UsableMarkets

Anuj Gangahar writes a rather interesting story in the FT this weekend. Dark pools — non-public markets where hedge funds and other privileged people can trade large amounts of stock — may be having an adverse impact on our efficient (and public) stock markets.

First, a little background.

It has long been posited that public markets, such as the Nasdaq and the New York Stock Exchange, follow the efficient market hypothesis. This hypothesis, backed by research, states that the price of stock in these markets incorporates all known information about that stock, so that no particular person can have an advantage. In other words, it’s unlikely that anyone can beat the market by having additional information that others do not have.

But dark trading pools, secret by nature, allow market participants to take a position on a stock without expressing it in the public, transparent stock markets. And, since these markets are not regulated, and therefore not transparent, insider trading seems likely. And even without insider trading, participants in dark pools could be trading on information which is not available to the public markets. This would give rise to differences in price. Which would give rise to arbitrage opportunities.

This situation could be resolved in one of three ways. One, the financial institutions that run dark pools will be true to their word and mark dark pool prices to the public markets at all times. This would be great, but may be expecting too much.

Two, arbitrage, being perhaps the only free lunch in financial markets, would give rise to opportunities that traders would be compelled to take advantage of. And in order to take advantage of these opportunities they would have to take positions in public markets, which would then, theoretically, bring that information to the public prices. If this process happened quickly enough, the difference in prices between the two markets would be arbitraged away.

The third outcome to this situation is the same as the second, only that it happens slowly enough that prices remain different between the two markets for significant periods of time (and I decline to comment on what a significant period of time is).

In this case either the public or the private market would be right about the direction in price, but certainly not both, and someone would lose money. Who loses (or which markets loses) depends on who has the better information. And one would assume (although it’s certainly not guaranteed to be true), that dark pools would have the better information, since dark pools are only open to the privileged (i.e. better informed).

Whatever the outcome it is unlikely that dark pools will go away anytime soon, since they play a valuable role for large institutions. They allow them to make large trades anonymously. This anonymity is valued since it allows them to express an opinion about a stock without tipping off anyone else what that opinion is. Or, in other words, they can keep their valuable information to themselves.

As always, thanks for listening.
~alex