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March 7, 2008

Buyside Stymied by Dark Pools

By Peter Chapman

Dark pools are more trouble than they're worth.

That's the sentiment of some members on the buyside, who lament the electronic crossing systems' lack of transparency, low crossing rates, exclusivity and sheer numbers.

"I'm not a big fan of them," Joe Burrello, the director of global trading at IronBridge Capital Management, said of dark pools. "They are dark. You don't really know where they are going or who is seeing them." Burrello maintained that his relationships with his brokers result in more fruitful trading.

The former Nasdaq trader with William Blair & Co. was speaking at this year's annual Security Traders Association of Chicago (STAC) conference. His thoughts were echoed by other buyside traders in attendance.

"The problem with dark pools is that there is a lack of information," said Bob Koci, a trader with Des Moines, Iowa-based Principal Global Investors. "I want to see more honesty and more openness. But we are dealing with dark pools. And it is not going to happen unless people are willing to show their cards better." Koci said he prefers the human touch. "You need a handful of relationships where you can say: This is what I have to do,'" he argued.

Dark pools are often categorized according to two types: large-order systems operated by specialty broker-dealers such as Pipeline Trading, Liquidnet and others, and smaller-order platforms operated by full-service broker-dealers such as Morgan Stanley, which internalize flow electronically. The number of these systems has mushroomed in recent years, with more on the way.

Neither type has a reputation for high crossing rates. They typically average about 5 percent. "It's like a fishing expedition," said Cheryl Cargie, a senior vice president at Ariel Capital Management. "I'll pop an order into a pool. Maybe I'll get a hit. But all I can do is buy 100- and 200- and 300-share lots. It drives me nuts. That could be five different dark pools. It's wasting my time." Like Burrello, Cargie also maintained that her human brokers do a better job of getting large blocks done for her.

The exclusivity of some pools also rankles the buyside. Burrello said he worries that a firm could miss a trade if it isn't a member of a certain pool. That could be the case if "you are not a large-enough shop or you don't have the technology," he explained. "At some point, we may have the government look into that."

For some on the buyside, there are simply too many pools to deal with. Principal Global Investors' Koci told STAC attendees he would welcome someone who could aggregate them all. "I have multiple boxes on my desktop," the trader said. "I have to leave my orders exposed, so my blotter can be scraped. Then I have to put the order in another pool because it is a little more passive. And you have to actively enter it in there; otherwise, it's not going to hit. And meanwhile, I am supposed to be out finding a live [broker] somewhere to help me get the job done."

Kain Cederberg, a trader with Institutional Capital, voiced similar concerns. "Trying to keep up with all the algorithms and dark pools is ridiculous," he said. "There's a new one cropping up everyday. Which algo seeks liquidity in which dark pool? It's a waste of my time."

The operator of one of the more popular dark pools is sympathetic to the buyside traders' concerns and doesn't entirely disagree with their complaints. Fred Federspiel, Pipeline's chief executive, warns traders to be wary when trading in the small-order pools of his competitors, as they may be populated with broker-dealer proprietary flow.

He claims his system shares the same goals as the buyside trader. "We want to do the same thing," Federspiel told the traders, "and that's to find the natural. What we bring to the table is the repeatability and reliability that can be gained with electronics. We can instantly disseminate information that you can't via the telephone. There are advantages in the control and speed and reach that electronics bring to the table."

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