The final issue of Institutional Investor's hedge fund magazine, Alpha, has a fascinating piece about so-called "dark pools" of liquidity (Alpha is being merged into II parent Euromoney's Absolute Return and renamed AR, which resembles the sound a dog makes when you snatch away his bone). Dark pools stem from the crossing-networks set up by institutional investors in the '90s to facilitate block trades without the front running that occurs on regular exchanges; they've now been adopted as well by hedge funds and prop traders. They have since proliferated and grown more sophisticated, and the Alpha piece is mostly about the intricacies of gaming these dark pools -- or protecting against gaming practices.
Dark pools, as the name suggest, are opaque; indeed, that's their greatest virtue. Perfect opaqueness (if that's ever possible: Information leakage is an ever-present threat in this strange world of "pinging" pools, fishing and algorithmic trading) and adequate liquidity allow investors to trade at a minimum of transaction costs. The original crossing networks cobbled together by Instinet and Posit were essentially secure electronic exchanges that used the vast inventory of assets of large institutions and the availability of information technology to match buy and sell orders. As in any trade there are potential liquidity limitations. Someone wishing to trade on a crossing network might have to wait to make the desired exchange of shares; but as liquidity grew that became less of a problem.
Crossing networks, and later dark pools, did create a regulatory conundrum. Crossing networks looked an awful lot like exchanges (they clearly sucked liquidity from exchanges), which, by regulation, must possess pricing transparency. Dark pools thus represented a retreat from the disclosure and transparency that had shaped financial regulation since the '30s. Nonetheless, the Securities and Exchange Commission allowed what seemed to be at first experiments to continue; today, we're well past that let's-see-if-it-flies stage, and indeed, there are signs of maturity. Counterbalancing that lack of transparency was the fact that users of dark pools -- institutions, pension funds, hedge funds -- are by definition sophisticated players. And users of the dark pools offered persuasive arguments that a degree of opacity was needed to create greater efficiencies and less price distortion. These large investors constitute a formidable lobby, particularly when major Wall Street firms join them. And dark pools, like the Internet, can be anywhere, creating easy regulatory arbitrage.
Let's be clear: Dark pools had absolutely nothing to do with the financial crisis, and there is clearly a market desire for the services they render. Dark pool operators like Liquidnet are now public companies and the biggest dark pool, Sigma X, is run by Goldman, Sachs & Co. (NYSE:GS). (Don't tell Matt Taibbi.) But their very presence -- a kind of shadow exchange system running parallel to highly regulated exchanges -- does pose a continuing challenge to transparency.
It's relatively easy to sit back and say we need the following reforms to deal with the perceived causes of a crisis. This is fighting-the-last-war syndrome, otherwise known as retrospective regulation. But the truly difficult "prospective" issues, from innovations like dark pools that contribute to efficiencies and drive prices down to the feel-good complexity of bubbles themselves, are far more difficult. There were always good arguments for credit default swaps; there were always good arguments for reducing bank capital, for bank consolidation and for keeping interest rates low. Only in retrospect did we realize how dumb we were for not recognizing the dark complement to those arguments. But how do you restrain or eliminate entirely a development that has not blown up, and that most of the political world has never heard about, even as they preach transparency? It is in those problematic and arcane cases that lobbying is most effective (because, face it, they have an effective case to make) and when, in retrospect, regulatory capture is likeliest to occur.
A final note that's less about dark pools and more about the passing of Alpha, which is part of a larger purging and restructuring that II is currently undergoing. True confession here: I spent a very happy decade in the '90s at II, beginning in the days when founder Gilbert Kaplan was still around and through the sale of the company to London-based Euromoney. It was a true long-form vehicle, almost a magazine of record when it came to money management, pensions and all things banking and Wall Street. There was a long-form tradition sill alive there and in those slightly shabby halls (hey, it was a magazine not an investment bank), with three decades of covers lining the walls, a collective memory of how we got to the present. Some great names, editors and writers, built that collective memory, some now gone. There's something to be said for coverage that's fast, opinionated, bloggy. But what's being lost, no more starkly than at II, is that deep memory and that long-form tradition, which remains the best protection against a world always threatening to turn itself into, well, dark pools. - Robert Teitelman
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Robert Teitelman is the editor in chief of The Deal
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These dark pools attract big orders that normally should go to traditional exchanges and make them even more liquid, with the development and the creation of more and more dark pools i think the individual traders should be concerned by that.