I can’t help but be amused as I watch the politicians, regulators and Wall Street do that voodoo they do do so well. First the traders and bankers hide while new rules and regs are proposed, and then the pols hide while the lobbyists eviscerate these same proposals. Further fun is trying to figure out what side of the issue academics will take, but I digress.
Making headlines lately is the subject of high frequency trading, or HFT. This is the part of the market dominated by algorithmic, aka black box, trading. Mathematical formulae are created that send signals to computers that initiate trades with no human intervention. These trading systems rely on ever-faster speed of execution in order to get to the trade before the next guy. Traders are paying fortunes for technology that will shave microseconds off the execution time. These systems can each generate millions of trades per day. This is how a pre-split Citibank stock could trade many times its actual float on a daily basis. This week one paper reported that Bank of America stock could now receive the same treatment.
To be sure, HFT is drawing attention. Daily articles either condemn it as killing the market, or praise it as providing liquidity. Then there are follow-up articles that refute
the previous position. Then come the academic studies that support or refute, well, you get the picture.
What amuses me about all this is that while all this attention is lavished on HFT, no one seems to be looking at other, more likely candidates for scrutiny. To this end I propose that the regulators, most prominently the SEC, take a long hard look at dark pools of liquidity. Dark pools are blocks of equities that are not shown to the market. They reside beyond the shadows, somewhere in the ether. The subject is apparently murky enough that Forbes Magazine ran two articles, one pro (May 18, 2009) and one con (May 22, 2010).
I’ve spent 35 years in the markets and I always thought that central marketplaces were good because they provided transparency and price discovery. Dark pools provide
neither. So what is their value to the marketplace? Dark pools gained traction when large trading firms decided they needed to find a way to move large quantities of stock without moving the market, and new technology emerged that could accommodate this need. But it seems to me to be an attempt to circumvent the laws of supply and demand. I thought that when there was a demand for a lot of something without a commensurate increase in supply, the price was supposed to go up. And vice-versa. The other reason usually touted is anonymity. No one wants anyone else to know what positions they carry or want to buy or must sell.
There is a lot of rhetoric about dark pools. It seems to boil down to this. Proponents believe they provide ways to trade large size without moving the market, losing anonymity and get better fills for their customers at lower cost. Opponents believe that dark pools are a way to game the system. Quotes are not displayed, trades may not be
reported in real time and liquidity may become fragmented.
In short, what has been created is an over-the-counter segment of an exchange-traded market; and an unlevel playing field. While not wishing to paint all market participants with a too-broad brush, it is safe to say that when there are ways to skirt the rules, there are some who make sure that they will be skirted. For example, if you don’t know an order exists, how easy is it to front- run.
I’m not sure how the concept of dark pools was sold to the SEC, but to me there is no doubt that they dropped the ball in allowing something that thumbed its collective nose at transparency and price discovery. Without these functions, what is a market? The recent push to put credit default swaps on exchanges and have them cleared is precisely to eliminate games like these. The SEC should come out of hiding and do its job.