As recently discussed in a post at Bull Bear Trader, the exchanges were beginning to join up with the operators of the various dark pools of liquidity. Now both the Financial Times and the WSJ are reporting a new union between the London Stock Exchange (LSE) and Lehman Brothers. Per the agreement, the LSE will offer trading of European companies that don't currently list on its exchange, matching buyers and sellers across more than ten European countries. The new service will be based on the Lehman Brothers dark pool trading environment. The multilateral trading platform, called Baikal, is expected to combine algorithmic trading functionality with dark pool liquidity. The venture with Lehman is hoped to allow the LSE to gain exposure into dark pools trading, and get back exchange volume that has been moving to other platforms and environments. According to the Tabb Group, dark pools currently account for about 10% of daily U.S. trading volume.

The recent trends toward dark pools and specialized trading has caused the exchanges to lose out to new electronic trading platforms that are aimed specifically at servicing computer-driven algorithmic traders. Such algorithmic traders are increasing responsible for driving trading volume and providing liquidity. Such threats are causing the margins in the public order books to come under increased pressure. Electronic-based algorithmic trading is also cited for the increase levels of volume and short-term price spikes that are seen in a number of equities and commodities. Unlike in the past, it is not that unusual anymore to see crude oil spike up or down $3-4 in less than an hour as a flood of buying or selling pressure hits the market from electronic orders.

The move to decimalization, with price spreads down to the penny, is also making it difficult for some specialists to create a market that is both profitable and also offers the level of liquidity that is required at each price point. Some market operators are even arguing for going back to larger spreads, such as a nickel, in order to increase the number of shares offered at each price and keep the exchanges in business, but it is doubtful the regulators will allow this. As more market participants use dark pools, the exchanges will look to move more trading volume to this environment due to the cost advantages over the public order books. As a result, the price transparency, increased liquidity, and smaller spreads that decimalization was ironically hoped to provide retail traders is likely to be compromised.

Dark pools of liquidity are back in the news again. See a previous WSJ article, along with two recent posts (here and here) for more background. As reported in a recent Financial Times article, the stock exchanges themselves may now be willing to throw in the towel, and begin looking for ways to work with the dark pools. The reason is obvious. Dark pools currently represent about 12% of all U.S. stock trading, and the exchanges are looking for ways to get this volume back. There is also the implicit admission that dark pools are not a passing fad, given that many of the exchanges are also developing their own dark pool trading environments. In addition to the threat of individual dark pools, of which there are now approximately 40 such pools, the exchanges are also worried that some or all of the individual dark pools currently in existence will get together and form their own exchange. Nothing focuses the business mind like the potential of a new, stronger competitor.

As I have written before, it does not surprise me that such pool of liquidity are developing as more hedge funds (which are also growing in numbers) look for greater trade protection. No one wants to have others front-run you while you are entering or exiting a large position. On the other hand, it is still amazing to me that more traders, investors, regulators, and members of Congress are not more concerned about such pools, or discussing what impact they may be having on price discovery. Not that I welcome such intervention by Congress, but I suspect that after the housing mess, credit concerns, and the reason for high crude oil prices (i.e., speculators) are off Washington's hearing list, dark pools may begin to see a little more light. How this story ends - unfortunately - is probably not that difficult to predict.

The Financial News is reporting how the current methodologies for non-exchange dark pools may be resulting in volumes being reported higher than they should be. Guidelines exist for reporting volume, but there is not a standard way for calculating them. Currently, both the buyer and seller volume are being counted, resulting in a form of double counting. This has been standard practice, but now smart-order routing is causing many sellside brokers and independent pools to count routed volume as well. For instance, by using smart-order routing, an order sent to a dark pool could be matched in the pool, or routed to another dark pool, causing volume to be counted two or three times. When it is match in the second dark pool, it is counted once again, possibly even two more times.

Double counting is often used as a standard practice, many times for no other reason than for marketing purposes in order to show the liquidity offered by a particular dark pool. Nonetheless, not everyone is following the same rules-of-thumb, making it difficult to compare dark pools, and more importantly, get a good read on the real level of trading volume. Some brokerages, such as Merrill Lynch, are choosing to not publish volume data given the industry-wide inconsistencies. To correct the problems, some are reporting both "volume" and "pass through." While using "pass through" to measure routing volume would seem to be an easy fix, it is not quite as simple as it seems given that some pass through trades are "not matched," some or "not eligible for matching," and some are just "touched."

To complicate matters, the exchanges are not free and clear when it comes to dark pools. While the exchanges have seen some trade volume move to the dark pools, and the non-exchange dark pools have generated criticism for their secretive nature, the exchanges are also involved in similar activities. In fact, exchange dark pools not only exist, but have been increasing as the exchanges try to fend off threats from non-exchange dark pools. Approximately 10-20% of consolidated volume occurs on Bats Trading, Nasdaq OMX, and the NYSE Arca exchange-based dark pools. As mentioned by Brian Hyndman, senior vice-president of Nasdaq transaction services: "We have the ability to break our non-displayed liquidity from our displayed liquidity. We are the largest exchange in terms of volume in the US and the largest for non-displayed volume." Such a badge of courage may make Nasdaq investors happy in the short-term, but may also cause problems in the future as regulators begin to look into dark pools and their affects on liquidity and price discovery. Given the recent talk of speculation in the commodities markets, in particular the crude oil markets, any discussion of lack of price discovery, even in a different non-commodity market such as the equity exchanges, may generate un-welcomed attention. The uncovering of increased dark pool activity may be something that not only results in embarrassment, but also causes investors to increase selling volume and execute their own method of price discovery.

There has been a recent resurgence in interest in dark pools of liquidity. No, this is not some Star Wars reference (at least I don't think so), but does refer to a procedure and method of trading that is once again causing some concern on Wall Street. For years, crossing networks have been matching buy and sell orders "off-exchange" in what have been referred to as dark pools of liquidity. The advantage of these pools it that they should make the execution of a large order safe, and allow the two market participants to execute the large order without moving price, while maintaining some privacy. While the amount of dark pool transactions is estimated to be a little over 10% (but including more than 20% of all trades in NYSE-listed stocks), it is continuing to grow as hedge funds look for less transparent ways to sell large positions, and brokerage firms look for more ways to generate trading income and possibly tap into the increase in trading revenue streams that the exchanges have been enjoying over the last few years.

Unfortunately, some are worried that gaming is allowing others to profit from the transaction, and of course potentially leaving one side of the dark pool transaction a little worse off. The problem has gotten significant enough that some are considering no longer using the dark pools, with 60% showing some hesitation. As recently highlighted in a Finanial News article, steps are being taken to tackle the problem, such as putting anti-gaming measures in place at both large and small firms. Steps being used and/or considered include physically monitoring patterns of trade abuse using a human element, using computer algorithms to spot trends, developing fair pricing models, and using anti-gaming logic.

While it is true that it may not always be known exactly what is occurring within the dark pools, it appears as if their operations are simply more organized ways to perform crossing of block trades, with a print of the tape after the transaction is complete. Nonetheless, it is still surprising to me how in the current financial environment that the SEC, other regulators, and some of the exchanges themselves have not spoken more about dark pools, their transparency (or lack of transparency), and the affect this has on price discovery. In fact, it seems to me that given current credit issues, this might not be a something the industry wants to advertise. Yet, this is apparently not stopping some.

As recently reported at the Deal Breaker blog, Goldman Sachs, Morgan Stanley and UBS have agreed to share their dark pools, such that each will allow for the secretive trading to take place between their clients. The dark pools include Goldman Sach's Sigma X, Morgan Stanley's MS POOL, and UBS's PIN ATS. The union further threatens to take business from the exchanges and furthers current consolidation of the brokerage industry. Right now exchanges are at a disadvantage when they try to compete with the dark pools since they are being regulated by the SEC, with new rules being put in place over the last year forcing them to share even more information and route trades to the exchange offering the best price and fastest execution. Dark pools have in many instances been able to avoid regulation by keeping trading volumes under a set threshold.

But again, while this is probably a good move for the financial institutions with regard to generating new business, lowering costs, and helping to tap into the monopolies of the exchanges, it is probably not the most public relations friendly move in the current credit environment. As is often unfortunately the case, this will surely cause some in Congress to start talking of new regulation, especially if someone goes way out on a limb and attempts to tie the practice to home foreclosures or high energy cost - adding a new level of regulation with the usual unintended consequences. If this happens, we may end up wishing that a dark pool of liquidity was truly just a Star War reference.