Growing Dark Pool Trading Volume Could Be Problematic for Exchanges
The Road to Consolidation
Tabb notes that while broker-dealer internal dark pools won't see much consolidation, other dark pools could be ripe for some M&A activity. "Dark pools such as Liquidnet, ITG Posit, Pipeline, NYFIX Millennium, and even BATS and LeveL will see some consolidation," he says.
Of course, natural competition also could lead many dark pools simply to go out of business. But what if the fragmentation continues and 20 or more dark pools each keep about 2 percent of market share? "That in and of itself could be a problem," Aite's Lee says. "It's too fragmented."
Lee also points out that with exchanges operating as public companies, many broker-dealers are beginning to view them as competitors. In a sign that they are looking to take the exchanges head on, most large broker-dealers already have made investments in regional exchanges, electronic communication networks (ECNs), alternative trading systems (ATSs), and their own internal dark pools and utility-model dark pools.
The Aite Group report estimates that while broker-dealers often are hesitant to release actual trade volume statistics, crossing rates "appear to be anywhere between 4 percent and 11 percent, with some of the largest platforms averaging anywhere between 40 million and 100 million in trade volume on a daily basis." Lee notes that these numbers are not to be scoffed at.
In addition, dark algorithms are upping the ante even more as dark pool routing can be more aggregated. Firms using dark liquidity algorithms heavily are seeing more than 40 percent of shares in certain orders filled in dark pools before routing out to displayed markets, according to Lee. "In reality it is a highly fragmented marketplace," he observes. "But virtually, it is consolidating as new technology comes into play."
The future for dark pools also could be exchange status, Lee adds. He points out that if one dark pool in particular pulled way out in front and garnered a significant amount of volume, it either could be acquired by an exchange or alter its business model and seek exchange status itself.
Which Pools Will Prevail?
So what determines the success of dark pools? Matt Sherman, senior equity trader at Ohio Public Employees Retirement System (OPERS), says volume is the first and foremost determining factor.
"People will go wherever they think volume can get done," says Sherman. "You can argue there are a few [dark pools] out there that capture the most shares, but you want to continue to follow the new ones that keep popping up, too. You have to be in front of it to make sure you're not missing something and doing due diligence to make sure you are getting the best execution on the desk."
Sherman points to a few other key areas that will contribute to a dark pool's ongoing success. "People will look for any additional ways to maintain their anonymity in the marketplace and alleviate any information leakage," he says, adding that maintaining costs also will be important.
When new dark pools pop up, Sherman says, he evaluates them based on market share and the liquidity they are providing. "There is some trial and error involved, especially through broker-sponsored algorithms," he relates. "They have to have access to a lot of different dark pools -- all the news ones -- and we have to be able to feel out what is best for our trading strategies."
As such, Sherman hopes the linking and partnership trend among dark pools continues. "We are limited in the technology we can acquire," he says. "A lot of the algorithms we are using that tap into dark pools are beginning to link better, and we can be in multiple dark pools at one time."
Sherman says he has found the most volume in the independent dark pools, such as Liquidnet, Pipeline and ITG. He adds that in the end, though, trading strategies have to be constantly monitored and changed to ensure that OPERS is in the right pools and the pools are the most effective for the firm's strategy.
TABB Group's Tabb adds that the ultimate success of a dark pool will be based on buy-side traffic. "The better the business model and the more sticky and stable the platform, the more long-lasting pricing power they have," he says. "You have to assume that the dark pool catering directly to the buy side has the ability to have greater pricing power."
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