You may have heard of the term “dark liquidity” but wondered what it means.

The term dark liquidity is well known in the US and will become well known in the UK with the advent of the Markets in Financial Instruments Directive (MiFID). Dark liquidity pools are made up of transactions that occur off-exchange and are therefore not visible to investors until after the transaction is complete. For fund managers dark liquidity can be useful when wishing to trade large blocks of shares without alerting the market.

In the US dark liquidity is already big business. According to one consultancy in Q3 2007 dark liquidity pools accounted for 15 per cent of US share trading. Another consultancy has predicted that the use of dark liquidity will increase significantly over the coming years and that by 2010 it will supersede trading on the US exchanges. Dark liquidity trading systems appear to be growing in number. There are reports that US analysts are estimating that there are as many as 40 dark pools available to institutional investors buying or selling stocks.

In Europe, once MiFID is implemented on 1 November, trading away from established exchanges will become easier. Under MiFID brokers will have to deliver best execution which includes not only best price but the fastest and most certain fulfilment of an order. In addition, MiFID establishes for the first time a comprehensive regulatory framework governing the organised execution of investor transactions not just on exchanges, but also through other trading systems and through investment firms themselves - so called systematic internalisers. MiFID also allows for the creation of multilateral trading facilities (MTFs). Broadly speaking an MTF is a system that brings together multiple parties (e.g. retail investors or other investment firms) that are interested in buying and selling financial instruments and enables them to do so. These systems can be crossing networks or matching engines that are operated by an investment firm or a market operator. Instruments may include shares, bonds and derivatives. This is done within the MTF operator’s system.

There are already a limited number of dark liquidity pools in Europe most notably ITG’s Posit and Liquidnet. However, there are many more in the pipeline ready for when MiFID comes into effect on 1 November. For example at the recent European Exchanges Summit delegates were told that Project Turquoise would provide a hybrid model which would bring onto a single electronic platform, via a single matching engine, a traditional transparent liquidity pool of a central limit order book and a hidden order book, or dark pool of off market liquidity.