Alternative Execution Venues

Liquidity Fragmentation

 

  • An aggregator merges quotes from various liquidity providers and market makers

    • Finds the tightest spread among liquidity providers

  • Quotes aren't firm

  • Send requests to trade at best price

 

Execution styles (sweep vs full amount):
 

Full amount places entire order with one LP. LP takes on associated risk.

  • Trade is contained so market impact is reduced.

  • LPs less likely to aggressively change prices since they control entire trade

  • Builds trust between client and LP

  • LP may quote higher prices to account for risk

  • Capacity limitations

 

Sweep executions split large trades into smaller parts executed across multiple LPs.

  • All trades occur nearly simultaneously, leading to a quick market response

  • LPs must hedge risk quickly which leads to volatile prices and higher transaction costs

 

Assessing quality of liquidity provider:
We can use the following criteria:

  • Visible spread determines the initial cost of a transaction. Narrower spread is more competitive pricing

  • Rejection profile shows the frequency and reasons for trade rejections by the LP

  • Market impact is the extent to which an LP usually affects overall market price. LPs smoothing flows reduce adverse impacts

  • Correlation is the similarity of quotes between LPs and the aggregator. Low correlation gives better diversification, high correlation adds redundant liquidity

 

Dark Pools

 

Mechanics and order placement strategies:

 

Mechanics are as follows:

  • Bid and offers sent without price, just quantity

  • When opposing interests match, fill is generated at the current mid-price

  • Can impose a minimum fill quantity or a minimum time before cancellation to avoid arb

 

Dark pools are used for anonymity, to trade at the mid-price and to trade large blocks without market impact. Tradeoff between this and adverse selection

 

Strategies are as follows:

  • HFT arbitrageur can buy deep into primary LOB to raise the price, then sell at the mid in a dark pool which will be greater than purchase cost

  • We form game theory problem. Toxicity metric is |r-r*| (closer to 0 means more toxic), where r is probability toxic trader submits trade and r* is nash equilibrium

 

To limit adverse selection:

  • Set limit prices on dark pool orders that make the strat unprofitable

  • Use toxicity metric to select execution venue and timing

  • A genuine trader with access to large data sets is most likely to win (i.e. a large broker)