August 13, 2012

Many people think dark pools are a complicated concept. But there are three points about dark pools and the U.S. equity trading market that even a casual observer in the financial services industry will recognize:

1. Dark pools primarily serve the needs of institutional investors and traders who need to execute very large amounts of stock with limited price movements

2. Dark pool participants appear to place a premium on remaining anonymous – so much so that they're willing to put an above-average amount of faith in the dark pool operator to protect the inner-workings of such a marketplace

3. Dark pools pose a tangible threat to the growth prospects of listed equity exchanges, based on recent assertions about how dark pools and other trading operations now make up 40 percent of equity trading volumes

Now perhaps you're thinking, "Thanks for the summary, Russ. Gotta go." But I'm not finished yet; my interest isn't in equities. Equities are so 2008. In my world, equities are nothing more than a hedging instrument and an input to a pricing model. Options will be the playground for the trading community in 2013 and beyond.

And you know what's going to grow options trading for the masses? Options dark pools. Yes, you heard me correctly.

I'll give credit here to firms like Ballista and Pipeline as they initially put together the first iteration of what an options dark pool could look like. The only downside to these business models was the fact that after they matched buyers and sellers, the final options trades still needed to be executed on an exchange (as was and still is required).

In order to make options dark pools a reality, the industry needs structural change and regulatory approval whereby options dark pools could exist in a similar structure to how equity dark pools operate today. Crazy? Maybe. Controversial? Likely. A way to grow interest and increase participation in options trading? Definitely.

I have no major problems with the existing options exchange structure. We've heard the basic justification for exchanges on many occasions: clear and transparent markets, known entities, decent safeguard, etc. All reasonable points. However, isn't it useful to shake things up a bit from time to time? Can't the status quo be challenged every so often to keep an industry on its toes? Exploring a different yet viable way of doing things has a number of positive outcomes.

Dark pools for options would certainly change the options trading landscape, but it would not lead to trading Armageddon as some might suggest. Although options by their very nature are quite different from equities, that hasn't stopped the options industry from incorporating aspects of equity trading into its own business practices. Decimalization, penny prices, maker-taker fees and other practices all got their initial traction in the equity space and eventually made their way into the options space. The options industry was legitimately wary as each type of equity construct made its way into options trading, but options traders eventually adapted.

Market participants will adapt to options dark pools, too.

What overall utility could options dark pools actually bring to the industry? Actually, a lot of the value in options dark pools would look surprisingly similar to those found in equity dark pools.

One of the biggest options industry gripes is that large traders can't do trades in big enough size in listed markets. If set up intelligently, specialized options dark pools could be geared towards providing larger size to its participants with less price displacement. Also, if given a choice, many options traders would likely gladly take greater amounts of anonymity in their trades, especially since many trades (like spreads) have multiple legs involved. Next, true options dark pools would be the conduit for more high-frequency firms to join the options trading arena in greater numbers, as their trading models would likely be more easily accommodated. Lastly, options dark pools provide intriguing competition for the existing options exchanges and force all parties to hone their business strategies and serve their targeted customer niches with much more acumen.

Realistically, options dark pools will not be approved any time soon. In this Dodd-Frank era of regulation and compliance, the clear trend is toward more exchange-type trading, not less. If the options industry wants to continue to expand its volume and its visibility, however, it would be wise to once again follow their equity brethren's lead and jump into the pool.

Russ Chrusciel is division head of SunGard's Valdi Options business.