Here are the previous pieces in this series;
Dark Pools I: A Primer to Darkness
Dark Pools II: Do they Exist? A TLDR inside.
Dark Pools III: Specific types of Dark Pools
Dark Pools IV: History and Possible Origin Story
Dark Pools V: addressing Conspiracies
Dark Pools VI: So are they good or what?
Dark Pools VIS: Intermission
So Dark Pools Part III, has information on Supplemental Liquidity Pools and Internalization in case you want a background understanding beyond what is covered here. Here is an excerpt from part III;
This is a small note to keep in mind as you fall deeper into depravity with your scrolling descent.
Before Internalization was made,
Internalization was proclaimed a threat to price discovery!
By one of the largest Market Makers that provide for this sort of practice today, I’m talking about Citadel Securities that bragged on Twitter for handling all the Market Orders during a specific idiosyncratic Stock Risk and sneeze in January 2021,
Was covered in this letter;
Posted/written by this company;
And this company was also fined for this;
The same corporation that also created their internalizer over seas in Europe. Obviously not to redo the same things. Obviously.;
lmao, while I’m dunking on Citadel, here is more dirt about their specific role in Internalization and Market Abuse with a product they call ‘Citadel Connect’;
And this specific talk is saying that they intentionally insert themselves as the middle man to arbitrage between traders. On in every four retail trades, that’s a lot of the chunk of retail, and that’s before the gamification and massive PFOF from Robinhood.
So Citadel here get a speed advantage and are able to later offload or onload equities as they see fit.
If you understand Slippage, arbitration, HFTs, and the significance of Latency for trades,
Then you understand that this last sentence quoted above is nothing to trifle with;
“We bridge the liquidity by buying from one and LATER selling to another.”
Thus Internalizers are, or have the power to, profit from temporal slippage. It’s arbitrage selling the difference in time between things. Sell one thing at a certain point in time when it’s high, then buy when it’s cheap. They get to essentially decide when they want to buy and sell, based on the displayed price they have for the National Bid and Offer.
So the people who were initially against Internalizers, became the thing they were against.
They said it was a threat to price discovery, which they are correct, and then they proved to the world that Citadel used internalization. . . To threaten Price Discovery, and ultimately Price itself. . .
Here’s a related clip;
This is what your order looks like if it goes to the market;
Well to understand Private exchanges, we have to understand how orders work, Specifically, the Order routing or ‘order flow’ process from your Granny placing the order to it being executed and fulfilled. We’re going to focus on where the order goes.
When a retail trader like you (because why are you on this site if you actually head an AUM of > tree-fiddy?) places a trade through your broker, it can look like this;
You place your order with the Broker, Your Order has been executed.
The Broker does it’s job as a Middleman or Broker, and actually brokers a deal to match your buy with a sell, or your sell with a buy. The Broker takes your order and places it on Da Market. Da Market has a bunch of other Brokers selling and Buying, and when two brokers have conditions that meet, they make a trade. When the transaction is done, Your Order has been fulfilled, and you should have either the shares or the cash in your account (give or take a settlement period).
Typically, if things were to happen properly. When you buy something, the Broker that is supposed to buy it for you, well, they buy it for you.
Supposed to. . .
And if things were to happen properly, when you sell something, the broker is supposed to sell it for you.
If. . .
Somehow, in the markets evolving today, we’ve gone backwards and sometimes they don’t even buy it for you, or route your order directly to market.
With the whole Continuous Net Settlement (CNS) system and the vault keeping that they do at the DTCC, there’s actually no guarantee that your buy or sell orders actually ever hit the market. The simplest way to describe it is; Some basement Troglodyte is just moving numbers on an excel sheet and no shares are actually moving. It’s all imaginary. . . But that’s a conversation for a different day.
This is the Order Flow process.
This is internalization;
A way for your orders to never hit the market, there’s a thing called Internalization.
“The process of taking the other side of the trade of the retail orders is known as “internalization.” -The SEC
Usually your broker has the shares in their inventory (under CNS) and they just do a quick trade with your order. They do it all at their ‘Desk’ which is lingo for in-house. In house is also lingo for Internalized, or internalizer. Essentially you trade with the internal private pool of the Trade Desk.
Internalization means that the order is not routed to the market, or other market participants. Instead the broker itself fills the order from its own inventory of shares. It’s basically done in-house or internally. Hence the name Internalizer or Internalization.
This is what your order looks like if it is internalized. It may be internalized in the Broker, and it never reaches the market. Sorry, I meant Da Market;
Notice how your order never reaches da Market
Your broker ultimately wants a balanced book of not owing shares and also having shares. (Delta hedging and all that jazz is partially/tangentially related.)
So if your broker is running low on supply of shares, they’ll contact another Market Participant to get some shares. The Market Maker will match broker-to-broker or to another Market Maker and provide the shares from somewhere, maybe their own inventory or some other trade.
Notice how your order never reaches da Market (still)
Yea, because your broker contacts another Market Participant with their own dark pool. Obviously they would gobble up that juicy trade. We can’t have orders actually affect the Market in Oddlots now, can we? People might get the delusion that the markets are free and fair, and we definitely can’t have that.
-What your broker might do is route that order to a Market Maker or Bank and try to get you those shares.
-The Market Maker (or bank) will then see if they got any on hand, to try and internalize it on their end.
-If not, they send that order to a big dark pool that connects other dark pools to try and find you a match.
Notice how I underlined ‘on hand‘, well, turns out, almost everyone has a dark pool. When I used the phrase “On hand”, that means they are checking their own dark pool(s) for shares to deliver to you. To fulfill their end of the obligation.
If they aren’t checking their dark pool, then they’re checking with the accounted ledger saying how many shares they should have on hand at the DTCC/(Cede and Co.). As long as they have more, or enough to create more, then they’re good to operationally pretend that they have your shares.
But of course, that’s assuming they had the intent to actually deliver you real shares. When these institutions buy on your behalf, they stick the ownership under their name as a ‘street name’ and allow the DTCC and other lending programs to loan out your shares for profit. Thereby giving you no shares, synthetics, or just making your investment decision unsavory as they intentionally manipulate the price.
Speaking of Synthetics and lending out shares.
What if they don’t want to -or cant- find shares?
If the Broker or Market Maker doesn’t have any shares in their inventory, and they also don’t want to buy any new shares from the exchange or other Brokers/Market Makers, then a Market Maker can sell shares short.
Technically, they could’ve done this from the get go. It was totally an option. It’s just not as profitable or it’s more risky to just sell phantom shares or borrow shares.
Simply issuing an I.O.U. for one share, while having a set amount of days for delivering to you that share. (usually a T+2 settlement). Buy hey, with FTD’s they could always Fail to Deliver in 13ish days and reset the FTD over and over again.
So your shares might never be bought, like ever, and be in perpetual limbo of non-existence that would piss of Cognitionary theorists. That’s a hint to think and therefore you are.
“or by selling the security short”
So, in their books (Broker) they say you have X shares of Stock without them ever having to buy any shares.
Let me say that again slightly tweaked just so you understand.
They never had your shares.
You’ve been Duped.
You’ve been Conned.
And dare I say, Bamboozled.
Welcome to Dark Pools my boy.
Remember, all of these orders then somehow affects stonk price, even though everything happened behind a curtain and doesn’t really appear on NBBO. So it actually doesn’t affect stonk price, that was a joke. I was lying to you. lmao.
The Price is fake and NBBO doesn’t mean jack shit. Remember?
And if you think that’s the worst of it, well, buckle up sweet toots,
Payment For Order Flow (PFOF),
PFOF; Historically, Retail Investors paid a fee or commission to their brokerages for executing personal trades. Today, most brokerages do not charge their investors a fee per transaction, rather, they earn revenue through rebates, kickbacks and other payments from market makers. These payments are collectively known as payment for order flow.
PFOF is simply, brokers routing their orders to specific exchanges or through market makers to get a rebate. Essentially they are getting paid via coupons and kickbacks to direct the orders through someone else.
It would be analogous to a game of poker. But instead, you’d have to show your opponent every card you get before it’s dealt to you. So they can basically screen-peak on what you have coming down the order-flow-piping before it hits a market.
And, the market maker can also decide which ‘market’ your orders hit too. Hell, they might even decide not to let it hit the market.
Here’s the simple picture with some captions;
You send your Order to the Broker. The Broker ‘Sells’ your order to a Market Maker. The Market Maker decides if they want to internalize the trade or let it hit the market.
Market Makers will intentionally pay for orders to be routed to them, they have many different reasons for doing this, some illegal, some legal. They can make money from selling the data, they can use the data to create predictive models, they can manipulate the price action by controlling the supply and demand side through order flow, and Market Makers can also profit from having Retarded Traders make bad bets.
Oh, Also the Market Maker can also trade ahead of you. I mean, they know what’s coming down the order pipe. They see what cards you got. Why wouldn’t they just do the rightfully illegal thing and skim some crème from the crop?
Essentially Market Makers are paying for Order Flow. It’s function is literally in the name. Payment for order flow.
The benefit for retail traders that have their order flow poached or sniped, is that they get Commissionless trades or some other shit. But basically, you lose more money if the market is rigged, so it sure feels like you got a ‘free trade’.
Just remember, if something is ‘free’ then you’re probably the product.
Market Makers pay for the order flow to go through them.
And if Market Makers can’t take the order, then they pay a fee to route the order flow to the actual lit exchange;
This creates a Strong interest and financial incentive for Market Makers to *GASP* not route orders to the lit exchange, like at all. Shocking.
They lose money if they do that. So why would you? If you’re in the business of making money, logically you would try your best to not lose money. So obviously, Market Makers would try their hardest to not route orders to lit exchanges.
So Market Makers would go ahead and take these trades at nearly any cost. This also lead to the GME Fiasco because some retarded people decided to gobble up more than it can chew, or take the other side of more trades than were in existence or could handle, thus they basically had to manipulate the price in order to not implode;
So, now that we talked about Internalizers and PFOF, let’s combine em’.
Internalization combined with PFOF;
This is an additional ‘feature’ of having Internalization and PFOF,
This allows for artificially larger spreads which means a bigger gap between the buy and sell (bid and ask), allowing for more slippage and wiggle room for Market makers to make more money by taking the other side of the trade when routing market orders from ‘clients’ (or shmucks) to market.
Because these market makers can control which buy or sell orders hit the market, they can effectively control the spreads. If they make it so that the spreads are larger, they can make profit by arbitraging the trades that they take in with the wider spread. So when you buy, you buy at a higher price, and when you sell, you sell at a lower price. That’s the simplified jist of it.
The Market Makers get a temporal advantage trading in internalization schemes because they have the action to determine at what price by virtue of ‘when’ to deliver a share or cash. This is basically a ‘fake share or cash’ because nothing really is being traded since nothing really gets delivered on time.
So they can decide to say that you Five Buy Orders were fulfilled, and then go buy them whenever they feel like it. You get your shares on paper, but the Broker never actually buys anything until they feel like it.
Same with selling. You get your cash on paper. But the Broker never sells unless they feel like it.
And by ‘Feel like it’, I mean they calculated their risks and saw profit potential and got their shares for cheaper than what you bought and pocketed the difference. Or they sold your shares for more than what you got and pocketed the difference. Often times they are not rushed to ‘Feel like it’ so they are probably making some money off your back.
Shares exchange hands in name and faith, by some excel spread-shit under the Broker or some ledger held at the DTCC under the CNS system.
This is why these Market Makers are fighting so hard. Imagine being able to scrape even fractions of a penny off of every trade. Billions of trade volume can turn into millions of dollars, very quick.
I mean, with the PFOF discussion earlier. They lose a penny or so per share that hits the lit Market.
Know that if they can lose pennies, then they can also make pennies.
Those pennies add up, and now you’ve got this profitable pathology.
This shit is realer than real.
Here is a simplified picture on how this affects Price Discovery;
By ‘Price Discovery’, I mean actual displayed price. Because the SEC bois don’t want to make it seem like the Price displayed is questionable, or else people would lose faith in the markets. Instead, they say ‘Price Discovery’ because it sounds like the ‘True Price’ hasn’t been found yet and that this whole sham scam isn’t just an elaborate game of smoke and mirrors.
Your ‘Buy orders’ can be routed into dark pools and internalizers, while your ‘Sell orders’ can be routed to the actual Market/exchange and tank the stock.
The reverse is also true,
Your ‘Sell Orders’ could be internalized, and the ‘buy orders’ could be routed to the Market to shoot the stock to the moon. Pumping it up like a Bull Run in Spain.
So price is a fickle thing that is definitely manipulated. This is what we call, market manipulation. And for the majority of the markets, it’s often played like this in some degree or manner. There’s a lot of hands in the pot, and a lot of hidden messages being passed around through oddlots and order flow, so, yea. . .
That’s the big takeaway,
That Dark Pools are abused with Order Flow and Internalization.
Here’s an Example;
This is more or less, relating to a very spicy topic that is actively a heated battle ground of the financial markets. This is one example with several SEC reports to indicate how fucked this whole Dark Pool Internalization thing is.
During the (ongoing) January GME Fiasco of 2021,
Brokers and Market Makers conspired to tank the price of Game Stop to internalize trades and buy shares for cheap. Market Manipulation. That’s a Fact. They actually did Conspire.
Citadel, (as mentioned earlier in this article, yea those guys), was allowed to cover their short positions using Internalization.
The Sold shares were internalized, and bought by the market makers. So the Market makers took the other side of the trade, to buy shares, to cover their own short position. This also tanked price, because of the shitty Position Close Only resulting in massive sell offs and margin calls resulting in more selling. Essentially a bear raid.
All of this to cover some of the shorts they borrowed.
See, the Market Makers and Brokerages can’t afford to even play fair, that’s how shitty their business model is.
If we corroborate the above information with this SEC report;
So, Off-exchange is another way to say ‘Dark Pool’;
About Half of all GME dollar and share volume was reported to the tape and executed on a national securities exchange. This is only counting the volume that appeared on the tape.
So that means,
HALF of the Share Volume DID NOT get reported to the tape and executed on a national securities exchange
So the volume that didn’t appear on the tape is, of course, unaccounted for. (but they can’t do that, unless they were breaking the law. . . )
And, 62.6% of GME volume was executed off exchange. That’s a good chunk for just one security.
At least now you know for sure, that the things discussed above are all plausible and that this one particular investigation is evidence of that.
Imagine if they did this for more securities,
all of them?
It took an SEC report to get more facts and figures, so who knows what the unknown numbers look like for the unseen hand that grips the market beyond just a single Stock ticker?
The Whole Market could be equally fucked.
If this could happen with one stock in one company (GameStop), how ‘secure’ are the other companies listed and IPO’d on the open exchanges?
Yea, turns out, not very secure at all.
So the market has a bunch of Dark Pools and it’s all a ‘bump in the night’ with internalization and price fuckery.
Markets are rigged homie.
Here is some comments on Dark Pool Internalization abuse;
This is assuming that the Market Maker Internalizes the Trade and prints it to tape without the desire to move the price itself. . . Until the Market Maker wants to actually move the price.
I think I can provide a useful example of how selective internalization could be used by legal means to manipulate the price.
Let’s say the spread is $215 – $220. Somebody puts in a market buy order for 5 shares. They are willing to take that share at $220, and maybe the next best ask is $225, maybe they would have bought that too. These Trades would be printed to the tape, and the share price would move.
But, if a clever market maker has a vested interest in the price not moving, they could internalize the trade and sell those 5 shares at for $219. So the open market ask does not get hit, and the price does not move. The trade is still within NBBO, and printed to the tape, so nothing illegal has occurred, but it’s not allowing accurate price discovery.
Now say somebody puts in a market sell order. It would be in the best interest of the market maker to not internalize that trade, let it hit the best bid price on the open market, and the next, and the next, moving the price downward. Again, trade is within NBBO and printed to tape.
Nothing about this strategy violates those two principals, but the option to internalize within the NBBO or let the order hit the market bid/ask would allow a market maker of sufficient scale to appropriate buy/sell pressure in this way, legally. . .-Random User
Here is a response to the above quotes by someone who worked with this specific function,
This is accurate, it’s certainly how internalization works. The trade prints, and it prints close to the ask. The market knows that there is buying taking place off-exchange. As the buys pile up, that signal and information is communicated out into the market.
While I prefer that such trading activity take place on-exchange, I don’t think for this thought exercise that matters. What you’ve described is not really manipulation, it’s just how internalization works. And there’s a material cost to the internalizer to do this. So I’m not really sure how this conflicts with what I’ve previously described in other posts.-Response
Some people argue for and advocate Internalization. Which is a thing, there are merits for Dark Pools but the downsides should be addressed. So, here is some banter with some fax between an Internalizer pusher and a Better Markets type person;
So here it is – spreads for the ENTIRE market are wider by 25% OR MORE. That costs pension plans, mutual funds and even retail investors money. And it makes any figures that cite “price improvement” a joke – because the improvement is being measured by the MMers against a spread that is wider due to THEIR actions!–Dave Lauer
It’s also meant that execution costs in the US are higher than other countries when you adjust for company size:
That’s from a study by XTX Markets, one of the largest HFT firms in the world:
“As you can see, after controlling for the company size, instantaneously available lit liquidity in US equities market is inferior to Tokyo Stock Exchange and Europe, and even to Korea for small stocks( below 1 bln USD free float).
In fact for small stocks the conclusion is strongly in favour of concentrating all liquidity onto a single CLOB, as both US and Europe do badly there, and even FTT in Korea doesn’t affect this conclusion.”
PFOF, among other “market features,” is damaging pension plans, repeatedly, day after day. And it leads to more complexity and isolation of retail orders, which keeps those orders from interacting with the market, and confines them to interact only with OTC market makers (e.g., Citadel and Virtu).–Dave Lauer
It’s all elementary really simple really, as a Market Maker you decide if the order hits market or not. You either delay the buys (or the sells), or internalize the trades so they don’t hit the real market, or just be a cuck and say that it failed to execute because *reasons*. Lost in the nether.
With Internalizers and PFOF you can add pressure to either move a stock up or down.
So, the market is rigged.
Your Orders might never hit the market.
And they actually make money by not having your Orders never hit the market.
You might never have any real shares. Only on some excel spreadshit.
Your cash is credited on paper. But as evidenced by history, your broker might be illiquid.
“Internalization was proclaimed a threat to price discovery!” and It is a threat to Price Discovery.
Price Discovery isn’t real.
The Price is Fake. NBBO doesn’t mean anything.
So, the big takeaway is;
Dark Pools are abused with Order Flow and Internalization,
And Markets are Abused by Dark Pools.
Have a nice day;
*Not Valid Financial, Legal, Life, or Any Advice