HAUKE: Sinking of dark pools may have consequences

I love a good swim. I try to get to the YMCA three or four days a week.

The YMCA does a nice job providing clean,
safe pools. And even though I have been swimming aggressively the past four years, I don’t like swimming in lakes or
oceans where I can’t see past the end of my arm. Something about the darkness gets me a little freaked out.

One consequence of the large stock market losses during 2008 is the Securities and Exchange Commission’s decision
to increasingly jump into the dark pools that have swallowed more than 15 percent of all the trading activity in recent years.
Dark pools are an actual cyber location where institutions can execute large stock trades anonymously with little to no effect
on current prices. They came about in the last 20 years as the SEC moved to condense trading spreads and force buyers or sellers
to publicly display the intended size and price of their trade.

Add this to the fact that, over the years, market
makers have been less willing to truly be the buyer or seller of last resort, and we’ve been left with institutions
having great difficulty trying to move large blocks of stock. Without any innovation, the system would continue to favor small
day traders who could see these large orders sitting slightly away from current pricing and essentially front-run the order.
If a pension fund wants to buy a million shares of General Electric today and it is bidding $16, it doesn’t really care
if it ends up paying $16.05 by the end of the day. But small traders could scan the world buying GE at $16.01 and sell it
to the institution for $16.05. With a dark pool, the million shares get done at $16 and that’s it.

These
dark pools are typically proprietary operations run by the largest banks in the world. UBS and Goldman Sachs run two of the
biggest pools, and there are more than 30 other firms involved on any given day. The SEC is in a stitch about these things
because the pool operators usually wait far longer than the exchanges to post their trades to the tape. And the fact that
they are run by large international banks and operate for the benefit of large institutions makes dark pools an easy scapegoat
for the 2008 debacle.

There is a hearing in Washington, D.C., in the next few days to discuss limiting dark-pool
activities. I expect to see a lot of media attention surrounding the topic.

If I were working with the SEC, I would
exercise some caution before issuing new regulations about these dark pools. It was the increasing regulations that caused
the market to move that way to begin with. In addition, there are liquidity benefits that are not normally seen by the average
investor.

Small-cap stocks are one of the biggest beneficiaries here. Throw a 10,000-share order into the market
for a stock that trades only 200,000 shares a day and watch how fast that stock hits the skids. Feed that stock in a little
at a time and some of the shares will find their way into one of those dark pools where some big cat has been waiting all
day to buy those shares. He takes them off your hands quietly and you both win.

We also have to keep in mind that
many of the firms trading in the dark pools represent pension and mutual funds, which are primarily benefiting the general
public. Believe it or not, reducing the dark-pool presence will offer the biggest benefit to someone like me, a smaller independent
money manager with access to the fastest trading platforms and the most cutting-edge analytical software. We are big enough
to afford the best trading technology, but we are small enough not to worry about size restrictions.

As with most
federal regulation changes, this isn’t anything the free market can’t handle, but a solid dose of meddling will
result in the usual path of unintended consequences. I have some ideas about what those consequences might be and how to profit
from them, so stay tuned.•

__________

Hauke is the CEO of Samex Capital Advisors, a locally
based money manager. His column appears every other week. Views expressed here are the writer’s. Hauke can be reached
at 203-3365 or at keenan@samexcapital.com.

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