More Light in Dark Pools
Dark pools are private trading venues, off the main exchanges, mostly run by large brokerage houses (although some are independent). On public exchanges such as the New York Stock Exchange or the NASDAQ, bids and offers are public. In dark pools, however, details of bids and offers are not transparently available to all participants in the marketplace.
There are risks in such a lack of transparency. But there are obviously also benefits, or market participants wouldn’t use dark pools. They’re growing in significance, now accounting for about 40 percent of all trading activity. What’s the attraction?
Institutional investors like the anonymity of dark pools because their trades are often so large that they would significantly affect the price of the traded securities if they were broadcast to participants on a public exchange. They also use dark pools because, they believe, the participants are diligently supervised and vetted by the company running the pool. Many of those companies have intensively marketed their dark pools as places where high-frequency traders are carefully monitored and their representation in the pool’s trading is kept within low and controlled limits.
Long-term readers will know that we regard high-frequency trading (HFT) as basically parasitic. High-frequency traders, by a variety of stratagems (some within the letter of the law, and some possibly outside it), insert themselves between buyers and sellers and skim off a portion of each trade. In essence, HFT functions as a covert and private tax on stock market trades — for the exclusive benefit of HFT firms. Our readers also know that we reject the notion that HFT ensures market liquidity. Experience has shown us that it is precisely in conditions of market stress, when liquidity is most critical, that HFT pseudo-liquidity evaporates. HFT is no substitute for the old market-makers who used to ensure stable markets during periods of stress.
In several high-profile cases, the operators of dark pools have now turned out to have been serving the interests of HFT firms, rather than the interests of their institutional customers.
Last July, we reported on a lawsuit filed by Eric Schneiderman, the Attorney General of New York, against Barclays (London: BARC), the British bank and financial services firm. The complaint alleged that Barclays LX, the bank’s dark pool trading venue, was infested with predatory high-frequency traders — even while the firm’s salesmen deceived customers by claiming that HFT represented only 10 percent of the trading activity in the pool. The complaint alleged a variety of other practices which, far from curtailing the activities of high-frequency traders, gave them preferential treatment, all while concealing these practices from pool participants and representing the pool as a place safe from HFT depredations.
In August, the Wall Street Journal reported on another similar investigation, this one of Credit Suisse (NYSE: CS), with similar allegations: that it misled participants in its Crossfinder dark pool about the extent of HFT participation.
According to sources, Barclays is now negotiating with regulators and has signaled it would like to settle; reportedly the settlement will be about $65 million (Barclays denies any wrongdoing in the case, and of course the deal could still fall apart.) Credit Suisse has reached an agreement with the New York Attorney General, and will pay about $85 million to the Securities and Exchange Commission and the New York Attorney General.
Of course, we are happy to see the New York AG’s continued vigilance about and continued pressure on HFT, dark pools, and other recent “innovations” in securities markets which, we believe, have been broadly detrimental to most market participants. However, we note that the fines and penalties likely represent a very small fraction of the gains made at investors’ expense as a result of the activities Mr. Schneiderman is investigating. As realists, we do not believe that these small and piecemeal measures will significantly alter the landscape. For now, we are grateful that the AG’s efforts are at least ensuring that the issues remain in the public eye.
Fortunately, higher-level regulators continue to push the issue. Commodity Futures Tading Commission (CFTC) chair Timothy Massad commented at a recent conference that “flash events” — brief but severe disruptions in trading — have become more prevalent in recent years. (The conference was on the U.S. Treasury bond market, which suffered a bout of disruption last October. Regulatory studies have concluded that HFT and algorithmic computer-driven trading have played a central role in the increasing frequency of such “flash crashes.” Massad and Securities and Exchange Commission (SEC) chair Mary Jo White both discussed proposals to stabilize markets when HFT and algorithmic trading induce flash crashes and cyber-panic. Of course, regulators have been analyzing and commenting on these problems for years… we can only hope, each time the subject is brought up, that it is a sign that the glacial pace of regulation is quickening