Hey Investors, You Up for a Dip in a Dark Pool?

by Odysseas Papadimitriou on January 31, 2013

They’re three of the most tried-and-true, commonplace expressions:  1) Look before you leap; 2) Don’t swim within 30 minutes of eating; and 3) Buy Low, Sell high.

While decidedly trite, we were raised on such sayings, and they typically don’t lead us astray.  But do they hold true in the post-Great Recession world of finance, which is marked by things like “shadow banking,” “floating-rate demand notes,” and “dark pools” that are not only unclear to most consumers, but could also get you in over your head and ultimately eat your lunch if you aren’t careful?  That remains to be seen.

We’ve discussed shadow-banking and floating-rate demand notes before, but what the heck are dark pools?

Simply put, that’s the term used to describe the sort of off-Broadway, off-the-strip type of stock exchanges that have been popping up in recent years.  They operate under a different set of rules than the likes of the New York Stock Exchange and NASDAQ and are growing in popularity, especially among online institutional investors, much to the dismay of the investing world’s Old Guard.

While public exchanges held about a three-quarters share of all trading activity in early 2008, that number had fallen to 68% by summer 2012.  There are now more than 50 dark pools in the U.S. – as compared to 13 traditional, or “lit,” stock exchanges.

So, what does this all mean for you?  Well, dark pools certainly have their benefits and drawbacks.

Benefits

  • Increased competition: The sheer number of dark pools in operation – headlined by Goldman Sachs’ Sigma X and Credit Suisse’s Crossfinder – necessitates differentiation, and the result has been an investor-friendly race to the top when it comes to costs and customer service. 
  • Faster transactions & lower costs:  Dark pools are said to offer sleeker transactional capabilities in that they are less burdened by safeguards and regulations than public exchanges.  Large institutional investors and algorithm-armed online players can therefore quickly buy and sell large amounts of stock without seeing processing fees eat away at their profits.

Drawbacks

    • Opacity borne from a lack of regulation:  The very things that make dark pools attractive to certain segments of the investing community can easily be construed as downsides to most of us.  A lack of transparency is a prime example.  While the fact that dark pools aren’t bogged down by the same rules and regulations as public exchanges makes them sleek, it also makes them difficult to read.  Dark pools don’t have to file the same types of data with the Securities and Exchange Commission as public exchanges, for instance, which means there is a far greater likelihood for impropriety.

 

    • Investor discrimination:  Public exchanges have to treat all investors the same, but dark pools can determine prices and access to shares on a case-by-case basis.  That’s great if you’re on the right side of things, but that’s far from guaranteed.

 

  • Increased risk:  The fact that so much about dark pools exists in the shadows makes it even less predictable than the traditional stock exchanges.  Yes, profits are boosted by lower operating costs, but the lack of safeguards means you could more easily wind up broke.

Dark pools aren’t the only source of competition for traditional public exchanges.  Wholesale equity brokers like Citigroup, TD Ameritrade, UBS, and Charles Schwab, which buy stock institutionally and then sell it in small amounts to individual investors, have also cut into the investing pie.  Their advantage over public exchanges is that they don’t have to abide by the SEC’s incremental pricing rules.  In other words, they can offer more attractive margins for investors by setting prices a fraction of a cent lower than the likes of the NYSE and NASDAQ.  The NYSE has requested the ability to engage in such pricing, but the SEC has not yet ruled on that matter.

What should investors take away from all this?

Well, it’s fair to wonder if dark pool investing could grow so large and ultimately lead to such widespread corporate overleveraging that it becomes the source of another huge financial crisis.  Put differently, are we in the midst of a problematic type of “adult swim” in which the investment world’s big hitters can play freely in their dark pools, knowing that you and me will be there to cover their you-know-what’s should they start to drown and bring the economy below the surface right along with them?

That is a question the SEC and other U.S. economic oversight authorities must answer, and they must do so soon before we have another credit-default swap fiasco on our hands.

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