Groping in the Dark: Navigating Crossing Networks and Other Dark Pools of Liquidity

While the number of traditional market venues continues to shrink, with exchange consolidation stretching its wings on a global scale, alternative trading venues seem to be cropping up left and right. The market’s new ECNs are gaining traction, the “co-opetition” between the brokers and the exchanges is raging full tilt and NMS is looming closer than ever. Amid all of this market structure shifting, one topic seems to be on everyone’s tongue – dark pool liquidity.

Though non-displayed liquidity is nothing new to the markets, in the never-ending quest for liquidity, an increasingly popular place to look for it is in the dark. In 2006, it seems like all the players that were not yet playing in dark pools waded in to the froth and activity related to the market’s non-publicly-quoting venues has been non-stop. There was the creation of new pools, many new algorithms targeting dark pool liquidity and new linkages between dark pools. And despite increased regulatory scrutiny that they will fall under, it is clear - dark pools are here to stay.

Each of these crossing networks and dark pools looks to match buyers and sellers together outside of the national market system, working outside typical exchange structures. While there are potential impact, price and informational benefits for large institutional investors to match orders in these non-publicly-quoting venues, there also are challenges. These challenges range from fairly simple but technical, such as how trades hit the consolidated tape; to larger issues, such as how to find the other side of the trade if it is not advertised. Market practitioners are struggling with quality of market issues like pool toxicity and are pondering what could happen to price discovery if the majority of trades were executed outside the national exchange infrastructure. The successful understanding and navigation of these new venues is a crucial and ever more pressing task for traders.

This TABB Group Vision Note looks at and attempts to bring clarity to the quickly expanding dark pool and crossing network landscape. The note will look at the various crossing models, how these models are being and will be used by both buy- and sell-side players, and what this will mean for the US market structure. Further, it examines the developing Asian and European market landscapes and how dark pools are impacting trading overseas. Finally, the report looks at where the liquidity is now and discusses interconnectivity versus consolidation, as well as where and what the growth will be.

Key findings and forecasts include:

• By the end of 2006, Crossing Networks and Dark Pools have captured an almost 10% share of the total equity market and are executing an average of 420 million shares a day.
• In the US, NMS poses certain regulatory challenges for the dark pools, but the barriers raised by MiFID in Europe are greater.
• There continues to be pent up demand for crossing and other low-touch execution venues in Europe and Asia.
• Dark pools are increasingly differentiating themselves by offering alternative indication, preferencing and pricing mechanisms and, more importantly, traders are identifying the types of liquidity in the dark pools.
• Dark Pool execution volumes will grow at an over 40% CAGR through the next several years.