Dark Pools 2009: Not So Dark Anymore

The rise of dark pools over the last couple of years has been one of many changes that the U.S. equities market has experienced, leading to a complete transformation of the institutional trading environment.

No one could have predicted that the U.S. equities market would go from two major market centers only a decade ago to more than 40 venues in 2009. Most of these new venues have been dark pools, whether owned by an individual broker/dealer or operated by a consortium or an exchange.

There is no doubt that the proliferation of dark pools has made the life of an average buy-side trader extremely difficult, as real-time decisions must still be made in terms of where the order should be routed to get the best possible execution. Living in today’s microsecond execution environment, market fragmentation certainly adds another layer of complexity to the buy-side.

Adding to the complexity is the air of controversy surrounding dark pools. Due to their “dark” nature, non-displayed pools are misunderstood by some, and downright distrusted by others. However, with increasing use of outbound and inbound indication of interests (IOIs) within certain dark pools, it is not currently clear whether the traditional definition of a dark pool still applies to a majority of the venues.

One thing is certain, however: the overall market share of dark pools continues to grow, and regulatory intervention appears inevitable.

In a new research report by Aite Group, based on interviews with buy-side firms, broker/dealers, high frequency trading firms, and 27 dark pools, key trends within the dark pool market are examined. The report highlights the major changes to the dark pool market over the last 12 months and profiles 26 dark pools, each with trade volume and high-level workflow.

Dark pools can be defined as execution venues that do not to provide public quotes. The core value of a dark pool is its ability to provide access to liquidity while minimizing market impact. Over the last 12 to 18 months, this rather restrictive definition of a dark pool has been challenged as an increasing number of dark-pool users appear to be willing to live with a certain level of market impact in return for higher fill rates.

Certain dark pools have also opted to link up with other dark pools in the hope of increasing the chances for client orders to get a significant portion of their orders done in the non-displayed market before being routed out to the displayed side.

The non-displayed market is not a homogeneous one. One important note is that due to the variations in business models and target client base, dark pools do not necessarily compete against one another. A dark pool that focuses on facilitating buy-side block trading, for example, might link up with a dark pool that aggregates sell-side flow to add diversity in order flow.

Similarly, broker-owned dark pools might link up with one another to increase overall fill rates for their collective clients. In fact, given the growing trend of dark pool linkages, co-opetition (i.e., certain level of cooperation between entities that otherwise compete) has become more common in recent months. Broadly speaking, there are five different types of dark pools within the U.S. equities market: block trading dark pools, agency dark pools, consortium dark pools, exchange-operated dark pools and internalization dark pools.

About the Author

Sang Lee is the Co-founder and Managing Partner of Boston-based Aite Group.