The other day, we were riding a trail that wound uphill through the trees on the north slope of the hill, which kept us riding in the dark shade of the massive blue oaks. As usual, my eyes watched our surroundings, my one hand on the reins communicated gently to my horse, and my whole body adjusted to the rhythm of our movement. Notwithstanding the need to remain aware and focused when riding, the dark shade subtly moved my mind to the notion of dark pools, an issue from another world. Latching onto this thought, a small piece of my mind worked through what I knew, what I thought about this contentious issue. Was I wrong to condemn this practice as one more example of them against us, one more example of the rich and powerful moving markets to their advantage and to our disadvantage? “I need to know more,” I thought …
A short time ago, I responded to a question about dark pools. Since then, I have done some research about this contentious issue. I have listened to high-powered, in-the-know, financial minds explain the purpose and the benefit of the dark pools, that these under-the-radar, massively large, block trades are designed to prevent undue influence on a specific market and that this practice is in the best interests of retail traders and instructional trades alike. I have also read testimony from James A. Brigagliano the Co-Acting Director, Division of Trading and Markets U.S. Securities and Exchange Commission. Below is an excerpt from that testimony that sheds some much-needed light on this rather obscure practice. It is long, but stay with it, as it just about says it all …
Another type of alternative trading system (ATS) is the so-called dark pool. An ATS that operates as a dark pool does not provide quotes into the public quote stream. The number of active dark pools transacting in stocks that trade on major U.S. stock markets has increased from approximately 10 in 2002 to approximately 30 in 2009. For the second quarter of 2009, the combined trading volume of dark pools was approximately 7.2% of the total share volume in these stocks, with no individual dark pool executing more than 1.3%.
Although the phrase “dark pool” is new, the concept is old. Dark liquidity–meaning orders and latent demand that are not publicly displayed – has been present in some form within the equity markets for many years. Traders are loath to display the full extent of their trading interest. Imagine a large pension fund that wants to sell a million shares of a particular stock. If it displayed such an order, the price of the stock would likely drop sharply before the pension fund could sell its shares. So the pension fund, assuming it could execute its trade at all, would be forced to sell at a worse price than it might have if information about its order had remained confidential.
In the not-so-distant past, the pension fund might have placed the order, or some part of it, with a broker-dealer, which would attempt to find contra-side interest (whether on the floor of an exchange or by calling around to other traders), preferably without giving up enough information to move the market against its client. Information leakage about a larger order was a serious problem, and the “market impact” of large orders would impose a major cost on investors.
Historically, many dark pools developed as computerized ways of searching for contra-side trading interest while preserving confidentiality. While early dark pools were designed to cross large orders, and such pools still exist today, most of the newer dark pools are designed to trade smaller-sized orders. In some cases, these small orders are derived from large ‘parent’ orders that have been chopped up into smaller pieces. In addition, some small orders represent orders that the broker-dealer operating the ATS is attempting to cross internally, rather than lose the execution to another market.
Looking at overall U.S. equity market structure, competition among different markets appears to have yielded significant benefits to investors, both retail and institutional: lower commissions, tighter spreads, faster execution speeds, and greater systems capacity. And from a systemic risk standpoint, having a network of interlinked markets is preferable to having a single point of failure. When trading is disrupted in one market, which happens occasionally, volume quickly migrates to other markets.
Our equity markets have faced serious tests since the onset of the financial crisis, and generally the markets have performed well. Despite record volumes and volatility, particularly in the fall of 2008, the markets for U.S.-listed securities have remained open and continued to operate in a fair and orderly manner and to perform their vital price discovery function. Buyers and sellers could see current prices and expect to execute their trades promptly at the prices they saw on their screens.
The above is both a big bite and enlightening, although it does not end my concerns about this practice. In fact, later in the testimony, Brigagliano discusses proposed regulations to prevent dark pools (and other trading practices) from creating “two-tiered markets in which selected participants are made aware of prices that are available in the market but that other investors don’t know about.”
On the one hand, my long-term portfolio appears to benefit from this practice, but on the other, as a trader, I wonder if I haven’t suffered in a trade or two that has moved in a manipulated direction from some unscrupulous traders abusing a practice set up to keep the trading field somewhat level and fair. I am sure I will never know …
Trade in the day; invest in your life …
