HFT and Flashboys controversy: Why the new Luminex dark pool faces major challenges

A group of nine major fund managers, including Fidelity, BlackRock and StateStreet will be launching a new dark pool later in the year. The pool will be called Luminex.

Fund managers have been growing increasingly frustrated at having to trade with high frequency traders who specialise in finding large institutional orders in the market with the use of algorithms.

Many fund managers believe that high frequency traders increase the costs of trading and therefore fund managers have been keen to execute their trades on dark pools - off exchange trading venues - in the belief that they would be safe from predatory high frequency trading counterparties.

A recent lawsuit against Barclays dark pool LX and fines against UBS's dark pool, both involving high frequency traders, have caused institutional investors to distrust dark pool providers and seek their own solutions for protection against high frequency trading.

On paper, Luminex sounds like a great idea, a trading venue where the big boys can trade without the fear of predatory high frequency traders.

However, what looks good on paper, doesn't always work so well in real life.

Issues facing Luminex

Many of the funds involved are major players in exchange traded funds (ETF) and tracker funds. State Street and BlackRock in particular are huge.

In the US they have a combined market share in the ETF space of over 60%.

Fidelity on the other hand is a relatively new arrival to the ETF space, but they have been able to grow their assets quickly with an offering of ultra low cost trackers.

The problem that Luminex will face is the same problem that Barclays found with its own dark pool LX. That problem is liquidity.

Where will Luminex find their trading counterparties?

For a trade to be settled you always need a counterparty, somebody to take the opposite side of your trade. If you are selling, you will need a buyer and vice versa.

A tracker fund will follow a designated index (clue is in the name).

If an equity index rises, the corresponding tracker fund will buy the stocks in the underlying index. If the index falls, the tracker will sell the underlying stocks in the index.

Many of these trackers will be run by the companies involved with Luminex and they will be doing exactly the same thing (buying/selling) at exactly the same time. Due to their size, these will not be small trades.

The big question is: who is going to be in this dark pool, taking the other side of the trade for trackers that make up 60% of the ETF market and whose combined assets under management are counted in the hundreds of billions (not a typo) of dollars?

Luminex looks like an interesting new comer to the dark pool market, but it won't be plain sailing.

Without liquidity there won't be a working effective dark pool trading platform.

The Banker's Umbrella is the world's most popular blog on private banking and wealth management.

The author, Jay Vaananen, is a former senior private banker with a wealth of experience in multi-asset portfolio management and he is the author of Dark Pools and High Frequency Trading for Dummies.