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October 4, 2007

Public Markets Tap Into Dark Pools

Displayed Markets Give Customers Access to Non-Displayed Liquidity

By Peter Chapman

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Orders sent to the public marketplace are increasingly not being filled there.

A handful of exchanges and ECNs, those entities that make up the public marketplace, have begun initiatives to pair their incoming orders that can't be executed with those sitting in dark pools. Rather than automatically route these orders to other public market centers, as is standard practice, they are looking to ship them to broker-dealers for a fill. The nascent trend is likely to increase the number of trades done away from the displayed markets.

"We are in the middle of building a dark-pool strategy," Brian Hyndman, a senior vice president in Nasdaq's transaction services group, told Traders Magazine. "We plan to introduce an order type that would not only route out to the public markets, but if the customer requested, would also route to certain dark pools."

Nasdaq is not alone. NYSE Arca, the ISE Stock Exchange, LavaFlow ECN, and Direct Edge ECN are also ramping up efforts to let their customers interact with non-displayed orders resident elsewhere. In most cases, that means the systems of broker-dealers, but it could also include those of the buyside.

Aggregation

What the exchanges and ECNs are doing is not entirely new. Direct Edge has offered an order type that routes incoming orders that can't be executed to certain "enhanced liquidity partners," [ELPs] including dark pools, since last year.

But the trend is picking up steam. Nasdaq says it will start development of its order type this quarter. Lava says it is in the early stages of development and is in talks with several dark pools.

The drive to "aggregate" dark pools is also not new. Most of the major broker-dealers have developed algorithms that can simultaneously "ping," or probe, several dark pools. And some of the dark pools themselves are either entering into order-sharing arrangements with each other or else electronically alerting sellside and buyside systems to orders they hold.

Both groups of broker-dealers are reacting to the explosion in the number of dark pools and the associated volume. By accessing as many of these pools at once, the brokers satisfy their customers' need to efficiently probe the systems. And by avoiding the public marketplaces, they avoid transaction fees.

For the exchanges and ECNs, the idea of pairing orders with those resting in third-party dark pools is not too far removed from their current practice of pairing incoming orders with orders resting undisplayed in their own systems.

Hidden Orders

Both Nasdaq and NYSE Arca in particular have found great success with hidden order types, or those resting undisplayed inside their systems. Nasdaq, for instance, says about 18 percent of its liquidity is invisible. Incoming orders have the opportunity to match up with these orders at the midpoint of the market.

The ISE, which operates an intraday crossing system called MidPoint Match, offers similar functionality. Traders using discretionary order types can trade against orders residing in the MidPoint Match at the BBO midpoint. Discretionary orders are those that display at one price on the ISE book but are set to trade at a more aggressive, undisclosed price.