May 8, 2008

Boom in 'Dark Pool' Trading Networks
Is Causing Headaches on Wall Street

By SCOTT PATTERSON and AARON LUCCHETTI
May 8, 2008; Page C1

When Cheryl Cargie, head trader at Ariel Investments LLC in Chicago, decided last month to buy 1.3 million shares of a midcap stock listed on the New York Stock Exchange, she spread orders among several "dark pools," the secretive electronic trading networks that match buyers and sellers anonymously.

The pools are booming in popularity as big institutional investors look for ways to trade blocks of stock without triggering ripples in the share price, as can happen on traditional stock markets such as the NYSE and Nasdaq Stock Market. But all that darkness is causing nightmares on Wall Street.

At the price Ms. Cargie was willing to pay, dark pools found sellers for only about 100,000 of her shares. The reason: So many dark pools have popped up that using them is increasingly frustrating and time-consuming. Users often have to "ping" numerous pools with small chunks of shares, which still can result in failing to make a trade at all.

"The market has become so fragmented, it's hard to find those big blocks," Ms. Cargie says.

Forty-two such U.S. trading networks now are competing for orders, up from seven dark pools five years ago, according to Tabb Group, a Westborough, Mass., research firm. Large brokerage firms, trading boutiques and even stock exchanges have designed systems that allow shares to be bought and sold out of the sight of prying eyes.

Dark pools "are helpful to investors to try to get block liquidity done," Duncan Niederauer, chief executive of NYSE Euronext, said last month, but "there's just too many of them." Nevertheless, theNYSE's parent will soon launch a joint venture with New York broker dealer BIDS Holdings LP in which orders from the two companies will interact in a dark pool.

There is no doubt that pension funds, mutual funds, hedge funds and many other big institutional investors are as eager as ever to buy and sell blocks of stock without pushing prices around. As a result, dark pools now account for about 10% of daily trading volume in the U.S., Tabb estimates, up from less than 1% in 2003.

Securities firms and their clients are expected to direct about 20% of their stock orders to dark pools by 2010, up from 17% this year, according to Boston consulting firm Aite Group LLC. The largest pool operators include Liquidnet Holdings Inc. and Posit, owned by Investment Technology Group Inc.

But dark pools haven't done much to stop order sizes from tumbling overall, the very problem they were created to address. The average trade was just 260 shares at the beginning of 2008, according to consulting firm TowerGroup. A decade ago, trades averaged 1,400 shares.

In a dark pool, investors indicate their interest and either negotiate with a counterparty or get matched with one by the dark pool. Many investors put up with the confusion of using the pools and the declining order sizes on some because the trades on dark pools can still be much bigger -- from a few thousand shares to tens of thousands at a time -- than those done on public exchanges.

A separate problem: Wily customers are using computer programs and advanced algorithms to search for buying and selling patterns in dark-pool stocks. Since large blocks of stock tend to push prices higher or lower, knowing that information ahead of most other traders can be highly profitable.

Seth Merrin, Liquidnet's CEO, says the dark pool has kicked out customers for using such tactics. "They weren't playing according to the rules," he says.

The headaches are likely to force some order into the chaos of dark pools. Erik Sirri, director of trading and markets for the Securities and Exchange Commission, which has been monitoring the pools, predicted in a February speech that dissatisfied customers will "pressure operators of the pools...either to consolidate with other pools or to cooperate with dark-pool aggregators."

Dark-pool aggregators attempt to offer institutional investors a one-stop shop linked to other dark pools, much like Internet search engines. OnePipe, a four-month-old aggregator launched by a joint venture between brokerage firm Weeden & Co., of Greenwich, Conn, and Pragma Financial Systems, a New York financial-software provider, provides access to more than 25 dark pools.

Liquidnet's H20 dark pool is open to outside orders. And most brokerages with dark pools provide access to other pools, though they usually attempt to cross orders within their own system first.

This week, the Nasdaq Stock Market will start routing orders to a number of "dark pools." This will allow Nasdaq to participate in trades that otherwise might have left its market.

Lawrence Leibowitz, head of U.S. markets at NYSE Euronext, says the NYSE, through its BIDS joint venture, might eventually link to other dark pools or allow brokers on the exchange floor to interact with the dark-pool venture using hand-held computers. The exchange company's NYSE Arca division also recently started routing some orders to dark pools.

"A shake-up is going to happen in the next six to 18 months, and there will be some very serious jockeying for position," says Rob Hegarty, managing director at TowerGroup.

Write to Scott Patterson at scott.patterson@wsj.com³ and Aaron Lucchetti at aaron.lucchetti@wsj.com