By Steve Grob
Fidessa’s Steve Grob looks at the need for aggregation across pools, assesses the trading risks inherent in the dark and evaluates the benefits that dark liquidity has for different types of traders.
The question of aggregation is becoming increasingly important as the number and variety of unlit venues continues to grow. Some brokers offer aggregation services to help their clients navigate through this complex network of venues. This provides these brokers with competitive differentiation and, more importantly, the opportunity to match a client order first.
On the other hand, this type of aggregation service is costly as it requires connectivity and commercial agreements to be put in place with the operators of other dark venues. Basically, everyone has to work out where they want to be in the queue for client order flow, which is a tradeoff between greater cost versus increased opportunity.
Are the risks to trading in dark pools overstated or is there still real danger of being gamed?
The key issue here is about pre- and post-trade transparency. It is important that a trader knows what type of liquidity they will be interacting with as there are a broad range of different dark pools available, ranging from buy-side crossing networks such as Liquidnet, broker crossing networks and proprietary pools such as that operated by GETCO. A lack of standard rules for post-trade reporting also make transparency a problem, but most brokers that run dark pools analyse the type of activity going on and share this with their clients.
Some operators such as Credit Suisse allow their clients to opt in or out of different sorts of interaction based on this analysis. This issue is one reason why the European Securities and Markets Authority (ESMA) has introduced Organised Trading Facilities (OTFs) as a new category of dark pool. The key difference of OTFs is that they are discretionary and so allow the operator to exclude certain types of firms from trading there
What type of trader benefits most from access to dark liquidity: institutional investors, algorithmic sales traders, prop desks, etc?
Contrary to popular belief most dark liquidity is not new, but is simply an automated version of the traditional upstairs or ‘call around’ market where brokers previously tried to find the natural other side to a client order without it ever reaching an exchange. The difference is that the phone and Filofax have been replaced by technology that seeks to match buyers and sellers, and regulators have tried to make this type of trading more venue-like. Because unlit trading is now increasingly automated, it also allows a much more sophisticated interaction, both within and between these different pools. This and the fact that trading in the dark is a growing phenomenon mean that few market participants can afford to ignore it.