Dark markets may be more harmful than high-frequency trading

Mon Apr 7, 2014 4:27am EDT
 
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By John McCrank

NEW YORK (Reuters) - Fears that high-speed traders have been rigging the U.S. stock market went mainstream last week thanks to allegations in a book by financial author Michael Lewis, but there may be a more serious threat to investors: the increasing amount of trading that happens outside of exchanges.

Some former regulators and academics say so much trading is now happening away from exchanges that publicly quoted prices for stocks on exchanges may no longer properly reflect where the market is. And this problem could cost investors far more money than any shenanigans related to high frequency trading.

When the average investor, or even a big portfolio manager, tries to buy or sell shares now, the trade is often matched up with another order by a dealer in a so-called "dark pool," or another alternative to exchanges.

Those whose trade never makes it to an exchange can benefit as the broker avoids paying an exchange trading fee, taking cost out of the process. Investors with large orders can also more easily disguise what they are doing, reducing the danger that others will hear what they are doing and take advantage of them.

But the rise of "off-exchange trading" is terrible for the broader market because it reduces price transparency a lot, critics of the system say. The problem is these venues price their transactions off of the published prices on the exchanges - and if those prices lack integrity then "dark pool" pricing will itself be skewed.

Around 40 percent of all U.S. stock trades, including almost all orders from "mom and pop" investors, now happen "off exchange," up from around 16 percent six years ago.

This trend is "a real concern," John Ramsay, former head of the U.S. Securities and Exchange Commission's (SEC) Trading and Markets division, said on the sidelines of a conference in February. "We have academic data now that suggests that, yes, in fact there is a point beyond which the level of dark trading for particular securities can really erode market quality."

Given the $21.4 trillion worth of U.S. stocks that were traded in 2012, even a small mispricing can move the needle by tens of billions of dollars.   Continued...

 
Traders work on the floor of the New York Stock Exchange at the opening of the trading session in New York October 5, 2012. REUTERS/Mike Segar