May 29, 2007

Joe Gudorf is head trader at Des Moines, Iowa-based Principal Global Investors, a diversified asset management business with more than $200 billion in assets covering a range of equity, fixed-income and real estate investments.

Gudorf actively trades in dark liquidity pools, and to execute his trades and serve his clients better, Gudorf needs to be in as many dark pools as possible. But as dark pools multiply — from only four a year ago to as many as 40 by recent counts — dealing with the fragmentation becomes increasingly challenging for Gudorf and his buy-side peers.

But all dark pools aren't the same and can't be lumped together under a single classification. In fact, there are four types of nondisplayed liquidity pools — the independent or agency-owned platforms, which include the likes of Instinet, Liquidnet and ITG's Posit; the broker-dealer internalization engines, such as Goldman Sachs' Sigma X, Credit Suisse's CrossFinder and UBS' PIN; the consortium-owned pools in which many broker-dealers are investing, such as BIDS and LeveL; and the exchange crossing networks that are anonymous and complete matches at set times during the day.

Gudorf employs a focused strategy for accessing these fragmented dark pools. He says he connects to a handful of the major dark pool platforms that are independent and broker-neutral, and then depends on these to connect to other dark pools, such as broker-dealer internalization engines and other crossing networks, to provide an extended reach and ensure he's in as many liquidity pools as possible.

But as the dark pools continue to proliferate, the reality has set in that it's impossible for a buy-side trader to connect to each as a one-off trading destination. And of course, there are different types of dark pools for different types of orders and different trading strategies. As a result, through partnerships, linkages or cooperation, operators of these dark pools are trying to find ways to offer more liquidity to keep traders coming back.

Dark Is Here to Stay

While traders grapple with the best strategies for trading in dark pools' nondisplayed waters, the amount of dark pool action will only continue to rise. TABB Group predicts that the combined daily volume of dark crossing networks and internal markets will increase from 512 million shares a day this year to nearly 1.5 billion per day by 2010. That would account for about 15 percent of total market share among the major exchanges, the regionals and ECNs.

"One hundred percent of the buy side is crossing some portion of their orders," contends Jeromee Johnson, senior analyst at TABB Group. "As the percentage of orders crossed continues to go up, by the nature of better tools to tap into different crossing networks the liquidity is improved and the hit rates are improved."

According to TABB Group, consolidation, aggregation and interconnectivity will be par for the course. But, the consultancy notes, the dark pools that will thrive will focus more on innovative types of liquidity and ways to differentiate themselves.

Principal's Gudorf found out the hard way that paying attention to which dark pools he's connected to and which are the most successful for his trading strategy was an ongoing process to be continually assessed and reassessed. "If you think the dark pools you're currently in are working well, I would recommend trying others," says Gudorf. "We were pleasantly surprised when we added another one or two and found we had been missing significant volume. The landscape is dramatically changing on a daily basis."

Let the Linking Begin

Dark pool aggregation is occurring on a higher level and is likely to continue until the dark pools shake out their competitive advantages. One major move came in March when Lehman Brothers and Fidelity Brokerage Services announced a direct link via FIX connection between their dark pools. This allows traders on both sides to access Lehman's Liquidity Center Cross and Fidelity's CrossStream to improve their hit rates.

And Lehman isn't stopping there. "We will be looking to link up with others as well and already have tentative agreements with some and are in talks with others," says Michael Bleich, the firm's head of liquidity strategy. "We're competitors but there's value we can deliver to customers by working together."

Lehman also is a Streaming Liquidity Partner on Liquidnet H20. The block-trading system opens up trading for buy-side members against smaller size order flow from the partners at the midpoint of the NBBO.

Additionally, Lehman is a member of LeveL, the consortium of dark ATSs that allows users to cross orders internally using LeveL as the internalization engine or interact with liquidity provided by other LeveL members. The LeveL joint venture also includes Citigroup, Credit Suisse, Fidelity and Merrill Lynch.

"It's a big plus that we're seeing these linkages now," says Principal's Gudorf. "The fragmentation of the marketplace is very real, and without gaining some efficiencies through these linkages, the market would be a tough place to operate, especially for institutional accounts."

Joan Stack, trading manager at the Ohio Public Employees Retirement System (OPERS), agrees that the fragmentation of dark liquidity has become a burden. "It's reached a point where fragmentation is more of a detriment than a benefit," she says. "Linkages will consolidate some of the liquidity, and I think it's a good thing."

Who's Linking to Whom?

"Most of our major competitors have begun running crossing networks within their firms," notes Lehman's Bleich. "So how do you unlock value by linking these different pools together?" he asks, adding that the marketplace is in a phase of experimentation with linking these dark pools.

Michael Plunkett, president of Instinet North America, says his company's CBX dark pool is "aggressively" linking to other dark pools, including Credit Suisse, Fidelity, Liquidnet H2O and ISE's MidPoint Match. Instinet made the decision a year ago to link to and form partnerships with other dark pools and "never looked back," he says.

However, Plunkett adds, while the physical FIX connection is relatively simple to establish, it's the philosophy and strategy of partnership and linkage deals that delay the process. For example, pricing — how much is paid to each partner when a transaction is passed though a linkage — is up in the air. "People will charge whatever price they want to, and we agree to that with each of our partners individually," says Plunkett. "Our opinion is that we should treat each other as partners and charge a fair rate that encourages trading with each other's platforms on behalf of our clients."

ITG was selective about with whom it partnered for its Blockalert product, according to Chris Heckman, the firm's managing director of U.S. sales and trading. "Our strategy was to initially focus on one partner, and a large partner like Merrill Lynch made the most sense for us," he says. "Over time we will evaluate adding other partners. But historically, when these consortium-type arrangements get too large it becomes impossible to move forward."

NYFIX Millennium saw the writing on the wall and also moved toward relationships with clients and passive liquidity providers. CEO Brian Carr says a formal aggregation effort around nondisplayed liquidity is in the works. "Liquidity begets liquidity, and the more we can match, the more compelling it is to put an order in," he says.

Differentiating Pools

The ultimate success or failure of the multitude of dark liquidity pools will depend on "unique liquidity offerings," according to Tim Reilly, managing director and head of North America electronic execution sales at Citigroup, which operates the dark book Liquifi. He says that major broker-dealers with their own internal crossing networks that are profitable and complement their existing business will continue to operate separately. Reilly points to UBS' PIN crossing network, which offers unique liquidity in the Schwab retail order flow.

But Reilly also says that Citigroup won't turn away affiliations with other liquidity pools for Liquifi. "They're in vogue now," he notes. "On the other hand, if you're Citigroup and you have Smith Barney retail flow and a healthy institutional business and principal liquidity that you can market in an appealing way, then why would we open up to another big guy and say, 'Come play in our thing'?"

The unique liquidity that Reilly points to as a driving force for successful dark liquidity pools includes consolidated retail order flow, derivatives flow, or delta hedge flow and transition services, he explains.

Trading costs also can make a platform stand out, says TABB Group's Johnson. "It's one of the biggest considerations when searching for liquidity and the judgment by a trader or algorithm where the total best execution is." But cost isn't the only factor in best execution. Are you getting the best execution if an order is being routed to multiple dark pools and taking longer to hit each than if it were to be routed to more-aggregated pools directly?

Principal's Gudorf explains that coming into a dark pool via a secondary linkage may have its disadvantage. "You're not getting the first look at liquidity, so there is a trade off," he says. "If I was going through the main pipe to hit Fidelity's CrossStream, then I'm getting in the fastest and time priority. If I come in through other means, though, ... I am kind of disadvantaged in some ways and can miss liquidity. But at the same time, if I had to physically cut my order into 10 pieces and route into 10 different places, I would be even more disadvantaged."

Gudorf adds that pricing among dark pools and whether orders are routed out to other pools doesn't matter much to him. "That's between the brokers themselves, really. Our commission is with the sponsor broker and the platform we use," explains Gudorf.

OPERS' Stack also cautions that algorithms hitting linked dark pools should be closely monitored. She wants to know if her algorithms are hitting internal pools first and how long they stay in certain pools and at what parameters. "I don't want the opportunity cost of missing liquidity somewhere because an order is lingering too long in a broker's internal pool," Stack says.

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