The London Stock Exchange Group plc's plans to form a Pan European dark liquidity pool with Lehman Brothers Holdings Inc. as its joint venture partner could be overshadowed by the potential sale of the firm.

Yesterday media outlets were filled with rumors that Lehman Brothers is up for sale and that a deal to sell the firm could be in the works with Britain's Barclays Bank but reports of a below-market bid caused the stock to plummet 11 percent. (Today the stock rebounded 5.8 percent to close at $20.96.) There are fears that credit losses could be lurking for the third quarter due out in July after Lehman stunned investors by reporting a $2.8 billion loss for the second fiscal quarter ending May 31. Even though the firm has revamped management and said it would raise $4 billion in capital through a common stock offering it has not been able to squash these concerns.

While the markets reaction to Lehman's write-downs and trading losses may be totally overblown, it certainly raises questions as to whether a major exchange such as the LSE should partner with a single broker or put all of its eggs in one basket, so to speak. Even though Lehman Brothers has global expertise in equity trading and algorithmic trading strategies, any uncertainty about its independence or financial status could hurt the chances of the joint venture.

Judging from the release, LSE, the United Kingdom's dominant stock exchange, is counting on Lehmans expertise in algorithmic trading functionality and its investment in new anti-gaming technology to set the dark pool from rivals. In a statement, Lehman was the first investment bank in Europe to offer direct access to its own dark liquidity pool, stated Jeremy Isaacs, CEO, Lehman Brothers, Europe, Middle East and Asia-Pacific in the announcement last Thursday.

The LSE's new trading system, named Baikal after the world's deepest lake in Southern Siberia will provide electronic access to securities across 14 European countries with smart-order routing to liquidity in at least 22 trading venues.

I spoke with Matt Samelson, senior analyst at Aite Group to get his take on the deal.
“This is a pre-emptive strike by the LSE and Lehman,”says the analyst. “It may help the London Stock Exchange stem the loss of flow. It's undoubtedly a good thing,” says Samelson.

Clearly the LSE is facing competition from a slew of alternative execution venues including Chi-X Europe Ltd., BATS Europe, Turquoise, Nasdaq OMX Europe and NYFIX Euro Millennium. Of the new entrants, Chi-X is the only one that’s live and has gained volume away from traditional European equities exchanges. In March, Chi-X told the press it expects to capture a quarter of trading in FTSE 100 stocks by next April.

But is the LSE starting late? Comparing this to the New York Stock Exchange, which waited years to react to competitors, Samelson gives the LSE credit for knowing its weaknesses and acting sooner. The LSE is “not resting on its laurels and waiting years to take action and it’s choosing Lehman, which is a well respected global brokerage firm that knows what its doing both technology wise and trading wise.”

But the devil may be in the details. It's unclear how the LSE's dark pool combined with algorithms will work, notes the analyst. From the announcement it sounds like, traders will be submitting orders and if they don’t execute in Baikal theyll be routed out to displayed markets. Another issue is that LSE will need to speed up to compete with the likes of Chi-X. Though LSE is automated, it’s pretty slow, says Samelson.

What we dont know is whether the LSE and Lehman have begun to build the trading system yet. The release said a Strategic Advisory Committee and working groups would be operational from Q3 2008. The system is expected to launch in Q1 2009 pending regulatory approvals, which would give LSE and Lehman three quarters of a year to finish the system.

But if the credit crisis were to force a sale of Lehman before that itme, how would it affect the LSE's plans to launch a dark pool with the broker's input? It probably won't scuttle the deal if the new owner maintains the joint venture, but it adds an element of uncertainty. On the other hand, LSE is already hedging its bets. The LSE said Baikal will be open to “economic participation”by others from the buy-side and sell-side and both parties have started discussions with them. Stay tuned.

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