“Dark pools of liquidity are literally everywhere,” says senior research analyst Jeromee Johnson, co-author of a just-released TABB Group research note, “Groping in the Dark: Navigating Crossing Networks and Other Dark Pools of Liquidity.”
According to TABB Group, dark pools and crossing networks captured nearly 10% of the total equity market with an average of 420 million shares executed per day, a number that will increase to 512 million shares a day by the end of 2007. Growing at a 42% CAGR, volume of non-displayed liquidity execution will triple to 1.5 billion a day in 2010 to hold over 15% of total equity market share.
While there are risks associated with the proliferation of hidden liquidity, the economic benefits for institutional traders are real, according to Larry Tabb, CEO and co-founder of TABB Group. He says that dark pools, when successfully navigated, can minimize information leakage, manage market impact and execute block trades at beneficial prices. “One thing that’s clear about the future of hidden liquidity, dark pools and crossing networks,” writes Tabb, “they’re here and here to stay.”
The TABB Group report suggests that buy-side traders ask questions such as “How big can – and should – the venues I trade in get?” and “How can I make sure I’m accessing them in the most effective way?” And they ask these questions because they believe that the answers have a direct impact on the systems that traders use, the process in which they work their orders, the timing or urgency of the order, the benchmark that the execution is measured against and any other relationship directive associated with the order.
For sell-side brokers, executing off-exchange through crossing networks and ATSs eliminates paying exchange fees, allows them to capture part of the spread while still giving price improvement to their customers, and furthers co-opetition with exchanges and other brokers through multi-broker efforts such as LeveL, a new non-quoting ATS, and the BIDS (Block Interest Discovery Service) ATS.
The TABB Group report also examines regulatory issues. In the pre-Reg NMS world, block trades could print outside the NBBO (National Best Bid and Offer), trading through the ask price in an aggressive buy or through the offer for an aggressive seller. Post-NMS, this will not be possible, says TABB. Execution must occur at or within the NBBO. In the case of an aggressive buyer or seller, the market venue or routing system must rely on NMS-defined intermarket sweep orders (ISOs) routed to displayed and auto-ex orders at the same time as executing the block. These ISOs will give a clear indication of the aggressive buyer’s or seller’s presence. Further, brokers’ block desks will soon be regulated as market centers. “If they’re not on the ball now, they’d better get moving,” says Johnson. “When the switch flips up on NMS, the lights may go down on those desks.”
In Europe, the first sections of MiFID (Markets in Financial Instruments Directive) that will directly affect development of dark pools in Europe deal with best execution. “But MiFID contains as many barriers to crossing as it provides access gates,” he adds. In addressing systematic internalization by firms and transparency in MiFID, concentration rules will be abolished and internalization will be subject to new rules. Rather than becoming an internalizer, firms will set up their own multi-lateral trading facility or join a consortium like Project Turquoise announced by seven major global investment banks to create a pan-European execution facility. “With just a few of these venues, the European markets could start to look like the early days of ECN trading in the U.S.,” says Tabb.
The TABB research note details the types of dark pools and crossing networks segregated by structure – internal market vs. exchange cross vs. block-crossing ATS – and timing or pricing type: scheduled cross or continuous, blind or advertised and derived or negotiated; and types of liquidity, including transient vs. resident liquidity, a significant designation that highlights how many pools function. It also covers pool size and venue selection; crossing models and ATSs, including their current and future use; how dark pools affect trading overseas, including the developing Asian and European market landscapes; execution volume estimates; the issue of interconnectivity vs. consolidation; and the leading players trading within the current market structure landscape.