Dark liquidity pools are flooding US equities trading and are quickly spreading to Europe. Now trading in dark pools, traditionally dominant in equities trading is also making its way to the FX market.

Trading in dark pools allows investors to remain anonymous and keep their trading activity private. They are called dark pools because market participants can not see the order book and therefore do not know the bid/ask or the depth of liquidity. These pools allow traders to execute big ticket trades without sounding an alarm to the market. This privacy is highly valued by investors such as hedge funds and presents an attractive alternative to trading on an exchange. It also allows more anonymity than trading on an ECN since with an ECN Central Limit Order bids and offers are displayed.

Trading in dark pools is flourishing in the US equities market due to regulatory changes and the anonymity and lower costs associated with trading in these pools. The two major factors that can explain the development of dark pool trading in the equity world are regulations Reg NMS and MiFID and stock exchanges consolidation trends NYSE/Euronext, LSE & TSE partnership. Those two majors elements are encouraging leading banks and brokers to develop their own internal order books. With the development of internalization in the equity market, participants have seen the number of dark pools flourish in the last few years, with every internalizer being de facto a dark pool of liquidity.

This is a concern to many market participants and this is one reason why we are seeing so much interest for cross-network solutions, and dark pool trading mechanism. It is always difficult to assess what the current level of dark pool trading is and the question that one should ask is who owns the transactions? The sell side firms are developing their internal order books but my sense is that eventually it is the buy-side firms that own the transactions. A sell side firms will execute the trade on the venue chosen by its buy-side clients, not vice versa. Nevertheless, there is a consensus on the market that dark pool trading is growing at double digits growth and will account for a significant part of overall trading volume in the future.

The growth of trading in dark pools is accelerating in part due to advancements in algorithmic trading. Before algorithms traders needed to search numerous pools of liquidity to match an order, a time consuming process. However, today, algorithms are used to point traders in the right direction. An algorithm can calculate the probability of finding a match in a specific dark pool. This functionality can be embedded in a smart order routing system (SORS). Another feature provided by SORS is that they route the order to the venue that should provide the best price, in the least amount of time while trying to maintain transaction cost to the minimum. In todays securities regulatory environment, with best execution requirements, one can easily understand why smart order routing systems are becoming so popular and by correlation why dark pool trading strategy is hot- since numerous market participants might be equipped to fish in those pools. And more algorithms are being designed to search for dark pools. For instance Credit Suisse Advanced Execution Services (AES) provides access to dark pools via AESs CrossFinder and Instinets Continuous Block Cross, following an agreement with Instinet.

With these advancements trading in dark pools has become more prevalent and tools to access them are now spreading to the FX market. Flextrade has been one of the first companies to provide the FX market with access to dark pools with its block trading solution, MilanFX. The company identified a need for a block trading solution specific to the FX market and is targeting the block FX community with its new platform. Flextrade chose what they call the dark pool paradigm to implement its solution. The platform indicates that block liquidity is available without indicating size, side or price.

Dark pools not new to FX
While there are new systems developing in the FX market to access dark pools, these pools have always existed in the FX market. Dont be fooled, dark pools in the FX market have been around for a long time. The difference is now there are more advanced trading tools and algorithms that can help traders identify the best pool for their trade. The other change is that dark pools are a hot topic in the equities market and has become a buzz word in the industry. But for example, the FX traders have for a long time known how to sweep very large orders to the market while keeping market impacts to a minimum. In fact, the FX industry could certainly explain a few of its tricks to the equity world when it comes to dark pool trading.

Dark pools are attractive in the equities realm where most trading is executed on exchanges. Traders and investors in the equities market need to execute trades away from the exchange floor in order for their trade to stay hidden from the market. Liquidity is also concentrated in the equities market around exchanges-this makes dark pools somewhat of a novelty in equities trading.

The situation is almost completely reversed in the FX market. Most trading in FX is conducted off the exchange floor and liquidity is fragmented. In addition limit order books have long been in existence in the FX market. Most trades are in effect executed in the dark. But things are changing in the FX market.

Winds of change
FX market volumes continue to increase. Since 2001, the FX market has experienced continuous growth in volume. This year we will likely see FX market daily trading volume break the symbolic mark of US$3 trillion. Celent predicts the market will reach $4 trillion by 2009 due to the interest from new market participants and new opportunities in currency pairs.

At the same time algorithmic trading has become increasingly prevalent in the FX market. In the interdealer market, algorithmic trading already accounts for 20% of the volume of the two leading platforms. In multidealer platforms, API features are already available to facilitate the development of program trading. It might be questionable to expect the same level of adoption in FX and equity, since the two market structures are very different. Nevertheless, some signs, such as UBSs development of FX algorithm services, point toward wider adoption of algorithmic trading. The development of algorithmic trading in the FX market is directly correlated to increasing access to dark pools. With algorithms it is easier to benefit from the fragmentation of liquidity in FX.

Another change in the FX market that is drawing more attention to dark pools is increased participation from the buy side. The importance of new market participants on the buy side and their ability to improve and generate liquidity is blowing the wind of change in FX markets. The buy side is also arguably the biggest beneficiary of dark pools.

Trading patterns
There is currently very little arbitrage opportunity between currency pairs. To simplify we can say that there are at least two different broad trading patterns in this market. On the buy-side, firms trade FX based on strategy, for example they strategise about what currency pairs to buy and when to buy them. On the sell-side transaction are more tactical, for instance the goal would be to get the best price for a specific currency pair. This strategy lends itself to dark pools trading: since the trader needs to execute a block trade at the best possible price while incurring the least market impact as possible. To ensure that, you can either slice the block into smaller tickets using an algo that will calculate when and where to place those orders to get a fair price and reduce market impact, you can execute the tra