What Is Anonymous Trading?
Anonymous trading occurs when high profile investors execute trades that are visible in an order book but do not reveal their identity. While most traders trade non-anonymously, there are several reasons that larger traders prefer to keep their participation in a market a secret.
Many stock exchanges, such as the London Stock Exchange (LSE), Toronto Stock Exchange (TSX), New York Stock Exchange (NYSE), and NASDAQ, as well as dark pools, offer anonymous trading for certain users.
- Anonymous trading may be important to large traders who don't want to provide clues to other traders that they are buying or selling.
- No regulated order is truly anonymous since the trades still need to be settled and cleared, and regulators still need access to trade information if they want it.
- Retail traders don't need to concern themselves with trading anonymously since they typically don't have a significant price impact and other traders aren't particularly concerned with smaller one-time orders.
Understanding Anonymous Trading
Anonymous trading is primarily used to avoid tipping off the market of a pending action, which could lead to front-running behavior or jockeying for the best position in an order book.
For instance, a large institutional buyer that's interested in acquiring millions of shares may not want to make their intentions known before they can complete the purchase. The risk is that smaller investors could bid up the price hoping to sell it to the institutional buyer for a quick arbitrage profit, or pennying could be used to unfairly gain execution priority.
Pennying is when other traders increase the bid by a penny, cutting in front of a trader who placed the initial bid a penny lower. Traders will often do this if they can see that there is an interested party willing to buy large amounts of stock. They cut them off, knowing that the larger party will likely keep buying even at higher prices.
Anonymous trading can occur through three different primary venues:
- Anonymous Exchanges: Many large stock exchanges started to offer anonymous trading when accessing the central order book due to competition from electronic communication networks (ECNs) that offer anonymous trading. Other stock exchanges offer hybrid trading systems that provide a choice of automated anonymous order execution and non-anonymous auction order execution.
- Dark Pools: Many ECNs offer anonymous trading through dark pools. Dark pools are private asset exchanges designed to provide additional liquidity and anonymity for trading large blocks of securities away from the public eye.
- Inter-Dealer Brokers (IDBs): IDBs facilitate and execute trades on behalf of institutional clients in listed and OTC financial markets. IDBs often work with large blocks of securities where there is low trading volume or when clients seek anonymity on their orders. When an IDB executes a trade on behalf of a client, only the name of the broker is revealed and not the
Dark pools are private exchanges for trading securities that are not accessible by the investing public. Also known as “dark pools of liquidity,” the name of these exchanges is a reference to their complete lack of transparency. Dark pools came about primarily to facilitate block trading by institutional investors who did not wish to impact the markets with their large orders and obtain adverse prices for their trades.
Dark pools are sometimes cast in an unfavorable light but, in reality, they serve a purpose. However, their lack of transparency makes them vulnerable to potential conflicts of interest by their owners and predatory trading practices by some high-frequency traders. While dark pools offer distinct advantages to large players, the lack of transparency that is their biggest selling point also results in a number of disadvantages. These include price divergence from the public markets and a potential for abuse.
Most anonymous trading is conducted by specialists and options market makers. Anonymous trades tend to be associated with a greater price impact, which is why the traders making these large orders want to be anonymous. That said, posting anonymous orders can be a tip-off to other traders that the anonymous trader doesn't want to be known, which in and of itself may cause front-running or pennying.
It should be noted that no trading on regulated exchanges is totally anonymous. Ultimately, settlement needs to occur and regulators must be able to access trade information if a suspicious transaction occurs. In this sense, anonymous means identity protection from other traders but not from regulators and other parties that must facilitate the actual trade and the clearing of the trade.
Small retail traders don't need to worry about anonymous trading since their orders have little price impact, other traders are not significantly concerned with other small trader's actions, and most retail traders trade through large brokers where there are thousands of traders so their identity is obscured to other traders anyway.
Example of Anonymous Trading on a Stock Exchange
A trader's specific identity is not publicly available when placing a trade through an ECN or exchange. Other traders don't know the name of the person making the transaction, but the brokerage or firm used to make the trade is visible.
For example, a transaction list on a Toronto Stock Exchange (TSX) listed stock will provide the time of the transaction, the price, the quantity, the exchange, as well as the buyer and seller broker/firm codes. This could provide clues as to who is buying or selling, especially if it is a firm with few clients, or it's a firm that trades its own capital.
On the TSX, an entity can have its name remain hidden by inputting an anonymous order. This shows up as a code 001, which means anonymous.
Each month, the TSX publishes reports on anonymous trading, revealing how many anonymous trades were conducted by each firm in the previous month. This provides some transparency to anonymous trading, yet still keeps other traders from know in real-time who is placing trades.
For retail traders trading through a large broker, anonymous trading is not important because there are so many clients at the brokerage that the broker will be constantly making trades in most equities. Only extremely large volume going through a particular broker may tip off other participants who know that certain clients trade with that broker.