Dark pools are on the regulatory front burner. They’re seen as competing with the displayed markets, even as they’ve captured a segment of trading from the desks of broker-dealers’ upstairs.
The Securities and Exchange Commission is now bearing down on issues related to trading in dark pools and how much flow can execute in individual pools without triggering obligations to the rest of the marketplace. To provide some perspective on this broader discussion, a panel at last week’s Traders Magazine Live conference addressed the core issue of what role is served by broker-operated dark pools that, by and large, do not print block trades.
The conference, which took place at the Down Town Association in New York on Sept. 24, drew a standing-room-only crowd of almost 200 trading executives. Robert L.D. Colby, counsel at law firm Davis Polk & Wardwell, in Washington, D.C., moderated the panel on dark pools. He is a former deputy director of the SEC’s Division in Trading and Markets.
Colby noted that the SEC has traditionally had a "binary view" of dark and lit liquidity, since the lines between them were much clearer. As the structure of the markets has evolved, dark and lit markets began to overlap. Now, Colby said, many venues are "semi-dark" or "semi-lit"–a shift that raises more complex issues for regulators.
Dark pools and exchanges now interact. Many dark pools route orders to one another, exposing flow to other alternative trading systems in the hunt for liquidity. NYSE Arca, Nasdaq, BATS Exchange and Direct Edge have programs enabling dark pools to stream quotes to them, so they can avoid routing orders to other markets if they can’t fill orders.
Pools such as Credit Suisse’s CrossFinder, Goldman Sachs’ Sigma, LeveL ATS and others also have average execution sizes of several hundred shares, not much more than the average execution size on exchanges. Liquidnet, in contrast, has an average execution size of over 49,000 shares.
For the SEC, this raises questions about whether the functions of these venues have changed in recent years. SEC Chairman Mary Schapiro said a week ago she was concerned that "the public markets may be deprived of the valuable trading information, including price discovery, available in dark pools." She mad that comment in a speech at the Financial Services Roundtable’s conference on Sept. 24.
Brian Hyndman, senior vice president for transaction services at Nasdaq OMX Group, noted at the Traders Magazine conference that dark pools play a role in the trading industry but that they clearly take information away from the displayed markets. He stressed that Nasdaq isn’t against internalization. "For the record," he said, "internalization and dark pools are good." But he went on to point out that "maybe price formation in the public markets could suffer" if enough liquidity doesn’t get to the public markets.
Exchanges, it should be said, also have their own dark orders types amidst their displayed market. At Nasdaq, for instance, about 16 percent of executed volume involves a party that was non-displayed. The percentage of volume at BATS that involves at least one dark order is a few percentage points lower.
The brokers on the Traders Magazine panel made a case for off-board trades. Owain Self, head of algorithmic trading for the U.S. and Europe at UBS, noted that blocks have historically traded upstairs and that they "were never done in the displayed market." Many of those big orders, he said, now execute algorithmically in dark pools, where they can seek to avoid the information leakage they might encounter in the displayed markets.
Dan Mathisson, head of Advanced Execution Services at Credit Suisse, admitted that "it’s no secret that blocks are all getting carved up," and executed piecemeal. This started with decimalization, he said, which produced "less size on the bid and offer and made it easier for people to jump in front of you."
He put an even finer point on the argument that broker-operated dark pools that don’t print blocks are nonetheless executing blocks. "Our view is that virtual blocks are the same as regular blocks," he said.
Mathisson argued that "people attribute a lot of importance to putting up 100,000 shares as one print." In his view, that "argument about blocks is a little artificial." The issue isn’t whether a trader can execute a big order in one piece, he said, but whether that order can be executed at a good average price over time. And he stressed that dark pools enable this by avoiding the information leakage that can occur on exchanges and ECNs.
Whit Conary echoed some of these comments. Conary, the chief executive of LeveL ATS, a dark pool run by a consortium of broker-dealers, said dark pools use technology to execute block orders that upstairs desks weren’t always able to execute because they couldn’t find the other side.
Instead of an upstairs desk calling around to find naturals, Conary said, a broker can use a dark pool strategy to rope together liquidity residing in numerous spots. Since this is done in an automated way, through algorithms or electronic messages between dark pools, this gives naturals a better chance of finding executions without exposing their intentions in the public markets, he said.
Many of these contra-side orders are now also in algorithms. As these orders interact over time, Conary said, the average execution size is bound to be within range of the average size in public markets.
Justin Schack, vice president for market structure analysis at Rosenblatt Securities, noted that "modes of dark trading are good for the market." Non-displayed orders, after all, have taken many forms over the years, from slips of paper resting in a floor trader’s pocket or buyside-to-buyside systems such as Liquidnet.
Schack pointed out that about 75 percent of the industry’s volume currently involves displayed liquidity, while the rest is non-displayed, whether that occurs through upstairs desks, dark pools or block crossing platforms. For decades, the volume done on public markets was around 80 percent, with the remaining 20 percent taking place off-board.
Nasdaq’s Hyndman raised a couple other issues with dark pools vis-a-vis the displayed markets. He pointed out that another reason these broker-operated pools exist is the "cost factor." It is cheaper for broker-dealers to execute in those pools than in the public markets.
He also argued that automated messages some of these pools send to one another to find liquidity essentially interlink these pools in a way that hurts the displayed markets. Those pools that interact in this way have essentially created "one large dark pool without the 5 percent threshold," Hyndman said. The 5 percent threshold is the SEC’s trigger level for displaying quotes and providing fair access (on a name-by-name basis) to the pool. It’s based on an ATS trading 5 percent in a particular stock in four of the previous six months.
The executives from Credit Suisse and UBS noted that dark pool IOIs can be harmful to customers for other reasons. From the brokers’ perspective, the chief worry is information leakage.
Both firms do not send out IOIs from their pools. UBS also doesn’t accept them, while Credit Suisse does consume them. If liquidity is elsewhere, Mathisson said, his firm’s pool will route orders to that other ATS. He referred to what his firm does as the "bathing suit on a nude beach strategy" since CrossFinder is not providing a view of what’s in its pool to others.
While the broker-dealer representatives on the panel believe their pools help investors execute efficiently, Self noted that the future of dark pools will depend on how the SEC approaches broker-operated dark pools that aren’t intended primarily for blocks. Broadly, he said, it will depend on "whether we try to regulate the effect, or try to regulate the cause."
Two "causes" for dark pools, in Self’s view, are concerns about getting pennied in the displayed markets and what he called "queue jumping." Institutional traders get pennied when someone jumps ahead of their limit order to grab incoming orders with the hope that they will be able to make a profit on the trade if the market moves in the direction they expect. Queue jumping, on the other hand, is when traders decide to execute in dark pools to avoid waiting in line for an execution behind existing limit orders in the displayed market.
