Will 'Dark Pools' Be the Capital Markets' Next Black Holes?

We can almost hear that ominous "Jaws" theme music in the background and can see that huge dorsal fin as it slices threateningly through the water - knowing full well that the real terror is hidden beneath the water’s surface.

But this time around, it’s not a "Great White" that’s sparking our fears; it’s a well-capitalized and broadly based series of secret stock exchanges known as "Dark Pools of Liquidity," "Dark Liquidity," or just "Dark Pools."

Most investors have never even heard the term - and are truly shocked to discover these "off-the-books" trading networks actually exist.

But to Wall Street insiders looking to anonymously move billions of dollars in stocks, bonds, and other investment instruments, dark pools are de rigueur - especially when you’re an institutional trader who doesn’t want to reveal your intentions or your actions to the "rest" of the market, until after the fact when the orders are "printed."

And that makes these dark pools of capital highly problematic when it comes transparency: There is literally none in most pools and only limited visibility in others.

Dark Pools: From Trading Haven to Heavyweight

Dark Pools are electronic "crossing networks" that offer institutional investors many of the same benefits associated with making trades on the stock exchanges’ public limit order books - without tipping their hands to others, meaning publicly quoted prices aren’t affected. This is the capital markets’ version of a godsend - especially for traders who desire to move large blocks of shares without the public investors ever knowing.

Some examples of so-called crossing networks include Liquidnet Inc., Pipeline, the Posit unit of Investment Technology Group (ITG), or the SIGMA X unit of Goldman Sachs Group Inc. (GS).

In an era in which "secret" transactions contributed to what’s shaping up to be the largest credit crisis in history, you’d think that any mechanism that allows insiders to trade in complete secrecy and with total anonymity would be scrutinized more closely than a Roger Clemens vitamin shot. But that’s not the case with Dark Pools.

As has long been the case, the old boys really do like to operate behind closed doors, on the other side of the "velvet rope" - beyond which the unanointed daily working stiff may never pass. And Dark-Pool operators are only getting more private as computerized trading becomes more sophisticated and large-scale-order placement evolves into a science all to itself.

Dark Pool ownership involves almost the entire institutional-trading sector, consisting of independents, broker/dealer-owned pools, consortiums and even - as hard as this is to imagine, given the public’s trust - the stock exchanges themselves (see accompanying chart).

And business is booming.

According to the latest data, nearly 12% of daily U.S. stock-trading volume is presently conducted via the 40 or so Dark Pools operated by the "usual suspects."

According to The Wall Street Journal, Credit Suisse Group AG (ADR: CS) is assembling a network of 30 Dark Pool partners, while JP Morgan Chase & Co. (JPM) is trying to become the Google Inc. (GOOG) of the Dark Pool world by aligning itself with Neovest Inc. Not to be left out, Goldman Sachs recently struck reciprocal deals with rivals UBS AG (UBS) and Morgan Stanley (MS) to allow previously proprietary trading algorithms to work on each other’s desktop trading systems.

This is something the stock exchanges don’t want to see because it strips them of order execution revenue. Which is why they’re getting into the game, too. At the present time, the Nasdaq (NDAQ) alone shunts some 18% of its volume - or roughly 350 million shares a day - through what insiders euphemistically refer to as its "non-displayed platforms," and also has struck a deal with five unnamed Dark Pool operators that are rumored to route nearly half of the total Dark-Pool volume in the United States today.

NYSE Euronext (NYX) plans to connect up to 30 such pools, so don’t think for a New York minute that this isn’t a global phenomenon - Dark Pools exist all around the globe.

We’re still in the early days of this movement. That means there are still lots of things to be worked out from a technical standpoint. For instance, there’s very little in the way of proprietary software that enables any Dark Pool operators to "talk" with their competition.

But we think that’s going to change in a real hurry in the next few years, when as much as 50% of all U.S. trading volume will be handled by "Dark Pool Alliances."

Dark Pool Downers?

While it’s hard to say just how this will affect individual investors like us, my experience as a professional trader suggests that there are a few "realities" we can count upon.

As you might expect, not all of them are good.

Let’s look at the top three:

• First, as more volume moves to the so-called Dark Pools, the very notion of what constitutes "public pricing" becomes suspect. Practically speaking, if we’re seeing only 50% of the trading volume in a given stock, who’s to say that the pricing we’re seeing is accurate if the other half remains a mystery?

• Second, the small- and mid-cap stocks that for so long have been the domain of smaller investors will likely become harder to trade. The reason: Dark Pools will absorb the liquidity that’s presently out in the open, just as a "black hole" in outer space sucks in all the matter that’s nearby. The net effect could be that smaller transactions become more inefficient, or that public pricing actually disconnects from private pricing. Either way, individual investors may not get the best possible prices.

• Third, you can bet regulators will get interested if there is even a whiff of impropriety at the expense of smaller investors who perceive (and rightly so) that they are being "locked out" of the markets by the big boys yet again.

On the other hand, maybe those regulators don’t care at all. With the economy going the way it is right now, there’s plenty more to worry about… like making it out of the water and back up onto the beach before the music stops and "you-know-who" grabs you from below……da-dun…da-dun….da-dun….da-dun.

Comments

[Nate C]

Amazing article. I had never heard of these "dark pools" before. Thanks for sharing the information.

[pdd]

Great article. how do you think it effects technical analy ?sis

[squashnut]

When I was a kid of about 9, my dad would occasionally take me out to Aqueduct Raceway. I wondered why neither he nor his group of friends
went up to the window very often. He explained in hushed tones that he was part of a "pool" which extended beyond their immediate group. We had paid the admission fee, why should the track get a piece of the action among 'friends". This is nothing particularly new or surprising.

[Annie Trust]

Thank you for this article, I've been waiting for this issue to come on the national radar. Isn't this illegal gaming? Or at a minimum, event-contract based transactions? I just don't get it: why are these legal? Isn't anyone concerned about the anticompetitive and anti-free market effect?

If I post a web site that says, "Gambling here! Bet that General Electric Stock will go down!" the Feds and the state and the Native American tribes would be all over that for illegal gambling. But aren't dark pools the same thing?

Or, at a minimum, illegal boycotts? Aren't the dark pools refusing to deal in an anticompetitive way?

We need some sunshine on these "dark pools", they defeat the purpose of the securities laws by totally hiding the major risks involved with investing -- which is the exact opposite of what the securities laws were supposed to do. The laws are to let people kick the tires, slam the doors and figure out if the stock is worth the price based on information available to everyone. If the major, market-moving information is secret -- the liquidity (volume of shares) traded -- then isn't that just admitting that the SEC is a farce, and basically the stock markets aren't based on free market, but rather based on collusion of the economically powerful private entities?

Am I overly paranoid? To me this is so obvious -- am I the only one?

Regulators? Business leaders? Hello?

[thepragamtist]

"99%of the wealth is owned by 1%of the population".unles... you're in this club,you're left to fight &claw with 99%,and you do not have access to the same"tools"t... 1%have.that's just the way it is.the game is rigged

[unlawflcombatnt]

I'd never heard of dark pools before either. I certainly appears to violate every principle of openness and transparency.

It seems like a market analyst or investor would be trying to predict market movements and make investment decisions with insufficient information.

It sure seems like it should be illegal.

[axis1231]

Good article - I would think the Govt will eventually step in. Information available to all universally seems to be one of the basic tenets of open markets. This will definitely test that if your scenarios comes true.

[Jim A]

The US stock and bond market non transparency is being turned in to a fools game for investors.

[peterthepainter]

glad i saw this article! hope to see this blown wide open. never underestimate the forces of greed. lets do all we can to get it stopped

[notsosmart]

cmon folks-i have been saying for years all this is vegas or casinos only slower. this has not been business for years.what a riot as more & more dumb & dumber americans get sucked into this "game". by the way the house wins all the time.

[justasmallfry]

hi,
dark pools have been around for years, they more recently have been promoting their liquidity to the institutions. pricing is reported to the tape, most trades are at or better than the NBBO(national best bid offer) and do not violate any rules or laws. why do you think they are illegal? if you have enough trading volume then you can inquire of them. if you never heard of them it will never even apply. have a great weekend... :)

[fran]

READERS--

illegal, unethical, the regulators/gov't should step in???


have you been paying attention??? mortgage loan fiasco[zero down, no income/residence verification,etc].
CDO, bank practices/compliances,... coverage/compliance. digital dollar proliferation/inflatio...

if persons/agencies in charge were in charge, would we be in this mess so deeply??

[oldtrdr]

I find it very odd that so many posters are just now hearing of dark pools. Granted, they're seldom, if ever, mentioned on SA, and this is the first piece I've seen here addressing them at length. Maybe those posters should read a bit more (aside from SA, I mean).

Jan

[Bob McGregor]

Apart from Dark Pools there is every reason for trading to revert to ONE centalised platform and that is the one that LISTS the Company. Siphoning off liquidity is at the expense of not only liquidity but also transparency.

Of further concern is the current push by USA Treasury and the USA Federal Reserve to pressure Congress to GRANT them more powers in Regulating USA markets - read that to "mean" Regulate World markets by default!

Strange, I thought they CAUSED the malaise in the first place. Additional powers would be like pouring more fuel on the fire.

PS Which of the two "entities" mentioned above is OWNED by the USA people? Who owns the other?

[Bob McGregor]

Forgot to mention earlier that a consortia comprising GS, MER, CS, MS in concert with 2 Australian Brokers COMMSEC and Macquarie Securities [subsidiaries of CBA and MQG respectively] own 50% of a dark pool - AXE - in conjunction with NZX [New Zealand's listed Exchange]. They currently have an application before the Australian Government to be issued a Licence to create a trading platform to trade in competition with the Australian Securities Exchange. Other dark pool applicants are Liquidnet and Chi-X.

Hopefully the Australian Government will reject such overtures and enforce the status quo - of restricting trading in Australian listed securities to the sovereign exchange on which they are listed.

[Jughead]

I hadn't heard of dark pools before but I have heard of ECNs and ATSs, aren't dark pools just an ATS/ECN for institutions? Am I missing something?

This is not news, major exchanges have been competing against alternative trading systems for years. Anyone remember Island or Archipelago? Both swallowed up by the NASDAQ and NYSE respectively.

From what I understand these "dark pools" take their pricing cues from the public markets anyways, simply splitting the public bid/ask spread. Oh and if any alternative exchange or network trades more than 5% of the daily volume of a security it is required to make its order book public. So I wouldn't lose too much sleep over dark pools unless you're a NYX or NDAQ shareholder and even then these companies have the benefit of alternative revenue streams such as listing fees and market data subscriptions.

[morgan77]

Interesting piece. Thanks