Dark Pools, Fast Trading, and the Loss of Visibility
The beast is creeping back into the shadows.
The elimination of “shadow banking” is a core principle of the reform of the financial system that brought the world to the precipice of total economic collapse. Deregulation had allowed the banks to run their trading businesses in private, away from the prying eyes of those pesky regulators and representatives of the public’s interest. As a consequence, when the banks suffered self-inflicted wounds as their shortsightedness and hubris brought them low, no one on the planet knew for certain the scope of the problems haunting their balance sheets. The most comically tragic example was the “Oh, by the way” moment as negotiations between the government and big banks over saving Lehman broke down and it was pointed out that AIG, the biggest insurance company in the world, was going toes-up because of margin calls by the very people sitting around the table.
I have never been an addict or a trader of securities or derivatives, but I know something about both. I know that the high experienced by a trader induces many of the same behaviors that addicts display. And since the brains of gambling addicts and drug addicts both exhibit surges of dopamine, why not traders? One thing that is certain about addicts is that they will employ any lie or deceit to keep the dance going, even those that are absurdly obvious to a sober observer.
Which brings me to the enormous rise of Dark Pools and Internalization. (See an in-depth discussion of Dark Pools and Internalization here.) The CEOs of the three largest stock exchanges are meeting with the SEC today to complain that the trading of equities is increasingly exiting the transparency (such as it is) of the exchanges and moving into electronic or partially electronic venues in which key information is not disclosed. The CEOs are complaining because it will cost them revenues. The public has a different bone to pick.
Back in the pre-Dodd-Frank days, banks would do transactions over the phone, using instant messaging or through brokers. No one knew whether these deals were fair and no one understood, at least outside of the banks, what their potential consequences were. Individual trading desks would construct complex portfolios with multiple positions (taken on in the shadows) and counterparties that interacted in terribly complex ways. There was nothing to worry about, though, because these interactions were measured and managed carefully and accurately by the computer whizzes at the banks. What a marvelous job the JP Morgan Chase risk professionals did with the London Whale portfolio!
But now trading is migrating to Dark Pools, trading venues in which buyers are matched with sellers via algorithms. Often, Dark Pools are run by banks which “interact” with the trading in accordance with rules that they, of course, write. One suspects that, as with Chemistry.com, the operator of the matching site often ends up having more fun than the customers who find matches. At any rate, all of this happens inside black boxes and information, the lifeblood of efficient markets and effective regulation, is withheld.
Dark Pools were once the refuge of institutional investors seeking to hide from rapacious high-frequency traders who could spot their prey easily in conventional exchanges (“Lit Venues” in the modern vernacular). That day has passed, not because predatory HFTs repented of their sins, but because their advances in pattern recognition software, like night vision goggles, allowed them to operate in the “Dark” with even better “intelligence” than their adversaries.
Dark Pools now exist because it became clear to banks that, if you created your own Dark Pool, traders and investors would use it as a vehicle for customers to access the liquidity offered by your absurdly leveraged, and government-subsidized balance sheet. A customer may not be entirely certain that he or she could dip into the pool without being ripped off, but execution in relative anonymity was certain. The Dark Pools became more and more the functional equivalent of the system of telephones, instant messages and brokers, though superficial analysis would classify them among the electronic trading venues that the SEC authorized and even promoted in a naïve effort encourage competitiveness. A bank sponsor could easily swim through the pool constructing its secret portfolio without ever having to answer a phone call or an IM.
More recently the practice of “Internalization” has surfaced. This is somewhat like a bank-sponsored Dark Pool without the trade matching algorithms. A customer proposes a trade to a bank trader. The banker will find a match for the transaction from other customers seeking transaction. Of course, the bank trader could offer to buy or sell while a match is found, only as a service to the customer mind you. This is no more than an over-the-counter derivatives or securities operation, but read from right to left instead of from left to right. It is shadow banking of the type that was to be eliminated, with the smallest of fig leaves to obscure the ugly truth.
This is the problem with laws and regulations that, out of fear of the bank lobbyists and financial power, seek to do as little as possible to disrupt their business, while still managing to protect the world from financial Armageddon. The resulting calibrations are so fine that those who are both subject to the rules and uncommitted to the spirit of the regulations (say, for example, traders) are tempted to take advantage of gaps until they are slapped down. It’s time for some slapping.
