CHAPTER 5

Dark Pool Liquidity and Alternative Trading Systems

To publicly display liquidity (the bids and offers posted by liquidity providers and shown on a Level 2 quote) is, naturally, to show one's hand to every other market participant. While there are situations in which some institutions may feel free to do this for one reason or another, it's typically not a good idea for an institution or hedge fund to display a large block since every other participant in the market can take advantage of the situation.

It would be disadvantageous to the large seller, as well as to others with long positions on the same asset, to show that they intend to unload a large amount of the asset as the rest of the market will immediately react and all or part of the seller's shares will end up transacting at a much lower price.

This is the primary reason for the existence of dark pools (alternative trading systems for hidden liquidity). Dark pool transactions (after a transaction has been completed) must be reported just as any other transaction must be. However, prior to execution, they are not publicly displayed. Their function is similar to hidden orders on the ECN systems except the actual order matching algorithms tend to be a completely different beast. Each dark pool is designed to offer big institutional traders, such as large hedge funds, unique benefits but is typically not time-price priority like the majority of ECN systems.

NYFix MILLENNIUM ATS

The Millennium Alternative Trading System was one of the first dark pool venues used by the first generation of dark pool traders at Swift Trade Securities. The system itself was touted by its operators, NYFix, as having been designed to maximize execution quality, reduce overall transaction costs, and minimize market impact for large traders and institutional market participants. The idea of Millennium was to combine the type of electronic order matching technology used by traditional ECN systems such as Arca and Island with access to dark liquidity.

When Millennium ATS was originally launched, it employed a network of primary exchanges and regional exchanges and offered its own advantage: a real-time order matching algorithm that executed trades at or better than the national best bid and offer.

An order type typically available on Millennium ATS is the stealth order, which passively posts an order using the NYFix Heat Map to split the total share size of the order down into smaller parts and attempts to fill against any dark liquidity showing the most volume at any given time. This allows large traders to effectively seek out dark liquidity.

CREDIT SUISSE CROSS FINDER

One of the most popular dark palgorithmic routes available on many direct access trading platforms is Cross Finder by Credit Suisse Advanced Execution Services, also known as X-Finder on some trading software.

Orders sent to Cross Finder should include a limit price, which may or may not be outside of the NBBO. The main function of Cross Finder is to seek dark liquidity at all prices up to your limit price by scanning Credit Suisse's network of independent as well as broker-owned dark liquidity venues. Cross Finder orders can also be pegged to the midpoint of the NBBO so that orders will only be matched (and executed) at the midpoint price or better.

An alternate order type, called Aggressive Cross Finder (also known as AX-Finder or Cross Finder +) is available; it has the same algorithm except it also scans the publicly displayed venues in addition to the dark liquidity venues to execute your order. Like the normal Cross Finder, it only matches at your specified limit price or better.

GETCO EXECUTION SERVICES ATS

GETCO is one of the largest proprietary trading firms of its kind and also a registered market maker in the U.S. equity markets. The GETCO Execution Services ATS is a large dark liquidity venue created by the company to offer algorithmic execution of orders against nondisplayed liquidity. The system provides IOC (Immediate or Cancel) orders and typically charges a flat fee.

KNIGHT CAPITAL GROUP'S DARK POOL ROUTES

Knight Capital Group, which had also been an instrumental part of the Direct Edge exchange's history, offers a selection of algorithmic dark liquidity seeking routes available on most direct access trading platforms.

Knight FAN (also known as NITEFAN): FAN is an algorithmic strategy offered by Knight Capital Group's Algorithmic Suite. FAN aggregates public and dark liquidity so that a trader's orders will sweep and post simultaneously to both types of venues for efficient order execution. Using Knight's smart order execution algorithm, FAN adapts to real-time trade executions and recirculates an order to the destinations where recent trade volume had taken place to optimize the chances of filling the order.

Knight COVERT: COVERT is a dark liquidity-only version of the FAN algorithm, and is also part of Knight Capital Group's Algorithmic Suite. Like FAN, COVERT also sweeps and posts to multiple venues using Knight's smart order execution algorithm, which considers recent trade volumes. The main differences is that while FAN will interact with both displayed and non-displayed liquidity venues, COVERT will only interact with dark (non-displayed) venues such as dark pools. COVERT is more likely to be used when avoiding the potential of exposing your trade size is a greater priority than getting your order filled as quickly and efficiently as possible. (FAN, on the other hand, would be the better choice to a large-sized trader if execution is a greater priority than anonymity.)

Knight Match ATS: Knight Match is a registered Alternative Trading System (ATS) offered by Knight Capital Group. It provides large traders with access to dark liquidity with a particular specialty in micro, small, and mid-capitalization stocks. Knight Match ATS is unique in that it provides access to order flow from Knight's retail broker-dealer clients with anonymous execution and opportunities for price improvement.

LEVEL ATS

Level ATS was created by eBX LLC, a joint venture of Citigroup, Credit Suisse, Fidelity Capital Markets, Lehman Brothers, and Merrill Lynch, and operates as a leading independent dark pool in the U.S. equity markets.

Order types on Level ATS include resting orders, IOC (immediate or cancel), and SmartBlock orders that allow traders to control the rate of execution if the stock moves away from the price.

GOLDMAN SACHS SIGMA X

SIGMA X is one of the largest dark pool systems in the U.S. equity markets and is connected to a large network of Goldman Sachs' customers as well as external liquidity providers. It allows traders to provide as well as remove liquidity from the infrastructure of Goldman Sachs, one of the world's largest bulge bracket investment banks.

* * *

From the standpoint of a smaller trader (small in comparison to a hedge fund or HFT operation transacting on the scale of hundreds of millions in capital and allocating a percentage of it to the market that you are currently trading), remember that bids and asks (limit orders resting at the market centers) can be canceled at any time, so it's also possible that many market participants do not actually hope to get the entire displayed size filled when placing these orders. They may also be hoping to get far more shares filled than the number displayed. It's essential to be aware of this because the Level 2 quote can often be manipulated at times to some degree, and can also be misleading since there is a wide variety of trading strategies that result in the total numbers shown. Not everyone is playing the same game, whether they are humans on keyboards or computer algorithms created by humans on keyboards at an earlier time. Also, many hedge funds and institutions tend to split their orders between different destinations to hide their real hand at any given time even if they use the public venues for their transaction.

Dark pools and hidden ECN orders—not to mention the ability to cancel a displayed ECN order in real time—are among the reasons why the Level 2 quote by itself is not a very reliable source of information about the near-future bias of the stock. They do, however, tell a story of their own: In some cases, large players might show their hand for a specific reason. (In some cases, it's better to read the other market participants' intentions, not the literal picture they are showing you, to better make use of the Level 2 quotes.)

While there are exceptions (on many of the most liquid stocks, during the most active trading hours, it's not too difficult to see where the pressure is), the rule of thumb is to combine the Level 2 quotes with the Time & Sales.

Unlike displayed quotes, the tape will not lie.