October 20, 2009

What We Should Do With Dark Pools

A word on the markets: options expired last week, while swaps and counterparty agreements pegged to volatility measures lapse tomorrow. Speculation and risk management trading are high as a result. If you expect your stock to behave as though everybody buying and selling it acts on fundamentals, you’ll encounter the unexpected.

The NYSE and Charles Schumer were talking today about rules for dark pools. The NYSE is partnered with dark-pool operator Liquidnet and is building a massive high-speed trading facility in New Jersey. The Nasdaq meanwhile plans to launch an exchange next year that will give priority to orders of size, to compete with the size advantage dark-pool operators offer.

What’s going on here? Politics, mostly. We’ve said plenty about this stuff. But the regulators – and IR folks too we fear – continue to misunderstand the central issue. The IR profession is about supporting capital formation and fostering productive, creative enterprises. At the rate we’re going, none of us will have jobs. If trading things is an end unto itself, why bother with all that work to start and run companies? Take your idea to a broker, have them issue an exchanged traded note representing your idea, hire an accounting firm to handle regulatory and financial reporting, and that’s all you need. Traders, have fun!

We’re being obtuse. But dark pools are like black markets. Black markets form in response to price controls. We can go back to the order-handling rule in 1996 in which the SEC set out to “create better pricing opportunity.”

Come forward to Reg NMS. It was a legitimate effort to minimize market arbitrage, but it in effect is a gigantic price control. It says that all trades (there are exceptions but stay with us here) must execute at the best national bid or offer. That’s like pouring Niagara Falls through a funnel. You have literally millions of different prices trying to match up for securities, but trades can only execute, simplistically, at that one best price. That supposes that all buyers and sellers have only one thing in mind: price. If that were the case with cars, we’d all drive Tata Nanos.

Dark pools formed to serve audiences that wanted something more than the best price at this split second in time without regard to supply. Who uses them? Mostly big institutions wanting to move sizeable amounts of shares without interference by parties with other objectives such as speculation, rebate-capture, high-frequency trading and risk-management.

What’s the response from regulators? To clamp down on dark pools.

We’re oversimplifying. And we have good friends running high-frequency trading platforms. We mean no offense to anyone. But the problem in our equity markets is that they’re efficient for parties that want the best price and which don’t want to commit capital and own things.

But they’re very inefficient for capital formation. In 1996, 675 companies IPO’d in US markets with prices over $5. In 2008, 21 such companies debuted here. Money has shifted to private equity by the trillions, and to international markets with fewer price controls.

This had better matter to us more than anyone else. This is our profession. Let’s defend it, rather than slice our collective noses off to spite our faces.

Share this article:

More posts

dreamstime m 105330423
June 19, 2024

One of our customers at EDGE calculated that 82% of Demand in the S&P 500 is from three stocks (NVDA – now the largest –...

June 12, 2024

High-frequency traders are data-dependent. The Federal Reserve ought not be.  I’ll explain. The U.S. central bank today concludes its open-market (FOMC) meeting. Jay Powell speaks. ...

dreamstime m 4536788
June 5, 2024

Somebody pulled a pin and dropped a grenade in the stock market and nobody noticed. Let me explain: Now, there were explanations. Index options on...

dreamstime m 36265338
May 29, 2024

Size matters.  Does trade-size matter?  The average trade in S&P 500 stocks is 87 shares this week (five-day average). Think about that. Quotes are in...

dreamstime m 87656041
May 22, 2024

It’s tough being a market strategist.  Mike Wilson, chief equity strategist for Morgan Stanley, has thrown his bear towel on the laundry pile and lifted...

dreamstime m 17907458
May 8, 2024

Should a stock like COKE rise 20% in a day?  Executives love it, sure. But it’s aberrant behavior at loggerheads with what the dominant money...