TOSS-UP: The term “dark pool” conveys mystery and intrigue—an impression that, until recently, had rarely been associated with the quantitative trading strategies of Wall Street firms. However, the dark pool and its partner in crime, the high frequency trade, have engrossed the public attention and brought a debate once limited to university symposiums and trading floors to the global (political) stage. Indeed, even as proposals for financial regulation evolve to include limits on bankers’ pay and bans on proprietary trading, the battle over dark pools et al rages on.
For background, some definitions from Investopedia:
Dark Pools—“A slang term that refers to the trading volume created from institutional orders, which are unavailable to the public. The bulk of dark pool liquidity is represented by block trades facilitated away from the central exchanges.”
High-Frequency Trading— “A program trading platform that uses powerful computers to transact a large number of orders at very fast speeds. High-frequency trading uses complex algorithms to analyze multiple markets and execute orders based on market conditions. Typically, the traders with the fastest execution speeds will be more profitable than traders with slower execution speeds.”
At first blush, the argument against dark pools and high-frequency trading appears rather compelling. Critics claim that because both practices rely on sophisticated technology and market access (via size and influence), they give large financial firms an unfair advantage over mom-and-pop investors. High frequency traders manipulate markets and rake in profits by moving in and out of a position before most counterparties can gather information or react. In a similar vein, dark pools give institutional traders the ability to unload large positions without displaying their asks, thus undermining market transparency. [1]
However, the champions of dark pools and high-frequency trading explain that such practices benefit the overall market by (i) fostering competition (either between financial firms or trading systems) and (ii) providing increased volume to the market and thus enhancing overall liquidity. They also argue that limiting such practices would be antithetical to notions of free competition and the opportunity to innovate, etc.
Ok, curveball: according to a piece in Business Insider, the current public debate falsely associates dark pools and high-frequency trading. In fact, they explain, “Dark pools are the antidote to high frequency trading. They’re where you go to hide from the computer algorithms who are making lightening fast trades in reaction to the bids and offers you post in the marketplace.” Dark pools = good, high frequency trading = bad. But couldn’t you argue the opposite—that high frequency trading enhances liquidity which ultimately translates into improved price discovery and reduced spreads? Meanwhile, dark pools provide an escape valve for big-time traders who want to engage without revealing themselves to the market and affecting prices.
So, is it fair to lump dark pools and high-frequency trading into the same bucket of Wall Street evil-doing? Or are they both simply the latest incarnation of good-old American financial innovation? And how about a third option—that one is constructive and the other nefarious?
A final thought: regardless of where you come out in the aforementioned debate, what appear to be at odds here are the competing principles of transparency and liquidity—both dark pools and high-frequency trading enhance overall market liquidity at the expense of transparency to the average investor. So, perhaps the most important question is how lawmakers should weigh the often conflicting values of transparency and liquidity in their approach to regulatory reform…?
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[1] To clarify, dark pool participants, like traders on the open market, are required to report to the consolidated tape. The difference is that instead of publicly displaying their bids/asks prior to a trade, dark pool players (i) only report the price agreed upon after the trade has been completed and (ii) are not required to disclose their identity.
