Saturday, July 04, 2009

Shedding New Light on Dark Pools

Do dark pools pose a danger for retail investors?

JUST THE NAME SEEMS SINISTER. DARK POOLS of liquidity sound as though they belong in a Gothic novel, not on Wall Street. And indeed, many individual investors view them with apprehension.

What is a dark pool? It is a fluid, private institutional stock market that trades large amounts of shares outside of normal stock exchanges. Anonymous participants can enter orders that, if matched by others in the pool, get executed. The price of the trade has to be at or between what’s known as the national best bid or offer (NBBO).The total size is never disclosed. Although no one is quite sure, it is believed as many as 40 or 50 dark pools exist at any given time, run by big brokerages, major stock exchanges and independent outfits, among other sponsors.

Such pools allow big investors to move large amounts of stock without affecting pricing in the general public marketplace. Were they to sell the shares on an exchange, they would either have to accept lower bids from investors who can see they are selling, or break the transaction into tiny pieces, thus accepting lots of different prices and taking up a lot of time.

Dark pools negate transparency; they also provide pricing and other benefits to the biggest institutions that the small investor can never hope to see. As such, the Securities and Exchange Commission, under new commissioner Mary Schapiro, is considering forcing a little more light into this marketplace through regulation—if it doesn’t ban dark pools completely.

“Large institutional investors, on a pre-trade basis, don’t want to tell everyone what they’re doing,” says Tim Mahoney, chief executive of BIDS Trading, an industry-sponsored service for block traders. He adds: “Before you place a trade, the fewer people who know your intentions, the better price you’re likely to get.” Once a trade occurs, it is reported within 90 seconds, but it is hard to tell from reports where the trade was executed.

Taking the little guy’s side, Chris Nagy, managing director of order routing, sales and strategy for TD Ameritrade (http://www.tdameritrade.com), says, “I think dark pools are an excellent example of a market structure that gives institutions a way to prey on unsuspecting retail clients,” because they have more access to liquidity.

Not too long ago, almost all trading was dark, since there was no public listing of transactions. William O’Brien, CEO of DirectEdge, a market center based on automated-order matching technology, (http://www.directedge.com), says the ability to trade a stock off an exchange has been around since 1979. “It used to be a cigar-chomping sales trader who would take calls from a select few clients and play golf with cronies a few times a month,” O’Brien says. He observes that during the last few years, off-exchange trading has become a lot more automated: “It has gone from a cigar-chomper to a server with a snazzy name.”

DARK POOLS NOTWITHSTANDING
, no one disputes retail traders have come a long way in recent years. Today, they have access to price data and trading capabilities that only professionals had a few years ago, and much of that information is free.

Several online brokers, including Interactive Brokers (http://www.interactivebrokers.com) and ChoiceTrade (http://www.choicetrade.com), allow retail clients to enter orders in ways that mask their true order size. And online retail-broker Sogotrade (http://www.sogotrade.com) routes customer orders to a variety of dark pools, including Credit Suisse’s version, Crossfinder. Sogotrade CEO Dave Whitmore says, “Our experience has been fantastic. We’re executing cheaper, my customers are getting good trades, and we’re able to keep our commissions low, at $3 per stock trade.”

Retail investors benefit in other ways, too. BIDS’ Mahoney notes mutual funds use dark pools, thus helping their individual-investor customers keep costs down.

Regulation NMS required brokers to route their orders so that trades are executed at the NBBO. Exceptions to the display’s provisions led to the creation of what we now call dark pools. The measure was passed in 2005, and implemented in 2007. It has had some important effects. One is that most NBBO prices visible on screens are for very small order sizes, like 100 to 500 shares. With large blocks of stock trading away from the visible markets—estimates range from 10% to 25% of total volume in heavily traded stocks—it is difficult to tell what the actual market price should be.

Although it is too early to say for sure, one worry is that, with large chunks of stock-trading occurring in dark pools, the spreads—the difference in price between the bid and the offer—will widen.

IN ANY EVENT, THERE
now are so many electronic bourses that the overall market is becoming very fragmented.

Adam Sussman, director of research at the TABB Group (http://www.tabbgroup.com), doesn’t think fragmentation affects retail players who are executing relatively small orders, say a few hundred shares at NBBO, and says retail clients are likely to get price improvement on their smaller orders: “Fragmentation is probably a positive, because there is bidding going on for liquidity providers, to get that retail flow.” As long as online brokers are doing what they should—negotiating terms to receive better executions in exchange for their order flow—retail traders should benefit. “Fragmentation is just another way of saying ‘competitive market,’ “ opines Sussman.

TD Ameritrade’s Nagy counters that there are a lot of transactions in dark pools that retail can’t interact with. “As you take volume out of the marketplace, of course you’re not giving that little guy any sort of transparency,” he says.

DirectEdge has applied to the SEC to become an exchange. Its Enhanced Liquidity Provider (ELP) offers access to non-displayed liquidity pools right in its smart-order router. So an order that utilizes ELP can access dark pools, while maintaining the possibility of getting filled on the exchanges as well, says O’Brien.

Providing complete information about orders routed to dark pools would require a great deal of regulatory oversight—which institutions and retail clients would probably rather avoid. Should it happen, my guess is that the institutional traders will find another way to keep their order information from being publicly displayed. ELPs, which sweep orders through both displayed and nondisplayed markets, appear to be the best solution for all players, given the current state of technology and regulation.

Published in Barron’s, June 29, 2009. 

Posted by twcarey on 07/04 at 11:24 AM
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