Growing Dark Pool Trading Volume Could Spell Trouble 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?

The Future for Dark Pools

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.

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."

Regulatory Notice

Given the growing influence of dark pools, regulatory concerns are not far from the minds of most traders. But so far the SEC has taken a staunch wait-and-see attitude. That could change, however, as dark pool volumes continue to rise.

Aite's Lee cautions that trading in dark pools has become somewhat the privilege of the few -- the institutional traders that can access these nondisplayed pools and their big broker-dealer counterparts -- at the expense of the retail investor. This is where the SEC might get into regulating these pools.

"It's almost inconceivable that regulators will stand buy and let [dark pools] grow unrestricted," says Lee. "There is going to be a certain growth threshold where they will have to look carefully at the impact on the overall marketplace." Lee adds, though, that there has to be some give and take, since the average trade size in public markets is below 400 shares and institutional businesses often are trying to move millions of shares.

But the future of regulatory involvement is still unclear, Lee continues. "For example, if a single dark pool all of a sudden accounts for 19 percent of market share, that could sound the alarm bell," he says. On the flip side, "Can the market facilitate the existence of, say, 20 odd dark pools, and does it even make sense?" asks Lee.

TABB Group's Tabb foresees regulatory intervention, however, only if dark pool market share climbs substantially to 20 percent or 30 percent. "If the quality of the market is negatively affected, and the displayed bid/offer spread becomes too wide, and retail investors don't have easy access to these dark pools and the price improvement, then I can definitely see the SEC saying, 'Why are individual investors being harmed here by not getting the best price?'" he says.