Dark Is Hot. But Is It Good?

Dark pools are all the rage. Those opaque matching venues where large blocks meet seem to be on everyone's hit parade. Whether it is Liquidnet's valuation (which seems to have occurred eons ago), the preponderance of announced sell-side internal crossing engines, the development of dark algorithms, the buy side's desire to participate with hidden flow, or just the loss of NYSE market share causing firms to hunt more judiciously for an execution, dark is hot.

Dark pools range from completely opaque to semi-transparent, and their order flow can range from transient to stationary. Opaqueness impacts fairness, as the more-transparent the liquidity pool, the easier it is to be manipulated. More-transparent crossing networks, such as Liquidnet, solve this problem by not letting brokers or more-active traders onto the platform and by policing their community and evicting poachers. Other crossing engines with some transparency, such as Pipeline or Posit, give away such limited information that it is difficult to take advantage of.

The majority of dark pools, however, tend to be completely dark and either match order flow periodically (these are call markets such as Posit, Instinet or the Nasdaq Cross) or continuously as orders flow to traditional exchanges. ITG's Posit Now, its continuous crossing network, and NYFIX Millennium leverage this transient matching model.

Brokers' internal markets, however, tend to work a little differently. To develop active internal markets, brokers need significant amounts of two-sided order flow (buys and sells). Firms obtain this flow in three major ways: leveraging retail flow, hosting liquidity in the dark book and attracting order flow from third parities. All three of these models are now deployed.

UBS has made extensive use of its retail order flow in its internal dark market, PIN. Since retail flow tends to be a bit more two-sided, leveraging retail order flow is a significant advantage in increasing a firm's matching rate and attracting institutional and hedge fund liquidity. Goldman Sachs' Sigma X platform extends its matching rates by attracting external liquidity providers. The majority of other bulge-bracket brokers are placing larger orders in the matching engine, so as their algorithmic, DMA or traditional flow moves through the crossing engine there are more opportunities to match.

But while dark is hot, is dark good? External crossing networks now execute approximately 5 percent to 8 percent of buy-side flow, while the largest sell-side firms cross approximately 6 percent to 10 percent of their institutional flow. Are we getting to a point where we should be concerned that the dark liquidity pools are beginning to impact the price discovery process of traditional markets?

Certainly the exchanges think so. At the SIA Market Structure Conference a few months ago, Catherine Kinney, president of the NYSE, had a few not-so-nice words to say about crossing - particularly broker internal crossing networks. She posited that dark books impair price discovery, and that every share that is crossed in the dark is a share that doesn't assist the market in determining an accurate price. Now, Ms. Kinney certainly has a vested interest in keeping flow on the exchange, but she isn't completely off base.

At what point should the market be concerned that limited amounts of retail order flow could adversely impact the price of very large blocks? Even if institutions are happy with their price discovery, are we as an industry comfortable with retail flow being matched against sophisticated flow and never making it to the market for all to see?

While all is fair in love and war, and what goes on in a dark room between consenting institutions and hedge funds is fine with me, when it comes to retail fiduciary responsibility, we should act as an industry before the regulators step in and mandate something that everyone will hate. So while dark pools are great for finding liquidity, let's be sure that these dark pools are honest fair, and provide best execution. While I am all for dark pools, it's black eyes I'm against.

Larry Tabb is founder and CEO of Westborough, Mass.-based TABB Group, a financial markets strategic advisory firm. [email protected]