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Article

Adverse Selection vs. Opportunistic Savings in Dark Aggregators

Serhan Altunata, Dmitry Rakhlin and Henri Waelbroeck
The Journal of Trading Winter 2010, 5 (1) 16-28; DOI: https://doi.org/10.3905/JOT.2010.5.1.016
Serhan Altunata
is research analyst at Pipeline Financial Group, Inc., in New York, NY.
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  • For correspondence: serhan.altunata@pipelinefinancial.com
Dmitry Rakhlin
is senior quantitative trader at AllianceBernstein in New York, NY.
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  • For correspondence: dmitry.rakhlin@alliancebernstein.com
Henri Waelbroeck
is vice president and director of research at Pipeline Financial Group, Inc., in New York, NY.
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  • For correspondence: henri@pipelinefinancial.com
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Abstract

Dark aggregators provide access to liquidity opportunities at multiple venues—yet the prevalence of high-frequency trading operations has raised concerns that these benefits may be lost to adverse selection. This article provides a methodology to separately measure opportunistic savings and adverse selection costs. These measures are far more accurate and less subject to selection bias than implementation shortfall. The authors find that in the case of dark aggregators and broker algorithms, most of the benefits of dark liquidity are counterbalanced by adverse selection costs. They analyze results from random marketneutral basket trade experiments conducted with Pipeline’s Algorithm Switching Engine to measure implementation shortfall without selection bias. The Engine uses a nonlinear model to predict participation rates and reduce adverse selection by switching into algorithms that are expected to perform well in the current market conditions. Predictive switching eliminates two-thirds of adverse selection costs relative to the continuous use of dark aggregators with only a small loss in opportunistic savings, resulting in a 40% reduction in the implementation shortfall. The authors show that a modified aggregator that blends traditional dark pools with displayed-market access to enforce minimum and maximum participation rates was able to provide full access to the benefits of dark liquidity while reducing adverse selection by 37%, contributing to a substantial improvement in trade performance for the desk.

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The Journal of Trading: 5 (1)
The Journal of Trading
Vol. 5, Issue 1
Winter 2010
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Adverse Selection vs. Opportunistic Savings in Dark Aggregators
Serhan Altunata, Dmitry Rakhlin, Henri Waelbroeck
The Journal of Trading Dec 2009, 5 (1) 16-28; DOI: 10.3905/JOT.2010.5.1.016

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Adverse Selection vs. Opportunistic Savings in Dark Aggregators
Serhan Altunata, Dmitry Rakhlin, Henri Waelbroeck
The Journal of Trading Dec 2009, 5 (1) 16-28; DOI: 10.3905/JOT.2010.5.1.016
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  • Article
    • Abstract
    • MAIN RESULTS
    • DEFINITIONS OF ADVERSE SELECTION AND OPPORTUNISTIC SAVINGS
    • ADVERSE SELECTION AND INTRADAY P&L IN UNBIASED RANDOM TRADES
    • APPLICATION TO INSTITUTIONAL TRADES
    • IS THIS A ZERO SUM GAME?
    • ENDNOTES
    • References
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