Dark Pools
How electronic trading and off-exchange venues took over.
Summary
Patterson, a Wall Street Journal reporter, traces the transformation of American equity markets from floor-based trading to automated electronic execution, and the rise of high-frequency trading firms that resulted.
The narrative centre is Josh Levine, the programmer who built Island, an electronic communication network that matched orders directly at prices finer than the sixteenth-of-a-dollar spreads that Nasdaq market makers maintained. Patterson presents Island as an attack on a cartel: academic research by William Christie and Paul Schultz had shown that Nasdaq dealers avoided odd-eighth quotes, keeping spreads artificially wide, and the resulting investigations and rule changes opened the market to electronic competition. He then follows the consequences through decimalisation, the Securities and Exchange Commission's Regulation National Market System, the fragmentation of trading across dozens of venues, the growth of firms including Tradebot, Getco and Renaissance, and the arms race in latency.
His argument is that the reforms intended to democratise markets produced a structure dominated by a small number of firms with speed advantages, that displayed liquidity became unreliable because quotes could be cancelled faster than they could be hit, and that complexity created fragility. The 2010 flash crash is his evidence.
The book is reported rather than analytical and Patterson takes a critical position without engaging the strongest counterarguments, which are that bid-ask spreads and explicit trading costs for ordinary investors fell substantially over this period, and that academic studies of high-frequency trading's effect on market quality are mixed rather than uniformly negative. It also predates several structural changes including the IEX speed bump and subsequent rule revisions. Michael Lewis's Flash Boys covers overlapping ground two years later with a narrower focus.
Key takeaways 7
- Nasdaq market makers maintained artificially wide spreads by convention, which academic research documented and which triggered the reforms.
- Island and other electronic networks broke the dealer cartel by matching orders directly at finer price increments.
- Regulation National Market System required orders to route to the best displayed price, which fragmented trading across many venues.
- Fragmentation created the opportunity for firms with faster connections to trade on price differences between venues.
- Displayed liquidity became unreliable because quotes can be cancelled faster than a slower participant can act on them.
- Speed competition consumed capital in infrastructure that produced no improvement in capital allocation.
- Market structure complexity created interactions that no participant fully understood, which the 2010 flash crash exposed.
Who should read it
Investors and market structure practitioners who want the history of how electronic markets displaced floor trading and what the resulting structure looks like.
About Scott Patterson
Reporter at The Wall Street Journal covering markets, trading technology and financial regulation.
The Quants follows Ken Griffin, Cliff Asness, Jim Simons and Boaz Weinstein through the August 2007 quant unwind and into 2008, showing how crowded factor positions liquidate against each other. Dark Pools traces the move from floor trading to automated matching and lays out the fragmented market structure that high-frequency firms operate inside.
Where it sits in the reference 3
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