OTC vs. Exchange Trading vs. Dark Pools

OTC vs. Exchange Trading vs. Dark Pools

What You Need to Know About Exchanges, OTC, Dark Pools and More
What You Need to Know About Exchanges, OTC, Dark Pools and More

While not without its critics, decentralized dark pool trading has become significant in the ever-evolving world market. Advocates say the positives of this no-transparency trading include limited market impact on large orders, lowered trade costs and better prices. Has modern technology combined with information — or lack thereof — tilted the power of negotiation in favor of the investor?

Exchange vs. OTC

There are two basic ways of organizing financial markets: an exchange market and over-the-counter (OTC) market. Exchange markets refer to the traditional, physical place where trades happen, such as the New York Stock Exchange (NYSE) and the Chicago Board of Trade (now part of the CME Group). Whether still a physical trading floor location, or strictly an electronic trading platform (such as NASDAQ), an exchange market centralizes the communication of bid and offer prices. Participants can take action by selling or buying at one of the quotes or by countering with a different quote. When both parties reach an agreement, the price is announced throughout the market. The transparency of exchange market-trading results in equal opportunity — any market participant can buy as low or sell as high as anyone else.

The OTC market has no central location, all the trading is done electronically through the telephone, email, and other computerized systems. OTC markets are for securities not listed on a stock exchange and therefore have less transparency than exchange markets. In an OTC market, trading is done directly between two parties, without others being made aware of the transaction price — agreements on bid and offer prices are not communicated throughout the market.

On to dark pools

Dark pools, the somewhat menacing-sounding name for private electronic forums, permit institutions to trade directly with each other outside of the central stock exchange. Dark pools are named for their complete lack of transparency and are not available to the investing public. In spite of the sinister term, dark pools came about to help investors carry out large block trading orders without negatively impacting the market. Proponents of dark pool trading point to reduced trading fees and costs, and say market participants still benefit if they are invested in mutual and pension funds.

One company whose clients would likely consider dark pool trading a positive development is PDQ ATS, Inc. PDQ, which stands for Procedure Derived Quotes, is a registered broker dealer that fosters competition to provide improved prices to its clients through slowed-down high-frequency trading (HFT). (HFT is a platform that uses powerful computers performing complex algorithms to carry out a large number of orders at extremely fast speeds.) In a recent Bloomberg Masters of Business interview with Keith Ross, CEO of PDQ, Ross explains how his company provides better pricing opportunities. “An order comes to us and we pause it for up to 20 milliseconds. But in that time, we do something very constructive for the order … we ping our liquidity providers with only the symbol and effectively bring back the question that used to be asked at the post: ‘What’s your best market?’” Ross says PDQ uses a dozen providers that are all responding. This on-demand auction model creates competition for every order.

Dr. Jim Mahar, St. Bonaventure School of Business Finance Professor, is an advocate of PDQ’s model, that is, sending out only the symbol on an order, without communicating the size of the order or if the order is for buying or selling, and receiving quotes back from multiple providers. “They (PDQ) essentially have recreated the old specialists' book. The customer then gets the best price. This, in my mind, is pure genius,” Mahar says.