As early as 1997, the financial markets comprised blue chip stocks traded by specialists at NYSE , other stocks traded at NASDAQ by specialists and a small scale electronic system. Fast forward to 2012, the US market comprises 40 trading destinations. There are four public exchanges – NYSE, NASDAQ, Direct Edge and BATS. Inside each of these exchanges there are various destinations. NYSE has NYSE Arca, NYSE Amex, NYSE Euro next and NYSE Alternext, NASDAQ has three markets, BATS and Direct Edge have two market destinations with in themselves. There are toxic Dark pools.There are Internalizers – Citadels , Knight tradings of the world that execute trades with in their trading pools. The system, as you can see, has become extremely complex. Dark pools and internalizers accounted for 40 % of all trading volume in 2012. The pace of developments have been unbelievable. How did this all come about ? Why has the average holding time of a stock gone down from 8 month in 2000 to 2 months in 2008 and finally drop to 22 seconds in 2011 ? This book tries to answer some of the questions. This book is not so much about dark pools as it is about tracing the personalities behind some important firms in the modern high speed trading world.

The market structure in US has completely changed in the last decade. The following visual summarizes the various firms that came in to existence and the way they were gobbled up by 2007.



The book starts off with Mathisson of Credit Suisse ECN , addressing a set of HFT traders, algo traders of the who trade in the lit pool. He sounds off a big warning to the audience that ECNs are being populated with AI driven trading bots and are all feeding on big orders from mutual funds and retail orders. He says that this aspect is fundamentally going to alter the trading behavior of many. Rightly so, sensing that trade bots are ripping off, the big institutions , the buy side asset managers are increasingly turning to dark pools where there is anonymity and lesser chance of bots attacking the order.

Using this speech as a prop, the author then poses various questions on the kind of mess that financial system has become with fragmented trading destinations, hunter-seeker algos populating the lit markets, dark pools etc.

2C__Cauldron_Books_Reviews_dark_pools_for_blog_haim_bodek Haim Bodek

The book profiles Haim Bodek, a math grad turned quant trader. After putting in about a decade of experience (1997-2007), at Hull, at Goldman and at UBS, he starts a venture Trading Machines under the assumption that he has enough skills to beat the market with all the fundas acquired. All is well in the first two years where his firm rakes in good money. At one point in time, the firm averages 17000 stock trades 6500 option trades per day. However by Dec 2009 , his strategies and the firm suddenly start losing money. He thinks it is an internal bug in the system and tries to fix it.

Despite hours of toil, he never managed to fix it. In the end, he realizes that the bug is external to the system from a chance conversation with an exchange official. Strange order types are being preferred at the exchanges and thus were making his trades sitting ducks. Complex order types always managed to stay at the top of the book and hence were able to profit from the spreads. Trading Machines was still in the old limit-order, market-order world and all his algos were designed for such a world. In the past, Bodek had made money precisely by staying ahead of everyone in the order book, using strategies like "Size Game" that involved putting big market/limit order so that they always managed to go ahead of everyone in the queue. Sadly this time around, he was eaten by other firms who were getting ahead of his trades in the queue. He hadn’t noticed that world has changed rapidly with exchanges sleeping with the enemy(HFT firms).

This story does made me pause : A guy who had spent years designing and trading strategies to get ahead of everyone in the order book was somehow ignorant of these complex order types that were being preferred over limit and market orders. If he was following the developments so closely, How did he miss the new development ? One obvious answer I guess is that the market had become increasingly complex and he couldn’t keep pace with the developments.

He also stumbles upon a paper on 0+ strategy that was being employed by HFT firms even before he had started his company. These firms were using strategies that looked for opportunities where probability of plus 1 tick was higher than minus 1 tick and were pumping in huge volumes to capture all such opportunities. Basically they created orders which were kind of hidden in the order book and were untouched by RegNMS regulation. They fed on limit order trades. They sensed a whale in the market , immediately ran past the whale, bought the relevant stock, jacked up the price, turned around and sold it to the whale. This was just one of the umpteen strategies that were being employed by HFT firms. Bodek tries to save his firm after understanding the situation. However with options market adopting maker-taker model too , he is forced to shut his firm. The story about Bodek goes on to show that order book based strategies have become increasingly complex and volatile in returns. You cannot be sure of any strategy.

The author traces back the decade long mindboggling pace of developments to a few people , whom he calls “the plumbers of modern financial world”. The people whom the author covers in depth are the following :

3C__Cauldron_Books_Reviews_dark_pools_for_blog_joshua  Joshua Levine

A college drop out joins Russo securities as a runner. Soon his boss at Russo pulls him to join Datek Securities. At Datek, Levine finds that traders are using NASDAQ’s SOES system to beat specialists at their own game. Subsequently Levine builds a lot of tools for the traders. While specialists at NASDAQ tried to eat the spread from the orders generated from retail and institutional clients, Datek traders exploited the loopholes in system to get ahead of the queue and extract a fraction of the spread that the specialists were making. These fractions multiplied by a huge volume of trades made Datek traders immensely rich. All the traders kind of knew that a big reason for their success was the toolkit that Levine built. These tools spanned the entire gamut of activities in the daily life of a trader, i.e from bid-ask quote streaming to back end assignment of trades .These tools also helped Datek launch an entire business catered to day traders.


One thing that especially bothered Levine was that the traders at Datek were often on opposite sides of a trade and they were going to NASDAQ to get their order executed. He figured out that if he had a system that could match the orders internally, the traders need not go to specialists and the traders might have less transaction costs. Thus was born the idea of "Island", a order matching system outside the confines of NASDAQ. Its super fast and super cheap execution attracted a lot of order flow and by 1996 , almost 50% of the order flow to NASDAQ was from Island. Since Island’s USP was speed , it was ripe play ground for many a trading start ups to use technology to make money. Levine’s dream of eliminating the power of specialists/middlemen was being fulfilled by Island. Renaissance, Getco, Tradebot and many successful outfits that we know today , were big users of Island in the 1990s.

Levine’s another strategy that paid off was,"maker taker " model for the Island crowd. By agreeing to pay traders who provided liquidity and take fees from traders who demanded liquidity, Island created massive liquidity as it attracted HFT traders. An irony here is that : Levine started Island to remove specialist middlemen , but actually ended up creating a new type of middleman, the High frequency trader. The HFT guys, on the pretext of providing liquidity were actually making the cost of trading higher for retail and institutional clients.They were playing the rebate game. Island later merged with Instinet, creating one of the biggest trading venue. Subsequently Levine left Island as he could never fit in the big firm culture of the merged entity.

5C__Cauldron_Books_Reviews_dark_pools_for_blog_Jerry_Putnam Jerry Putnam

Jerry Putnam, a failed brokerage firm owner was trying to make headway out of his professional crisis. A chance encounter with a founder of a trading-software firm gave him the first exposure towards electronic trading. He wants to create an outfit for day traders from Chicago similar to Datek NY. He starts a venture focusing on applying strategies on SOES to make money. He recruits day traders, improves the UI of the trading systems to create faster and easier interface for day traders. External regulatory environment that lead Order Handling rules and the ECN creation rules, gives him an idea of creating an ECN out of Chicago. Soon, he realizes that there are already faster powerful players in the market. So he hits upon a counter intuitive and an ingenious idea, i.e. to route the orders to other pools. Instead of being market centric, Jerry Putnam chose to execution centric. In the hindsight it was a brilliant move that finally made his firm – Archipelago(name chosen to connote linked islands) a highly successful venture. It was later gobbled by NYSE thus marking a shift in the NYSE culture where it squarely acknowledged that electronic trading is the future.

6C__Cauldron_Books_Reviews_dark_pools_for_blog_Dave_Cummings Dave Cummings

Dave Cummings, a Chicago pit trader decides that there must be a better way to make markets and starts Tradebot , an automated market making machine. His idea is scoffed at umpteen number of places before he meets GETCO founders. GETCO immediately latches on to the idea and partners with Tradebot. With ECNs exploding, SECs order handling rules helping HFT traders, Tradebot and GETCO grow rapidly. With in a span of two years, they account for 10% of all trading in NASDAQ stocks. Tradebot and Getco part ways as they fail to agree on the business strategy. Dave Cummings does a lot of things to improve speed of execution like colocation that subsequently became a standard approach for any HFT player. Later, after a wave of mergers and acquisitions in the ECN space, Dave Cummings gets worried that he would end up paying more fees as a result of behemoths, i.e. Island-Instinet-NASDAQ and NYSE-Archipelago. He then starts BATS in Nov 2008 and it becomes a huge hit with the traders.

All the above stories are trying to say that  : The idea and the work done by Joshua Levine in creating Island had so many repercussions that with in a span of 10 years the whole trading landscape changed.

The penultimate part of the book covers the various events in the last few years that have given rise to many people voicing the problem of hyper speed trading and fragile markets. The events that have been narrated more like a story format are Goldman’s programmer Mikhail Malyshev stealing code, Flash crash, Senator’s Kauffman’s fight against toxic trading, Arnuk and Saluzzi’s creating awareness amongst general public etc.

The book ends with a series of events happening around the world that seem to be making, the trading venues not only in US but through out the world , far more complex and terrifying. More and more people are turning to machine for trading, be it generating signals for arb or making markets.

The author concludes the book quoting the story of a start up that uses a completely automated machine for its fund management. The fact that the book ends with machine beating the market in 2010 and 2011 leaves a reader wondering about the future of trading. What is the author finally trying to say ? Is the `increasing automated trading’ a good sign or a bad sign ? Well I guess the answer depends on which part of the world you are and what are your vested interests? . I think the countries that have recently adopted dma or algo trading have an advantage of learning from the mistakes that have happened in the developed markets. Or Do they ? Aren’t ‘Greed’ and `Fear’ universal emotions and no system ever designed by a human is ever immune to them?. In any case one thing is for sure, the recent events have made a whole lot of people really skeptical about the utility of ECNs and HFTs. Are we trying to eliminate human middlemen(specialists) and substituting them with computerized middlemen(Bots)?

takeaway Takeaway :

This book is not so much dark pools as the title goes.The book is primarily about the founders of Island, Archipelago, Tradebot, GETCO and other such firms that have had a tremendous impact on the US financial system. All the stories are peppered with just enough numbers, just enough anecdotes, just enough quirky facts, that the book sustained my interest till the very end.