dark pools: what they are

the traditional brokerage system

Twenty years ago, virtually all trading between professional investors was conducted through stockbrokers as middlemen.  This traditional system had three big advantages:

–brokers are constantly in touch with a large number of potential buyers and sellers–including other brokers–of a wide variety of securities.  This means that orders can be executed quickly and in large size.

–in some cases, brokers may use their own capital to buy less liquid securities from a customer right away–securities that would otherwise be hard to sell–hoping to trade out of the positions at a profit over a period of time.

–because brokers see lots of orders from very many customers, they may be able to spot trends in the markets faster than an individual investor.  So they may be a source of market intelligence.

Using a broker has one big disadvantage and one smaller one:

–the smaller one is that they’re more expensive than dealing directly with another professional investor would be,

–the larger one is that your broker knows who you are and what securities you’re transacting in.  The more you deal with a given broker, the more insight he will gain about your plans and methods of operation.  In a sense, he gradually comes to “own” them.  He can use this information in his proprietary trading or pass it on to your rival investment managers.

The bigger the institution, the savvier the investment manager, the more valuable this information is–and therefore the more likely it is to be passed on to others.

anonymous trading networks…

Advances in computer technology, both software and hardware, allowed entrepreneurs to create the first anonymous computer trading networks, or “dark pools” for institutional investors about a decade ago.  Investors register with the network operator, but place all their buy and sell orders on the network without revealing their identity.  Nor can they find out who the other side of any transaction is.

The advantages of dark pools are:

–anonymity, and

–very low commission costs.

The main disadvantage is:

–liquidity in a given issue may be low, meaning that execution of a large order may take a considerable amount of time.  An institution can mitigate this problem somewhat by placing orders with a bunch of dark pools at the same time.

…have become very popular

As time has passed and investors have become more accustomed to the concept, the use of dark pools has increased to where some estimates have them accounting for more than one trade in four in the US.  Three reasons:

–more users means better liquidity

–SEC-regulated investors have a positive obligation to seek the lowest-cost executions in their trading.  Using electronic crossing networks demonstrates they’re doing so

–as brokers have deemphasized stock research as a way to cut costs, the need to do enough business with brokers to get full access to research information has diminished.

where Pipeline Trading Systems comes in

Pipeline (PTS) is a broker- dealer who decided to cash in on the dark pool trend by creating one of its own.  It intended to make money, as any dark pool operator would, by charging a fee to anyone using its service.  It opened for business in September 2004.

In its advertising, PTS touted its anonymity and its ability to provide “natural” buyers/sellers for the other side of any trade.  Although, as the SEC notes in its recent cease and desist order, natural doesn’t have a precise legal definition, its use is meant to convey that the other party is another institutional investor, and not a financial intermediary like a broker or short-term trader.

Despite this claim, even before opening, PTS created a wholly-owned trading affiliate to take the other side of trades.  Its idea appears to have been that liquidity in the dark pool would thereby appear bigger than it actually was.

PTS didn’t disclose this to clients.  Quite the opposite.  It continually assured them that this was not the case.

As it turns out, the PTS dark pool was a bust.  In the early years, PTS itself provided well over 90% of the other sides of institutional members’ trades.  And it lost a lot of money doing so.

So PTS decided to put its head trader in charge of the brokerage affiliate, with the task of whittling down the losses.  The in-house broker promptly began to act in a way I see as being against the interests of its institutional clients.  Contrary to what it was telling clients, PTS gave the broker privileged access to the dark pool’s trading data, so it could study customers’ trading patterns; traders were given bonuses for money-making trades; the broker gave suggestions to its parent on how to tweak the dark pool rules in the broker’s favor.

PTS continued to lose money, however, though at a lower rate.  And then it was caught by the SEC.

PTS and two principals were together fined $1.2 million.  They also agreed to stop their illegal behavior.

Although the PTS crew were a hapless bunch, the SEC administrative proceeding against them shows that the agency is finally beginning to examine the operation of dark pools.  At the same time, the case shows that an enterprise like PTS can operate for the better part of a decade without being detected.