If something happens in the dark, its full impact can be difficult to assess until the lights come on.
This notion is at the heart of concerns on Wall Street about how much equity trading is now taking place on internal crossing networks, or as they have been more mysteriously termed, dark pools.
Dark pools are private interbank or intrabank platforms that are widely used to trade stocks away from exchanges. They are used by clients such as hedge funds to buy and sell large blocks of shares in anonymity, avoiding the risk of moving the public price of a stock on an exchange as a result of copycatting by other traders. According to consultancy The Tabb Group, dark pools already account for 12 per cent of US daily stock trading volume and rising.
The spread of dark liquidity has been so significant that the term ‘light markets’ has even recently entered the financial vernacular to describe transparent public markets, with which dark pools compete.
But several market participants have expressed worries that the desire to avoid moving the public price of a stock might actually be having a detrimental effect on that public price. The argument is that if so much activity is going on behind closed doors, how can the price quoted on the public markets be truly indicative of the investor interest or sentiment on a particular stock?
For many years, trading on exchanges, with publicly displayed price quotes and traceable transactions, has been deemed to guarantee that the maximum amount of information available and obtainable in the market is included in the process of price formation for every stock.
This information includes the intentions of other traders and indications of their confidence in a particular stock due to their trading activities. This price determination is by its nature an efficient process that, despite the threat and practice of some traders piggybacking on the actions of others, ensures that prices accurately reflect actual supply and demand or actual confidence and pessimism. It follows that separating certain trading activity from this price formation process means prices will not include the fullest information available and could therefore cause capital to be allocated inefficiently.
Fans of dark pools argue that the availability of public prices and their use as the basis for dark pool prices makes the concerns about public price discovery less of a problem. That may be true of the participants who have access to public and private markets. But it is more of a leap to accept that those who transact only on public markets are not going to miss out on some price discovery because of the activity taking place on dark pools that they have no knowledge of.
The allure of such dark pools to institutional investors is easy to understand: if competitors learn about your market activities they are in a position to disrupt your trading. So why not do it in secret?
Against the backdrop of heightened concern about financial markets in the wake of the credit crunch, it is strange that regulators have yet to at least ask serious questions of dark pool operators or that a debate on public price discovery has not become more, well, public. The Federal Reserve and other regulators have made no secret of their desire to rebuild the credit markets much more transparently. But dark pool activity in equity markets continues unchecked. Even if the impact on public prices is minimal, regulators would do well to run the rule over the practice before dark pools expand to such an extent that they potentially add to systemic risks.
In the current regulatory enivironment, exchanges are at disadvantage against dark pools because the former are regulated by the SEC and must route trades to the exchange offering the best price and fastest execution.
The coming expansion of dark pools to areas beyond equities such as options and other derivatives means regulators should ask questions before dark pools get too deep to be lit.
