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A Good Probe

06/27/2014

Suppose you own $200 million of XYZ Company stock and want to sell half of it.  If you simply hit the SELL button and flood the market with stock, the price will go down, reducing the value of the stock you sold, plus the stock you kept, plus the value of stock held by other stockholders.  That is because all transactions on the public stock exchanges are public information.  Every buyer will see the market for those shares is being flooded and will therefore offer less.  There is nothing sinister or illegal about this.

So, large banks operate what are called “dark pools.”  In this example, you would give your $100 million of stock to the bank who would then sell $5 million to twenty other clients.  By doing this, you get the best price for the stock you sold as well as the stock you kept. Plus, this is good for other shareholders who are keeping their stock.  All this is possible, because the transactions are secret.  No buyers realized the market was being flooded with shares to sell.  Mutual funds and pension funds are the primary users of these dark pools, and  38% of all equity trades are now done in them.  There is nothing sinister or illegal about this either.

Of course, secrecy breeds conspiracy theories, and there have been many rumors about what else happens in these dark pools.  There sure is a lot of smoke . . .

This week, we learned that the New York Attorney General is probing the second largest dark pool.  Apparently, they are focusing on whether the bank was honest in what was happening inside the dark pool, with the suspicion that they allowed high-frequency trading (described as petty larceny on a grand scale). While I believe it is sinister to allow high-frequency trading in a dark pool, I know it is not illegal.  But, it is illegal to tell clients you are not doing it when you really are.

It is good that this dark pool is being probed and is focusing attention on all dark pools.  These huge secret pools could easily pose a systemic risk to our financial system and need to be better regulated.  My suggestion would be annual audits by the SEC and criminal liability of Chief Investment Officers who abuse the secrecy.

Now, what happens if a rouge dark pool loads up on European derivatives, for example?  Well, that’s why God invented the SELL button!

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