US MARKET STRUCTURE SOLUTIONS

Shedding Light on Dark Pools

Reserves of liquidity — known as dark pools — are becoming increasingly popular
December 2007

Highlights

  • Dark pools are similar to what the NYSE was before it became an automated market
  • Anonymity provided by dark pools allows more control over order information, minimizes the impact of large orders, and prevents reverse engineering of trading strategies
  • Dark pools offer flexibility to customers and are particularly popular with brokers who use computer-executed strategies
  • Orders can be routed to a dark pool directly or through an algorithm; the pools combine resident and transient orders to generate matches
  • There are four types of dark pools: independent platforms, broker-dealer internal matching engines, consortium-led pools, and exchange-crossing networks (figure 1)
  • With Liquidity Cross (LX), Lehman became the first investment bank to offer a direct-to-dark-access tool

In seeking optimal order execution in today's market, one of the biggest challenges brokers face is accessing liquidity on behalf of their customers. With an increased risk of market making, specialists and traditional liquidity providers have sought to reduce exposure by reducing quote size, which has resulted in less liquid and deep markets, more price volatility, and reduced opportunities for price improvement.

The need to minimize the negative impact of trading in a fragmented market has led to a demand for tradingClick to enlarge image strategies and execution venues that preserve anonymity. Dark pools — platforms that facilitate executions of, but do not publicly display, the orders or indications of interest they receive — address the liquidity and anonymity concerns of customers and are becoming increasingly popular.