The secret stock market
'Dark pools' and other new-age exchanges rewrite the rules, under the radar
By David Weidner, MarketWatch
Last Update: 5:23 PM ET May 11, 2007
NEW YORK (MarketWatch) -- Fourteen floors above Seventh Avenue, in an office more than a mile from the trading floor of the New York Stock Exchange, a trumpet sounds reveille over a loudspeaker.
Liquidnet Holdings Inc., an alternative trading system used by institutions, has just executed a block trade of a million shares or more.
Shades of murkiness
Players in alternative exchanges
DARK POOLS Liquidity Ping, VortEx, PositNow, Continuous Cross Buyers and sellers are matched anonymously
CALL MARKETS
Opening Cross,
Posit Match Trades executed at market prices but done anonymously
NEGOTIATION POOLS
Liquidnet, BIDS Buyer contacts and bargains with seller
Unlike the bulk of trading in stocks, this trade was made anonymously and was executed outside of the market where retail investors and institutions meet. And unlike a trade on the floor of the New York Stock Exchange, no one will ever know who put a million shares up for sale and who just bought them.
Liquidnet is one of dozens of new private trading networks that -- in just two years' time -- have ushered in a sea change that challenges Wall Street's top institutions while posing vexing questions for regulators and investors alike.
Driven by the boom in electronic trading and other technological advances, a range of upstart entrepreneurs now are doing the kind of bulk trading that up until a few years ago was practiced exclusively in upstairs trading rooms at big brokerages like Morgan Stanley and Lehman Brothers.
"We're in the middle of a revolution," said Tim Mahoney, chief executive of BIDS, a trading system launched by a consortium of top-tier Wall Street firms.
These so-called alternative trading systems are propagating rapidly, are often labeled "dark pools" because of their nebulous and murky nature. Estimated to handle about 1 out 10 shares traded each day in the U.S., dark pools are meeting a need by institutions to grab or dump stocks quietly -- and anonymously. Like Liquidnet, many of them sport imaginative brand names in a nod to science fiction, such as Sigma X, VortEx and Block Alert.
In the harsh light of a public marketplace like the floor of the NYSE, an institution trying to pull off a massive trade runs the risk of making a big splash that will move the market. But in a dark pool, a big fish can jump in without so much as a ripple.
'Both the innovators and exchanges are profoundly affected and, depending on their actions, will reap the benefits or squander the opportunities of dark pools.'
— Jim Ross, NYSE
In a matter of months more than three dozen dark pools have taken shape, creating a new and wild frontier that is largely unregulated. And the industry is growing so fast regulators can't keep up. Moreover, some observers fear these private marketplaces could take too much trading volume from the public markets -- putting retail investors at a disadvantage.
What's certain is dark pools have radically altered the way big institutions trade. And because private trading networks are extremely profitable, an array of old-line Wall Street firms is following in the footsteps of independent startups that have carved out the industry's hottest new niche.
"Execution-only technology has become a big business," said Jim Ross, vice president of MatchPoint, the dark pool that the NYSE is poised to launch next month
Purveyors of dark pools, also known as alternative trading systems, have taken a small investment in technology, as little as $20 million, and produced a business, that in the case of that Liquidnet trade, will produce $20,000 in fees, or 2 cents a share.
In return, investors who are looking to shed or buy huge blocks of stocks obtain anonymity and avoid moving the price of the stock by showing their hand.
As Dan Shaffer, owner of Shaffer Asset Management, put it at a dark pools conference recently, "Anytime you put an order in the system, the smart people know about it and talk about it."
Without the easy access granted by dark pools, big institutions would have to move big orders through the market by calling a broker who would, in turn, send that market to the floor. As the information leaked -- first to the broker, then to the floor -- an investor's intentions were exposed.
But in a dark pool, a big institutional investor like Fidelity Investments or New York Life can shop or put a buy order out for stock without alerting a regular broker. Though alternative trading systems aren't water-tight, they do minimize information leakage, traders say.
"There's leakage everywhere," said Robert Gauvin, director of equity trading at Pioneer Investments. "It's just a matter of how much."
But with every revolution comes struggles. These markets are largely unregulated and because of the anonymity are open to abuse. They are, at times, inefficient. Critics say they run counter to the spirit of new market regulations by the Securities and Exchange Commission that require that investors get the best price available for their order.
Who's in?
Such concerns have failed to hamper the growth of dark pools. A decade ago there were no platforms outside of traditional broker-dealers where trades could be executed. Now, there are 500 million shares a day trading in dark pools and that number is expected to swell to 1.35 billion by 2010, according to the Tabb Group, a market-research firm based in Westborough, Mass.
A combination of technology and profit potential are driving a boom of startups. The Tabb Group estimated there were 38 dark pools up and running as of May 1. Among them are three major categories of services that represent varying shades of anonymity.
Some are true dark pools, where buyers and sellers are matched anonymously. Players in this segment include Liquidity Ping, VortEx, PositNow, Continuous Cross and Pin.
Call markets such as Opening Cross and Posit Match execute trades at a price -- usually set by the public market -- anonymously.
Negotiation-based pools, run by the likes of BIDS and Liquidnet, which match up buyers and sellers who then bargain on a deal price.
As for the owners, the most common are actually the old-line brokerages. Goldman Sachs Group Inc. has Sigma X. Merrill Lynch & Co. runs Block Alert with a company called ITG and Citigroup Inc. runs the ACE platform.
BIDS, launched earlier this year, is owned by consortium of brokers and banks including Bank of America Corp. , Bear Stearns Cos. , Credit Suisse , Deutsche Bank AG , J.P. Morgan Chase & Co. and Knight Capital Group Inc.
Exchanges such as the International Securities Exchange
, Nasdaq Stock Market Inc.
and Instinet run 10 of the platforms, and a few, such as Liquidnet, Pipeline Trading and NYFIX are independent.
Retail investors
As dark pools take a larger share of the market, individual investors may be losing out, critics say. For instance, a big sell order of 1 million shares might, to the chagrin of the seller, drive down the price of stock XYZ if it hits the floor of the NYSE or the order book at the Nasdaq. Defenders of the system say that's how the market should work.
In an automatic dark pool, that order might get filled without affecting the price in the public markets.
But Seth Merrin, who runs the Liquidnet system, argues that even as dark pools expand -- Merrin prefers the term "wholesale market" -- most retail investors will continue to get small orders matched in the public market. To his mind, most so-called individual investors are actually savvy day traders.
Still, to level the playing field, Liquidnet has developed a platform called H2O where individuals can place orders. "There's going to be better prices for everybody," Merrin said.
And, dark pool advocates point out, big institutions actually are running funds -- through retirement and pension accounts -- that often make trades on behalf of ordinary people.
"Small investors are benefiting from these pools of liquidity," said Harvey Pitt, a former chairman of the SEC who now runs a Washington-based consulting firm. "The institution reflects the individual."
To many of those behind the dark pools -- entrepreneurs and tech heads who cut their teeth in jobs at electronic exchanges -- the nascent industry's rapid growth came out of necessity. The volatility of prices and whimsy of retail investors trading on the exchanges after the tech bubble burst left behind a changed landscape. Cutthroat competition from new, low-cost electronic markets erased already thin profit margins.
"It got to be a lot harder to make money in these markets," said Kevin Callahan, head of sales and strategy at JonesTrading Institutional Services LLC, a third-party trading platform.
Dark pools also took advantage of a slew of regulatory reforms -- new rules governing stock trading, the move from fractions to decimals in the marketplace -- at a time when established exchanges such as the NYSE were caught playing catch-up.
"Exchanges have been complacent, and people thought of new and innovative ways of doing things," said James Leman, who helped build trading platform and networks at Citigroup Inc. and HSBC Holdings. "So we're seeing a lot of experimentation." |
