Terms like “dark pools,” and “HFT” and “bid and offer” cause eye-rolling. There’s no particular reason to be fearful of them, but there are plenty of reasons to be cautious about some of the more esoteric manipulations on Wall Street…and places which aren’t Wall Street.
For example, a Dark Pool is a private fund for trading securities which is “dark” because the prices and sales are no made available to the public. One of these may be run by a large bank as part of its proprietary trading desk(s). The good news for investors is that the pools are largely unregulated, but they are subject to what is known as NBBO (National Best Bid and Offer). And, the broker-dealers who swim in these pools are members of FINRA (Financial Industry Regulatory Authority) and are subject to audits. The other side of the coin is that it’s hard to regulate what you can’t see, and while FINRA is a good institution it is hardly independent — it’s actually a private corporation which acts as a self-regulating authority in the financial markets. Ergo, there are critics who describe this as a classic case of Fox and Hen-house.
An HFT (high frequency trader) [CNBC] is associated with the financial strategies — for making money — by outfits like Getco, and Citadel LLC. The idea is to find out the price being asked by sellers and the price being sought by buyers of various kinds of securities, and then apply the age old strategy: Buy low and sell high. Since information like this is time sensitive the fastest machines in the world win. The “Bid-Ask Spread” is the key:
“The amount by which the ask price exceeds the bid. This is essentially the difference in price between the highest price that a buyer is willing to pay for an asset and the lowest price for which a seller is willing to sell it.” [Investopedia]
The process can get pretty sophisticated and essentially mathematical, but that’s really the basis for the success of the HFT’s.
Here are some cautionary points:
#1. It is true that Dark Pools and HFTs aren’t doing business with the average retail investor. Most of their clientele is made of professional investors. Large professional investors. Here’s where the “little investor” comes in. If your pension administration is dealing in securities then you need to know where the money is going and what happens to it along the way.
When the ‘East Deer Breath Association of Retired Taxidermists’ administration decides to unload 10,000 share of Wonder Widget Inc’s stock, where is the order going? Will the order be transparent or caught in one of the Dark Pools, not to be completely explained to the investors who put the stock into the market? If the ‘East Deer Breath Association of Retired Taxidermists’ wanted to buy 10,000 shares of Wonder Widget Inc. then is the buy order being executed at the price shown on the computer screen when the ‘buy’ button is pushed, OR will be price of the security magically increase before the final order is accomplished?
The idea of investment banking is to match buyers and sellers, to facilitate the flow of capital (money) from surplus to need. The problems appear when the ‘middle’ people start milking the system for tiny margins which in large volume can remarkably profitable. Michael Lewis’s book Flash Boys describes the process in the middle and is highly critical of the way investment institutions treat their investors. The process also has its defenders, such as the mutual fund Vanguard’s CEO, who asserts that HFT’s mean better value for investors. [FT]
#2. Beware of ‘weasel words.’ One of the most misused and overused explanations for everything is “liquidity.” The term covers a multitude of sins, large and small, and may generally be assumed to mean anything the speaker intends. Do HFTs add “liquidity” to the markets? Forbes once attempted to argue that the HFTs were making money, but just not THAT much money, and therefore were adding … wait for it…. “liquidity to the markets.” The core argument of the article depends on whether or not the reader believes Liquidity is a lovely thing and should be encouraged no matter how it is accomplished.
#3. Ask for precise information. Heaven knows you won’t usually get it from the cable television business news outlets who are more often interviewing CEOs about the Great Things They Are Doing In Their Industries. Be aware that you (and your pension plan or 401(k) manager) aren’t seeing the entire picture. You aren’t seeing the trading that’s going on in the Dark Pools, and you aren’t seeing exactly where your investment decision (buy or sell) is heading through the pipeline. So when the ticker runs along the bottom of the TV screen you’re probably getting the NBBO numbers for the day and all the “volume” activity that the public is supposed to know about.
These aren’t necessarily the indications of financial Armageddon, since Dark Pools have been around since the days of old in which it was referred to as “trading upstairs,” BUT as more and more pressure is applied to individuals to be responsible for their own retirement and savings strategies it is imperative that more people come to more sophisticated conclusions about the management of their money.
#4. Read carefully. Consider the source. Are the criticisms coming from sources which provide verifiable information and data? Are the encomium pieces coming from fund managers, or better still from the banks running Dark Pools or the HFTs themselves? Do you understand the concept of “front running” and how it might apply to the investments you make or which are made for you?
Some suggested reading: “Is High Frequency Trading as Bad as Michael Lewis Wants You To Think?” The Wire, April 1, 2014. MHP, “Narratives and Numbers,” MHP Financial. “NY Attorney General Eyes exchange in high frequency probe,” Reuters, May 2, 2014. Business Day, “Sacrificing Sense for Speed,” New York Times, April 10, 2014. Nick Baumann, “Too Fast To Fail?” Mother Jones, Jan/Feb 2013. Sarah Anderson, “Derailing the High Speed Trading…”, Huffington Post, April 30, 2014. Bob Swarup, “5 Myths about High Frequency Trading,” Huffington Post, April 14, 2014.