Dark Books: The Next Chapter
As the U.S. equity marketplace continues to fragment, many traders are finding themselves between a block trade and a hard place. Some have found success with the block crossing networks, such as Liquidnet and Posit, which generally match trades in volumes of 10,000 or more. But it seems increasingly unlikely that traders will be able to match all of their large-lot orders in one place - first, the market continues to fragment, with a new player announced nearly every month; and second, the buy side still may be executing trades with particular brokers to pay for broker research, rather than seek best execution, although the SEC now has provided guidance on soft dollars that should give buy-side traders more freedom to choose venues.
According to Aite Group, as of Q2 2006, the NYSE Group exchanges and Nasdaq accounted for 78 percent of the volume of the U.S. equities market. At least 20 other execution venues are battling for the remaining 22 percent share, while about 13 percent of the volume falls into the broker-internalization category. This mode of trading is exceedingly popular with brokers, as it allows them to match incoming orders from customers without paying fees to an exchange.
Increasingly, brokers have consolidated this unadvertised liquidity into automated dark books and built algorithms that direct orders to this hidden liquidity. Aite Group senior analyst Brad Bailey estimates that there are as many as 40 dark pools currently in operation.
Although the appeal of avoiding the inefficiency and cost of exchange trading appears to be growing, as traditional venues continue to lose ground, questions about how to access all of the dark liquidity in a timely manner abound. And there are deeper questions of whether "going dark" is actually in customers' best interests, since the dark books cannot be evaluated side by side with open markets before a trade is executed.
New Venues to the Rescue
Perhaps sensing that buy-side traders are beginning to feel frustrated with the preponderance of dark pools, brokers have developed two new networks that purport to help solve the fragmentation problem.
Debuting in mid-October, LeveL is a crossing network run by Citigroup, Credit Suisse, Fidelity Brokerage Co., Lehman Brothers and Merrill Lynch. The aim of the system is to enable the brokers to efficiently cross their internal orders as well as interact with others, according to Jose Marques, a director at Credit Suisse. It also will be possible to route out to other execution venues to fulfill Regulation NMS obligations, he adds.
"It is our intention to deliver a solution to the problem of dark liquidity fragmentation in a venue that is fair and competitive," Marques says. "Clearly, our goal is to create a deep liquidity pool that can deliver reasonable fulfillment rates compared to other pools. It's hard to say what would be considered 'reasonable'; it depends on the demands of the orders coming in, and the importance of the immediacy of fulfillment versus the volume of fulfillment."
There are two levels within LeveL, Marques explains. Level I crosses broker-dealers' internal order flow on a periodic basis. Level II crosses external orders on a time-price priority, more like a traditional ECN.
The other new broker-backed network, BIDS, or Block Interest Discovery Service, takes a slightly different approach from LeveL, running a negotiated marketplace alongside an automated-execution market. The network, a venture of Citigroup, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley and UBS, will launch in early 2007 using technology from Alberta Market Solutions (AMS), which was founded by former employees of EFA Software, an exchange software company that was acquired by Computershare in 2002. Although it has been common practice for brokers to acquire or develop ATSs with the intention of selling them or floating an IPO, BIDS is meant to be a nonprofit utility, which may reassure participants, relates Paul Hanson, director of AMS.
"Our intention is to enable clients to discover interest and conclude trades," says Hanson. "If you are willing to do trades with a side equal to yours, then we do an automatic match. But we will also let you work with your counterparty to execute a trade." Traders have the capability to set their own minimum order size and to filter out counterparties that did not serve them well in previous transactions, even though they never actually learn the identity of those counterparties, Hanson notes.
Although algorithms most commonly are deployed in automated markets, Hanson says, there is plenty of interest among the partners in developing algorithms that can conduct negotiations on large block trades. Brokers sponsor buy-side participation but do not learn the identity of traders until trades have cleared, he adds.
It's likely that the strongest competitors of BIDS and LeveL - Liquidnet and Posit - will connect to these platforms in an effort to retain trader desktop space and mind share. In the third quarter, Liquidnet matched about 27 percent of all orders entered in its system, including 40 percent of all marketwide block volume and 60 percent of the more-difficult mid- and small-cap names, says Steve Greenblatt, Liquidnet's VP of corporate strategy, who adds that he is not particularly intimidated by the new entrants.
"It has taken us five years to amass the largest institutional pool of liquidity," Greenblatt asserts. "Many of the investors in all these systems have invested in other systems, which makes you wonder: Where are they going to put their liquidity?"