The Financial Industry Regulatory Authority, Wall Street’s self-regulatory body, last month sent 15 examination letters to operators of “dark pools”—lightly regulated, off-exchange trading venues that have been a rising concern for regulators and some investors as more activity shifts away from exchanges.
Finra is seeking details about how the increasingly popular venues operate, what they disclose to clients and whether they adequately police trades. It could bring enforcement action against dark-pool operators or issue recommendations for tighter oversight, depending on the answers it receives and additional examinations, said John Malitzis, executive vice president of market regulation at Finra. The letters are a follow-up to an initial round of questions the regulator circulated last fall.
“We want to understand whether [dark pools] are disclosing to their customers how their orders work [and] whether customers are informed who their orders will interact with,” Mr. Malitzis said in an interview. “A big part of this is to get an understanding of practices that may or may not be problematic.”
Here’s an interesting bit:
Dark pools don’t disclose traders’ buy or sell orders and only publish trade data after transactions occur. About 13% of all stock-market action takes place on dark pools, up from about 4% five years ago, according to Tabb Group, a market-research firm. Most dark pools are run by broker-dealers—firms overseen by Finra that buy and sell assets on behalf of customers as well as trade for their own accounts.
While dark pools command an expanding slice of trading volume, regulators still have little idea about how they operate since, unlike exchanges, they aren’t required to regularly disclose detailed information about their trading systems.
I see. “more activity shifts away from exchanges”; dark pools “command an expanding slice of trading volume”; their volume has more than tripled in 5 years. Growing volume! Growing market share! That sounds sinister, doesn’t it?
Note that the possible nefarious practices under investigation, if they occur, would result in the users of dark pools are getting screwed. If that’s true, why are they flocking to the pools in increasing numbers? The most plausible explanation for a growing market share is that dark pools offer better value-not worse-to those who have the opportunity to choose where to trade.
I am particularly skeptical about the idea that dark pools are hugely exploitive because sophisticated buy side firms are among the most extensive and loyal users of dark pools. Buy side firms analyze their execution costs with considerable detail. They evaluate execution costs in lit and dark markets, and slice and dice the data in sophisticated ways, uncovering the circumstances under which it is cheaper to execute in one venue or another, and allocate their trades accordingly.
In other words, if they decide to execute more in dark markets, it’s because they have decided after thorough analysis that they are more likely to get screwed in broad daylight on exchanges.
This isn’t rocket science.
There is a potentially more intellectually reputable case against off-exchange trading. Dark pools utilize a variety of techniques that are designed to screen out informed, or opportunistic, traders. Uninformed traders-firms or individuals trading for portfolio balance or cash flow or hedging reasons-suffer losses when dealing with the informed. They can reduce execution costs by trading in venues where there is a lower likelihood of dealing with a better-informed trader.
But this “cream skimming” of uninformed order flow by dark pools that screen out the informed increases the trading costs of those uninformed traders who for whatever reason cannot avail themselves of dark markets: those left behind have a higher likelihood of dealing with someone with better information, and incur higher trading costs (due to adverse selection).
Dark pools free ride off the price discovery in lit markets, and cream skimming impairs price discovery. Thus it is possible-possible-that this externality reduces welfare.
Possible, but not necessarily so. The free riding externality reduces welfare if there is no other inefficiency in the lit markets. But that is not necessarily the case. As I pointed out about 15 years ago, there are other sources of inefficiency on exchanges. For instance, exchanges may exercise market power. In this case, second best considerations imply that the free riding externality may improve welfare because the benefit of increased competition for order flow from the dark market may more than offset the cost of degraded price discovery. I have produced formal models that show that this can occur under conditions that have existed in securities and derivatives markets.
As another example, much informed trading can be a form of rent seeking. Market participants expend real resources to produce information because this allows them to profit at the expense of the uninformed. This profit is a transfer from the uninformed, and unless there is some external benefit arising from more informative securities prices, the real resources expended to gain this transfer are a pure waste. By reducing the profitability of informed trading, dark pools reduce this rent seeking and improve welfare.
Both of these analyses are applications of the theory of the second best, which says if there are multiple departures from “perfect” conditions (perfect competition, no externalities), eliminating one imperfection may actually make things worse, not better. In the dark pool case specifically, if there are other imperfections (imperfect competition on and between lit markets, rent seeking informed trading), dark pools’ ability to free ride on exchange price discovery may improve welfare because it mitigates these other inefficiencies.
Determining the welfare impacts of dark pools in the presence of these various departures from first-best conditions is devilish hard. For instance, it is arguably impossible to determine the costs and benefits of informed trading. It is also difficult to determine the degree of imperfect competition in lit markets, and the costs of this market power.
But what can be said is that the kinds of things FINRA is looking at are totally irrelevant to addressing these issues. FINRA is focusing on activities that would be agency problems, or fraud. But it is hard to square the proposition that these problems are widespread with the observation that dark markets are growing relative to lit ones, especially given that most of the patrons of dark markets are quite sophisticated, and devote considerable attention to evaluating the cost and quality of the services that they obtain.
So what is going on here? Quite likely political economy, capture, and rent seeking. For the past couple of months exchanges have been importuning regulators to do something about dark pools, precisely because they are bleeding business. This headline from Bloomberg says it all:
Stock exchanges seek curbs on dark pools to curb exodus.
In other words: exchanges are losing a competitive battle, and are recruiting regulators and legislatures to hamstring the competitors that are eating their lunch. A very, very, very old story.
I have to give the exchanges credit. They have done a marvelous job of shaping the narrative, playing skillfully on the quite different connotations of light and dark. The exchanges are like a Scout master telling a ghost story beside a campfire, his face scarily illuminated by a flashlight. They have proven masterful at scaring regulators into action against the evils lurking in the dark
My bottom line? It is possible that dark pools are, on net, inefficient, but the case has not been made. Moreover, their commercial success should be considered as evidence that they actually enhance welfare. Indeed, their commercial success is almost impossible to reconcile with claims that dark pools are somehow deceiving or defrauding those who trade on them, especially given that these traders are often quite sophisticated, and quite on guard against getting screwed.
So don’t be afraid of the dark. Be especially skeptical about stories detailing the horrors allegedly stemming from the activities of entities that are gaining market share. And always remember that incumbents are past masters at inducing regulators to crack down on inconvenient competitors. Be afraid of what regulators do in the light, not what goes on in the dark.