Goldman Sachs Shows That High Frequency Trading May Not Be All it's Cracked Up to Be

Banks can churn profits from the dark side of transactions.

May 3, 2014 at 9:00AM

It seems like the financial community just cannot get over Michael Lewis' explosive new book investigating high-frequency trading -- Flash Boys.

Flash Boys tells the story of the rise and market-rigging of traders who make their money through inconceivably fast trades on infinitesimally small price fluctuations. One of the ways that they are able to do this is through analyzing orders of privately operated trading venues known as dark pools.

With the recent spotlight on high-frequency trading, coupled with past computer problems such as those that contributed to the so called "Flash Crash" of 2010, big banks such as Goldman Sachs (NYSE:GS) are beginning to reevaluate their positions in these controversial exchanges.

So, what is a dark pool?
Dark pools were initially used by institutional investors to move large blocks of stock. Transactions between traders are hidden from the public until they were complete, preventing a price fluctuation induced by volume from moving against these institutional investors. Their use has evolved to include smaller stock transactions as well.

Dark pools are a rather recent phenomenon from the mid-2000s, but are quickly gaining traction. According to Rosenblatt Securities, a firm that tracks dark pool activity, about 38% of all stock transactions currently take place in places other than public exchanges, such as these dark pools.

However, this dark pool/public exchange divide may temporarily shrink. Goldman Sachs made headlines when it said it was considering closing its dark pool, Sigma X. Sigma X is consistently one of the largest alternative trade venues and its closure would be a significant event. If this were to occur, it could prompt competitor venues such as the Citigroup (NYSE:C)Citi Cross and the Credit Suisse Group AG (NYSE:CS)Crossfinder platforms to cease their own lucrative dark pool operations as well.

No company breaks down exactly how much it brings in from its dark pool ventures, but two things are known for certain about this market:

The dark pool market is highly fragmented
Dark pools compete based on the proprietary systems that run their networks. For example, Citigroup boasts an even-allocation matching algorithm for its Citi Cross platform. However, the statistics show that this is not a significant differentiator.

A SEC report documented over 40 dark pools in operation, with the top five in size making up only 47.07% of the volume that goes through these exchanges. This indicates that the market is largely commoditized, with the only variation in each venue coming from the name of its owner.

Five Largest High Frequency Traders
Orders $1.5 Billion
Average Order Size $364 Million
Share of Dark Pool Trading Dollar Volume 49%

A second SEC report notes that the agency is concerned that such fragmentation will interfere with "the efficient execution of transactions, best execution of investor orders, price transparency, and an opportunity for investor orders to interact with each other." This leads to the second known fact about this market.

Dark pools won't avoid regulation for long
The SEC has investigated ways to regulate dark pools. Dark pools have not been subject to the various stipulations of public exchanges. In his "60 Minutes" interview, Lewis attributes the lack of oversight in this area to the complexity of the operations that go on between dark pools and high-frequency traders.

The actions of dark pool operators have not done much to appease these concerns. Last year, Credit Suisse announced that it was ceasing to disclose the amount of trade volume that went through Crossfinder.

Even Goldman's own President and Chief Operating Officer, John Cohn, believes that regulation is needed. In an op-ed in the Wall Street Journal, he stated "some issues cannot be addressed by market forces alone and require a regulatory response."

It is my opinion that the consideration of shedding Goldman's dark pool operation is a telling sign of the future -- a move towards increased regulation and scrutiny. 

The dark pool market is evolving to the point where finding alternative venue solutions in a third party will ultimately be the wiser move for banks. Therefore, I anticipate Goldman to be the first of many big banks to begin shutting down in-house dark pool operations and throwing support behind specialized dark pool companies.

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Article by David Post, edited by Marie Palumbo and Brendan Marasco. None has positions in any stocks mentioned. The Motley Fool recommends Goldman Sachs. The Motley Fool owns shares of Citigroup. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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