The Buy Side Demands More Transparency Into Brokers' Dark Pool Algorithms

As brokers begin to code dark pool access into all of their algorithms, the buy side is demanding more disclosure into their executions.

As more and more broker algorithms execute institutional orders in dark pools, the issue of transparency into those executions continues to grow in importance. The buy side remains wary of the secrecy surrounding executions in dark liquidity pools and is beginning to demand disclosure of which dark pools algorithms reach and where their orders are being executed. Some buy-side traders outright question the motives of the sell side in routing to certain dark pools.

With widespread recognition on the buy side that executing equity trades in hidden liquidity pools is one way to avoid moving the market, brokers are working to make dark pools accessible to all of their algorithmic trading strategies. Whereas in the past brokers had pure play strategies that searched hidden liquidity pools -- such as Credit Suisse's Guerrilla or Instinet's Nighthawk algorithms -- brokers now have written the code to enable every algorithm they offer to reach into dark pools.

According to observers, the trend is driven by the buy side's concern over information leakage and brokers' obligation to provide clients with best execution. It also reflects the proliferation of dark pools in a fragmented market and the fear of missing liquidity if one doesn't participate in these hidden pools.

Dark pools are nondisplayed liquidity sources that by definition do not publish quotes. They are opaque networks operated by third parties, brokers or exchanges that match institutional flows against other customer flows and sometimes include an operating broker's own proprietary flows.

"There's no question there's a trend to make algorithms more accessible to dark pools," relates Larry Tabb, founder and CEO of TABB Group, a Westborough, Mass.-based financial markets advisory and research firm. "The reason for that is that folks are getting good executions within some of these dark pools. They are finding liquidity, and the liquidity is being matched at best bid or offer or better than the best bid or offer."

The economics of executing in dark pools also makes them attractive, Tabb adds. "The commission associated with matching is generally better than an exchange or ECN," he explains. With "less impact, better execution and lower cost," dark pools provide an attractive option for buy-side firms, Tabb continues. "So you're seeing more algorithms adopting dark routing technology."

Citi, Credit Suisse and Goldman Sachs reportedly are among the first brokers in algorithmic trading that have coded dark pool routing into their offerings. Most recently, Instinet, the global agency broker, connected all of its algos to dark pools following its merger with Nomura Securities in the fourth quarter of 2007.

"Most of the major players in e-trading long ago realized that we needed to connect everywhere and look under every rock for liquidity," says Timothy Reilly, managing director and head of electronic execution sales at Citi. "Today, if a client is using an algorithm, their expectation is the technology will search for liquidity wherever it lies -- as long as speed, best execution and client anonymity are never compromised," says Reilly.

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio