Growing Dark Pool Trading Volume Could Spell Trouble for Exchanges
As dark pools become a staple routing destination and their overall share of trades in the market continues to climb, how will they continue to evolve, and what does it all mean for the future of traditional exchanges?
By Cristina McEachern
December 03, 2007
During a panel discussion on dark liquidity at a recent trading event, one panelist made a bold statement. He said that the buy side doesn't need to execute on displayed markets at all anymore, espousing that the future for trading was in dark liquidity and trading effectively without hitting open markets.
While the same panel also noted that dark pools saw a drop in volume during the late-summer market volatility, the theory that trading in dark pools alone could be the future nonetheless piqued significant interest.
There's no denying that dark pools are mainstream these days. As algorithms and partnerships have made it easier to spray the various venues and hit as many as possible through fewer connections, traders have become more and more comfortable routing trades to these nondisplayed liquidity pools. But as dark pools become a staple routing destination and their overall share of trades in the market continues to climb, how will they continue to evolve, and what does it all mean for the future of traditional exchanges?
A recent report from Aite Group entitled, "Rise of Dark Pools and the Rebirth of ECNs: Death to Exchanges?" estimates that dark pools, including independent block-trading platforms, broker-dealer crossing engines and utility models, account for about 15 percent of all U.S. equities market share as of Q3 2007. And Sang Lee, cofounder and managing partner at Aite, says that number is expected to rise to 20 percent by the end of 2011.
Considering the fragmented state of dark pools, the increase in dark pool market share is being driven by better connectivity and linking and more algorithms focused on hitting multiple dark pools before routing out to public markets, Aite says. As a result, exchanges have seen a "significant decrease" in average trading volume, according to the report, dropping 5 percent from Q2 2006 to Q3 2007.
Larry Tabb, founder and CEO of TABB Group, says dark pools have become their own self-fulfilling prophecy when it comes to building volume. "As more and more trades are matched, and the technology and connectivity become more seamless, and accessing the dark pools becomes quicker and quicker, there becomes less opportunity cost because the speed is there," he explains.
Tabb adds that as more and more buy-side firms use dark algorithms to access the fragmented pools, the dark pool market share only will continue to rise and propel the ongoing cycle (see related chart, page 25). "If they can match in a dark pool and bypass the exchange, they can generally execute at a better market price or with less market impact, and more and more generic algorithms will wind up accessing the dark pools," he says. "Then the question becomes: Where does that leave the visible exchange market?"
Exchanges Fight Back
But as dark pools continue to pull bigger market share, Tabb contends, the trend will light a fire under the exchanges. He says he expects them to get more aggressive in the marketing of their own hidden reserve matching platforms, such as Nasdaq's Nasdaq Crossing Network or NYSE's MatchPoint technologies.
According to Tabb, if the exchanges price their matching platforms at a rebate and pay people to use them, they have the ability to "drain the dark pools." But so far the exchange-driven dark pools have not caught on.
Tabb notes that while broker-dealer internal dark pools won't see much consolidation, other dark pools could be ripe for some M&A activity. "Dark pools such as Liquidnet, ITG Posit, Pipeline, NYFIX Millennium, and even BATS and LeveL will see some consolidation," he says.
Of course, natural competition also could lead many dark pools simply to go out of business. But what if the fragmentation continues and 20 or more dark pools each keep about 2 percent of market share? "That in and of itself could be a problem," Aite's Lee says. "It's too fragmented."
Lee also points out that with exchanges operating as public companies, many broker-dealers are beginning to view them as competitors. In a sign that they are looking to take the exchanges head on, most large broker-dealers already have made investments in regional exchanges, electronic communication networks (ECNs), alternative trading systems (ATSs), and their own internal dark pools and utility-model dark pools.
The Aite Group report estimates that while broker-dealers often are hesitant to release actual trade volume statistics, crossing rates "appear to be anywhere between 4 percent and 11 percent, with some of the largest platforms averaging anywhere between 40 million and 100 million in trade volume on a daily basis." Lee notes that these numbers are not to be scoffed at.
In addition, dark algorithms are upping the ante even more as dark pool routing can be more aggregated. Firms using dark liquidity algorithms heavily are seeing more than 40 percent of shares in certain orders filled in dark pools before routing out to displayed markets, according to Lee. "In reality it is a highly fragmented marketplace," he observes. "But virtually, it is consolidating as new technology comes into play."
The Future for Dark Pools
The future for dark pools also could be exchange status, Lee adds. He points out that if one dark pool in particular pulled way out in front and garnered a significant amount of volume, it either could be acquired by an exchange or alter its business model and seek exchange status itself.
So what determines the success of dark pools? Matt Sherman, senior equity trader at Ohio Public Employees Retirement System (OPERS), says volume is the first and foremost determining factor.
"People will go wherever they think volume can get done," says Sherman. "You can argue there are a few [dark pools] out there that capture the most shares, but you want to continue to follow the new ones that keep popping up, too. You have to be in front of it to make sure you're not missing something and doing due diligence to make sure you are getting the best execution on the desk."
Sherman points to a few other key areas that will contribute to a dark pool's ongoing success. "People will look for any additional ways to maintain their anonymity in the marketplace and alleviate any information leakage," he says, adding that maintaining costs also will be important.
When new dark pools pop up, Sherman says, he evaluates them based on market share and the liquidity they are providing. "There is some trial and error involved, especially through broker-sponsored algorithms," he relates. "They have to have access to a lot of different dark pools -- all the news ones -- and we have to be able to feel out what is best for our trading strategies."
As such, Sherman hopes the linking and partnership trend among dark pools continues. "We are limited in the technology we can acquire," he says. "A lot of the algorithms we are using that tap into dark pools are beginning to link better, and we can be in multiple dark pools at one time."
Sherman says he has found the most volume in the independent dark pools, such as Liquidnet, Pipeline and ITG. He adds that in the end, though, trading strategies have to be constantly monitored and changed to ensure that OPERS is in the right pools and the pools are the most effective for the firm's strategy.
TABB Group's Tabb adds that the ultimate success of a dark pool will be based on buy-side traffic. "The better the business model and the more sticky and stable the platform, the more long-lasting pricing power they have," he says. "You have to assume that the dark pool catering directly to the buy side has the ability to have greater pricing power."
Regulatory Notice
Given the growing influence of dark pools, regulatory concerns are not far from the minds of most traders. But so far the SEC has taken a staunch wait-and-see attitude. That could change, however, as dark pool volumes continue to rise.
Aite's Lee cautions that trading in dark pools has become somewhat the privilege of the few -- the institutional traders that can access these nondisplayed pools and their big broker-dealer counterparts -- at the expense of the retail investor. This is where the SEC might get into regulating these pools.
"It's almost inconceivable that regulators will stand buy and let [dark pools] grow unrestricted," says Lee. "There is going to be a certain growth threshold where they will have to look carefully at the impact on the overall marketplace." Lee adds, though, that there has to be some give and take, since the average trade size in public markets is below 400 shares and institutional businesses often are trying to move millions of shares.
But the future of regulatory involvement is still unclear, Lee continues. "For example, if a single dark pool all of a sudden accounts for 19 percent of market share, that could sound the alarm bell," he says. On the flip side, "Can the market facilitate the existence of, say, 20 odd dark pools, and does it even make sense?" asks Lee.
TABB Group's Tabb foresees regulatory intervention, however, only if dark pool market share climbs substantially to 20 percent or 30 percent. "If the quality of the market is negatively affected, and the displayed bid/offer spread becomes too wide, and retail investors don't have easy access to these dark pools and the price improvement, then I can definitely see the SEC saying, 'Why are individual investors being harmed here by not getting the best price?'" he says.
New Dark Pools on Horizon
Despite the regulatory uncertainty surrounding dark pools, OPERS' Sherman says he sees the dark pool trend continuing to grow and expanding into other areas -- new asset classes and internationally. "There is starting to be a big push for additional dark pools to capture liquidity in the international space," he says.
Aite's Lee agrees, pointing to the proliferation of dark block-crossing engines in Canada and Europe and even in Asia. "Liquidnet, for instance, has realized there are opportunities elsewhere and is pursuing those aggressively," he relates.
And once equity dark pools became a viable alternative, it wasn't going to be long before other asset classes followed suit. And lo and behold, an options dark pool is launching.
Archangel is a block-crossing dark pool for U.S. equity options developed by 3D Markets. It will differ from typical equities dark pools because trades can't be executed outside of an options exchange due to regulatory constraints. Users, therefore, will settle on a price within the NBBO and trade details via the platform and then automatically route out directly to an electronic options exchange.
Lee says that the potential for dark pools in even more asset classes is very much a reality. "It depends on the marketplace," he says. "But whenever there is a highly liquid market that is fragmented and people are looking for an improved way of providing execution services, there is going to be a market for these dark pool types of platforms." |
