Published in Money Manager Edition 9 – the Finance publication of Indian Institutes’ of

Management at Ahmedabad, Bangalore and Calcutta.

alternative trading systems (ATS)

Lighting Up Dark Pools
maintained by broker-dealers that match
buyers and sellers within their private system
without displaying the quotations to the
Abstract
public.
As Main Street and Wall Street find ways
An Alternative Trading System (ATS) is a
to cohabitate symbiotically in the
trading system that is not regulated as an
aftermath of the financial meltdown of exchange, but is a venue for matching
2008, capital markets are poised to the buy and sell orders of its subscribers.
witness a slew of changes with the
passage of the Dodd-Frank Act into law
A Typical Equities Trade Flow
and given the heightened regulatory
focus. This article aims to take a dekko There are many ways in which an order
at one of the sure shot targets of future might originate – either by a buy-side
regulation - dark pools of liquidity. We‟ll OMS/EMS, a sell side trader or an
discuss the electronic equities trading automated algorithmic engine that forks
business, evolution of these dark pools orders based upon trading goals. When
and their journey in Asia. captured by the broker‟s trading system, the
Introduction
order normally undergoes an array of
enrichments, toxic checks and messaging
Introduction
protocol conversions after which it enters
the order routing engine. An order
With the advent of computers and big
originating in Financial Information
money technology investment by broker-
Exchange (FIX) protocol will need
dealers and stock exchanges alike, especially
conversion into the in-house messaging
in the last decade, equity trading of the yore
protocol that is compatible with the brokers
stands completely revolutionized. What was
trading system.
once a painstakingly manual and a relatively
slow process involving open out-cry in
An Order Management System (OMS) is
trading pits has transformed into a
an electronic system developed to execute
technology intensive process with computer securities orders in an efficient and cost-
systems matching trades electronically in a effective manner.
fraction of a second.
The order would then move to the order
Online trading brought about much-desired
routing engine which oftentimes has the
transparency, as trading activities became
capability to connect to multiple dark pools
visible through real-time price
of liquidity, stock exchanges and ECNs.
dissemination. The capital markets
This routing engine is loaded with a plethora
witnessed a massive increase in trading
of complex algorithms and trading logic that
venues, evolution of Direct Market Access
enables it to work on the order based upon
systems, complex trading strategies and a lot
the trading strategy. Figure 1 below illustrates
more. Somewhere along the way, informal
a generic equities order flow.
electronic trade matching and settlement
systems, called the „dark pools‟ of today
sprung up. Dark pools of liquidity are
Published in Money Manager Edition 9 – the Finance publication of Indian Institutes’ of
Management at Ahmedabad, Bangalore and Calcutta.
Figure 1
Dark Pools and Smart Order Routing
Regulations like Reg NMS in US and MiFID
in Europe led to greater emphasis on smart
order routing in order to meet the
requirement of best executioni. To be smart,
the order routing engine needs an active
market data feed from the various trading
venues it connects to. As best execution is
not just capturing the best price, the broker
has to factor in the trading costs, volume
available, likelihood of order fulfilment
without significant market impact, trading
limits imposed for that venue etc. Based
upon the price and liquidity available at the
trading venues, the order router will split the
parent order into one or more child orders
and route them to the destination which has
the most favourable quote available. As the
process of seeking price and liquidity is
electronic, the impact on costs and order
latency is reduced.
Best Execution refers to the responsibility
of brokers to provide the most advantageous
or best price, order execution for customers.
With some dark pools, investors can signal
their interest in buying or selling a stock but
that indication of interest is communicated
only to a group of market participants.
Smart routing also involves posting or
shadow posting a child order to the dark
pool first as an Immediate or Cancel (IOC)
order to seek favourable execution. If
matching prospects are available, the order
gets partially or fully executed in the dark
pool. Else, it gets cancelled. A feedback loop
into the trade flow ensures that the
OMS/EMS is aware of the fate of the child
order and does the trade management
accordingly.
The Growth Story
According to the Securities and Exchange
Commission, the number of active dark
pools dealing in stocks on major US stock
markets trebled to 29 in 2009 from about 10
in 2002. Dark pools accounted for 15% of
all US equities executions in August 2010ii.
Given that dark pools accounted for only
1% of the trading volume in 2003, the
industry has witnessed tremendous growth
as far as the evolution of dark pools goes.
An Immediate Or Cancel (IOC) order
requires all or part of it be executed
immediately after it has been brought to the
market. Any portions not executed
immediately are automatically cancelled.
There are at least two dozen brokers that
operate dark pools today. Figure 3 shows the
major dark pools in the US and their
execution volume for August 2010. Each of
these pools are open to a mix of users, some
are open only to institutional investment
Published in Money Manager Edition 9 – the Finance publication of Indian Institutes’ of
Management at Ahmedabad, Bangalore and Calcutta.

managers whereas some cater to both the companies are extremely concerned about
buy and the sell side. the impact cost of execution of large orders
at the exchanges. For them, dark pools act
as a preferred alternative trading venue that
US Equiy Execution Venue Split - addresses these concerns.
Aug 2010 While the clients of broker-dealers offering
Dark Pools Exchanges/ECNs
dark pools enjoy the benefits of having their
execution out of the public gaze, the broker-
15%
dealers gain a two pronged advantage –
collecting transaction fees from clients and
85%
simultaneously saving on exchange
membership costs as the execution
Figure 2 essentially took place within the confines of
Matched Single the broker-dealer.
Broker Dark Pool
Counted (millions)
Credit Sussise CrossFinder® 151 Dark pools aren‟t without their detractors
Goldman Sachs SIGMA-X 112 though. Some market participants believe
Knight Knight Link 100
Getco Execution Services 92 that when trades are executed anonymously,
Level
Morgan Stanley
Level ATS
MSPool
68
56
the price listed on the exchange may
Barclays LX 46 become skewed, leading to incorrect pricing
Instinet Instinet Crossing 34
Citi Citi Match 28
and ultimately inefficient markets.
iii
Liquidnet Liquidnet 24 Participants contend that dark liquidity
BIDS Trading BIDS 22
simply clouds the marketplace and makes it
Matched Single One share bought and one share sold equals one harder for traders to tell what‟s happening.
Counted matched.
At times, users have to “ping” numerous
pools with small chunks of shares, which
Figure 3 still can result in failing to make a trade at all
Some pools allow orders to rest for any due to the increased fragmentation of the
amount of time till they find a match. A market. iv
majority of large dark pools also operate in As dark pool trade matching happens within
Europe and Asia, such as CrossFinder by the broker-dealers private system, stock
Credit Sussise and SIGMA X operated by exchanges are beginning to lose substantial
Goldman Sachs. transaction volume to dark pools. The
Who benefits and who doesn’t London Stock Exchange has lost more than
a quarter of the market to alternative
Without dark pools, big institutional traders
platforms, in particular Chi-X.v
would have to route their orders directly to
the floor of the exchange, exposing their In response, NYSE, LSE and many western
intentions to the market and thereby causing exchanges have since set up their own dark
considerable price impact. Traders seek the pools to fend off competition.vi
advantage of anonymity which allows them Regulation and Critique
to complete their transaction out of the
Post the financial crisis triggered by the
public eye. Enter dark pools. Institutional
subprime crisis of 2008, the Securities and
investors like hedge funds, pension funds
Exchange Commission has often expressed
and other investment management
Published in Money Manager Edition 9 – the Finance publication of Indian Institutes’ of
Management at Ahmedabad, Bangalore and Calcutta.
displeasure at the “darkness” of dark pools
and has called for increased regulation.
According to the Securities and Exchange
Commission, the characteristic lack of
transparency in dark pools could create a
two-tiered market that deprives the public
of information about stock prices and
liquidity. vii
On October 21 2009, the SEC put forth
several proposals for comment that would
among other things, treat actionable
indications of interest (IOIs) as actual
quotes and be therefore subject to the same
market disclosure as public quotes. The SEC
also wants the dark pools to trade report
real time and include the name of the dark
pool that handled a given stock trade. It
believes that Alternate Trading Systems
should be subjected to the same post-trade
information disclosure requirements as
exchanges by amending existing rules to
require real-time disclosure of the identity of
a non-displayed venue that executed a
trade.viii
Some industry participants believe that the
modified post trade reporting requirement
might actually harm the investment
management funds as they would get worse
prices while buying or selling large amounts
of stock should dark pools be forced to
identify themselves real time.
The SEC hasn‟t ruled on the matter yet. As
it ploughs through the massive workload of
converting legislation into rule making with
the passage of the Dodd-Frank Act in July
2010, it has also resolved to make progress
on issues affecting equities markets.ix The
buy side and the sell side are not too
enthusiastic about releasing too much
information too soon and as various
industry participants debate on this issue,
time will only tell what compromise formula
actually gets arrived at.
Asia Focus
Dark pools, alternative trading systems,
hidden liquidity etc are still relatively new to
the emerging markets in Asia. As opposed
to the US and Europe, Asia is a market
presenting unique challenges to dark pools
operators. It has a large number of
countries, each operating its own set of
exchanges and associated regulatory and
clearance bodies. Each of these 12-13
countries has their own currency, different
set of rules and regulations. Moreover, stock
exchanges are perceived as national assets
and change is relatively more gradual. The
depository and clearing bodies are often
owned by exchanges, implying that the dark
pools operators can earn fees for matching
trades but they wouldn‟t be able to make
money from clearing and settling trades.x
While broker-dealers operating dark pools
acknowledge that penetrating the Asian
markets would be a challenge, they are
committed to expanding the footprint of
dark liquidity in the trading landscape here.
At the moment, dark pools operators
command an approximate 1 to 3 percent
share of equity execution in Asia on the
larger exchanges and close to zero on the
smaller ones. The Hong Kong and Japan
market currently commands the biggest slice
of the pie in terms of dark pool presence.
As the markets in Asia start seeing an
expansion of the capital base pooled into
the markets, new trading venues will spring
up to tap them. Goldman Sachs launched
the SIGMA-X dark pool in Hong Kong in
March 2009 which allows for trading of the
stocks listed on the Hong Kong Stock
Exchange.xi Chi-East, the joint venture
between Chi-X Global and the Singapore
Published in Money Manager Edition 9 – the Finance publication of Indian Institutes’ of
Management at Ahmedabad, Bangalore and Calcutta.

Exchange (SGX), has recently received

xKevin Lim and Adrian Bathgate: ANALYSIS-Regulation may
regulatory approval from the Monetary dim growth of „dark pools‟ in Asia -Financial Regulatory Forum
Authority of Singapore (MAS) to operate a August 2010

dark pool trading platform.xii xiGoldman Sachs Electronic Trading, March 2009
http://gset.gs.com
Dark pools haven‟t found home in India yet. Chi-East Press Release, Oct 4 2010: Chi-East Receives
xii

At the moment, brokers are not allowed to Regulatory Approval to Launch

Independent, Pan-Asian, Non-Displayed Trading Venue
square trades within their private network. http://www.chi-east.com
It‟s a market where Direct Market Access Other General References
and algorithmic trading itself were a http://www.investopedia.com
relatively recent phenomenon and as these http://www.marketswiki.com

further develop and spread in the

marketplace, the needs for dark pools will
hopefully become apparent.
India and other Asian countries have a great About the Author
opportunity to learn from the experiences
Dushyant Sahgal is a first year MBA student at
(both good and bad) of the US and Olin Business School, Washington University
European markets and work towards well in St. Louis. Prior to joining Olin, he was
working at Goldman Sachs in the Equities
thought of liberalization of their capital
Technology division. He is reachable via email
markets as far as the expansion of at dsahgal@wustl.edu
alternative trading systems goes.
Notwithstanding how the dark pools of
tomorrow shape up, dark pools of today –
downright opaque or bright enough? Your
call.

iMd Julfikar Rahaman,2009: Journal Article on Smart Order

Routing: What it Brings to the Table
iiTabb Forum Liquidity Matrix August 2010
http://www.tabbforum.com

Jason Shough August 2010: Chicago investor groups and traders

iii

debate the benefit of 'dark pools'

Scott Patterson and Aaron Lucchetti, May 2008 WSJ: Dark Pools
iv

Drain Liquidity
vKevin Lim and Adrian Bathgate: ANALYSIS-Regulation may
dim growth of „dark pools‟ in Asia -Financial Regulatory Forum
August 2010
viKevin Lim and Adrian Bathgate: ANALYSIS-Regulation may
dim growth of „dark pools‟ in Asia -Financial Regulatory Forum
August 2010

Securities and Exchange Commission: Statement on Dark Pool

vii

Regulation Oct 21 2009 http://www.sec.gov

Matthew Samelson, Oct 2010 - Early thoughts on SEC Dark

viii

Pool Regulation: Advanced Trading http://

www.advancedtrading.com
ixPeter Chapman, Sep 2010: Traders Magazine - Dodd-Frank
Won't Derail SEC's Market Structure Work
http://www.tradersmagazine.com