Dark pools threaten the existence of LSE, NYSE and Euronext
14 Jul, 2008, 0908 hrs IST,Sudeshna Sen, ECONOMICTIMES.COM
LONDON: Deep, dark pools, dark algorithms, smart order routers, top secrecy, forces of the 'light' side taking on the 'dark' side. Sounds like a plot for a Star Wars sequel, but isn't. It's just one of the biggest structural changes in equity trading to hit the American and European markets in 20 years, is threatening the very existence of exchanges like LSE, NYSE and Euronext, already accounts for 12% of all American equity trades daily, and is expected to rise exponentially.
The wave is now sweeping through Europe, and the 'lit' side; main exchanges like LSE and Euronext are launching their own dark pools to take on competition from their own biggest customers. The trend is moving to Japan now, and is expected to inevitably find its way to Asia. "European equity trading is going through the biggest structural change since the Big Bang," says one trader.
Dark pools, to put it simply, are essentially trading platforms and exchanges that match block institutional orders, bypassing the main exchanges completely in off-market deals, and don't publish stock quotes. The geeky jargon in the circuit is primarily because it's been made possible by increasingly sophisticated technology like algorithmic trading tools. Algorithmic trading, says one study, will account for more than 50 % of all shares that change hands in the US by 2010.
Why dark pools? Since most bids and offers on say, LSE, NYSE or Nasdaq are shown publicly, trading on these exchanges is like, as one report says, "playing poker with an open hand."
Dark pools, by contrast, guarantee absolute anonymity and secrecy to buy-side traders worried about revealing their strategies, accesses available liquidity outside the exchanges, and is only reported to the light side post-trade. It is, of course, all intensely regulated and painstakingly legal – dark pools have taken off in Europe only after the introduction of MiFID, which discourages internalisation of trades, and Regulation NMS in the US.
A consortium of major banks including Citigroup, Goldman Sachs, Deutsche Bank, Merrill Lynch, UBS, Morgan Stanley and Credit Suisse et al are due to launch Turqoise, a pan-European dark pool trading platform come September. In retaliation, the London Stock Exchange has just announced its own version, a tie-up with Lehman Brothers, called Baikal, named for the world's deepest fresh water lake. Both Euronext and NYSE have dark pool plans, even as platforms like Liquidnet have emerged as one of the top ten traders in the US. There are, at last report, some 40 –odd such platforms, with exotic names like Chi-X, Turquoise, Posit, and Crossfinder, and more coming up every day.
This poker table is not meant for small fish; most pools have hefty minimum order sizes, and constantly monitor any attempts to manipulate prices through unnecessary 'pinging' or 'fishing'.
Ask top market experts here, and they'll tell you that dark pools are an innovation that addresses an already existing phenomenon, non-disclosed trading. On background, top traders here say, "About 40% of the business volumes in London never make it to any public order book."
Non-disclosed trades, or the OTC market as it is called here, is essentially where you call up your pet broker and he calls his pals and tries to find you a match without revealing identity or order size, what used to be proprietary trading. Traders in London reckon that telephonic is still about 25%, but dark pool exchanges like Liquidnet have started eating into that share, and now account for about 6% of London volumes.
Dark pools all began in the US, with big Wall Street names matching and executing institutional block orders through their own internal books, outside of the exchange. Over time, in order to access more such internal order books, and regulatory changes, traders started linking up with each other and creating dark pools. Exchanges and platforms like Liquidnet emerged as hosts, providing a trusted and regulated environment, allowing big traders and brokers to access each others private order books.
Hedge fund managers and big traders love it: the value of their liquidity goes up, thanks to non-disclosure of quotes, strategies stay secret, it saves them vast chunks in exchange fees, and they can retain larger shares of their commissions. Increasingly, now, it gives them access to all available sources of liquidity. Market players here say that the fragmentation of liquidity thanks to dark pools has meant that block orders may need to access 20 different sources to find what they want.
Enter smart order routers and dark algorithms. Smart order routers, which most traders now use as a given, do exactly what the name suggests, scan multiple options and sources of liquidity and routes your order through to the best price. Dark algorithms allow disguised orders to be matched electronically without going through the Big Board, or letting anyone else know what you're up to.
Naturally, the key to dark pool success is collaboration; unless banks and dark exchanges share private order books, they can't provide the largest and deepest pools. The larger the number of participants, the bigger the pool is – balancing the chance of information leaking, and the willingness to share, versus a wider choice, is where all the technology comes in. One of the guarantees that exchanges like Liquidnet and Baikal give is of anti-gaming controls, market surveillance and state of the art systems to address the issue.
It's not happening any time tomorrow, but sooner or later dark pools will wash up on Indian shores. NSE and BSE will have more to worry about than each other as competition. |
