Darkness at High Noon

Searching for Dark Liquidity

Investment Technology Group is banishing broker algorithms from POSIT. Liquidnet is suing ITG for patent infringement. All of a sudden, the once-quiet backwater of anonymous electronic crossing is getting nasty. What gives?

In the past year or so, about 20 organizations have either launched or announced plans to offer intraday crossing systems like POSIT and Liquidnet. If they all make it out the gate, the number of such systems will swell to about 30 by mid-year. That’s a lot of dark pools. “The competition is leading to dark wars between dark pool providers,” says Carl Carrie, head of product development in the electronic client services group of JPMorgan, one of just a handful of large brokers not currently rolling out its own dark pool to cross customer and internal flow.

The problem, in Carrie’s view, is fragmentation. “It’s not good for the industry to have isolated dark pools-and there’s no natural connectivity between dark pools as there is in the displayed market,” he says.

With so many new players piling into the market, liquidity could disperse among them. Some alternative trading systems could see their match rates drop. And all will be forced to differentiate themselves from the new contenders.

Market Share

Electronic crossing systems in general don’t execute more than 5 to 10 percent of their flow. However, their importance to the buyside-and their share of the market-is increasing. This year automated crossing systems and dark pools are likely to account for 5.4 percent of overall equities volume, according to the TABB Group, a research and consulting firm based in Westborough, Mass. By 2009 that figure is expected to reach 10 percent.

The surge in the number of dark pools over the past year is a response to the problems traders face in getting large blocks executed in the displayed markets, the relatively high price charged by the traditional crossing networks, and brokers’ desire to avoid routing to exchanges and paying their fees.

The new dark pools come from roughly two types of players: full-service brokers and utility-like entities. Most of the bulge-bracket firms have now built systems to cross various streams of order flow: retail, institutional and internally generated flow from program trading, proprietary trading and other desks.

Those positioned as utilities include market centers such as the ISE Stock Exchange and broker-formed consortia such as Block Interest Discovery Service, or BIDS. These initiatives target the sellside, whereas the full-service firms have constructed their platforms largely to service their buyside customers and improve efficiency by pooling and crossing their own internal flow.

“For years the sellside has sat back and watched electronic communication networks make money from the sellside’s liquidity by getting tape revenue and transaction fees,” says Bill Harts, head of strategy for equities at Banc of America Securities. “This is a way for them to build their own system that allows them to profit directly from that liquidity.” Harts declined to say whether BofA is building a dark pool.

The newcomers are taking on the old-guard agency brokers such as ITG, Liquidnet, Pipeline, NYFIX Millennium and Instinet. Instinet launched the first crossing platform-an after-hours cross-20 years ago last month.

For customers, the benefits of intraday crossing systems are anonymity and lower market impact costs. Orders are also price-improved since what’s crossed gets executed within the national best bid or offer.

The spate of contestants in the land of the dark means that competitive juices are starting to flow. In November, ITG informed Credit Suisse-the dominant provider of trading algorithms to buyside traders-that Credit Suisse’s algos could no longer access the popular POSIT crossing products. ITG, under the hand of recently installed CEO Bob Gasser, says it told other broker-dealers it would shut the door on their algos as well. Many see this as a bid to control access to POSIT.

Also in November, Liquidnet, the popular buyside-only indications platform, filed a patent-infringement suit against ITG.

Liquidnet didn’t waste time. Days earlier, the firm had received the patent it applied for in 2001. The patent covers a business method that enables orders in order management systems to be searched and turned into non-binding indications of interest that are then sent to an electronic marketplace. ITG’s Block Alert product, a joint venture with powerhouse broker Merrill Lynch, uses a blotter-scraping technology akin to Liquidnet’s to identify the contra side of large orders inside buyside customers’ OMSs.

Dark Wars

At this point, lawsuits and shut doors are extreme measures when it comes to dealing with competition. Most tactics used by crossing platforms are more traditional.

Pricing, access, functionality, execution quality-all of these are either in flux or likely to change in the coming months as intraday crossing systems fight one another for liquidity.

Clever pricing is one way brokers and the utility-like services are competing with veteran block systems. Liquidnet and Pipeline charge customers 2 cents per share-a premium rate for crossing. Customers that can cross large blocks without showing their hand and adversely impacting the market price have so far not hesitated to pay this rate.

Broker systems charge much less. They also have a variety of order flow that enables them to experiment with different pricing and price-improvement ratios for different types of orders.

Take midpoint pricing. Executing at the NBBO midpoint has been the mainstay on crossing platforms such as POSIT and Pipeline. Now most broker systems are trying to attract liquidity by offering customers executions at various price points within the inside market, based on their execution urgency and aggression.

Morgan Stanley’s MS Pool launched with NBBO midpoint pricing last fall, but will switch to more flexible pricing within the spread in the next quarter. Some systems, such as Fidelity Brokerage Company’s CrossStream and BIDS, don’t allow customers to choose midpoint pricing. Although orders may get executed at the midpoint, the matching engines determine where orders execute, based on customers’ limit orders and other parameters.

Commission Costs

Brokers’ internal crossing platforms are also testing the waters with commission costs. These systems charge customers different per-share commissions based on the firm’s relationship with those customers, as is customary. But some have also unveiled different pricing for resting and streaming orders. Resting orders stay in a system for a period of time-from a few minutes to hours or until the order is executed. Pass-through, or streaming, liquidity zips through a system on its way to other dark venues or the displayed markets.

On some platforms, such as NYFIX Millennium, pass-through orders pay less than resting orders. “We provide more value to hidden block liquidity in terms of lower market impact and anonymity,” says NYFIX Millennium CEO Brian Carr.

Brian Fagen, U.S. head of electronic sales at Lehman Brothers, says his firm’s Liquidity Center Cross also charges a higher fee for resting orders that interact with transient flow. He notes that this is the opposite of what occurs on ECNs. “The pricing models around ATSs are still in flux,” he says. “There are lots of different models based on the type of flow [brokers] have.”

Perhaps cheapest are the utilities-the broker consortia and exchanges that are in a strong position to attract flow from sellside firms and can therefore pass on the benefits resulting from economies of scale.

LeveL launched in October as an aggressively low-cost aggregator. The ATS charges nothing for resting orders within its system, while liquidity-takers-those that provide streaming liquidity-pay $0.0003 per share (3 cents per 100 shares). LeveL is owned by eBX, a joint venture by Citigroup, Credit Suisse, Fidelity Brokerage Company, Lehman and Merrill.

Pricing is expected to decrease for orders executed in crossing systems, but not necessarily across the board. Liquidity remains the key to success in crossing. “Pricing should come down, but clients are willing to pay for liquidity, so those that succeed won’t have to compromise on price as long as they’re competitive,” says Tim Reilly, head of U.S. electronic execution sales at Citigroup Global Markets.

Exchanges Crossing

Like the consortia-owned platforms,the exchanges are also catering to broker-dealers with utility-like pricing and services. As more volume gets auto-executed within the NBBO, they’re loath to abandon their traditional claim to that flow. And with Regulation NMS fueling competition between exchanges, they’re not about to cede that right-of-way to a competitor.

Market participants say exchanges possess two main advantages in the crossing space: connectivity and pricing. Exchanges have the connectivity and relationships, the technology and the scale to compete aggressively and cheaply for flow.

Nasdaq is widely considered the name to watch. This quarter the exchange will enter the game with a series of scheduled intraday crosses that execute at the NBBO midpoint.

Nasdaq’s Intraday Cross directly targets ITG’s commanding POSIT Match. “Customers are looking for a cheaper alternative,” says Brian Hyndman, senior vice president for Nasdaq transaction services. “Brokers wanted it to be a utility-something they could offer out to their customers that could save them money.” He expects the average order size to be comparable to the block sizes executed on POSIT and Pipeline.

Low Cost

The exchange will provide its crossing product free for the first six months, and will charge $0.001 per share (10 cents per 100 shares) afterward. That is three times more than LeveL’s fee-and LeveL charges for only one side of the trade. However, Nasdaq is offering a scheduled crossing product, whereas LeveL’s is continuous. As POSIT has proved, scheduled crosses aggregate flow at just a few points in time, increasing the likelihood of a fill.

And Nasdaq is determined to build that liquidity. It is connecting to brokers, OMSs and direct-market-access platforms, so broker-dealers can then make the Intraday Cross available to their customers. Hyndman says Nasdaq already has 75 percent of Tier 1 and Tier 2 broker-dealers connected.

“If I were POSIT or Pipeline, I’d watch out,” says Murray Finebaum, chief executive of FutureTrade, a broker-dealer and vendor of execution management technology. “If Nasdaq does it right, it could be a very substantial competitor.” He adds that exchanges are expert at bringing liquidity to the table.

Match Point

The New York Stock Exchange, the world’s largest and deepest liquidity pool, is also readying its plan to enter the intraday crossing space. The exchange intends to launch a series of intraday crosses later this year, using the technology it acquired last July through the purchase of MatchPoint Trading.

The NYSE will commence its new crossing ventures by overhauling its current after-hours portfolio crossing sessions in the second quarter, says Jim Ross, who founded MatchPoint after running Instinet’s global crossing business in the 1990s and who now heads the NYSE’s MatchPoint initiative.

Down the road, the exchange may use its new crossing platform to enable customers to cross their own internal flow and then anonymously cross unfilled flow against orders from the exchange’s wider community-all in a single match. That would pit the NYSE’s product against LeveL’s initiative. LeveL already lets brokers cross internal flow as well as interact with flow from other brokers.

Against the onslaught from large broker-dealers and exchanges, the traditional crossing players are juicing up efforts to maintain their edge-and liquidity-through new functionality and services.

For its part, ITG last year decided to band with Merrill Lynch to re-launch Block Alert. The system, originally called POSIT Alert, was designed to elicit block trading interest and increase flow to its near-continuous crossing system, POSIT Now. Unlike Liquidnet, Block Alert executes only at the NBBO midpoint.

Liquidnet and Pipeline both now allow streaming, smart-order-routed liquidity from brokers to interact with block orders on their systems. In both systems, those orders execute at the NBBO midpoint.

Liquidnet’s H2O platform lets naturals choose to cross against that smaller flow, improving the ability of institutions to get blocks executed. To prevent gaming, Liquidnet imposes various constraints on algo providers. Brokers can access H2O only through smart order routers, with no human interaction. The end customers cannot know where their orders executed and Liquidnet cannot be selected or “preferenced” as a destination for algorithmic orders.

Pipeline also allows in streaming liquidity but requires algorithms to meet the system’s giant minimums for orders. This is done to prevent information leakage from algos trying to probe Pipeline to see what orders are resting within the system. Fred Federspiel, Pipeline’s founder, stresses that on Pipeline, unlike on Liquidnet and Block Alert, all orders are firm and “neither party has a chance to back away from a trade.”

Passive Liquidity

Like ITG and its Block Alert service, NYFIX looked at Liquidnet’s success and decided to take a page from its playbook. Positioning itself as a dark liquidity aggregator, Millennium is now negotiating access to pools of passive liquidity. These include large investment management firms that do not have their own internal crossing systems.

Carr explains that Millennium can send “trade messages” or “indicators” to black boxes at large asset management firms, to alert their systems-but not individuals-of interest in particular names. If the system is active in those names, its routing engine will know to send orders into Millennium to interact with Millennium’s resting liquidity.

“It’s increasingly important to get to the top of the routing list, or as close to the top as possible,” Carr says. “You’ll see more flow, and it’s more green fields-nobody’s looked at it yet and it hasn’t had any market impact.” He refers to orders that pass through multiple layers of broker-dealers’ systems, algorithms and dark pools, before being finally exposed to exchanges, as “exhaust.”

The exchanges and many others dispute that characterization, but they are all competing for the first look at orders. After all, those are the orders that stand a better chance of finding liquidity and have not yet produced any market impact.

But despite the innovations being tested and rolled out by these and other players, many in the industry suspect that 30-odd dark pools may not ultimately be sustainable. Some will thrive, while others will die.

“Some models are built to compete directly against existing ATSs,” says Lehman’s Fagen. “Others are built to benefit from changes in market structure and eventually get consolidated.” Only when Reg NMS is fully implemented and its impact on trading behavior is clear, he suggests, will consolidation begin to reshape the crossing landscape.