Financial marketsCitadel Connect and Dark Pools.

Kennnedy MuturiFebruary 4, 202354316 min

Before dark pools, institutional investors had to trade in blocks of shares outside of trading hours to avoid upsetting the market. Now, the utility of dark pools is so great that several market makers have integrated them into their operations. There are some advantages here in enhanced liquidity, but there is also another side to the coin.


Retail traders discovered substantial short positions held by hedge funds in several stocks during 2021. Many retail traders assume naked short selling is involved. Hedge funds have together lost $12 billion to this point. Citadel Connect, a dark pool run by Citadel Securities, is one of the most recent developments in this drama.

Citadel Securities and Citadel Connect are two companies that work together to provide financial services.

If you haven’t been keeping up with the WallStreetBets drama via many Senate Banking Committee hearings, here’s a quick rundown. Citadel Securities LLC, the largest Designated Market Maker (DMM) on the NYSE, accounted for 47 per cent of US-based retail trading volume in Q1 2021, as well as a substantial percentage of Robinhood‘s Q1 2021 revenue, according to Robinhood’s PFOF (paid for order flow) business model.

PFOF is a highly contentious technique because it can lead to conflicts of interest, so it is outlawed in many Western countries (the UK, Canada and Australia). On June 9, current SEC Chair Gary Gensler mentioned some potential routes for misuse.

“Payment for order flow presents several critical issues.” Are there inherent conflicts of interest in the work of a broker-dealer? If this is the case, are customers receiving the best execution in the context of that conflict? Is it in the best interests of broker-dealers to urge consumers to trade more frequently than is in their best interests?”

In the same statement, Gensler observed that around 9% of January’s trading activity was executed on alternative trading systems (ATSs), sometimes known as dark pools. Dark pools, as their name implies, have the effect of obstructing market resolution. As stated by Gensler, the aggregate quotation reporting on the bid-ask quote spread — the National Best Bid and Offer (NBBO) – is skewed in stock market jargon:

“First, as indicated in January, approximately half of equities trading interest is either in dark pools or is internalized by wholesalers.”

Internalization implies that the order is not sent to the market maker but that the broker fills the order from its stockpile. Citadel Securities, for example, was fined $22 million in 2017 for “misleading claims implying that it would supply or attempt to obtain the best rates it saw for retail orders routed via other broker-dealers.”

Continuing with dark pools, Gensler came to the following conclusion:

“The NBBO does not account for dark pools and wholesalers.” Furthermore, the NBBO is only as good as the market. As a result of the existing market’s fragmentation, approximately half of trading and many retail market orders occur outside of the lighted markets. I believe, may have an impact on the width of the bid-ask spread.” Citadel Securities owns and administers Citadel Connect, one of 50 such dark pools in the United States.

What is a Dark Pool, and Can It Be Misused?

Alternative trading systems (ATSs), often known as dark pools, are private exchanges that provide liquidity but can also disguise deals. They account for more than 40% of the global equity market when combined with internalizers. Following the SEC’s approval of Regulation NMS in 2005, dark pools gained traction (National Market System). NMS revolutionized the stock market into what it is now. As a result, dark pools are entirely legal and regulated.

On the other hand, dark orders are so-called because they do not appear on the exchange’s order books. The apparent objective of this feature is to stabilize the market by not alerting other market participants when significant orders from institutionalized investors are placed. Other players would initiate a downward price movement if the order size were in the open — on the lit market.

Dark pools boost liquidity and market efficiency by preventing this from happening. Nonetheless, just as dark pools are designed to minimize transparency, they can also mask conflicts of interest. Some historical examples of how dark pools have been abused are as follows:

  • On October 3, 2012, the SEC charged EBX LLC with failing to protect its subscribers’ sensitive information, allowing other parties to use the information
  • On June 6, 2014, the Securities and Exchange Commission charged a New York broker with mishandling confidential information and utilizing it for marketing purposes.
  • The SEC charged UBS Securities LLC on January 15, 2015, for failing to disclose an order type that is only offered to market makers.
  • The SEC charged ITG and AlterNet Securities on August 12, 2015, running a secret trading desk and misusing confidential trading data.
  • On January 31, 2016, the SEC charged Barkley Capital and Credit Suisse with various crimes, including the execution of 117 million illicit sub-pennies.
  • Citigroup was charged by the SEC on September 14, 2018, for misleading dark pool users and routing orders in other trading venues. The SEC charged ITG and AlterNet Securities again on November 7, 2018, for similar offences as before.

It offers you an idea of the types of misuse that occur in dark pools. Having said that, because it is a private trade, each private pool has its own set of rules and limitations. Some, for example, only accept large orders or blocks, whereas others focus on high-frequency trading (HFT), which is how dark pools became famous in the first place.

Front running is the most common type of abuse found in dark pools. With the information that a trader is about to make a deal, another trader can trade the stock – sell or purchase – first and then sell it at a profit to satisfy the original request.

Is Citadel Connect a Dark Pool?

Citadel Connect is a dark pool, according to numerous reputable accounts. Citadel Connect, on the other hand, is not registered as an ATS and does not report its trading volume to FINRA, which is controlled by the SEC, according to a 2015 Reuters story:

“Connect, unlike Apogee, is not designated as a “Alternative Trading System” and does not disclose volumes to FINRA.”

According to Reuters, Citadel Securities intends to close its previously registered dark pool Apogee in 2015 because Citadel Connect has already outperformed it by five times. The market maker refers to connect as an “off-exchange trading” or “Immediate-or-Cancel order (IOC) platform.” Among its features are the following:

  • Deep and distinct main liquidity
  • reducing market impact
  • Intelligent order routing

These characteristics are in line with the objective of dark pools. However, SEC Chair Gary Gensler distinguished between dark pools (ATSs) and off-exchange wholesalers, noting that:

“That leaves around 38%, the majority of which was carried out by off-exchange distributors.” The vast majority of this group was made up of just seven wholesalers…” We are seeing concentration in the off-exchange market maker industry. According to one firm, it conducts roughly half of all retail volume.”

As you can see, the market is all about the flow of information and whose companies are best positioned to tap into this data flow.

“…since a sizable and growing portion of retail orders are routed to a small, concentrated group of wholesalers, certain market makers have access to more data than others.”

As we’ve seen in many other areas of our economy, a few central actors benefit from increased data use — whether in search, e-commerce, or, in this case, data from transaction flows.”

It is impossible to predict how this situation will affect the short squeezing of meme stocks until the conclusion is reached.

Kennnedy Muturi

Ken is a Quantitative Trader with experience in investments, quantitative finance, financial modelling and algorithmic trading in Global Investable Markets (GIM). He enjoys using Bayesian Statistics, Time Series and Machine Learning in developing Robust consistent Alphas in Equities Market, FX, ETPs and Derivatives instruments. He enjoys deep dives in understanding High Frequency Trading infrastructures and improving how the African financial markets work. He holds a Bachelor's in Actuarial Science from Strathmore Institute of Mathematical Sciences : An Executive Program in Algorithmic Trading (EPAT) certificate in Algo Trading from QuantInsti : A current MSc student in Financial Engineering at World Quant University.

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