dark side of dark pools

8/7/2019 Dark side of dark pools

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nthetrade nissue 14 noct-dec 2007 95

Exchanges are lining up tojoin the dark side. In late

October, NYSE Euronext

launched Project SmartPool,a non-displayed liquidityplatform for trading large

blocks of European listedstocks. Then in earlyDecember, virt-x announced

it was partnering withNYFIX to set up a non-dis-played block trading service

for Swiss blue-chip equities.The new entrants bring

the number of dark poolsavailable in Europe to

around 20 (see Figure 1).These range from darkcrossing networks such as

Liquidnet and ITGs POSIT

Now, to brokers internalpools of liquidity, as well asthe recently announced

exchange-backed services.What they have in commonis the ability to trade large

blocks away from theexchanges displayed orderbooks, stemming informa-

tion leakage and reducingmarket impact.

Another four or five dark

pools are set to emerge,according to Frdric Ponzo,managing director of tech-nology consulting firm

NET2S UK. While most arelikely to be sponsored bybrokers, he believes the buy-

side will also show its hand

nMarket report

Dark liquidity

Dark side ofdark poolsAs average trade sizes reduce and it becomesmore difficult to hide large orders, buy-sidetraders are turning to dark pools of liquidity.But be warned, do dark pools offer what they

say on the tin? Are all internalised executionsundertaken in the best interests of the client?And what are the risks of being gamed andmanipulated by unscrupulous hedge fundtraders emerging from the shadows?

Ben Dyson

Digital Vision


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and champion its own initia-tive. In the next 12 months

I expect to see an asset man-agement consortium comeup with an alternative trad-

ing venue or dark pool ofliquidity, he predicts.

Block trading off-

exchange is not new. Buy-side traders have long beenable to access brokers inter-nal liquidity pools or block

trading desks. But in thepast, this meant calling up asales trader, in the process

revealing the traders inten-tion and running the risk ofinformation leakage. Todays

generation of dark crossingvenues, however, are prod-ucts of the electronic trading

age and are built to keeporders hidden.

The advent of new alter-native pools of liquidity, sig-

nalled by the introduction ofMiFID and the abolition ofthe concentration rule,

could not have come at amore apposite time for trad-ers in Europe. As algorithmic

trading techniques advanceand hedge funds continue topush the trading horizon,

trades are being sliced intoever smaller pieces. The aver-age number of shares pertrade on the main exchanges

in Europe fell to 3,610 in2006 from 7,345 in 2004,according to TowerGroup.

This is making it more

difficult to conceal largetrades on the order book at atime when buy-side institu-

tions are receiving ever big-ger orders from clients.

US ss h If order size acts as a spur tothe uptake of dark pool trad-

ing, Europe can look to theUS, where decimalisationhad a similar impact, to map

the execution landscape ofthe future.

By the end of 2006, darkpools and crossing networks

accounted for 10% of the USequity market and were exe-cuting on average 420 mil-

lion shares a day, according

to a Tabb Group report,Groping in the dark: navi-gating crossing networks and

other dark pools of liquidi-ty, published in January2007. The report predicted

that dark pool execution vol-umes in the US wouldexpand at a compound

annual growth rate of morethan 40% year-on-year.

Dark pools are more

important than I could possi-bly have imagined a year ago,and I have always been prettybullish on their prospects,

says Kyle Zasky, president ofUS agency broker and trad-ing software company

EdgeTrade. When EdgeTrade

Posit Match

VWAP Cross

Euro Millennium

Liquidnet

MLXN

SIGMA X

Trajectory Crossing

Crossfinder

PIN

Liquifi

LX

TBA

TBA

TBA

Posit Now

Intraday

Block Alert

End of Day

Continuous

AXP (Algo Cross)

Pool

Source: TABB Group, individual companies, Fidelity Capital Markets

figUre 1: Dark poolS anD croSSing networkS in eUrope

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98 nthetrade nissue 14 noct-dec 2007

unveiled FAN, its smart orderexecution and liquidity-seek-

ing algorithm, the companywas expecting between 5%and 10% of orders put

through the algorithm to beexecuted in dark pools.However, Zasky says that on

average, 30% of orders putthrough FAN in the US arefilled in dark pools.

Zasky is in no doubt that

the success of dark pooltrading will spread else-where. Were still climbing

the learning curve in the USand discovering that darkpools are effective for many

different reasons, he says. Iexpect that to be the sameoverseas.

There is already evidenceof this in Europe. Darkpools have always proved tobe popular in the US and we

knew it was a tactic well-suited for European trad-ing, says Adam Toms, head

of electronic sales trading,Europe, at Lehman Brothers.In April 2007, Lehman

Brothers started grantingdirect electronic access to itsLiquidity Cross (LX) dark

pool. The take-up weveseen has been fairly astonish-ing, notes Toms. Whatsinteresting is that European

clients who arent as familiarwith dark pools have taken aleap of faith. It has been

incredibly encouraging.

Lehmans dark pool is nowcrossing $1.3 billion-worth oforders a day. In terms of per-

day order flow, it makes usequivalent to one of the small-er exchanges in Europe, says

Toms. Lehman Brothers is notthe only firm seeing strongtake-up in its dark pool.Liquidnets European buy-

side-only crossing networktraded shares with a principalvalue ofE9.1 billion in the

third quarter of 2007 a 22%increase on the previous quar-ter and a 131% increase on

the third quarter of 2006.Liquidnet Europe had arecord trading day on 12

December, when it tradedmore than $1 billion in prin-cipal for the first time.

Shds yThere is no doubting theupsurge of interest in off-

exchange trading, but is the

stage set for a period uninter-rupted growth? For this to

happen the buy-side will haveto supply a steady stream oforder flow, and their reaction

so far is mixed.Christian Schoeppe, equi-

ty trader, Asia and Americas

at asset manager DWSInvestments, part of theDeutsche Bank Group, wel-comes the advent of alterna-

tive trading platforms. Theygive us the opportunity toexecute more anonymously,

which is useful especiallyin the less-liquid stocks ontraditional exchanges, he

says. We have been access-ing US dark pools for quite awhile via algorithms. For a

growing number of tradesthe percentage of executionsdone in dark pools is higherthan the regular market, he

notes. For Schoeppe, darkpools are a welcome addi-tion to the trading land-

scape. We can executeblocks in alternative wayswithout having a big impact,

and thats exactly what thefund managers want.

For other buy-side trad-

ers, given that dark pools arestill in their infancy inEurope, they are only nowgearing up to use them.

Were being told that anincreasing amount of busi-ness is going through dark

pools. It is driving us to

We have been accessing

US dark pools for quite a

while via algorithms. For a

growing number of trades the

percentage of executions

done in dark pools is even

higher than the regular

market.Christian Schoeppe, equity trader, Asia and Americas,

DWS Investments

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nMarket report

Dark liquidity


upgrade our IT capabilitiesto trade through algorithms

that have access to thesepools of liquidity, saysAndrew Munro, global head

of trading at HendersonGlobal Investors. We are atthe very early stages of this at

the moment, so for us, it ishard to gauge how muchbusiness is being crossed inthese venues, but we are

looking to take on brokeralgorithms that can ensureaccess to a large number of

these pools.While dark pools have

clearly struck a chord with

some buy-side houses, oth-ers are far from enamoured.I dont have a huge

amount of time for darkpools of liquidity, says onebuy-side head of desk. Itsall a bit of a buzzword.

Someone has tried to makeout that it is somethingnew. It isnt. It is old-fash-

ioned broking, he says.

Brokers are trying to makeit sound mysterious and say,

If you dont get involvedyoure not going to get thebest price for your client.

Thats rubbish becauseweve got a best executionpolicy which the brokers

have signed up to. We areprofessional clients asdetermined by MiFID andthey need to make sure we

have access to anything rele-vant in that execution.

The sell-side may even

have an ulterior motive forpromoting dark pools,whether internally or

through consortia such asTurquoise. Brokers arehappy for us to use algo-

rithms and dark poolsbecause it means were notusing risk capital, saysMunro. Capital commit-

ment is becoming anincreasingly expensive com-modity and by steering the

buy-side community intodark pools and algorithms,that commodity is being

used less.

pd Some concerns go deeper.One worry is the risk ofgaming or pinging, wheretraders send small orders

into a dark pool to try anddetermine others inten-tions. There is always a

concern about leakage of

Capital commitment is

becoming an increasingly

expensive commodity and by

steering the buy-side

community into dark pools

and algorithms, that

commodity is being used less.Andrew Munro, global head of trading, Henderson GlobalInvestors

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nMarket report

Dark liquidity

information, says VijayKedia, president and CEO

of trading technology pro-vider FlexTrade Systems. Ifyou expose large orders to

dark pools, how can you besure there is no misuse ofthat information?

A related concern is thatit can be difficult to knowwhat types of entities aretrading in dark pools. For

example, a long-only man-ager could end up in a poolwith statistical arbitrage

traders or sell-side institu-tions proprietary tradingdesks, both of which have

different intentions andtrading horizons from theirown. The fear is that buy-

side traders could be leftopen to manipulation andend up with a bad fill.

You would hope that the

ethics of a dark pool are100%, but there is alwaysthat lingering fear of, Im

using XYZ brokers darkpool. Who else is let loose inthere? proffers one broker.

You have no control andno knowledge of the flowyou are going up against.

There are lots ofaggressive, predatory hedgefunds that might be partici-pating in dark pools, and

they would like to learn asmuch as they can fromthem, observes Kedia.

Buy-side traders with a

longer-term outlook maynot want such participants

coming in and accessingthe same dark pools.There should be more dis-

closure, argues Kedia, sobuy-side traders know whois being given access to the

dark pools they use.There are also worries

that once a broker sends abuy-side order to its dark

pool, it will serve its ownneeds first rather than thoseof its client. For example,

the broker may choose toexecute an order in its ownpool when the order may

have got a better fill else-where, whether to keepcosts down or boost cross-

ing rates. If the broker hasto route an order outside itincurs an execution cost,says Kedia. The brokers

first preference will alwaysbe to internalise the orders,but at what cost to the buy-

side customer? This issomething a buy-side traderdeserves to know.

This particular concern isexacerbated because the darkpool infrastructure in

Europe to date is still in itsinfancy, and there are fewlinks between brokers inter-nal dark pools. Because of

this, some worry that orderscould get stranded in certaindark pools, whether inten-

tionally or not, and the buy-

side could miss opportuni-ties on other trading venues.

Some believe this lack of

connectivity is hamperingthe uptake of broker-con-trolled dark pools. Right

now, dark pools in EMEAare still relatively unimpor-tant, says Mark Wheatley,

managing director, EMEAexecution services, MerrillLynch. There is a big part

for them to play going for-ward, but until they becomeslightly more easy to accessthrough an independent

point, as opposed to directlythrough a broker, then theywill stay somewhat on the

periphery.

If you expose large orders

to dark pools, how can

you be sure there is no

misuse of that information?Vijay Kedia, president and CEO, FlexTrade Systems

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nMarket report

Dark liquidity


Unfortunately for dark

pool providers, it matterslittle whether these concernsare founded or not. If they

want to attract traders tothese pools, they will haveto solve both real and per-

ceived problems. The moreliquidity an entity attracts,the more paranoia the buy-

side has about whethersomeone can see their trad-ing footprint, says PhilSlavin, head of European

product strategy at tradingtechnology provider Fidessa.Even if this is not happen-

ing, the fact the buy-side

believes it is, means thepeople offering the dark

pools have to be able tomitigate those concerns.They have to be able to sell

the fact that they are notusing the dark pool to gaugeintentions.

pvv msusFor their part, providers feelthey have answers to most of

the concerns relating to darkpools. Many, for example,have built anti-gaming safe-

guards into their dark pools.A common strategy is toimpose a minimum order

size to prevent traders send-ing in small orders to sniffout others trades.

Lehmans LX pool, forexample, contains featuresthat monitor the activitiesand trading behaviour of

participants. Other brokershave also added mechanismsto their dark pools to protect

traders. A lot of effort andwork has gone into the typesof orders you can input, at

what level the price is deter-mined, and what the mini-mum sizes should be, specif-

ically to alleviate most ofthese worries, saysWheatley at Merrill Lynch.However, he adds: Its

almost impossible to allevi-ate them 100%.

Some firms also put pro-

tection in place to ensure

traders are only crossingwith counterparts they are

comfortable with. One com-pany, for example, onlyroutes a set portion of the

orders it receives through itsdark pool. The order flow itexcludes is typically from

statistical arbitrage traders.It does this because it recog-nises that some traders witha longer term view may see

this type of order flow asadverse.

These efforts by brokers

have not gone unnoticed bythe buy-side. Most of thebig global broking houses

take this issue very serious-ly, so you dont get anystrange counterparties and

prices when you trade viatheir algorithms, saysSchoeppe at DWS. Theyare providing dark pools

with reliable sources; forexample, private client net-works. The quality of most

executions I got resolvedany doubts.

There are also ways to

prevent orders gettingtrapped in any one darkpool. The smart order rout-

ing and liquidity-seekingalgorithms that havealready been tried and test-ed in the highly-fragmented

US market are making theirway to Europe. These tech-nologies give traders the

ability to send trades else-

The more liquidity an

entity attracts, the more

paranoia the buy-side has

about whether someone can

see their trading footprint.Phil Slavin, head of European product strategy, Fidessa

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nMarket report

Dark liquidity

where if an order is notbeing filled adequately on

the venue it was first sentto. What were seeing isthat people tend to prefer

using a strategy with anincremental layer of darkpool sweeping, rather than

just leaving an order sittingin a dark pool, says Toms.That way, they can get amarket execution, manage

the opportunity cost to anextent, but at the same timeexpose themselves to that

higher level of crossing viadark pools.

Goldman Sachs, for

example, is giving clients theability to choose whetherthey want an order to stay

solely in the dark, or wheth-er they want to trade theirorders on a combination ofdisplayed and non-displayed

venues. The adoption of thecombined dark and dis-played trading style has

grown considerably, saysBrad Hunt, managing direc-tor, equities at Goldman

Sachs International.And although there may

be few links between bro-

kers dark pools now, manyare confident they will devel-op. Wheatley believes thatTurquoise, once it is

launched, could helpimprove access to Europesdark pools. Once Turquoise

is up and running as a dark

liquidity pool, I can haveaccess myself and so can any

other broker member, hesays. Thats probably whereall the investment banks

internal dark pools will con-join into a centralised place.

Some believe brokers

best execution obligationsunder MiFID should alsoplay a role in ensuringorders do not get stuck.

Equally, best executionobligations should ensurethat at all times, brokers are

acting on behalf of their cli-ents when directing ordersinto an internal dark pool.

That is a valid thing for cli-ents to think about, but interms of the regulation, it is

almost impossible to do,says a sell-side source.

If, despite these safe-guards, orders are executed

badly in dark pools, this willnot go unnoticed. The buy-side now has a wide array of

transaction analysis tools atits disposal. The proof is inthe numbers, says Hunt.

What is different now froma year or two ago is that theability to quantitatively eval-

uate execution performancehas grown and become moresophisticated, says Hunt.Clients can now look at the

finer points of detail todetermine whether tradingin the dark is good for

them or not.

th s vyUltimately, buy-side traderswill need to take the plungeand determine the efficacy

of dark pools by swimmingin them.

After being a little sus-

picious at first aboutwhether dark pools werereally such a big thing, I

must now admit they arequite helpful as they sup-port me well in achievingbest execution, says

Schoeppe at DWS. Themessage from users seemsto be, Dont knock them

until youve tried them. n

I expect to see an asset

management consortium

come up with an alternative

trading venue or dark pool of

liquidity.Frdric Ponzo, managing director, NET2S UK

n

dark side of dark pools

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