Dark Trading, Clear Results

How the Signal and Speed Bump help IEX avoid the gray pool problem

What is the gray pool problem?

A classic market microstructure problem, often called the “gray pool” problem, involves dark midpoint trading on lit exchanges. Lit exchanges with large quotes typically see inferior performance on dark midpoint orders, the conventional wisdom being that those large quotes incentivize lots of high-alpha (or “toxic”) spread-crossing orders. This is evidenced by the significant amount of adverse selection seen on near-side trades on other maker-taker exchanges. Those spread-crossing orders will sometimes happen to hit a dark midpoint order on their way to the far touch, and in those situations, that dark midpoint order typically gets “run over” by these aggressive spread-crossing orders. These aggressive contras bring down the average performance of the midpoint order, so venues with more quotes have more aggressive spread-crossing orders, thus worse midpoint performance.

By contrast, 96.5% of IEX’s midpoint trade volume traded is executed against a contra order priced at the midpoint. It’s no surprise that IEX has historically managed to avoid the gray pool problem and achieve dark performance on par with the best ATSs. One way to measure this performance difference is by looking at the “stability” of midpoint trades. We define a stable midpoint trade as one where the Midpoint of the NBBO is unchanged 2ms after the trade. We see that on Maker-Taker exchanges, midpoint trades are nearly 3x more likely to be “unstable”.

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IEX Displayed Growth

As we discussed in a recent blog, IEX’s displayed trading has grown significantly, more than 2.5x in recent months. However, the unique architecture of IEX's Speed Bump and Signal¹, along with its pricing structure, have historically helped maintain best-in-class dark midpoint performance despite becoming a displayed exchange and garnering a competitive amount of lit quoting and trading. With IEX's recent growth, we wanted to check in on that dark trading performance to ensure that IEX's ability to avoid the "gray pool problem" continues.

D-Peg continues to shine

As we can see in the above chart, D-Peg continues to perform as well as ever. To us, this is no surprise, since D-Peg rests behind the displayed quote in priority, exercising only the necessary discretion to step up to the midpoint. This means that by design, spread-crossers can't "run over" D-Peg at midpoint, because D-Peg will only step up to the near touch to trade with them, and it will only trade with them at all after they have exhausted IEX's displayed quote and any non-displayed interest at the near touch. Lastly, D-Peg benefits from Speed Bump and Signal protection, so if IEX receives spread-crossing orders while the market is already in transition (when IEX's Signal has just fired), D-Peg turns off its discretion entirely, resting 1 tick outside the NBBO.

What about M-Peg?

Given those protections, one might suspect that IEX's M-Peg order type, which rests on the book at the midpoint (similar to other exchange midpoint order types), and does not have the benefit of the Signal might be more "at risk" to the gray pool problem of deteriorating performance as IEX gains lit market share.  However, the below chart suggests that this is not the case.

We attribute this to two factors. First, M-Peg still benefits from the Speed Bump, which allows IEX to peg orders more accurately than other exchanges and dark pools, preventing trades at potentially stale midpoint prices. Second, IEX's fee to remove displayed liquidity is 33% cheaper than most other major exchanges, which we believe attracts more favorable spread-crossing flow. Historical data shows that IEX's near touch markouts resemble those of inverted venues, with flatter patterns that signify less adverse selection compared to other maker-taker exchanges. This means that when a spread-crossing order "runs into" a resting M-Peg order, that M-Peg is less likely to suffer from adverse selection.

Even as IEX’s displayed trading volume has grown, our dark order types have continued to perform as well as ever.

For more information on IEX dark order types, see https://www.iexexchange.io/products/order-types.

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