Five years after the flash crash, buy-side investors aren’t sleeping any easier. The recent arrest of British trader Navinder Singh Sarao for allegedly helping trigger that event, which sent U.S. stock markets into a brief and sharp tailspin, reminded them how perilous buying and selling securities has become. Among other charges, the Commodity Futures Trading Commission has accused Sarao of repeatedly placing orders he planned to cancel, an illegal activity known as spoofing.
As they hunt for liquidity — and try to avoid showing their hand to high frequency traders and market makers — buy-side firms are all too familiar with illusory offers. Those seeking refuge in one of dozens of dark pools, private venues where parties can execute large trades before the details become public, often try to confirm an offer only to see it vanish.
“They hate the fact the other side of the trade walked away and took information from them,” says Michael Cashel, a senior vice president at Fidelity Trading Ventures, a division of Fidelity Investments, headquartered in Boston. Having learned that someone is looking to buy a big block of shares, the other party can profit from that knowledge.
In search of a safe haven, nine large asset managers led by Fidelity have joined forces to create their own dark pool, Luminex Trading & Analytics. Cashel serves as interim CEO of the Boston-based venue, which is slated to go live by the end of September.
Luminex will be open only to the buy side. Besides attracting a large and diverse group of investors, the plan is to simplify orders for institutional block trades and stop information leaks. This new player may offer protections missing from current dark pools, but can it provide enough liquidity to reach critical mass?
When it comes to liquidity, Luminex has one clear advantage: The nine co-sponsors manage about 40 percent of U.S. mutual fund and exchange-traded fund equity assets, it estimates. Besides Fidelity, they include Bank of New York Mellon Corp., BlackRock, Capital Group Cos., Invesco, J.P. Morgan Asset Management, MFS Investment Management, State Street Global Advisors and T. Rowe Price. Another 175 asset managers have signaled that they would like to sign on.
“I’m sure that this will be successful,” says Manoj Narang, founder and former CEO of Tradeworx, a high frequency trading firm based in Red Bank, New Jersey. “You’re talking about some of the largest asset managers in the world.”
Luminex won’t reinvent dark pools, which handled 16.11 percent of consolidated U.S. equity trading volume last year, according to Rosenblatt Securities, a New York–based institutional agency brokerage. That’s slightly off 2013, when volume peaked at 16.63 percent.
“They’re not trying to replace the existing market structure or take over the world,” Justin Schack, a managing director and partner at Rosenblatt, says of Luminex, which he describes as a utility-like service with a good chance of success. “They are trying to carve out a niche and provide a low-cost way for asset managers to cross blocks with one another. It’s a pretty narrow and well-defined goal.”
Unlike its competitors, Luminex is owned and run by buy-side institutions. It will also set itself apart from venues such as Liquidnet Holdings by excluding everyone but long-term investors. Another difference: Luminex users must commit to a minimum trade, partly to avoid disappearing offers and other tricks. And even though trades take place anonymously, all parties on the system will be known to members.
By contrast, Liquidnet, whose average trade in the first quarter of this year was 43,000 shares, bars high-frequency traders in its main dark pool but has 13 so-called liquidity partners in the U.S. that participate through its separate Liquidnet H2O platform. “Liquidity partners can send an offer into the pool, and if the membership wants to interact with it, they can, but they don’t have to,” says Brennan Warble, the New York–based firm’s head of U.S. equities.
Luminex’s membership rules could limit its potential, Narang contends. “It remains to be seen how much flow gets done on this,” he says. “It’s been proven time and time again that the model of a buy-side aggregator adds very little liquidity.”
Many dark pools have found that this approach doesn’t yield much volume, so they end up asking trading firms to participate, Narang explains. The reason: Buy-side traders invest based on fundamentals, and they often have the same opinions on particular stocks. That makes it hard to match a buyer and seller, especially at the same price, Narang says. “To have a healthy, well-functioning market, you need a mix of players with a variety of time horizons and trading and investment styles so that shares can actually exchange hands.”
Still, Luminex appears to be filling a need. The idea for the platform was hatched two years ago at Fidelity Trading Ventures, which approached 18 major asset management firms that control about two thirds of all U.S. equity fund assets. “We talked with them about their pain points in sourcing equity block trades,” interim CEO Cashel recalls.
Everyone agreed that it’s gotten tougher to execute such trades, he notes. One obstacle for institutions: a fractured U.S. trading landscape consisting of 11 national securities exchanges along with 35 dark pools that accommodate block trading. Although improving technology helps buy-side investors navigate this terrain better, it doesn’t reduce the complexity of the marketplace. To make things worse, last December the average dark pool trade size was just 207 shares, according to Rosenblatt — half of what it was in early 2009. “It’s hard to find that liquidity right now,” Cashel says.
Asset managers also told Fidelity that they wanted a trading venue with buy-side owners who put the interests of the community before making a buck. “Because all the entities we trade with are for-profit, there is always an incentive to allow others into the pools just to increase the amount of trading that happens within,” says Kevin Cronin, global head of trading at Invesco in Atlanta.
In the deal that Fidelity hammered out with Luminex’s co-sponsors, lead equity traders from all nine firms sit on the dark pool’s board and have a say in design and operations. Fidelity owns 60.8 percent of the company, and each other sponsor has a 4.9 percent stake. The founding firms have contributed start-up capital to meet regulatory requirements and run Luminex for three years — enough time for it to become self-supporting, according to Cashel.
“They’re just basically looking to pay the rent every month,” Rosenblatt’s Schack says. “That allows Luminex to focus on institutional block crossing to an extent that other, for-profit firms might not be able to because they’re focused on maximizing profits and generating returns for shareholders.”
Trading costs will be kept low, with excess cash flow going to a reserve for operating and capital investment, Cashel says. Luminex intends to charge a quarter of a cent per share traded versus the usual one or two pennies. “The reason for doing that isn’t to create a price war,” Cashel explains. “It’s to achieve the stated goal of retaining alpha.”
Luminex is designed to prevent information leaks and vanishing offers. Users must define the maximum number of shares they want to buy or sell, along with the size of the trade they’re willing to automatically execute if a counterparty is available. The latter must be at least 5,000 shares or $100,000 worth of stock, whichever is less; Luminex will reject anything smaller. “By having a greater minimum size, it adds real value to the participants who are accessing real liquidity,” says Paul Whitehead, San Francisco–based managing director and co-head of Americas trading at BlackRock.
If orders from a buyer and seller match on the same stock, Luminex is set up to execute the highest number of auto-executable shares the two sides have offered. The trade, if it goes forward, will execute at the midpoint of the current national best bid and offer. It will not immediately execute if Luminex detects an opportunity to boost the size of the trade based on the maximum order amounts entered by each side.
If the potential for a bigger trade is there, both sides will be invited to increase it. They have 20 seconds to decide how much larger a trade they would like, up to the maximum entered with the order. To prevent information leaks, neither side will know what the other entered for a higher trade, and Luminex will execute it based on the highest common number of shares each party has offered.
The trade will be priced using a weighted average midpoint calculation based on the time it takes to determine the total size. If there’s no agreement to size up, Luminex will execute a trade for the highest common number of auto-executable shares, using weighted average NBBO pricing.
For some observers and potential rivals, doubts about Luminex persist. Low transaction costs for its users wouldn’t translate into best execution, according to a trader at a U.S. dark pool. “To get best execution you need liquidity and a rich enough membership so you’ve got the other side of the trade,” he says. “I don’t see how there’s enough new liquidity being added into the system. It seems to me it’s being further fragmented.”
“I don’t think we need another dark pool,” he says. “A lot of the trade flow within the dark pool will be subtracted from exchanges, which is not good for price discovery in the broader market.”
But Rosenblatt’s Schack, who points out that the market is already fragmented, doesn’t think one more venue will make things materially worse. “No one will be forced to execute there if they don’t want to,” he adds. If Luminex succeeds in the U.S. equity market, Schack says, it stands to reason that its founders would want to expand by offering a similar service in other parts of the world and in other asset classes.
Narang believes the current regulatory environment favors the expansion of dark pools. For example, the prohibition of spoofing under the Dodd-Frank Wall Street Reform and Consumer Protection Act creates an incentive to use them, he says. “If you have a large trade to do, the bluffing ban makes it impossible to shield your intentions to mitigate market impact.” In the past, to get better price execution, traders could issue bluffing orders to disguise the block trade they intended to make. “Banning bluffing is extremely stupid,” Narang says. “It basically means you have to show your cards.”
Come September, Luminex could make trading less of a gamble for anxious buy-siders. •
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