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Growing Dark Pool Trading Volume Could Be Problematic for Exchanges

As dark liquidity pools garner more and more volume, how will they evolve going forward, and what does it all mean for exchanges?

During a panel discussion on dark liquidity at a recent trading event, one panelist made a bold statement: He said that the buy side doesn't need to execute on displayed markets at all anymore, espousing that the future for trading was in dark liquidity and trading effectively without hitting open markets.

While the same panel also noted that dark pools saw a drop in volume during the late-summer market volatility, the theory that trading in dark pools alone could be the future nonetheless piqued significant interest.

There's no denying that dark pools are mainstream these days. As algorithms and partnerships have made it easier to spray the various venues and hit as many as possible through fewer connections, traders have become more and more comfortable routing trades to these nondisplayed liquidity pools. But as dark pools become a staple routing destination and their overall share of trades in the market continues to climb, how will they continue to evolve, and what does it all mean for the future of traditional exchanges?

Exchange Impact?

A recent report from Aite Group entitled, "Rise of Dark Pools and the Rebirth of ECNs: Death to Exchanges?" estimates that dark pools, including independent block-trading platforms, broker-dealer crossing engines and utility models, account for about 15 percent of all U.S. equities market share as of Q3 2007. And Sang Lee, cofounder and managing partner at Aite Group, says that number is expected to rise to 20 percent by the end of 2011.

Considering the fragmented state of dark pools, the increase in dark pool market share is being driven by better connectivity and linking and more algorithms focused on hitting multiple dark pools before routing out to public markets, Aite says. As a result, exchanges have seen a "significant decrease" in average trading volume, according to the report, dropping 5 percent from Q2 2006 to Q3 2007.

Larry Tabb, founder and CEO of TABB Group, says dark pools have become their own self-fulfilling prophecy when it comes to building volume. "As more and more trades are matched, and the technology and connectivity become more seamless, and accessing the dark pools becomes quicker and quicker, there becomes less opportunity cost because the speed is there," he explains.

Tabb adds that as more and more buy-side firms use dark algorithms to access the fragmented pools, the dark pool market share only will continue to rise and propel the ongoing cycle. "If they can match in a dark pool and bypass the exchange, they can generally execute at a better market price or with less market impact, and more and more generic algorithms will wind up accessing the dark pools," he says. "Then the question becomes: Where does that leave the visible exchange market?"

But as dark pools continue to pull bigger market share, Tabb contends, the trend will light a fire under the exchanges. He says he expects them to get more aggressive in the marketing of their own hidden reserve matching platforms, such as Nasdaq's Nasdaq Crossing Network or NYSE's MatchPoint technologies.

According to Tabb, if the exchanges price their matching platforms at a rebate and pay people to use them, they have the ability to "drain the dark pools." But so far the exchange-driven dark pools have not caught on.

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