August 12, 2015

Dark Costs

Credit Suisse. Deutsche Bank. ITG. Pipeline. Barclays. UBS. BNP Paribas. Citadel. Goldman Sachs. Liquidnet. Bank of America Merrill Lynch. Citigroup.

What commonality unites these firms? All have been fined for violating rules on so-called dark pools, private stock-trading venues.  At least three are now defunct, Pipeline shutting in 2012, Citi halting its Lavaflow unit last December after paying $5 million to regulators for compromising customer data, and Citadel saying in March this year it would mothball its Apogee platform.

Morgan Stanley and JP Morgan have been investigated but as yet have had no knees capped in the twilight. This is no collection of backwater outfits but a brokerage Who’s Who. These firms are running your buybacks and underwriting your offerings, the pillars upholding equity market-making and liquidity for shareholders.

Ask any Vice President of Marketing at a public company how the firm’s products and services are sold and you’ll get an unhesitant response. But your CFO likely doesn’t know what a dark pool is or why the big brokers running them are continually afoul of rules. You’re the product manager of the equity market if you’re occupying the IR chair. You’ve got a golden opportunity (and in a sense a duty) to be the expert.

Word is ITG, a publicly traded firm itself and among the largest independent operators of markets serving as alternatives to the big exchanges, will pay more than $20 million to settle allegations of trading against customer orders in 2010. It’ll be a test for the company to survive a wallop of this proportion.

Citadel, the hedge fund founded by mogul Ken Griffin, has been fined more than 20 times for breaching various rules. A bad actor?  Visit the Finra newsroom (formerly the National Association of Securities Dealers, Finra is the watchdog for stock brokers) and you’ll see a continuous litany. In the past month alone Goldman Sachs, Raymond James, Wells Fargo, LPL Financial and Aegis Capital were fined tens of millions collectively for demeaning market rules. In May and June, Morgan Stanley paid $3 million.

If everybody is paying regulators, could it be market rules are like the tax code – so byzantine that everybody is routinely in violation? We could countenance a concatenation of penalties for fringe firms jobbing the innocent. But fines are the central tendency. It feels like Las Vegas when Bugsy Siegel ran it.  You’re gonna pay the vig. (We think regulators want to end dark pools. Since they created the rules – Regulation ATS and the Order Handling Rules – that birthed dark pools, they don’t want to reverse themselves. So they may instead penalize alternative venues out of existence.)

Why would public companies accept a market so complicated that Goldman Sachs can’t comply? It gets once more to the IR job today.  At minimum we should understand and measure its performance as we would any other market to ensure that our best interests and those of customers and shareholders are being served. If you want to sell in China, the market is big but what determines whether you can or not is structure.

“Dark pools” is an inaccurate term but if you’re an investor-relations officer you should understand them.  Exchanges like the NYSE cannot give preference and must post prices. They’re public markets.

Dark pools are not public. You need permission from the market’s operator to use one, and most don’t list prices for shares because the reason they exist is to escape a bizarre feature of the stock market: List a price and somebody will attempt to be above or below it in order to keep your price from being matched. Prices are today like the way a friend of ours in California describes using turn signals when driving: A sign of weakness.

So dark pools decide who gets to enter, and the products in dark pools like your shares are listed by amounts, not price. If a pool has 10,000 shares of XYZ, the price will be halfway between the best bid to buy them and offer to sell them in the public market. Ostensibly nobody knows I’m after at least 5,000 shares so I get more at a decent price.

See?  Now think about that. A mall brings people wanting to consume things together with retailers selling them.  In the stock market, complex rules make it challenging to find anyone selling what you want to buy, and the moment you lift a finger, the price changes (this is why your investors increasingly use ETFs and other derivatives – it’s too complicated to get big amounts of the underlying asset).

You say, “I’m a road warrior, a vagabond of highways and jetways, a troubadour of the corporate story. I don’t have time for this stuff!”

Have we got it backwards? Shouldn’t we first understand – and have a say in – the market for our shares before we market our wares?  (I fashioned that rhyme myself.)  Structure counts. Caveat emptor.  Latin but timeless.

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