Public Markets Tap Into Dark Pools

Displayed Markets Give Customers Access to Non-Displayed Liquidity

Orders sent to the public marketplace are increasingly not being filled there.

A handful of exchanges and ECNs, those entities that make up the public marketplace, have begun initiatives to pair their incoming orders that can’t be executed with those sitting in dark pools. Rather than automatically route these orders to other public market centers, as is standard practice, they are looking to ship them to broker-dealers for a fill. The nascent trend is likely to increase the number of trades done away from the displayed markets.

“We are in the middle of building a dark-pool strategy,” Brian Hyndman, a senior vice president in Nasdaq’s transaction services group, told Traders Magazine. “We plan to introduce an order type that would not only route out to the public markets, but if the customer requested, would also route to certain dark pools.”

Nasdaq is not alone. NYSE Arca, the ISE Stock Exchange, LavaFlow ECN, and Direct Edge ECN are also ramping up efforts to let their customers interact with non-displayed orders resident elsewhere. In most cases, that means the systems of broker-dealers, but it could also include those of the buyside.


What the exchanges and ECNs are doing is not entirely new. Direct Edge has offered an order type that routes incoming orders that can’t be executed to certain “enhanced liquidity partners,” [ELPs] including dark pools, since last year.

But the trend is picking up steam. Nasdaq says it will start development of its order type this quarter. Lava says it is in the early stages of development and is in talks with several dark pools.

The drive to “aggregate” dark pools is also not new. Most of the major broker-dealers have developed algorithms that can simultaneously “ping,” or probe, several dark pools. And some of the dark pools themselves are either entering into order-sharing arrangements with each other or else electronically alerting sellside and buyside systems to orders they hold.

Both groups of broker-dealers are reacting to the explosion in the number of dark pools and the associated volume. By accessing as many of these pools at once, the brokers satisfy their customers’ need to efficiently probe the systems. And by avoiding the public marketplaces, they avoid transaction fees.

For the exchanges and ECNs, the idea of pairing orders with those resting in third-party dark pools is not too far removed from their current practice of pairing incoming orders with orders resting undisplayed in their own systems.

Hidden Orders

Both Nasdaq and NYSE Arca in particular have found great success with hidden order types, or those resting undisplayed inside their systems. Nasdaq, for instance, says about 18 percent of its liquidity is invisible. Incoming orders have the opportunity to match up with these orders at the midpoint of the market.

The ISE, which operates an intraday crossing system called MidPoint Match, offers similar functionality. Traders using discretionary order types can trade against orders residing in the MidPoint Match at the BBO midpoint. Discretionary orders are those that display at one price on the ISE book but are set to trade at a more aggressive, undisclosed price.

Despite interest on both sides of the bright/dark divide for additional exposure, a closer partnership is not a slam dunk. The bright pools are nervous about throwing their orders into dark places. The dark pools are equally nervous about exposing their orders to the light (or to other dark pools, for that matter). Each group is worried about surrendering information to the other side.

Dark pools typically suffer from low match rates. Thus, they are eager to interact with the outside world. But they are reluctant to share their orders with others, lest they leak valuable information. So while they want contact, they want it on their terms.

And while they are not averse to alerting outsiders to the presence of specific orders resting in their systems, dark pools are nervous about letting outsiders in simply to poke around. In the past year, two dark pools-Investment Technology Group’s POSIT and Pipeline Trading-banned access to broker-dealer algorithms.

Others are cautious as well. “Everybody wants us to give them a feed into our dark pool,” says Andy Brenner, head of the ISE Stock Exchange, “but we’re not comfortable with that.”

Soliciting Interest

If the customer permits, the ISE can also send out alerts to its broker-dealer members about the existence of an order inside MidPoint Match. The ISE sends out what it calls a “solicitation of interest” that offers up the name of the stock only. It does not include any price or size information, as would a typical “indication of interest.” The SOI doesn’t indicate whether it’s a buy or sell order.

Agency broker BNY ConvergEx is grappling with the same issue as its new VortEx dark pool gets off the ground. BNY will allow ECNs and exchanges to transmit IOIs to VortEx, but has so far decided not to send VortEx orders out. “We are trying to be very careful about our client information,” says Carey Pack, president of BNY ConvergEx Execution Solutions.

Dark pools’ reluctance to throw down a welcome mat partly explains the approaches of the two ECNs trying to get inside the systems. If a Direct Edge customer opts to seek out liquidity on the books of one of the ECN’s six enhanced liquidity partners, Direct Edge will first send an IOI to the dark book. It will not simply ping the system. (When it first launched the service, it was pinging the pools, sources say.) The dark book can refuse the trade.

“Dark pools want to be dark,” says Bill O’Brien, Direct Edge’s chief executive officer. “They don’t want to put a displayed order on our book. We are not forcing them to trade.”

Despite the uncertainty of a fill with this method, Direct Edge is having some success with its ELP program. On a recent day, the ECN traded about 18 million shares of dark liquidity. That was about 5 percent of the total 320 million shares hitting Direct Edge that day. (Direct Edge’s match rate is about 50 percent.)

The percentage of Direct Edge volume trading against dark flow is up considerably from when the program started, O’Brien says. And it is likely to go higher still, he adds. “We intend to add more partners, as well as raise the profile of the program,” he says.

Recently, Knight Capital Group, the owner of Direct Edge, sold a large stake in the ECN to Goldman Sachs and Citadel Derivatives Group. Some expect the two big trading firms to become enhanced liquidity providers. O’Brien would only say that the ECN has plans to disclose the name of its ELPs in the near future as part of its branding.

Citi’s LavaFlow ECN is in the early stages of developing its dark-pool aggregation, or “hub,” plan. It is taking a different approach. Rather than ping the dark pools or transmit IOIs to them, LavaFlow plans a kind of order-sharing arrangement. An order sitting in a dark pool can simultaneously sit undisplayed in LavaFlow. If a contra-side order comes into LavaFlow and doesn’t match, it has the option of matching with the dark order in the dark pool.

Dark Strategies

LavaFlow will deliver the contra order to the dark pool. If the dark-pool order is still unexecuted, the two will match. If the order has been executed, the pool will reject the LavaFlow order. Lava is, in effect, mimicking the order-delivery functionality some exchanges offer ECNs. It is offering the dark pools the option of having orders delivered to them for possible execution. That eliminates the possibility of a double execution.

John Procopion, director of sellside execution services in Citi’s electronic trading group, describes LavaFlow as a “next-generation ECN” because it performs the traditional ECN role of displaying liquidity and also acts as an aggregator of dark liquidity.

The goal is similar to the one that put Lava Trading on Wall Street’s map nearly 10 years ago. At a time when traders were trying to cope with a growing number of ECNs, it introduced its ECN-aggregator product. Known as ColorBook, the product was a roaring success. Today, ColorBook also connects to dark pools.

More Flow

LavaFlow is being positioned to tap into the tremendous order flow passing through ColorBook. About 1.5 billion to 2 billion shares pass through the system each day. With the launch of LavaFlow earlier this year, ColorBook users have had the option of checking the ECN’s book for fills before traveling on to their destination. The ECN is open to other direct access systems although it does not route those orders out.

All trades occurring in LavaFlow are printed using the FLOW market participant identifier. All orders that route out and trade on other public venues are printed using the GOTO identifier. (A past article in this magazine mischaracterized GOTO as an algorithm that searches dark pools.) If a routed order trades in a dark pool instead, it will print under that pool’s market participant ID.

Procopion maintains LavaFlow’s order-delivery methodology is superior to both pinging and using IOIs, which expose valuable information. “Customers are not inclined to show their hands if they don’t have to,” Procopion explains. “They are willing to participate if there is something to do on the other side. They don’t want to blindly ping some proprietary engine and potentially tip their hands.”

As for IOIs, they are not firm orders. Thus, using them is not as effective as order delivery, Procopion says. “This is an actual order resting in LavaFlow,” he says of his firm’s methodology.

Exchange Strategy

Nasdaq would not discuss its strategy-IOIs, pinging or order delivery-but its plans include using its Nasdaq Execution Services broker-dealer to route to dark pools. Nasdaq is considered the most aggressive of the exchanges in this area. In fact, many sources question if industry regulations even permit exchanges to interact with undisplayed markets. Some exchange execs say it is easier for an ECN to offer these services than an exchange.

Brian Carr, president of NYFIX Millennium, one of the larger dark pools, says he is uncertain as to whether Millennium could interact with an exchange, but says the field “is wide open” for ECNs. Millennium, like ISE MidPoint Match, sends electronic alerts out to buyside and sellside systems if the customer permits. Carr says Millennium is open to sending the alerts to ECNs. “We don’t treat ECNs any differently from broker internalization or other matching systems,” he says. “We’ll talk to anyone who has a pool of liquidity that we can easily connect to and share liquidity.”

At the ISE, Brenner says his exchange is “thinking about creative ways” to aggregate dark pools, but won’t be more specific. “Wouldn’t everybody love to be the place where all that order flow sits?” he adds. Executives from the Chicago and Philadelphia stock exchanges say they have no immediate plans to offer access to dark liquidity, but they are studying it due to its growing importance.

Princeton, N.J.-based Order Execution Services is a specialty broker-dealer that routes orders from one public marketplace to another on behalf of the outbound routing marketplace. Mike Barth, an executive vice president at OES, sees interest from his firm’s customers, often the broker-dealer units of exchanges, to “find ways to access dark pools.” Barth notes that reducing transaction costs is partly driving interest. “Everyone recognizes the value that the dark model brings,” he says, “so there is an effort to try to integrate it into Reg NMS.”