Dark Pools: The rise of A.I. trading machines and the looming threat to Wall Street

I have just finished reading Dark Pools by Scott Patterson. This book compliments Patterson's earlier book The Quants, which I have previously reviewed. Again, not the kind of book you would want to read if you are only interested in sports gambling. However, if like me, you are interested in automated trading of sports betting exchanges then this is a useful read. Plenty of names are familiar to me, having worked for Reuters, the former owner of Instinet, a "pool" discussed in the book.

Dark Pools discusses the rise of automated trading on Wall Street, beginning in the 1980s. Initially, there was resistance from NASDAQ and NYSE who wanted to protect the human market makers through whom stock trading was solely performed. Many algorithmic traders believed (correctly) that they were being ripped off by the market makers who would agree amongst themselves as to the appropriate spread for a particular stock so as to milk the most profit for themselves. If the trader was a big bank then market makers would also "front run" their own orders to get in first and push the stock price up further, again for profit.

The growth of personal computing combined with networking allowed for the creation of the first independent exchange (Island) through which buyers and sellers could electronically transact stock sales quickly and cheaply with narrower spreads. This form of trading developed into algorithmic trading (routing an order to the exchange with the most favourable price) and then to high-frequency trading as technolgies improved. Liquidity and volume increased and spreads narrowed. Even traditional exchanges like NYSE went electronic. It looked as though everyone was happy.

As ever, when money is involved, the bottom line corrupted the system as trading houses and exchanges colluded to make profits. High frequency traders and electronic exchanges split commissions between them using the maker-taker system of trading. The maker who put up the price sharing the commission with the exchange, whilst the taker of the price paid the commission. These rebates (as the maker commissions were called) became a raison d'ĂȘtre for HFT who now placed orders simply to hoover up these rebates. Special orders were created by the pools that favoured the high-frequency traders front running the market and that were not available to other investors.

With decimalisation of the exchanges, spreads were so tight that the only way high-frequency traders could make any money was through the maker-taker rebates. The more trades the more rebates, which made up for the market making trading losses. The scrapping of the up-tick rule for short selling allowed the bots to move the market in any direction they so chose. All of this resulted in an average holding time for a stock of 22 seconds and fewer IPOs for new companies. Hardly the ideal way of investing in your country's economy. Regular investors were duped through dark pools where institutional investors could get the best prices. Pension funds and day traders in their homes ripped off with the worst prices in the lit pools.

Dark Pools is a fascinating read that will be of use to the automated sports trader for a little insight into what it takes to reach the top as a programmer in financial markets. You may even get a few ideas that you can use on the sports exchanges.

Amazon - Dark Pools