May 24, 2011

A Lighter Shade of Dark

Want to know about dark pools? Join the NIRI Virtual Chapter at noon eastern time Wednesday May 25.

I’m moderating the discussion. The all-star panel includes Nicole Olson of storied dark pool Liquidnet; Adam Sussman of expert market-structure research firm TABB Group; and Joe Saluzzi at Themis Trading, one of today’s leading voices on the nature of trading markets. You know him from Bloomberg, 60 Minutes and CNBC.

Two weeks ago at the NIRI finale for the season here in Denver, we were indulging in the benefits of having brewery Molson Coors in the chapter. And someone was talking to me about “black pools.”

I thought, “IR folks don’t get dark pools yet.”

This afternoon an IR pro in California emailed, asking how to figure out what percentage of their shares trade in dark pools. You can’t know, exactly.

Aside: That’s reason #4,032 why you should support the Issuer Data Initiative. If 35,484 of your shares traded at Liquidnet, and 5,203 at Lavaflow today, don’t you think you’re entitled to know? You are. But rules on trades and data for public companies divided in some faded and yellowed wood, and public companies are most definitely on the road less traveled.

Which brings us back to dark pools. The term “dark pool” to me is like trying to describe a process as if it were a place. There are facilities like Liquidnet and Pipeline that specialize in matching trades without displaying prices. But we’re talking about behavior – trading at a posted price, or looking for bargains where prices aren’t shown.

Think about it. This is as old as the hills, old as human nature. You could go to the bazaar where lots of hawkers of wares would list their prices for things. You could do this in ancient Samaria or right now at Walmart.

Or you could instead negotiate with someone in private in hopes of a deal that would keep secret how much or little of the product you wanted. And you might say, “I can get it for two bucks at the market.”

The rules for trading – except for the 14-15 major exceptions and exemptions – require exchanges to display the best prices at which parties are willing to buy or sell shares. Regulations also require the many marketplaces where stocks trade to be connected so everybody always knows the best national deal. Trade there, or pass it on.

What happens when human beings are forced to behave in a prescribed manner? Right, exactly. Humans start looking for ways around it. Dark pools.

Now, dark pools can’t be outside the best bid or offer. But they can be inside it. It’s no different than saying, “I can get it for two bucks at the bazaar,” except that everybody from CFOs to retail investors thinks that the displayed stock prices are best.

But price is only one reason deals meet behind closed doors. Often it’s to keep size secret. What would happen to price if you had to tell the whole world, by rule, that you wanted ten million shares at close of business today?

Now add in one more feature. Since all these markets are required to be connected, and in fact many of the dark pools are linked too, there’s an Ethernet boulevard running through them. Fast machines can race back and forth.

Do you think there’s a wee chance that traders might, oh, display one price out there and a different one in the dark?

That would be human nature. That would also be arbitrage if matched simultaneously.

Regulators seem okay with this dichotomy. When all the different motivations and drives and purposes of many, many disparate beings running myriad mathematical calculations behind trades are forced into deciding between the displayed best price and the unknown un-displayed market lurking darkly in a pool right there beneath that 100-share surface, you are as much as flashing a neon sign that says “please arbitrage at will.”

As a result, we have remarkable machine synchronicity juxtaposed with utter value confusion. Are displayed prices better? Or are investors being gamed by arbitragers in dark pools? The truth is, nobody knows.

When rules attempt to force human beings to do things that they are naturally indisposed to do, the better idea is to get rid of those rules. Why can’t humans decide for themselves what constitutes a good deal, be it price, size, speed or slow but grand service?

Or we can beat every trade into the brick wall, which means a lot more futility from the IR chair, talking and talking to investors about your great business without changing the way your price behaves.

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