Dark Pools and Other Financial Arcana

“Dark pools” and “flash trading” sound like terms you’d find in a Harry Potter movie. But if you work for a large investment bank, these terms are as familiar as stocks and bonds and the NYSE. Too bad mom and pop investors don’t know what they are or how they can affect the value of your savings. The Wall Street Journal defines dark pools as “private markets where large orders are transacted.” [Source: “Traders Blamed for Oil Spike,” Ianthe Jeanne Dugan and Alistair MacDonald, WSJ, 7/28/09.]

Usually used by investment banks, hedge funds, and mutual fund brokers to disguise large purchases and sales of stocks and mutual fund shares (the trades are undertaken anonymously and don’t appear on any public exchange), dark pools are privately run and not subject to regulation by any governmental authority. Recently the SEC has recommended that dark pools register with the government and provide basic information on their activities. The companies that own and run dark pools are largely in favor of this mild increase in scrutiny, probably because they fear the SEC and Congress will close them down entirely if they don’t submit to some form of regulation.

The companies that utilize dark pools to avoid price run-ups or steep declines are resisting the government’s move to bring their activities to light. They argue that dark pools smooth price swings and thereby benefit small investors who would be afraid to invest in a more volatile market. But that’s the very best reason to regulate or shut down dark pools entirely. As with mortgage fraud, the federal regulators must go after any mechanism or scheme that makes the act of investing in the stock market and/or mutual funds seem safer than it really is. If people fully understand the risks of what they’re doing, they will make better choices for themselves. At the very least, we can hope that fewer people will unwittingly commit financial suicide by borrowing money on a line of credit or taking out a second mortgage in order to pour that cash into the stock market.

I can’t even pretend to understand how flash trading works. But I do know that it’s one of many strategies that takes advantage of the speed-of-light trading that’s evolved since the computerization of the markets. With the introduction of the Internet, broadband, fiber optics, and other technological marvels, high-volume traders can now make vast sums of money on the fraction-of-a-penny difference between the millisecond when an order to buy or sell a security is placed and when that order is actually fulfilled. Money can also be made on how trades are routed through our vast computer system, because vultures wait at every step of the way to skim fractional cents. Not so very long ago—about ten or twelve years in the past—skimming fractional cents was considered fraud. Not anymore. Now it’s considered the right of every financial behemoth; a right that must be ardently protected...if you believe the big financial firms that are lobbying Congress and the SEC to stop any proposal that would ban flash trading.