2007 Review: Darkness Spreads: Who Turned Out the Lights?

The Year in Trading

The year Regulation NMS was implemented also turned out to be the year of dark liquidity. But in retrospect, the connection isn’t simply ironic.

The Reg NMS-spurred decline in order size on exchanges prompted traders to look elsewhere for larger fills. At the same time, Reg NMS put its stamp of approval on the national best bid and offer as a benchmark price for crosses. The electronification of the markets and desire to avoid exchange fees and market-impact costs further fueled the appeal of remaining dark. Finally, the presence of alternative trading systems ensured that dark liquidity–which previously existed on blotters, on upstairs desks and in brokers’ vest pockets–could be quantified.

There are now upward of 40 dark pools that cross non-displayed order flow. Buyside firms direct 15 percent of their order flow to crossing networks and dark pools, up from 9 percent in 2006, according to research firm TABB Group. And those numbers do not include hidden and reserve orders sent to exchanges and electronic communications networks.

Credit Suisse and UBS executives speculate that 5 to 7 percent of the market volume takes place through crossing systems and broker dark pools.

But the real story behind dark liquidity may not be its growth. Greg Tusar, head of electronic transaction services at Goldman Sachs, noted at a recent Financial Times conference that what’s more striking is the “profound impact technology has had on market structure.” There are now few venues that do not have dark order types and hidden midpoint pegs. And these order types are immensely popular. Nasdaq’s Chris Concannon, executive vice president for transaction services, says 18 percent of the exchange’s Nasdaq-listed executions involve dark liquidity.

Even the New York Stock Exchange is getting in the game. It announced in October that it would join hands with BIDS Trading to form a block crossing system, due out by mid-2008, whose orders can interact with the Big Board’s displayed book.

As dark liquidity has become commonplace, distinctions have emerged. There are the crossing veterans–ITG’s POSIT, Liquidnet and Pipeline–and there are broker internalization engines. There are block venues and dark pools that cross exchange-size flow; utility-like consortia and proprietary venues; continuous crosses and point-in-time matches. There are dark pools that attract “patient” flow and pools that are the last check on the way to the market.

Meanwhile, buyside traders became more comfortable sending order flow into dark pools. Concerns about gaming continue, but traders pay closer attention to the type of flow in various pools, as well as trading and matching-engine rules. Traders avoid predatory executions, particularly in pools with low average trade sizes, by putting limits on their orders and indicating a minimum crossing size.

To cope with the multiplicity of dark pools, the sellside has provided–and buysiders are adopting–algorithms that hunt for hidden liquidity in many venues at once. Around 30 broker algos aggregate that dark liquidity and piece orders out to pools, relocating liquidity based on where executions are occurring and how those prices relate to the NBBO. Some of the algos create complex virtual order books of dark liquidity that parallel displayed order books.

The use of these algos has surged–including, as this summer proved, during times of volatility. Many of these algos access traditional crossing networks as well as hidden orders in the markets. Credit Suisse’s Guerrilla now represents more than half of the firm’s algorithmic customer agency flow. Goldman Sachs, ITG, UBS, Lehman Brothers, and others have also seen their dark algos take off.

Some dark pools are also quietly linking to one another. Dan Mathisson, head of the Advanced Execution Services group at Credit Suisse, notes that a dark pool’s “currency,” in terms of connecting to another pool, is how much that broker crosses. He says the need for scale, which allows firms to lower their fees, is the catalyst for connectivity between pools.

For the time being, there’s no slowdown of interest in dark liquidity. BNP Paribas has said it will soon launch a dark pool. Four other brokers–two large and two mid-tier that don’t already have internalization engines–are in the process of making LeveL, a low-cost utility-like ATS, their outsourced internal crossing system, according to LeveL’s president, Whit Conary.