May 31, 2007

Dark pools have caused a ruckus on the Street. And not just because of the way they are fragmenting the marketplace, but simply because of their name. Just about every bulge-bracket firm I've talked to, from Citigroup to Goldman, has mentioned that they ban the use of the word "dark" book or pool internally, hoping to move away from the negative connotations that dark trading implies. As Citigroup's Tim Reilly, notes, "It sounds sinister." One dark pool operator almost chose to refrain from being listed in our dark pool directory (see pull-out poster inside) because of its title. The preferred term is nondisplayed pools of liquidity.

Whatever the industry chooses to call them, they are not only multiplying, they are gaining share. Currently, in aggregate, stocks traded in dark pools represent about 10 percent market share, and all predictions suggest that share will increase. How much depends on who you ask. I've heard predictions ranging from 17 percent to 25 percent by the end of next year. As a result of this growth, buy-side traders have to become savvy about the way they navigate the growing list of liquidity pools. As Michael Fenske, senior trader, ING Investment Management, puts it, "It's hard to be everywhere." Fenske and the ING domestic equities desk (featured in this issue's "Anatomy of a Trading Floor," page 18), use many dark pools, including ITG, Liquidnet and Pipeline. And more important, the buy side has to discern which pools are shallow and which are deep, so to speak. Thus, new trading strategies are being adopted to test the waters. Now that most buy-siders have dabbled in the dark, traders must create strategies to uncover the liquidity. You might be missing something if you don't try them all, warns Jeff Gudorf, head trader, Principal Global Investors (see "Linking Liquidity," page 20).

At a recent TradingScreen event, one dark book operator suggested having a list of 10 dark pools in which you actively trade. He suggested trading most heavily in the top three, where you're getting the best fill rates. If, say, No. 7 on your list starts to generate more fills, you might want to move it up higher on the list. The order will constantly change as the market changes, so monitoring the various pools' liquidity is critical.

As for the dark pool operators themselves, the race is on to differentiate the winners from the losers. Each wants to be the Island or Archipelago of the '90s — the last ones standing when the market shakes out. They are racing to expand internationally, add new features, link to gain liquidity and offer a distinctive type of liquidity to set them apart.

The landscape of nondisplayed pools of liquidity likely will look completely different two years from now. Dark pools may not be sinister, but keeping up with the new entrants and new features — as well as weeding out the puddles from the pools to determine which will continue to flow — is a shot in the dark.

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