By Monil Singhal

Edited by Michelle Cherian,  Associate editor, The Indian Economist

In the various explanations of the causes of the global financial crisis, the common point has been the role of the ‘greedy’ bankers. And hence came about a new Basel Accord, a wide range of banking regulations, restructuring and introduction of ‘values’ and ‘scorecards’ by banks themselves. Yet, six years down the line from the crisis, the day when investors can rely on banks just doesn’t seem to get any closer, with one scandal or the other lurking around every corner.

Barely out of the LIBOR interest rate fixing, major banks have now been drawn into a deepening probe of banks’ anonymous ‘dark pool’ trading venues. Following the lawsuit filed against Barclays in late June by the New York Attorney General’s office over its dark pool, UBS, Credit Suisse and Deutsche Bank are the latest financial institutions to confirm that they have received subpoenas from authorities, demanding details of their operations.

Dark Pools are like private exchanges, forums for trading securities, which are not accessible by the investing public. They allow investors to trade large blocks of shares anonymously, without moving the market price against them. They have been growing in importance since 2007, but have come under fire from authorities in recent months for their lack of transparency and the role of predatory high-frequency traders within them, which gives them an unfair advantage over other traders.

This raises two questions. Firstly, how do these developments affect banks? Liquidity in some dark pools, especially for Barclays has dried up, but the loss of liquidity in a dark pool doesn’t lead to loss of liquidity in the bank itself. Also, in the worst-case scenario, only a segment of the banks’ investment banking operations will be affected. But the stock prices of banks have definitely taken a hit (Barclays stock price dropped 6% within a day), once again shaking investor confidence in bank stocks. Dealing with regulatory authorities will be another headwind for the industry and its barely recovering reputation.

The more pertinent question however is about the impact of dark pool trading for the overall market. The rationale behind dark trading facilities is that they provide the possibility of price improvement when mid-point of quoted bid and ask price is used for the transaction and also lead to reduced transaction costs by saving on the bid-offer spread and exchange fees. Consider a large fund that wants to shed a million shares of firm. In the absence of a dark pool, the fund can either sell the shares at once and receive a low volume weighted average price, or carry out the transaction in small steps over a long period of time, leading to high exchange fees and transaction costs. However, with dark pools, it is easier for the fund to find large buyers, sell their stock anonymously and get a better price. Clearly, in principle, this can lead to more efficient and faster transactions and even aid price discovery once the trades are executed and reported.

In recent times, the dark pools initially meant efficient trading avenues for select institutional investors are attracting away large proportions of trading volumes from the ‘lit’ exchanges. As more and more transactions move away from the public eye, the problem of information asymmetry will increase as the investing public will remain unaware of large volumes of trades and market quality will deteriorate.

While discussing the various advantages, ‘no information’ leakage is always assumed. The problem with assumptions is that often, they are far from facts. This is the cause of the most recent and pressing concern regarding dark pools. High frequency trading (HFT) firms employ tactics to unearth large transactions and use these to gain an unfair advantage by engaging in arbitrage and front running. This threatens the very basis of dark pools existence, their lack of transparency and casts doubts over their long-term viability.

At present, the implications of regulations to put a cap on dark pool trading and probes into HFT involvement remain unclear at best, with no certainty that these will direct market trading back to public exchanges. In the debate regarding dark pools, while the concept can be defended, it is clear that the potential for their misuse holds adverse consequences for global financial markets.

Posted by The Indian Economist | For the Curious Mind