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December 6, 2006

Desert Conference Brings "Dark Pools" to Light

By Michael Scotti

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  • Desert Conference Brings "Dark Pools" to Light

The rise of crossing networks, or "dark pools," in equity trading was a main topic of discussion at the Security Traders Association's annual meeting last month in Scottsdale, Ariz.

Dark pools came up on just about every panel during the first two days of the conference. The topic also got its own panel: "Shining Light on Dark Pools," moderated by Tom Joyce, CEO of Knight Capital Markets. The panel discussed issues such as transparency, leakage, price discovery, gaming and connectivity.

Joyce began by saying "dark pools is a lousy term" for the crossing networks, which have been popping up throughout the industry. He called it lousy because the name implies that something "sinister" is happening. Dark pools are undisplayed, off-exchange liquidity. They've multiplied in the last year, an outgrowth of decimal pricing in 2001. Their popularity stems from the rise of electronic trading, which lowered the average trade size and made block trading difficult for institutional investors.

In the last two months, two separate broker consortiums announced they were forming their own crossing networks-BIDS Trading and Level ATS. And there is widespread belief that more will be created and join the estimated 33 systems either in operation or that have been announced. This, many fear, will lead to more fragmentation and an inability to trade because orders will have difficulty reaching numerous pools.

Panelists agreed these systems will continue to grow in number and will gain a greater percentage of the average daily volume, now estimated at about 5 percent of all equity trading. However, several speakers said dark books would have to grow beyond 30 percent of the daily volume to have a negative impact on the marketplace and price discovery. None of the panelists said they expected that type of growth. However, Pipeline Trading Systems has said it expects dark books to garner 40 percent of the market.

Fred Federspiel, Pipeline's president, said systems such as his limit information leakage-and market impact. "It makes no sense to have pre-trade transparency for large [institutional] orders," he added, pointing out that blocks contain information that could be used against the buyer or seller. "A market structure that gives you the best chance to avoid leakage is critical to the health of the markets." Federspiel said the flow currently matching in dark pools does not need price discovery.

On price discovery, Brian Carr, CEO of dark book NYFIX Millennium, said upstairs trading desks play an important role. Upstairs desks match between 10 and 15 percent of the daily volume. This, he believes, is where price discovery will continue to take place. "We are not talking about a huge change in price discovery [in the future], even as dark liquidity grows," Carr said. "Brokers are still driving price discovery...it's not being done in a vacuum."