Look before you leap – Stewart Eisenhart scratches below the surface of dark liquidity pools to find a niche in the industry primed for consolidation, which is set to impact those firms using crossing networks, ECNs and ATSs for large block orders

The growth of dark pool trading venues in the US and the anticipated expansion of similar liquidity sources in Europe present buy-side managers with unprecedented execution options. The benefits of tapping into non-quoting liquidity pools – crossing networks, ECNs and ATSs – in terms of price and market impact, have been realised but accessing dark liquidity has nonetheless become an increasingly complicated proposition. Stewart Eisenhart reports

The proliferation of dark pools over the last few years means that knowing when to utilise them – and which of them to utilise – requires greater arsenals of decision-making and analytical tools on buy-side trading desks; the differences in types and levels of liquidity as well as safeguards against information leakage can vary considerably from one dark pool venue to the next. Until widely expected consolidation across dark pool providers takes hold, the ability to discern the value of accessing a particular dark liquidity venue within a veritable sea of such sources is a crucial one for the buy-side trader.

Financial services industry sources estimate the number of dark pool venues currently active in US markets at around 40. Driven and necessitated by several years of market fragmentation, tighter spreads and smaller trade sizes, dark pools have become valuable resources for traders seeking block-sized equity executions.

Buy-side firms need to assess the impact on their dark pool strategies brought to bear by the sheer number of dark pools available, the technologies required to access them, and the looming impacts of both consolidation and market-changing regulations of Reg NMS in the US and Mifid in Europe.

For all the buy-side interest that dark pools have garnered, these liquidity sources are hardly in a position to threaten the dominance of major exchanges. Still, dark pool volumes are set to increase dramatically, according to financial technology consultancy Tabb Group.

A study released by the consultancy earlier this year, Groping in the dark: Navigating crossing networks and other dark pools of liquidity, indicates that dark pool trading volumes in North America will increase from just over nine percent this year to 15% in 2010, at the expense primarily of the NYSE and Nasdaq.

Given this projected increase, Tabb report authors Jeromee Johnson and Larry Tabb advise that managers keep an eye on the size of the dark pool venues they are accessing and ensure their means of accessing those venues is as efficient as possible – two issues that should have a bearing on which technologies and processes managers embrace to conduct their dark pool trades.

In terms of technology infrastructures needed to access dark pools and transact within them, connectivity and execution management capabilities are obviously key. Beyond those elements, though, managers should stay cognisant of which dark liquidity providers stand to add value to their investment strategies and which do not.

Jason Lenzo heads equities and fixed-income trading at Russell Investment Group, the Tacoma, Washington-based manager with $200 billion under management. He describes the build-and-buy technology approach devised by Russell to not only ensure efficient access to dark pool providers, but also to evaluate which venues are worth accessing to begin with.

"We've built and bought technology, and use that combination of methodologies to integrate with dark pools when it makes sense from an execution perspective and from what our clients are trying to accomplish," says Lenzo.

"There's not a single off-the-shelf solution that does everything you need it to – if you figure that there's a new dark pool being marketed or added on a daily basis, that's a continual process for evaluating what's really going on – what's its business model? Does it benefit the client? Where in our execution process does it fit?"

Timothy Olsen, senior vice-president and head trader at ICM Asset Management, a Spokane, Washington-based buy-side firm with $1.8 billion under management, says his firm's technology requirements for accessing dark pool venues are relatively straightforward, emphasising trust and anonymity as essential components.

"The technology to access dark pools is important, but the underlying trust and anonymity aren't that different from the relationships we have with our traditional brokers," Olsen explains.

"Systems that allow us ease of access and integration with our order management systems while taking up the least amount of desk-top real estate – along with the requisite anonymity and trust – are the basic things we have to have… it comes down to some of the same counterparty fundamentals that I hope everybody is paying attention to."

As dark pool providers themselves evolve and multiply, the challenges buy-side traders face directing order flow to these venues have in turn changed.

According to Johnson at the Tabb Group, the issue of determining which dark pools to utilise has been addressed by the development of algorithmic tools to aggregate various dark liquidity sources. Now, some dark pool providers are forming partnerships with one another to offer larger execution opportunities; links between Credit Suisse's CrossFinder and Instinet's Continuous Block Cross (CBX), and Lehman's Liquidity Center Cross (LCX) link with Fidelity Brokerage's CrossStream link, are recent examples. Managers had best keep on top of such moves, says Johnson.

"In looking to aggregate different pools, we've moved beyond algorithmic aggregation to reciprocal pool access," he says. "You're seeing a lot of different dark pools tying directly into each other. From a buy-side trader's standpoint, with reciprocal access you need to be aware of how the different pools are tying in with one another – it's not just about size and price, it's about the types of liquidity you're interacting with."

Johnson observes that many recent dark pool offerings provide functionality for controlling types of liquidity with which users can interact – traders can internalise their orders, as well as set preferences to deal with particular groups of dark pool venues such as Lehman and Fidelity, or Morgan Stanley and Merrill Lynch.

"With all these different dials and controls, you want to recreate the same functionality electronically that was available via human interactions on trading floors to control the types of liquidity buy-side traders access," he says.

Russell's Lenzo explains that his firm evaluates distinctions between various dark pools and the liquidity they provide through collaboration between portfolio management, quantitative research and trading components in order to determine which trades will garner the most value through executions in alternative venues.

"You have to approach this in a disciplined fashion," says Lenzo. "Throwing spaghetti on the wall and seeing what sticks won't let you control the risk associated with the execution."

Lenzo describes three general categories of dark pools with which he deals. First are pools with native orders whose prices and sizes aren't displayed; these pools can be "traded through" on the way to some other destination such as a major exchange.

Second is the model set by LiquidNet, in which multiple counterparties negotiate in terms of size, price or both.

A third type of dark liquidity provider entails consortia of broker-dealers pooling together their indications of interest, according to Lenzo.

"We're interacting with different types of liquidity from very different sources," he says. "You need to be out in multiple venues, accessing multiple liquidity sources."

Access to multiple dark pool venues is clearly necessary to increase a trader's chances of executing an order on favourable terms. But buy-side firms would be ill-served establishing connectivity to such a vast number of providers on their own; relying on sell-side counterparties and third-party connectivity vendors makes better sense – along with a robust due diligence process.

Michael Plunkett, president of crossing network and dark liquidity provider Instinet's North American operations, sees ample technology available to support substantial connectivity between buy-side managers and dark liquidity sources. He cites efficiency, access and speed as key issues managers weigh in choosing their alternative execution venues.

"Managers need to think about efficiency – what are the fewest number of times I have to enter an order? – as well as access and speed, because latency is becoming a big issue," Plunkett says. "These three factors will dictate where managers want to go, and then hopefully a provider can provide them with access tools so they don't have to worry about latency or installing four different front-ends in order to connect to all these venues."

Olsen at ICM Asset Management says he relies on his brokers to connect to dark pool venues, but takes a cautious if not sceptical approach when it comes to adding new venues to his roster of execution options.

"We have to understand which different pools my algorithms are going to tap into, and I'm starting to understand that relationship – that's why it's taken me a lot longer to take the next step," Olsen says, adding that he is not convinced that access to some dark pools warrants the effort if their order flows are inadequate.

"I'm not going to go into those dark pools individually, I'm going to leave that to my brokers to understand how they work and then explain it to me.

"This second tier of so-called dark pools with smaller average execution sizes is a wild frontier that might have more problems than it's worth," Olsen continues.

"There are firms that offer algorithms that will access several of these for me, but is that really a good thing? Do I know what the leakage potential is for each of these pools of un-displayed liquidity that I am accessing? If there isn't enough volume to worry about, do I even want to use these new algorithms or smart order routers?"

Alasdair Haynes, chief executive of long standing dark pool provider ITG's international operations, emphasises the role of analytics to address what he sees as an ongoing and fundamental challenge for buy-side clients – deciding which dark pools to access.

"The problems for the buy side are – who do I go to first, how do I get there and when and how should I trade in that venue?

"It now comes down to execution management," explains Haynes. "The buy side in the past has had order management, but this is now about decision-making tools for pre-trade analytics, real-time analytics and then post-trade analytics. It's a technology investment that managers have to make."

Despite dark pools' undisputed value in the buy-side investment process, their utilisation continues to challenge trading desks. Given the finite amount of liquidity available through dark pools, it's only a matter of time before consolidations, acquisitions and outright failures narrow the playing field and managers can more easily determine where to direct their dark order flows.

Lenzo at Russell describes a labour-intensive due diligence process at his firm to vet individual dark pool venues, but doesn't believe the current environment can last long-term.

"We have to keep up our due diligence process in terms of finding out how much volume is being traded in a dark venue and whether it's beneficial to us to access a particular dark pool," Lenzo says. "We have to look at the stability of the venue and whether it can last."

The trader adds: "There's a baseline of flow these dark pools have to maintain in order to stay in business, so there will either be acquisitions or consolidations. I can see it narrow down to three or four large players. We're at over 40 dark pools right now, and that's not sustainable."

ICM's Olsen sees the first wave of dark pool venues that stepped in to address underserved block trading needs in the wake of market fragmentation at an advantage when it comes to consolidation; and that's fine by him. "They fulfilled a need – successful business models do this," Olsen says.

"The add-on firms trying to take advantage of that need, and which don't have a new approach will not be successful and we ultimately won't have to worry about them in a few years."

Olsen argues that the excessive number of dark pools stands to further fragment order flow in alternative venues. "I believe that this is a short-term problem that natural market forces will figure out." >