It's Gray Out There
Dark pools turn to automated IOIs, raising concerns about leakage
By Nina Mehta
June 2008
Gray is the new black. Dark liquidity is going gray and the industry is mixed about whether this development is good or bad for investors and the marketplace.
Many non-displayed alternative trading systems, a.k.a. dark pools, are expanding their reach. They're no longer as dark or as passive as they initially were. That means orders that enter their pools don't simply cross against other orders resting there or passing through, such as a broker's algorithmic flow. Some pools are getting more aggressive. They're willing
to send out information about orders in their pools or receive electronic messages based on order flow elsewhere, with the goal of finding the contra side. Cumulatively, this evolution is seen as the graying of the dark pool landscape.
For some, this development raises the specter of information leakage. The concern revolves around the latest breed of message being shipped to and from dark pools in search of liquidity: automated indications of interest. "The distribution of electronic IOIs can be dangerous," says Greg Tusar, head of Goldman Sachs Electronic Trading. "When you're asking people to trust your pool enough to put substantially sized orders in it, IOIs are a leak in the bucket."
Credit Suisse, which has the second-largest dark pool after Goldman's Sigma X, is also skeptical about the industry's budding enthusiasm for indications. "The whole goal of trading in a dark pool is to trade without leaking information," says Dan Mathisson, head of the firm's Advanced Execution Services unit. "An IOI is leaking on purpose."
Not everyone agrees. Tim Mahoney, CEO of BIDS Trading, a dark pool whose parent company is owned by a consortium of 12 big broker-dealers and NYSE Euronext, points out that precautions can be taken in the electronic world of machine-based interactions and smart order routing, just as precautions against leakage are taken in face-to-face interactions between people.
According to Mahoney, what's driving the trend toward dark pools accessing one another's liquidity is fragmentation. With 40-plus dark pools in the industry and more being formed every couple months, he notes, institutions don't want to sit in just one or two pools, waiting like wallflowers for liquidity to turn up before them. In his view, indications or other order types that allow liquidity in separate venues to find contra-side interest enable traders to spread their bets, increasing their chance of getting executions.
Carl Carrie, global head of algorithmic products at JPMorgan, goes a step further. He thinks indications represent the way forward in a trading landscape dotted with separate and discrete liquidity pools. "We'll see more peer-to-peer, dealer-to-venue and venue-to-dealer kinds of liquidity trading," he predicts. "That's only going to grow."
Dark IOIs
What's crystal clear in the changing landscape of dark liquidity is that the business of electronic IOIs-what some call an "IOI handshake"-is in flux. The automated IOIs sent from one dark pool to another non-displayed market or third party are different from traditional IOIs sent by brokers to targeted buyside clients. The new, high-speed IOIs are sent to trading engines, not individuals, and are read and responded to only by machines.
These indications are also different from IOC, or immediate-or-cancel, orders. IOC orders are executable and are immediately canceled if they're not filled. Algorithms and some dark pools use IOC orders to "ping" venues for liquidity. If they get a hit, they usually route more flow to those pools. Indications, in contrast, are not executable orders.
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