Lenzo emphasizes the importance of evaluating the business model of every party a dark pool operator interacts with before sending any trades that firm's way or relying on any of its software. "[Dark pool] platforms are largely similar operationally," he says. "What sets them apart is: How are they making money? What is the natural philosophical bent that they have? What was the kernel of an idea that went into the product before all that math was put on top of it?"
Trusting the Relationship
This question of bias and philosophy, and the importance of trust, runs throughout buy-side traders' evaluations of their relationships with execution vendors' pools, brokers and technology vendors. For some large investment houses, relationships can be spread very thinly across dozens of brokers, with analysis centralized in-house so as to capitalize on the expertise of some players, while diluting the bias of others that nevertheless represent significant liquidity.
At San Diego-based Allianz Global Investors Capital (formerly Nicholas-Applegate), head trader Kevin Chapman relies on more than 80 brokers as well as numerous dark pools to execute his trades. Charged with managing $48 billion across a broad spectrum of strategies, Chapman uses ITG's ACE (Agency Cost Estimator) solution to determine dark pool performance based on implementation shortfall. He says this information helps him determine where he is giving away information and disadvantaging the trade and direct his efforts toward venues with the most liquidity.
"If you can see that 1 percent of your executions are getting filled in 10 places, someone is probably using that information against you," Chapman says. "We need the capability to dynamically shift the order to a venue where we can complete in size."
Despite all of the services and information available, Chapman relates, he finds his analysis hampered by the inconsistency of real-time information. While he says he appreciates the visual efficacy of the heat maps and timely reporting provided by the likes of Instinet and ITG, Chapman is challenged by the inconsistency of and lack of details in some brokers' trade reporting.
"I am trying to get the locations of my trades in real-time from all my providers," says Chapman. "I am trying to get that information through FIX messaging, and our IT people and our brokers' people say they can't do that right now. But I don't understand why that is the case -- if they are sending back the time stamp and fill, why not the location?"
Chapman believes the market is heading toward intraday analysis and real-time dissemination of trade information across all trading venues, including dark pools, despite the debate over whether real-time dark pool trade reporting would provide more ammunition for high-frequency traders. But broker relationships will remain important, he insists, adding that he will continue to select brokers based on particular skills to perform tasks as specific as working a single small-cap trade for a couple of days once a year.
Aggregators Heed the Call
In fact, because algorithmic and electronic trading have fractured the market so significantly, some buy-siders now look to brokers more than ever to piece everything back together and make sense of it all for them. For example, at Spokane, Wash.-based ICM Asset Management, a 20-person firm that focuses primarily on small-cap value and large-cap global stocks, dark pool management is almost entirely in the hands of its primary broker, Greenwich, Conn.-based Weeden & Co., which operates an aggregator tool called OnePipe.
"My traders on the sell side are now taking more responsibility for making those choices," relates Tim Olsen, SVP and head trader at ICM. "I don't want to take my focus away from something I can add value to, by guessing and pecking and hunting for which pool I should be in." Dark pools are nevertheless vital to Olsen's strategy, as small-cap shares are illiquid and trade rarely -- when a large block can be found, it must be executed quickly, he explains.
Olsen notes that he likes the single-ticket convenience of orders placed via an aggregator, especially as many pools have disappointingly low liquidity in the shares he needs. He adds that he performs analysis on his own systems but trusts that his brokers are providing accurate reporting on their dark activities.
"It's critical for me to have that relationship with my broker, who knows my style, knows what I want to do, knows my parameters and takes care of me," Olsen says. "Paying full price for executions in dark pools might sound unusual, but it makes sense for us. I still think our clients are better off in the end."