Big Traders Dive Into Dark Pools

October 4th, 2007

It’s absolutely fascinating that these institutional players have had to form private networks to run their rackets.

How this is allowed is a mystery to me. It makes no sense from a simple supply and demand standpoint! You know, the basic principal of a “free market.”

These guys are essentially able to hide their real block sizes from the public side of the market.

If you’re not on the inside of this club, what’s the real size of the bid and ask books at any given time?

Sorry, you can’t know that. You’re not in the club.

Ahh, the free market. So transparent. So efficient.

Those index numbers and stock prices might as well be displaying random digits.

Via: Business Week:

It’s not easy being a big player in the stock market. Trading huge quantities of stock on traditional exchanges has become ever more challenging, costly, and potentially disruptive. And if other players see your moves, they can disrupt your trades. That’s led to the emergence in recent years of alternative trading systems known as dark pools. And their growth could have significant implications for big stock exchanges—and individual investors.

Dark pools sound like something from Greek mythology or a sci-fi epic, but in stock-market speak they are private trading networks that big brokerages such as Lehman Brothers (LEH) and Merrill Lynch (MER) have developed primarily for the internal matching of orders between buyers and sellers who are clients of the same brokers. But dark pools have developed links among Wall Street firms as well, so that orders can be matched across different brokerages. Indeed, some firms are teaming to launch new dark pools such as BIDS Trading.

Alternative trading systems, or ATSs, have gained an increasing share of equity trading in the past few years. In addition to dark pools, ATSs include crossing networks, such as independently owned Liquidnet and Pipeline, that match orders for execution without having to first route them to an exchange or market center where they could be viewed publicly. Besides enabling investors to execute an order without affecting the public price quote, crossing networks match orders at a specified price, typically the midpoint of the bid and ask prices on stocks at the point in time of the trade. Electronic communications networks (ECNs), which trade stocks and currencies, are another type of ATS.

The proliferation of dark pools could have ripple effects beyond just block trading, says Lee at Aite Group. As long as they remain a niche market, they’re probably of little consequence. But if the equities market becomes increasingly dark as more trading shifts to these platforms, while retail investors continue to see only the public portion of equity trading, it calls into question the actual meaning of public price quotes, Lee says.

On a practical level, if retail investors get the price they think they’ll get when they submit an order and they’re happy about it, they probably wouldn’t care what the actual reality of the marketplace is, he says.

Regulators would care, however, regardless of whether individual investors have concerns. In fact, Reg NMS modified a 1997 regulation by lowering from 20% to 5% the ceiling on average daily volume of any given stock that ATSs are permitted to represent before being required to disclose information to the public market, Lee says.

Cline believes that not only are dark pools ultimately a good thing for investors but that “to not take advantage of dark pools is failing to live up to the best execution mandate of Reg NMS.”

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