The Buy Side Demands More Transparency Into Brokers' Dark Pool Algorithms
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 the 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 can 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 (see related sidebar, page 24) brokers now have coded 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.
"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 at the end 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.
Dmitri Galiametdinov, director of Credit Suisse Advanced Execution Services (AES), says the broker accesses dozens of dark pools, but he will not disclose how many or which ones. "It's not how many," Galiametdinov says. "It's how."
The methodology that a broker uses to search for liquidity in dark pools and protect against information leakage and predatory behavior is more important than how many dark pools to which it is connected, agrees Citi's Reilly. "It's easy to spray every venue out there ... without understanding the mechanics of that dark pool and without any antigaming logic," he explains. "That is pure connectivity."
To differentiate themselves, Reilly adds, brokers must look at the historical performance of dark pools to determine where they can find liquidity and route to those pools. "We can then overweight those venues with the highest hit rates and lowest potential for adverse selection," he says.
Routing in the Dark?
It is the logic behind brokers' dark pool routing methodology that concerns buy-side traders. In particular, many question the neutrality of brokers that have stakes in dark pools.
"Some people are paranoid about the dark pools because some of the dark pools are provided by the bulge-bracket firms," explains James Morrow, COO, sales and trading, at Capital Institutional Services (CAPIS), an institutional agency broker in Dallas. "You're trading against their internal flow," he says. "Some people are a little concerned about what's happening to [their orders] and the motivation behind them going into a broker's internal flow."
"The concern for me is how the broker allocates the trade among the different dark pools," says Rob McGrath, head of trading, Americas, at Schroder Investment Management North America, which has $280 billion in assets under management. McGrath says he still fears that there is an obvious economic incentive for the brokers to execute trades against proprietary flow.
While there is financial incentive for brokers to execute trades in their own dark pools, "I'm motivated to get the trade done in the dark pool that has the best liquidity," McGrath says. "Something neutral would be better."
In January, Pragma Financial Systems and institutional agency broker Weeden & Co. launched OnePipe, a liquidity management system that quantitatively allocates orders among more than 30 dark pools. Though Timothy Olsen, head of trading at ICM Asset Management (Spokane, Wash.), uses OnePipe via his relationship with Weeden, he admits that he is not sure from where he gets the fills. "They can't tell me because of the confidentiality agreements that these brokers have signed with each other," he says.
In fact, many brokers have signed confidentiality agreements with a dozen or more of the estimated 40 existing dark pools to access their liquidity. One reason for the secrecy, according to some insiders, is that dark pools have inconsistent pricing policies; a dark pool might charge a buy-side institution more to access its liquidity than it would charge a broker. If the buy-side customer were to find out, it likely would bypass the dark pool and trade only through the broker. Hence the contractual agreements preventing brokers from disclosing the dark pools they access.
But this creates a problem, according to ICM's Olsen. "For my best execution requirements, I need to know who my contra-parties are," he says. "There are some dark pools that I don't want my flow exposed to because of their ownership structure."
Further, Olsen says, he worries that brokers route his orders to dark pools that charge lower execution fees as opposed to routing to a venue that has the best liquidity. "Am I not getting the best liquidity provider because the execution cost isn't very good?" he ponders.
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
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