The ‘dark’ side of order crossing

NEW YORK — Despite the proliferation of "dark books" on Wall Street, institutional investors are in no rush to switch to the bulge-bracket firms from pure agency brokers for the automated crossing of blocks of shares off-market.

No data are available to track the volume handled by two dozen new order-crossing networks that do not display quotes — hence their moniker. But anecdotal evidence indicates a number of these youngsters still lack significant institutional order flow at a time when agency dark books Liquidnet Inc., ITG Inc. and Pipeline Trading LLC keep experiencing volume growth.

Executives at a few Wall Street firms have told analysts their dark books match significant volume, but it is impossible to distinguish whether this comes from institutional orders or from the firms' proprietary trades.

For institutional investors, the slightest risk of information leakage — including after the trade is done — remains a concern despite the Chinese walls that separate a firm's block-matching facility and its proprietary trading desk. For instance, matching 100,000 shares on a Wall Street firm's crossing network could signal to that broker that another batch is waiting in the wings.

Larry Peruzzi, vice president of Boston Co. Asset Management LLC in Boston, said "the information leakage is a major issue."

"The comfort level may not be quite there," he explained. "Brokers are trying to have two products out: proprietary trading and a black box. There are Chinese walls, but for as long as these firms are going to be in both of those businesses, people are going to have their doubts."

For Kevin Callahan, managing director at JonesTrading Institutional Services LLC in New York, an agency broker that does not operate an automated crossing facility, concern about information leakage is heightened by fund managers' greater involvement in all aspects of portfolio performance, from research to execution.

"Institutional investors are handling more and more money. They are investing more and more resources to develop their own portfolio ideas. The last thing they want is to have someone free-riding on their ideas in the marketplace," Mr. Callahan said.

To put such concern to rest, major Wall Street firms that already have their own dark books are setting up crossing network consortia that will operate independently from their founders.

Citigroup Inc., Credit Suisse Group, Fidelity Brokerage Services LLC, Lehman Brothers Inc. and Merrill Lynch & Co. Inc. recently launched LeveL, a dark book that supports multiple strategies but still needs to gain traction.

Citigroup, Lehman and Merrill also are in the Block Interest Discovery Service or BIDS consortium, now in beta testing. BIDS was co-founded with Goldman Sachs Group Inc., Morgan Stanley and UBS AG.

These consortia could provide another benefit: The Employee Retirement Income Security Act bars asset management units of Wall Street firms from using their firm's brokerage arm to trade, an issue that independently operated crossing networks might solve.

Among the Wall Street firms that operate dark books, a few, such as UBS, are attracting significant order flow, according to analysts. Although UBS did not provide specific figures, spokesman Kris Kagel said, "UBS executes more than 400 million shares a day in the United States, nearly half of which is retail. We see crossing as a natural and necessary function of any effective broker, and give our clients access to crossing opportunities through PIN, our liquidity network."

The multiplicity of crossing networks also poses a serious technology challenge tied to finding liquidity in a fragmented market.

Frederic Lexow, head of U.S. equity trading at JPMorgan Asset Management in New York, said: "I want to go where there is the most liquidity," which could be on many different venues at different times because "every trade is an individual event."

Mr. Lexow added, "The challenge we have on the buy side is to make sure we can keep up with the technology and access these different pools of liquidity as they continue to arise. We constantly have to reinvent how we access these pools of liquidity, as more and more of these pools continue to evolve."

Despite the hype, dark books do not solve all of the institutional investors' problems when it comes to moving large orders. Letting an order reside for an extended time in a dark book creates the risk that, if the market moves suddenly, the buy-side trader might end up with poor price performance, Boston Co.'s Mr. Peruzzi noted. This particular risk, which affects both agency and full-service brokers' closed facilities, has boosted the use of algorithmic trading solutions in open markets.

Seth Merrin, founder and chief executive officer of Liquidnet, sees the multiplicity of execution options as evidence "the age of the block-trading desk is gone" because "the institutions have outgrown the market's ability to handle their orders." "The success rate of starting a crossing network is very, very low," Mr. Merrin said. "Back in the late 1990s, B2B exchanges were the rage, but none is left because they could not create a critical mass to keep people's interest."

Another hurdle the new dark books need to overcome is their firms' limited experience in the area.

ITG Managing Director Chris Heckman said ITG has been running its Posit crossing network since the late 1980s, "so, we have perfected this business line with our clients for a quarter century."

"I don't think any of these new systems have traction the way we have traction because our products are integrated with others," Mr. Heckman said, referring to ITG's pre-trade analysis and post-trade measurement as well as a suite of execution solutions integrated into the new ITG Solution Network subsidiary.

Merrill Lynch, which has its own MLXN dark book, has recognized this expertise and joined forces with ITG with a new crossing network, BLOCKAlert, which seeks out potential matches in customers' blotters.

Exchanges are also vying for institutional order flow and coming up with innovations of their own. The Nasdaq Stock Market, which will launch new intraday and post-close fully anonymous crosses in March, just received regulatory approval for a new order type that could amount to a real challenge for the dark books.

Brian Hyndman, senior vice president of Nasdaq transaction services, said large orders will reside in the Nasdaq book, hidden as reserve, while being pegged to the midpoint price between the national best bid and offer, so that they can be executed at the best prevailing price whenever they find a partial match.