Rise of the dark pools

[Marv Gandall]

From a speech to the Senate by Delaware Senator Ted Kaufman, published in
yesterday's Huffington Post:

(High frequency or flash trading refers to the growing practice of
investment houses like Goldman Sachs to locate and program servers next to
exchanges, giving them split second advance access to market information
which allows them to engage in automated front-running, executing orders on
their own account ahead of their customers and other traders.)

* * *

[...]

Due to rapid technological advances in computerized trading, the stock
markets have changed dramatically in recent years. They have become so
highly fragmented that they are opaque - beyond the scope of effective
surveillance. And our regulators have failed to keep pace.

The facts speak for themselves. We've gone from an era dominated by a
duopoly of the New York Stock Exchange and Nasdaq to a highly fragmented
market of more than 60 trading centers. Dark pools, which allow confidential
trading away from the public eye, have flourished, growing from 1.5 percent
to 12 percent of market trades in under five years.

Competition for orders is intense and increasingly problematic. Flash
orders, liquidity rebates, direct access granted to hedge funds by the
exchanges, dark pools, indications of interest, and payment for order flow
are each a consequence of these 60 centers all competing for market share.

Moreover, in just a few short years, high frequency trading - which feeds
everywhere on small price differences in the many fragmented trading
venues - has skyrocketed from 30 to 70 percent of the daily volume.

Indeed, the chief executive of one of the country's biggest block trading
dark pools was quoted two weeks ago as saying that the amount of money
devoted to high-frequency trading could "quintuple between this year and
next."

Mr. President, we have no effective regulation in these markets.

Last week, Rick Ketchum, the Chairman & CEO of the Financial Industry
Regulatory Authority - the self-regulatory body governing broker-dealers -
gave a very thoughtful and candid speech, which I applaud. In it, Mr.
Ketchum admitted that we have inadequate regulatory market surveillance.

His candor was refreshing but also ominous: "There is much more to be done
in the areas of front-running, manipulation, abusive short selling, and just
having a better understanding of who is moving the markets and why."

Mr. Ketchum went on to say:

There are impediments to regulatory effectiveness that are not terribly
well understood and potentially damaging to the integrity of the
markets...The decline of the primary market concept, where there was a
single price discovery market whose on-site regulator saw 90-plus percent of
the trading activity, has obviously become a reality. In its place are now
two or three or maybe four regulators all looking at an incomplete picture
of the market and knowing full well that this fractured approach does not
work.

Mr. President, at the same time that we have no effective regulatory
surveillance, we have also learned about potential manipulation by high
frequency traders.

[...]

...One industry expert has warned about high-frequency malfunctions:

The next Long Term Capital meltdown would happen in a five-minute time
period. ... At 1,000 shares per order and an average price of $20 per share,
$2.4 billion of improper trades could be executed in [a] short time frame.

This is a real problem, Mr. President. We have unregulated entities - hedge
funds - using high frequency trading programs interacting directly with the
exchanges.

As Chairman Reed said at last week's hearing, nothing requires
that these people even be located within the United States. Known as
"sponsored access," hedge funds use the name of a broker-dealer to gain
direct trading access to the exchange - but do not have to comply with any
of the broker-dealer rules or risk checks.

[...]

Even those on Wall Street responsible for overseeing their firms' high
frequency programs are not up to speed on the risks involved, according to a
recent study conducted by 7city Learning. In a survey of quantitative
analysts, who design and implement high frequency trading algorithms,
two-thirds asserted their supervisors "do not understand the work they do."

And though quants and risk managers played a central role exacerbating last
year's financial crisis, 86% of those surveyed indicated their supervisors'
"level of understanding of the job of a quant is the same or worse than it
was a year ago," and 70% said the same about their institutions as a whole.

[...]

Full:
http://www.huffingtonpost.com/sen-ted-kaufman/breaking-wall-streets-boo_b_348494.html

[CEJ]

I guess the question here is: were the trading markets any less opaque
back in the 1980s or late 1920s or the first decade of the 20th
century? Were financial markets?

On the one hand, the mess they are in now looks to be much like any
number of previous messes in how it all came about.
OTOH, the staggering increase in scale seems to support the argument
that something is different--and even scarier--this
time around.

The irony is most Americans will probably learn more from going to
Michael Moore's and Oliver Stone's films than
they will from reading or watching the media.

CJ

[Marv Gandall]

----- Original Message -----
From: "CEJ" <jan...@gmail.com>
To: "Marxist Debate" <marxist...@googlegroups.com>
Sent: Sunday, November 08, 2009 5:12 AM
Subject: [Marxist Debate] Re: Rise of the dark pools

>
> I guess the question here is: were the trading markets any less opaque
> back in the 1980s or late 1920s or the first decade of the 20th
> century? Were financial markets?
>
> On the one hand, the mess they are in now looks to be much like any
> number of previous messes in how it all came about.
> OTOH, the staggering increase in scale seems to support the argument
> that something is different--and even scarier--this
> time around.

==============================
Yes, I think that's the point. The scale and technology seems to have
outstripped the capacity of regulators to police the markets - at least,
those with the will to do so. I noted on another list that "the comment in
the Huffington Post article by a witness to the Senate Finance committee
that 'a Long Term Capital meltdown would happen in a five-minute time
period' may be hyperbole, but it does reflect a genuine fear among global
regulators about whether and how these proliferating and opaque forms of
modern finance can be monitored and controlled in the interests of the
system as a whole. Delaware Senator Ted Kaufman's observations that dark
pools have risen from 1.5 to 12 percent of market trades in five years and
that flash trading has 'skyrocketed' to 70% of daily trading volume, if
true, can't be easing those concerns."

The more immediate issue with flash trading may be more easily addressed -
the sale of split second access to market information by the exchanges to
selected investment firms. Acting on a complaint by New York Senator Chuck
Schumer
(http://schumer.senate.gov/new_website/record.cfm?id=316252&%29,), the SEC
has since proposed banning the practice. Apparently, a SEC rule requires
that a full second elapse before the exchanges can make trades public.
Shumer is advocating on behalf of investors who are disadvantaged by the
bigger hedge funds and investment banks, but the issue taps into and won't
resolve the larger one noted above, ie. that computerized trading, apart
from encouraging market manipulation, can also magnify market swings,
especially on the downside, and be profoundly destabilizing to the
capitalist world economy.

[CEJ]

>>> Yes, I think that's the point. The scale and technology seems to have
> outstripped the capacity of regulators to police the markets - at least,
> those with the will to do so.<<

But was the regulation of capitalist governments ever adequate? Isn't
that one reason why the bubbles get so big and so bad for such a long
time? Was the oversight adequate in 1905? 1929? 1987? 1997? 2001?
Etc. etc.

CJ

[Marv Gandall]

CJ writes:

> But was the regulation of capitalist governments ever adequate? Isn't
> that one reason why the bubbles get so big and so bad for such a long
> time? Was the oversight adequate in 1905? 1929? 1987? 1997? 2001?
> Etc. etc.

============================
I don't think they ever expected to eliminate crashes, but they had
reassured themselves that they had curbed their system-threatening severity
until this latest one jolted that confidence. They're also more worried that
competing national regulators no longer have the capacity to manage an
increasingly integrated global financial system, and that computerization
has made it easier for banks and other investors to trade outside regulated
markets. But it's an inherently chaotic system where the foxes are in charge
of the henhouse, so your point that regulation has never really been
adequate is a valid one.

[CEJ]

And we are not they, so people like you, me and CB forsee (if not
precisely
predict) such things. I think the scale issue means not only does
oversight
and regulation become inadequate, but the extent of what is broken is
near
incomprehensible. I'm still trying to figure out how trillion has
become
a practical number.

CJ