Thursday, September 17, 2009

A Dive Into Dark Pools

Earlier this week the luncheon topic for the NIRI Houston chapter was “Dark Pools”. This is a subject that has received much press lately, most of it with ominous overtones to accompany the rather sinister name, so I went with much anticipation, much like you’d go to a scary movie. I have to confess that I knew very little about all of this before I went, and when the luncheon was done, I was more confused than ever. So on the premise that I can’t be the only one who is confused, I decided to do a little more research and, at the expense of stretching a metaphor, try and shed some light on Dark Pools.

First, what are these things? As I understand it, a Dark Pool is an electronic crossing network that allows buyers and sellers of stock to place liquidity (an offer to buy or sell) into a pool anonomously and wait for execution while disclosing little, if any, information. Only when an order is executed is the information on the trade made public. To use a phrase from Bruce Springsteen, these market participants are “Dancing in the Dark”. This is in contrast to normal markets where public order flow allows market participants to judge supply and demand for a stock and adjust accordingly.

Second, are these things inherently good or bad? The ostensible purpose of Dark Pools is to allow holders of large blocks of stock to execute their buy or sell orders without indicating to the markets what they intend to do. Therefore Sellers can sell without driving the price down and buyers can buy without driving the price up. The pricing is done within the Best Bid or Offer context of the National Market System, so price discovery is occurring using normal market systems. This seems like a good thing if you are a large institution looking to move large blocks of stock. Additionally, if you are looking to buy or sell a relatively illiquid stock, dark pools can help you do so with a minimum of price disruption. If you are a company, it would seem that this balances itself out, especially when you consider that institutional investors trade approximately 80% of the stock volume in the U.S.

Third, why the big deal about all of this? Follow the money. The Exchanges – NYSE and NASDAQ, hate these things because they pull significant amounts of orders off the exchanges, which means less order flow and less earnings for them. Traders and specialists hate them because they obscure market information and eliminate trades that they would otherwise execute by putting it all into a machine. This eliminates both the lifeblood of traders – information – and jobs. So much volume has come off the floor of the NYSE that there are significantly fewer traders these days and they have been forced to close trading rooms.

Finally, are there things that should be of concern? If too much volume comes off of the visible Bid/Ask market system, the bids and offers shown on the publicly displayed market quotation system might not accurately reflect true supply and demand. This is why we are seeing rumblings by the SEC to regulate areas of dark pools if too much volume is traded in them. (The nature of regulators is to regulate.) While dark pools are good for large institutional investors moving large blocks of stocks and companies that trade using sophisticated algorithms, it is considerably less clear that they offer any benefit for anyone else.

I think what is happening here is that technology is opening up new channels for trading and moving things away from the old duopoly of the NYSE – NASDAQ. As they are the ones with the most to lose, they are also the ones that will yell loudest. At the end of it all, the lesson is that not all investors are equally suited to all markets. With the emergence of several new ways to trade stocks we are moving away from a “two markets fits all” approach to customized execution based upon the needs of the investor. Many permutations on order execution are bound to follow. The exchanges better figure out how they fit into all of this or they will be left behind.


catherinec said...

Interesting perspective. This was a hotly debated topic at the NIRI annual conference and the overwhelming sentiment seemed to be that things needed to change with respect to Dark Pools. I look forward to checking back for additional comments.

Dan Dykens said...

John for somebody who claims to know little about dark pools I would say that you did a pretty good job of explaining what they are and how they work.

Dark pools actually help improve liquidity and reduce volatility. Large orders are executed without moving the market which is a good thing. It is not easy to buy or sell large quantities of stock as the other side tends to move away from you.

As for the exchanges hating dark pools...The NYSE recently announced the acquisition of NYFIX which operates the Millennium Dark pool. As the old saying goes if you can't beat 'em...join 'em.