Dark Markets and Risk Policy

Is the Availability of Market Data a Consideration in Your Organization’s Risk Policy?

Dan Zastawny

President, Neutral Markets

Market design and evolution comes down to risk management. When it comes to managing risk in commodity markets, access to accurate and timely market data (ex. daily price curves, transaction prices, bids, offers, depth, indices, etc.) is crucial. Market data is something that must be collected, anonymized, aggregated, and often processed into averages, trends and other useful information. Producing market data involves the participation of market participants and third parties (ex. Price Reporting Agencies, Brokers, Trading Platforms, Exchanges, News Services, Analysts, etc.). In markets with high liquidity this data is almost always available and generally everyone contributes to the data as part of the aggregation process. It is no coincidence that reliable transaction data is readily available in all liquid markets.

There are many less liquid commodity markets (or yet-to-commoditize product markets), however, whose participants choose not to contribute market data for distribution. Instead, they prefer to maintain an imbalance of trading information to exploit market inefficiencies. These are the “dark markets”, where market data is either inaccessible or suffers from such high latency that it renders it useless. I’ve spent my entire career building, or trying to build, liquidity in dozens of different markets and this is the single most common reason why market evolution stalls and growth stagnates.

The question is: does this behaviour add to the risks for market participant organizations and should it at least be considered in corporate risk policy?

Before we delve into the rationale for considering this in your risk policy, it’s important to consider why accessible, low-latency market data is so vital to the evolution and growth of the underlying industry.

Price Discovery

Price discovery refers to the process of determining the fair market value of a commodity based on the interaction of supply and demand factors. With real-time data, traders can identify market trends and spot potential price movements, allowing them to adjust their strategies accordingly. Accurate price discovery benefits all market participants by promoting fair prices and minimizing information asymmetry. Fair markets with a more level playing field optimize the supply-demand balance and encourage more participation.

Informed Decision Making

Access to reliable market data in a timely manner provides participants with a clear view of current market conditions and prevailing prices. It helps to inform traders about responses to supply, demand, and inventory levels, enabling them to make well-informed decisions about buying, selling, or holding commodities. Informed decision-making lowers risks and is the basis for investment.

Improved Market Efficiency

When participants have access to market data, it enhances the overall efficiency of the market. Low latency ensures that the time gap between data generation and its availability to traders is minimal, enabling them to respond swiftly to changes in underlying fundamentals or shifts in direction. Efficient markets enable traders to react and pivot to changing conditions with less effort and risk.

Mitigation of Market Manipulation

Low latency and real-time market data act as powerful tools against market manipulation and unfair trading practices. In highly transparent markets, participants can easily detect abnormal or sudden changes in price and/or trading volume. Suspicious activities can be flagged promptly allowing for oversight at the corporate governance and, often, regulatory level.

Increased Market Liquidity

Low-latency, widely accessible market data encourages higher market liquidity, attracting more participants and enhancing overall trading volumes. Liquid markets ensure that traders can execute their orders quickly without significantly impacting prices, allowing for smoother transactions, lower slippage costs, and lower risk in opening/closing trading positions. Liquidity also has a snowball effect as markets grow, where higher liquidity causes more investment, more new participants, stronger market depth and more trading volume, further increasing liquidity.

Risk Management

For businesses that heavily rely on commodities for their operations, market data is increasingly becoming an essential risk management tool. Access to real-time information allows companies to monitor their exposure to price fluctuations more effectively. Armed with accurate data, businesses can react to adverse market movements, pro-actively plan and execute their hedges, forecast credit and trade finance requirements, and generally stabilize their operations. Dark, illiquid markets, on the other hand, make it difficult to measure volatility in order quantify the value-at-risk in opening/closing trading positions.

Facilitating Innovation and Investment

Transparent commodity markets attract more investment and stimulate innovation. When investors can access reliable data on market trends and price movements, they are more likely to engage in long-term investments. Additionally, startups and entrepreneurs may find opportunities to develop new products or services based on market insights, fostering competition and driving market growth. Market data brings eyes to the market that is followed by capital.

Considering all these benefits, why are dark markets preferred by traders in so many illiquid commodity markets? The answer that I almost always hear is because of the belief that the information asymmetry benefits the organization. That the lack of market data results in wider spreads, more control over dictating the market price, and greater price arbitrage between uninformed counterparties – ultimately, greater profit potential for the trader and their organization.

Traders who support dark markets usually do so based on the notion that they benefit most or all the time from the absence of market information. While there may be cases where this is true, more often this is a result of a rigid belief in the dark markets fallacy. What are the pillars of the dark markets fallacy?

First, in many “dark” markets there is no formal source of market data, but the market data is still distributed to almost everyone via brokers or word of mouth networks. Quite regularly the balance of market information is already there (ex. everyone ‘knows’ the price or ‘knows’ about a trade that just happened) but there is a perception that it isn’t. This tends to be combined with the notion that if everyone sees “my” anonymous trade data that they will know it’s me and use the information against me (I’ve found that usually people think that they have hidden their trades from view when in fact they are widely known by other traders via modern communication channels).

Second, everyone remembers the wins and tries to forget the losses. The dark markets fallacy is so pervasive that many will fall into the trap of confirmation bias and status quo bias even when trading results are mixed. Often the number of wins may add up but the size of the losses either greatly diminish or completely negate those wins. Large losses in dark, illiquid markets are a considerable risk but even more so when you are trading with a false confidence that you control key market data.

Third, markets adjust. If you continually gain on the back of information asymmetry, the odds are that over time either market liquidity will fall sharply, or others will hoard equally vital information from you. While relying on an imbalance of information to pad profits might seem like a logical strategy in the very short-term it might seriously impair future opportunity for the organization.

Fourth, there is a divide between the interests of traders and shareholders in many organizations. In the short-run dark markets can drive trading profits, but in the long run dark markets keep new participants and new investors away. This has a stagnancy effect on the value of industry assets, many of which are often controlled by the corporations that are trading around them. For most market participants their core business is not trading. They are producers, consumers, or other asset-based companies along the supply chain that happen to have a trading desk to optimize their activities. The trading desk is motivated through bonus incentives to grow trading profits, but the shareholders of the company are often more motivated by the value of the non-trading growth of their business. When you build an asset you are taking a substantial up front risk to take a long term long position in a given commodity market. It can be somewhat easy to lose sight of this in the day-to-day clamour of the trading floor.

It is my assertion that dark markets add risk to organizations in commodity or developing commodity markets and, on balance, almost all organizations are better off with the availability of easily accessible, low-latency market data. A lack of price transparency and access to other low-latency market data makes it nearly impossible to quantify risks accurately and builds an exaggerated (if not false) trading confidence amongst those who feel that they benefit from information asymmetry. There is no way to adequately test the perceived value of this information asymmetry because of an inherent confirmation bias and status quo bias. Furthermore, shareholders often wear the risk of the dark markets that they are in since the value of the corporation’s assets tend to be constrained by the illiquidity that dominates dark markets.

At a minimum, I feel that all organizations should consider their contribution to price transparency and accessible market data in the markets they participate in. I fully believe that any short-term pain felt from adopting a pro-transparency position will be more than offset by medium and long-term gains to the industry and to the value of existing assets. If you choose to affirm dark markets as the best practices for your business, then senior management and shareholders should be on board with that decision. And if so, there should be some consideration of the risks inherent in that choice. This would raise awareness so that informed decisions can be made should returns on the business suffer.