Weekend Market Commentary: Special Edition

Written by Gary

Weekend Market Commentary: What Are Dark Pools And Should You Be Concerned?

UPDATED: 1045 EST 2014-08-01

I can’t speak for all of you, but I hate Dark Pools and these ‘secret trading guilds’ as they do not contribute to the well being of the retail market traders and investors; people like you and me. If someone is going to dump a truck load of shares back onto the market, I want to know about these trades that are secretly hidden from our view.

Just the words ‘Dark Pools’ conjure up scary movies where the monster slithers and slimes out of the Acheronian water underworld and scares the bejesus out of you. Who ever started using the term ‘Dark Pools’ knew exactly what the practice was all about and the name apply describes this process of hiding trades. According to some these sometimes draconian business practices of hiding financial commerce from you and me are actually helpful. First let’s look at the definition of ‘Dark Pools’.

Wikipedia defines ‘Dark Pools’ as a none transparent means of trading via private contractual arrangements.

In finance, a dark pool (also black pool) is a private forum for trading securities that is not openly available to the public. Liquidity on these markets is called dark pool liquidity. The bulk of dark pool trades represent large trades by financial institutions that are offered away from public exchanges like the New York Stock Exchange and the NASDAQ, so that such trades remain confidential and outside the purview of the general investing public. The fragmentation of financial trading venues and electronic trading has allowed dark pools to be created, and they are normally accessed through crossing networks or directly among market participants via private contractual arrangements.

One of the main advantages for institutional investors in using dark pools is for buying or selling large blocks of securities without showing their hand to others and thus avoiding market impact as neither the size of the trade nor the identity are revealed until the trade is filled.

However, it also means that some market participants are disadvantaged as they cannot see the trades before they are executed; prices are agreed upon by participants in the dark pools, so the market becomes no longer transparent.

The real question, beyond transparency, is why should traders some get preferential treatment and others do not? A favorite theme in politics is discriminatory treatment between the rich and poor and so we now have a dilemma of large business transactions being recorded without anyone’s knowledge and your disadvantage. You may own that particular issue and I believe you have the right to know if someone’s actions are going to effect your financial security.

Real transparency and the dissolving of these ‘broker-dealer and exchanges’ is the answer and NOT the problem. Seven Pillars Institue says, [there is] “the loss of price discovery, fragmentation of information and liquidity, lack of access to dark pools, and information leakage.” This concept is very simple and easy for all parties to understand, so why isn’t something being done about this malady?

In the following article the argument is ‘what is the big deal’ and these dark pools are just a fact of life and you should just chill out. These are the same folks that think the Fourth Amendment of the U.S. Constitution is a unreasonable block in the road for government interventionists and should be circumvented when ‘necessary’ (in their opinion).

Do “Dark Pools” Threaten the Health of America’s Financial Markets?

While dark pools sound menacing, they are really just off-exchange forums where traders can buy and sell stock in private – without letting the broader market know what they’re up to. And these frameworks serve a simple purpose: to allow institutional investors who often manage huge portfolios to buy and sell large blocks of stock without causing price movements detrimental to those investors.

For instance, Pension Fund X might want to buy a big block of Exxon Mobil shares. Once word gets out in the market that a big pension fund is buying all these shares of Exxon Mobil, smaller funds will jump in ahead of it, causing the price to skyrocket and the fund to get a bad deal. A dark pool gives the fund a place to anonymously execute the entire order at once, and get the best price possible.

So what are the big exchanges all up in arms about? First of all, these pools are taking away their business. In an environment where trading levels are already down significantly, these dark pools are capturing an increasing amount of the exchanges’ erstwhile business. According to a recent Fox Business report, “as much as 40% of all trading now occurs off the exchanges, a sharp rise from just a few years ago.”

But according to some critics, dark pools are more than just a danger to the big exchanges’ bottom lines. When the SEC announced that it would be investigating the possibility of updating regulations on dark pools, officials indicated that they could harm “price discovery,” the markets’ ability to find the best price for a security. If much of the trading in a specific security is done off exchanges, supply and demand information isn’t being gathered all in one place.

Seven Pillars Institue says in its article, Shining a Light on Dark Pools.

Policy Suggestions

It is clearly beneficial to fix the two deontological imperfections of dark pools: unfair lack of access and information exclusion.

The most aggressive approach is for regulators to outright ban the practices of limiting clients and sharing data with a select group of clients. Despite its simplicity, however, this option will likely face fierce opposition by those who benefit from such practices.

Dark Pools: Over 40 Private Stock Markets

This specialized approach to trading big blocks of securities has been around for over 25 years. However, investment banking has changed dramatically and the use of dark pools has changed even more during the last two decades.

By most accounts, there are now over 40 dark pools being operated by large financial companies. It is now estimated that more shares trade in a dark pool environment than on the New York Stock Exchange.

Bottom line is that you are screwed again! But that is OK, because the SEC has been doing something about this – oh, never mind. You know that anything they say they are doing for you is BS, piled high and smelly.

What do you think?

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Written by Gary