficult but fascinating. Many research reports are available on the consequences of high-frequency trading for the financial markets. However, the information available on the strategies deployed by high-frequency traders and Dark Pools is very limited.

Thus, I would like to sincerely thank the people who were able to help me in the elaboration of my book both for their availability despite their professional requirements and for having explained to me some complex aspects relating to the functioning of the markets, to high-frequency trading and Dark Pools.

More than 7 hours of interviews were conducted in order to provide as much information as possible on the concepts of market microstructure, high-frequency trading and Dark Pools. More than 500 hours were necessary just for the drafting of this document. Not to mention the hours and nights spent doing preliminary research. The books written by Alexandre Laumonier, Joe Saluzzi, Scott Patterson and Michael Lewis have been of great use to me.

More specifically, I would like to thank Alexandre Laumonier, book publisher and independent researcher on market microstructure and high-frequency trading, for all the emails exchanged, for the hours spent interviewing on Zoom, for the recommendations on who to contact, for lending me some books and even for our interview in Paris.

I would like to thank Joe Saluzzi, partner and co-founder of Themis Trading and co-author of the book Broken Markets, who was the first person to grant me his availability to exchange on the topic of high-frequency trading and Dark Pools. The exchanges carried out with Joe, helped me a lot in the development of my book, in particular on the new SEC market proposals of December 14th 2022, the evolution of the US markets, the front-running strategies, the description of the different commission systems and on some specific orders used by high-frequency traders.

Many thanks to Dave Lauer, CEO at Urvin Finance, for giving me his time to discuss the topic of high-frequency trading and Dark Pools. I particularly thank Dave for having shared his experience of high-frequency trading with me by providing concrete examples of the strategies deployed by high-frequency traders on financial markets, I thank him for his recommendations in terms of research and for enlightening me on the modes of price determinations on Dark Pools as well as on their functioning.

I would like to thank Benoît Lallemand, Secretary General of Finance Watch, for having accepted to help me in my research by giving me his time. The exchanges carried out with Benoît were very useful, in particular on the aspects of supervision and regulation of activities related to high-frequency trading and on the contributions and disadvantages of high-frequency trading for financial markets. I would like to thank Benoît for describing his speech to the Deutscher Bundestag and for his experience in the field of regulations relating to high-frequency trading.

I would like to thank Jean-Philippe Bouchaud, co-founder and chairman of Capital Fund Management (CFM) and member of the French Academy of Sciences, for giving me his time. His indisputable expertise on market microstructure and his vision on the contributions that high-frequency trading can have for financial markets have been of great help to me.

I would also like to thank Donald MacKenzie, Professor of Sociology at University of Edinburgh and author of the book Trading at the Speed of Light: How Ultrafast Algorithms Are Transforming Financial Markets for his availability but also for his explanations on certain complex aspects related to high-frequency trading.

Finally, I would like to thank Nelson Da Silva and Suzanna Da Silva for their help regarding the final proofreading.

I dedicate this book to my parents and to my former colleagues of Crédit Mutuel Group Risk Department who have always been there to help me over the past two years. These two years have been difficult to reconcile work, courses, writing the book and swimming training and competitions. I had to be very organized with fewer hours of sleep but their support allowed me to go all the way while continuing my passions.

About the author

Passionate about the functioning of financial markets for several years, William Troyaux decided to conduct his own investigation into the aspects of High-frequency Trading and Dark Pools. His research led him to interview experts in market microstructure and high-frequency trading in Belgium, Scotland, the United States and France.

Currently, Senior Risk Analyst at Sumitomo Mitsui Banking Corporation, William Troyaux has extensive and solid experience in the field of Banking Risks especially in internal models, monitoring of rating systems and risk control and management. Prior to joigning Sumitomo Mitsui Banking Corporation, William held several positions in the Risk Department of Crédit Mutuel group within the internal models and risk control teams. William holds an Executive MS in Financial Management and Management Control from ESSEC Business School. He also own a Master’s degree in Management Control and Professional Accounting and a Bachelor degree in Management Control and Professional Accounting.

His main passions are stock markets, high-frequency trading, travels, swimming and to practice sports as a whole. He also writes during his free time articles on economic and financial topics. William’s articles can be viewed directly on the website Medium (https://medium.com). Today, William is still swimming competitively after more than 17 years.

Author’s message

High-frequency trading is a small world that is difficult to access. I have spent a large part of this last year writing this book, taking into account the interviews I have been able to carry out in order to democratize as many aspects as possible. I hope you will enjoy this book and that it will help you to better understand the little-known aspects of high-frequency trading and Dark Pools.

Who this book is for

This book is for anyone who wants to learn more about market microstructure, high-frequency trading and dark pools. However, you will need to know how to read an order book and know the basic orders on the stock markets.

About the people interviewed

Alexandre Laumonier is an independent editor, author and anthropologist in market microstructure and high-frequency trading. Alexandre is known for having been one of the first people to focus on the aspects of high-frequency trading. He is the author of many books such as 6: The Rise of the Machines, 5: Back to the Future, 4/3.

Founder of Éditions Zones Sensibles, he has been conducting research on financial markets since 2013. Since March 2018, he has been working on the chair of the École Polytechnique Analytics and models for regulation. Alexandre is one of the people in Europe who have most and best studied the functioning of the financial markets. He is also known to high-frequency traders under the nickname Sniper thanks to his many articles on high-frequency trading.

Joe Saluzzi, co-founder and co-director of Themis Trading LLC, is a reference figure in the United States in the field of high-frequency trading. He is also co-author of the book Broken Markets – How High-frequency Trading and Predatory Practices on Wall Street are Destroying Investor Confidence.

Joe is a frequent speaker at conferences involving market access, algorithmic trading, and buy-side and sell-side aspects. He has provided expert commentary in Washington for the SEC but also for media outlets such as CBS’s 60 Minutes, BBC Radio, Bloomberg Television & Radio, CNBC, Fox Business, BNN, The New York Times, The Wall Street Journal, USA Today, Reuters, Associated Press, Los Angeles Times and Bloomberg News. Joe has also authored articles for Traders Magazine, Dow Jones and Journal of Investment Compliance.

Prior to Themis Trading LLC, Joe led the equity sales and trading team for large institutional accounts at Instinet Corporation for over nine years. He graduated from the University of North Carolina at Chapel Hill with an MBA in Finance and received a Bachelor’s Degree in Finance from New York University.

Dave Lauer is also a leading figure in the field of high-frequency trading in the United States. Dave is a market structure and technology architecture consultant. He is an expert in the new electronic equity and commodity market, with extensive experience in designing and building the infrastructure that underlies many modern electronic trading systems. Dave has several years of experience as a quantitative analyst and as a high-frequency trader. His current work focuses on both designing highly scalable technology architectures and helping organizations understand and navigate modern stock markets. He has testified before the Senate Banking Committee and appeared on a SEC panel to discuss high-frequency trading and the implications of the technology on modern market microstructure.

Dave has been featured in the Wall St. Journal and is a frequent source of high-frequency trading articles in The New York Times, The Wall St. Journal, CBS MarketWatch and many other publications. His previous work includes electronic trading at Allston Trading and Citadel Investment Group, and he was one of Tervela’s first employees. Dave serves on several for-profit and non-profit boards and holds a master’s degree in international economics and finance from Brandeis University in Massachusetts.

Benoît Lallemand has been Secretary General of Finance Watch since 2017. Benoit spoke in 2013 before the Finance Committee of the German Bundestag to give his opinion on the proposal for a High-Frequency Trading Act. He was previously Senior policy analyst (mainly MiFID 2), senior advisor to Better Markets on European affairs and head of strategic development and operations at Finance Watch. He also launched the Citizens’ Dashboard of Finance, a platform for a wide range of stakeholders, including pioneers of sustainable business and financial services, academics and civil society organizations, to engage in a global campaign to change finance.

Before joining Finance Watch at its inception in 2011, Benoît spent more over ten years in the financial sector – more specifically in clearing and settlement (market infrastructures).

He started as a team leader before moving into management positions in the asset-servicing departments, focusing on fixed income, structured products and regulatory reporting.

Jean-Philippe Bouchaud, is a French physicist. He is co-founder and president of Capital Fund Management (CFM), associate professor at the École Normale Supérieure and co-director of the X-CFM chair of Econophysics & Complex Systems. He is a member of the French Academy of Sciences and holder of the Bettencourt Innovation Chair at the Collège de France in 2020. A former student of the École Normale Supérieure, he is President and Director of Research at Capital Fund Management. A specialist in statistical physics, he is one of the pioneers of econophysics, a discipline that seeks to apply the concepts and methods of physics to economic systems and financial markets. He is the author of more than three hundred and fifty scientific publications, including several books and journal articles. His publications concern in particular markets microstructure and the functioning of financial markets. He received the CNRS silver medal in 1996 and the Quant of the Year award in 2017 and 2018. He was elected to the Academy of Sciences in 2018.

Donald MacKenzie is Professor of Sociology at the University of Edinburgh in Scotland and author of the book Trading at the Speed of Light: How Ultrafast Algorithms Are Transforming Financial Markets.

Donald MacKenzie is a sociologist of science and technology. His research covers topics such as high-frequency trading and how financial market participants use mathematical models. His book on HFT Trading at the Speed of Light: How Ultrafast Algorithms Are Transforming Financial Markets, was published by Princeton University Press in May 2021. Donald has conducted numerous interviews and publications related to high-frequency trading.

90% of finance doesn’t know how the US stock market works.

– Haim Bodek

PART I: PRESENTATION, EVOLUTION AND SUPERVISION OF FINANCIAL MARKETS

Chapter 1: Presentation and evolution of financial markets

1.1 The main US markets

1.2 The main European markets

1.3 Financial markets competition

Chapter 2: The structure of equity markets today

2.1 In the USA

2.2 In Europe

2.3 Classification and financial market players

2.4 The main supervisory bodies

Chapter 3: Financial markets evolutions as a source of high-frequency trading

PART I:

PRESENTATION, EVOLUTION AND SUPERVISION OF FINANCIAL MARKETS

Chapter 1:

Presentation and evolution of financial markets

Since their creation, financial markets have evolved a lot. When you think of US markets, you immediately think of NYSE and NASDAQ. So far you’re not wrong, these two regulated markets have long formed a duopoly in the United States.

You also think of a group of individuals in blue coats on the NYSE trading floor shaking their shoulders and making equally incomprehensible noises and signs in order to place market orders. This is no longer the case today.

US financial markets have known, during their history, several major events such as the emerging of competing electronic trading platforms and the liberalization of US markets with new SEC regulations such as Reg ATS and Reg NMS. More recently, after a period of 17 years, the SEC proposed on December 14th 2022 a new series of amendments to reform US markets microstructure whose operation is largely based on the Reg NMS adopted in 2005 and implemented in 2007. These new proposals (4 proposals for approximately 1600 pages of text) which aim to protect retail investors were subject to consultation until March 31st 2023.

On the other side of the Atlantic, European markets have taken longer to develop. While the Nasdaq was already automated in 1971, the Paris Stock Exchange was still operated by shouting, sponge and chalk until 1986. With technological developments, European stock exchanges were gradually automated, catching up with the US markets.

It is only since 2007 and with the MIFID regulations that European markets were put in competition with other trading platforms. A share could now be listed on several trading venues. In Europe, it is no longer Euronext but the Chicago Board Options Exchange which has the largest market share.

With the MIFID regulations, European equity markets have been deeply inspired by the Reg ATS and Reg NMS regulations governing the functioning of the American financial markets.

Today, the trend on the main world stock exchanges such as the Frankfurt Stock Exchange, Euronext Paris or the London Stock Exchange is still based on the American financial markets, which constitute the main barometer in terms of market trends. On Euronext Paris you can have a CAC 40 index at +1.5% at 2 p.m. to finally end around 5: 30 p.m. at -0.5% because of the US markets having opened in the red at 3: 30 p.m. (Paris time in summer) or at 2: 30 p.m. (Paris time in winter).

In view of their importance, it seemed essential to me to retrace the major events in the history of the financial markets in the United States and in Europe. Competition and the gradual automation of financial markets have also facilitated the emergence of new players: high-frequency traders.

1.1 The main US markets

First of all, it is not the NYSE, but the Philadelphia Stock Exchange which is the oldest stock exchange in the United States. Created in 1790, under the name Board of Brokers of Philadelphia, this regional stock exchange was bought by the NASDAQ in 2007 for the sum of 652 million dollars.

The NYSE (New York Stock Exchange) was established on May 17th 1792¹ by 24 brokers signing the Buttonwood Agreements². These agreements, which were very short (only two sentences), stipulated on the one hand that brokers had to exchange stocks among themselves without the use of intermediaries and on the other hand fix a uniform commission rate of 0.25% for all transactions carried out on behalf of their clients.

Originally, quotations on the NYSE trading floor were made by outcry. Then, US financial markets were gradually automated. To date, the NYSE is the only stock exchange to have kept its human market-makers in cohabitation with the machines on the trading floor.

On the trading floor of the NYSE you could find up to 5000 traders, in 2022 they were only a hundred.

When it was created, only two bank stocks and three government bonds were listed on the NYSE. By the end of the first half of 2022, about 2,500 companies are listed on the NYSE (1,900 American companies and 600 international companies) for an overall capitalization of about 25 trillion dollars. On the NYSE, you can now trade stocks, options, ETFs³ and stock indexes.

To date, the main indexes on the NYSE are:

•The Dow Jones Industrial Average (DJIA): This index, the oldest stock market index in the world⁴, includes the 30 largest companies listed in the USA and has changed a lot during its history. Today, you will find in this index large market caps like Apple, Coca-Cola, Intel, Microsoft and Walt Disney. In 1896, the DJIA quoted 40 points for its first quotation. At the beginning of August 2022, the DJIA rated 32,803 points with a peak of 36,953 points in January 2022;

•The NYSE Composite: this index, created in 1966, brings together all the quotes made on the NYSE, in other words, in the first half of 2022, the 2,500 companies listed on the NYSE. In 1966, the NYSE Composite quote was 50 points. The NYSE composite was reintroduced in 2003 with a new calculation methodology bringing the value of this index to 5000 points. At the beginning of August 2022, the NYSE Composite quoted 15,273 points;

•The Standard & Poor’s 500 (S&P 500): is an index that includes the 500 largest market capitalizations of companies listed on US stock exchanges. Created by Standard & Poor’s on March 4th 1957, this index is considered to be the most representative of the evolution of the financial markets and the economic situation. The S&P 500 represents more than 80% of companies listed on US stock exchanges. In the early 1980s, the S&P 500 traded below 100 points. In August 2022, the S&P 500 index was about 4150 points.

The Nasdaq⁵ was created on February 8th 1971. This market is therefore very recent if we compare it to the Philadelphia Stock Exchange or the New York Stock Exchange. However, unlike the latter, the Nasdaq is a fully automated market since its creation. Subsequently, you will not find human market-makers but rather an absolute calm with computers and servers. In the United States, the Nasdaq is the second largest stock market behind the NYSE.

US financial markets quickly evolved toward automated markets because of the will of certain market participants like Joshua Levine, Thomas Petterfy or Jerry Putnam to make markets fairer, open and accessible to all,