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
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.