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October 19, 2006

Vying to Become the Next ITS

By Peter Chapman

In contrast to the rosy scenario of millions of shares passing out of stock exchanges and through OES' pipes, there is a "dark" cloud on the horizon: The number and popularity of blind crossing networks, or dark pools, is surging. Traditional "public" systems such as Posit and Pipeline are seeing healthy volume growth while many large broker-dealers are building their own platforms.

Buyside traders, frustrated by their inability to get large blocks done on the exchanges without adverse price impact, are demanding alternatives. The so-called dark pools that match orders out of sight of the broader marketplace are considered possible solutions.

There are now close to 10 public crossing systems in operation, including two new ones from Nasdaq and the International Securities Exchange. An equal number are in development at large shops such as Merrill Lynch and Lehman Brothers.

By and large, the systems are operating on the front lines of the trading landscape, capturing order flow before it reaches the exchanges. The phenomenon may not be good news for exchanges or the routers that serve them.

No one knows how successful these nascent systems are likely to be, but most industry experts agree that more flow is likely to pass into them.

For OES, there is a silver lining: Crossing systems traditionally have very low matching rates. Perhaps 90 to 95 percent of the inflow never crosses and flows right back out of these systems.

Integrating the Dark

Many of the owners of these systems are in discussions with their competitors and connectivity providers to link their systems.

Thus, an order that does not match in one system could find a contra-party elsewhere. OES hopes to act as a linkage between dark pools and the broader marketplace. "We are positioning ourselves to provide a dark book integration model into the national market system," Barth says, referring to the country's stock exchanges.

"The dark books are going to be a key component of the marketplace going forward, because there will be a lot of internalization," he adds.

Thus, the stock market of the future could manifest itself as a network of open and closed trading centers. The open marketplaces would be the exchanges with their displayed quotes. The closed centers would be the blind crossing networks.

Connecting these disparate pools is the goal of OES. "No one has yet to emerge to integrate dark books under Reg NMS," Scheckel says. "I think we can."

OES into Options

With its plan to link the nation's stock exchanges to each other and to the broker-dealer community well under way, OES is setting its sights on the options market. Earlier this year the firm hired Corey Zimmerman, formerly a specialist at options house Botta Capital Management, to spearhead the new venture. The plan first offers broker-dealers connectivity to the six options exchanges. Then, OES execs say, they will look to link the exchanges to one another.