Gray is the new black. Dark liquidity is going gray and the industry is mixed about whether this development is good or bad for investors and the marketplace.
Many non-displayed alternative trading systems, a.k.a. dark pools, are expanding their reach. They’re no longer as dark or as passive as they initially were. That means orders that enter their pools don’t simply cross against other orders resting there or passing through, such as a broker’s algorithmic flow. Some pools are getting more aggressive. They’re willing to send out information about orders in their pools or receive electronic messages based on order flow elsewhere, with the goal of finding the contra side. Cumulatively, this evolution is seen as the graying of the dark pool landscape.
For some, this development raises the specter of information leakage. The concern revolves around the latest breed of message being shipped to and from dark pools in search of liquidity: automated indications of interest. “The distribution of electronic IOIs can be dangerous,” says Greg Tusar, head of Goldman Sachs Electronic Trading. “When you’re asking people to trust your pool enough to put substantially sized orders in it, IOIs are a leak in the bucket.”
Credit Suisse, which has the second-largest dark pool after Goldman’s Sigma X, is also skeptical about the industry’s budding enthusiasm for indications. “The whole goal of trading in a dark pool is to trade without leaking information,” says Dan Mathisson, head of the firm’s Advanced Execution Services unit. “An IOI is leaking on purpose.”
Not everyone agrees. Tim Mahoney, CEO of BIDS Trading, a dark pool whose parent company is owned by a consortium of 12 big broker-dealers and NYSE Euronext, points out that precautions can be taken in the electronic world of machine-based interactions and smart order routing, just as precautions against leakage are taken in face-to-face interactions between people.
According to Mahoney, what’s driving the trend toward dark pools accessing one another’s liquidity is fragmentation. With 40-plus dark pools in the industry and more being formed every couple months, he notes, institutions don’t want to sit in just one or two pools, waiting like wallflowers for liquidity to turn up before them. In his view, indications or other order types that allow liquidity in separate venues to find contra-side interest enable traders to spread their bets, increasing their chance of getting executions.
Carl Carrie, global head of algorithmic products at JPMorgan, goes a step further. He thinks indications represent the way forward in a trading landscape dotted with separate and discrete liquidity pools. “We’ll see more peer-to-peer, dealer-to-venue and venue-to-dealer kinds of liquidity trading,” he predicts. “That’s only going to grow.”
Dark IOIs
What’s crystal clear in the changing landscape of dark liquidity is that the business of electronic IOIs–what some call an “IOI handshake”–is in flux. The automated IOIs sent from one dark pool to another non-displayed market or third party are different from traditional IOIs sent by brokers to targeted buyside clients. The new, high-speed IOIs are sent to trading engines, not individuals, and are read and responded to only by machines.
These indications are also different from IOC, or immediate-or-cancel, orders. IOC orders are executable and are immediately canceled if they’re not filled. Algorithms and some dark pools use IOC orders to “ping” venues for liquidity. If they get a hit, they usually route more flow to those pools. Indications, in contrast, are not executable orders.
As IOI relationships between dark pools grow, an emerging concern is that buyside traders don’t always know exactly what information about the orders they place in dark pools may be sent to other venues. And understanding how liquidity is sourced in those pools may be difficult because of the thicket of connections between smart order routers, algos and dark pools at broker-dealers, as well as nondisclosure agreements around many dark pool linkages themselves.
Get Liquidity
Confusing terminology also doesn’t help. Information about order flow sometimes zips among dark pools as “indications,” “alerts” or “conditional orders.” They’re all versions of the same thing: messages that alert another pool that liquidity in a certain name resides in the pool sending the message. If the second market or multiple pools have potential contra-side interest, those pools must send either an order back to the first pool or a message telling that pool to ship an actual order. In addition to a security’s symbol, IOI messages sometimes include side, size or a size range, and price. All executions in dark pools take place within the national best bid and offer.
Automated IOIs also raise concerns about promiscuity. A dark pool could indiscriminately send out indications in an effort to boost its executed volume and avoid sending unfilled orders back to their source. Exacerbating this is the cost for brokers to access one another’s dark liquidity through smart routers. The fee brokers pay each other is reciprocal and minimal, and in some cases non-existent, several brokers say.
For the Securities and Exchange Commission, IOIs that ricochet between dark pools raise a different issue. Depending on the information sent out, automated IOIs, according to the regulatory watchdog, are quotes and produce potential disclosure obligations if a dark pool executes 5 percent or more of a stock’s consolidated volume in four of the previous six months (see sidebar, “An IOI Is a Quote”).
IOI Games
More broadly, the concern about IOIs is that they could create opportunities for gaming. One fear traders report is that a proprietary trading desk could respond to IOIs with orders on both sides of the market to glean information about what’s being indicated out. Another worry is that a broker’s prop desk sending an IOI or conditional order through that broker’s pool to other venues may be able to fade away, or avoid trading with orders that arrive in response to the query. By then, those on the other side will have revealed their interest.
Goldman’s Tusar notes that electronic indications occupy a slippery slope in the trading world. “If the only place an IOI ever goes is into the brain of a smart router, and if no one’s seeing it, that’s fine,” he says. “But once a pool makes the philosophical leap that it’s okay distributing information, controlling access is pretty tough.”
Doug Rivelli, a managing director at institutional broker Weeden & Co., adds that what the venue receiving an indication does with that message is crucial. He points out that just because an indication goes to a trading engine rather than a person doesn’t mean it’s invisible. “If a dark pool sends an automated market maker an IOI, no human eyes see it,” Rivelli says. “But that market maker’s model can take the information and use that to change its market. With an IOI, you’re giving away information that some counterparty wants to process to make a decision.”
IOI Growth
For all the cautionary voices, though, the world of IOIs is growing. A number of brokers say they take in electronic IOIs from a dozen or more ATSs and third-party venues. Many of the biggest automated market-making firms and liquidity providers, such as Knight Equity Markets and Automated Trading Desk, a unit of Citi, also send out streaming indications to algos, smart routers and trading engines at dark pools.
With IOIs, as with almost all trading, there’s a balance between finding liquidity and revealing too much information. “Brokers and dark pools can claim lesser degrees of exposure or information leakage, but it’s hard to claim none,” says Michael Plunkett, president of institutional agency broker Instinet. “What’s important is for traders to figure out how aggressive they want to be about accessing liquidity.” He says agreements with pools often specify what can be done with the information being sent or received, militating against information being abused by a pool or the pool’s customers. “But in the end,” Plunkett says, “there’s definitely a trust factor, like with so many things in this business.”
For JPMorgan’s Carrie, the trend of IOIs probing dark pools is a natural evolution of the trading landscape. Just as some algos offer simultaneous intelligent access to multiple dark pools, so some dark pools, exchanges and ECNs will ally with one another, he says. This is a response to the fragmentation of liquidity.
“Internalization venues will wire themselves together and find new, creative ways of migrating liquidity from one venue to another, so traders don’t have to make too many decisions about which venues they’re in,” Carrie says. “They’ll be able to be exposed to multiple venues, potentially even simultaneously.”
Seat at the Table
JPMorgan wants a seat at that expanding table. The broker, which for a long time did not have its own dark pool, recently launched an ATS called JPMorgan Lighthouse. The intention is to aggregate liquidity for customers by combining internal orders with flow from so-called “liquidity partners.” Carrie says JPMorgan Lighthouse is designed to send out short-duration IOIs and receive IOC orders from its liquidity partners. When it sends indications out, he says, the pool provides side and size information along with the symbol. The messages go directly to electronic liquidity sources, not humans.
JPMorgan’s clients can pick and choose which pools they want to access. They can nix those destinations they don’t want to try. Carrie says customers can also turn off JPMorgan Lighthouse’s outbound indications for their algorithmic orders. “Customers have a choice about how dark their order flow is,” he says. “They can decide how much information leakage [to permit], to which liquidity destinations and under what conditions.”
Morgan Stanley decided to address the issue of black vs. gray dark pools by starting a separate pool just for indications. Andrew Silverman, head of electronic trading distribution at Morgan Stanley, describes the firm’s new ATS as a “gray pool.” The pool, known as ATS6, will send out electronic indications about liquidity residing within its walls. ATS6 is built and will go live when there is customer demand for the product.
The big broker created this pool for two reasons, Silverman says. First, the broker didn’t want clients wondering about what was happening with large orders they were sending to MS Pool, the firm’s dark pool for single stocks. MS Pool is “100 percent black,” according to Silverman. “It doesn’t IOI or IOC out, and there’s no information leakage. It’s as standard and plain-vanilla a dark pool as you get.”
Morgan Stanley’s second reason was to be ready with a clearly delineated electronic IOI product if customers cottoned on to the idea of finding liquidity through dark pool IOIs. ATS6 is therefore a practical hedge for the broker.
“There’s a balance between being in a true dark pool, where there’s no information leakage, and wanting liquidity,” Silverman says. “Some customers are more willing to attract liquidity at the price of some information leakage. For those customers, on an opt-in basis, we’ll provide full transparency about what’s happening through ATS6.” For now at least, when the pool sends out indications it will send out just the symbol, with no side information. Silverman doesn’t know how many customers may choose to use the new dark pool.
Some 50 Million
For the last year or two, brokers’ dark pools have been differentiated by the types of liquidity they attract, their rule sets and their matching engines. But now, how brokers seek contra-side liquidity is becoming another distinguishing feature.
Agency broker BNY ConvergEx Group, like Morgan Stanley, has pursued a dual dark pool path by creating separate dark pools to accommodate different types of order interaction. But its focus has been on distinguishing between block flow that might require negotiations, through ConvergEx Cross, and smaller streaming flow in VortEx that could match up against incoming IOIs.
The broker’s VortEx dark pool takes in high-speed IOIs from 10 to 12 “external liquidity providers,” including exchanges, ATSs and electronic market makers, says Craig Viani, managing director in charge of electronic trading product management at BNY ConvergEx. By aggregating close to 50 million IOIs daily, he adds, “we expand the breadth of our liquidity pool without the latency that results from blind pinging.”
The liquidity in VortEx, which includes resting customer orders and streaming algorithmic flow, can cross against other customer flow or match up against indications from the external liquidity providers. In the latter case, when there are potential matches, ConvergEx sends IOC orders to those firms, which then execute and print the trade. About a dozen brokers that have dark pools are customers of VortEx, Viani says.
Goldman also draws a line between sending information out from its pool and pulling information in. “We consume IOIs from whomever will give them to us for our smart router and liquidity-seeking algos,” says Rishi Nangalia, head of product development at Goldman Sachs Electronic Trading. Goldman has said in the past that half a dozen third parties send liquidity to Sigma X, including NYFIX, Liquidnet H2O and ATD.
Brokers with ATSs that send out IOIs uniformly agree that transparency about what a dark pool does and how it operates is fundamental in Dark Pool Land. That transparency is seen as vital reassurance for clients seeking liquidity. But unlike Morgan Stanley, many brokers don’t think it’s necessary to provide that through a separate ATS. Instead, they say, transparency can be achieved through information, clear rules and consent.
“This is a complicated area,” says Instinet’s Plunkett. “Everyone has a different approach and a different model. But the firms that are the most open in terms of what they do probably have the most transparency to their models.” Instinet’s dark pool does not send or receive IOIs.
The Responders
Among broker dark pools, NYFIX Millennium is one of the earliest independent ATSs that has been open to sending and receiving both IOC orders and indications. Last year, NYFIX brought out a Millennium PLUS order type that allows clients trading in Millennium to elect to send out alerts, or liquidity indications based on their orders, to other dark pools, broker internalization engines and buyside institutions that NYFIX calls “responders.” If those venues have contra-side liquidity, they respond to that alert with orders.
Brian Carr, NYFIX Millennium’s CEO, observes that sending out indications can be risky. “Concerns about information leakage are valid,” he says. “The information going out is on actual orders. No one wants indications of their orders falling into the wrong hands.” But he says the dissemination of information about orders residing in a dark pool can be managed in two ways: by controlling the types of firms that can receive the information and through rules about what can be done with the actual message.
NYFIX’s audience of responders are primarily the internalization engines of agency brokers and do not include proprietary trading desks. The alerts go out with symbol and side, Carr says, and “all of the responses come in systematically, with no manual intervention.” That means a trading engine receiving an indication must respond instantaneously with an IOC order, if it has interest on the opposite side. Carr adds: “Since the Millennium PLUS mechanism operates system to system, [the order information] is unseen and undigested.” As users experimented with Millennium PLUS over the last six months, executed volume through the order type has increased as a percentage of Millennium’s volume.
IOI Audience
Like Carr, Mahoney at BIDS believes the desire to represent orders more widely is gaining traction in a world of greater fragmentation. At BIDS, he notes, a customer can have a buy order in the system that’s not committed to BIDS. “If there’s an opportunity to trade away, the trader can do that,” he says. “And if a seller comes in, he’ll be invited to firm it up. So he can be in two places at once, but won’t be able to be traded on automatically in BIDS.”
Mahoney acknowledges that this trading scenario is different from two firm orders meeting in a dark pool. In the latter case, both parties have the same risk because a trade can be executed immediately. But when one order is firm and the other conditional, the conditional order may know there’s a seller around. “Potentially, there’s some information advantage,” Mahoney says. “That why we track how often a firm’s order goes from a conditional to a firm state.” BIDS relies on scorecards and filters to help customers make trading decisions based on a counterparty’s previous trading behavior.
These concerns about information leakage aren’t new to the dark pools that have been operating for a while. Liquidnet and Pipeline Trading Systems have dealt with this for several years. Pipeline has giant minimums for executions to thwart those trying to smoke out institutional flow, while Liquidnet restricts its main pool to the buyside and offers auto-ex functionality for those who don’t want to negotiate.
Liquidnet tackled concern about information leakage in Liquidnet H2O, a separate ATS, a different way. Liquidnet H2O enables block flow and residuals from institutions executing in Liquidnet’s main pool to transact against smart-order-routed flow from 22 brokers and market centers. That flow is sent to H2O in response to indications H2O sends out about names it can execute. “Many pools are very temporal,” says Jay Biancamano, director of corporate strategy at Liquidnet. “Orders move from one pool to another in a nanosecond, circling each other.” Liquidnet H2O, he notes, allows one side to meet the other through the draw of executions against block liquidity.
To protect its institutional customers, Liquidnet requires brokers’ flow to come directly from smart routers in the form of IOC orders on the way to the displayed markets. “We also require the streaming liquidity partners to digest information we share in a way that’s hidden from all their users,” Biancamano says.
The ISE Stock Exchange, the only exchange that tries to rustle up contra-side liquidity for participants, deals with the provision of information differently. The exchange’s “solicitation of interest” order type enables participants to request liquidity from anyone who wants to receive an SOI. However, as an exchange, the ISE can disseminate only the symbol, not the side, without the message requiring public display. “Our SOIs are always executable, unlike IOIs,” stresses Andrew Brenner, who heads the exchange. “Unless the stock moves, you get executed.” The exchange recently reduced the required exposure period for SOIs to one second from five seconds and lowered the minimum size to 500 shares from 2,000. This was done to protect SOI initiators and to spur algorithmic liquidity, according to Brenner.
Brenner observes that interest in finding contra-side liquidity through indications or similar messages is growing. The ISE, he says, has more firms using the SOI functionality than it did six months ago. “There are firms that are willing to have their orders be a speck less dark to try to find the other side,” the exec says.
SIDEBAR #1: An IOI Is a Quote
The Securities and Exchange Commission has allowed dark pools to flourish and compete for liquidity with the displayed markets. But now, while a swath of the non-displayed ATS trading community is focused on the costs and benefits of sending out automated indications of interest to scout for liquidity, the SEC is emphasizing the definition of a quote. An IOI, according to the commission, is just an alternative spelling of “quote,” and with a quote come potential obligations.
At a Securities Industry and Financial Markets Association symposium on dark pools in February, Erik Sirri, director of the SEC’s Division of Trading and Markets, said Regulation ATS, which laid down the law for dark pools, “does not permit ATSs to circumvent the display requirement by disseminating information on the availability of liquidity that effectively functions as a quote.” Trading interest “displayed” to either a human being or an electronic system, such as through an automated IOI, is a quote, he said.
Robert Colby, deputy director of Sirri’s division, put it more bluntly at the same conference. “You can call things un-firm, but that doesn’t make [them] un-firm,” he said of automated IOIs. Colby added that an IOI with “a price and a side at a minimum that’s firm” is a quote.
Under Reg ATS, a dark pool or crossing system must meet the fair-access requirements that public markets are subject to for any stock in which the ATS is responsible for 5 percent or more of the average daily volume in four of the previous six months. On reaching that threshold, the pool must provide broad investor access to its services. And if that ATS publishes quotes to more than one person or entity at a time, the quotes must be displayed publicly.
However, there remains great uncertainty in the industry about what this means in practical terms. ATSs don’t have to publicly report their monthly volume, so knowing when an ATS crosses the threshold is impossible. To many, it’s not clear how an ATS would provide access to its liquidity to a broad array of market participants. If an ATS must display a quote, it’s unclear whether the ATS could display just a token amount. And for broker-dealers with dark pool look-alikes that sit within their market-making divisions, there’s additional uncertainty about whether these rules touch them.
SIDEBAR #2: Watching IOIs
Several crossing networks and dark pools are thinking about how to adapt to an increasingly automated and algorithmic trading environment through the use of indications or similar messages. These include Pulse Trading, an agency broker whose BlockCross platform is geared to institutions, and Level ATS, a dark pool owned by a consortium of broker-dealers.
Pulse’s BlockCross includes several execution services. Paul Filipski, a software engineer who works on connectivity and integration for BlockCross, says the firm is now trying to figure out how buyside traders can let sellside firms pinging the system’s auto-ex platform with 5,000-share-minimum IOC orders know they might be able to interact with large-size orders in what the firm calls its “confirmation mode.” That mode has giant minimums.
“It wouldn’t be an IOI,” Filipski says. “It would be a message sent when we already know a sellside engine is active in a name.” Filipski acknowledges that the firm is wrestling with this issue: “There could be a bit of information give-up when traders try to attract an order that meets the [bigger] minimums,” he says. BlockCross’s minimum size for large caps in the confirmation mode, in which customers negotiate for size but not price, is 100,000 shares. For small caps, it’s 5,000.
If Pulse goes down this road, it would put in place strict rules around the order interaction. “The information would go only to engines,” Filipski says. “And we would expect an extremely high rate for brokers’ delivery of orders, perhaps 90 percent or higher.” Buyside traders would also have full control over the type of flow they interact with.
Whit Conary, president of Level ATS, is also weighing new ways to let customers solicit liquidity. Level currently does not send out indications or pull any into its pool, but it’s cautiously pursuing the ability to push out IOIs.
“We may implement the functionality to send out IOIs,” Conary says. “But the only way we would consider it is with customers’ knowledge and permission. It’s their trade information.” He points out that having a separate order type for customers who want to indicate out could be a smart way for a dark pool to differentiate between those orders that stay put in the pool and those that travel out. Level, he adds, wouldn’t take in indications from third parties.
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