How Long Can You Do It in the Dark?

As buzzwords go, "dark liquidity" is the best I've heard in a decade. Of course, it refers to pools of liquidity that escape the blinding light of regulated markets. They exist because when a huge chunk of liquidity enters regulated markets, it is quickly eaten up by the piranhas-a force that will never let up.

The trading networks that refrain from publishing quotes to open markets appear to be falling into particular categories, as Carl Carrie, head of product development in JPMorgan's global executions services group, points out. Carrie cites the major emerging dark pools: static pools such as Posit from ITG; continuous pools such as those from Pipeline Trading, the International Securities Exchange (ISE) and Nyfix Millennium; event-driven pools; and the very secret negotiated pools.

Of course, Carrie has to keep his eye on dark liquidity. Like others in the industry, Carrie and his crew at JPMorgan have just released algorithms to contend with a quickly stratifying market. The nascent Aqua algorithm is for big orders in liquid markets while the Arid institutional trading algorithm targets illiquid markets, including small cap stocks. Part of JPMorgan's Electronic Client Solutions (ECS) suite, Aqua and Arid are intended to help clients trade stocks via dark books, exchanges and ECNs. The new algorithms are available via the execution management system of Neovest, which the bank acquired last year (DWT, June 27, 2005). The new algorithms are part of other order management systems as well. "Dark pools are part of the landscape," he says.

JPMorgan is not alone in providing dark liquidity seeking offerings. Instinet recently launched its liquidity aggregation algorithm, dubbed Nighthawk, that will access most major pools of dark liquidity like Liquidnet H20, Nyfix Millennium, Pipeline and other sources of upstairs liquidity from Instinet (DWT, June 26). Clients can also add an ECN sweep module to Nighthawk.

If dark pools are part of the landscape, I have to ask: How long will dark pools be a reality?

The conventional wisdom is that up to 50 percent of equity transactions may be done via these dark venues, especially as we move forward with the Regulation NMS and Mifid market structure reforms.

In fact, those government-sponsored regulatory reforms coupled with the almost daily news of merging exchanges should distract government reformers for awhile. But not forever.

The combined impact of these reforms and newly co-joined exchanges could easily heighten the need for increasingly electronic trading capabilities. This will make it difficult for market participants to hide their liquidity especially if dark liquidity begins to overshadow light liquidity.

While market regulators are slow to react to market trends, they do get there in the end. My guess is that this phenomenon is on the radar of governments and regulations will come.

Of course, by then, those crafty enough to create dark liquidity will have found another way around the regulators.

Send your comments my way to eugene.grygo@incisivemedia.com.

Eugene Grygo
Editor