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Dark pools—A dark matter needing light?

Finance Blogger: Anthony Harrington Anthony Harrington

The US Securities and Exchange Commission has been exercising itself in recent months over the topic of “dark pools.” What are dark pools? Let’s take a step back for an instant and approach the definition by way of a brief consideration of the practical reason why dark pools (which have been around, in one form or another, for as long as markets themselves) came into existence.

When an institutional investor decides that being long in a particular FTSE 100 or S&P 500 company is no longer in its best interests, it naturally enough wants to shift out of that stock. Herein lies a dilemma. It could stride heedlessly up to the market and yell: “Anyone want to buy 2 million shares of company A whose prospects I now regard as dim?” Of course if it did this investors would make off at their best speed and the price of Company A would tank dismally.

In the good old days, an institutional seller could wander upstairs and have a quiet backroom word with his (it would have been a “him”) broker-dealer who would have set about disposing of this large block of shares in as stealthy a manner as possible, drip feeding lots into the market as occasion presented, hoping all the time that one of the buyers would not nudge another and say: “Hello, Bloggins is trying to bail out of Sunny South Sea Island stocks—I’d dump it too if I were you, old chum!”

In the modern era, a reasonably large number of broker-dealers, headed by Goldman Sachs, but also including the likes of Credit Suisse and others, accomplish this matter very effectively via specialist trading platforms which both split the stock into manageable lot sizes and conceal both the seller and the volume of the total order from the general market—hence the rubric, “dark pools.”

On the plus side, this enables said institutional investor to dump a large quantity of company A shares without seeing the market move rapidly against him/her as a result. On the negative side, there are concerns that this could all get a bit too cozy and Joe Public (here we are definitely talking about the US, because the UK variant of Joe Public is not, by and large, a particularly adept or avid trading animal when it comes to stock markets) could be being excluded from some juicy trades in what amounts to a variant of insider (or at least, “in-coterie” dealing).

In recent testimony on “dark pools” and the SEC’s concerns over them, James A. Brigagliano, the Co-Acting Director, Division of Trading and Markets at the SEC, sums matters up nicely: “Information leakage about a larger order [is] a serious problem, and the ‘market impact’ of large orders could impose a major cost on investors. Historically, many dark pools developed as computerized ways of searching for contra-side trading interest while preserving confidentiality. While early dark pools were designed to cross large orders, and such pools still exist today, most of the newer dark pools are designed to trade smaller-sized orders. In some cases, these small orders are derived from large ‘parent’ orders that have been chopped up into smaller pieces.”

The SEC is very much in favor of Alternative Trading Systems (ATS) which exist apart from public exchanges (until they “morph” into them by applying for a public exchange license, which some have done). What it is worried about is that “searching for contra-side trading interest is one thing, flashing Bloggs a short “eyes-only” message on a private trading screen that is the equivalent of saying: “Come grab some Company A stock 10% under market” is something else again.

Exactly how the SEC will solve the dark pools problem in the interests of fair play for all remains to be seen, but it should be fun to watch. At the very least dark pools are another instance of just how hard it is to create and police “fair-to-all” markets.

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Tags: broker-dealers , institutional investors , SEC , stocks and shares , trading
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