Enter the Dark Pool

by wjw on April 1, 2014

Michael Lewis, author of Liar’s Poker and Moneyball and other fine works about money (and who owns it and how it moves), has a new bestseller in Flash Boys, about a few brave souls who discovered that the U.S. stock market was rigged, and who decided to do something about it.

What did they do?  They started their own stock exchange.

An adaptation can be found over at Zero Hedge.  

Eventually Brad Katsuyama came to realize that the most sophisticated investors didn’t know what was going on in their own market. Not the big mutual funds, Fidelity and Vanguard. Not the big money-management firms like T. Rowe Price and Capital Group. Not even the most sophisticated hedge funds. The legendary investor David Einhorn, for instance, was shocked; so was Dan Loeb, another prominent hedge-fund manager. Bill Ackman runs a famous hedge fund, Pershing Square, that often buys large chunks of companies. In the two years before Katsuyama turned up in his office to explain what was happening, Ackman had started to suspect that people might be using the information about his trades to trade ahead of him. “I felt that there was a leak every time,” Ackman says. “I thought maybe it was the prime broker. It wasn’t the kind of leak that I thought.” 

...The big investors who trusted Katsuyama began to share whatever information they could get their hands on from their other brokers. For instance, several demanded to know from their other Wall Street brokers what percentage of the trades executed on their behalf were executed inside the brokers’ dark pools. Goldman Sachs and Credit Suisse ran the most prominent dark pools, but every brokerage firm strongly encouraged investors who wanted to buy or sell big chunks of stock to do so in that firm’s dark pool. In theory, the brokers were meant to find the best price for their customers. If the customer wanted to buy shares in Chevron, and the best price happened to be on the New York Stock Exchange, the broker was not supposed to stick the customer with a worse price inside its own dark pool. But the dark pools were opaque. Their rules were not published. No outsider could see what went on inside them. It was entirely possible that a broker’s own traders were trading against the customers in its dark pool: There were no rules against doing that. And while the brokers often protested that there were no conflicts of interest inside their dark pools, all the dark pools exhibited the same strange property: A huge percentage of the customer orders sent into a dark pool were executed inside the pool. Even giant investors simply had to take it on faith that Goldman Sachs or Merrill Lynch acted in their interests, despite the obvious financial incentives not to do so. As Mike Gitlin of T. Rowe Price says: “It’s just very hard to prove that any broker dealer is routing the trades to someplace other than the place that is best for you. You couldn’t see what any given broker was doing.” If an investor as large as T. Rowe Price, which acted on behalf of millions of investors, had trouble obtaining the information it needed to determine if its brokers had acted in their interest, what chance did the little guy have?

…predatory strategies depended on speed. It was Katsuyama who had the crude first idea to counter them: Everyone was fighting to get in as close to the exchange as possible — why not push them as far away as possible? Put ourselves at a distance, but don’t let anyone else be there. The idea was to locate their exchange’s matching engine at some meaningful distance from the place traders connected to the exchange (called the point of presence) and to require anyone who wanted to trade to connect to the exchange at that point of presence. If you placed every participant in the market far enough away from the exchange, you could eliminate most, and maybe all, of the advantages created by speed.

…If the Puzzle Masters were right, and the design of their new exchange eliminated the advantage of speed, it would reduce the informational value of investors’ stock-market orders to zero. If those orders couldn’t be exploited on this new exchange — if the information they contained about investors’ trading intentions was worthless — who would pay for the right to execute them? The big Wall Street banks and online brokers that routed investors’ stock market orders to the new exchange would surrender billions of dollars in revenues in the process. And that, as everyone involved understood, wouldn’t happen without a fight…

A fight to make the stock market honest?  Gosh.  Why do you suppose that would be necessary?


Watch Michael Lewis, his co-author Brad Katsuyama crush the CEO of BATS on CNBC today!

Plus, the SEC and the FBI, after years of ignoring the dangers of high-frequency trading, have now opened investigations into the system.  It didn’t take people losing hundreds of millions of dollars, all it took was one best-selling book.

John Appel April 2, 2014 at 3:15 am

As the employee of a financial company that explicitly does not engage in HFT because our executives, shockingly, possess a strong sense of ethics, my response is “About freaking time.”

DensityDuck April 2, 2014 at 5:57 am

And, as with so much else about modern life, the whole thing was predicted twenty years ago by those silly “Ess-Eff” genre-trash paperback-only magazine-rack garbage books aimed at virgin teenage boys, whose covers were nothing but women with big tits and big guns.

wjw April 2, 2014 at 8:55 pm

Yeah, there was this book called ‘Hardwired,’ if I remember correctly.

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