TOWERGROUP: CROSSING NETWORK EXPLOSION THREATENS TO PERMANENTLY ALTER TRADING LANDSCAPE

London - 12 December 2006

New TowerGroup Report Examines Implications of Recent Flood of New Crossing Venues

There was a new arms race on Wall Street on 2006 – this one in pursuit of so-called “dark pools” of liquidity. At the start of the year, TowerGroup was tracking four major block crossing networks, while anticipating the launch of four additional broker offerings. A mere nine months later, the number of crossing networks that TowerGroup is tracking has risen to 40.

The new TowerGroup research report titled “Dark Pool or Mirage? Will the Explosion in Crossing Venues Quench Traders’ Thirst for Liquidity?” is attached.

TowerGroup defines block crossing networks (often registered as alternative trading systems or ATSs) as electronic systems bringing together potential buyers and sellers for the purpose of trading large blocks of securities (10,000 shares or more). While crossing systems are by no means new, the buzz surrounding them has increased in the trading world following the rapid succession launch of a series of similar systems focused largely on crossing smaller orders.

“The real story here is the explosion in the number of largely retail crossing networks offered by institutional brokers,” said Rob Hegarty, managing director of the TowerGroup Securities & Investments group. “This rapid growth in solution offerings is dominated by brokers providing crossing networks designed to internalize retail order flow. Their goal is to reduce expenses, gain access to external crossing flow, and create another compelling product to offer to clients. While the flood of crossing networks coming into the marketplace threatens to fragment the very liquidity they were meant to aggregate, connectivity between these networks serves to re- aggregate liquidity and move more trading volume away from the exchanges.”

Below are highlights of the findings:

Brokers are building and launching crossing networks primarily as alternative trading systems (ATSs) and are opening them up to other brokers. This is both enabling aggregation and causing a rapid commoditization of the marketplace.

Many crossing networks are also open to new algorithms designed to seek out “dark pools” of liquidity not visible to the public, “illuminating” that non-displayed liquidity within the network.

While these new offerings look much like their block crossing counterparts (i.e., ITG POSIT, Liquidnet and Pipeline), they are emerging as distinct solutions offered by institutional brokers trying to internalize flow. Even within this new class of solutions, TowerGroup is seeing distinctions emerge between those being built to capture retail flow and the largely bulge-bracket broker offerings that have the potential for cross-institutional flow.

“In the cyclical pattern typically following the evolution of market structure, fragmentation leads to aggregation and finally consolidation,” said Gavin Little-Gill, research area director in TowerGroup Securities and Investments practice. “Similar to how smart routing brought together the electronic communications networks earlier this decade, TowerGroup believes that algorithmic trading will unite the disparate dark pools of crossing networks and internalization engines. Although fragmentation appears to be a problem for buy-side firms now, it will become a non-issue within 12 months as the algorithms become more sophisticated in their liquidity-seeking capabilities and order routing.”

Little-Gill added, “The biggest difference between the evolution in the dark pool market and the consolidation of ECNs is that most brokers will likely continue to operate their internalization engines – providing significant internal economic value to the firm even after algorithms connect the broad array of crossing venues.”

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