Exchanges in battle with dark pools

NEW YORK (Reuters) - As traditional exchanges fight and "dark pools" fight over investors, differences between the old and new trading venues are starting to melt away, a development that is likely to lead to a wave of consolidation.

According to New York-based consulting firm TABB Group, some 10 to 12 percent of securities trading in the United States now takes place in more than 40 dark pools, where buyers and sellers anonymously match large orders but keep details about size and price concealed.

This market share has come at the expense of more traditional markets, such as the New York Stock Exchange (NYX.N) and the NASDAQ (NDAQ.O).

In the past year, the NYSE and NASDAQ, along with other exchanges worldwide, have been acquiring rival exchanges both large and small in a global round of consolidation that continues.

Now, facing a growing threat in the form of dark pools, the exchanges are responding by investing heavily in their own dark pools.

The New York Stock Exchange is an investor in the BIDS Trading consortium, a dark pool specializing a large block trading, and it is beefing up its MatchPoint Trading dark pool.

"We are embracing undisplayed pools," said Colin Clark, the NYSE's vice president of strategic analysis, explaining that the pools fill a market need for anonymity when trading in large volumes. At The NASDAQ, Adam Nunes, the vice president of transaction services, said the exchange was looking into ways of improving how it handles large trades, but for now, such trades are broken down and worked on throughout the day.

The exchanges' dark pools may have an advantage because they can also offer traditional markets as alternatives, allowing clients to switch quickly between say the NYSE's traditional exchange and one of its dark pools.

The NASDAQ is already allowing some pools to connect to the exchange and enhance their liquidity.

At first glance, it might seem as though the exchanges are accelerating their own demise. But entering the fray is a way for them to keep control of trading as it migrates to new venues.

"The lines are blurring," said Andrew Brenner, who heads a new stock exchange owned by International Securities Exchange (ISE). "Exchanges are beginning to look a lot more like ATS's (alternative trading systems, or dark pools), while ATS's are looking more like exchanges." ISE, an electronic stock options market, also owns dark pools.

The focus of the pools so far has largely been equities, but some pools are beginning to explore options and other derivatives. And dark pools are also cropping up in Europe and Asia, with NYFIX Inc NYFX.O recently launching Euro Millennium.

SHAKEOUT

Many in the industry believe trading in such a variety of liquidity pools is unsustainable and only the largest, nimblest and those that find a unique niche will survive.

"I fully expect that the number of these markets is going to start to condense, we're going to start seeing mergers," said Bernard Donefer, associate director of a finance institute at New York's Baruch University.

Pools started by bank and broker consortia such as Project Turquoise, supported by Deutsche Bank and Goldman Sachs among others, are already in question.

"They are going to struggle because brokers are horrendous at collaborating," Tower Group analyst Dushyant Shahrawat said.

AITE Group LLC, a consulting firm, predicted in a report late last year that many of the successful dark pools will make tantalizing acquisition targets for the NYSE and the NASDAQ.

But there is a constraint on consolidation. As pools merge, they will have to be careful not to grow too large. U.S. securities regulations require trading venues to display quotes to the public if they trade more than 5 percent of a single stock's overall volume in four of the past six months.

In the battle for market share, the decisive weapon that will determine who will flourish and who will perish will depend on who has the best and fastest technology.

For example, algorithms offered by the dark pools claim to reduce price manipulation and help clients build trust so that others will trade with them.

For a while, dark pools that offered the quickest execution had the edge, but speed has become easier to obtain. Now, dark pools also must provide network stability, storage capacity and connectivity with other pools to survive.

"It's an arms race," said Andrew Lo, who directs the Massachusetts Institute of Technology's Laboratory for Financial Engineering.

The stakes are so high that most Wall Street firms, and the exchanges themselves, treat technology development like a Manhattan Project and create their latest weapons in house.

For example, Banc of America Securities (BAC.N) offers an algorithm named "Ambush" that it says helps clients control information leaks and trade based on how urgent their orders are.

Major players in the industry say that all of this secrecy, technology and, eventually, consolidation, is in pursuit of a single determining factor.

"It's all about one thing: liquidity," said the ISE's Brenner. "Those that attract or control liquidity will survive."

(Reporting by Phil Wahba; Editing by Eddie Evans)