The hunt for liquidity: Dark Liquidity & the Secrecy of Dark Pools

Wall Street has taken electronic platforms to new levels of sophistication. More and more, traders are executing big money trades away from the exchange floors and into “black boxes” and “dark pools”. When Participants, such as hedge funds, prop desks or pension funds, want to sell large orders, tens to hundreds of thousands of shares at a time, they look to these pools for anonymity and secrecy. While these Participants are believed to benefit from such trading veils, the broader market fails to price in all the shares that are crossed in the dark, impairing price discovery and the whole notion of an Efficient Market. The lack of transparency creates innumerous conflicts for institutions and smaller investors; all investors have felt the effect of black boxes in recent events.
Dark pools are electronic systems of order execution and trading networks that do not publish quotes in the open market. Essentially, it is stealth trading for an upstairs market where liquidity is key. The public has no access to complete share volume as trades are made in the “dark” and in most dark pools, the counterparty to the trade is unknown.
In dark pools, automated algorithmic trade orders are executed gradually, minuscule shares at a time. Gamers “ping” a pool, sending in a whirlwind series of small lot offers to see if there’s a buyer taking the bait. In the same way a predator senses the presence of big prey from small pieces of flesh, pinging can tell a gamer if there’s a big buy order in the dark pool. By buying in small lots, the predatory trader will replicate the block in their own portfolio, driving the price up with each trade. Once the gamer has accumulated a block, they turn around and offer it for sale at the peak price, gouging a profit from the buyer. Many of the approximate 40 dark pools have some kind of anti-gaming measures in place. Yet, traders act surprised at how little institutions know about the predators they face in these murky waters.
Hedge funds, prop trading desks, broker dealers and banks all use dark pools. Some of the big Participants that use them are: BNP, Barclays, BNY ConvergEx, Citi, Credit Suisse, Fidelity, Goldman, Knight Capital, Lehman, Merrill, Morgan Stanley, UBS, ISE, NASDAQ and NYSE. There are over 40 dark pool trading systems and the volume of executed equity trades ranges from 10-20% of shares. Liquidnet, one of the main players in the dark pools stated that the average lot size is about 52,000 lots. Dark pools exist in most markets; public equities, derivatives and OTC. They operate all the time because the Participants want increased anonymity, speed and don’t want to be the “Big dumb elephants leaving big footprints”.
Now, an essential part of any investors sensible risk evaluation is their counterparty strength. Recently, the market has seen enough examples of counterparty failure. The lack of transparency in dark pools results in an inefficient evaluation of counterparty strength, which unexpected economic circumstances can drive serious losses. In the OTC market, where most dark pools operate, a serious loss among one group of counterparties can render the entire chain susceptible to failure. This is why the FED felt they couldn’t allow AIG to fail; the unraveling would be like nothing we have ever seen before. Not only have the counterparty risks with dark pools ruined institutions, it has misled smaller investors and is a threat to traditional exchanges’ volume in cash equities and should be banned. Public equity should be required to trade on an open, public exchange at all times. The whole premise of the stock exchange and trading is that all players are entitled to equal participation and a level playing field. Fundamentally, dark pools run contrary to this notion and therefore calls into question the legality of such systems. Insider trading is illegal and dark transactions limit information to the priviledged; so what is the actual meaning of public price quotes anyway?
It’s no coincidence that Lehman Brothers had plans to become a large player in the dark pool market. In fact, in June it was announced that Lehman would launch their dark pool joint venture with the London Stock Exchange, called Baikal. True to form, the name comes from the deepest freshwater lake in Siberia, which is replete with toxic substances, according to Greenpeace. It is slated for delivery in the first quarter of 2009 and despite Lehman’s “bankruptcy”, it will continue on track. Now, since Barclay's is a member of Turquoise (a dark liquidity pool launched 9/22/08), and a main competitor in the dark pool markets, would this not be one of the greatest acquisition since Barclay's will now takeover the joint venture between Lehman and LSE at a fire sale price? Maybe this is why the Lehman exec's are getting their big fat bonuses...