Posted on 03/12/2008 4:28:08 AM PDT by TigerLikesRooster
Columnists: Locust: Crossing networks – Dark traders
Locust shines a light on the dark pools of liquidity seeping into the financial world
A lively public stock exchange is often considered the necessary centrepiece of any successful economy. Yet at the O’Reilly Money:Tech conference in New York in February, which looked at how the internet is affecting the financial industry, one session discussed two troubling developments in the world of share trading: dark pools and crossing networks.
Dark pool is the umbrella term for any “non-displayed liquidity”, or trades that are hidden from public view, many of which are block trades carried out by big institutional investors away from the public exchanges.
A crossing network is an electronic system for dark pool trading. It matches buyers and sellers without publishing prices on a public exchange.
Low touch channels
The emergence of these pools and networks, explained Larry Tabb of Tabb Group, is part of the general shift away from high-touch trading channels, involving speaking to a trader, to low-touch channels, where everything is done electronically. The figures are astounding: 79 per cent of trading was high-touch in 2004, and this has fallen to 37 per cent in just four years. This is hitting brokerages hard, and their woes are compounded by the resultant plummeting commission rates. They are therefore establishing dark pools to match “buy” orders and “sell” orders automatically before they arrive at the public bourses.
The pools operate without publishing any quotes or price information. Large institutional investors will often appreciate being able to keep their buying intentions under wraps. But the lack of publicly available prices can have a negative impact on price discovery across the entire market, since the fragmentation of the market brought about by networks across which prices are not communicated makes it difficult to establish precisely what the market price is.
In effect, there is no single market and therefore no single market price. This can have a negative impact on the informational value of prices, or at least call for extraordinarily complex, multi-network-sweeping algorithms to make sense of the fragmented price information, with more networks leading to ever more fragmentation complexity. This may suit the big investment houses, but it shuts out small investors.
On the increase
Dark pools are still relatively unknown outside the world of finance. This is likely to change as the size of the pools and the number of crossing networks grows. In October 2006 the Financial Times reported that banks were “beginning to dip” into the pools. By October 2007 BusinessWeek had big traders “diving” into them.
The adoption of dark trading by financial institutions is likely to accelerate further as the 37-and-counting dark pools and crossing networks that are in or near production in the US go live. And as an increasing proportion of trades take place out of public view in these walled gardens, public concern will mount about their transparency and accountability.
Public interest in crossing networks is also likely to grow on account of the fact that so many aspects of them have names prefixed with “dark”. The algorithms used to sweep the pools, for example, are “dark algorithms”. And the pools themselves are sometimes also referred to as “dark liquidity” or “dark books”. The marketing folks who gave us “subprime” and linked the idea of not-quite-sirloin to the rotten mix of debt obligations they were peddling must have been unavailable for this one.
In fact, the last time anything set out on so clear a collision course with public relations disaster on account of what it was called, Exxon had just named a ship after itself.
Watchdog
With such clear incentives for an increasing exodus of trading to the ultra-low cost environment of the crossing exchanges, the conference host, Tim O’Reilly, asked Larry Tabb whether order flow might end up like the Colorado river. In other words, never reaching the bourses just like the Colorado apparently is drained of water before reaching the sea.
Tabb suggested this was unlikely, since price discovery would be impaired and there would be an end to mom-and-pop order flows. He estimated the Securities and Exchange Commission could step in as early as when 15 per cent market share was reached by the networks.
But with the politically powerful New York exchanges already losing market share to the dark pools and with the growing public and political distaste for all things opaque in finance, it would not be surprising if regulators and lawmakers were to start taking a closer look even more quickly than that.
Ping!
Cool, if true. Makes the average Joe investor do his homework before buying or selling a particular stock and puts a big clamp on the brokers from insider trading possibilities (running their mouths at cocktail time about tomorrow’s orders and who).
If they haven’t already, the ii’s are going to figure a way to swap securities hiding the true cost of the “buy” and the true gain from the “sell”. If you think the NYSE is nasty when you cut them out of its share, wait until the IRS figures out they’ve been cheated. Hit, poop, fan.
Oh yeah, our famously pro-active and vigilant SEC is drawing up the papers already. They have a guy watching a screen all day long with his finger half an inch above the "Initiate Investigation" button.
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