Rapid changes in the equity trading environment over the past six months have found an eloquent response in the buy-side’s shifting preferences for certain trading tools and techniques over others. As volumes and volatility exploded in September and October, many buy-siders made greater use of sales traders as they tried to make sense of the market around them. Dark pools went out of favour, but innovation and further changes in market conditions are reversing that trend.
Largely as a result of the post-Lehman Brothers frenzy, sales traders captured 44% of total buy-side flow in 2008, compared with 37% in 2007, according to a survey of US institutional equity trading published by research consultancy TABB Group last December. Passive VWAP algorithms were abandoned in September, not least because of their reliance on historical data. Then, a near halving of trading volumes (turnover in European equities, for instance, fell from EUR 1.88 trillion in September to EUR 0.98 trillion in November) increased the buy-side’s appetite for more aggressive liquidity-seeking algorithms in the last two months of the year.
But while volumes dipped, volatility remained at high levels. Many were reluctant to interact with dark liquidity for fear of leaving an order too long and being caught out by a rapid change in market sentiment. Now, in 2009, trading volumes are still depressed (European equity trading turnover slumped to EUR 0.93 trillion compared with EUR 2.21 trillion 12 months earlier), but volatility is somewhat becalmed. In these circumstances, it should be no surprise that some buy-side firms are returning to dark pools and crossing networks. With some operators reporting a greater use of immediate-or-cancel order types, traders are again prepared to trade in the dark, rather than risk their intentions being exposed by the low liquidity levels currently experienced by many displayed venues.
But at a time when traders are already voicing concern about the lack of transparency in trade execution performance information available from dark pools, the picture is being muddied by yet more new entrants. In the US, NYSE Euronext has launched the New York Block Exchange (NYBX) with BIDS Trading, while the same US-French exchange group has also introduced SmartPool in Europe. The London Stock Exchange will add to the list of European dark pools in Q2 2009 with the debut of Baikal, which also promises a dark liquidity aggregation service akin to functionality being developed or offered by Turquoise and financial technology group SunGard among others. Clearly not all dark pools are built the same, but what are the main differences that impact execution quality?
In both Europe and the US, the main distinction can still be made between buy-side-focused crossing networks such as Pipeline, Liquidnet and ITG Posit and brokers’ proprietary dark pools that largely automate the traditional ‘upstairs’ trading desk by matching flow from across its client-based and proprietary flow businesses. A third type, or perhaps a subset of broker dark pools, is that which is developed from a sell-side firm’s market-making activities for retail clients. One example is Knight Capital’s Knight Link, which was originally derived from the firm’s need to provide broking services in US mid-cap stocks to domestic retail-level investors. Both Knight and Citi’s CitiMatch, which also mingles retail with institutional flow, are due for European launches in Europe, offsetting low execution sizes with low costs.
The most obvious difference between sell-side and ‘independent’ pools is in matched order size; while Pipeline claims an average order size of 50,000 shares, the figure is closer to 400-500 in many broker-owned dark pools. Increased likelihood of execution is balanced by increased risk of interacting with toxic order flow, according to buy-side-focused crossing networks. Thus, it is little surprise that the buy-side-oriented offerings have suffered in matched volume terms recently due to the asset managers’ prioritisation of execution certainty.
Although independent crossing networks are responding through innovation, TABB Group’s 2008 institutional equity trading report noted a reduction in block trading volume and a fall in the percentage of volume executed on crossing networks for the first time since 2004. Senior consultant Laurie Berke says increased use of aggressive liquidity-seeking algorithms in volatile times has heightened buy-side awareness of another distinction between non-displayed venues. “Brokers’ dark pools are more willing to accept algos and the buy-side sees value in that,” she says.
Berke adds that US buy-side traders commonly rely on smart-order routing (SOR) capabilities to avoid dark pools that do not allay satisfactorily their concerns over gaming. But the main use of SOR is to route between US broker dark pools based on cost of trading. With European buy-siders already expressing concern that broker-owned SOR routes to displayed venues based on liquidity-taking rebates rather than best execution, and brokers increasingly focused on the cost of execution on behalf of valued clients, all-in costs for trading in dark pools will only rise higher up the agenda.
As the imminent increase in dark pool aggregation tools suggests, consolidation is unlikely to reduce the number of dark pools available to the buy-side any time soon. Once established, most brokers view them as a sustainably low-cost means of executing client flow while avoiding exchange fees. As aggregation offerings come onto the market, in parallel dark pool operators such as US agency broker BNY ConvergEx, which runs Vortex, are upgrading matching capabilities to speeds that earn favourable comparisons with displayed markets.
Although the pace of change in the non-displayed sector may hamper buy-side attempts at differentiation, the level of innovation suggests that dark pool trading will evolve to serve traders’ needs in a widening range of trading environments.
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