What are dark pools of liquidity and internal crossing networks?
Robert Hogan
Head of Client Trading
Deutsche Securities, Tokyo
June 20, 2007
Note: Of late, we have received a lot of requests from our readers to post articles in different areas within the discipline of algorithmic trading and agency execution. One such area, which is quite topical, is liquidity pools and internal crossing networks. We requested Robert Hogan, an expert in the area of Algo and quant trading, to explain the concept to our readers. Here is his explanation.
The importance of liquidity sources outside of exchanges is rapidly increasing. This trend is well formed in the U.S. and Europe . In Asia this is more of a future direction than a present reality. The term "dark liquidity pools" or simply "dark pools" refers to trading venues that give investors the opportunity to transact large blocks of stock but are fundamentally different from exchanges in two key areas:
- they do not publish any quotes or other indications of supply and demand. In this sense they are "dark".
- they rely on the price discovery mechanism of exchanges and alternative trading systems to set their price levels. Some pools allow crossing at the current mid-price or last trade. A few allow limited negotiation among parties to determine price, but fundamentally there is no auction or similar multi way mechanism to discover price.
Institutional investors are finding dark pools to be a very attractive means to transact large blocks because they do not need to be concerned about expressing to the market their large supply or demand in names where the knowledge of their order potentially would move the market. Dark pools of liquidity have become the modern electronic equivalent of the up-stairs market where large blocks can be moved quickly and efficiently.
A form of dark pool that operates within the flow of a single broker dealer is often described as an "internal crossing network" or even simply "internalization". This concept is explicitly recognized in the MiFiD regulations which impose best execution standards on financial institutions in Europe later this year. The language of MiFiD makes reference to SIs or "systematic internalizers" which essentially means "financial institutions that operate systematic means to continuously perform internalization on their orders".
Once again institutional investors are generally positive on this development as it presents the opportunity to achieve price improvement and reduce exchange fees.
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