No Shallow End

A fair amount of entities and people are flailing about trying to keep afloat in current financial markets. One response is to trade in the  growing number of dark pools. These are, essentially, private networks of traders who wish to trade without the cumbersome regulations and margin requirements imposed by the public exchange. However, there is yet another reason why traders are drawn to them:

Using software developed in part by Fidelity Investments a decade ago, Pipeline set out to provide a way to buy and sell stocks away from the public stock exchanges. On its alternative system, large investors would be protected from what many find an irksome species: rapid-fire traders who use powerful computers to spot orders as they emerge and instantly trade ahead of them. [link]

The ramifications of using these platforms are obvious — decreasing transparency, and a move away from public trading. Informational efficiency (or the infiltration of information into prices) of equity prices is one of the long-standing hallmarks of US markets. Several have even claimed that that the last financial crisis was predicated on the failure of this informational efficiency. Whether or not you are a believer in efficient markets (long or short-term), the increase of trading in dark pools is not going to help any one. And this problem is not going away any time soon, it will only get worse before, hopefully, it gets better. From the above article:

Dark pools now number more than 50 and account for 12% of U.S. stock trading, up from 4% in 2005, according to research firm Tabb Group. By design, though, they are opaque, and investors have long wondered what might be going on beneath the surface. Pipeline was a dark pool that lived up to the term.

The story of Pipeline is an interesting one. Initially started as an independent trading platform to facilitate off-exchange trading, they actually got into the business of market-making which is buying and selling shares for appropriately bid prices:

The groundwork for it was laid inside a technology lab at Fidelity in the early 2000s. The Boston mutual-fund firm was looking for ways to trade large blocks of shares away from the public market, where it feared opportunistic traders could jump in front of its big orders, affecting prices. A few alternative trading systems existed, but Fidelity wanted to build a better mousetrap, said a former executive.

Key to making Pipeline work was an ample flow of orders. Pipeline officials hoped Fidelity would use the pool for a sizable chunk of its trading, but just before Pipeline went live in September 2004, it became clear Pipeline would get only a sliver of Fidelity’s orders.

Without assurances of substantial volume, Pipeline’s parent holding company, Pipeline Financial Group Inc., took a fateful step: It created an internal trading outfit to make sure orders got filled. If an investor wanted to buy some shares and there was no seller for the same shares in Pipeline’s dark pool, this affiliate could try to fill the order by first buying shares on the open market.

This is how an alternate trading universe is born, and this is also how increasingly large numbers of shares are now traded privately. Like with the economy, we are now seeing a two-tiered stock market. Those who have to follow the rules, and those who can pretty much make them as they go along. As I said before, it looks like it can only get worse before it begins to get better.

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