Just as Michael Lewis’ newly published book, Flash Boys: A Wall Street Revolt is shedding light on the practice of high-frequency trading (HFT), a new threat to market transparency is beginning to rear its ugly head: dark pool trading. This is the practice of trading “off exchange” through independent firms set up for this purpose or broker-owned pools where clients trade mostly with other clients of the broker.
While HFT essentially concerns the practice of banks and brokers stepping in front of their client’s orders for their own benefit, trading in “dark markets” is about trade secrecy in which information on a given trade is known after the trade has been executed. If a trade can be executed in secrecy (as it relates to price, size and identity) the primary advantage for the dark pool trader is to avoid market impact costs. Theoretically, those trading outside the dark pools are placed at a disadvantage given this lack of price transparency.
That this is becoming an emerging challenge to market transparency is discussed this week in an April 7, 2014 Reuters article, “Dark Markets May be More Harmful than High-Frequency Trading.”
In spite of the fact that Lewis’ book has brought the somewhat nefarious practice of HFT into the limelight, it comes at a time when HFT is actually on the wane. “Revenues for these firms have been declining for years: in 2013, they were about $1 billion, after peaking at around $5 billion in 2009, according to estimates by Rosenblatt Securities,” the Reuters article notes, contending that the bigger concern is the fact that, “around 40% of all U.S. stock trades … now happen ‘off exchange,’ up from around 16% six years ago.”
“Dark Pools, Internalization, and Equity Market Quality” is an informative study on the impact of dark pool trades conducted by the CFA Institute in October 2012. The study, which examined the trades of 450 stocks between the first quarter of 2009 and the second quarter of 2011, showed that dark pool trading actually improves market quality (e.g., bid-offer spreads decrease) up to a certain point. That point, at which trading in lit markets (i.e., on the exchanges) is less than 50%, according to the CFA Institute study. At that point, the bid-offer spreads begin moving in the other direction and market quality deteriorates.
In summary, as the practice of HFT becomes more widely understood, more light is also now being shed on the issue of dark pool trading and how it disadvantages investors who trade on the exchanges at a publicly known price, quantity and identity. The fact that investors utilizing dark pools are nearing the 50% mark should be a major concern. For just as HFT effectively siphons off investor return, dark pool trading, once it has passed a certain threshold, has the potential to degrade investor return as well.
