The rapid growth of electronic trading
since 1976 has benefited equity market participants by improving competition, reducing cost and increasing liquidity while insuring better pricing.
One unexpected side effect has been the recent emergence of
"dark pools of liquidity", or the secret stock market.
The
New York Stock Exchange (NYSE) is arguably the world's single largest cash equity market: roughly 2,700 companies with a market capitalisation exceeding $25
trillion dollars are listed on the NYSE, Every day some 1.67 billion shares or over $63 billion dollars changes hands (data as of 2006).
But not all shares for NYSE listed companies are traded on this exchange.
Many institutional investors use electronic trading services called
"Crossing Networks" to match buy and sell orders. Such networks are known in the buiness as "dark pools of liquidity", and while their emergence is a fascinating, competitive story, it is the possible ending that interests equity market researchers the most.
Crossing Networks provide two services critical to the institutional investor - anonymity and liquidity. Such networks allow participants to anonymously buy or sell large blocks of securities, without using listed stock exchanges or impacting publicly quoted prices on those exchanges.
The attraction of such networks to institutional investors is easy to understand: if competitors learn about your market activities they are in a position to disrupt your trades. Disrupting trades may be as simple as
front running orders, or attempting to trade mispriced securities before you do. In other words, public activities
may lead to price disruption, with risk of trading losses.
There are many such networks, each operating in specific niches or providing specialised services. For example,
SIGMA X claims to offer
"the largest pool of non-displayed liquidity in the United States", while
BATS has taken the lead on aggressively reducing trading costs year after year. Merrill Lynch and ITG's joint offering,
Block-Alert, allows institutional investors access to a large standing pool of liquidity, capable of absorbing buy or sell orders
without matching.
At present crossing networks account
for over 10% of all equity market trading, with business growing in excess of 40% per annum. Considering the vast sums of money attracted to dark pools of liquidity, their numbers are certain to continue growing. But precise data about crossing networks is difficult to come by, due to their international scope and the fact they serve the needs of private, institutional class investors.
However the dark pools of liquidity are converging, and, in some cases, emerging into the public eye.
Today Goldman, UBS and Morgan Stanley
agreed to provide shared access to their own dark pools, creating, in a virtual sense, a single, large Crossing Network. As economies of scale are critical to equity trading, other dark pools will be certain to follow. And how might this story end?
As dark pools continue to converge, enlarging their liquidity base while doing so,
they are beginning to compete for business with traditional, organised exchanges such as
NYSE / Euronext.
BATS has
already applied to the SEC for registration as "national securities exchange", an action that
existing organised exchanges aren't welcoming. One of BATS competitors,
DirectEdge, has indicated it also intends to
apply for exchange status as well.
It will be fascinating to watch as dark pools of liquidity converge, growing larger as they do so, in many cases emerging from the shadows to threaten entrenched competitors such as NYSE / Euronext. This is a scenario that played out to its endgame, can only benefit all equity market participants.
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Also, as several firms offer advanced routing services which automatically break up large block trades to suit the limited liquidity each pool can offer, many institutional class investors find that on aggregate, they are paying higher transaction costs than if they had used existing exchanges. But that's the price they are willing to pay for anonymity in the harshly competitive world of trading.
And what about the firms offering dark pools of liquidity? How do they make their money? Well, in many cases they are matching orders between buyers and sellers, thus earning commissions based on trading volumes.
Other firms which offer standing pools of liquidity are effectively accepting risk from market participants. Such organisations either utilise active risk management practices, thus rendering their trading books market neutral, or seek to offload such assets as rapidly as possible.
The most interesting thing about the story of dark pools of liquidity is circularity; while NYSE was busy acquiring any and all competitors, crossing networks operating in the shadows, were slowly building a client base, providing much needed, missing services. This fragmentation, in retrospect, actually was a good thing. Had new exchanges sought to compete from the outset with the established exchanges, they most certainly would have been driven from business.
Now pools of dark liquidity are emerging from the shadows, seeking to obtain full fledged exchange status and in doing so, completing a circle from secretive organisation to public entity.
A fascinating story.
posted by Mutant at 10:14 AM on May 20, 2008 [3 favorites]