(Bloomberg) — Wall Street’s infamous dark pools are getting even darker.
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A decade after being engulfed by a controversy that culminated in multiple enforcement actions and a regulator clampdown, these off-exchange trading platforms are touting a way to buy and sell stocks that’s even more opaque.
They’re offering what are dubbed private rooms, gated venues that take the core benefit of a dark pool — the ability to hide big equity deals so they won’t impact prices — and add exclusivity, specifying exactly who can partake in any trade.
Created within the dark pools themselves, the rooms are independent from one another and each is invisible to anyone not invited, raising questions about both market transparency and fragmentation. But with more than half of all US stock trading now happening away from public exchanges, they’re in high demand from firms eager to choose whom they do business with, often to help them carry out individual orders more efficiently.
“It’s like shopping when you know exactly the item you want, and who and where you are buying or selling it from, instead of going to Walmart on Black Friday,” says David Cannizzo, the head of electronic trading at Raymond James and Associates. “You’re controlling the terms of engagement.”
Right now, it’s impossible to say how many private rooms exist, or how much activity is moving through them. Companies operating alternative trading systems, or ATS — the formal term for dark pools — say it’s a minority of their volumes at present, since the growth in demand is a relatively new phenomenon.
But they’re seeing rapid adoption by everyone from broker-dealers and market makers to hedge funds and asset managers, so much so that private-room volumes at one major ATS — Stamford, Connecticut-based IntelligentCross — now eclipse the total trading activity at nine rival dark-pool operators.
Dark pools are so-called because the trades they handle happen away from the “lit” public exchange. That helps prevent order details leaking to the broader market and triggering adverse price moves before they can be executed. But there’s still a downside: a pool is open to anyone, and firms inside never know who their counterparty is in any trade. Private rooms can be even more discreet.
“It’s about exercising control, what liquidity a broker wants to interact with to achieve better execution quality,” says Roman Ginis, CEO of Imperative Execution, the parent company of IntelligentCross.
There are myriad reasons why users may opt for private rooms. Take the case of CastleOak Securities, a New York-based minority-run brokerage. The firm wants to trade with similarly minded businesses, so it uses a private room provided by the ATS operator OneChronos.
“It’s about exercising control, what liquidity a broker wants to interact with”
Carlos Cabana, head of equity sales and trading at CastleOak, dubs the room a “diversity pool,” because the participants are all minority-operated brokerage firms. While in this instance CastleOak doesn’t know specifically who is on the other side of every trade, it knows it will be one of about 10 counterparties who meet certain eligibility criteria related to ownership and investment goals.
“Think of it as an apartment that’s hosting a party, and there’s one purpose for the party with only invited guests,” says Cabana.
Thanks to CastleOak’s increasing use of the diversity pool, OneChronos is now its third most-used trading venue, behind only the New York Stock Exchange and Nasdaq, Cabana says.
Execution Excellence
Private rooms are known by a slew of other names including hosted pools, restricted-access rooms, ATS pools, and custom counterparty groups. They’re gaining popularity in the huge, ultra-fast modern market as a way to help firms avoid losing out against players who may be able to move quicker or who have access to superior information.
For instance, many brokers and market makers are keen to take the other side of retail investor orders. Those small, less volatile trades are generally unlikely to impact prices — so a market maker won’t see an adverse move occur the instant it agrees to fill an order, as might happen with another type of counterparty.
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Brokers who take orders to private rooms typically expect to fill the order at the midpoint of the national-best-bid and offer, or NBBO (assuming the rule of the room is set up that way, which is usually the case). If for some reason the order is not filled in the room at the midpoint, it can move to the broader ATS where multiple other parties can compete to fill it. And if a broker has bad experiences with a private room, they can change to another in the future, avoiding those counterparties.
“The problem we have is, how do we identify good versus bad liquidity?” says Jatin Suryawanshi, global head of quant strategy at Jefferies, who estimates that 15 in every 100 shares executed by the firm’s algorithms currently move via a room. “In using private rooms, you can prioritize who you want to interact with.”
Private room growth has accelerated amid the migration of stock trading away from public exchanges and as their use has become more common. They emerged at the ATS firm LeveL as far back as 18 years ago. LeveL started by allowing firms to match their own orders, in what’s known as internalization. That expanded to other forms of segmentation, including bi-lateral and multi-lateral agreements, where one party agrees to trade with another, or multiple parties agree to only interact with each other, within the same ATS.
Following requests from its own clients, IntelligentCross started offering its version of private rooms about a year-and-a-half ago, and OneChronos joined the party last year.
Private rooms are not generally needed by big banks or brokers who have the resources to create their own ATS or what are called single-dealer platforms. That’s another breed of off-exchange trading venue where the operator is always the counterparty to any trade.
But for smaller players, it’s too expensive and cumbersome to build and manage an ATS or SDP, meet the associated regulatory reporting requirements and set up the necessary connections. Arranging a private room at an established ATS is a solution.
“There are various factors of why a firm would want to outsource this activity than keep it in house,” says Steve Miele, CEO of Kezar Markets, the parent of LeveL. “It could be a cost, an overhead they don’t necessarily have to take on if we can build it, then scale it” using the existing network, he says. “We lower the barrier to entry.”
At IntelligentCross, the majority of rooms currently offered serve institutional brokers that don’t have capacity to conduct similar activities internally. Jefferies trades in a private room provided by the firm where it interacts with seven other brokers who don’t have their own ATS, but have institutional orders, according to Suryawanshi.
“These are always created at the request of a subscriber, who is the host that invites others to be guests in their book,” says Ginis at Imperative Execution.
Dark Disclosure
Not every ATS is rushing to embrace private rooms. New York-based PureStream offers “pools” that operate like rooms, but they are disclosed to all subscribers if they are created, and anyone can join. In essence, the room is open to all.
So far no one has asked to set up a pool at PureStream, so there is zero volume in so-called sub-pools, according to CEO Armando Diaz. He says offering a private room that isn’t open to all subscribers raises questions about the regulation. “The more the host controls the room, the more they are operating an ATS, and that opens up regulatory risk,” he says.
Perhaps the biggest criticism of private rooms is that they create phantom liquidity, because transactions taking place inside a room are simply lumped in with the total activity reported by its dark pool parent. That creates a misleading picture for anyone trying to gauge market depth, since reported trading volumes include activity not available to those outside the room.
ATS are regulated trading venues, overseen by the Securities and Exchange Commission, which in 2018 enhanced its supervision of such venues by imposing new disclosure requirements. Each dark pool must now file a form, ATS-N, which gives an overview about the specific trading mechanisms on its platform.
These publicly available forms go into various details, including whether private rooms are available. But they don’t say how many exist or who is in them, and the varying language and levels of disclosure used mean it can sometimes be difficult to determine if an ATS is even hosting any rooms.Wall Street Dark Pools to Come Out of Shadows Thanks to SEC
“There are no rules to force ATS to break out the identity of single-dealer rooms or their volume,” Larry Tabb, head of market structure at Bloomberg Intelligence, wrote in a May note. The Financial Industry Regulatory Authority “does a good job of ATS volume reporting on a post-execution basis. Yet there are no rules to aid analysts or users looking to break down the percentage of ATS volume executed in the open pool vs. the private room, or the volume executed using segmentation strategies,” he wrote.
“It’s about exercising control, what liquidity a broker wants to interact with”
Dark pools are no strangers to transparency worries. Their opacity provoked extensive media coverage and regulatory scrutiny about a decade ago amid speculation they gave high-frequency firms advantages against other investors — attention partly prompted by the bestselling book Flash Boys.
Representatives for both Finra and the SEC declined to comment.
‘Growth Mode’
For their users, private rooms are a handy tool, but still one of a set. Hosted pools represent a single-digit percentage of IntelligentCross’s overall volumes for now — an average of about 5.4% last year — because they’re so new, according to Ginis. “It will take brokers some time to optimize for this,” he says.
CEO of OneChronos Capital Markets Vlad Khandros says its rooms represent less than 5% of volume at present as “it’s newer for us, so it’s still in growth mode.” But demand is strong. “We’ve seen increased interest from both retail and institutional brokers,” Khandros says. “The focus on execution quality will continue to grow.”
LeveL declined to disclose the number of rooms it operates or how much activity takes place in them, with Miele saying the absence of industry-wide criteria for categorizing rooms means it could be “misleading to quantify.”
Mark Gurliacci, senior vice president and senior quantitative trader at AllianceBernstein, reckons up to 75% of the firm’s activity is now happening off-exchange, including in private rooms. While the latter is a small slice of their trading at present, he thinks it’s set to grow.
“Many firms are setting up private rooms these days,” says Gurliacci, who used to work for the NYSE. “They are innovative, and here to stay. There is more going on there than most people know.”
–With assistance from Lydia Beyoud.
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