Institutional Investor's Alpha Magazine - July/August 2008 - (Page 54)

“We don’t allow fast money,” says Alfred Eskandar, head of corporate strategy for dark pool provider Liquidnet. the dark side may be susceptible to information leakage, which other traders can proﬁt from. A former securities lawyer who was a vice president in the equities division of Salomon Smith Barney, Gawronski says the challenge for traders who want to use dark pools is to comprehend what they are getting into. They must determine which pools offer the most liquidity for speciﬁc stocks, what information is shared with other traders and what security measures are in place to protect information. And they must understand how the software they use accesses dark pools. “People need to ask which pools are meaningful,” Gawronski says. “Which tools can I employ that will keep me from getting hurt? Do I need a dark pool aggregator [which connects to various pools], and if so, which one? Can I manage the effort myself, and does my order management system connect to the pools I need most? If you want to play in this complex world, you better understand all the tools and all the tricks of the trade.” Indeed, trading in dark pools today is much different than it was at the start of the decade. The original dark pools were straightforward off-exchange electronic trading venues for large blocks of stock — members-only sites where asset managers could meet anonymously to execute big trades. Brokerage ﬁrms and other, independent, pool operators worked to keep secret the identity of players and what stocks were being traded. If someone offering a block matched up with someone wanting to buy the same stock, they struck a deal at a price based on the exchangelisted price of the shares. It seemed the perfect solution for block trades: quiet, discreet and effective. And unlike algorithms that cut up big blocks into small orders that could be slowly sprinkled into the market, dark pools allowed traders to buy and sell big chunks of stock quickly and anonymously. One of the earliest dark pool providers was New York– based Liquidnet, which launched in 2001 and remains the dominant player in big block trades. According to a recent Rosenblatt report, Liquidnet has an average trade size of 52,600 shares. Its closest competitor is New York– based Pipeline Trading Systems, with an average trade size of 46,000 shares. “We have members who trade million-share blocks, but they never know who they trade with,” says Alfred Eskandar, head of corporate strategy for Liquidnet. The Liquidnet pool is an exclusive trading club with 514 carefully screened buy-side members (including about 100 hedge funds) who can trade only with one another. Each candidate has to demonstrate the ability to trade big blocks. To prevent ﬁ shing for information in the pool, Liquidnet requires members to act on one of every two matched opportunities or risk losing their membership. “We are pretty strict,” Eskandar says. “We don’t allow fast money or day trading ﬁrms.” In 2005, Liquidnet branched out with a new venue called H2O, which connects to some outside pools and allows smaller trades than did the original Liquidnet market. H2O is one of several new dark pool services that have shrunk the size of trades and greatly expanded access. The group includes pools run by prime brokers that tap their own internal order ﬂow as a source of liquidity and allow algorithmic trading. Most of these newer dark pools have an average trade size of 250 to 500 shares. The proliferation has given rise to new software designed to connect traders to a series of pools. By hopping from pool to pool using these new electronic tools, traders are able to search quickly for liquidity across multiple sources. “If you connect a lot of these dark pools together, you get a greater chance of getting orders ﬁlled before you hit the public market,” says Sang Lee, a managing partner at Aite Group, a Boston-based ﬁnancial research company. “The game now is adding a lot of ﬂexibility for the user.” Dark pool access is now part of trade order management systems and can be adjusted based on which brokers and services are being used. Traders can turn speciﬁc pools on and off, adjust order size, use algorithms and automatically route trades to exchanges after searching for liquidity in dark pools. Thanks to electronic execution, transactions in dark pools are lightning-fast. But hunting for liquidity there can take time, and many traders prefer to stick with display exchanges for high-volume stocks like Microsoft. One dark pool player, a hedge fund trader who asked 54 • INSTITUTIONAL INVESTOR’S ALPHA • JULY/AUGUST 2008

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - July/August 2008

Institutional Investor's Alpha Magazine - July/August 2008 Contents Letter from the Editor Longs & Shorts Pension Corner: Mr. Big Goes Small The Good Guys: Adopt This School! Interview: Man's Great Hope Cover Story: The Gentleman Activist Strategies: The New Bankers Profile: Staying Alive Research Center: The Best of the East The Asian Sensations Alpha Bytes: Into the Light Unhedged: Commentary: Speculating on Washington

Institutional Investor's Alpha Magazine - July/August 2008

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