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Elaine Wah

Modern Markets, Modern Metrics - A Blog By IEX

In this blog by IEX's Elaine Wah, the newest public exchange looks to refute public claims that the metrics it uses are designed to inflate its own volume numbers and mislead people.

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April 16, 2007

Dark Pools' Pricing Could Impact Routing Decisions

By Editorial Staff

Also in this article

  • Dark Pools' Pricing Could Impact Routing Decisions

The decision last month by Pipeline Trading Systems to block orders from buyside traders delivered via brokers' algorithms highlights a growing concern in some sectors of the trading industry.

Pipeline, which operates one of the largest block crossing systems, says it banned algo-borne buyside orders from its platform out of concern that money managers relying on dark algos might not be getting the fills they expect. The worry was that some brokers might have sacrificed liquidity in favor of cheaper executions.

"The profit incentives were not correctly aligned-and that's a problem for some in the brokerage community," says Pipeline founder Fred Federspiel. He adds that brokers' customers did not get the best execution possible if the algorithm they were using limited executions on Pipeline simply because they cost the broker more.

"Some destinations are offered at a discount, others at a premium," says David Brooks, head of equity trading at Boston Company Asset Management. "How could that not factor into the sequencing of brokers' routing decisions?"

Brooks adds that he has found it difficult to determine the "preferencing logic within algorithmic strategies"-and even which pools algos try to extract liquidity from. Preferencing refers to priority that may be given to certain pools over others in an algo's routing schedule.

Per-Share Rates

Institutions can still access Pipeline directly or through direct market access platforms such as BNY ConvergEx Group's Sonic, Banc of America Securities' InstaQuote and Goldman Sachs's REDIPlus.

DMA platforms, like algorithms, provide broker-sponsored access to Pipeline and other crossing systems. The difference is that the buyside customers pay the cost of those executions. With broker-provided algos, the broker pays for the executions and charges customers separately.

Merrill Lynch, Goldman Sachs, Morgan Stanley, UBS, Instinet, ITG-all these and other brokers charge customers different per-share rates for executions through their dark algos. Those rates reflect the type and overall quantity of business the client does with the firm. However, the various rates the brokers themselves pay for algorithmic executions (typically lower than what customers pay when they go directly to the ATS) vary based on where the executions occur.

For algos, Pipeline was the most expensive venue, based on its explicit per-share execution cost, while NYFIX Millennium, for example, occupies the middle range. In comparison, the fees charged by the broker consortia and exchanges (or planned fees for those that haven't yet launched) are minimal.

Price Considerations

The fear is that brokers will engineer their routing tables (order-routing schedules) to take into account the prices they are paying different venues. They could do that by giving preference to destinations that charged them lower rates, including their own dark pool or internalization engine.

The vast majority of brokers say their dark algos do not consider price-or do so only minimally. The goal, they state, is finding liquidity for their clients. If they don't do that, clients would make a beeline for other brokers.