Molecule Software Blog

The Molecule Software ETRM/CTRM Blog

Dark Pools - Not to Be Taken Lightly

There has been a lot of controversy and chatter these past couple of weeks on high frequency trading and dark pools -- especially after the release of Flash Boys by Michael Lewis (which I haven't been able to put down!). While HFT shops are being poked and prodded by the U.S. Justice Dept and other regulators, the problem of dark pools may, actually, be much bigger. Maybe the regulators should be spending more time and energy there? We think so.

Dark pools are trades that are matched up by the dealer, usually broker or bank, off exchange. This lets the dealer avoid the exchanges fees. Yep. True story. In the short term, dark pools may have been built to cater to the HFT crowd, as they paid much more money to have access to the pools than what the brokers saved in exchange fees. However, HFTs are on the decline - while dark pools are growing. An estimated 40% of U.S. stock trades now happen off exchange. This includes almost all small orders now, not just large institutional block orders who originally were interested so they wouldn't tip off the market.

The problem? So much trading is off exchange that the market can no longer provide enough efficiency to properly reflect a share price which matches supply & demand. This will cost average investors and institutionals WAY more money than HFT mischief. According to a University of Melbourne study, price erosion happens when 10% of a security trades off market.

We believe in markets that are transparent.

We believe in markets in which everyone gets the price that is reflective of the current value.

Commodities are heading that way, happily, but the regulators need to wake up and mend the equity markets from going the opposite direction.