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 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
While most retail investors aren't trading in enough volume to be significantly victimized directly by HFT operators in dark pools, the side effects of what's going on affect everyone.
One of the biggest threats dark pools present, particularly as a greater percentage of all stock trading goes through them, is harm to what is known as "price discovery."
You see, stock prices are determined by the number of buyers and sellers for any given equity. As more of these orders "go dark," they aren't being used to set a stock's price, which increases the chances a stock will be mispriced at any given time.
For retail investors, that means paying too much for a stock - or getting a lower price than you should when selling.
Of course, the HFT operators pay for private access to the order flow, so as more trades happen in dark pools, they gain an even greater advantage.
The other thing that has Gilani worried is the potential for the combination of HFT and dark pools to exacerbate a stock market crash.
That's because HFT and dark pools have changed the nature of the markets, increasing volatility to the point where it no longer makes sense for institutional investors to keep "resting orders" - standing orders to buy or sell at a particular price. Now it's more practical for them to buy and sell at market.
But those resting bids - orders to buy at lower prices - in the past acted to slow market crashes.
"That's the real problem - no bids," Gilani said. "In a panic there will be no bids. The HFT guys will just turn their computers off if the market is going down, all that volume will disappear, and stocks will go down a lot faster."
At this point you're probably wondering what the market regulators, particularly the U.S. Securities and Exchange Commission (SEC), has been doing about all this.
It's not a pretty story.
The SEC Has "Turned a Blind Eye" to Dark Pools
While dark pools and HFT have been in the news a lot in recent weeks following the debut of Lewis' book, the SEC has known about these activities since they started some 15 years ago.
"The SEC created this problem by letting it go for so long," Gilani said.
In fact, the SEC has periodically looked into HFT and dark pools over the years, but has done little more than "study" the issue.
"It's over their heads," one former bank executive told the International Business Times. "They have no idea what is really happening."
When Brad Katsuyama - the head of the Royal Bank of Canada's U.S. trading desk who devised a system to thwart HFT operators by slowing down trades - presented his findings to the SEC, they had a stunning response.
"What you are doing is not fair to high-frequency traders. You're not letting them get out of the way," an SEC staffer said. RBC later discovered that since 2007 more than 200 SEC employees had left the agency to work for or lobby for HFT operators.
Earlier this month, the SEC announced that it was looking at testing a possible reform that would force dark pools to route trades back to traditional exchanges like the NYSE unless the trade could be executed at a "meaningfully better price."
In other words, don't expect the SEC to rock the boat on HFT or dark pools. The announcement was most likely made to give the appearance that it was "doing something."
Gilani said it's too late for the SEC to start getting tough at this point.
"They turned a blind eye to it for years," he said. "They'll look foolish if they do anything now. They let it happen."
Shah Gilani is worried about other things than HFT and dark pools - like how American ideals like individualism, which propelled our capitalist economy, is getting stifled. And you have one guess as to who's to blame...
- International Business Times: Michael Lewis' "Flash Boys" Exposes Shady World Of Dark Pools
- Reuters: SEC Eyes Test That May Lead to Shift Away from 'Dark Pools'
About the Author
David Zeiler, Associate Editor for Money Morning at Money Map Press, has been a journalist for more than 35 years, including 18 spent at The Baltimore Sun. He has worked as a writer, editor, and page designer at different times in his career. He's interviewed a number of well-known personalities - ranging from punk rock icon Joey Ramone to Apple Inc. co-founder Steve Wozniak.
Over the course of his journalistic career, Dave has covered many diverse subjects. Since arriving at Money Morning in 2011, he has focused primarily on technology. He's an expert on both Apple and cryptocurrencies. He started writing about Apple for The Sun in the mid-1990s, and had an Apple blog on The Sun's web site from 2007-2009. Dave's been writing about Bitcoin since 2011 - long before most people had even heard of it. He even mined it for a short time.
Dave has a BA in English and Mass Communications from Loyola University Maryland.