Of Note:

When buyers and sellers want to shield an order from the public, they use dark pools of liquidity. These off-exchange
venues are growing in Canada, leading to questions about opportunity and control

Institutional investors can use them to make big trades without tipping their hand.

Canada can expect more dark pools. U.S. provider Instinet Inc. plans to open two this year.


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News from globeandmail.com
Do we know the power of the dark side?

Tuesday, February 8, 2011


NICK ROCKEL
Special to The Globe and Mail

Robert Young admits so-called dark pools of liquidity are saddled with an unfortunate moniker.

"'Satanic Evil Empire' might have worked better," jokes the managing director of Liquidnet Canada, one of two Canadian dark pools. "It's not the best of names, but I don't think we get to re-choose it now."

Popular in the United States but only now making inroads in Canada, dark pools are off-exchange trading venues that allow buyers and sellers to shield an order from the public or displayed markets until it gets filled and printed. Institutional investors can use them to make big trades without tipping their hand.

Canadian investors are starting to wade into dark pools - partly because regulators here and abroad have begun to distinguish between good and bad ones, Mr. Young says. "In the U.S. and Europe, we're seeing people who drive the process; go out there and say, 'We recognize that not all dark pools are equal, but there are some dark pools that create benefit.'"

Canada can expect more dark pools. U.S. provider Instinet Inc. plans to open two this year. Like their U.S. counterparts, Canadian stock exchanges are joining the race too by offering so-called dark order types. With the nation's regulators mulling new rules for dark liquidity, the big question is how closely our dark market structure will mirror that of the U.S.

South of the border, dark pools and exchange-based dark orders have multiplied rapidly since 2007, when they accounted for just 3 per cent of equity trading volume. In December, their market share was 16.7 per cent, according to New York-based Rosenblatt Securities. By comparison, only about 2 per cent of Canadian equity trading happens in the dark. And while Canada is home to just a pair of dark pools, the U.S. has more than 40.

Dark pools fall into two main categories. The first are called crossing networks, like New York-based agency-broker Liquidnet, which opened its Canadian branch in 2006. These pools specialize in institutional-size trades as big as several hundred thousand shares. Liquidnet's members are buy-side-only, Mr. Young explains. "All we do is large-block trading for pension and mutual fund holders."

The second category handles trades of just a few hundred shares. Frequented by institutional and retail clients, they account for the bulk of activity in U.S. dark pools. Many operators of dark pools use them to keep trades to themselves, a practice known as internalization.

Match Now, Canada's other dark pool, is operated by TriAct Canada Marketplace, a subsidiary of New York brokerage Investment Technology Group (ITG). Ian Williams, ITG Canada's head of trading, notes that as much as 90 per cent of Match Now's business is institutional. But unlike Liquidnet, he says, the pool is open to everyone. "Match Now combines the retail plus the institutional trader."

Where two Liquidnet members negotiate an order execution, Match Now uses an algorithm to match orders.

Another difference between the two pools is order size. While Liquidnet's average trade in the fourth quarter of 2010 was 67,000 shares, Mr. Williams pegs Match Now's at 600 to 700.

As Canadian regulators scrutinize dark liquidity, order size is a sticking point. For the past two years, the Canadian Securities Administrators and the Investment Industry Regulatory Organization of Canada have been seeking opinions on a regulatory framework for dark pools and dark orders.

In a November, 2010 position paper, the two bodies recommended that orders be exempt from pre-trade transparency only if they meet a still-unspecified minimum size. The regulators also proposed that in some cases, dark orders should provide a "meaningful" price improvement of one trading increment over the national best bid and offer.

Another recommendation: At the same price on the same market, visible orders should execute before dark ones.

Katie Walmsley, president of the Toronto-based Portfolio Management Association of Canada, praises the two regulatory bodies for acknowledging the importance of dark pools. "They're recognizing that there is a need for them, and that the basic need is [from] larger asset managers when they have large-volume trades."

Still, order size is the subject of much debate. Greg Mills, head of global equity sales and trading at RBC Dominion Securities Inc., wants minimum order sizes for certain dark pool users to discourage them from gaming its institutional clients.

For example, a high-frequency trader might go "fishing" in a dark pool by dispatching small sell orders for a particular stock. If the gamer keeps getting orders filled, it's a sign that there's a large buy order resting in the pool. He or she can then bump up the stock price by purchasing shares on the public market. The next step is to send a big sell order to the dark pool and unload those shares at a premium on the original purchase price.

"Either HFTs [high-frequency traders] or people running other types of strategies are out there trying to expose the large institutional order to in some way get ahead of it," Mr. Mills says.

Noting that Match Now users have the option to set a minimum order size, ITG Canada's Mr. Williams doesn't think the regulators will impose new rules. In any case, he argues, doing so would mandate information leakage from dark pools. "If you know there's a minimum order size in there and you get fills for 400 shares, you as a user know the size of the other order."

For Mr. Williams, the central issue is internalization: Will Canada follow the lead of the U.S., where dark pools can trade at the national best bid and offer? "If a dark market can step in front of visible orders and internalize order flow, then it further fragments the market, and the incentive to post bids and offers on the exchange for price discovery is greatly diminished."

Judging from what just happened to Alpha Trading Systems Ltd., Canadian regulators don't favour internalization. Canada's largest alternative trading system, Alpha is owned by nine major financial institutions including RBC Dominion Securities.

Last December, the Ontario Securities Commission rejected its proposed Alpha IntraSpread Facility on the grounds that it would deny access to dealers outside the ownership group. Alpha has since floated a revised proposal.

Meanwhile, Toronto Stock Exchange owner TMX Group will launch two dark order types next month. Robert Fotheringham, senior vice-president of trading, says TMX eliminates market fragmentation by having its new non-displayed orders interact with the country's biggest liquidity pool. "That integrated aspect of our offering, as opposed to having a different standalone dark pool, ... will be a big differentiator for us."

Kevin Sampson, TMX's director of product development, believes regulators are moving in the right direction. Given the comparatively limited liquidity of the Canadian market, though, he doubts that dark pools will ever become as widespread here as in the U.S.

RBC's Mr. Mills agrees, predicting that Canadians will be cautious about dark pools. "They'll understand if there's a benefit in protecting anonymity and managing market-impact costs, and if there's a benefit to price discovery, they'll use it," he adds. "If there's not, these [pools] will become orphaned very quickly."


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INTO THE DARK POOL

2

Number of dark pools in Canada (Liquidnet Canada and Match Now)



40+

Number of dark pools in the United States



2%

Proportion of Canadian equity trading volume held by dark pools and dark orders



16.7%

Share of U.S. trading volume held by dark pools and dark orders (December, 2010)



67,000

Number of shares in an average Liquidnet Canada trade (fourth quarter of 2010)



600 to 700

Number of shares in an average Match Now trade




Sources: Liquidnet Canada, ITG Canada, Rosenblatt Securities

Nick Rockel



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GLOSSARY

Dark pool:
An off-exchange marketplace that offers no pre-trade transparency.


Dark order:
An order on any marketplace that is entered with no pre-trade transparency.


Indication of interest:
Messages sent from a marketplace that contain information about resting orders. They may include symbol, size and/or price.



Liquidity-seeking orders:
"Active" orders passing through a dark pool on the way to another marketplace, or interacting with liquidity on a transparent market-place.


Smart order router:
A tool that scans multiple marketplaces for the best displayed price and then routes orders to that marketplace for execution.

Source: Canadian Securities Administrators and the Investment Industry Regulatory Organization of Canada

Nick Rockel



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