How High-Frequency Traders Use Dark Pools to Cheat Investors

High-frequency trading (HFT) has an evil cousin: dark pools.

While dark pools are not inherently bad, the abuse of dark pools by high-frequency traders has made it easier to exploit everyone else in the market, and increases the odds that a market downturn could quickly become a stock market crash.

So what are "dark pools," anyway?

Dark pools are off-exchange platforms that allow large investors, such as hedge funds and pension funds, to trade stocks anonymously. Dark pools arose in the late 1990s from a desire by these big players to conduct large-scale trades without tipping their hand.

Dark pools allow large investors to establish or exit positions in a stock at the best possible price. There was nothing wrong with that; the dark pools made up a very small portion of daily volume and made it easier for big investors to trade.

But a few years ago the high-frequency traders realized they could use the dark pools to their advantage…

Dark Pools: You're Either Predator or Prey

High-frequency trading uses speed to discover a trade before it happens. It allows the HFT computer to execute a trade before the original buyer or seller can. When the original trade does get executed, there's an HFT operator on the other end, who benefits from the price being changed by a penny or so.

But the more trades the HFT operators can "see" – no matter where the trades happen – the better high-frequency traders can predict the direction of any given stock.

Getting into the dark pools lets the HFT operators detect what big institutional investors were doing in addition to what was going on in the conventional exchanges like the New York Stock Exchange and Nasdaq. This helped HFT operators make even more money.

Also making more money were the companies running the dark pools, some of them investment banks like Goldman Sachs Group Inc. (NYSE: GS) and Morgan Stanley (NYSE: MS). They charged the HFT operators fat fees for access to the order flows coming through their trading platforms – and weren't shy about peeking at it themselves.

But the big institutional investors, and to a lesser extent everyone else in the markets, were getting burned, losing on every trade.

"The dark pools are a shady proposition," said Money Morning Capital Wave Strategist Shah Gilani, who witnessed the early days of HFT and dark pools as a hedge fund trader in the late 1990s. "The order flow is the game. The Big Banks trade against it, too."

Driven by HFT, dark pool trading has increased from about 16% in 2008 to 40%.

The dangerous intertwining of dark pools and HFT features prominently in the Michael Lewis book "Flash Boys," which has set off a sharp debate over whether such activities should be legal.

"The hidden passages and trapdoors that riddled the exchanges enabled a handful of players to exploit everyone else," Lewis said in his book.

And everyone is at risk…

How Dark Pools Can Hurt Retail Investors