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January 13, 2009

Dark-Pool Blocks Shrink

Volatility causes one-way markets

By James Ramage

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There was a tidal wave of trading near the end of 2008, but not for the industry's electronic crossing networks.

In September and October of last year, share volume hit records highs. But the surge of trading during those months did not lift all boats: Electronic crossing systems actually saw a decline in volume. This is because extreme volatility daunted many buyside traders from using them to execute as many blocks.

The impulse traders have when the market gets volatile has been to get the trade done as quickly as possible, says Justin Schack, a market structure analyst at Rosenblatt Securities. This would mean using algorithms, heading to the displayed markets and avoiding the types of big block-crossing networks that they might consider during a calmer period, he adds.

"In a really fast-moving market," Schack says, "you don't want to be out there in a dark pool hoping that you're going to find a natural counterparty for a really big trade because the market could swing against you while you wait."

Traditional block-trading dark pools offered by Liquidnet, Pipeline Trading Systems and Investment Technology Group saw their market share for those two months drop 39 percent, compared with their average during the previous eight-month period, January through August. Liquidnet, Pipeline and ITG collectively averaged 0.67 percent of overall market volume in September and October, against 1.1 percent they averaged from January through August, according to dark pool volume estimates the consultancy TABB Group supplied Traders Magazine.

Volume Swells

Collectively, their volume dropped 6.5 percent to 70.8 million shares per day, single-counted, in September and October. This compared with the 75.7 million shares a day, single-counted, they traded the prior eight months, TABB data showed.

Overall market volume from January through August averaged about 6.9 billion shares a day, says TABB. But September and October's combined average daily volume grew to 10.5 billion shares-or nearly 53 percent over the first eight months of the year's average daily volume.

The TABB numbers include the top 14 dark pools-broker and agency-and do not include unreported dark volume.

The problem was volatility-and its impact on liquidity-says Laurie Berke, a senior consultant with the TABB Group, and author of a recent report on institutional trading.

Volatility, or the rapid and extreme fluctuation in stock prices, originates from uncertainty, and a disappearance of buyers or sellers. Conditions are generally considered volatile when the Chicago Board Options Exchange's volatility index-or VIX-measures at least 25.

All About the Volatility

By May, last year was shaping into one of the most volatile years since the Great Depression. The VIX was clearing 25 routinely, after having mostly averaged in the teens since 2004.

But in mid-September, the VIX catapulted skyward and eventually crossed the 80 mark. It averaged 30.2 in September and 61.2 for October. And along with volatility comes a fear of committing too many shares at a moment in time at one price.

"If I'm a buyside trader with an opportunity to put up a block right now in a market that could have my stock moving either way to my benefit, or moving away from me by 50 to 100 basis points in the next half-hour," Berke says, "I'm going to be somewhat reluctant to do that."