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Wednesday, December, 12, 2007

Dark Pools (Of Liquidity): Slang term for electronic crossing networks—alternative trading systems that match willing buyers and sellers of stocks anonymously and outside the eye of public bourses.

Mama always said, "Never dive into a dark pool because you don't know if and where you'll come out." As PMBA started writing this, the Dow Jones Industrial Average had just finished the day 2.5%, or 360 points, less valuable than when the day started. And as it puts on the final touches, the Dow is finishing a three-day rally that netted around 500 points or so. It is fitting to discuss dark pools of liquidity on such days, as PMBA's personal portfolio seems to be regularly submerging, reemerging and diving again into a dark pool of its own. And on days like these, individual investors sit back in frozen awe as the market mechanism works its way down, down, down, up, up, up—unseen, unknown and unstoppable. Who knew to sell today; who knew to buy. Gold is down, oil is down, the dollar is up (for a change), GM is down and Google is up. This newsletter has looked at market makers and chartists and beta, among other factors in a typical trading day, but it's the dark pools of liquidity that have people talking. The dark pools are as mysterious as their name, which, in and of itself, seems to scoff at notions of market transparency. But these dark pools are here to stay, having sprung onto the scene in recent months to play a larger and larger role (they are estimated to already handle more than 10% and maybe as much as 20% of U.S. stock trades) in the markets.

Dark pools are essentially the guy on the street corner opening his coat and hissing, "psst, you wanna buy a watch?" But without the counterfeit. Truth is, if you've ever gotten anything done on Craig's List or ebay—and Pocket MBA snagged a plum writing gig on Craig's List—as opposed to traditional classifieds and/or stores, you already have a jump on knowing what a dark pool is. It's just another way of trading securities in a digital age—one that is primarily used by large financial institutions, hedge funds and certain traders seeking to move large blocks of stock outside the watchful eyes of the public exchanges. Why would you want to do that? Well, if you want to buy one million shares of Apple, you'll probably impact the price if you post your bid the traditional way—that is, in public. And if you trade through the NYSE or NASDAQ, your bid will show up on a public board. Dark pools allow the matching of willing buyers with willing sellers at a secret price that is, by and large, near the going public price. (If it wasn't the system wouldn't work.)

The dark pool concept only seems strange because people are so indoctrinated by the traditional outcry system, which is going the way of the typewriter anyway. Once trading went electronic, it was only a matter of time before institutions figured out they could do the trading thing on their own. So, now they do.

There are currently around three dozen or so dark pools, according to a variety of reports, and the number is growing. They were originally begun by large Wall Street firms, who have long used them to execute trades between clients, which cuts out the cost of the middle men. Now they are expanding outside their original brokerage base, but the largest dark pool is still Goldman Sachs's "Sigma X." Even the NYSE is getting into the act, as it recently announced a joint venture with BIDS Holdings LP, itself a unique dark pool joint venture among Bank of America, Bear Stearns, Citigroup, Credit Suisse Group, Deutsche Bank, Goldman Sachs, JPMorgan Chase & Co., Knight Capital Group, Lehman Brothers, Merrill Lynch, Morgan Stanley and UBS. The purpose of the NYSE/BIDS JV is to "improve execution quality and access to liquidity in block trading."

The biggest concern about dark pools expressed by some market observers is the lack of transparency represented by them. Trading goes on that impacts supply and demand for equities, but non-dark pool investors can't see it. And the price depressant or stimulant that a large order would bring to the public markets is a benefit for small investors, who can act on the price action to start or close a position more advantageously. Some would argue that's how a market should work. For the dark pool buyers and sellers, there really isn't a best price guarantee, as the bids and offers are not published, although the execution (but not the parties involved) is noted on the exchanges. One assumes that the "best execution" requirements on the brokerages render the prices close to that involved in public trading, although for most dark pool participants, anonymity is more important than the absolute best price. A second, systemic concern is that increased trading funneled to dark pools means less liquidity for small investors who don't work through the dark pools.

For its part, the SEC hasn't waded into the recent surge in dark pools as yet. The only comments that Pocket MBA or other publications have found are those by Erik Sirri, Director of Trading and Markets in this September 20, 2007 speech commenting on increased competition among market participants:

[T]he increased opportunity to step ahead has prompted a counter-reaction by those market participants that wish to trade in size without revealing too much of their trading intent. Among other things, this counter-reaction has taken the form of hidden liquidity and, particularly in the equity markets, can be seen in the numbers of new dark pools that have been much discussed in the press. What may be less recognized is the extent to which the public markets, including exchanges, also have a "dark" component that closely interacts with their displayed trading interest. In particular, many exchanges have order types that allow their customers to submit trading interest that is entirely undisplayed, typically at prices inside the best displayed prices. They also offer order types that allow the submitter to display some part of trading interest at a price, while keeping the rest of the size hidden in reserve.

I believe that a not insignificant percentage of liquidity on some equity exchanges could be of the "dark" variety. Consequently, these exchanges could in fact operate the largest dark liquidity pools in the U.S., not some of the ATSs that have been highlighted in the press recently. The increased use of hidden liquidity across all markets has prompted some concern that price transparency and market efficiency could eventually be harmed if the trend continues.

***

When competitive innovations are presented for Commission review, I do not believe that the Commission's proper function is to select or promote any particular business model. Rather, the Commission must be concerned with the Exchange Act goals of protecting investors and the public interest and promoting fair competition. The Commission's review should focus on the likely effect of proposed innovations on market quality as it affects investors, including such quantitative indicia as effective and quoted spreads, market depth, and transitory price volatility.

So it appears that, for the time being, unless proof of trading imbalances arises, the SEC will keep its feet out of the dark pool. And can anyone blame them? It's awfully tough to see clearly in murky waters.

Posted at 11:06AM | Permalink | Comments (0)

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