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To exchanges, the emergence of “dark pools” of liquidity – trading venues where huge blocks of equity trades are done away from the public gaze – has been a threat.
But now some of the largest exchanges are thinking the once-unthinkable: linking up with these anonymous trading venues. They are working out how to connect to these increasingly disparate venues that already account, according to consultancy The Tabb Group, for up to 12 per cent of US daily stock trading volume.
Dark pools are private interbank or intrabank platforms that are widely used to trade stocks away from exchanges. They are used by clients such as hedge funds to buy and sell large blocks of shares in anonymity, avoiding the risk of moving the public price of a stock on an exchange as a result of copycatting by other traders.
Both NYSE Euronext and Nasdaq, the two largest “displayed” or “light” markets are trying to offer their clients access to the roughly 40 dark pool networks that have sprung up. Liquidnet, which claims to be the world’s largest operator of dark pools, is in talks with both exchanges and others around the world about link-ups. It has also approached the London Stock Exchange, although the LSE has not yet said whether it is interested in dark pools.
Why is this happening now?
Exchanges are under relentless pressure to find the best ways to accommodate new types of traders beyond the simple trading flow from brokers on behalf of large institutional clients. That explains why some exchanges have started by offering – or planning to offer – their own dark pool-like platforms.
But Larry Leibowitz, chief operating officer at NYSE Euronext, said that the sheer number of dark pools available could lead to confusion among investors and sees a role to consolidate. “We are the natural aggregators of these dark pools,” he said.
Alfred Eskandar is head of corporate strategy group at Liquidnet, one of the largest dark pools containing equities from 29 markets around the world. He says that the benefit of dark pools – being able to hide your full trading intention – are not being realised because of the way dark pools have been designed. That has limited the ability of dark pools to supply sufficient liquidity for large orders. He believes that will lead to a consolidation of dark pools – which may drive some into the arms of exchanges as well.
Some analysts suggest the dark pool providers could eventually join together, combining their individual dark pools and apply for exchange status, something exchanges are obviously keen to avoid. Indeed, some investors and participants have already expressed concern about the consolidation of dark pools.
These centre on the ability of pools to continue to be absolutely dark if they become more accessible. Leakage of information would defeat the very point of dark pools - to provide anonymous block trading capabilities without impacting the public price of a particular stock.
Currently, Nasdaq executes about 18 per cent of its overall volume, or about 350m shares a day, through its non-displayed platform, which, like dark pools, offers anonymity to clients, up from around 10 per cent just over a year ago. Nasdaq estimates it will eventually route up to 10 per cent of its volume through its dark-pool allies.
Other banks are not resting on their laurels as they move to ease investors’ worries over the fragmentation of the dark pools market. Goldman Sachs, Morgan Stanley and UBS recently said they would allow their clients to access each bank’s dark liquidity pools.
The move by the three banks stops short of combining their respective dark pools - at least for now. “These are access arrangements,” Will Sterling, managing director, UBS Electronic Trading, said. “These agreements should offer clients access to additional high-quality liquidity without making their trading process more complex.”
The arrangements, which apply at present only to the US, allow algorithmic trading orders received by each firm to interact with the US equity liquidity found in three of the largest broker-dealer-operated dark liquidity pools in the US - Goldman Sachs’ Sigma X, Morgan Stanley’s MS Pool and UBS’ PIN Alternative Trading System.
Several other brokers in the US operate their own dark pools.
In Europe, Turquoise, the bank-backed challenger to established exchanges aims to tap into the rapidly growing use of dark pools. The uptake of dark pools has in Europe lagged that in the US but with the advent of Mifid, which breaks down the monopoly that traditional exchanges such as the London Stock Exchange and Deutsche Börse have enjoyed, their development looks set to speed up.
Under Mifid’s ”best execution” rules, brokers must find the best price for a stock, no matter where it is offered, hence the emergence of platforms like Turquoise. The Turquoise strategy hinges on the notion that as dark orders get larger, the likelihood of finding an exact match for a trade diminishes.
Turquoise has developed, with its Swedish technology provider Cinnober, a system that allows dark orders to be matched - or “crossed” - with orders in its main order book, where orders are posted in smaller batches.
Winning the battle for liquidity will continue to be one of the keys to success for trading venues. Consolidation in the exchange sector in recent years has been driven at least in part by a desire to establish the broadest and deepest pools of public liquidity.
In spite of this, several new venues have been established recently, adding still further to the complexity of the equity trading landscape and potentially adding to costs for clients looking to access multiple sources of liquidity.
By Anuj Gangahar and Jeremy Grant