March saw a new record in U.S. equities trading executed away from registered exchanges, according to commentary released by the Tabb Group.
The new commentary, Tales from the Dark Side: Out of Sight but Very Much In Mind, was written by Tabb founder and chief executive Larry Tabb and Cheyenne Morgan, research analyst and manager of Tabb LiquidityMatrix.
The two writers comment that, although most instinctively expect non-exchange orders as flow diverted to dark pools, Tabb and Morgan estimate that dark pools themselves account for just 13% of U.S. equities trading volume. The rest, 24%, is executed via internalization.
Internalization is the practice of brokers matching orders internally on their own trading desks – before orders are either sent to dark pools or exchanges.
According to the commentary, the internalized and dark pool figures totaled only 15% in 2008.
“The million dollar question is why is such a large amount of US equity trading now making its way outside of traditional exchanges?” both Tabb and Morgan write.
From an operations standpoint, Morgan told Securities Technology Monitor, traders will need to make sure they have access to all dark venues. This would require that they are connected both on their desks and via their algorithms to all available off-exchange venues since that is where liquidity is headed.
Also, traders would need to make sure they are comfortable trading with off exchange venues.
“They’ll want information how each dark pool operates. Meaning-they’ll want to know the profile of the flow they could potentially be interacting with,” Morgan told STM. “They’ll need to know if high frequency traders are in these dark pools, whether or not they’re interacting with proprietary flow, retail flow, etc. They’ll be able to better direct their order flow once equipped with this information.”
To-be-sure, the desire to prevent market impact is noted as a key motive, but the commentators state that there are number of factors in place here.
First, reduced volumes are pushing traders into the dark quicker. For instance, U.S. equity volume is down 14% from the same time period in 2011. Tabb Group’s most recent conversations with the buy-side traders pointed out that traders were turning to internalizers and dark pools much earlier in their trading process than in the past. As volumes fades, liquidity is simply harder to find and the search for matches often lead traders off exchange.
Second, an increasing amount of order-flow is being managed electronically. As markets increasingly fragment, humans don’t have the facility to track liquidity across 50 venues operating at increasingly lower latencies. The old NYSE exchange, before the days of the Regulation National Market System promulgated by the U.S. Securities and Exchange Commission in 2005, matched orders in seconds. Today matching times are measured microseconds.
Third, managing cost has become critical as commissions, especially the fees associated with execution, are under pressure. The buy side wants to allocate more of their commission dollars to research, corporate access, and the underwriting calendar, while traders are allocating less of their commission wallets to execution. This puts pressure on trading desks to reduce internal expenses, a significant portion of which come from exchange fees. If trading desks can match orders internally, then they don’t need to pay exchanges for execution.
Fourth, dark pools and internalization engines are becoming more sophisticated. Increasingly, not only are dark pools sending messages to other dark pools, but trading desks are increasingly connecting to liquidity providers and giving them notice of incoming flow.
Historically, trading desks were able to match buying and selling interest received concurrently on the desk. As technology now allows messages to be sent and responded to in microseconds, trading desks can send out messages to solicit the other side of the trade. If an order can’t be found directly, it then moves into the firm’s dark pool. If still unable to be matched, the dark pool sends messages to a wider array of market participants to trade. If still unexecuted, the order is sent to other dark pools that message a wider group of traders. If by the time the order went through two or three different dark pools and messaging cycles and the order remained unexecuted, it would then go to the exchanges. This all occurs in a fraction of a second, all managed by a series of electronic routing engines.
Exchanges, in this day and age, only get orders that virtually nobody wants, according to the commentary.
The Tabb paper asks this question about the trend: As nearly 40% of order-flow is being dragged away from exchanges, besides exchanges’ being furious, does anyone care? Unfortunately, the writers declare, that’s hard to determine.
“While some traders are upset that their orders are being surreptitiously spammed around the market and others complain about fleeting quotes and un-executable liquidity, there’s a core group of traders who view higher dark execution rates and lower commission levels as outweighing the information leakage messaging barrage,” Tabb and Morgan write in the commentary. “It’s also a fair point to say, if execution was that terrible, wouldn’t traders stop sending orders to the more egregious spammers?”
Another important detail to watch, they say: What will the SEC do as these kinds of trade reach 40% of equities activity?
Morgan told STM that it is hard to say whether this trend will accelerate this year. However, she said, “it appears to us that the exchanges have lost a significant amount of market share to the dark for good.”
“Exchanges the biggest losers if this trend continues and they’ll need to step up in order to prevent the loss of more market share,” she said.
This story originally appeared in sister publication Securities Technology Monitor.
