Dark Pools Of Liquidity Are Increasing, As Are Potential Problems

There has been a recent resurgence in interest in dark pools of liquidity. No, this is not some Star Wars reference (at least I don't think so), but does refer to a procedure and method of trading that is once again causing some concern on Wall Street. For years, crossing networks have been matching buy and sell orders "off-exchange" in what have been referred to as dark pools of liquidity. The advantage of these pools it that they should make the execution of a large order safe, and allow the two market participants to execute the large order without moving price, while maintaining some privacy. While the amount of dark pool transactions is estimated to be a little over 10% (but including more than 20% of all trades in NYSE-listed stocks), it is continuing to grow as hedge funds look for less transparent ways to sell large positions, and brokerage firms look for more ways to generate trading income and possibly tap into the increase in trading revenue streams that the exchanges have been enjoying over the last few years.

Unfortunately, some are worried that gaming is allowing others to profit from the transaction, and of course potentially leaving one side of the dark pool transaction a little worse off. The problem has gotten significant enough that some are considering no longer using the dark pools, with 60% showing some hesitation. As recently highlighted in a Finanial News article, steps are being taken to tackle the problem, such as putting anti-gaming measures in place at both large and small firms. Steps being used and/or considered include physically monitoring patterns of trade abuse using a human element, using computer algorithms to spot trends, developing fair pricing models, and using anti-gaming logic.

While it is true that it may not always be known exactly what is occurring within the dark pools, it appears as if their operations are simply more organized ways to perform crossing of block trades, with a print of the tape after the transaction is complete. Nonetheless, it is still surprising to me how in the current financial environment that the SEC, other regulators, and some of the exchanges themselves have not spoken more about dark pools, their transparency (or lack of transparency), and the affect this has on price discovery. In fact, it seems to me that given current credit issues, this might not be a something the industry wants to advertise. Yet, this is apparently not stopping some.

As recently reported at the Deal Breaker blog, Goldman Sachs, Morgan Stanley and UBS have agreed to share their dark pools, such that each will allow for the secretive trading to take place between their clients. The dark pools include Goldman Sach's Sigma X, Morgan Stanley's MS POOL, and UBS's PIN ATS. The union further threatens to take business from the exchanges and furthers current consolidation of the brokerage industry. Right now exchanges are at a disadvantage when they try to compete with the dark pools since they are being regulated by the SEC, with new rules being put in place over the last year forcing them to share even more information and route trades to the exchange offering the best price and fastest execution. Dark pools have in many instances been able to avoid regulation by keeping trading volumes under a set threshold.

But again, while this is probably a good move for the financial institutions with regard to generating new business, lowering costs, and helping to tap into the monopolies of the exchanges, it is probably not the most public relations friendly move in the current credit environment. As is often unfortunately the case, this will surely cause some in Congress to start talking of new regulation, especially if someone goes way out on a limb and attempts to tie the practice to home foreclosures or high energy cost - adding a new level of regulation with the usual unintended consequences. If this happens, we may end up wishing that a dark pool of liquidity was truly just a Star War reference.