Dark Pool Investing: The Secret Stock Exchange

Hi Everyone,
I've been posting at DailyKos lately, but I wanted to share this with all of you. I stumbled on this topic yesterday and I think it's worth sharing. It's a whole side of the financial world I never knew existed.

The Secret Stock Exchange, (my phrase) is called dark pool investing, a.k.a. a "crossing network" is actually a loose confederation of major financial players who buy and sell stocks "off the grid." That is to say, they buy and sell without using a normal stock exchange. This is done through back doors at ordinary Stock Exchanges, such as NASDAQ and through specialty stock exchanges such as Liquidnet.

I brought it up yesterday in this dailykos diary and I think it's something that needs to be dragged out into the open. If we can bust this into the mainstream, it'll be one more reason to question the policies of the last eight years. I think that this is an election issue.

Personally, I'm not all that financially literate and I'm still doing my best to understand this stuff. I've included as much source material as possible to ensure accuracy.

Conde Nast Portfolio News describes it very well in this article:

Behind the boom in dark pools are large hedge funds and institutional clients that want to build and liquidate large stock positions at lower costs, while also being shielded from those who might profit by knowing their intentions.

An activist hedge fund, for instance, may not want to reveal that it is buying up large blocks of stock in a company it is about to attack, or a mutual fund might want to sell a large amount of stock without causing a downdraft that would hurt any shares it still holds.

Here's where we worry:

Exchanges are at a disadvantage as they try to compete with dark pools. The S.E.C. regulates traditional exchanges, and new rules being phased in over the next few months will require them to share information fairly and mandate that trades be routed to whichever exchange gives the best and fastest price.

Dark pools, by contrast, can largely avoid regulation if they keep their trading volumes under a set threshold. This makes them attractive to big institutional traders seeking to avoid being so transparent about their trading patterns that competitors can anticipate their actions or otherwise gain an edge.

The S.E.C., meanwhile, is worried that the fundamental lack of transparency in these pools might lead to price manipulation or other abuses.

Well yes, a lack of transparency IS a problem. How does this translate into problems for everyone else? Well, I took a stab at it yesterday and probably missed the mark a bit.

In this article in the New York Sun, someone better qualified takes a closer look. First, the issue of transparency:

In the wake of the subprime mortgage debacle of the past two months, the importance of transparency is obvious. The packaging and repackaging of impossibly shaky mortgages into sophisticated investment products resulted in securities that were overly complicated and not well understood, and that ultimately went bust and brought down an entire industry.

On an ordinary day:

This has an impact on the average investor by shrinking the amount of trading that is being funneled through traditional channels, and which is available for filling the orders that such small investors place through their brokers. That is, it reduces liquidity and transparency in the marketplace for the small investor, while enhancing it for the big players. Less liquidity means less opportunity for "price improvement," wider spreads, and, ultimately, more costly executions.

The article goes on:

Also, over time, internalization will mean a continued consolidation in the brokerage industry. Those firms such as Goldman Sachs that have giant order flows already are obviously best positioned to fill orders in-house. They profit off a spread between the price they paid for a stock and the price they charge the buyer. While initially they are likely to seek narrow spreads so as to attract business, if there is a fall-off in the number of competitors, the spreads will likely widen.

This sort of parallel system has drawn the attention of the SEC, but as usual, they aren't doing anything. (As of October 2007.)

Recently, more than 20% of all trades in New York Stock Exchange-listed stocks have been funneled through these dark pools, up from just 3% to 5% two years ago, according to NYSE figures.

Asked about the SEC's view of dark pools, a spokesman cited a recent speech by the head of the Division of Market Regulation, Erik Sirri, who said that "while the increasing use of hidden orders may be troubling," the SEC believes the new venues are available to all market participants. He suggested that the SEC is not in the position of favoring one market model over another. It would appear that until the trend toward dark pools has a measurable impact on investors, the SEC is willing to be simply an observer.

Here is a excerpt from a Financial Sense University article that outlines some risks:

And “what about the risks?” Don’t all these ‘dark vehicles’ greatly increase the risks in the market? Consider:

1. It is pretty clear that the ‘dark pool algorithms’, which are designed to trade large orders in liquid markets, are automated trading operations otherwise known as “program trading.” But haven’t automated trading platforms played a big part in major company and market meltdowns?

2. Isn’t an essential part of any investors’ sensible risk evaluation a function of evaluating counterparty risk? That is, a counterparty is the party who takes the other side of any particular investment transaction in which any of us is involved? But the capacity to make good on any such transaction is a function of counterparty strength or weakness. Suppose the counterparty fails? And suppose the counterparty on any particular investor transaction is at great risk because of its ‘dark book’ transaction with other ‘dark’ parties. Who would know, and how could the risk be evaluated?

Indeed, we certainly have enough recent examples of Counterparty Failure to cause concern. Consider that the Amaranth Hedge Fund in recent months and Long-Term Capital Management in recent years are only two examples of this.

3. Moreover, consider the foregoing in conjunction with a couple of other observations by noted financial observers:

“The inflationary recession continues to deepen with economic reporting generally surprising markets on the downside of expectations and inflation surprising markets on the upside.” April 3, 2007 Flash Alert, John Williams, Shadow Government Statistics. That is, Williams’ is describing our current state of stagflation.

Couple this observation with one attributed to Mark Precter (the Elliott Wave theorist) which we paraphrase as follows: “Currency inflations can go on forever, but credit inflations have a finite end point.” Indeed are we not seeing the beginning of the end of the massive (Fed Caused) Housing Credit Market inflation that we have seen in recent years manifested, for example, in the New Century Financial bankruptcy at the beginning of April, 2007?

Does not the “darkness” of “dark pools” impair our capacity to cope with the foregoing challenges?

4. And what about “Fundamental Fairness” and “Level Playing Fields” in The Markets? Equal timely access to price information is essential to fairness to the investing public but “dark pools” and “dark transactions” in principle limit such information to the privileged few.

5. And what about “conflicts of interest?!” One blogger wrote: “But if a bank sets up an (dark pool) exchange, some of the biggest traders on the exchange will also be the bank’s biggest customers in other areas. This is a massive conflict of interest situation. Remember what happened in the 1990s when investment banks noticed that their equity research divisions could be used as a marketing tool? Imagine using execution speeds and pricing for the same purpose.”

6. And what about lack of oversight?

7. And what about the potential for fraud?

8. And, above all, for the investor, do these “dark pools” not put at risk all their hard earned wealth and profits, as a result of some “dark pool” event which has not been foreseen or planned for?

It certainly seems that the lack of transparency, in dark pools and dark books, lack of the ability to evaluate counterparty strength, conflicts of interest, and the continuing stagflation and impending credit bubble bursts certainly do not bode well for the future or for portfolios,

I'm going to throw a new term out here: dark agreements. Because when you have anonymous trading going on, where the trade is posted only after the fact with little disclosure, you can have secret contracts. The potential for abuse is enormous.

Although this hasn't been discussed in any detail in financial articles I've come across, probably because there is no proof, it's the sort of problem that can easily plague the financial industry just like in the halcyon days of Microsoft and its secret contracts with computer makers.

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I sure hope you can push this into the mainstream media. It's our monies and futures at stake let alone the country.