Liquidity dearth pushes buy-side to dark pools

Lower equity trading turnover in Europe throughout 2009 is prompting buy-side traders to seek more liquidity in dark pools and execute more aggressively when opportunities are found.
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Lower equity trading turnover in Europe throughout 2009 is prompting buy-side traders to seek more liquidity in dark pools and execute more aggressively when opportunities are found.

European trading turnover in the first three quarters of 2009 – including auctions and dark trading – has mostly hovered around €500-600 billion, according to data vendor Thomson Reuters. By comparison, turnover for 2008 to August – before the extreme peaks and troughs caused by the financial crisis – ranged between €800 billion and €1 trillion.

“The one tool that has helped counter these effects is the increased ability to source and get fills out of dark liquidity pools,” said Richard Balarkas, CEO of agency broker Instinet Europe. “Thin markets create a wider spread for anyone dealing in anything more than a few hundred shares. The good news about dark pools is that trades are priced at the mid of the primary market.”

Balarkas estimates that just over 20% of Instinet Europe’s business is executed in dark pools. “Clients are saving just over half of the spread costs and we are getting substantial amounts of liquidity that you simply wouldn’t find on the visible books.”

Paul Squires, head of trading at AXA Investment Managers, confirms that dark pools have proved useful in 2009’s thinner markets. “We have definitely increased our use of dark pool algorithms where we sit passively in a dark pool to see if there is any liquidity there because we can’t find enough in the lit venues,” he said, adding that his firm also trades in the dark to avoid market impact.

Squires estimates that AXA IM trades 5-10% in dark pools such as Liquidnet, a buy-side-only crossing network. “While it doesn’t sound like a big figure it is probably up 50% or so as a proportion of our activity,” he said.

Traders are increasingly combining the use of displayed and non-displayed liquidity to maximise liquidity capture. “We have noticed a big uptick in is the use of ‘I would’ strategies,” said Balarkas. “You are actively working a order to the best extent you can on the visible market but you are placing a large amount of the balance of the order in dark pools in the hope that you get chunks filled at the mid.”

In addition to dark pools, traders are making more use of liquidity-seeking algorithms to scour the market for opportunities to trade rather than trading more passively and expecting liquidity to come to them. “The client take-up of liquidity-seeking strategies relative to other strategies has strengthened over the year,” said Rob Boardman, head of electronic trading at agency broker ITG.

Because liquidity is harder to find, particularly in smaller-cap names – or in some cases even towards the bottom of large-cap indices – traders need to react quickly when opportunities arise.

“With liquidity being scarce, particularly for hard-to-trade stocks, when you find liquidity you probably want to jump on it because you might not get another opportunity for a day or two,” said Boardman. “The opportunity cost of not trading when you find liquidity in a second-line name can be quite high.”

Traders’ increasing aggressiveness is showing up in their transaction cost analysis (TCA) results. AXA IM measures its performance against standard VWAP and ITG’s Agency Cost Estimator (ACE) adjusted implementation shortfall benchmark. “We are still capable of finding liquidity within the spread a lot of the time, which gives us a favourable TCA result overall against ACE, but quite often because we are trying to be slightly more aggressive to get reasonable size done, we might end up being quite expensive against VWAP,” said Squires.

Although trading turnover in Europe looked to be improving towards the end of 2009 – it grew to €742.9 billion in September and €810.5 billion in October – there was a slump back to €673.1 billion in November, indicating that challenging times may not yet be at an end.

The slump can also be seen in European exchanges’ November trading statistics for equities. German exchange group Deutsche Börse’s November turnover of €96.5 billion was 21% down on November 2008 and 16.5% down on October 2009. The London Stock Exchange Group’s November traded value fell 14% month-on-month. NYSE Euronext’s European average daily volume in November was down 10.2% year-on-year and 16.5% month-on-month.