Big Traders Dive Into Dark Pools

The alternative trading systems are luring big institutional customers by offering greater privacy and lower costs. Their growth could affect big exchanges

by David Bogoslaw

It's not easy being a big player in the stock market. Trading huge quantities of stock on traditional exchanges has become ever more challenging, costly, and potentially disruptive. And if other players see your moves, they can disrupt your trades. That's led to the emergence in recent years of alternative trading systems known as dark pools. And their growth could have significant implications for big stock exchanges—and individual investors.

Dark pools sound like something from Greek mythology or a sci-fi epic, but in stock-market speak they are private trading networks that big brokerages such as Lehman Brothers (LEH) and Merrill Lynch (MER) have developed primarily for the internal matching of orders between buyers and sellers who are clients of the same brokers. But dark pools have developed links among Wall Street firms as well, so that orders can be matched across different brokerages. Indeed, some firms are teaming to launch new dark pools such as BIDS Trading.

Growing Popularity

Alternative trading systems, or ATSs, have gained an increasing share of equity trading in the past few years. In addition to dark pools, ATSs include crossing networks, such as independently owned Liquidnet and Pipeline, that match orders for execution without having to first route them to an exchange or market center where they could be viewed publicly. Besides enabling investors to execute an order without affecting the public price quote, crossing networks match orders at a specified price, typically the midpoint of the bid and ask prices on stocks at the point in time of the trade. Electronic communications networks (ECNs), which trade stocks and currencies, are another type of ATS.

The initial proliferation of ATSs stemmed from policy changes by the U.S. Securities & Exchange Commission that were designed to encourage competitive pricing. More recently, the motivation for using them has been the quantities of stock being traded and the ability to keep these transactions hidden—and anonymous. Dark pools also make it easier to trade small- or mid-cap stocks, which are often lower-profile companies that, because they're less liquid, are harder to trade publicly.

When New York-based Liquidnet launched in April, 2001, block trades of 10,000 shares or more represented 60% of the New York Stock Exchange's total trading volume and currently account for only 18%, says Alfred Eskandar, who heads Liquidnet's corporate strategy group.

Much of that decline in volume is tied to a change in the way prices of NYSE-listed stocks are expressed, from fractions to decimals, starting in 2001. With stocks priced in cents, instead of sixteenths, it's less likely that an investor will find a buy or sell match for his order at a price both sides can agree on, which has thinned block trading volume.

The Lure of Lower Trading Fees

In a September, 2007, report, Aite Group, an independent research firm in Boston, predicted that exchanges' market share in U.S. equity trading would continue to decline from the current 75%, before stabilizing at around 62% by 2011. The formation of 35 to 40 ATSs has exacerbated fragmentation of the marketplace.

It's not just the faster processing speed that has lured institutional investors with their jumbo trades to ATSs, but lower trading fees. The difficulty of finding the necessary liquidity to match big-block orders forces traditional exchanges to slice and dice an order of 100,000 shares into smaller chunks of a few hundred shares each that are then executed at a range of different price points.

Eskandar calls Liquidnet a wholesale trading community, which gives investors a break on transaction costs because they're trading such huge quantities. "It doesn't make sense when wholesalers pay a premium for something," he says. "Institutions should benefit from their large size."