Dark pools

Pirkko Juntunen throws light on the alternative trading systems that are catching on in Europe

Innovative ways of accessing liquidity are being marketed to institutional investors, and in an increasingly fragmented market Europe looks likely to follow the US, where smart order routing, used to seek out liquidity across multiple venues, has taken hold. So perhaps it is time you found your dark (sometimes called black) pools of liquidity and learned that a Guerrilla is not only a fierce fighter and that Snipers are not necessarily secretive killers but could actually help you trade more efficiently; at least that is where the promise lies.

The ease with which these new alternative trading systems (ATSs) are catching on in Europe has been helped by the implementation of the markets in financial instruments directive (MiFID), which in effect removed barriers to cross-border and off-exchange trading. It is perhaps ironic that a law that was intended to increase transparency has given rise to a practice where anonymity is one of the key elements - the law of unintended consequences perhaps.

Rob Boardman, head of algorithmic trading at ITG in Europe, says the benefits of dark pool trading are not direct cost cuts. Rather they are efficiency in trading through matching and the reduction of the implicit costs of trading, such as information leakage. In addition, anonymity is vital to protect strategies. Boardman argues that pre-trade anonymity does not have a negative effect “as long as there is post-trade transparency and prices are set by the market and not in the system”.

Christopher Miller, CEO of Allenbridge Hedgeinfo, the global hedge fund research and ratings firm, says pure transparency is not necessarily the Holy Grail. He uses the example of Gordon Brown’s fateful decision to sell off British gold reserves and argues that had he done so via a dark pool instead of in a transparent fashion, the market need not have moved so much.

He also argues that before the concept of dark pools, stockbrokers still used crossing without putting it on the exchange but with the price reference to the market price. In the cases of forced sellers, such as index investors who need to rebalance, deals work better for them off market because of the anonymity that would hide their desperation to sell, giving them a fairer deal.

Currently, major investment banks are busy bolstering systems to capture liquidity from the numerous dealing platforms. These dark pools refer to trading systems that are not exposed to the public market, or off-exchange trading. It is estimated that the current volume of equity trading done through dark pools in the US is 10-12% and is likely to double in the next few years.

The popularity of the dark pools was borne out of dissatisfaction among US institutional investors with the open book because of information leakage and the difficulty in executing large trades without moving the markets as well as the increasing importance of transaction costs and the impact that has on performance.

Scott Cowling, head of trading at Barclays Global Investors (BGI), says clients are increasingly requesting matching services for their trades because of the loss off opportunity that comes from having to wait. He also points out that the increased volatility in markets also increases the risk of not executing a trade, which is where finding a match quickly becomes valuable.

There are several kinds of offerings. Credit Suisse, for instance, is the primary broker on Instinet’s pan-European ATS, Chi-X. Credit Suisse’s algorithms are called Gorilla and Sniper. Algorithmic trading can source liquidity that is commonly not visible and get significant quantities of trades done relatively quickly without moving the price. TradeCross’ Wetra is also filtering orders from the major exchanges in Germany.

Block trading platforms such as Liquidnet Europe and ITG’s Posit are enabling growing numbers of investors to trade with one other anonymously. The crossing networks typically accommodate very large orders, often in illiquid small and mid-cap securities, from investment banks, hedge funds and institutional investors.

Market participants are increasingly demanding access to the dark liquidity pools, which also exist on Europe’s major exchanges. So-called ‘iceberg orders’ and hidden orders - which rest in the exchange’s order book but are not visible or are only partially visible to the market - account for increasingly significant dealing volumes on Europe’s exchanges. Traditional exchanges are also competing for the business by linking up with electronic trading providers, rather than just relying on their existing hidden orders.

Most agree that although dark pool services take some trade volume away from exchanges, they are still in a good position to compete within the field. Miller says that the erosion of the monopoly power of the exchanges is good for the market in general.

Lee Hodkinson, CEO of SWX Europe, part of SWX Group, the home exchange of Swiss blue chip stocks, says exchanges offering dark liquidity services have the advantage of being neutral as opposed to the many broker-sponsored ATSs. He believes that the business model in the US can be transferred to Europe, predicting a bright future for dark liquidity services. SWX Europe is launching a dark liquidity services for Swiss blue chip stocks in association with NYFIX, an electronic trading provider.

NYFIX recently launched Euro Millennium, aimed at supporting the needs of both sell-side and buy-side clients in Europe who are seeking price improvement and minimal market impact. Euro Millennium, the first truly open European dark pool, currently matches UK-listed equities and will be rolling out other major European markets during 2008. Euro Millennium is built upon the technology that powers NYFIX Millennium, an independent US dark pool.

The service was developed with the direct participation of an advisory board that worked with NYFIX for nearly a year. The board includes representatives from Allianz Global Investors KAG, Baring Asset Management, BNP Paribas Securities Services, Citi, CA Cheuvreux, Credit Suisse, DWS Investments, Insight Investment, JPMorgan Asset Management, JPMorgan, Merrill Lynch, Resolution Asset Management, Schroder Investment Management and UBS.

Meanwhile, Lehman Brothers has expanded vendor access to its dark liquidity offering, Liquidity Cross (LX), which anonymously pools active order flow from across the US investment bank’s European equity trading desks with its non-active inventory. Lehman clients dip into the dark pools via the bank’s electronic direct access algorithms. They can obtain access to LX through all the major execution management systems and via the FIX protocol.

Adam Toms, head of portfolio and electronic sales trading at Lehman Brothers in London, says the debate within the asset management industry is increasing as client knowledge builds and an increasing number of providers offer various trading solutions. “Clients are increasingly faced with new trading venues and new products from the brokerage community; it is a real challenge to keep up with the current shape of rapid growth in electronic trading,” he says.

Jason Nabi, head of Financial Intermediaries UK, at BNP Paribas Securities Services, says that as the buy-side becomes more scientific in its approach it is likely to drive the growth of dark pool services, which will become more mainstream, on par with exchanges. “With the diverse and increasing number of offerings, a buy-side client needs to consider the pedigree of the platform they choose, which include the capabilities of post-trade settlements.”

He argues that dark pool trading puts a buy-side client in a better position to calculate its execution and settlement costs. “The dark pool mechanisms improve transaction costs and therefore in the long run also performance.”

It is widely expected that the number of providers, currently approximately 40 in the US, will continue to grow and reach 20 in Europe in the next few years, with consolidation in the market in 2010-2011. The different providers are likely to create niches within different communities and/or provide unique technology and connect to different smart order routing in order to align themselves with different segments of the market.

Beyond equities, some argue that there would be scope for dark services among the less-liquid bond issues.

All agree that not all trades are suitable to be done off market and that the different platforms will suit different clients at different times. It is, therefore, vital for institutional investors such as pension funds to know what they want and find the best solution and execution for their trading requirements.