Rick Welch: Dollars and $ense

"Trading in the Dark (Pools)"

Would you be surprised to learn that each day over 40% of all stock trades in the US are conducted outside of the public stock exchanges? Examples of domestic public stock exchanges include the two most commonly known exchanges, the New York Stock Exchange (NYSE) and NASDAQ. The question then is if trades are not executed in the public exchanges, how and where are they executed? The answer is dark pools or off-exchange venues, which are defined “as private electronic trading networks in which the matching of buyer and seller is done entirely within the control of the venue and the bid, offer and eventual sale price remain private or dark.”  Originally the concept of the dark pool was to allow large institutional investors like pension funds, asset managers and mutual fund companies, to place large trade orders without disclosing them or their trading strategies, thus distorting the market and causing prices to move against them.  These large institutional investors were initially attracted to dark pools largely because these venues offered protection from the predatory pricing tactics of high-frequency traders. More recently, dark pools have received increased scrutiny from regulators as many dark pool operators (there are 50 dark pools in the US) are now welcoming those same high-frequency traders into their networks.  It should be noted that the average trade size within the dark pools is just 187 shares, which suggests that these private venues are no longer solely the domain of the large institutional investor.

A recent civil complaint by the New York Attorney General against Barclays PLC charged the British bank with fraud in the operations of its dark pool, the most serious allegation being that Barclays misled customers about the way its dark pool favored high frequency traders.  As reported recently in the WSJ, “essentially all client orders were routed to Barclay’s dark pool first, despite assurances that it treated all trading venues equally based on the client’s best interests.  This routing of orders not only produced significant revenue for the Barclays business unit, it also did little to protect institutional clients who often served as the counterparty in trades with high frequency traders.  The allegations went as far as to suggest that Barclays even slow processed some orders to allow favored high frequency traders time to act. These few extra seconds allow high speed traders to front-run the order flow, which is a way of taking advantage of pending orders to buy or sell before the orders are executed.”

Dark pools, though legal, sound mysterious and unfair and offer the potential to tilt what is supposed to be a level playing field.  Proponents of dark pools suggest they add much needed liquidity to the market and lower transaction costs for all investors. That may be true, but, the trade-offs are a  lack of transparency and the impairment of true price discovery – with so many shares trading hands in secret, the broader market is unable to derive a true and accurate price for many shares.  This lack of transparency, and its ability to hide inefficiency, potential conflicts of interest and outward manipulation, is contrary to what the typical investor wants or expects to find in public markets.     

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