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April 16, 2007

Algos Take Aim at the Dark

Aggregating Crossing Networks is Really Hard Work

By Nina Mehta

Dark pools are big news these days. Buyside traders want to access and navigate all of them easily. Traders Magazine presents a two-part story about this contentious issue. The first part focuses on efforts to provide traders with efficient access. The second part, which begins on page 66, deals with some of the costs associated with that access.

One step forward and one step back. That's the situation when it comes to the touchy business of aggregating dark pools. Some brokerages are welcoming rivals into their private realms with open arms. Others are slamming the door in their faces.

No sooner had Lehman Brothers and Fidelity Brokerage Company announced an agreement to link their respective crossing systems than Pipeline Trading Systems, operator of one of the major "independent" dark pools, revoked access to the broker-sponsored algorithms used by buyside firms.

The moves by these firms highlight the stop-and-go nature of the industry-wide effort to ease access to the ever-growing number of dark pools.

"Access is the name of the game right now," says Michael Bleich, head of liquidity strategy for U.S. equities at Lehman Brothers. "Fragmentation is the problem brokers need to solve on behalf of their clients."

Most of today's 30-plus crossing systems didn't even exist a year ago. They mushroomed in response to traders' needs for more efficient methods of trading large blocks of stock.

Dark Algos

Traders got what they wanted, but are now reeling under too many choices. They must take into account all of these different systems when seeking liquidity. They would like the process of accessing dark liquidity to be easier and swifter.

Access can take many forms. Brokers have built algorithms to access multiple dark pools at once. Many of these "dark algos" use smart order routing to intelligently extract liquidity from those venues. Dark pools can also link to one another directly, as Lehman and Fidelity did. Finally, brokers can send order flow to utility-like consortia such as LeveL and BIDS. These platforms are designed to pool diverse forms of liquidity for customers through sponsoring brokers.

Today, algorithms are the most popular option, in part because buyside firms are comfortable trading in the displayed market via algos. Close to two-dozen broker-dealers have developed algorithms that search multiple dark pools, and new algos are launching every few weeks. Six months ago, only a handful of dark algos existed.

The New Race

Algorithms that hunt for non-displayed liquidity are also popu-

lar because brokers can expect a windfall of business as more buysiders turn to algos to access dark liquidity.

"Clients will eventually use algos almost exclusively to access these pools of liquidity," says Tim Reilly, head of U.S. electronic execution sales at Citigroup. "It's time-consuming and complicated to go from one pool to another."

UBS, Lehman and Banc of America Securities all launched dark-liquidity algos last fall. All say these algos were the quickest to gain traction and attract order flow among their various algorithmic offerings. BofA's Ambush algo is the firm's "most successful algorithm to date," says Bill Harts, head of strategy for equities at Banc of America Securities. UBS's Tap algo already accounts for more than 30 percent of UBS's algorithmic executions, says Will Sterling, that firm's global head of electronic equities trading.