Shining a Light on Dark Pools
In this post I want to focus the spotlight on dark pools, the mysterious venues that allow hedge funds and the proprietary trading desks of investment banks to move large quantities of securities without detection. While presently legal, dark pools are controversial, and appear to be receiving renewed regulatory scrutiny at the same time that many hedge funds themselves are subject to greater regulatory oversight. Given their dependence upon complex, software-driven, high-speed trading strategies to give them an edge in the markets, the future of dark pools and hedge funds intersect. The co-dependence between dark pools and hedge funds discloses the same overwhelming shift toward both technology and secrecy in financial markets that we have witnessed in the defense intelligence community.First, some particulars about dark pools. The advent of electronic trading via alternative trading systems (regulated via SEC Rules ATS & NMS) heralded the emergence of both high-speed trading and the multiplication of “off-exchange” trading markets that do not publish bids and offers for securities and that also take advantage of rules that guaranteed the anonymity of transactions. Credit Suisse Group, UBS, Goldman Sachs, and Barclays are among the major operators of dark pools in the United States. In recent years, off-exchange trading has increased from 25% to 36.2% of total trading. Trading within dark pools has mushroomed from 4% to 14.7% of total trading volume. The loss of trading share and trading volume now threatens the viability of the “lit” exchanges such as NYSE Euronext, Nasdaq OMX, and BATS Global Markets, which have emerged as vocal opponent of dark pools.
Dark pools is a term hedge funds and operators of electronic trading systems no doubt dislike, conjuring, as it does, images of danger, deceit, stealth, cunning, and evil (think Gollum lurking in stagnant pools beneath the Misty Mountains). And dark pools clearly do violate the commitment to the transparency of capital markets. Yet they persist, and not only do they persist, they thrive. Off-exchange electronic trading systems benefit from the commissions generated by high-speed trading. Hedge funds and proprietary trading operations of investment banks benefit because dark pools allow them to accumulate substantial trading positions (often via large numbers of incremental trades) without tipping their hand to frontrunners or other competitors.
According to proponents, dark pools encourage trading, particularly trades of larger sizes, and thereby promote market liquidity, which presumably creates greater market efficiency and stability. However, concerns have in recent years mushroomed about: a) the impact of dark pools on volatility; b) their structural advantages in relation to lit exchanges (which cannot compete with the speed, the spreads; and c) the benefits of stealth and anonymity offered by dark pools); and the opportunities dark pools present for insider trading.
Indeed, the federal indictment in the $276 million insider trading case – the largest ever – against Mathew Martoma of SAC Capital, alleges that dark pools facilitated the secret sale of SAC’s $700 million position in pharmaceuticals Elan and Wyeth (and creation of a substantial short position) in advance of negative news about clinical trials of an Alzheimer’s treatment, causing the shares of both companies to collapse when the bad news became public. Prosecutors have received nearly 2.5 million pages of emails sent and received by Martoma, which include the opinion of an SAC senior trader that trading through dark pools “clearly stopped leakage of info from either in (or) outside the firm and in my viewpoint clearly saved us some slippage.”
The ecosystem that has emerged around alternative trading systems, high-speed electronic trading, and dark pools presents many of the same philosophical issues that the intersection of technology (Big Data) and secrecy in the military-intelligence complex governed by the National Security Agency. In both cases, supporters claim significant benefits for the uses of technology even while the requirements of secrecy makes it almost impossible for them to demonstrate those benefits. Indeed, in a stranger twist on the observer effect in particle physics and quantum mechanics, managers of both dark pools and of the cyber-intelligence regime for the NSA tell us that were they to disclose more information about these systems to serve the goal of transparency in a democratic society, the benefits would disappear because those benefits depend on absolute secrecy.
Additionally, both with regard to high-speed trading within dark pools and the strip mining of communications data by the NSA, technology has significantly outpaced the ability of public officials, scholars, journalists, and citizens to understand how these secret systems operate and how they affect both financial markets and national security. As we have learned, the outsourcing of national security technology to consulting firms such as Booz Allen both reflects and reinforces the technical backwardness of the federal government. Intelligence programs now depend completely on data mining systems the NSA could never design, develop, maintain, upgrade, and monitor on their own. Similarly, financial regulators such as the Securities and Exchange Commission and the Commodity Futures Trading Commission have essentially thrown up their hands and said we really don’t have a clue what goes on inside of dark pools and we do not know what impact they have on financial markets.
For these reasons, both trading institutions and the national security establishment are quite openly dismissive of public officials who seek to establish and enforce rules of transparency and accountability. And efforts to establish transparency and accountability inevitably fail, which only reinforces the perception among those who use advanced technologies to move money and monitor communications that civic commitments to openness, transparency, and privacy embodied in our Constitution are both archaic and pathetic.
In 2009, the SEC held hearings and issued proposed rules to more fully regulate dark pools. None of these proposals led to more robust regulation. More recently, FINRA distributed an examination letter to 15 electronic exchanges operating dark pools requesting detailed information about practices that might, among other consequences, facilitate communication of privileged information for insider trading purposes. Much has been made of a regulatory “ramp-up” that could require more transparency from dark pools or requirements that all electronic exchanges execute at the best price available, no matter where it originates. In theory, these changes could shed more light on the activities of dark pools, level the playing field with lit exchanges, and minimize the risks that dark pools could facilitate insider trading.
However, there is little reason to believe these probes will actually result in meaningful change. Despite publication of a damning research report on dark pools, Australian regulators ended up scaling back reform efforts. European Union proposals to more closely regulate dark pools appear headed for deadlock. Broker-dealers operating dark pools and institutional investors benefiting from them have ramped up their own election spending and lobbying campaigns against any structural reform of the existing system. Which defaults the burden for protecting investors to prosecutors (specifically, Preet Bharara, who heads the U.S. Attorney’s Office for the Southern District of New York, and who has presided over insider trading indictments of 76 people since 2009, leading to 71 convictions). However, prosecution inevitably follows a trail of misdeeds and can never anticipate it, nor fully comprehend or engage the underlying causes of these misdeeds. Prosecutors will always be a day late and a dollar short.
In his interesting and informed book, A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation, Richard Bookstaber (MIT economics PhD, proprietary trader for Morgan Stanley, risk management director at Salomon Brothers and several major hedge funds, and now Senior Policy Adviser to the Director at the SEC, in the Division of Risk, Strategy, and Financial Innovation) argues that hedge funds hide behind a cloak of mystery. When we examine the evolution of their activities and practices, however, hedge funds turn out to be really no different from registered investment companies, except they experience less regulation and so are more unconstrained with respect to leverage, trading strategies, and choice of trading venue. According to Bookstaber, we mystify hedge funds and imagine them to be unfathomable, when in fact the absence of significant difference between hedge funds and traditional funds argues for uniform investment company and investment management regulation. Bookstaber directly challenges the idea that technology-driven market innovation cannot tolerate regulation, and specifically recommends that deleveraging funds and slowing down the speed of market transactions would reduce volatility and restore both safety and transparency to financial markets.
More generally, one might argue that the defense intelligence community, and the codependency of its relationship with Silicon Valley, also hide behind the mysteries of technology, when in fact the realities and challenges the intelligence and national security establishment address remain ultimately, political, and hence subject to full transparency and debate. In my next post, I will discuss digital currency and Anti-Money Laundering regulation!