Bulge-bracket brokers are morphing the accepted perception of dark pools by using their own internal non-displayed venues for more than just large ‘block’ trades, according to Justin Schack, vice president of US boutique brokerage Rosenblatt Securities.
Rosenblatt’s monthly US dark liquidity tracking service, Let there be light, analyses dark pool volumes across the 18 largest independent, broker and agency-owned venues. The firm’s latest report for September shows a 46% increase in average daily volume in dark pools from August, although total consolidated US trading volumes grew by 53%.
“Dark pools are now dominated by a handful of bulge-bracket pools,” said Schack. “The experience a trader gets from these pools is different to the more traditional block crossing networks, such as ITG’s POSIT or Pipeline.”
Dark pool flow accounted for 8.4% of total US trading in September, down slightly from 8.81% in August, as extraordinary volatility may have discouraged the buy-side from using them.
Following the collapse of Lehman Brothers on 15 September and government bail-outs of a number of firms, trading volumes went through the roof as investors looked to manage and get out of risky positions.
Many of the top performing dark pools were broker-owned, such as Goldman Sachs SIGMA X and Credit Suisse’s Crossfinder pool, which captured 1.4% and 0.84% of consolidated volume respectively.
As brokers look to internalise and automate their own institutional equity order flow, the new features added to their non-displayed venues are appealing to buy-side investors. Unlike block crossing networks, broker-owned pools do not have minimum order constraints, and as such are able to be probed by algorithms that slice orders into smaller lots. Rosenblatt’s analysis shows these kinds of venues to have average trade volumes of between 225 and 600 shares.
Schack considers this functionality as an important reason why dark pool use did not fall more dramatically during a violently volatile month.
“In the old block-crossing world, it can take a while to find the other side,” said Schack. “That is not where you want to be in a fast-moving market where prices are swinging wildly intraday. The 53% rise in consolidated volume and volatility in September was more in line with a lot of broker-sponsored pools, whose volumes grew by 40-50%, compared to some of the more traditional venues, which only saw increases of less than 30%.”
Non-displayed broker venues have also taken the lead in sharing flow. Credit Suisse has taken the most proactive approach, linking to 27 US dark pools. Goldman Sachs, UBS and Morgan Stanley announced a deal in May, allowing each other’s algorithms to access their respective pools.
Independent venues on the other hand, have taken their own initiatives and started to introduce new functionality.
“Independent dark pools seem to have realised there is a natural ceiling they will reach with just a block crossing product,” notes Schack. “They need to help users execute what they don’t get done on the dark platform and also interact with the displayed markets.”
Liquidnet, for example, has a Supernatural order type, which filters unexecuted portions of block orders in its system through the displayed markets. Supernatural orders accounted for 29% of Liquidnet’s volume in September, up from 20% from July.
However, Schack still believes there is a role for block crossing. “I think we are seeing a trend toward multiple types of liquidity and if you want to continue to grow, you can’t be confined to block crossing,” he said. “Sometimes I think the buy-side’s desire to execute in blocks is overstated. If it was as big as commonly thought, firms like Liquidnet would be even more popular than they are now.”
To continue building their volumes, Schack thinks dark pools should focus on being pro-active in offering customers a variety of execution methods. “You need to help your customers interact with different types of order flow. Block orientated use will continue to evolve and still be an important part of the dark pool landscape, but if you are only focused on blocks you might not grow as quickly as others with more functionality.”