Buy Side Order Flow Could Shift Away from Dark Pools

As the news continues to be grim from Wall Street and the bailout bill has stalled, dark pools could start to feel the crunch.

Dushyant Shahrawat, senior research director, investment management at TowerGroup, points out that we could see a shift in order flow from dark pools to crossing networks.

In his latest research note entitled, "How the Massive Upheaval on Wall Street Will Impact the Investment Management Business," Shahrawat says that the buy side may shy away from broker-dealer sponsored dark pools in the aftermath of the credit crisis turmoil.

“The broker-dealers are in trouble and in that environment its questionable to what extent they will support their liquidity pools,” says Shahrawat. “If you’re a money manager and your trading strategies depend on directing five to ten percent to dark pools and you see Lehman collapsing you might think twice.”

He sees buy side to buy side crossing networks such as Liquidnet and Pipeline as an attractive alternative, as well as exchange offerings. “Firms want to be comfortable trading and now they are concerned about counterparty exposure being a risk,” says Shahrawat. “They’d rather deal with buy side shops they know.”

The only issue is how much liquidity is present in those types of pools. “It’s still about eight to nine percent of the overall market but some of these issues might push even more order flow towards these types of crossing networks,” he adds.

Exchanges have also been “stepping up a lot now,” says Shahrawat and have more attractive offerings that buy side firms may be looking at for directing order flow.

Overseas dark pools may also see changes, although because the total participation in dark pools is not as high as it is here the impact may be less, says Shahrawat.

“Ownership of a lot of the networks in Europe is not that different, there are a lot of U.S. firms with equity stakes,” he says. “And those companies still have the same pressures.”

With quite a few dark pools gearing up for launch in Europe Shahrawat says it couldn’t be worse timing. “The business was already going in a different direction—reaching a point where consolidation was imminent and the benefits being derived from more competition in the execution space were outweighed by fragmentation,” he explains.