Occasionally we journalists are given a present on a plate. The emergence of dark liquidity pools is one such moment. Until recently, the...

Occasionally we journalists are given a present on a plate. The emergence of dark liquidity pools is one such moment.

Until recently, the topic of trading equities away from an exchange - say, on a private bank network - seemed rather technical and dull. But then some bright spark devised the tag "dark liquidity pools" to describe this activity.

So now, we can bin headlines about the future of "electronic communication networks"; instead the hot topic is: "will dark liquidity pools engulf the London Stock Exchange?" Trading technology has never seemed so cool - or akin to an episode of Star Wars.

Perhaps this is just as well. For what is emerging in these alternative share-trading venues does deserve much wider attention from investors, especially, but not exclusively, in Europe.

Next week, ITG, an American company, will open a platform in London that allows investors to continuously match equity orders of any size without needing to trade on an exchange. The key draw of this, ITG says, is that investors who like to stay in the shadows - such as hedge funds - can trade cheaper, and without disturbing the share price. Thus far, this news has not left the LSE quaking; after all ITG is not a household name. But the system purports to be Europe's first fully-fledged "crossing network", and it is a fair bet it will soon have rivals.

The introduction of MiFid later this year will make it much easier for investors to trade shares away from a stock exchange. Indeed, European investors, particularly in London, are already starting to trade using investment banks' internal books. And seven investment banks are now threatening to launch a trading network to rival the LSE, known by the cheery tag of "Project Turquoise".

So what does this mean for the established exchanges?

Right now, the LSE insists it can rebuff this new threat. And in some respects, it may be right. After all, whenever investment banks have launched rival trading networks before in Europe, these have essentially failed. Plus, it still remains unclear whether platforms such as Project Turquoise will outgun the LSE in terms of technology.

Nevertheless, this time round, the regulatory climate is very different and the fact that the US has already seen an explosion of dark liquidity pools since it changed its regulations a couple of years ago, is giving greater momentum to the move away from exchanges.

Just look at the fascinating BATs saga, described on the page opposite. Or note that TABB consultancy recently estimated that 10 per cent of US equity trading is already in dark liquidity pools - and will swell further, TABB says.

Moreover, what could provide a particularly pernicious challenge to platforms such as the LSE is an ongoing change in investor mentality. As NET2S, another consultancy, points out, the spectre of dark liquidity currently comes in three forms: alternative trading networks; order matching on an investment bank's book, and direct buyside-to-buyside deals.

Right now, the first two activities grab most attention. But NET2S suspects the third category could be most important. For, increasingly, it is seeing deals where a hedge fund will place a small part of a share sale on an exchange (say 5 per cent), give some to investment banks to trade on their private networks - and then handle the rest (as much as 80 per cent), in private deals.
This, in a sense, is the darkest of the dark liquidity - and NET2S thinks it will explode. As a result, it guesses that in five years' time, around half of all equity trading will occur within dark liquidity pools; equity markets, in other words, are heading towards a major wave of fragmentation.

No doubt the LSE would vehemently reject this projection as mere advertising from consultants who want to earn advice fees. However, correct or not, there are two points to ponder. First, a shift in investor activity of this magnitude - or even part of that - certainly does not seem to be priced into the LSE's current share price (as Nasdaq keeps pointing out, seemingly in vain.)
Second, if buyside-to-buyside activity does swell, it is not just exchanges who could suffer; investment banks may feel the effects as well.

Dark liquidity, in other words, is now unleashing a fascinating fight which could redefine boundaries in the financial world, in Europe - and elsewhere. Moreover, this multi-dimensional battle is likely to have numerous instalments.

http://www.ft.com/cms/s/1ba2d9e6-b7e2-11db-bfb3-0000779e2340.html