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January 1, 2007

Darkness at High Noon

Searching for Dark Liquidity

By Nina Mehta

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Investment Technology Group is banishing broker algorithms from POSIT. Liquidnet is suing ITG for patent infringement. All of a sudden, the once-quiet backwater of anonymous electronic crossing is getting nasty. What gives?

In the past year or so, about 20 organizations have either launched or announced plans to offer intraday crossing systems like POSIT and Liquidnet. If they all make it out the gate, the number of such systems will swell to about 30 by mid-year. That's a lot of dark pools. "The competition is leading to dark wars between dark pool providers," says Carl Carrie, head of product development in the electronic client services group of JPMorgan, one of just a handful of large brokers not currently rolling out its own dark pool to cross customer and internal flow.

The problem, in Carrie's view, is fragmentation. "It's not good for the industry to have isolated dark pools-and there's no natural connectivity between dark pools as there is in the displayed market," he says.

With so many new players piling into the market, liquidity could disperse among them. Some alternative trading systems could see their match rates drop. And all will be forced to differentiate themselves from the new contenders.

Market Share

Electronic crossing systems in general don't execute more than 5 to 10 percent of their flow. However, their importance to the buyside-and their share of the market-is increasing. This year automated crossing systems and dark pools are likely to account for 5.4 percent of overall equities volume, according to the TABB Group, a research and consulting firm based in Westborough, Mass. By 2009 that figure is expected to reach 10 percent.

The surge in the number of dark pools over the past year is a response to the problems traders face in getting large blocks executed in the displayed markets, the relatively high price charged by the traditional crossing networks, and brokers' desire to avoid routing to exchanges and paying their fees.

The new dark pools come from roughly two types of players: full-service brokers and utility-like entities. Most of the bulge-bracket firms have now built systems to cross various streams of order flow: retail, institutional and internally generated flow from program trading, proprietary trading and other desks.

Those positioned as utilities include market centers such as the ISE Stock Exchange and broker-formed consortia such as Block Interest Discovery Service, or BIDS. These initiatives target the sellside, whereas the full-service firms have constructed their platforms largely to service their buyside customers and improve efficiency by pooling and crossing their own internal flow.

"For years the sellside has sat back and watched electronic communication networks make money from the sellside's liquidity by getting tape revenue and transaction fees," says Bill Harts, head of strategy for equities at Banc of America Securities. "This is a way for them to build their own system that allows them to profit directly from that liquidity." Harts declined to say whether BofA is building a dark pool.

The newcomers are taking on the old-guard agency brokers such as ITG, Liquidnet, Pipeline, NYFIX Millennium and Instinet. Instinet launched the first crossing platform-an after-hours cross-20 years ago last month.

For customers, the benefits of intraday crossing systems are anonymity and lower market impact costs. Orders are also price-improved since what's crossed gets executed within the national best bid or offer.