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April 3, 2008

Dark Pool Consolidation Debated

By Peter Chapman

There are upward of 40 dark pools out there. Will their numbers grow, shrink or stay the same in the coming years? The experts disagree.

Some believe the number will decline as less-efficient players drop out and exchanges exert their dominance in the provision of anonymous trading services.

"Over the next couple of years, as people look for different ways to reaggregate the activity in these dark pools, there will be consolidation," Eli Lederman, chief executive of European trading facility Turquoise, told attendees at a recent industry conference.

Jamie Selway, chief executive of the institutional brokerage White Cap Trading, speaking at the same Securities Industry & Financial Markets Association symposium, echoed Lederman. "The exchanges-New York and Nasdaq-will end up as the biggest crossing networks," he said. "It is a flight to simplicity."

Selway said cheaper pricing will be behind the shift. A few years ago, he explained, dark pool trades were priced in the pennies per share. Now they are increasingly in the sub-pennies. "With organizations like the New York Stock Exchange and broker consortia getting into it," Selway said, "it's going to sub-tenths of cents."

Nasdaq is already the biggest dark pool, according to Chris Concannon, Nasdaq's executive vice president for transaction services. "Anywhere between 18 and 20 percent of our executed liquidity is a hidden component of an order," Concannon said. "Either the entire order or a reserve portion."

Driving out marginal dark pools are inefficiencies in the technological infrastructures of banks and brokerages, Lederman noted. "There will be a major efficiency play there," he told the crowd. "Someone will come in with a pool that a lot of brokers-maybe not the bigger ones-will get comfortable with. It makes sense. It will happen."

Not all executives are convinced of a pending shakeout. Greg Tusar, a Goldman Sachs managing director in charge of electronic trading, said some dark pools are inseparable from brokers' operations.

Tusar said that the number of brokers operating dark pools could actually grow. He noted that technology is becoming cheaper and easier to deploy. "There's a cottage industry around providing smaller brokers with the tools and technology they need," Tusar said.

"Whether it's smart routing or operating an alternative trading system or a limit order book, brokers who wouldn't otherwise have the capability will be able to establish a pool," he said.

Larry Tabb, speaking recently at a Credit Suisse conference in Miami, maintained that buyside demand will keep the number of dark pools from shrinking. Due to the diversity of buyside order types, the market will be able to support many different models. He believes it is necessary to have more liquidity pools because it gives the buyside different ways to trade. Also because buyside traders face a lot of competition when their orders are taken to displayed markets, they are better off sitting in a dark pool for awhile.

A dark pool's exclusivity means a buyer, for instance, has to contend with far fewer competing buyers when trying to find a seller. He can simply pay the best offer and avoid the queue at the exchange.

Tabb admitted that he used to expect consolidation of trading venues. Now, he said, "I don't think we will reach the point where the dark pools will ever consolidate. There is an incentive for buyside traders to sit in those dark pools, finding orders that they want before they get to an exchange. There's much less competition to get those orders."

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