It's not easy being a big player in the stock market. Trading huge quantities of stock on traditional exchanges has become ever more challenging, costly, and potentially disruptive. And if other players see your moves, they can disrupt your trades. That's led to the emergence in recent years of alternative trading systems known as dark pools. And their growth could have significant implications for big stock exchanges—and individual investors.
Dark pools sound like something from Greek mythology or a sci-fi epic, but in stock-market speak they are private trading networks that big brokerages such as Lehman Brothers (LEH) and Merrill Lynch (MER) have developed primarily for the internal matching of orders between buyers and sellers who are clients of the same brokers. But dark pools have developed links among Wall Street firms as well, so that orders can be matched across different brokerages. Indeed, some firms are teaming to launch new dark pools such as BIDS Trading.
Alternative trading systems, or ATSs, have gained an increasing share of equity trading in the past few years. In addition to dark pools, ATSs include crossing networks, such as independently owned Liquidnet and Pipeline, that match orders for execution without having to first route them to an exchange or market center where they could be viewed publicly. Besides enabling investors to execute an order without affecting the public price quote, crossing networks match orders at a specified price, typically the midpoint of the bid and ask prices on stocks at the point in time of the trade. Electronic communications networks (ECNs), which trade stocks and currencies, are another type of ATS.
The initial proliferation of ATSs stemmed from policy changes by the U.S. Securities & Exchange Commission that were designed to encourage competitive pricing. More recently, the motivation for using them has been the quantities of stock being traded and the ability to keep these transactions hidden—and anonymous. Dark pools also make it easier to trade small- or mid-cap stocks, which are often lower-profile companies that, because they're less liquid, are harder to trade publicly.
When New York-based Liquidnet launched in April, 2001, block trades of 10,000 shares or more represented 60% of the New York Stock Exchange's total trading volume and currently account for only 18%, says Alfred Eskandar, who heads Liquidnet's corporate strategy group.
Much of that decline in volume is tied to a change in the way prices of NYSE-listed stocks are expressed, from fractions to decimals, starting in 2001. With stocks priced in cents, instead of sixteenths, it's less likely that an investor will find a buy or sell match for his order at a price both sides can agree on, which has thinned block trading volume.
The Lure of Lower Trading Fees
In a September, 2007, report, Aite Group, an independent research firm in Boston, predicted that exchanges' market share in U.S. equity trading would continue to decline from the current 75%, before stabilizing at around 62% by 2011. The formation of 35 to 40 ATSs has exacerbated fragmentation of the marketplace.
It's not just the faster processing speed that has lured institutional investors with their jumbo trades to ATSs, but lower trading fees. The difficulty of finding the necessary liquidity to match big-block orders forces traditional exchanges to slice and dice an order of 100,000 shares into smaller chunks of a few hundred shares each that are then executed at a range of different price points.
Eskandar calls Liquidnet a wholesale trading community, which gives investors a break on transaction costs because they're trading such huge quantities. "It doesn't make sense when wholesalers pay a premium for something," he says. "Institutions should benefit from their large size."
Looking at Liquidnet
On average, Liquidnet charges customers 2¢ per share, with no volume discounts. Given that the average trade size on Liquidnet is 52,000 shares, that's a bargain, says Eskandar. Commissions are the same at Pipeline and ITG POSIT, one of the first crossing networks, whereas BIDS (Block Interest Discovery Service) charges half a penny per share, the Aite report said.
Liquidnet operates by embedding its software into institutional investors' desk-top order management systems. The software essentially scans a customer's electronic trading blotter for buy or sell orders, which then pop up on the Liquidnet screens only of other customers whose blotters have comparably sized opposing-side orders of the same stocks.
"We're not soliciting merchandise that [institutional investors] are not interested in, so there's no noise," Eskandar says. "We're simply giving information based on the information they share."
The growing use of alternative platforms has traditional exchanges scrambling to come up with ways to preserve their market share.
In the past year and a half, the NYSE has snapped up Archipelago, an ECN, and converted it into its electronic Arca exchange. It has also merged with Euronext, a European exchange, enabling NYSE members to trade foreign stocks. In addition, it bought a 5% stake in India's National Stock Exchange and has entered into a strategic alliance with the Tokyo Stock Exchange.
Yet, even as it expands into other markets, the Big Board is closing two of its four remaining physical trading rooms by November, and increasing rebates to traders who post bids or offers on the Arca system by 25% in an effort to protect its piece of the equity-trading pie.
Its biggest move to stem the tide of trading volume to other venues may be MatchPoint, its own crossing system for big-block trades, which it plans to roll out in October or November, pending approval from the SEC.
Instead of the continuous crossing that most ATSs provide, MatchPoint will offer a series of scheduled crossing sessions, probably every hour on the hour during the regular trading day.
Jim Ross, who created MatchPoint and developed many crossing features at Instinet during the 14 years he worked there, believes that by amassing liquidity over time, the NYSE will be able to accommodate bigger blocks than a single-point continuous crossing system. While orders accumulate, all information is hidden and there's no interaction between participants, but users are able to edit, cancel, or add orders to the system. Orders become firm at the appointed match time and are matched on a pro-rated basis according to size using a national-best-bid-and-offer price derived from an external data provider.
A new securities regulation known as Reg NMS has leveled the playing field by requiring that all trading venues ensure the best execution of trades. The changes, which went into effect in December, 2006, were a catalyst for the formation of more of these alternative venues, which recognized that orders would find them as long as they could compete on price, says Bill Cline, chief executive of Acai Solutions, a capital markets consultancy in New York.
"Anyone who thinks [ATSs aren't] a threat to traditional exchanges' volume in cash equities is probably wrong," Cline adds.
Preventing Information Leaks
Driving investors' quest for greater anonymity and lower market impact costs are their well-founded fears that information was leaking whenever they placed orders with sell-side brokers, which prevented them from getting the best execution on their trades, says Cline. That's why Liquidnet remains essentially a club for buy-side investors only. And even if its H20 model lets in selected sell-side brokers, it's only to add liquidity to the pool for its buy-side members, not to give sell-side participants equal access to buy-side order flow.
Victory Capital Management in Cleveland has been using Liquidnet to execute large stock orders for the past two years. For Greg River, head of equities trading, the lack of information leakage is critical.
"We're large enough and a few of our specific investment strategies are that significant that when we do something it's visible, and people can [use it to] act against us," River says. "[Liquidnet] is a tool that allows us to trade and gets things done without revealing everything to every player out there."
Limiting Trading Partners
Probably because it was founded by some of the biggest brokerages, BIDS Trading doesn't believe in barring sell-side players. The more participants invited in, the better the chances of matching buy and sell orders, says BIDS Chief Executive Tim Mahoney.
Instead, BIDS provides score cards that track users' past trading behavior and enables members to filter out counter-parties whose behavior is suspect. For example, members can limit users they're willing to trade with to those with a record of completing most of the trades they've entered into. "If you were going to discriminate against someone, you should discriminate based on their behavior, not on whether they're on the sell-side or buy-side," Mahoney says.
MatchPoint's solution for preventing order leakage is its point-in-time, or scheduled, crossing system, which makes it harder for would-be predators to identify where individual orders are within the system, Ross says. That keeps the predator from jumping in with his own order elsewhere and disrupting the intended trade.
What It Means for Investors
The proliferation of dark pools could have ripple effects beyond just block trading, says Lee at Aite Group. As long as they remain a niche market, they're probably of little consequence. But if the equities market becomes increasingly dark as more trading shifts to these platforms, while retail investors continue to see only the public portion of equity trading, it calls into question the actual meaning of public price quotes, Lee says.
On a practical level, if retail investors get the price they think they'll get when they submit an order and they're happy about it, they probably wouldn't care what the actual reality of the marketplace is, he says.
Regulators would care, however, regardless of whether individual investors have concerns. In fact, Reg NMS modified a 1997 regulation by lowering from 20% to 5% the ceiling on average daily volume of any given stock that ATSs are permitted to represent before being required to disclose information to the public market, Lee says.
Cline believes that not only are dark pools ultimately a good thing for investors but that "to not take advantage of dark pools is failing to live up to the best execution mandate of Reg NMS."
Whatever their advantages, it seems clear there isn't enough liquidity available for all of the alternative trading venues to survive in the long run. There's already been some consolidation, and more is sure to follow.
In the battle for market share, the exchanges are in a better position than ATSs because they have other revenue sources, such as market data and stock listings, that allow them to be more aggressive on pricing, says Lee.
When NASDAQ came under attack by ECNs, it slashed its prices for a while to attract customers and its market share stabilized. And just as NASDAQ ended up buying some ECNs to boost its market share, Lee says he wouldn't be surprised if ATSs become buyout targets for the big exchanges. But for now, more Wall Street players may decide to test the waters of the dark pools.