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October 14, 2008

ITG Study Fuels Debate on the Dark

By Nina Mehta

Statistics on trading costs in dark pools have been in short supply. Now, a new study by agency broker ITG analyzes the market-impact costs associated with 10 dark pools and knocks down several assumptions about executions in non-displayed venues.

The study, undertaken by ITG managing director Ian Domowitz and two colleagues, argues that institutions can trade blocks more cheaply by executing directly in dark pools, rather than through algorithms that aggregate access to multiple pools. The study also quantifies how much performance degrades in specific dark pools as the time to complete an order increases.

Domowitz noted that information leakage could be the culprit behind increasing trading costs over the life of an order. The likely presence of "information leakage, even though everyone believes they are trading in the dark, has some legs," he said at a press briefing last month.

The study analyzed 10 dark pools, including three from ITG: POSIT Now, POSIT Match and POSIT Alert. All are venues that ITG's dark pool algo accessed last year. ITG's report, called "Cul de Sacs and Highways," is based on execution data from 21 million buyside orders in 2007. (The report refers to dark pools as cul de sacs and algos as highways.)

ITG calculated trading costs relative to an arrival-price benchmark. For buy orders, the benchmark price was the national best offer at the time the broker received the order. For sell orders, the benchmark was the national best bid.

The study found that executions in dark pools add value by reducing trading costs, compared with trading in the displayed markets. ITG's own dark algo resulted in an average trading cost of 4 basis points for orders, compared with 12 basis points for the "ITG peer universe," which refers broadly to trades resulting from direct-market access, crossing systems and other trading styles. However, the study found that executing in POSIT Match, ITG's point-in-time crossing product, outperformed the benchmark by 4 basis points.

"Dark pool execution is beneficial," whether the execution occurs in a single pool or through a liquidity aggregator, Domowitz said. But aggregators, or dark pool algos, do not "increase the ability to trade in size or reduce costs." This finding contradicts arguments by brokers that their algos help institutions execute block orders by efficiently scooping up liquidity residing in multiple dark pools. About two-dozen brokers have dark pool algos, according to Traders Magazine research.

Dan Mathisson, head of Credit Suisse's Advanced Execution Services unit, whose popular Guerrilla algorithm accesses multiple dark pools, cast a skeptical eye on some of the study's results. "The paper concludes that traders are better off parking their trade in a dark 'cul de sac' versus driving around on a data aggregation 'highway,'" he said. "But the old word for cul de sac is 'dead end,' which is what going to only one destination often turns out to be." Credit Suisse's dark pool was not among those analyzed in ITG's paper.

The ITG study drilled down to the execution quality in specific pools. It found that trading quality in all pools worsens the longer an order remains unfilled. "You're paying the price for the life you live," Domowitz said. Market-impact costs across all 10 pools, including ITG's three intraday pools, increased the longer the order was in play.

A spokesman for Liquidnet, the buyside crossing system operator, said his firm agreed with ITG's findings that using multiple pools increases the risk of information leakage.

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