Dark Pools and Dark Matter: Completing the Theories of Everything

4/12/2010 - David Buckham CEO of Monocle

The Johannesburg Stock Exchange (JSE) is in the process of launching its own non-displayed order functionality, taking into consideration international regulatory developments. Russel Loubser, the Chief Operating Officer of the JSE Limited recently announced that the JSE will be introducing a dark pool towards the end of May 2010. This will accommodate large orders on the JSE’s central order book, with a hidden order category for trades larger than a minimum size.  

Dark pools, otherwise known as crossing networks, are an alternative trading venue where institutional investors can transact large blocks of shares that are listed and traded on stock exchanges. These venues do not display quotes in the public market, so brokers and their clients can place larger transactions anonymously, or ‘in the dark’ so to speak.  

The fact that the expression contains the word `dark` makes it sound fairly ominous. Although the term “dark pool” is relatively new, the concept of matching exchange liquidity is as old as stock trading itself. Crossing networks originated in the early 1970s with the private phone-based networks used by buy side traders. In the 1980s they went electronic with the introduction of Instinet and POSIT. The current usage of the term `dark` likely originated with the Island ECN electronic-exchange platform, which in 2002 got into a tussle with the US Securities and Exchange Commission over the handling of exchange-traded funds (ETFs). Since then, a decision was made that all orders on Island in ETFs would be hidden, saying it would go `dark` on those names.  

The analogy to dark matter is inevitable. There is simply not enough mass in the Universe to make the maths works for galactic rotation, gravitational lensing, and the temperature distribution of hot gas in galaxies and clusters of galaxies. Most of the stuff in clusters of galaxies is invisible and, since these are the largest structures in the Universe held together by gravity, scientists have concluded that most of the matter in the entire Universe is invisible or dark matter. There is an evident paradox in dark matter illuminating the physicists’standard model, which can be seen almost as a “Theory of Everything”.  

Top contender for economists’ Theory of Everything must certainly be the efficient market hypothesis (EMH), formulated by Eugene Fama in 1965. The weak form of the EMH holds that current stock prices reflect historical price and volume data. The semi-strong form of the hypothesis holds that prices include not only historical data, but also all publicly available information about the company. The strong form of the hypothesis is the most stringent and holds that stock prices fully reflect all information, both public and private. The EMH is itself paradoxical in that it contains an internal inconsistency. Sanford Grossman and Joseph Stiglitz have pointed out that if all relevant information were reflected in market prices, market agents would have no incentive to acquire the information on which prices are based.  

It would seem that we now have dark pools to support our need for efficient markets, just as we have dark matter to support our theories of the universe. But just as the Higgs Boson continues to elude us, so dark pools may falsify the “price is right" component and the “no free lunch” component of the EMH, the former simply because the price is a priori unknown, and the latter because liquidity is by definition incomplete. In reality markets are never perfectly efficient. Rather than being an issue of black or white, market efficiency is more a matter of shades of gray. In less efficient markets, acquiring “all relevant information” may allow substantial outperformance.  

Irrespective of these philosophical questions, hypotheses, metaphors, and rambling thoughts, the bottom line is that there is a shift in trading behaviour. It is commonly argued that by fragmenting trading and liquidity, and in particular by siphoning off large blocks of order flow, dark pools degrade price discovery on exchanges.  

The JSE is accountable to South Africa’s Financial Services Board (FSB) for market regulation. Their common objective is to collaborate on matters that could undermine investor confidence. At the conference held in March 2010 by the Association for Savings and Investment in South Africa (ASISA): “SA Inc 2010 and beyond” Bert Chanetsa (Deputy Executive Officer: Investment Institutions, FSB) and Russel Loubser stated that an agreement had been reached on dark pools.  

Regulators, both in South Africa and elsewhere, seem very concerned with dark pools. In June, both the SEC and the European Commission announced reviews of the impact of off-exchange equity trading platforms with respect to market access, price transparency, and liquidity deepening or price fragmentation.  

Dark pools internationally are mainly run by private electronic trading networks developed by big brokers and active trading houses to internalise the order flow from their customer base. This bypasses the exchanges. The cost to customers is generally lower, while the brokerage coins it by acting as principal as well as agent. Brokers are required to fulfil orders wherever they get the lowest price. This facilitates the need for dark pools. The possibility exists of a fundamental shift in trading being driven by greater access to proprietary dark pools, particularly with the advent of liquidity mapping tools. High frequency traders have already moved aggressively into dark pools. Stock exchanges are more regulated and therefore have higher costs to investors. In effect the exchanges are losing business.  

In September 2009 the Federation of Securities Exchanges wrote a letter to regulators demanding that dark pools be regulated more extensively, and that measures be implemented to move more trading onto exchanges. Dark pools have forced traditional exchanges to innovate in order to remain competitive, but one imagines that exchanges would be far happier if dark pools were highly regulated so that the playing fields were more level.  

Our conception of ‘the world as we know it’ is that it at least ought to be efficient. The resistance to dark pools is based on the fact that they are not transparent. In order for us to have liquidity and efficient prices we also need transparency. The trading shift is further shaped by the fact that market participants would prefer transparency to the vague concept of efficiency. The JSE has realised this, and is probably acting on the premise that if you can’t beat them, join them.  

David Buckham, CEO of Monocle

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