In a previous post, I described some of the magic benefits of dark liquidity in terms of alpha. That article highlighted benefits from reduced friction and partial diversity of trading algorithms. Every time I think about dark liquidity, I visualize greater benefits. I'm certainly not the only one with dark liquidity pools popping up everywhere and now accounting for an astonishing 10% of current US equity volume.
Emerging Intelligence. The CASTrader market makers will provide for a fluctuating price spread between the CASTrader dark markets and the real, outside world markets they mirror. They will also provide for 24/7 trading as well, even where their real counterparts do not. The bulk of the trader agents in CASTrader II will trade the dark market, not the real market. To the degree CASTrader II is a success, the bulk of trader wealth will be with the dark market traders. I'm fairly certain that a dynamic price spread fluctuation will eventually develop between the two markets and that within the price spread fluctuations a kind of "intelligence" will emerge in the frictionless trading environment.
The fluctuations will allow the agents to cooperatively explore (via price fluctuations relative to the real market) the strength of consensus "beliefs" about the direction of market. Such explorations will enhance frictionless liquidity and potentially allow traders to exploit the apparent consensus of their peers. Predator and prey relationships between agents may (and hopefully will) develop. The price fluctuations will also give partial diversity a significant boost by allowing the agents to achieve partial diversity across time via price exploration.
Capital Cannibalization. The magic of all of this is that it potentially allows CASTrader agents to cannibalize each other's capital before the real market eats them alive, which is obviously much more beneficial to my own capital stockpile. I dub this concept "capital cannibalization" for lack of a better term. Traders will have two sources of profits: the real market and each other. In fact, since the bulk of traders will trade with each other, rather than the real market, the focus is on cannibalization. In my view, this is directly akin to the "intelligence" that can emerge in complex adaptive systems. It is a related but potentially much richer dynamic and more powerful than what I defined as partial diversity before. CASTrader will still present one "net" trade to the market via the arbitrageurs, but there will be a lot more than meets the eye going on behind the scenes.
Capital cannibalization is just a theory, but I'm about 80% sure it's a phenomenon that can emerge as an important force in a system like CASTrader. The challenge is how to provide the conditions to nurture it's emergence. The detection of it will be relatively easy: to the degree trading volume on the dark market significantly exceeds volume between the dark and real markets for extended periods, I think it's safe to assume capital cannibalization has emerged. The probable best way to enhance it's potential to emerge is to increase the partial diversity of the agents. Another key will be the ability of the market makers to provide liquidity without leaking too much capital to the real markets.
Update: it's my belief that the above will primarily be a result of the fact that the CASTrader dark market will be essentially frictionless (except for bid-ask spread) relative to the real market. New research examines the impact of transaction costs on prices.
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