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April 16, 2007

Exchanges Take on Dark Pools With New Order Types

By Peter Chapman

Exchanges are going dark. Faced with growing competition from so-called dark pools, the nation's stock exchanges are offering traders hiding places of their own.

In recent months, Nasdaq, NYSE Arca and the American Stock Exchange have each rolled out what the industry is calling "dark order types."

The new nondisplayed order types join a growing array of similar order types quietly introduced by various exchanges over the past year or so. They represent direct competition for the 30 or so dark pools, or crossing networks, operated by broker-dealers.

"When people think of dark pools, they think about the little independent ones," Dan Mathisson, head of electronic trading at Credit Suisse, told a gathering of buyside traders recently. "But it is Nasdaq and NYSE Arca that are by far the biggest dark pools."

Mathisson estimates that about 15 percent of all order flow residing on Nasdaq is in the form of nondisplayed orders. Unlike so-called iceberg or reserve orders, no part of the dark order type is visible. That appeals to traders who wish to conceal their intentions completely from other traders.

The downside, though, is that dark order types typically do not offer time priority. A dark order can be passed over for a fill by a similarly priced displayed order that hit the book subsequent to the dark order.

The Amex is the latest exchange to introduce a dark order type. Last month, it received approval from the Securities and Exchange Commission to offer its Passive Price Improvement order type. It can be used by Amex specialists and registered traders to price-improve the best quote electronically.

The Amex's offering follows on the heels of a new order type from Nasdaq called the Mid-Point Peg, which can be used in displayed or nondisplayed fashion.

Nasdaq's promotional literature says the order type "provides firms with the benefits of dark pools and of the continuous market at the same time. Why go to a separate facility or wait for a specific time of day when you want to get your orders done now?"

Nasdaq offers four other order types that can be used in either displayed or nondisplayed fashion, including two types of limit orders and two types of pegged orders.

For its part, NYSE Arca received SEC approval last fall to roll out a nondisplayed order type called a Passive Liquidity Order. It can only be used by NYSE Arca lead market makers, or specialists.

The move by exchanges to offer dark order types concerns some industry executives. Vanguard, the large mutual fund complex, for instance, protested to the SEC that NYSE Arca's new order type was a bad idea.

"Hidden orders," Vanguard wrote in a comment letter, "are a disincentive to displaying limit orders, which we do not believe is in the best interest of an efficient market structure."

Vanguard may be crying in the wind. Just about every exchange, including newly reinvigorated regionals such as the Chicago Stock Exchange, is offering the dark facilities.

Says Credit Suisse's Mathisson, "On certain names you can get higher fill rates with dark orders than you get with displayed orders. Nobody pennies you. And on the exchange dark pools, our fill rates are more than 10 times what they are on individual dark pools. The true dark pools are Nasdaq and NYSE Arca. There's not a whole lot to gain by going to the independent ones."