They sound ominous, and some folks believe them to be pernicious, but so-called dark pools are the newest thing in securities. After the last newest thing in securities – the ability to chop up debt and convert it to tradable derivatives – blew up in our faces and created the current global financial crisis, perhaps the nabobs deserve a little attention this time around.
Dark pools are basically unregulated exchanges that allow for the anonymous matching of large-scale buyers and sellers of shares. Prices are known only after completion of the trade.
These venues are on my mind today because within half an hour I came across two news stories – one from Reuters and one from The Financial Times – that explored the marketplace for these transactions.
The term dark pool debuted in The Economist over two years ago (so I guess it’s not so new). At that time, it was explained within the context of the divergence of interests between stock exchanges and prime brokers. Once upon a time, the exchanges (or seats on them) were owned by the brokers – that’s no longer the case, and the fat margins that brokers used to enjoy have been chipped away at by the exchanges, who are now acting in the interests of their new shareholders. Dark pools were then posited as a place run for brokers, by brokers, or as The Economist had it,
Another way in which banks and brokers are circumventing the big exchanges is through “internalisation”: dealing with each other directly. There are now dozens of “dark pools” of liquidity, in which banks and institutional investors anonymously trade large blocks of shares. Computer software trawls through brokers’ order books looking for matches. When they are found, both sides are alerted. Banks have long traded directly with each other through their “block desks”, but the use of pools enhances this and technology makes it easier for the pools to link up. This week, for instance, Credit Suisse and Instinet, a broker, signed a mutual access agreement for their dark pools in Japan. An estimated 10-15% of all stock trading is now done in the dark. As the head of one exchange puts it: “The liquidity is no longer in the marketplace. It's on trading desks.”
Last year, The Economist hazarded that 20% of all shares will be traded via dark-pool transactions by 2012. What implications does this have for the retail investor?
Price discovery, for one, will suffer. Going forward, without significant new regulation, it is going to be harder and harder for retail investors to “see” the market. Prices and trading volumes will be less reliable indicators of value and movement. Indeed, there will be a whole world of stock-market activity taking place that won’t be public. This will lend itself to arbitrage (a less kind person would call it fraud) by brokers who can see both dark and light pools of stock transactions.
Still, one can’t help but have a grudging admiration for the financial industry. The consequences of the current trillion-dollar bailout have not even played out yet, and already, Wall Street’s alchemists are back at work playing the angles. Having said that, I can’t imagine that dark pools are a good thing for anybody but big arbitrageurs. The biggest problem is that the very existence of dark pools subverts the notion of a public market. As for how it actually affects the average Joe in practice, the answer is probably not much, unless he likes to handle his investment portfolio himself. Small investors will lose market transparency; however, institutional investors (pension funds and the like) will be able to move large amounts of stock without triggering market moves against them, because no one will know who is doing the buying and selling.
Dark pools are Anglo-Saxon financial innovation at its best…and worst.
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