Scott Warner on the impact that Dark Pools have impact equity markets and their participants

The adoption and proliferation of Dark Pools constitutes a major structural change in the equity market microstructure. Developing along a similar trajectory as traditional Electronic Communication Networks (ECNs) in the late 90s, Dark Pools have become an important source of liquidity in global equity markets and are having an impact on both hedge funds and broader equity markets. As such, their development is important for pension fund managers and their advisors to understand and factor into investment decisions.

In their simplest form, Dark Pools are private crossing networks that allow investors to access market liquidity while maintaining an anonymous position. Because of the anonymity of these liquidity venues, traders using them may enjoy many of the efficiencies of public limit order books, but without having to reveal their identity or the size of their order to the broader market.

Dark Pools are useful to institutional investors such as pension funds because they offer the ability to anonymously buy or sell shares in private marketplaces without revealing their executed price until all trades are completed. Upon finalising a trade, the dark pool will provide a delayed transaction report to the consolidated tape, listing the transaction as an over-the-counter exchange.

Large investors have increasingly shown a preference to trade in pools when they wish to trade sizeable blocks of shares, out of fear that announcing their intentions will set off a run in prices. This favourable position has continued to attract interest, and subsequently, equity trading volume. According to Rosenblatt Securities, a frequently referenced agency broker that tracks 18 US based venues, Dark Pool volume doubled in 2008 to account for nearly 10 per cent of total consolidated equity volume in the US.

Europe is following a similar path, with Dark Pool volume increasing dramatically in the past year. Recent estimates indicate that Dark Pools account for about four per cent of all European equity trading, increasing from just €2.2 billion in January to roughly €9.5 billion as of October (according to US-based financial research and advisory firm Tabb Group, and Thomson Reuters).

Migration
As a general rule, traders will follow liquidity. Regardless of the underlying strategy, managers are focused on obtaining the best possible execution and minimising the price impact of their orders. With a substantial amount of volume moving off the exchanges and into dark pools, traders have followed. As a result of this structural shift, many traders have noted that the public limit order book has become increasingly 'shallow'. Effectively, this means that the depth of outstanding and visible limit orders has declined.

With over 60 different Dark Pools worldwide (and 40 in the US), liquidity in equity markets has become increasingly fragmented (as volume is dispersed over more venues). As a result of this fragmentation, the ability to trade large blocks of stock at a single location has been diminished. Increasingly, traders are being forced to explore these alternative trading venues in their search for liquidity.

We have seen a substantial migration of our underlying hedge fund managers and pension plan clients now incorporating these trading venues as part of their best execution practices. In the hedge fund arena, Dark Pools were first adopted by managers in the equity market neutral strategy, but over the past few years, many fundamentally focused managers have also begun to utilise these pools.

Clearly, with the proliferation of trading venues, sourcing liquidity is made significantly more difficult. As liquidity is broken down into various venues, traders need to be able to source liquidity from many different and discrete venues to ensure best execution. Assisting in this effort have been many technological advances in the area of trading algorithms and smart routers.

Currently, traders can purchase trading software that will 'ping' various Dark Pools to see if there are any active orders in each of the pools that they are registered in. These smart routers use different algorithms, or search patterns, to break up large trades and scour trading venues.

Another driver of the proliferation has been broker and dealers trying to internalise some of their own order flow. As equity traders have improved their execution costs by relying on low-touch trading venues, brokers and dealers have attempted to capture some of their own internal order flow.

By internalising order flow, they are able to reduce exchange costs and generate commissions from other traders in the pool. In addition, it also allows them a venue for trading their proprietary books while still maintaining anonymity to the public.

Risk awareness
As with many of the more recent financial innovations, Dark Pools have posed a challenge to regulators trying to keep pace with market innovations.

With the increase in popularity of these opaque trading venues comes the increased risk that these trades are being 'gamed' and that some investors are being disadvantaged. With the advent of 'flash' orders (which enable certain high frequency traders the ability to see orders less than a second before the order is released to the public) and liquidity rebates (small incentives to traders providing liquidity to a particular venue) this concern has been magnified.

A senior staffer in the US Securities and Exchange Commission's (SEC) trading and market's division recently described the challenge for the industry and regulators as having to "monitor these changes and update a market's structure when needed".

On 21 October, the SEC issued a proposal to increase transparency of Dark Pools through a number of amendments to the Exchange Act. In essence, the SEC aims to promote market transparency by increasing the amount of reporting a Dark Pool must provide to the public (e.g. real-time post trade information and increased information surrounding indications of interest in a pool).

The SEC is currently seeking public comment on their proposal, and in our opinion, some form of additional reporting requirements will likely take effect in 2010. Likewise, the Financial Services Authority (FSA) is currently reviewing the volume associated to Dark Pool trading and may take similar actions as the SEC.

What's next?
It could well be that the increased popularity of Dark Pool trading is simply another shift in the structural dynamic of the equity marketplace.

As such, a move towards greater regulation and transparency across all alternative trading venues should be welcome, as Dark Pools should be subject to a heightened level of regulation. While the anonymity of order flow and minimal information leakage provided by these venues are valuable considerations to many large market participants, heightened regulation and safeguards should be in place to ensure the integrity of global equity markets and fair access to all participants.

A number of hedge funds are becoming more active participants in Dark Pools as they continue to source liquidity from alternative sources. While estimates of hedge fund activity in Dark Pools remain a relatively modest eight per cent (according to an estimate by the TABB Group on 16 June 2009) of total Dark Pool activity, it is expected that this will grow in the coming years. There has also been an increase in their usage by traditional managers. Ultimately, traders will migrate to where the liquidity is, and as such, hedge fund participation in Dark Pools is likely to increase.

It is therefore critical for pension fund managers and their advisors to know how their traders and asset managers are employing Dark Pools.

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