Dark pools in battle with pricing predators

By Kristina Cooke and Emily Chasan - Analysis

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.