Dangers of the Dark?

Yesterday, Tabb Group released some statistics on U.S. equity volumes that should raise some eyebrows as to why order flow is going underground. According to the market research and advisory firm, 32.96 percent of US equities trading volume — or nearly one third— is traded away from the primary exchanges. Due to an error, the firm originally reported that 37 percent of US equities trading volume was traded off-exchange, suggesting that internalization had reached a new high.

But today, Tabb Group corrected the error. "This did not represent a historic high. Nevertheless, the error does not invalidate the concerns expressed in our comments about the rise in off-exchange trading," noted co-founder and CEO Larry Tabb in a statement.

But the surprising part is that dark pools only make up about 13 percent of U.S. equity volume. The rest (19. 3 percent) is being executed through internalization — a practice whereby brokers match the orders internally on their own trading desks — before the orders are sent to dark pools or exchanges, according to Tabb.

In February, off-exchange trading was 34 percent of U.S. equity volume (including both internalization and dark pools) , so that has dropped to about 33 percent in March, By comparison, in 2008 internalization and dark pools totaled 15 percent, according to the market research and advisory firm.

We already knew that for the past few years, buy-side institutions have preferred to execute in dark pools first before going to the public markets. Dark pools are private, electronic networks that match buy and sell orders — to avoid market impact, preserve anonymity and execute at the midpoint of the bid-ask spread. But what’s behind the increase in internalization?

Is the equity market structure so fragmented and complex that it’s simpler for traders to operate in the lit markets. Are asset managers looking to avoid the high frequency traders who are chasing the rebates? What about the small order sizes that make it challenging to execute block-size orders?

Tabb Group cites a number of reasons for the trend toward internalization. First, lower volumes in the U.S. equities markets are pushing traders into the dark quicker. Since US equity volumes are down 14 percent from the same period in 2011, it may be easier to scoop up liquidity in the dark since matches are harder to find.

Second, it’s become impossible to track 50 execution venues that have arisen, so institutional clients are perhaps leaning on their brokers- as execution consultants to manage the orders. The brokers can electronically handle the order flow and they are hooked into all the various venues.

Cost is also a huge factor. Since equity-oriented asset managers are facing cost pressures with their commission budgets, which they must allocate to pay for research, corporate access and new issues, buy-side traders are allocating less commissions to executions. This in turn, puts pressure on the sell-side, to manage their expenses which are heavily made up of exchange fees, according to Tabb Group. So, brokers prefer to match orders internally rather than pay exchange fees, hence, the percentage of order flow executed internally is going up.

The sophistication of internalization and dark pools is also a key factor, and along with the other reasons cited by Tabb, this to me, is a catalyst in the growth of internalization. According to Tabb's Senior Analyst and Manager of Liquidity Matrix, Cheyenne Morgan, internalization is often an automated process. Brokers are receiving order flow through the sales desks, via algos and in response to indications of interest (IOI) messages. Technology allows them to send messages such as IOIs, seeking liquidity, or respond to messages, to find the other side of the trade, all within microseconds. So the brokers can first choose to internalize an order and if they don’t find a match, route it elsewhere to their own dark pools, which are connected to still other dark pools. “If by the time the order went through two or three different dark pools and messaging cycles and the order remained unexecuted, it would then go to the exchanges,” wrote Tabb and Morgan.

With market data feeds from the primary exchanges, the brokers are able to offer executions at the national-best bid or offer (NBBO), so there is less concern about not getting the best price.

But what should be of concern, is that the exchanges are receiving order flow as the last resort. If the Tabb numbers are accurate, then nearly 33 percent of order flow has left the exchange gate. It remains to be seen whether this is a bad thing since all the exchanges and dark pools and internalization engines are connected. There are also cyclical factors to consider. If volatility spikes up and volumes increase, experts say we may see the exchanges become more popular again.