When to Use Alternative Trading Systems

What Alternative Trading Systems Actually Do

Alternative Trading Systems (ATS) are SEC-registered trading venues that match buy and sell orders outside traditional exchanges like NYSE and Nasdaq. The category includes dark pools, crossing networks, and electronic communication networks (ECNs).

The core value proposition is reduced market impact. When you place a 50,000-share order on a lit exchange, other traders see it and trade against you—pushing the price before you complete your fill. On an ATS, your order size is hidden until execution. Studies show that ATS execution reduces market impact costs by 15-40 basis points for large institutional orders compared to aggressive lit-market execution.

The practical consideration isn't whether ATS venues are "good" or "bad." It's matching the venue to the trade. Block orders benefit from dark pool execution. Retail orders under 1,000 shares rarely do. Understanding the tradeoffs prevents both overpaying for execution and leaving money on the table.

Types of Alternative Trading Systems

Dark pools: Private venues where order information (size, direction, identity) is hidden until execution. Approximately 40 active dark pools operate in U.S. equities, handling 12-15% of daily volume.

Crossing networks: Venues that match orders at a specific time or price reference (typically the midpoint of NBBO). Orders wait for contra-side flow rather than executing immediately.

Electronic Communication Networks (ECNs): Lit venues that display orders but operate independently from primary exchanges. ARCA and EDGX function as both ECNs and exchanges.

The key distinction: Dark pools hide your order until execution. Crossing networks hide your order and wait for matching flow. ECNs display orders but may offer different fee structures or order types than primary exchanges.

When Dark Pools Make Sense

Good use cases:

1. Block orders (>10,000 shares or >$500,000 notional). Displaying a 50,000-share buy order on NYSE signals to the market that a large buyer exists. Front-runners and high-frequency traders trade ahead, moving the price 10-30 basis points before you fill. Dark pools hide your size.

2. Sensitive positions. If you're accumulating a 5% stake in a company, you don't want the market to know until required disclosure. Dark pool execution prevents information leakage.

3. Low-urgency orders. If you're willing to wait for natural contra-side flow, dark pools can provide better prices (midpoint execution rather than crossing the spread).

Poor use cases:

1. Small orders (<1,000 shares). Market impact is negligible. The execution uncertainty and potential for partial fills make dark pools counterproductive.

2. High-urgency trades. Dark pools don't guarantee execution. If you need 10,000 shares immediately, aggressive lit-market orders (taking the offer) complete faster.

3. Illiquid securities. Dark pools work when there's contra-side flow to match. Thinly traded stocks have limited dark pool liquidity.

The decision framework:

Worked Example: Market Impact Comparison

You need to buy 25,000 shares of XYZ Corp, trading at $50.00 bid / $50.05 ask. Average daily volume is 500,000 shares (your order is 5% of ADV).

Approach A: Aggressive lit-market execution

• You hit the $50.05 offer repeatedly
• After 5,000 shares, offer moves to $50.10
• After 15,000 shares, offer moves to $50.20
• Final 5,000 shares execute at $50.25
• Volume-weighted average price (VWAP): $50.14
• Market impact: $0.14 per share (28 basis points)
• Total impact cost: 25,000 × $0.14 = $3,500

Approach B: Dark pool midpoint execution

• Your 25,000-share order rests at midpoint ($50.025)
• Over 3 hours, you receive fills as sellers arrive
• 18,000 shares fill at $50.025 (midpoint)
• Remaining 7,000 shares: switch to lit market at $50.08 average
• Blended VWAP: $50.04
• Market impact: $0.04 per share (8 basis points)
• Total impact cost: 25,000 × $0.04 = $1,000

Savings: $2,500 (71% reduction in execution costs). The tradeoff: dark pool execution took 3 hours vs. 20 minutes for aggressive lit-market.

Regulatory Framework: What Reg ATS Requires

Alternative Trading Systems operate under SEC Regulation ATS, which imposes specific requirements:

Fair access requirements (for large ATSs):

• ATSs trading >5% of any NMS stock's volume must file with SEC
• ATSs trading >5% must provide fair access to all broker-dealers
• Disclosure of order types, matching priorities, and fee structures required

Transparency requirements:

• Form ATS-N requires detailed public disclosure of operations
• ATSs must report trades to the consolidated tape (publicly visible after execution)
• Quarterly volume statistics published by FINRA

What this means for traders:

• You can't access most dark pools directly; you need a broker relationship
• Your broker's "smart router" decides which ATSs to access
• You can request (and should review) your broker's execution quality reports

The point is: ATS venues are regulated, not unregulated. The opacity is in pre-trade information (order visibility), not post-trade reporting. All executions eventually appear on the tape.

Common ATS Misconceptions

Misconception 1: "Dark pools are only for institutions." Reality: Retail orders frequently execute in dark pools via broker smart routers. When you place a limit order with E*TRADE or Schwab, it may route to a dark pool where a market maker provides midpoint execution. You benefit from price improvement without knowing it.

Misconception 2: "Dark pools always provide better prices." Reality: Dark pools provide better prices when there's contra-side flow at your price. If you're buying and there are no sellers in the pool, your order sits unfilled. For urgent orders, aggressive lit-market execution completes faster even if costlier.

Misconception 3: "High-frequency traders prey on dark pool orders." Reality: Some dark pools allow HFT participation; others exclude it. Independent pools like Liquidnet and IEX specifically design against latency arbitrage. Know your venue's participant mix before routing.

Misconception 4: "All dark pools work the same way." Reality: Matching rules vary dramatically. Some match at midpoint only. Some allow limit orders. Some cross orders once per second; others match continuously. Venue selection matters as much as the decision to use an ATS at all.

Evaluating Your Broker's ATS Routing

Your broker decides which ATSs receive your orders. Evaluate their execution quality:

Request execution quality reports. Brokers must provide Rule 605/606 reports showing:

• Percentage of orders routed to each venue
• Price improvement statistics (how often you beat NBBO)
• Execution speed and fill rates

Ask about payment for order flow. Some brokers route to specific dark pools because they receive payment. This isn't inherently bad (you may still get price improvement), but understand the incentive structure.

Check for internalization. Broker-dealer pools may internalize your order against the broker's proprietary inventory. This can be advantageous (immediate fill, price improvement) or disadvantageous (broker trading against you). Review disclosed conflict policies.

Implementation Checklist

When considering ATS execution:

• Assess order size relative to ADV. If your order is <0.5% of average daily volume, market impact is negligible. Lit-market execution is fine.

• Define urgency tolerance. Dark pool execution may take hours for large blocks. If you need completion within 30 minutes, use algorithms that access both lit and dark.

• Request broker routing reports. Review which ATSs your broker uses and their execution quality statistics. Switch brokers if transparency is inadequate.

• Specify routing preferences for large orders. Most platforms allow you to specify "seek dark liquidity" or similar settings. Enable this for orders >5,000 shares.

• Monitor partial fills. Dark pool orders frequently fill partially. Set fill-or-kill or IOC (immediate-or-cancel) conditions if partial fills create problems.

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Cross-References

For understanding execution algorithms, see Algorithmic Execution Basics: VWAP, TWAP, POV. For measuring execution quality, see Measuring Slippage and Implementation Shortfall.

Regulatory Note

SEC Regulation ATS (17 CFR 242.300-303) governs alternative trading systems. FINRA Rule 5310 (Best Execution) requires brokers to seek the most favorable execution terms reasonably available.