Dark pools are not all that sinister, though they do offer a major challenge to the world of traditional public stock exchanges. For all their evocativeness, dark pools are simply computerized trading systems, often known as crossing networks, that provide a service by matching buyers and sellers in the private marketplace. Over the past decade, institutional investors and hedge funds have increasingly turned to these venues as trading speeds have accelerated and stock exchanges have consolidated, making it more difficult to mask large trades, curtail price volatility and reduce market impact.
Today, institutional investors choose dark pools when they want to buy or sell blocks of shares and escape detection from traders who might cause prices to move against them. Institutions typically use algorithms to chop large block orders into smaller pieces -- so-called child orders -- that are then executed in the market, some of them in dark pools.
The great advantage of dark pools compared to regulated exchanges is anonymity. If an institution wants to buy 200 shares of stock at a specified price, it can enter the order in a dark pool without anyone seeing the price. If another investor wants to sell that same security "at the market" (without a specified price, or at whatever the best bid is), it can indicate interest but never see the potential buyer's price. The computer then puts them together, in the dark, as it were.
Other TRF includes broker capital commitments and internalizations Other Exchanges includes NYSE Amex, CBOE, Chicago, National and PSX
Source: Credit Suisse AES® Analysis
Apart from the anonymity, investors use dark pools to get a better price, or to move more shares, than on established exchanges. "Most dark pool volume gets executed at the midpoint of the best bid and offer quoted on the exchanges," says Justin Schack, managing director of market structure analysis at Rosenblatt Securities Inc. in New York. "So if I want to buy XYZ and the public quoted spread is $10 bid and $10.05 offered, I can enter an order in a dark pool and buy it for $10.025. If I do that enough times while working a very large order, it can add up to substantial cost savings."
Once a trade is completed, dark pools post it to the consolidated tape, a public market listing that provides last sale and trade data. However, as an over-the-counter transaction, the pools disclose only price and volume, not the names of buyer and seller.
These benefits have attracted increasing numbers of investors, along with intensifying pressures to trade ever more quickly and cheaply. Today, some 50 dark pools offer an array of strategies and ownership structures, from independent firms to broker-dealer ownership, consortia and even traditional exchanges.
The emergence of dark pools has not been without controversy. Dark pools are part of a larger trend in which trading and share listings have been shifting from public to private markets. Latter-day corporate stars like Facebook Inc. now raise money privately through Wall Street banks, where they can maintain more control and perhaps cut more favorable deals. Dark pools offer similar advantages in block trading.
But dark pools do raise some contentious issues, particularly in a financial world still recovering from the economic crisis. Dark pools are often used by high-frequency traders, and they're often associated with the kind of rapid-fire, low-cost trading that feeds speculation. Dark pools are also the province of sophisticated investors; ordinary investors can't get in. This raises the specter of a two-tier trading system: one for wholesale, the other, costlier and slower, for retail. Perhaps most significantly, dark pools are a challenge to the transparency that has been a central doctrine of exchanges since the New Deal. To many critics, the financial crisis was a matter of eroding standards of transparency, particularly among newer, more complex instruments like derivatives. The Dodd-Frank reform legislation attempts to rectify some of that, particularly by requiring much of the OTC derivatives market to use clearinghouses. Always hanging over the dark pools is the threat that regulators will force transparency upon them, thus eliminating their very reason for existing.
And the owners of dark pools like Liquidnet face many operational and dealmaking challenges. Exchanges, public or private, survive on liquidity. The more liquidity that an exchange attracts, the more investors will want to use it and the more liquidity it will attract: It's a virtuous cycle that drives consolidation. This consolidation among traditional public exchanges has gone on globally for years now and has recently accelerated. The same forces driving NYSE Euronext into the arms of Deutsche Börse AG seem certain to sweep through the fragmented, 50-strong collection of dark pools.
A decade ago, dark pools were an exotic outlier in a world dominated by exchanges, an experiment in institutional trading tolerated by regulators and something of a mystery. They gained much of their initial traction in the Internet boom, when long-only investment firms saw assets under management soar. Companies like Liquidnet emerged to satisfy a growing demand to trade ever-larger blocks. The share of trading in dark pools has risen as U.S. market volatility, measured by the Chicago Board Options Exchange's VIX index, has declined (that ended, of course, with the financial crisis in 2008). The decline has since resumed. In December 2010, the VIX hit its lowest level since mid-2007. And dark pools' share grew as big banks and brokerages centralized order flow, used algorithms to match buyers and sellers, and increasingly sought to reduce execution risk.
Today, dark pools make up 13% of the U.S. cash-equities business, according to Rosenblatt. Broker-dealers like the big banks use a process called internalization, in which they try to match orders from their own customer trading flows before sending them out to dark pools or public markets; this accounts for 17% or more. So at least 30% of the equities business is bypassing traditional public stock exchanges.
For the past year or so, dark pools have continued to expand. Rosenblatt's Schack expects that their market share in cash equities will grow to 15% this year. Much of that increase has been driven by the big bank-owned dark pools, such as Credit Suisse Group's CrossFinder, which has a leading 2.82% share of equities, and Goldman Sachs Group Inc.'s Sigma X, which has 1.53%, according to Rosenblatt. Those shares have been driven by brokers routing order flows from their trading desks to their own dark pools. This can be lucrative. When a broker gets an order, whether from a prop trading desk or a customer, he'll run it through the bank's dark pool first, rather than routing it to an exchange and paying the typical 25 to 30 cents per 100 shares. It obviously boosts liquidity, share and profits.
Liquidnet operates differently. The firm has a smaller 0.39% market share, lagging other pools such as Getco Execution Services LLC, with 1.28%; Knight Capital Group Inc.'s Knight Link, with 1.33%; Morgan Stanley, with 0.74%; and Investment Technology Group Inc.'s Posit, with 0.59%. But it is one of the few venues to trade large blocks, an average of 50,586 shares versus a 271-share average at Credit Suisse CrossFinder. A traditional block averages 10,000 shares, though those that are broken into child orders tend to be much bigger. And market share might not be everything. Merrin says Liquidnet's share has never been higher. "We're a top 10 broker in the U.S. and the top one or two agency broker in the U.K." he says.
Still, for all the growth, running dark pools is one tough business, both competitive and dynamic. It requires a delicate balancing act, particularly when it comes to high-frequency traders. On one hand, these traders, armed with blindingly fast computers and finely honed algorithms, swarm the dark pools in search of opportunities and provide a considerable portion of their liquidity, a testament to the fact that traders are happy to earn fractions of pennies on high-volume trades.
On the other hand, while institutions, generally speaking, crave the liquidity provided by high-frequency traders, in the markets they also fear that they will be "gamed" by them, that traders will discern their plans and anticipate their intentions. As a result, dark pools have their own algorithms that try to protect their institutional clients' anonymity.
Indeed, beneath the surface of dark pools unfolds an intense arms race of computer power and algorithms between those who wish to "see" into the pool and those, mostly the pools themselves and their institutional clients, that want to retain opacity.
High-frequency trading is no minor phenomenon. Barry Silbert, CEO of New York-based SecondMarket Holdings Inc., a firm that matches buyers and sellers of illiquid assets in the private market, claims that high-frequency trading now accounts for 60% to 70% of the average daily volume in U.S. equities. Silbert calls them a menace. "The average holding period for a publicly traded company has gone from an average of five years in the mid-1990s to less than three months today," he says. They've created a "casino-like trading" market, he argues, where long-term investors have been replaced by those with short-term interests.
Managers of dark pools complain that they're often identified with controversial high-frequency traders -- a point that rankles them, but one that also suggests how tricky their position is. "When we first started talking to corporate CFOs and investor relations officers, they were really very hostile to us because we're a dark pool and all they'd heard is that dark pools are creating all the problems in the world today," says Liquidnet's Merrin, who has tried to combat the perception by teaming up with NYSE Euronext on a new business called InfraRed for corporate equity offerings. InfraRed provides public companies with a free snapshot of institutional trading sentiment of its stock and has picked up 450 companies; Liquidnet wants to sell those corporates its capital markets products.
Liquidnet and others argue that they provide order in a chaotic frontier of finance. "It's the Wild West out there with these exchanges and internalization engines," says Merrin. "Our customer base spends probably 80% to 90% of their time trying to dodge these bullets. They want to hide their order, protect it. We've created an institutional pool that has all these protections built in already."
Such protections help make Jennifer Setzenfand, a vice president and trader at Federated Investors Inc. of Pittsburgh, "a big fan" of dark pools. She uses them to source liquidity and place orders discreetly. She even appreciates what the traders bring to the game. "I want to protect my order flow from being gamed," she admits. "But on the flip side, it's a good thing if I'm using a vendor that trades with high-frequency traders because they've forced [the pool] to go faster. I want to be in the race and get the best price I can for my fund."
Ultimately, she says, it's tough to know how scrupulously, or effectively, the pools protect her from the gamers. She selects which pools she uses very carefully, but she depends on track record and trust. "Obviously, I don't want to go to Joe's dark pool," she says. "Unless you went to college to write [computer] code, you have to believe that [the service] they're selling is protected."
There are other threats to dark pools. In recent months, there's been a kind of backlash among global exchanges against nimbler high-tech rivals like dark pools. These bigger bourses have moved to shore up market share by building global platforms and entering growth markets like derivatives. M&A, stifled by the financial crisis, has resumed. In February, both the NYSE Euronext deal with Deutsche Börse and the London Stock Exchange Group plc merger with Toronto Stock Exchange operator TMX Group Inc. were announced. While these deals could hit regulatory snags, the urgency to get larger, more diverse and more global won't disappear.
Meanwhile, merger fever is also spreading to unlisted off-exchanges, essentially over-the-counter venues, as evidenced by news in February that Chi-X-Europe Ltd. and Bats Global Markets Inc., the operator of the third-largest stock exchange in the U.S., plan to merge. Bats is also widely expected to seek a stock market listing.
Critics say that even if traditional exchanges merge, they're waging a losing battle against faster, nimbler dark pools and off-exchanges. Such a prediction seems premature, given the obstacles that all trading venues face. Battle lines are still being drawn. Everyone -- exchanges and dark pools -- is ultimately constrained by growth limits in cash equities, a market that has matured in developed markets. Not surprisingly, some of the larger dark pools are looking at expansion opportunities overseas, particularly in faster-growing emerging markets. Last year Liquidnet started trading securities in eight countries, including Malaysia, Indonesia, Israel, Mexico, Poland and New Zealand. Brazil is now on Merrin's radar.
You can't count the big exchanges out. They can do some things dark pools currently can't, such as diversifying into alternative asset classes like derivatives and listed options. Dark pools are limited in what they can trade by U.S. regulations. For instance, "you cannot match a listed options trade off an exchange [where that option is already traded] and then report it to the market that is not on the exchange where the option is traded," says Andy Nybo, head of the global derivatives group at research firm Tabb Group LLC. "All trades have to be brought down to an exchange and traded on an exchange. It's different than an equity market, where you can trade in a dark pool and then report it to the tape."
Dark pools also face regulatory and competitive hurdles. While the Securities and Exchange Commission (which allowed dark pools to develop, despite the break with traditional disclosure requirements) has been preoccupied with writing Dodd-Frank regulations, it's already aired some of its views. On Oct. 29, 2009, the regulator unveiled a three-point proposal for regulating dark pools, including a more punitive threshold for price and volume disclosure. Right now, when a dark pool handles 5% or more of the volume in a given security, it must display quotes in that security. The SEC has proposed dropping that threshold to 0.25%. The agency has also proposed real-time disclosure of trade executions and bringing reporting in line with registered exchanges. Dark pools currently don't report trades until they're completed.
More recently, the SEC has floated the possibility of a "trade-at" rule, which has sent chills through the dark pool world. Such a rule would essentially prevent private trading venues from matching prices at the national best bid and offer, or NBBO, forcing them to either match at a significantly improved price or to route orders to a venue that could then complete the trade at the NBBO. To some extent, this provision reflects concerns that an increase in private share trading may be hurting the accuracy of publicly available prices set by exchanges. A trade-at rule would likely kill off dark pools as they operate today.
True to their scrappy roots, dark pools insist they're not going away. "It's very hard to imagine anyone just turning their dark pool off. There are thousands of employees, millions of dollars invested in hardware, and thousands of connections to clients. Nobody's just going to turn those switches off," says Dan Mathisson, managing director and head of advanced execution services at Credit Suisse in New York. "But if dark pools were killed by regulation, the next battle would be on the light side," he predicts. Mathisson anticipates that dark pools, if pressed, may end up altering how they do business, still protecting investors against short-term traders while operating more transparently -- that is, like so-called displayed venues.
All exchanges and displayed venues get what is called "order protection" under Regulation NMS, or National Market System, a set of rules the SEC established in 2005 to improve fairness in price execution, quote displays and market access. Dark pool orders are not protected under Reg NMS. So if someone offers 5,000 shares in a dark pool at $10.52, where nobody knows the seller's identity, the stock can trade at $10.53 even though the seller wants a lower price. That is called a "trade-through," which can't happen if an institution displays that offer of $10.52 on the public market. Orders on exchanges and displayed venues are protected from trade-throughs. If the price can't be met, the order is routed elsewhere.
Indeed, Credit Suisse insists that it has come over to the proverbial light side. In March, it launched what it called the market's first-ever "light pool," an equity platform that competes directly with exchanges and, unlike dark pools, will reveal its prices to the market, like any other displayed venue and exchange. However, unlike exchanges, it will take steps to protect institutions from high-frequency traders. Credit Suisse says it won't sell them high-speed data feeds and will bucket clients into different categories that will prevent the interaction of institutional with opportunistic clients.
"Traders want the majority of their orders protected, which is why, despite all the hype, dark pools are still a small percent of the market, about 14%," says Mathisson. "What about the other 86%? It's mainly because people want Reg NMS protection." Mathisson sees the light pool as a niche business servicing institutions. "If it got a few points of market share, we think that would be very successful," he says. "We're not looking to take over the world."
In years ahead, dark pools may be forced to reinvent -- or at least reinvigorate -- their operations. Cheyenne Morgan, an analyst with Tabb Group, recently took part in a conference that explored how dark pools are starting to focus on maintaining market share. "How can they stay front and center with investors? They're exploring expansion into other asset classes, expanding their offerings, offering more anti-gaming tools," she says. Many pools have started ranking profitability of clients to get a better handle on how to allocate resources -- basically, who should get the best service based on the business they bring. "There's pressure in terms of competition," she says. "There are six or seven dark pools that need to provide some other offering because, as time goes by, all of them will become commoditized."
That sounds a lot like what's already happened with mainstream exchanges, which suggests dark pools may need a similar battle plan: to gain greater scale through consolidation. Any consolidation would probably be limited to independents such as Liquidnet, Instinet Inc., ITG, Nyfix Millennium LLC, Pulse Trading Inc., BlockCross Holdings LLC, RiverCross Securities LLLP and Pipeline Trading Systems LLC.
"It seems like there are a lot of venues and [some in the market] would like to see consolidation," says Michael Buek, a portfolio manager in the quantitative equity group at Vanguard Group Inc., who says he uses dark pools and appreciates how they've helped bring greater price efficiency to the market. Even so, he says, "I think competition is good, but at some point [you have to question] having 16 venues. You want to make sure they're treating your orders properly and not playing games with pricing to lure size. Maybe there are too many."
That could be a compelling issue as exchanges look to expand their own growth possibilities. While several major exchanges have denounced venues like dark pools for eroding public price integrity, most also recognize that they play an important role with investors. And many would like nothing more than to have the kind of close ties that dark pools often forge with institutions. In a 2009 interview with Bloomberg News, Xavier Rolet, CEO of the London Stock Exchange, praised dark pools for contributing to the stability of markets. They are necessary, he said, to prevent volatility caused by large movements of assets.
These days, such comments might be taken as an open invitation to merge. Even NYSE Euronext, which has done its share of dark pool bashing, has shown a willingness to partner with Liquidnet and has launched its own London-based dark pool, SmartPool, with a group of banks. All of this suggests that despite the connotations of their name, dark pools may be on their way toward respectability. Whether many of them will be comfortable in that role is another question. After all, they've won considerable market share by taking advantage of the perceived flaws of the exchanges and by competing fiercely as underdogs. But their very success only increases the pressure to bring some light to the darkness that has worked so well for them.
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