Dark pools in battle with pricing predators

NEW YORK (Reuters) - Investors looking to discreetly buy and sell large blocks of stock may have found a new home in alternative trading venues, known as dark pools, but with each trade they risk falling prey to traders trying to manipulate prices.

Dark pools, anonymous off-exchange stock trading venues where traders can match large orders while concealing price and volume, have been rapidly gaining market share. By allowing traders to hide their cards, the pools limit the impact on stock prices before an order is complete, reducing costs for the trader.

But the very anonymity that draws investors to dark pools also gives cover to those seeking to manipulate the system. And that has forced pool operators to fight back and ramp up their spending on tools they claim will stop predators.

Investing in anti-gaming technology makes good business sense for the operators of dark pools as it helps to maintain the trust of clients in both the pool and the other investors frequenting it.

Timothy Olsen, head trader at ICM Asset Management, for example, said he has experienced suspicious activity in several dark pools.

"I feel I have been gamed before," Olsen said. "I have used systems that I have decided not to use again, because they haven't given me an adequate explanation of what happened."

In one case, Olsen said a buyer backed away at the last minute after convincing him to disclose his order size and intentions. To avoid the information being used against him, Olsen went to a different pool to get his order filled -- and never returned.

Gamers, which is the industry term for the traders who try to manipulate prices in the dark pools, have found that they can exploit the darkness in the pools by finding an information leak others cannot access.

PINGS AND LEAKS

"Pinging" is perhaps the most common technique used for gaming. To glean information about liquidity in a dark pool, a gamer submits a small order to see if there is someone else in the pool willing to take the other side of the trade.

Because the final price of the transaction will be derived from the public market, if the gamer finds there is liquidity, he will try to manipulate the price of the stock on an exchange by buying or selling a few shares.

The pinger will then return to the pool to complete the trade at the price that is more favorable to him.

Information leakage can also be a problem in so-called "gray pools" where traders try to increase the chance of matching their order by sending an indication of interest (IOI) to a few other counterparties, making their intentions known to buy or sell a certain stock.

Jeff Brown, chief investment officer at HighStreet Asset Management, however worries that IOIs can be too easily corrupted by gamers.

"They'll throw in an indication of interest with no numbers behind it -- that's gaming," Brown said.

Whether or not gaming is illegal is a source of much debate among dark pool operators -- some say it is a legal gray area.

But any attempt to manipulate market prices can be seen as breaking the law, warned Frederick Lipman, a securities attorney at Blank Rome in Philadelphia.

A gamer could be prosecuted if he "manipulates the market price to facilitate really what is a fraud on the buyer of (his) shares on the alternative trading system," Lipman said.

"Generally you have to show the intent to manipulate, and usually it has to be egregious," he added.

The pool operators, however, hope they can control gaming before it gets out of hand and are spending millions to keep gamers out of their systems.

"There are always going to be people who may try to create an advantage for themselves, but I think the smart market operators are paying attention to that and are making sure it can't be done in their marketplace," said Harvey Pitt, former chairman of the U.S. Securities and Exchange Commission.

"Any venue where people are capable of gaming the system is going to lose its customer base and lose it pretty quickly."

FIGHTING BACK

Brian Carr, the chief executive of agency broker NYFIX Inc, which runs the dark pool "Millennium" said its investment in its anti-gaming technology has accelerated in the past year, while Citigroup Inc said the amount it spends on anti-gaming innovation for its CitiMatch venue had surged in the past two months, up to 50 percent of its budget from about 25 to 30 percent as it launches a new anti-gaming product.

"Gaming is real, and it comes in many forms, some of which are more obvious than others," said Dan Keegan, head of global electronic execution sales at Citi.

"It is incredibly necessary not only to police your own pool to protect clients, but also to recognize the dynamics in the pools you are interacting with which could cause price aberrations that could affect your customers."

Tony Huck, managing director of agency brokerage Investment Technology Group Inc, said anti-gaming technology has become a key selling point for prospective clients of its pool.

And at a recent dark pools conference in New York this certainly rang true, as each pool provider was touting the effectiveness of their anti-gaming logic over their competitors.

Many were also quick to point fingers at their rivals as being more susceptible to gaming, whether it was due to their client base or relative lack of resources or expertise to adequately protect investors.

Anti-gaming logic can be both coded into algorithms that tap dark pools as well as into the matching technology in the dark pools themselves. The aim is to make gaming stick out like a sore thumb, and prevent pingers from executing orders at prices favorable to them.

The offerings vary from an eBay-style credibility rating that allow investors to see their counterparties' track records for completing orders and opt out of interacting with certain investors, to a minimum order size to deter "pingers". They can also use limit prices to minimize potential price manipulation after "pings".

But while the technologies may reduce gaming, they can not eradicate the risk entirely, the providers said.

A trader at a major broker told Reuters on the condition of anonymity about writing an internal report, which outlined how straightforward it was to circumvent existing anti-gaming tools. "I was able to write algorithms around all the anti-gaming logic I found," the trader said.

To be sure, gaming and insider trading is a concern in any market. But former U.S. Securities and Exchange Commissioner, Roel Campos, who left in September to join law firm Cooley Godward Kronish LLP, said it may be more difficult to pinpoint in dark pools.

"To the extent that the bids and asks don't show up on exchanges and in the traditional mechanisms, there's less evidence. There are techniques for looking for that, but it's more difficult to find if there were to be insider trading or some market manipulation," he said.

CONFLICTS OF INTEREST

Regulators, for now seem content to let the pools police themselves.

Erik Sirri, the SEC's director of market regulation said in a speech last year that it was not the SEC's proper function "to select or promote any particular business model."

But some investors are worried about conflicts of interest among different types of pool operators.

"What they're selling is a concierge-type service, it's privacy, but people talk," Blank Rome's Lipman said. "Knowing the way Wall Street works, I think sooner or later a dark pool won't be as dark as they thought it was."

It is illegal for brokers to execute orders on a security for their own account before filling orders submitted earlier by their customers, a practice known as front running. And while no pool operators said they had seen outright front-running, it does not stop investors from worrying about it.

ICM's Olsen said he has also made a conscious decision not to use the internal dark pools of any of the big brokerage firms, as he is concerned their proprietary trading desks and internal hedge funds could potentially see the order flow and act on it in a way that is detrimental to buysiders.

"I'm not trying to point fingers at any one firm," he said, "And I know they all say their proprietary desks can't see the flow, but you know it feels to me that I don't want to take that risk."

ITG director of sales and trading Gabriel Butler last year likened the disciplining of gamers to the taming of the Wild West, which cut down on opportunities for bandits but created a lawful environment in which business could flourish.

On the other hand, there are also concerns that over-zealous anti-gaming logic could lead to too many restrictions and make executing an order more difficult.

Bob Koci, a trader with Des Moines, Iowa-based Principal Global Investors, said his own common sense -- such as being aware of anomalous price moves and changing trading strategies often -- makes him feel more secure than anti-gaming tools.

"As far as the operators are out there trying to write better code, there's someone else who is just as smart trying to write against it," he said.

(Reporting by Kristina Cooke and Emily Chasan; Editing by Eddie Evans)