Are Dark Pools Obscuring True Insider Sentiment?

March 25, 2008 –

Dark pools are pools of stocks listed on private or proprietary electronic exchanges that allow a buyer or seller to move large blocks of stocks anonymously without causing the bumps in the price of a particular stock as would happen if an investor were to buy or sell a large position of a stock in a publicly followed exchange. For example, if an individual or an institution wanted to offload a block of 2 million shares in a dark pool, this transaction could be executed without affecting the stock’s trading price that day whereas normally such action by an influential individual or institution would cause the stock’s shareprice to fall. Erik Sirri, Head of the Division of Market Regulation for the U.S. Securities Exchange Commission, stated that “while the increasing use of hidden orders may be troubling,” the SEC plans to do nothing until it is clear that the use of hidden orders in dark pools is damaging the individual retail investor’s ability to buy and sell stocks at a fair price.

In 2007, an estimated 17% to 25% percent of shares listed in the NYSE exchanged hands via dark pools, a significant percentage of the total market. In today’s environment, Sirri’s comments do not bode well for the retail investor. The trading activity of large institutions and influential individuals, and along with it, their real feelings about the U.S. economy, often remain hidden from public view via trades executed within the secretive confines of dark pools. As none of the problems of systemic risk in the financial system have been solved by any of the U.S. Federal Reserve’s actions within the past two weeks, it may very well be that the activity reflected in these dark pools as of late directly contradicts the story being spun to the public. The problems with these dark pools is succinctly summarized by NYSE President Catherine Kinney, who stated that every single share traded in the dark was a share that would not assist the market in determining a fair price for that share. In other words, without the benefit of knowing the extent of buying and selling volume occurring in these dark pools, retail investors would indeed be purchasing and selling the same shares without critical market information, aka, “in the dark”.

While dark pools are certainly beneficial to large institutions and even individuals that wish to keep their trading strategies undisclosed, in today’s market conditions that demand the highest level of transparency, dark pools certainly hinder rather than aid the ability of the retail investor to truly understand the health of global stock markets. Remember, it is well believed that 20% or more of all shares listed in the NYSE trade hands through dark pools today. That type of volume is more than adequate to handle the sales orders of Wall Street institutions and executives that may not wish to disclose specific sales, and thus, tip the public’s hand about their true opinion of certain companies. It provides a mechanism for the boy’s club to remain intact whereby they can publicly offer statements vouching for each other’s financial health while privately offloading shares of the very same companies they continue to publicly support. Unless there were restrictions regarding the use of dark pools to offload shares, if I were a Wall Street executive that wished to sell shares of financial stocks, to avoid public scrutiny in today’s environment, I most definitely would use dark pools to accomplish this. Though insiders must publicly report sales of shares in their own company almost immediately, selling activity that involves their peers can be just as revealing. Dark pools allow such sales to remain obscured in the present time.

In the U.S., ownership of dark pools is dominated by the familiar faces: Goldman Sachs, Citigroup, Merrill Lynch, J.P. Morgan, Credit Suisse, and Bank of America. In Europe, the trend towards trading in dark pools is the same. Citigroup, Goldman Sachs, Deutsche Bank, Merrill Lynch, UBS, Morgan Stanley and Credit Suisse have formed an internal continent-wide equity trading system that will challenge traditional European stock exchanges like London Stock Exchange Group and Euronext. Though institutions dominate the trading volume in dark pools, independently run dark pools like Liquidnet offer platforms for individuals to buy and sell shares anonymously as well. By the time it becomes clear to the SEC that dark pools have damaged the individual retail investor’s ability to buy and sell stocks at a fair price, the damage will most likely have been done, with institutions and influential individuals possibly having offloaded shares of U.S. stocks they know are disasters waiting to happen via these dark pools while simultaneously presenting the retail investor with a much different rosy picture of market bottoms and imminent recoveries.

The bulk of this rally in U.S. markets is probably over and while the salesmen of the investment industry would like you to believe that the Dow’s recent excursion below 12,000 marked the absolute bottom of this market and that a 16,000 Dow is just months away, given the loads of systemic risk that has remained unsolved in the global financial system, just because the U.S. Federal Reserve was attempting to artificially manufacture a Dow rally to 13,000 doesn’t mean that they will be successful in doing so. In fact, this rally may have already served its hidden agenda (allowing Wall Street executives and institutions a much better exit price from their stocks), and if so, buyer beware, because I would then have grave doubts as to whether the Dow would even be able to breach 12,850. Though I suspect there has been much selling of U.S. financial, housing, and insurance (monoline) stocks via these dark pools in the past week as institutions and individuals scrambled to take advantage of the significant rebound in these sectors, there is no way to truly know if this happened. If we could only just peer into these dark pools for merely a couple of hours, the activity we discover just might reveal what Wall Street truly thinks of the economic future of America.

[tags] dark pools, U.S. recession, bear market[/tags]

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