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Dark Pools of Liquidity Are a Big Problem for Free Markets

Everything runs on liquidity. Unless you know something I don't, that dollar bill in your pocket is just as likely to buy a can of Pabst Blue Ribbon today as it was yesterday, and will be tomorrow.

Or you could sell 1,000 lbs. of gold – if you have that lying around – without fear of completely scuttling the global gold market. Your bank has to have cash, liquidity, lying around somewhere in the back if it wants to stay in business.

And in many cases, it's easy to see or verify this liquidity. It helps everyone feel better about doing anything.

But there are markets where this liquidity is kept off the open exchanges, where it can be used to juice up huge deals. Or it can prevent these huge deals from having the impact that they "should" have, keeping the hands of large traders hidden.

These are the sinister-sounding dark pools of liquidity.

Dark liquidity is generated and stored in a variety of ways, most of which are possible due to the huge variety of trading venues, electronic and traditional.

With dark pools, neither the size of the order nor the entity making that order can be known until the order is completed. Rosenberg Securities Inc. estimates that fully 15% – trillions of dollars – of all trades occurring on American exchanges, every day, utilize dark pools.

Not Playing Straight Poker

And the markets, like nearly everything else, operate on the wide availability and transparency of good, reliable information. A poker game gets its lurid thrills from the partial presence of that information, or the possibility that the information could be faulty. You wouldn't want to play with all your cards face-up. You just don't know, and that's why it's fun to play poker.

But the markets, despite some inkling to the contrary, can't function with true optimum efficiency if good information isn't available to the widest possible group of participants.

It's not that a player has to have the information, but it should be available to the player if things are going to work the way they should. One is a vying, gambling game, and the other is a free market. We should be able to tell the difference.

And there are nowadays big incentives and compelling reasons for large traders, for high-frequency traders, to maintain this half-plentiful supply of good information. Why? It's simple. They're making a killing off of arbitraging market inefficiency.

Billions of dollars are made, every day, from this activity, and none of it would be possible without dark pools. Entirely new companies, like Pipeline Trading Systems LLC, and Level ATS have popped up like mushrooms from dung to offer "private" counterparties for trades.

Some of these companies have already paid millions in fines, and they keep on keepin' on. If that's not an indication of the allure of dark liquidity, I don't know what is.

There's a New (Old) Sherriff In Town

The Financial Industry Regulatory Authority (FINRA) is the securities industry's private self-regulator. It polices its own securities business, usually pretty well, and makes recommendations to the Securities and Exchange Commission for regulation. FINRA has the power to ban individuals and organizations from the industry for bad behavior.

FINRA has just approved a plan that would require dark pools to disclose – and even better – detail all the transactions that take place.

The ultimate aim isn't just to illuminate the dark pools, but to make market manipulation more apparent to those who seek to quash it.

Just who FINRA and the SEC want to punish for market manipulation is something we've covered before, but most of their targets have received only minor penalties.

We may be faced with an environment in which dark pool trading is actively punished, but where the dark pool users gleefully fork over fines which amount to little skin.

This is part of a larger trend where regulators, in response to a growing outcry from retail investors, and in the face of another collapse caused by those who aren't playing straight poker, attempt to crack down on various novel electronic trading tools.

As always, the regulators, the tail-end Charlies, will be hard-pressed to keep up with those who stand to gain tremendously from these methods.

Related Links:

  • Wall Street Journal:
    Finra Plan Would Shine Light on 'Dark Pools'
  • Bloomberg:
    Pipeline Settles With U.S. SEC Over Dark Pool Claims
  • Join the conversation. Click here to jump to comments…

    1. H. Craig Bradley | July 18, 2013

      DARK Pools have been swirlling around since the Clinton years. So far, few investors seem to object or even care as far as I can see.

    2. Fred | July 20, 2013

      Investors likely do not care because your article about dark pools tells us nothing. There is no real technical definition of dark pools, exactly what they are or where they are and nothing about the real effect on markets. All we learn is that these are supposed to be illegal and that typically small fines are paid when discovered.

      Would this be anything really like telling us of the liquidity crunch nationwide and the fix of it…with say Citicorp buying a Columbian bank to launder drug money to get that cash ? No. This article is filler…nothing more.

    3. Jacob Steelman | July 20, 2013

      Keep the regulators out of intervening in business. Let the market regulate business, since markets do it best.

    4. RePete | July 22, 2013

      How naïve Jacob. That's like saying, if there are no state troopers, everyone would still drive the speed limit on the freeway. Yea, right. Without regulators, the Bernie Madoffs in the world would multiply to the point of creating a complete lack of confidence in financial markets. It's already bad enough as it is.

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