n Chapter 6
Algorithms in action
Dark pools and
algorithmic trading
The evolution of ‘dark pools’ and how algorithms access and interact
with non-displayed liquidity
George Sofianos*
D espite the title, we will
refrain from using the term
‘dark pools’, which has sinister
connotations! Instead, we will use
the more neutral and more general
term ‘non-displayed liquidity’.
There is nothing sinister about
non-displayed liquidity: most
liquidity is non-displayed, non-
displayed liquidity has always been
with us, and will always be with
us. The nature of non-displayed
liquidity, however, is changing
over time. Moreover, the rise
of algorithmic trading creates
challenges on how algorithms can
best interact with non-displayed
liquidity. In this chapter we first
describe the different types of non-
displayed liquidity, summarise
the evolution of non-displayed
liquidity over time and then discuss
how algorithms can take advantage
of non-displayed liquidity.
1 Also see Kwaku Abrokwah and George Sofianos, ‘Accessing Displayed and Non-Displayed Liquidity’, Journal
of Trading, Vol.1, No. 4, Fall 2006, pages 47 to 57.
n algorithmic trading 2nd edition
1
The different types of
non-displayed liquidity
We define non-displayed liquidity
broadly to include any willingness
to buy or sell that is not publicly 
displayed. Exhibit 1 lists the
different types of non-displayed
liquidity at execution venues. Non-
displayed liquidity at execution
venues consists of reserve orders on
electronic limit order books, orders
represented by floor brokers on the
floor-based exchanges, the orders
in public crossing networks, and
non-displayed liquidity at agency
brokers and broker-dealers.
Electronic limit order books
(ELBs) electronically aggregate and
display limit orders (the quantity
traders are willing to buy and
*
sell at different prices). ELB 1 in George Sofianos,
vice president,  
Exhibit 2, for example, displays Equity Execution
traders willingness to sell 1,000 Strategies
shares at $25.01 or higher. ELBs Goldman Sachs
n a buy-side handbook n the trade 2007
 n Chapter 6

Algorithms in action

Exhibit 1:
Different types of non-displayed liquidity at execution venues

Crossing networks Crossing networks

Reserve orders
Working orders Working orders
Electronic Agency Broker- Dealer capital
limit order brokers dealers
books
(ELBs)

Traditional
floor-based
Stand-alone exchanges
crossing networks Reserve orders
Floor-broker orders
Specialist capital

2 Throughout this
may also have a reserve feature broker-dealer sponsored crossing
chapter we will (in addition to the displayed networks (e.g. Goldman Sachs
refer to electronic
limit order
quantities, they may electronically SIGMASM X). Agency brokers may
2 books as ELBs.
A broader group
aggregate non-displayed liquidity also sponsor crossing network
than just ECNs,
at different prices). At ELB 1 in (e.g. Pulse Trading’s recently
ELBs include Exhibit 2, traders are willing to sell announced BlockCross). The
both registered
exchanges with
an additional 9,000 share at $25.01, term ‘dark pools’ usually refers
ELB platforms but this quantity is not displayed.2 to just crossing networks but
(e.g. Nasdaq
Single Book) and
Crossing networks do non-displayed liquidity is much
ECNs (ELBs not not display any orders. They broader, with crossing networks
registered as an
exchange, e.g.
electronically aggregate accounting for a relatively small
BATS). non-displayed liquidity and part of total non-displayed
3 The SEC defines anonymously match buy and sell liquidity.
crossing networks
as “systems that
orders, usually at the prevailing Agency brokers execute non-
allow participants market mid-quote.3 Once a displayed client orders over
to enter un-
priced orders,
potential match is established time and across liquidity pools.
which are then between two orders, some crossing Agency brokers may also cross
executed with
matching interest
networks allow negotiation over client orders and proactively – but
at a single price, the execution price. Crossing can discreetly – seek counterparties
typically derived
from the primary
be continuous (e.g. Liquidnet) (non-displayed latent liquidity).
public market or at specific times (e.g. Nasdaq Agency brokers do not use
for each crossed
security.” SEC
Crossing Network). Another their own capital to facilitate
Concept Release, distinction is between stand-alone trades. Non-displayed liquidity
Regulation of
Exchanges, 23
independent crossing networks at agency-brokers, therefore,
May 1997 (p.15). (e.g. NYFIX Millennium) and consists of just the client orders

n algorithmic trading 2nd edition n a buy-side handbook n the trade 2007

 n Chapter 6

Algorithms in action

Exhibit 2:
Reserve orders in electronic limit order books (ELB)

&-#
 &-#

Buy quantity Price Sell quantity Buy quantity Price Sell quantity
$25.03 500 0 $25.03 3,000 0
$25.02 1,000 5,000 4NBSU
SPVUFS $25.02 4,000 0
$25.01 1,000 9,000 $25.01 4,000 0

3,000 1,000 $24.99 0 6,000 $24.99

3FTFSWF
PSEFST
ELB = Electronic Limit Order Book

the brokers are working over liquidity at investors. This non-

time. Broker-dealers, in addition
to performing all the functions of
agency brokers, may also use their
own capital to facilitate trades.4
Non-displayed liquidity at broker-
dealers, therefore, in addition
to the client orders worked over
time, also includes dealer capital.
Algorithms at agency brokers and
broker-dealers are themselves big
depositories of non-displayed
liquidity.
The traditional floor-based
exchanges combine ELBs (e.g. the
NYSE Display Books), broker-
dealers (e.g. the NYSE specialists)
and agency brokers (e.g. the NYSE
floor brokers), all at one physical
location. The main advantage
of floor-based exchanges is the
centralisation of the interaction
between floor brokers representing
non-displayed liquidity, specialists
and ELBs at one physical location.
In addition to non-displayed
liquidity at execution venues, we
must also consider non-displayed
displayed liquidity consists of the
orders on the trading desks of
investment managers and, most
importantly, latent liquidity. We
define latent liquidity as non-
displayed liquidity that must be 3
proactively solicited. Suppose
investment manager AlphaMax
wants to buy 200,000 shares XYZ,
the current best ask is $25.01 and
the total amount of displayed and
non-displayed liquidity at the
various execution venues at this
price is 50,000 shares. Another
investment manager, BestReturn,
is not actively in the market but,
given the right opportunity, may
be interested in selling XYZ shares.
If AlphaMax could somehow
directly indicate to BestReturn its
willingness to buy XYZ, a trade 4 A market-maker
is a broker-dealer
may take place at or close to the with special
best ask. Matching AlphaMax responsibilities:
e.g., must
with BestReturn, tapping latent display buy
liquidity, is one of the functions and sell quotes
continuously
of traditional agency brokers and during the regular
broker-dealers. Brokers access trading hours.

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 n Chapter 6

Algorithms in action

n “Non-displayed liquidity has been around for a long time

in the form of orders represented by floor brokers on the
trading floors of the NYSE and the other exchanges. In this
respect, therefore, non-displayed liquidity is as old as the
NYSE itself.”
latent liquidity through carefully
targeted discreet calls to potential
counterparties.
Most liquidity is not displayed
and non-displayed liquidity is
fragmented across a large number
of broker-dealers, crossing networks
and investment managers. In the
next section we discuss how the
 nature of non-displayed liquidity is
changing over time.
The evolution of non-displayed
liquidity
Non-displayed liquidity is a
fundamental feature of financial
markets. It arises from traders’
concern that if they widely
advertise their intention to buy a
large amount of stock, they will
drive the price of the stock up
ahead of their trade. Non-displayed
liquidity has always been around,
but its nature is changing over
time. Exhibit 3 presents a stylised
timeline of the evolution of non-
displayed liquidity in the US.
Non-displayed liquidity has
been around for a long time in the
form of orders represented by floor
brokers on the trading floors of
the NYSE and the other exchanges.
In this respect, therefore, non-
displayed liquidity is as old as
the NYSE itself. Non-displayed
liquidity has also always been
around for a long time in the form
of non-displayed orders worked by
upstairs brokers and in the form of
dealer capital.
In the late 1980s, technology
began to rapidly change the nature
of non-displayed liquidity with the
appearance of the first electronic
crossing networks: ITG’s POSIT
and Instinet’s The Crossing
Network. The 1990s saw the rise
of ELBs. Initially, ELBs were only
electronically displaying liquidity,
but over time ELBs added reserve
orders, incorporating non-
displayed electronic liquidity. At
the same time crossing networks
were innovating and evolving.
Liquidnet’s appearance in April
2001 was another milestone.
Liquidnet’s main innovation was to
embed itself in the buy-side order
management systems. In this way,
buy-side traders could work the
order while simultaneously seeking
natural counterparties among

n algorithmic trading 2nd edition n a buy-side handbook n the trade 2007

 n Chapter 6

Algorithms in action

Exhibit 3:
The evolution of non-displayed liquidity

Broker- 2nd generation

dealer Late 1980s: initial crossing networks
capital crossing networks

Reserve orders
Reserve orders Broker-dealer
Exchange crossing facilities
trading
floors Late 1990s

Liquidnet’s other buy-side users. n Technological advances

NYFIX Millennium and Pipeline
are other examples of second-
generation crossing networks.
Liquidnet, Pipeline, NYFIX
Millennium are – at least for the
time being – agency brokerage
crossing networks not affiliated
with any of the major full-service
broker-dealers. Over the past
couple of years broker-dealers
have started introducing their own
crossing networks, like Goldman
Sachs’ SIGMA X. Exchanges are
also introducing crossing networks:
the ISE Stock Exchange MidPoint
MatchTM in September 2006, the
Nasdaq Intraday and Post-Trade
Crosses in June 2007 and the NYSE
MatchPoint coming up later in
2007.5 All combined, currently
there are at least two dozens
crossing networks operating in the
US alone.
There are several reasons for the
proliferation of crossing networks
in the US:
improved the capabilities
and performance of crossing
systems and made it easier
to create and scale-up new
systems from scratch. 5
n Commission rates at the main
crossing networks remained
stubbornly high. For example,
2 cents per share at Liquidnet
(8bps in Europe).6
n The reduction in the NYSE’s
share of trading volume over
the last couple of years (from
84% in 2001 to 54% in March
2007) together with the rollout
of more automation as part of
5 The ISE launched
the NYSE Hybrid is reducing MidPoint Match
the importance of the NYSE on September
8, 2006 and
floor as a pool of non-displayed Nasdaq launched
liquidity. The migration of Crossing
Network on June
non-displayed liquidity away 4, 2007. The
from the NYSE creates an NYSE acquired
MatchPoint
opportunity for new venues for Trading Inc. on
non-displayed liquidity. July 17, 2006.
6 The TRADE, Issue
n The buy-side’s increasing use of 11, Jan – Mar 07,
low-touch execution channels page 113.

n algorithmic trading 2nd edition n a buy-side handbook n the trade 2007

 n Chapter 6
Algorithms in action
Exhibit 4:
Crossing networks in the long run
-FBSOJOH
GSPN
UIF
FWPMVUJPO
PG
&-#T
*OTUJOFU
&$/
Breakthrough Imitation, experimentation, innovation
5IF
FWPMVUJPO
PG
DSPTTJOH
OFUXPSLT
Breakthrough *NJUBUJPO
FYQFSJNFOUBUJPO
JOOPWBUJPO
We are here
6
is reducing the average
commission rates received by
full-service broker-dealers.
Pressure on commissions
is forcing broker-dealers to
streamline their execution
process and maximise the
internal crossing of client
orders.
The current proliferation of
crossing networks mirrors the
proliferation of ELBs in the
market for Nasdaq stocks in the
1990s. This proliferation is part
of the typical evolution process
from major innovation through
imitation, experimentation
and innovation to eventual
consolidation. Exhibit 4 illustrates
the evolution of ELBs from the
n algorithmic trading 2nd edition
/BTEBR

Smart-routers eased 4JOHMF
#PPL
the transition
5 –10 years
Consolidation
5 –10 years?
Consolidation?
initial breakthrough ELB (the
Instinet ECN in 1997), to at some
point more than a dozen ECNs
(maximum market share less
than 20%), and ultimately to the
inevitable consolidation (Nasdaq
Single Book): Instinet merged
with Island to form INET (2002)
and then Nasdaq acquired both
the INET and Brut ECNs and
consolidated them with its own
ELB (SuperMontage) into Single
Book (2006). The consolidated
Single Book now accounts for
more than 50% of the trading
volume in Nasdaq stocks.
ELB consolidation was
inevitable because of economies
of scale, network externalities,
and because ELB innovations
n a buy-side handbook n the trade 2007

n “Despite their proliferation, crossing networks remain
marginal players in terms of their share of total executed
volume. The independent crossing networks account for
about 3% of the total executed volume.”
(e.g. reserve orders) were easily
replicated by competitors. As the
ELBs evolved it became harder to
distinguish among them, forcing
them to compete on price. Under
pure price competition, taking
advantage of economies of scale
is critical, and the lowest-cost
provider captures market share and
consolidates. Network externalities
accelerate the process – the ELB
that has the biggest volume has
better ability to match order and
deliver better execution quality.
It took between five to ten years
for the market for Nasdaq stocks to
go from ELB proliferation to ELB
consolidation. During these years,
smart-routers eased the transition
from proliferation to consolidation
by efficiently aggregating the
electronically displayed liquidity
across the competing ELBs
into essentially a single virtual
electronic book.
Just like ELB consolidation,
crossing network consolidation
is also inevitable, and for the
same reasons. The only questions
are how long will it take, and
what venue will emerge as the
consolidator.
n algorithmic trading 2nd edition
n Chapter 6
Algorithms in action
Despite their proliferation,
crossing networks remain marginal
players in terms of their share
of total executed volume. The
independent crossing networks
account for about 3% of the
total executed volume.7 Broker-
dealer crossing networks account
for another 3%, bringing the
combined total to 6% of total
executed volume. If fill rates differ 
across venues, however, executed
volume is a poor indicator for
comparing posted non-displayed
liquidity. Crossing networks, in
particular, have relatively low fill
rates compared to ELBs and the
traditional exchanges. The crossing
networks’ share of executed
volume, therefore, underestimates 7 Estimating
the crossing
the amount of non-displayed networks share of
liquidity at these venues. Assuming executed volume
is complicated
an average fill rate on crossing because we
networks of 10%, suggests that the must rely on
spotty advertised
non-displayed liquidity residing volume by the
in these systems is ten-times the various venues
that may be
amount actually crossed (6%), double-counted
or the equivalent to 60% of the and may include
both matched
executed volume in NYSE stocks. and volume
The large amount of non- merely routed
through. All our
displayed liquidity sitting in the estimates are
crossing networks and the low approximations.
n a buy-side handbook n the trade 2007
 n Chapter 6

Algorithms in action

Exhibit 5:
The three main components of an algorithm

Parent order

-JRVJEJUZ
BDDFTT
$IJMEPSEFS

1
PWFS
UJNF HFOFSBUJPO
MPHJD

A B C D E

Child order

A
$IJMEPSEFS

2
QMBDFNFOU
MPHJD

-JRVJEJUZ
BDDFTT

BU
B
QPJOU
PG

8 UJNF

Smart router

3 4NBSUSPVUFS

MPHJD

Execution venues

fill rate create a challenge for displayed liquidity. We set the

algorithms: how to more effectively stage by describing the three main
access and interact with this non- components of a typical algorithm
displayed liquidity. (Exhibit 5).

Algorithms and non-displayed 1. Child-order generation logic:

liquidity This can be defined as the logic
We will now focus on the the algorithm uses to slice-up a
interaction of algorithms and non- parent order and distribute child

n algorithmic trading 2nd edition n a buy-side handbook n the trade 2007


n “The proliferation of crossing networks creates a
challenge for algorithms: where to optimally post orders?”
orders across brief time buckets
over execution horizon. A full-day
VWAP algorithm, for example,
will slice up the parent order in
proportion to the historical volume
smile over the day. Ideally, the child
order generation logic should have
flexibility to re-allocate child orders
across time buckets and its market
footprint should not be predictable.
2. Child-order placement logic
This is the logic the algorithm uses
to determine how to execute each
child order within its designated
time bucket. For example, to
execute the child order as a market
order or as a limit order and try to
capture the spread? If a limit order,
at what limit price and when and
how to adjust this price? When to
switch a limit order to a market
order to guarantee execution? The
child order placement logic may
further subdivide a child order
into grandchild orders. Just like
the child order generation logic,
the placement logic should have
flexibility to re-allocate child orders
across time buckets and should not
leave a predictable footprint.
3. Smart-router logic
Once the algorithm determines
how to place each child order,
n algorithmic trading 2nd edition
n Chapter 6
Algorithms in action
the smart-router logic determines
where to place each child or
grandchild order across the various
execution venues. The smart-router
logic should optimise execution
across as many displayed and
non-displayed pools of liquidity
as possible, while minimising
information leakage.
Non-displayed liquidity comes
into play in all three components
of an algorithm. As an algorithm’s
child order generation logic slices 
up the parent order, the child
order placement logic immediately
begins actively working the first
child order (A in Exhibit 5).
The residual parent order (child
orders B through E) remains non-
displayed within the algorithmic
engine waiting for the scheduled
trigger to place the next child
order. The child generation logic
itself, therefore, creates a large pool
of resident non-displayed liquidity
that can potentially interact with
other orders.
At GSAT® (Goldman Sachs
Algorithmic Trading), the extent to
which the residual non-displayed
parent orders take advantage of
non-displayed liquidity ahead
of their scheduled time depends
on how rigidly each particular
n a buy-side handbook n the trade 2007
 n Chapter 6
Algorithms in action
n “To avoid the risk of double-execution, algorithms
distribute the quantity to post across the various crossing
networks… This allocation is sub-optimal and this is exactly
one of the problems the fragmentation of non-displayed
liquidity creates for optimal execution in general.”
algorithm prescribes a time-size
schedule. Algorithms that rigidly
prescribe a time schedule (e.g.
TWAP or VWAP algorithms)
limit the extent the child order
generation logic can take advantage
of non-displayed liquidity outside
the prescribed schedule. Even for
10 these algorithms, however, the
GSAT child order generation logic
retains some flexibility to interact
with non-displayed liquidity at
favourable prices, consistent with
not getting too far ahead of the
prescribed time-size schedule.
Algorithms that do not prescribe
a rigid time-size schedule (e.g.
shortfall algorithms) allow greater
flexibility for the parent order
to interact with non-displayed
liquidity. The GSAT 4Cast and
Sonar algorithms, for example,
while slicing up and sequentially
routing child orders for execution,
post without displaying a large
part of the residual parent order
on the various crossing networks.
To avoid information leakage to
predators ‘pinging’ the crossing
networks, GSAT algorithms specify
n algorithmic trading 2nd edition n a buy-side handbook
a minimum quantity to respond to.
The GSAT child order placement
logic also dynamically adapts to
bring forward or delay executions
depending on the liquidity
experience of the current child
order executing in the market. The
child order generation logic of the
GSAT portfolio algorithm (PORT
X), in taking advantage of non-
displayed liquidity is subject to a
further constraint: that the overall
portfolio risk exposure does not
get out of line over the execution
horizon.
The proliferation of crossing
networks creates a challenge for
algorithms: where to optimally
post orders? We can use a simple
example to illustrate one of the
challenges. Suppose there are only
two crossing networks, CN-A and
CN-B, and the algorithm wants
to post a 100,000-share buy order
in symbol XYZ. There is a non-
displayed 200,000-share XYZ sell
order in CN-A and nothing in
CN-B. Since the liquidity is non-
displayed, to the algorithms CN-A
and CN-B look identical. Should
n the trade 2007

the algorithm post the whole of
the 100,000 shares at each venue
or distribute the 100,000 shares
between the two venues? The first
strategy increases the probability
of crossing the most quantity: the
algorithm will cross all 100,000 at
CN-A. This strategy, however, runs
the risk of double execution and
overfilling the order: what if part of
the order also crosses at CN-B?
To avoid the risk of double-
execution, algorithms distribute the
quantity to post across the various
crossing networks. For example,
post 50,000 shares at CN-A and
50,000 shares at CN-A. This
allocation is sub-optimal and this is
exactly one of the problems the
fragmentation of non-displayed
liquidity creates for optimal
execution in general. One way to
get around this problem and
increase quantity crossed is to learn
from experience, posting more size
in crossing networks with higher
fill rates. Another way to increase
quantity crossed is to quickly
redistribute posted orders towards
the venue that just executed.
Continuing our example, as soon
as the 50,000 shares execute at CN-
A, quickly reallocate the remaining
50,000 shares across the two
venues, so another 25,000 shares
execute at CN-A, and so on. One
downside of this strategy is that the
redistributed orders may lose time
priority.
n algorithmic trading 2nd edition
n Chapter 6
Algorithms in action
The GSAT Sonar algorithm
posts limit orders in the Goldman
Sachs SIGMA X crossing network
and in several external crossing
networks. GSAT is also upgrading
all its algorithms to post ‘pegged’
limit orders in multiple crossing
networks.
The proliferation of crossing
networks also creates challenges
for the smart-router logic
of algorithms: where to seek
liquidity? In seeking liquidity, the
GSAT Sonar algorithm takes full
advantage of the Goldman Sachs
SIGMA smart-router and SIGMA
X crossing network. SIGMA X
was launched by GSEC (Goldman 11
Sachs Execution & Clearing, L.P.),
the Goldman Sachs electronic
executions affiliate, in July 2005,
complementing its SIGMA smart-
router introduced in 2002. SIGMA
X combines a host of external
liquidity providers (XLPs) together
with limit orders clients post
directly into SIGMA X to create a
virtual consolidated pool of private
non-displayed liquidity. The
external liquidity providers consist
of:
n Crossing networks, e.g.
Liquidnet H2O and NYFIX
Millennium.
n Electronic market makers, e.g.
Knight and ATD (Automated
Trading Desk).
n Goldman Sachs (GSCO)
broker-dealer liquidity
n a buy-side handbook n the trade 2007
 n Chapter 6

Algorithms in action

Exhibit 6:
SIGMA smart router and SIGMA X crossing network
Liquidity-seeking -JRVJEJUZTFFLJOH
PSEFST
TUSFBNJOH

(market orders) OP
EFMBZ
(4&$
4*(." /POEJTQMBZFE
MJRVJEJUZ %JTQMBZFE
MJRVJEJUZ
Client orders
FIX direct
REDIPlus
GSAT Sonar SIGMA X External Electronic GSCO
4*(."
9 posted crossing market Exchanges ELBs Broker-
liquidity
liquidity networks makers dealer
Liquidity-posting Opt-out quotes
(limit orders)

GSEC &MFDUSPOJD
FYFDVUJPO
TFSWJDFT GSCO 'VMMTFSWJDF
CSPLFSEFBMFS

1. Goldman Sachs Execution & Clearing, L.P., an affiliate of Goldman, Sachs & Co., is a separately registered broker-dealer that offers
its clients order entry and routing capabilities to a variety of US and non-US market centres either on an agency basis or purely as a
technology provider.

consisting of the orders logic of GSAT algorithms like

2 executed by the Goldman Sonar also enters liquidity-seeking
Sachs full-service broker-dealer orders into SIGMA. SIGMA first
affiliate. SIGMA X clients instantaneously streams these
may opt-out from interacting orders through the SIGMA X
with the GSCO pool of non- liquidity pool to find a match or
displayed liquidity. inside the consolidated best bid
Through REDIPlus® or FIX and offer. In this way, liquidity-
connections, GSEC clients can post seeking orders access all the various
block-sized orders in SIGMA X. pools of non-displayed liquidity
These orders are non-displayed aggregated by SIGMA X. If no
top-of-book limit orders and match is made within SIGMA
interact with incoming flow while X, SIGMA immediately accesses
waiting for a natural cross. GSEC the public markets and routes
clients posting orders in SIGMA X and executes orders against the
include the GSAT Sonar algorithm. displayed liquidity and ELB reserve
Exhibit 6 summarises how the orders, or against the broker-dealer
SIGMA smart-router and SIGMA public quotes. Every day over 300
X interact to maximise crossing million shares pass through the
opportunities. Through REDIPlus SIGMA smart-router.
and FIX connections, GSEC clients Reserve orders on multiple
enter liquidity-seeking orders into ELBs, just like multiple crossing
SIGMA. The child order placement networks, also challenge

n algorithmic trading 2nd edition n a buy-side handbook n the trade 2007


algorithms. Because reserve orders
cannot be seen, they are difficult
to optimally consolidate across
venues. In Exhibit 2, for example,
the displayed best ask at ELB 1 is
1,000 shares at $25.01 with 9,000
additional non-displayed shares.
The displayed ask at ELB 2 is 4,000
shares at $25.01 but with no reserve
orders. The smart-router receives a
market order to buy 10,000 shares.
For optimal execution, the smart-
router should send at least 6,000
shares to ELB 1 and the rest (if
any) to ELB 2, buying all 10,000
shares at $25.01. The smart-router,
however, cannot see the 9,000
reserve shares at ELB 1. Taking
just the displayed liquidity into
account, the smart-router will only
send 2,000 shares to ELB 1 and
the remaining 8,000 to ELB 2. In
this case, the smart-router will buy
6,000 shares at $25.01 and 4,000
shares at the higher price $25.02, a
sub-optimal execution.
The SIGMA smart-router uses
a feature called MemoryMatch
to alleviate this problem.
MemoryMatch keeps track where it
places reserve orders and optimally
uses this information to route
market orders where they are most
likely to fill at the best price.
The way forward
In interacting with non-displayed
liquidity, algorithms face two
other challenges: restricted access
n algorithmic trading 2nd edition
n Chapter 6
Algorithms in action
and latent liquidity. Some venues
restrict access to their liquidity
pool. Liquidnet, for example,
only allows buy-side firms to
participate in its crossing network.
The proliferation of broker-dealer
crossing networks also creates an
access issue: will a broker-dealer
allow competing broker-dealers
to access its crossing network?
And if access were allowed, will a
broker-dealer provide liquidity to a
competing broker-dealer’s crossing
network? The recently launched
BIDS crossing network, formed by
a consortium of broker-dealers is
an attempt to solve the problem
of fragmentation of non-displayed 13
liquidity across competing broker-
dealers. The consortium includes
Citi, Goldman Sachs, Lehman
Brothers, Merrill Lynch, Morgan
Stanley and UBS.
Perhaps the greatest challenge
for algorithms is how to access
latent liquidity. What is the
algorithmic equivalent of the
‘discreet, well-placed’ telephone
call of traditional brokers? What
is the best way of pulling latent
liquidity into the market? Latent
liquidity raises fundamental issues
over how liquidity is generated
and dynamically replenished.
Execution strategies and algorithms
that minimise liquidity impact
throughout an order’s execution
horizon may not always be optimal
because they may fail to elicit
n a buy-side handbook n the trade 2007
 n Chapter 6

Algorithms in action

sufficient latent liquidity and best accessed the traditional

prolong execution. Aggressively way. And algorithms will never
executing a larger amount upfront, completely replace flesh-and-
8 See, for example,
with higher liquidity impact, may blood brokers. n
Anna Obizhaeva bring more latent liquidity into the
and Jiang Wang,
‘Optimal Trading
market, speeding up execution.8
Strategy and The initial high-impact child
Supply/Demand
Dynamics’,
execution, essentially acts as a
working paper, wake-up call to latent liquidity.
http://mit.edu/
people/obizheav/
It is possible, however, that
OW060408.pdf latent liquidity will always be

This material was prepared by the Goldman Sachs Equity Execution Strategies Group and is not the product of
Goldman Sachs Global Investment Research. It is not a research report and should not be construed as such.
14 The information in this article has been taken from trade data and other sources we deem reliable, but we do not
represent that such information is accurate or complete and it should not be relied upon as such. This information
is indicative, based on among other things, market conditions at the time of writing and is subject to change
without notice. Goldman Sachs’ algorithmic models derive pricing and trading estimates based on historical
volume patterns, real-time market data and parameters selected by the GSAT user. The ability of Goldman Sachs’
algorithmic models to achieve the performance described in this article may be impacted by changes in market
conditions, systems or communications failures, etc. Finally, factors such as order quantity, liquidity and the
parameters selected by the GSAT user may impact the performance results.

The opinions expressed in this article are the authors and do not necessarily represent the views of Goldman,
Sachs & Co. These opinions represent the authors’ judgment at this date and are subject to change.

Goldman, Sachs & Co. is not soliciting any action based on this paper. It is for general information and does
not constitute a personal recommendation or take into account the particular investment objectives, financial
situations, or needs of individual users. Before acting on any advice or recommendation in this paper, users should
consider whether it is suitable for their particular circumstances.

GSAT®, SIGMASM, and REDIPlus® are registered service marks of Goldman Sachs Execution & Clearing, L.P.

Copyright: Summer 2007 by Goldman, Sachs & Co.

n algorithmic trading 2nd edition n a buy-side handbook n the trade 2007