Every major broker dealer says it has the best anti-gaming technology to prevent information leakage in dark pools. However, institutional traders I spoke to recently seemed skeptical of whether sell-side firms would police their dark liquidity pools,suggesting that the independent firms (ITG, Liquidnet and Pipeline) were more likely to expel participants that were sniffing out institutional orders or trying to manipulate prices.

This may be more perception than reality, as the sell-side executives I spoke to seem extremely serious about protecting their institutional customers’ orders. However, there does seem to be confusion out there as to how the dark liquidity pools operate, not only with respect to anti-gaming, but on disclosing other matters as well. That point was driven home yesterday when Greenwich Associates released a study saying that a significant proportion of institutional investors are “in the dark” about certain important policies and practices of broker-dealers and exchanges providing dark liquidity.

In fact, Greenwich is saying that some of the broker-dealer or exchanges call their platforms “dark” but they actually may not be. The venues route orders to external destinations and systems have varying policies about anonymity and information sharing/leakage, according to the study. The survey, which lists “Ten Questions That Every Institution Should Ask its Dark Pool Providers,” was conducted in July 2008 with 64 institutions that say they are active users of dark pools with 90 percent located in the U.S. and the rest in Europe and Asia.

I found it surprising that nearly half of the respondents told the research firm that sell-side broker-dealers and exchanges they tap for dark liquidity do not disclose the types of orders their dark pools will accept or the anti-gaming parameter and controls they have in place with respect to their dark pools. Practices also differ on how volume is calculated, what types of orders are accepted, and how client orders interact with proprietary orders, noted the report.

Clearly this points to a need for more education on the part of the sell-side to explain their policies practices to their institutional customers. Then again, with 48 or 50-something dark pools out there, perhaps it’d difficult for the buy-side to keep this straight without some sort of a report card. Because they are, to an extent flying in the dark, institutional traders told me that they rely on their own trading skills, using limits and slicing and dicing orders and setting parameters in broker-supplied algorithms, to control the amount of information they expose in a dark pool. As is, buy-side firms told me they spend a lot of time monitoring the market before and after their executions to make sure they didn’t receive an adverse fill in a dark liquidity pools.

Now many of the sell-side firms have automated tools monitoring for signs of manipulative activity, as well as human experts on the desk reviewing these patterns. Weeden & Co. and Pragma Financial Systems introduced Lifeguard, a quantitative anti-gaming technology serving as an extra layer of protection on top of OnePipe Optimal Liquidity Management System, the dark pool liquidity aggregation network operated by both firms.

Some institutions are skeptical of whether or not brokers will turn away certain order flow that might be predatory. However, they cite the example of Liquidnet as a crossing network they trust that has been talking about anti-gaming since it launched in April of 2001.

Coincidentally, yesterday I received brochure and fact sheet from Liquidnet, titled, “Lifeguarding the Pool,” explaining how it proactively monitors member behavior. (Liquidnet has had that term since the Q1 and just began marketing it!) I was impressed by the following line: “Since we began trading seven years ago, we have suspended 103 member firms globally, collectively representing $1 trillion in equity assets under management (as of June 30, 2008).” Liquidnet is apparently not afraid to take disciplinary action. In addition to monitoring the participants for signs of gaming, the buy-side wants the dark pools to enforce the rules.

What the buy-side told me they liked about Liquidnet and wanted other dark pools to adopt is a grading system (a.k.a. Positive Action Rate) that rates member behavior. If a member exhibits negative behavior they can be put on a watch list. (ITG has a similar list.) Systems monitor the behavior of the member to see if it positively changes, and if the member’s behavior conforms to the community norm over a three-month period, they are removed from the list. More importantly, this information is spelled out and available so that institutions are not left in the dark when it comes to anti-gaming. Perhaps other dark pool operators should think about disclosing their anti-gaming enforcement policies to buy-side institutions that are active users of their dark pools.

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