High-frequency trading is generating a lot of attention since Michael Lewis’ book “Flash Boys” was drawn into the spotlight. Along with it, some in the financial world are trying to turn some of that attention to what they say could be an even bigger problem – “dark markets”. This refers to trading activity that happens outside official exchanges and some claim that so much of it is happening now that official exchange quotes may be meaningless. A broker can fill a customer order via their own collection of customer orders, called “internalizing”, or send them onto another dealer that has a “dark pool”. These orders are matched up outside the public exchanges, never seen by the broader market. This can allow for someone to secretly offload a large number of shares without anyone publicly knowing that unusual trading activity is happening until after the fact. For all the orders taken out of the public exchanges, large or small, this takes away from market liquidity, price transparency, and in some cases momentum. It’s estimated that 40% of US stock trades happen via these “dark pools” and brokers use public exchanges only as a last resort. There are 13 public US exchanges, compared to around 45 dark pools and 200 internalizers. When trades happen outside the public exchange, it is not a matter of record. The fact that there is a buy or sell order does not show up. The trade is only recorded after it’s been executed. That was sort of the point of the dark pools to begin with – being able to trade a large block of stock without upsetting the market. For example, if someone put in a massive million lot order, traders on the sell side could run the price up. While that makes sense, the majority of trade activity going through the dark market are 200 shares or less. The CFA Institute did some research that shows once a given securities trade volume reaches less than half on public exchanges, the price starts to become skewed as the price discovery process is eroded. So far, financial regulators in Canada, Australia, Hong Kong and Europe are looking at ways to cut back on the dark market growth. Whether outrage over high-frequency trading here in the US will eventually bleed over into this practice will be interesting to watch.
There has been a lot of buzz early this week in regard to the 60 Minute’s interview with Michael Lewis, author of the book “Flash Boys,” in regard to High Frequency Trading (HFT). If you missed it you can CLICK HERE. One of our readers wrote in with this follow-up: Kevin, I am sure you caught the 60 Minute’s piece on HFT. The one I watched actually described how the RBC beat the HFT’s. Basically he sent his order to the farthest away exchange first and the closest exchange last, so that they all arrived at the same time. By not sending it to the closest exchange first, the HFT’s could not go out to the other exchanges (the HFT’s have faster connections) and lift the offers ahead of him. He then went on to quit his job and start a new exchange where no advantage is there. He also put in 60 km of fiber optic so that any HTF’s originating orders from his exchange had to travel extra distance before it got out from his exchange. I love it!!!! And, he says, he knows it works as the HTF’s asked if there was a back door or if they could pay premiums for a faster hookup/connection. If you really think about it, all these clearing houses/brokers that route (or get paid to route) orders to a specific trading place/exchange, are simply cheating their customers. The real solution is to put all orders onto one exchange again. Then when a live order hits, there is no one racing out to the other exchanges and lifting offers or front running the trades. That original order would simply take all that was offered in the one and only marketplace, because it was ALL “listed” on one exchange. From my perspective, it is good to see this coming out into the open and being discussed. The one good thing that has come from all of this High Frequency Trading is cheaper investment costs for individuals. Never before in history has it been so inexpensive for the average “mom and pop” to invest or trade in the markets. I should note the FBI is now investigating whether the HFT’s are actually breaking the law.