Europe has seen considerable growth in trading volumes on dark pools in the first half of 2010, driven by demand from buy-side firms. For multilateral trading facilities (MTFs) this offers a potential funding pipeline in an extremely competitive market.
However this growth seems unlikely to continue at recent levels. Parent MTFs see limits to the proportion of liquidity that their dark pools can provide without falling foul of regulatory restrictions, while concerns over liquidity quality also dog non-displayed trading venues.
Dark liquidity pools do not display quotes, but match orders anonymously instead to minimise the market impact of large trades. This makes them attractive to the buy-side, which typically does not require aggressive matching of orders and is increasingly keen to avoid interaction with high-frequency orders on lit books. This growing attractiveness is reflected in recent usage levels.
MTF Turquoise saw monthly turnover on its dark pool rise from €1.3 billion to €4.3 billion from January to June. Two other MTF-owned dark pools, Chi-Delta and BATS Europe, saw rises from January to May – from €3.4 billion to €5.2 billion for the former, €900 million to €1.4 billion for the latter – but both were hit by rumours of information leakage in May, at which point their levels dropped off to €4.3 billion and €1.08 billion respectively.
“The use of MTF dark pools is growing in Europe,” confirms Brad Hunt, head of electronic execution, Europe, at broker Goldman Sachs. “This is due largely to a few factors: a growing number of end-investors are trying to access as much liquidity as possible without signaling to the broader market their trading intent, while more brokers have built the capability to display orders in both dark and lit pools, resulting in more resident liquidity.”
Despite this demand, the MTF run pools are not expecting to see significant further growth. Jerry Avenell, manager of UK business development, Chi-X Europe, explains, “We do think the market will grow but to about 5% or thereabouts of our total volumes. The idea that dark trading will take over the world is a non-starter. Our business lives and dies by the lit book.” He adds that the smart order router capability that Chi-Delta is developing will allow small- and mid-tier brokers to interact with dark pools. This could add an additional 3% to Chi-X Europe's average daily volume to the dark pool, meaning a total of 8% of our total daily volume eventually might be conducted on Chi-Delta. “That would equate to 1-1.5% of Europe tops,” he concludes.
Of the leading MTFs, Turquoise has generated the largest proportion of its volumes from the dark side in 2010, with non-displayed trading making up more than 10% of its turnover in June. Commercial director Natan Tiefenbrun does expect further growth but not at the same rate. “Our dark pool is proportionately large but that reflects our leadership position and the institutional make-up of our customers. However, I don't think it will necessarily continue to grow in that proportion to our lit pool,” he says.
The very opaqueness that gives them their appeal also raises concerns. Dark order flow might typically be expected to represent block trades placed on behalf of fund managers. Conversely smaller trade sizes can be indicative of trades placed by algorithmic trading strategies that can potentially take advantage of big block orders.
According to trading technology provider Fidessa, the average order size across FTSE 100 stocks on Chi-Delta from 5-9 July was for 1,906 stocks, at a value of £6,521. For Turquoise dark pool it was 1,435 stocks at a value of £5,246 and BATS dark pool 2,212 stocks at a value of £7,354.
Compare that to Liquidnet, the buy-side only crossing network, which saw an average sized order for the same stocks over the same period of 62,980 shares with a value of £431,146.
Any suggestion that these smaller trade sizes reflect a disproportionate number of algorithmic participants is refuted by Tiefenbrun. “We believe we have more institutional order flow than other dark pools. Participants principally measure the quality of liquidity by looking at adverse selection, e.g. having traded, what happens next? Some use average trade size as a proxy for quality, and while ours has recently been lower than some of our competitors, inferring assumptions about our client mix would be incorrect. We are very comfortable with the mix of participants that we have.”
Following recent buy-side concerns about information leakage the credibility of dark pools may be harmed if issues around the diversity of participant in some non-displayed venues run by MTFs goes unresolved.
“There are many factors to consider, but the main differences are that many interact with lit volume (via smart routers), are mid-point only, and accept immediate or cancel orders from the broader market,” says Goldman Sachs' Hunt.
“By their very definition, MTFs are multilateral, which implies a diversity of liquidity participants which is different to more homogenous sources – thus they behave more like a hybrid public market. This is not to say any of this is less valuable. It is liquidity after all and MTF dark pools are definitely important places to go, but algorithms need to account of differences when they trade.”