SKARBECK: Growth of private trading should have us all worried

July 27, 2009

Most investors are probably under the impression that all the stock trading carried out every day is taking place on a stock exchange and is visible to the entire investing public. However, that is not the case, as many large investors are now executing trades on a rapidly growing system of private institutional stock markets known as “dark pools.”

The growth of these trading pools and the increased presence of high-frequency trading have grabbed the attention of market regulators. One NASDAQ regulator recently questioned whether dark pools would “pass the regulatory smell test.” Securities and Exchange Commission Chairwoman Mary Shapiro said the SEC will take a look at “the potential investor protection and market integrity concerns raised by dark pools.”

In the past, large institutional orders were phoned into trading desks, and a broker working on the floor of the exchange would parcel out the order over time to limit its price impact. Today, with technology replacing floor brokers, institutions argue that large trades are harder to execute, spurring the formation of dark pools.

Dark pools allow participants to trade anonymously and purportedly allow big investors to buy and sell large amounts of stock without affecting the stock price that the general public sees. Whereas on a stock exchange, when a large order is placed, it becomes visible for all investors to see and can affect a stock’s price.

Also, institutions complain that sophisticated traders have the technology to spot large market-moving orders and execute trades that take advantage of the institution’s order. For example, a short-seller who identifies a large sell order will sell the stock short in anticipation of the lower prices caused by the institution’s stock sale. The increased selling will tend to drive the stock price even lower, saddling the institution with a poor execution price.

Thus, with today’s advanced order-routing technology and high-frequency traders providing liquidity, dark pools allow institutions to trade off the stock exchanges. Their total size of trading is not disclosed, but is estimated at 9 percent of all daily trading, and it is believed that 40 to 50 dark pools exist.

Prices are posted only after the trade has been completed, but must meet the national best bid and offer.

It is ironic that in the aftermath of the credit crunch, with investors calling for more market transparency from Wall Street, these opaque trading markets are thriving. And while advocates of dark pools cite liquidity and limited market-price disruption as benefits, critics wonder who is getting the better deal—Wall Street or Main Street.

Another concern is a repeat of the 1987 market meltdown caused by program trading, when a large number of big-money participants were all trading in the same way, at the same time.

Considering what has transpired over the past 18 months, you begin to wonder how much more Main Street can stomach. A slimmed-down Wall Street appears to have rebounded with record profits earned from proprietary trading systems and fees from stock and bond offerings that were needed to plug holes in balance sheets and repay bailouts. However, if investors begin to believe that the deck is stacked against them, the loss of confidence in the markets could be long-lasting.•
Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.


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