Last week, dozens of stock prices experienced violent swings because of strange trading activity that had people all over Wall Street scratching their heads.And while the investing public doesn’t know who (what firm) caused these price fluctuations, or why they engaged in the activity that had these stocks going nuts, we do know that, whoever they were, they were trading in a dark pool.
Which prompts the question: What the heck is a dark pool and why are people trading in them?
To answer that, Business Insider contacted the MIT Sloan School of Management and spoke to Professor Haoxiang Zhu. He does research on how dark pools are impacting investors, exchanges, trading… the works.
But before we get into Professor Zhu’s fascinating research, let’s nail down where dark pools come from.
Our first dips into dark pools.
Dark pools started in the 1980s when some institutional investors got together to trade in a place where they could avoid the prying eyes of public exchanges or brokers. They wanted to be able to buy or sell large quantities of stocks without affecting the market and thus get better execution prices.
Around 2005 these dark pools only made up 3%-5% of market activity.
Then things started changing in 2007, when the SEC passed new regulations known as Reg NMS (Regulation National Market System).
In Reg NMS were provisions that seriously upped competition for the exchanges. For one, it got rid of rules that protected manual quotations by exchanges. All of the sudden investors had the option of skipping exchanges if they could find a better price more quickly elsewhere.
Broker-dealers saw an opportunity in this (and in the rise of automated trading), and they started setting up their own dark pools. Institutional investors and bulge bracket banks started heading over to them to save on trading costs.
Today trading in dark pools accounts for about 12% of volume in the US.
Ultimately, the key benefit of trading in the dark pool is “price improvement”. Say the bid for a stock on an exchange is $10.00, and the first asking price is $10.10. A typical dark pool will set the price at $10.05, the midpoint between the bid and the ask.
And traders like that. No, they love that.
Trading in the dark.
The thing is, though, you don’t know who else is in the dark pool with you and you don’t know if anyone wants what you’re selling at all
So how do brokers decide to send an order into a dark pool if they don’t know what’s inside?
Some brokers cut “payment for order flow” deals where they agree to send orders to a certain dark pool.
Another, more controversial way they do this is by getting “indications of interest” (IOI) from dark pools. The IOIs can contain any of the following pieces of information — the ticker of stock, the buy/sell interest, the price, or how much is up for grabs.
Sounds like a price quote right? Nope.
This IOI is not a hard and fast quote and is not made public across the market. The SEC has proposed making them quotes, but it hasn’t happened.
Another downside to the dark pool, which comes from not knowing whether or not what you need (a buyer or seller) is even in there, is the fact that you may not be able to get your order filled as quickly as on the open exchange.
That’s where Professor Zhu’s latest research comes in. His paper is called “Do Dark Pools Harm Price Discovery.”
According to Zhu, even though you can get a good price in a dark pool, investors lose when they can’t get their order filled ASAP. In the end, he says, it all has to do with risk and volatility.
“You really want to sell this stock because it’s costly to hold it on your balance sheet,” Zhu explained. “The more you delay the more the stock price could move, which is volatility. The higher the volatility the more costly it is to hold the position.”
And waiting is especially bad if you’re trading on information — academics call these traders “informed traders”. Ultimately, a wait time could mean the difference between an informed trader making their trade before anyone knows what they know, and getting caught in the herd.
“Information can become stale, that’s an informed traders’ delay cost,” said Professor Zhu.
How dark pools widen spreads on open exchanges.
To ensure that someone, like a market maker, is on the other side of their trade when they need them, Professor Zhu has found that informed traders are heading back to the exchanges. They’re self-selecting.
That means two things. Market makers at the exchanges learn more precise information about a stock from informed traders trying to make the best trade. When market makers see more informed traders coming, they widen the spread between the bid and ask so they don’t lose too much.
In short: The prices on the open exchanges become more precise, according to Professor Zhu, but market makers are widening spreads to protect themselves from the onslaught informed traders.
Meanwhile uninformed traders — investors who are trading to hedge, for example — can stay in the dark pool where they’re nice and anonymous. That means they’re not on the open exchanges to help market makers by adding liquidity, and thus narrowing spreads.
What does this mean for you?
On the upside, it means investors handling your retirement account etc. could be getting better deals on stocks in a dark pool.
On the downside, if what Professor Zhu’s thesis is correct, dark pools are widening spreads on open exchanges, which no one likes because it makes a stock more expensive.
That aside though, the biggest hazard in dark pools is that we don’t know how they operate or who’s operating inside them.
Earlier this month the SEC charged one dark pool operator, eBX LLC, with sharing their clients’ confidential trading information with an outside company. That includes information about their clients’ unexecuted orders.
From the SEC:
“Dark pools are dark for a reason: buyers and sellers expect confidentiality of their trading information,” said Robert Khuzami, Director of the SEC’s Division of Enforcement. “Many eBX subscribers didn’t get the benefit of that bargain – they were unaware that another order routing system was given exclusive access to trading information that it used for its own benefit.”
eBX paid an $800,000 fee to settle the charges, but who knows how much they gained by sharing the information.
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