December 2018 Unlocking the Mysteries of Dark Pools Cryptocurrency Series, Part 4 In the fourth paper of our cryptocurrency series, we explore the private exchanges’ dark pools, whereby investors, typically large financial institutions and high-net-worth (HNW) individuals, can make trades anonymously.1 We discuss how their application has extended to the buying and selling of cryptocurrency and the implications for investors. Institutional and high-net-worth investors in the The Advent of Dark Pools United States have traditionally looked to private exchanges such as dark pools, also known as alternative Darks pools were introduced in the 1980s as an trading systems (ATS), as a means to execute on large alternative to central exchanges for executing large volume trades anonymously and discretely, without block trades for qualified investors, such as pension significantly moving the markets. Due to the opaque funds, private equity managers, and HNW. The goal was nature of ATS, their application has broadened to include to provide liquidity in a cost-efficient manner and help the buying and selling of cryptocurrency, most notably minimize the market impact from large orders that might by hedge fund and private equity managers for qualified occur if filled on a central exchange like the Nasdaq. HNW investors. With the launch of computer algorithms and the rising liquidity at the dark pools, the global market experienced To its biggest proponents, Bitcoin (BTC) offers the a dramatic increase in off-exchange trading. potential to disrupt both global payment systems and traditional currencies. Institutional investors tend to Relatively attractive fee structures, price improvements, trade it over the counter due to liquidity constraints at the and quicker processing speeds have been key draws for central exchanges, which can involve the arduous task dark pool investors. There are three main types of dark of locating an individual or entity to transact with directly. pools: As dark pools have evolved, they are becoming a more broker-dealer owned exchanges, such as efficient option for institutional and HNW investors, which Morgan Stanley’s MS Pool and Goldman Sachs’s in turn has boosted BTC liquidity at the exchanges. Sigma X; Nonetheless, dark pools have been characterized independently owned exchanges for private by trade violations and excessive price volatility trading; and driven by financially motivated traders. BTC activity private exchanges operated by public exchanges, is fragmented on dozens of exchanges across the such as the NYSE’s Euronext. globe, and the majority operating in the United States aren’t registered with the Commodity Futures Trading Dark pools in the past represented around 3–5% of Commission (CFTC) or the Securities and Exchange total stock trading volume in the United States, but Commission (SEC). This is shifting, however, as this changed in 2007 after the SEC passed Regulation regulators take note of the influx of investors who may NMS allowing qualified investors to use noncentral not fully understand the underlying risks. With dark exchanges to obtain price enhancements.2 Since then, pools becoming more ubiquitous in the global BTC ATS trading has surged to more than 40% of all stock markets, regulatory bodies may want to review rules trades in the United States, with dark pools accounting to increase transparency and security at the ATS. for 10–15% of the total trading volume.3 1 Dark pools give “investors/clients” the opportunity to place orders and make trades without publicly revealing their intentions during the search for a buyer or seller. 2 L. A. Aguilar, “Shedding Light on Dark Pools” [Public Statement], November 18, 2015, https://www.sec.gov/news/statement/shedding-light- on-dark-pools.html. 3 J. D’Antona, “FLASHBACK FRIDAY: Trading Bitcoin” (January 19, 2018), https://www.marketsmedia.com/flashback-friday-trading-bitcoin/. pnc.com Unlocking the Mysteries of Dark Pools With still-evolving regulations around dark pools, it has Chart 1 also led to market violations at some broker-dealer Front Running—the Illegal Practice of Purchasing a firms. Due to advances in trade technology, investors Security Based on Advance Nonpublic Information have become vulnerable to so-called “front-running” tactics by high-frequency traders (HFT) using complex computer algorithms to execute orders at fractions of a second (this front-running practice as described is not Client orders a large stock permissible). Most HFT brokers have the ability to see purchase a client’s large buy order in process and jump ahead of the order to buy it for themselves, thus making a profit on shares they’ll turn around and sell at a slightly higher price to the client (Chart 1).4 Broker executes his own order (front Such activity is especially prevalent among hedge running a client) funds and proprietary trading firms, even though dark pool operators claim to vet out front-running behavior. The 2014 book Flash Boys by Michael Lewis Broker executes caught the attention of the SEC and media because it client’s order gave a troubling inside look at the HFT industry and how it has been used to take advantage of traders with slower price feeds. In the past few years, the SEC has ramped up its scrutiny of ATS and proposed new measures that would require companies to disclose Stock price goes up their rules of operation to regulators and clients, including whether they give preferential treatment to specific brokers. Source: https://corporatefinanceinstitute.com/resources/ Given the uptick in government investigations, knowledge/trading-investing/front-running/ a number of financial institutions have paid millions of dollars following allegations they encouraged HFT practices at their exchanges. In 2016, Deutsche Darks Pools Infiltrate the Crypto World Bank paid $37 million to settle SEC charges of trade The need for covert liquidity is especially critical in the manipulation, while Barclays and Credit Suisse paid cryptocurrency market, and the number of dark pools a combined $154.3 million for allowing front-running serving this purpose has expanded as the industry activity.5 In September 2018, the SEC determined that has evolved. This has helped enhance liquidity at the Citigroup misinformed clients about HFT at its dark exchanges to meet rising demand from qualified pool Citi Match, which charges a premium fee for investors such as hedge fund and private equity screening out such predatory traders. Citi was fined managers. The development of ATS is critical for trading $13 million for $9 billion (17% of all transactions in large blocks of digital coins while at the same time its dark pool) in high-speed trades.6 maintaining marginal price slippage and market impact. Price slippage is when a digital coin price changes while an order is being filled, resulting in a different execution price than expected. It’s a disadvantage associated with placing big trades on central exchanges as inadequate liquidity can lead to a large order being split into several smaller orders. 4 “What Is Front Running,” CFI, https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/front-running/. 5 S. Mamudi and A. Massa, “Quick Take: Dark Pools,” https://www.bloomberg.com/quicktake/dark-pools. 6 “SEC Charges Citigroup for Dark Pool Misrepresentations,” Securities & Exchange Commission, https://www.sec.gov/news/press- release/2018-193/. 2 Unlocking the Mysteries of Dark Pools The cryptocurrency company Kraken launched the probe with the CFTC, examining whether the price first dark pool for trading BTC in 2015, with the goal of BTC had been overly influenced by a few primary of creating a private and secure system for matching owners of the digital coin. While the CFTC regulates and executing large volume orders. The online broker the trading of futures linked to the price of BTC, the TradeZero and Bitfinex exchanges soon followed with agency has authority to enforce penalties if it discovers their own BTC dark pools. Kraken initially claimed the fraud in the spot markets.12 In July 2018, the SEC voted anonymous feature of their exchanges would limit to enforce laws to increase the regulation of ATS. As price manipulation by allowing investors to fill orders a result, dark pools will be required to file detailed without revealing their intentions to other traders,7 public disclosures regarding their operations, potential but in August 2017 Kraken decided to introduce new conflicts of interest, policies around prioritizing some trading guidelines to help minimize incidences of clients’ trades before others, and fee information. It front-running schemes at their dark pools.8 will also be mandatory to have safeguards in place to prevent client trade information from being revealed to BTC and other popular altcoins have been high-speed traders.13 susceptible to price volatility and trade speculation. Adding to the problem, about 40% of BTC is held by just 1,000 blockchain users, giving some The Future of Dark Pools shareholders the ability to manipulate prices in the The start-up company Republic Protocol (REN) raised market.9 A University of Texas study published in $34 million in 2018 from major hedge funds in an June 2018 concluded that at least half of the surge initial coin offering to create the Republic Terminal, in BTC’s price in 2017 from $1,000 in January to the first decentralized dark pool for the peer-to-peer $20,000 by December was due to synchronized price exchange of BTC, Ether, and ERC20 through the use of manipulation by a few traders on the global dark pool cross-chain atomic swaps. Before the arrival of atomic exchange Bitfinex.10 swaps, exchanges such as Kraken used a third-party In December 2017, the CFTC sent a subpoena to broker to match buyers and sellers. Republic removes both Bitfinex and Tether (a digital coin pegged to the need for this trusted intermediary by providing the dollar used by Bitfinex to help prop up the price economic incentives for miners to match traders on the of BTC during that time) regarding their dark pool blockchain network (traders pay miners a small fee in relationships and trade practices.11 In May 2018, the REN coins).