Shining a Light on Dark Liquidity

Buy-side and sell-side participants acknowledge the need to increase the transparency of dark liquidity pools, but hope to do so without losing the benefits that come along with executing in a non-displayed venue.

"Everyone is for increased transparency but everyone also worries that it may hurt the clients who participate," says Dmitri Galinov, head of Crossfinder at Credit Suisse. He spoke on a panel at the Best Execution USA conference, hosted by WatersTechnology. "In less liquid stocks, it could take a fund manager a week to build their position. If real-time or even daily reports were provided, that client's intent would be visible. Consequently, the dark pool would be showing the patterns it was designed to protect."

Dark liquidity pools "largely offer protection from sophisticated traders picking off clients," says panelist Simon Spenser, a senior vice president at D.E. Shaw.

According to analyst firm Tabb Group, about 10 percent of order flow is executed in dark liquidity pools. However less-liquid stocks can see up to 40 percent of their trading volume executed in dark liquidity pools.

Dark pool operators already report details of the trades to clients and provide reports as to where trades are routed, in order to comply with the US Securities and Exchange Commission's (SEC's) Regulation 606B, says Galinov. "Today, clients want real data on executions. They will not rely on salespeople or on conjecture. We provide a range of reports including real-time fills that include where the trade was executed as part of the transaction cost analysis (TCA) we provide.”

As part of the operation of dark liquidity pools, most brokers conduct extensive monitoring of the trading activity, according to the panelists. "We have a number of real-time, anti-gaming protections and scrutinize every trade to see what is being done," says Galinov.

Since dark pools match at the National Best Bid and Offer (NBBO), large illiquid stocks are closely tracked. "We look to see if there is a [small] trade in the visible market that may move the NBBO and take advantage of the order in the dark liquidity pool," he explains. When Credit Suisse finds a pattern that could indicate gaming activity, its system generates an alert. "Once the program finds it then a human eye is watching it," Galinov adds.

Redeeming IoIs
Although indications of interest (IoIs) have gained a bad reputation recently, panelists say IoIs are a necessary mechanism in the marketplace to move block orders.

"It's the glue for a fragmented market," says D.E. Shaw's Spenser. "In the past there was not full disclosure around who was using IoIs. People were surprised about the practices in the market."

"Now, brokers are stating that they never ‘IoI out' and we prefer brokers don't use IoIs," says panelist Dmitry Rakhlin, head of quantitative trading at Alliance Bernstein. "IoIs can potentially be abused and that is why regulators are talking about making them quotes."

But do IoIs contribute to information leakage? Panelists say every action contributes to information leakage and that IoIs do not contribute more than any other actions. IoIs, they add, are a much better mechanism than flash quotes.

"With IoIs, there is a consequence," says Credit Suisse's Galinov. "If the recipient is not well-behaved, they will lose the business."