Non-displayed US trading venues’ increasing use of indications of interest (IOIs) and immediate-or-cancel (IOC) orders is challenging their definition as ‘dark pools’, according to a new study by research and consulting firm Aite Group.
The study, ‘Dark Pools 2009: Not so Dark Anymore…’, contends that users of non-displayed venues are now willing to live with a certain level of market impact in return for higher fill rates.
US dark pools have evolved from stand-alone entities to venues that have forged links between themselves and displayed liquidity sources, said Aite. In addition, brokers have also developed liquidity-seeking algorithms that aggregate non-displayed liquidity, which Aite said have become popular with buy-side traders that feel compelled to trade in the dark without fully understanding each pool’s workflow or liquidity profile.
As they seek to boost crossing rates, dark pools have increasingly adopted IOIs – both the more widely-used inbound IOIs, which result in the order being routed out to an external venue, and the more rare outbound IOIs, in which the pool sends out details of resident orders. Aite said only three pools – Liquidnet, NYFIX Millennium and the International Securities Exchange MidPoint Match (now part of Direct Edge) – publicly acknowledge their use of outbound IOIs, but the report reasoned that outbound IOIs are probably more used than reported because more venues accept inbound IOIs than outbound IOIs.
Another potential source of information leakage, said Aite, is IOCs, of which, like IOIs, the inbound variety is more common given the higher leakage probability for outbound IOCs.
Aite estimates that dark pools accounted for 12% of US equities trading at Q2 2009, up from around 8% in Q1 2008. The firm acknowledges, however, that this could be a conservative estimate as only 19 of the 27 dark pools interviewed for the study gave average daily volumes and not all of these provided historical average daily volumes. Interviews with broker-dealers suggest dark pools have a 20% market share, while trade reporting facility numbers suggest 14%.
High-frequency traders have provided an increasing amount of liquidity to dark pools, according to Aite. These firms traditionally shunned dark pools because of the lack of a reliable price discovery mechanism. However, the pools’ growth, coupled with aggressive execution fees and greater availability of performance data, has tempted them in. The report asserted that increasing high-frequency flow has played a vital role in dark pools’ market share growth over the last few quarters.
Dark pool development will not continue unchecked, however. A raft of regulatory concerns has been raised about dark pools in recent months. While arguing that an outright ban on dark pools is unlikely, Aite said standardisation of trade reporting and the use of IOIs and IOCs are already on the regulators’ agenda.
“If regulators ultimately decide to implement tighter controls over dark pools, IOIs and IOCs will certainly be two of the major issues to be addressed,” the report said.