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Growing Dark Pool Trading Volume Could Spell Trouble for Exchanges

As dark liquidity pools garner more and more volume, how will they evolve going forward, and what does it all mean for exchanges?

During a panel discussion on dark liquidity at a recent trading event, one panelist made a bold statement. He said that the buy side doesn't need to execute on displayed markets at all anymore, espousing that the future for trading was in dark liquidity and trading effectively without hitting open markets.

While the same panel also noted that dark pools saw a drop in volume during the late-summer market volatility, the theory that trading in dark pools alone could be the future nonetheless piqued significant interest.

There's no denying that dark pools are mainstream these days. As algorithms and partnerships have made it easier to spray the various venues and hit as many as possible through fewer connections, traders have become more and more comfortable routing trades to these nondisplayed liquidity pools. But as dark pools become a staple routing destination and their overall share of trades in the market continues to climb, how will they continue to evolve, and what does it all mean for the future of traditional exchanges?

A recent report from Aite Group entitled, "Rise of Dark Pools and the Rebirth of ECNs: Death to Exchanges?" estimates that dark pools, including independent block-trading platforms, broker-dealer crossing engines and utility models, account for about 15 percent of all U.S. equities market share as of Q3 2007. And Sang Lee, cofounder and managing partner at Aite, says that number is expected to rise to 20 percent by the end of 2011.

Considering the fragmented state of dark pools, the increase in dark pool market share is being driven by better connectivity and linking and more algorithms focused on hitting multiple dark pools before routing out to public markets, Aite says. As a result, exchanges have seen a "significant decrease" in average trading volume, according to the report, dropping 5 percent from Q2 2006 to Q3 2007.

Larry Tabb, founder and CEO of TABB Group, says dark pools have become their own self-fulfilling prophecy when it comes to building volume. "As more and more trades are matched, and the technology and connectivity become more seamless, and accessing the dark pools becomes quicker and quicker, there becomes less opportunity cost because the speed is there," he explains.

Tabb adds that as more and more buy-side firms use dark algorithms to access the fragmented pools, the dark pool market share only will continue to rise and propel the ongoing cycle (see related chart, page 25). "If they can match in a dark pool and bypass the exchange, they can generally execute at a better market price or with less market impact, and more and more generic algorithms will wind up accessing the dark pools," he says. "Then the question becomes: Where does that leave the visible exchange market?"

Exchanges Fight Back

But as dark pools continue to pull bigger market share, Tabb contends, the trend will light a fire under the exchanges. He says he expects them to get more aggressive in the marketing of their own hidden reserve matching platforms, such as Nasdaq's Nasdaq Crossing Network or NYSE's MatchPoint technologies.

According to Tabb, if the exchanges price their matching platforms at a rebate and pay people to use them, they have the ability to "drain the dark pools." But so far the exchange-driven dark pools have not caught on.

Tabb notes that while broker-dealer internal dark pools won't see much consolidation, other dark pools could be ripe for some M&A activity. "Dark pools such as Liquidnet, ITG Posit, Pipeline, NYFIX Millennium, and even BATS and LeveL will see some consolidation," he says.

Of course, natural competition also could lead many dark pools simply to go out of business. But what if the fragmentation continues and 20 or more dark pools each keep about 2 percent of market share? "That in and of itself could be a problem," Aite's Lee says. "It's too fragmented."

Lee also points out that with exchanges operating as public companies, many broker-dealers are beginning to view them as competitors. In a sign that they are looking to take the exchanges head on, most large broker-dealers already have made investments in regional exchanges, electronic communication networks (ECNs), alternative trading systems (ATSs), and their own internal dark pools and utility-model dark pools.

The Aite Group report estimates that while broker-dealers often are hesitant to release actual trade volume statistics, crossing rates "appear to be anywhere between 4 percent and 11 percent, with some of the largest platforms averaging anywhere between 40 million and 100 million in trade volume on a daily basis." Lee notes that these numbers are not to be scoffed at.

In addition, dark algorithms are upping the ante even more as dark pool routing can be more aggregated. Firms using dark liquidity algorithms heavily are seeing more than 40 percent of shares in certain orders filled in dark pools before routing out to displayed markets, according to Lee. "In reality it is a highly fragmented marketplace," he observes. "But virtually, it is consolidating as new technology comes into play."

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