Book Review: Dark Pools by Scott Patterson
Every day, I work on a platform that captures intraday and end-of-day tick data from multiple exchanges. Some of them are very popular like NYSE and NASDAQ but they themselves have several different feeds such as NYSE ARCA, NYSE MKT and NASDAQ TOTALVIEW-ITCH. Then, there are some other ones that are not as popular but still very significant in terms of the daily market volume they handle. For example, BATS has two exchanges BATS BYX and BZX and Direct Edge had Direct EDGA and Direct EDGX.
Before I read Scott Patterson’s Dark Pools, I knew very little about these exchanges and their history. How did they come into existence? What is NYSE Arca? What does Arca stand for? What about NASDAQ TOTALVIEW-ITCH?
When my colleague recommended the book to me, I thought the book would be about, well, dark pools. As in, these mysterious, secretive pools created by companies (mainly investment banks) for trading. They are considered ‘dark’ because they don’t disclose what transactions take place in the pool. Instead the book was about ‘lit pools’ or rather, the quest of a man called, Josh Levine, to make the US exchanges as transparent as possible.
Just like Michael Lewis’ Flash Boys (review) is about Brad Katsuyama’s quest to make the exchanges ‘fair’ through an exchange called IEX, this book is about Josh Levine’s quest to make the markets more efficient and transparent through a ‘lit’ pool called The Island. Back in the day, 1980s, exchanges were not as open as they are now. If you wanted to trade a NYSE listed security, you would have to call a NYSE specialist and have him execute the order. This was a slow process and can be quite stressful if they didn’t like you. Moreover, the specialists made handsome profits due to wide spreads.
NYSE listed stocks were denominated in 1/8th. This meant that the min spread was 12.5 cents. The reasoning for this goes back to 400 years ago when the Spanish traders used to trade in gold doubloons. These doubloons were divided into 2, 4 or 8 pieces so traders could easily count them on their fingers. The denomination was then altered to 1/16th reducing the spread to 6.25 cents. Finally, in 2001, SEC ordered all US exchanges to decimalize – stocks could be quoted in pennies. The Island played a major role in making this happen. It allowed stocks to be quoted in decimals before NASDAQ and NYSE did.
Josh Levine created The Island to fight off NASDAQ. He hated it. He wanted to have an electronic exchange where trades could be executed instantly and not have to go through people. He wanted an exchange that could automatically handle millions and millions of orders and most importantly, provide information about these orders to the users. Josh Levine founded The Island in 1996 with Jeff Citron. The Island was a state-of-the-art system at the time and provided its users with a data feed called ITCH. NASDAQ and NYSE refused to create their own ECNs (electronic communication networks) and simply watched Island steal their market share.
As The Island was gaining market share, another ECN emerged. It was called Archipelago and it was created by Jerry Putnam. You will notice some interesting similarity between the two names – Island and Archipelago. While Island only tried to match orders amongst its users before routing to Nasdaq, Archipelago was matching orders amongst different pools as well such as Island and Instinet. This is why Putnam named it Archipelago which is a word used to describe a chain of islands.
Here is a quote from the book explaining role of Archipelago:
“Putnam’s solution was counterintuitive – and ingenious. Why not create an electronic routing system that could send orders to other pools? If a Chicago Trading client put in an order to buy Intel for $20, the system would first check to see if it had an internal match. If it didn’t, it would instantly route the order to the pool that had a match, whether it be Nasdaq, Island or Instinet.”
What’s funny is that while I didn’t know history of these exchanges, I do know the ending. I know that currently we have NYSE Arca and NASDAQ TOTALVIEW-ITCH. Island hated NASDAQ and Archipelago hated NYSE. Then, what happened? In 2005, Island was bought by Instinet who later sold the technology to NASDAQ. On the other hand, NYSE bought Archipelago and formed NYSE ARCA. These acquisitions encouraged David Cummings to create a new exchange called BATS which stood for Better Alternative Trading System. Interestingly enough, BATS merged with Direct Edge in 2014 and last week, CBOE agreed to buy BATS for $3.2bn.
After talking about Island and Archipelago, the book dives into the rise of automated trading, especially high frequency trading. Scott argues that our current markets are too fragmented, rigged and too sophisticated. A lot of what he talks about is later emphasized in Flash Boys by Michael Lewis.
Overall, I loved reading Dark Pools and would highly recommend it to anyone looking to understand how all these exchanges came to be what they are today. Scott is a very entertaining writer and makes it very easy to understand all the technical concepts.
Update: I wrote a post recently called A brief history of ECNs which discusses a lot of ECNs mentioned in Dark Pools.