Dark Pools: Fragmentation Without Innovation

By: Jim Ross

File Under: MatchPoint, NYSE Euronext

• 3 Comments
• Email Entry

When the Securities and Exchange Commission wrote Reg. National Market System (NMS), they highlighted the importance of "competition between markets" as a way to foster innovation which would thus help "minimize" transactions costs for investors. Yet today we find a marketplace awash in alternative trading system (ATS) business models competing on the basis of liquidity, speed and rates rather than dark-order innovation and quality of execution. Sure there are a bunch of ways to commercialize existing internal liquidity or pricing schemes to attract new order flow, but most dark pools are pretty much the same. All are anonymous and their primary innovation focus seems to be concessions on order opacity to improve their hit rate. It is not a quality-of-execution strategy but a quantity-of-execution strategy.

This lack of quality innovation is not just an interesting sidebar; it has profound consequences for the investor and our marketplace.

If we reflect on our old friend the “transaction cost iceberg” it is clear that fees and spreads are just the visible tip of the iceberg. Underneath the "waterline" are the hidden transactions costs of market impact, execution delay, information leakage, price drift or slippage and gaming. It is these hidden costs not the visible ones that threaten to sink the investor's "ship" and the ultimate irony is that the SEC’s “competition between markets” philosophy adopted by the ATS marketplace has actually increased rather than decreased transaction costs for investors.

Clearly some of the blame falls on the ATS industry's commercially driven focus on the quantity strategy (visible costs) as opposed to the quality strategy (hidden costs). We seem more eager to find new ways of making a dark order more visible (and executable) and yet still call it dark than to actually create new ways to control information leakage or reduce execution delay. Just look at the ATS average trade size, the growth of dark algorithms, rebate models, indications of interest (IOIs) and routing out.

And to compound this problem there is the fragmentation caused by so many competing dark pools and their collective effect on liquidity. Investors are forced to probe, ping, IOI, slice and dice their way through 50+ competing and independent dark pools. By the time they complete their order, delay has eroded their investment alpha and thousands of trades to the tape have betrayed their valuable order and trading-strategy information. Whatever intrinsic value that may be found in each individual dark pool, it is forfeited (and then some) by the hidden costs arising from the over-serviced ATS marketplace.

Interestingly, the solution to the ATS fragmentation problem and the way to effectively reduce transactions costs for investors will be found not through dark-pool competition but through exchange neutrality. Rather than fragment liquidity through competition, an exchange facility as a neutral business and trading environment can bring competing brokers together and aggregate liquidity for everyone's benefit.

The power of neutrality can be seen through the dramatic rise of the pioneers in the ATS industry; the electronic agency brokers. They used their agency neutrality as a primary way to attract liquidity. But of course, as agency brokers their neutrality begins and ends with "best efforts" execution. As they have gotten bigger, they have become more of a competitor to other brokers than a neutral destination.

But, exchange facilities like NYSE's MatchPoint and the soon-to-be-launched New York Block Exchange, using neutrality as a core principle, represent the next and possibly final chapter of the ATS revolution.

Supported by published rules governing fairness and operational transparency, global infrastructure, and a robust surveillance and enforcement effort, these neutral exchange facilities are a perfect blend of dark-order innovation and exchange neutrality. A winning combination for all investors.

The author is vice president of NYSE MatchPoint and ATS Strategy, NYSE Euronext.