Third Market

Third market trading is a very interesting topic – before I joined the fixed income trading desk, I was a programmer responsible for 3rd party vendor system integration with in-house equity order management system (OMS) and execution management system (EMS).

One of the projects I worked on was Liquidnet integration (these systems later ballooned as “everyone under the sun” jumped on the bandwagon – more on this in a bit).  Liquidnet’s dark pool qualifies as a third market, because it facilitates the trading of exchange-listed securities (stocks) between institutional investors (in an over-the-counter format) instead of routing them through an exchange.

Systems like this bypass traditional brokers (a source of information leak) and allows large (and sometimes rival) institutions’ block orders “cross” with each other while anonymity rules prevent either side from knowing the identity of the counter-party.

There are additional rules and logics built into flow management interfaces, but those are often proprietary information cannot be shared with the public.

Liquidnet’s “dark pool” from a 30,000 feet perspective

Unfortunately, as mentioned earlier, everyone who didn’t have a dark pool system decided to create one.  Credit Suisse, GS, ITG, etc all had competitor projects.  Dealers were especially aggressive, because the mentality at the time was “instead of fighting [dark pools], we will create our own.”

To make the matter worse, there was the controversy (or scandal, depends on how you read it) of Pipeline Financial Group’s dark pool system – one of the oldest dark pools in the industry.  Instead or allowing institutions to “cross,” Pipeline routed some flows to a trading entity owned by its parent company, which handled the transactions without informing its clients.

Many dark pools are facing the constant battle of balancing “number of institutions” with “quality of the institutions.”  For example, a $600bn asset manager signed up to a dark pool may face fewer than expected counter-parties, because out of the hundreds of advertised “institutions,” many are not even $50bn and do not have the capability of crossing with truly large institutions, and then there are those hedge funds joined just to try to “sniff” flows…

Fourth Market and how it differs from Third Market

Personally I have not came across concrete examples of fourth market trading, for a good reason.  Trading directly with another institution involve much regulatory hurdles and large mutual funds would find it extremely risky in terms of information leakage (just imagine two asset managers, competitors, trade blocks of shares with each other).  Technically, fourth market trading differs from third market trading in the way that there is no intermediary.  Institutions directly trade with each other without brokers or dark pools.