September 26, 2006

While it may have seemed recently that the galaxy of equity trading was contracting around Nasdaq and the New York Stock Exchange, never fear: Fragmentation is back with a vengeance.

Brokers, always seeking to own more of their clients' trading activity and minimize price slippage in the open market, have responded to the trend of exchange consolidation by crossing client orders in so-called "dark pools" or "dark books" - liquidity pools similar to crossing networks that offer an alternative to the public equity markets. Dark books match buy and sell orders without publishing quotes. By controlling information leakage and taking both the bid and offer sides of a trade, brokers simultaneously can give clients improved pricing on shares and earn higher commissions.

If this sounds like brokers' silver bullet against the Nasdaq-NYSE juggernaut, that may be part of their intention. But the age-old rule of "liquidity begets liquidity" still applies, and the mysterious powers of dark books are vulnerable to a special form of regulatory kryptonite.

Under Regulation NMS, any trading venue that accumulates more than 5 percent of U.S. equity volume must provide open quotes to the broad market, thus destroying the advantage of dark pools. Given this fact, buy-side traders are faced with managing numerous sources of liquidity off-exchange that are limited in size and fiercely guarded by brokers, which, in turn, are faced with the prospect of trying to attract more flow - but not too much - without exposing their private inventories or client trading behavior to their competitors.

So how can clients access numerous dark books efficiently? There are several methods under development.

Technically, any off-exchange marketplace that executes shares anonymously (without quoting) could be considered "dark" in that it provides limited opportunity for information leakage. Currently, there are at least 12 dark books in the marketplace, each with a slightly different approach, according to TABB Group analyst Jeromee Johnson. These include broker-dealers' internal crossing networks as well as some of the external crossing networks. According to TABB Group, crossing networks handle 5 percent to 8 percent of buy-side flow.

Broker-dealer dark books include Goldman Sachs' Sigma X, which finds crosses between customer and proprietary trading interests but also reaches out to other market makers; Credit Suisse's CrossFinder, which uses algorithms exclusively within the firm's own inventory; and UBS' Price Improvement Network (PIN), which makes heavy use of retail order flow. Other broker-dealers that are launching dark books include Lehman Brothers and Morgan Stanley.

Before the bulge-bracket firms launched internal crossing networks, or dark books, the market traded anonymously using crossing networks such as ITG's Posit, LiquidNet, Instinet Crossing, NYFIX Millennium and Pipeline. These networks - which also are considered dark as long as they don't quote to the market - match buy and sell orders anonymously at given hours or, in some cases, continuously, as with ITG's Posit Now. LiquidNet is unique in that it forbids broker participation entirely. And ITG recently struck a deal with Merrill Lynch by which Merrill participates in Block Alert, a system that notifies clients when a potential cross is available in selected securities.

Since the trend toward dark crossing networks directly disadvantages the exchange model, exchanges are getting in on the action before it passes them by. Anonymous trading systems are appearing from the likes of Nasdaq, which has a crossing network, and the International Securities Exchange (ISE), which plans to open an anonymous matching system in September 2006.

But further fragmentation of the market could make the buy-side trader's job more difficult. Joan Stack, trading manager for equities for the $70 billion Ohio Public Employees Retirement System, recently told Advanced Trading's Kerry Massaro that this was a real concern for her and her team ("Editor's Letter," August 2006). "I wish there were a way for my desk to centralize liquidity so I would not have to tap dozens of pools of liquidity. I need to find a highway to liquidity," she said. "It hasn't gotten better with consolidation, because as quickly as the ECNs have consolidated, the crossing networks have refractured the markets."