Joseph Gawronski, president and chief operating officer of New York–based Rosenblatt Securities, fields a constant barrage of questions from clients about trading methods and strategies. He says that over the past year one topic has seemed to be getting all the attention: dark pools.
These private electronic trading networks have been multiplying so quickly that more than 40 now exist, offering alternative arenas for traders to buy and sell stock away from traditional exchanges. The rise of dark pools has created a complex web of alternative liquidity sources that are difficult to manage, integrate and assess.
“People are naive if they think there is an easy answer,” Gawronski says. “There is a lot of education and homework required.”
In the discreet world of hedge fund trading, dark pools seem the perfect venue. Shrouded in secrecy — even a basic statistic like volume is hotly debated — they offer a way for hedge funds to trade large blocks of stock without attracting attention. But not all dark pools are created equal. Some inky-black ones strive to guard every tidbit of information; others more gray than black afford outsiders a foggy glimpse of trading activity. And the mix is constantly shifting as new players arrive and traditional trading service providers, like banks and exchanges, expand dark pool access.
Software developers have been scrambling to keep up, trying to create easier ways to access dark pools while also erecting safeguards to protect traders. But danger often lurks behind a user-friendly dark pool interface. Software that readily transports the trader from desktop to the dark side may be susceptible to information leakage, which other traders can profit from.
A former securities lawyer who was a vice president in the equities division of Salomon Smith Barney, Gawronski says the challenge for traders who want to use dark pools is to comprehend what they are getting into. They must determine which pools offer the most liquidity for specific stocks, what information is shared with other traders and what security measures are in place to protect information. And they must understand how the software they use accesses dark pools.
“People need to ask which pools are meaningful,” Gawronski says. “Which tools can I employ that will keep me from getting hurt? Do I need a dark pool aggregator [which connects to various pools], and if so, which one? Can I manage the effort myself, and does my order management system connect to the pools I need most? If you want to play in this complex world, you better understand all the tools and all the tricks of the trade.”
Indeed, trading in dark pools today is much different than it was at the start of the decade. The original dark pools were straightforward off-exchange electronic trading venues for large blocks of stock — members-only sites where asset managers could meet anonymously to execute big trades.
Brokerage firms and other, independent, pool operators worked to keep secret the identity of players and what stocks were being traded. If someone offering a block matched up with someone wanting to buy the same stock, they struck a deal at a price based on the exchange-listed price of the shares. It seemed the perfect solution for block trades: quiet, discreet and effective. And unlike algorithms that cut up big blocks into small orders that could be slowly sprinkled into the market, dark pools allowed traders to buy and sell big chunks of stock quickly and anonymously.
One of the earliest dark pool providers was New York–based Liquidnet, which launched in 2001 and remains the dominant player in big block trades. According to a recent Rosenblatt report, Liquidnet has an average trade size of 52,600 shares. Its closest competitor is New York–based Pipeline Trading Systems, with an average trade size of 46,000 shares.
“We have members who trade million-share blocks, but they never know who they trade with,” says Alfred Eskandar, head of corporate strategy for Liquidnet.
The Liquidnet pool is an exclusive trading club with 514 carefully screened buy-side members (including about 100 hedge funds) who can trade only with one another. Each candidate has to demonstrate the ability to trade big blocks. To prevent fishing for information in the pool, Liquidnet requires members to act on one of every two matched opportunities or risk losing their membership.
“We are pretty strict,” Eskandar says. “We don’t allow fast money or day trading firms.”
In 2005, Liquidnet branched out with a new venue called H2O, which connects to some outside pools and allows smaller trades than did the original Liquidnet market. H2O is one of several new dark pool services that have shrunk the size of trades and greatly expanded access. The group includes pools run by prime brokers that tap their own internal order flow as a source of liquidity and allow algorithmic trading. Most of these newer dark pools have an average trade size of 250 to 500 shares.
The proliferation has given rise to new software designed to connect traders to a series of pools. By hopping from pool to pool using these new electronic tools, traders are able to search quickly for liquidity across multiple sources.
“If you connect a lot of these dark pools together, you get a greater chance of getting orders filled before you hit the public market,” says Sang Lee, a managing partner at Aite Group, a Boston-based financial research company. “The game now is adding a lot of flexibility for the user.”
Dark pool access is now part of trade order management systems and can be adjusted based on which brokers and services are being used. Traders can turn specific pools on and off, adjust order size, use algorithms and auto-
matically route trades to exchanges after searching for liquidity in dark pools. Thanks to electronic execution, transactions in dark pools are lightning-fast. But hunting for liquidity there can take time, and many traders prefer to stick with display exchanges for high-volume stocks like Microsoft.
One dark pool player, a hedge fund trader who asked that neither his name nor his firm’s be used, says he goes to Liquidnet for big block trades but also routes trades to more than a dozen other dark pools through his order management system. His daily hunt for liquidity requires constant monitoring. “On any given day it varies dramatically which dark pool is the best,” he says.
One of the newest systems that aggregates dark pools is OnePipe, a joint project of Weeden & Co. of Greenwich, Connecticut, and New York–based Pragma Financial Systems. Launched earlier this year, OnePipe acts as an electronic agent that plumbs 31 dark pools, using software that is promoted as being smart enough to know the best sources of dark liquidity at any moment.
“We make it possible to expose yourself to maximum liquidity,” says Peter Fraenkel, director of quantitative services at Pragma. “It is pretty much impossible to duplicate this on one’s own.”
But even with OnePipe there remains the question of whether the right pools are being tapped. Liquidnet, for example, doesn’t allow outside connections, so OnePipe starts out without a link to the pool with the biggest transactions. (OnePipe does connect to H2O.)
For active traders the array of dark pool sites also means coordinating several different routing tools to fill orders. Drina Loncar, a senior trader at Pentwater Capital Management, a Chicago-based hedge fund, accesses several prime broker dark pools as well as OnePipe.
“You have to be where the liquidity is,” notes Loncar, whose firm manages $1.25 billion.
Rosenblatt’s Gawronski says one way to monitor a dark pool router is to measure which pools end up with your orders most often. If the router is supposed to access 20 pools but almost all of your orders wind up in the same one or two, it’s a good idea to find out why, particularly if your trades are being consistently routed to the pools that charge your provider the lowest fees.
One issue that faces all dark pool users is information leakage. “If you are putting orders in 30 dark pools, can you imagine the possible information leakage you are causing?” says Rishi Nangalia, who manages Goldman, Sachs & Co.'s global electronic trading business. Dark pool quality is more important than quantity, he adds.
If a sly trader can discover a dark pool block trade before it gets consummated, particularly if the stock is thinly traded, then the game is on. Using small trades in the public market, the gamer can move the stock price up or down, then jump back into the pool to take advantage of the price change by executing against the block trader. The most common strategy to set up the sting is to “ping” dark pools by sending a small order for, say, 100 shares of a stock to see if any nibbles come back.
“I know there are people who use computer programs to try to game pools,” says the hedge fund trader who asked not to be identified. “I analyze it quite a lot and tend to route to places where I know there is more policing going on.”
Dark pool operators and service providers now tout their antigaming strategies in their marketing. OnePipe’s software includes antigaming logic that hunts for various types of price manipulation. Pool operators have rules that ban gaming and banish suspected violators.
Pentwater Capital’s Loncar isn’t convinced that the anti-gaming tactics offer effective protection. She considers her own diligence and constant review of her dark pool trading as her last defense. “I don’t think antigaming is very good, frankly,” Loncar says. “What you have to do is manage your orders. If you don’t look after [them], somebody else may get the better of you.”
Gamers are not the only hazard dark pool traders need to watch for. Because pools are sought as sources of liquidity, it is important to know how much trading takes place in them. But they are notorious for fudging their numbers by counting both sides of a trade. Andrew Silverman, co-leader of electronic trading at Morgan Stanley, has been making the rounds of investment seminars lately, telling traders that estimates of dark pool volume — which have been pegged at as much as 20 percent of all stocks traded — are highly suspect. He says the pools account for no more than 9 percent of trading volume, and could be considerably less.
Morgan Stanley, like several brokerage houses, offers its own dark pool and also routes to ten others, including those of competitors UBS and Goldman Sachs, as part of a new dark pool alliance among the three firms. Silverman says that because most of the volume can be found in the top ten pools, traders don’t need access to dozens. Extra routing just leaves more footprints, he adds.
Larry Tabb, founder and CEO at research and consulting firm TABB Group, believes there may be some value in extending past the top ten pools, especially when dealing in thinly traded stocks. Technology has made shopping a large number of dark pools not only possible but extremely fast. “You can go blast out to 20 dark pools and see if there is liquidity in five milliseconds,” he says.
But though the execution may be fast, the technology is not necessarily easy to use. Craig Viani, head of electronic trading at BNY ConvergEx Group, says the range of dark pool options is part of a dizzying array of electronic possibilities confronting today’s trader. ConvergEx, which is partly owned by Bank of New York Mellon, tries to cut through the complexity with a smart router that looks for liquidity in dark pools and more traditional markets.
The bottom line is that dark pools offer some advantages to traders, but knowing which ones to use and how to access them requires work. “It is the obligation of the hedge fund trader to know what he is using and how he is using it,” Gawronski says.
