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There are at least 48 dark pools either in production or preparing for rollout. While the term "dark pool" implies symmetry, in reality all dark venues are different, and firms need to understand the unique benefits, challenges and opportunities of executing in each venue they visit. To fully understand these pools, it is beneficial to segment them by ownership, matching frequency, price formulation, access and liquidity indications.
Dark pools have four ownership structures: independent, exchange-owned, broker-owned and consortium-owned. Each has its own set of pros and cons.
While important, matching frequency has become less critical as most dark pools match orders continuously. Conversely, price formulation, while seemingly straightforward, is actually complex. While Reg NMS requires all equities trades to be matched between the National Best Bid and Offer (NBBO), there can be a lot of leeway in the NBBO. While few platforms offer negotiation, most platforms provide automatic execution, so understanding how your orders are priced can make the difference between a good execution and a fair one.
Access into and out of the dark pool is becoming increasing critical. Access is important because it dictates if you can play, whom you are playing with and the satisfaction of your matching experience. Dark pools do not have equal or fair access -- not everyone can play, and not everyone is equal. The owner of the pool, like a co-op board, has complete control, as it dictates access, terms, pricing and experience. Some only allow the buy side in; others, such as brokers, court their own clients but are increasingly allowing other brokers to access their liquidity. And still others cater to larger blocks and do not allow algorithmic access.
Access out of dark pools is increasingly becoming a hot topic and bleeds into my last point -- liquidity notifications. As dark pools continue to fragment the execution fabric, it becomes increasingly challenging to find the other side of the trade.
To alleviate this, algorithmic providers are increasingly using liquidity alerts or indications of interest (IOIs) to notify liquidity providers of a trading opportunity. As opposed to an algorithm that actively looks for passive liquidity, this tool actively notifies traders of passive liquidity and, to some extent, represents the exact opposite of a dark pool's premise -- to passively wait for an execution while providing little if any information leakage.
While I am not saying that liquidity notifications are good or bad, there needs to be an understanding of when IOIs are employed, how they work and how much information is being provided. Defining when, how, who and what type of information is being disseminated, and how much control the user has in limiting these features, will become increasingly important as the quest for liquidity becomes increasingly difficult.
It is becoming more apparent that traders need to shine a light on dark pools as matching volumes in these venues reach 19 percent by 2011 -- not that matching in the dark is bad, or that dark venues are malicious, and not because dark pools have a sinister moniker, but because dark pools are a critical tool for the modern trader. Traders must realize that all dark pools are not the same, and until traders understand how each pool works, who is in them and what protections guide them, the trader will be like the player at the poker table wondering who the sucker is -- when all along it is most likely him.
ADVANCED TRADING'S DARK POOL DIRECTORY
breaks out the various dark pools by ownership type:
