Dark Pools 101

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Dark pools. Even the name sounds ominous. Like some great, oozing mass of primordial sludge that will suck anything that gets too near it down into a black, inescapable abyss. Unfortunately, from a middle-class investor's viewpoint, it's a metaphor that works.

Size matters
Dark pools are private exchanges where stock trades are executed out of sight and out of reach of the average investor, allowing big investors to move massive amounts of shares anonymously and with prices posted publicly only after trades are done.

If you happen to be a large investor, this is clearly advantageous. Trying to sell a large block of shares on a public exchange will almost inevitably move the market in and of itself, distorting it and driving share prices down. In this sense, there's a case to be made that dark pools level what would otherwise be an unfair playing field for big investors.

But a similar case could be made that dark pools benefit small investors, too. If retirement-investor you is trying to sell 10 shares of Company Z at the same time that fund-manager William Bogsworthy III is, except that his sell order is for 100,000 shares, you could find the price for your shares driven artificially lower, too.

There's clearly a need, then, for some sort of non-public stock-exchange mechanism, but not the one that's currently in place.

Attack of the financial ooze
CFA Institute, a worldwide association of investment professionals that champions ethical investing, has just released a new study: Dark Pools, Internalization, and Equity Market Quality. It examines the impact of dark-pool trading on market-depth and bid-offer spreads (metrics used to determine market quality) and shows that while increases in the amount of dark-pool trading correlate with improving market quality at first, when the majority of trading occurs in dark-pool exchanges, market quality deteriorates.

And an increase in dark-pool trading is exactly what's happening. The report cites the volume of dark-pool trading has grown by almost 50% in the last three years, and now accounts for around 33% of the total volume of trades executed in the U.S. Alarmingly, even the public exchanges are getting in on the dark-pool action. In August, the New York Stock Exchange  (NYSE: NYX  )  launched what it calls its Retail Liquidity Program, a dark-pool trading system for retail equity orders. The Nasdaq (Nasdaq: NDAQ  ) is working on a similar program.

Not only is 33% a lot of trading volume that's now out of the hands of displayed-trading investors, but dark-pool trading also hampers price discovery -- one of the key reasons for being of any stock market.

Waiting for the next great crisis
The American stock market is a people's market, a way for the middle-class to get a share in the country's burgeoning commercial activity, and therefore a way to build wealth beyond what one does for a living. The Dutch East India Company was one of the first public companies to let anyone off the street buy a share, and it's critical that this idea of a stock market for everyone continues.

As a solution to the problem of greater and greater volumes of trades being executed in dark pools, CFA Institute recommends that "public policy measures should support fair competition and protect investors who display quotes in the public markets" -- a formal way of saying regulators need to get involved. As of right now, the Securities and Exchange Commission has considered regulatory proposals related to dark pools but hasn't passed any measures.

Until some regulatory entity does, the great financial sludge will keep spreading, eating up more and more of the stock market until, potentially, average investors stop believing it's worth their while to participate. At that point, regulators will likely take notice and do something. Must it always take a crisis to get anything done?

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