Big Traders Dive Into Dark Pools

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Limiting Trading Partners

Probably because it was founded by some of the biggest brokerages, BIDS Trading doesn't believe in barring sell-side players. The more participants invited in, the better the chances of matching buy and sell orders, says BIDS Chief Executive Tim Mahoney.

Instead, BIDS provides score cards that track users' past trading behavior and enables members to filter out counter-parties whose behavior is suspect. For example, members can limit users they're willing to trade with to those with a record of completing most of the trades they've entered into. "If you were going to discriminate against someone, you should discriminate based on their behavior, not on whether they're on the sell-side or buy-side," Mahoney says.

MatchPoint's solution for preventing order leakage is its point-in-time, or scheduled, crossing system, which makes it harder for would-be predators to identify where individual orders are within the system, Ross says. That keeps the predator from jumping in with his own order elsewhere and disrupting the intended trade.

What It Means for Investors

The proliferation of dark pools could have ripple effects beyond just block trading, says Lee at Aite Group. As long as they remain a niche market, they're probably of little consequence. But if the equities market becomes increasingly dark as more trading shifts to these platforms, while retail investors continue to see only the public portion of equity trading, it calls into question the actual meaning of public price quotes, Lee says.

On a practical level, if retail investors get the price they think they'll get when they submit an order and they're happy about it, they probably wouldn't care what the actual reality of the marketplace is, he says.

Regulators would care, however, regardless of whether individual investors have concerns. In fact, Reg NMS modified a 1997 regulation by lowering from 20% to 5% the ceiling on average daily volume of any given stock that ATSs are permitted to represent before being required to disclose information to the public market, Lee says.

Cline believes that not only are dark pools ultimately a good thing for investors but that "to not take advantage of dark pools is failing to live up to the best execution mandate of Reg NMS."

Revenue Sources

Whatever their advantages, it seems clear there isn't enough liquidity available for all of the alternative trading venues to survive in the long run. There's already been some consolidation, and more is sure to follow.

In the battle for market share, the exchanges are in a better position than ATSs because they have other revenue sources, such as market data and stock listings, that allow them to be more aggressive on pricing, says Lee.

When NASDAQ came under attack by ECNs, it slashed its prices for a while to attract customers and its market share stabilized. And just as NASDAQ ended up buying some ECNs to boost its market share, Lee says he wouldn't be surprised if ATSs become buyout targets for the big exchanges. But for now, more Wall Street players may decide to test the waters of the dark pools.

Bogoslaw is a reporter for BusinessWeek's Investing channel .