Increases In Dark Pool And Algorithmic Trading Volume

As recently discussed in a post at Bull Bear Trader, the exchanges were beginning to join up with the operators of the various dark pools of liquidity. Now both the Financial Times and the WSJ are reporting a new union between the London Stock Exchange (LSE) and Lehman Brothers. Per the agreement, the LSE will offer trading of European companies that don't currently list on its exchange, matching buyers and sellers across more than ten European countries. The new service will be based on the Lehman Brothers dark pool trading environment. The multilateral trading platform, called Baikal, is expected to combine algorithmic trading functionality with dark pool liquidity. The venture with Lehman is hoped to allow the LSE to gain exposure into dark pools trading, and get back exchange volume that has been moving to other platforms and environments. According to the Tabb Group, dark pools currently account for about 10% of daily U.S. trading volume.

The recent trends toward dark pools and specialized trading has caused the exchanges to lose out to new electronic trading platforms that are aimed specifically at servicing computer-driven algorithmic traders. Such algorithmic traders are increasing responsible for driving trading volume and providing liquidity. Such threats are causing the margins in the public order books to come under increased pressure. Electronic-based algorithmic trading is also cited for the increase levels of volume and short-term price spikes that are seen in a number of equities and commodities. Unlike in the past, it is not that unusual anymore to see crude oil spike up or down $3-4 in less than an hour as a flood of buying or selling pressure hits the market from electronic orders.

The move to decimalization, with price spreads down to the penny, is also making it difficult for some specialists to create a market that is both profitable and also offers the level of liquidity that is required at each price point. Some market operators are even arguing for going back to larger spreads, such as a nickel, in order to increase the number of shares offered at each price and keep the exchanges in business, but it is doubtful the regulators will allow this. As more market participants use dark pools, the exchanges will look to move more trading volume to this environment due to the cost advantages over the public order books. As a result, the price transparency, increased liquidity, and smaller spreads that decimalization was ironically hoped to provide retail traders is likely to be compromised.