January 5, 2011

Money Loves Darkness

Happy New Year! Good to be back after a two-week break from The Map. Karen and I spent Christmas in Texas, where there remains a general lack of fear of federal government.

I’m glad when winter solstice passes, that shortest and gloomiest of days. After that, we’ve rounded the corner from darkness toward light no matter what winter yet holds.

But in trading markets, darkness thrives. Monday in the Wall Street Journal, Jacob Bunge, who covers the exchanges, wrote that 34% of trades in December matched up off the exchanges in “dark pools,” doubling from last year. Why is money streaming off exchanges in search of darkness, and does it mean your shares aren’t priced right?

Let’s clarify “dark pools.” There are trading facilities like Liquidnet, Pipeline, ITG Posit and Aqua that offer twists on paths to more share-supply. They’re like the Millionaire Matchmakers of trading, finding liquidity love for willing parties. But these independent platforms and their broker-dealer counterparts at Credit Suisse (Crossfinder), Goldman Sachs (Sigma X) and Barclays (LX) command about 12% share.

Where’s the rest? Let’s use an analogy. In the BCS championship bowl game between Oregon and Auburn next week, the stadium will fill up with fans. That’s like an exchange, or any place including dark pools where people gather for a purpose.

The other 22% of your trades are occurring in undefined places. It’s more like online gaming, where the game flows to players who gather no particular place. The trades meet and the meeting is logged on the tape and rolled into your daily volume.

Like this: A Merrill/BofA algorithm handling a rebalance for a mutual fund flings bits across thousands of other interwoven algorithms, and a tiny dab finds the other side of a trade on Sungard’s Assent linkage platform that’s shuttling back from a rebate trade at Lavaflow. They meet, kiss, and print to the tape.

Multiply that by millions. That’s trading today. It’s a vast archipelago of mostly meaningless interactions.

In November, our clients averaged 2.1 “rational” prices. In other words, just over twice in the entire month for a given company did mathematics reveal behavior reflective of thoughtful stock-picking. The other eighteen days, price was set by other behaviors.

In December, the number of rational prices dropped 40% to 1.3 on average. Nearly 20% of clients had no new rational price at all, and 75% had none or one.

Disenchanting? No, it’s logical. Rational thought isn’t boomeranging about every few seconds. But most behaviors are programmed to respond rather than viscerally drawn.

Back at the exchanges, everything is defined and controlled by rules. While the same rules apply to dark pools including trading at the best bid or offer, at the exchanges you’re banging and jostling with everyone. You can’t fall in love with a stock here. You can get in line and try to keep up.

That’s why money loves darkness. It’s quiet in the shadows. For the players looking to score, there’s arbitrage between light and dark markets.

Bottom line, dark pools aren’t hurting your share price, structure is. Worst for issuers, the data from this loopy structure are fragmented into a million little pieces.

The answer isn’t to force behavior back to the place it’s fleeing, but to change what’s causing it to flee in the first place. Price should be set by who values something most. Not simply by being the other side of a trade, and fastest to get there.

For any who say “but we need the volume,” I refer you to our rational-price statistics and the Flash Crash: Value and volume are not interdependent.

We can change this structure. If a thousand public companies banded together and demanded that the SEC change the structure, change would occur. If not, then we have much bigger problems than machined shares.

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