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December 1, 2009

What Egyptian Pigs and Dark Pools Have in Common

The poor pigs. Last April 29, the government of Egypt ordered the immediate slaughter of every pig in the nation. The order was carried out with a ruthless efficiency, as an estimated 300,000 porcine souls were led to an untimely meeting with their maker. The reason for such a brutal campaign? An unfortunate name.

A newly discovered virus, dubbed "swine flu," was spreading rapidly in Mexico at the time. And just as the Ayds appetite suppressant demonstrated some 20 years ago, an association with a deadly disease doesn't enhance your brand. And so, after what must've been quite a messy few days, the pigs of Egypt were soon but a memory.

Is there a lesson in this story for Wall Street's latest product to come under public fire, the unfortunately named "dark pools"? Barron's said in a July article, "Dark pools of liquidity sound as though they belong in a Gothic novel, not on Wall Street." The Economist said the name "sounds ominous." A November article about dark pools in The New York Observer was accompanied by a picture of a corpse-like hand protruding from a dark lake, either desperately beckoning for help, or possibly threatening to pull you in. The underlying message was clear: Something spooky is going on here.

The truth is much less romantic: They are not spooky at all. Dark pools are computerized trading systems that match buyers and sellers without publicly displaying bids and offers. They are only dark before the trade. After the trade, just like exchanges, they must report to the tape immediately for the whole world to see. The first one was created in 1987, although the name "dark pool" only became popular within the past 10 years.

 

The Name Game

Now swept up in the same regulatory vortex that is whirling around short selling and high-frequency trading, these obscure trading systems have suddenly begun drawing rants from bloggers, tirades from editorial writers, proposals from regulators and even inquiries from U.S. senators. It all begs the question: Is it time to rename the damn things?

Shortly after Egypt's mass pig-ocide, the World Health Organization announced its own giant renaming effort to avoid a further pandemic of pig panic: From here on out, the flu formerly known as swine would be called by a name only a bureaucrat could love: "H1N1." Although governments around the world dutifully picked up the nom-de-PR, everyone else continues to call it "swine flu." With a vaccine now being aggressively distributed, the disease will likely be eradicated before the name "swine flu" is. The H1N1 experience demonstrates why renaming "dark pools" is unlikely to work. Once a name sticks with the public, unsticking it is close to impossible. Since the name can't easily be changed, are dark pools as doomed as the pigs? Not if we learn anything from our Egyptian friends.

A few weeks ago, The New York Times ran an article titled "Belatedly, Egypt Spots Flaws in Wiping Out Pigs." As the story described, "The pigs used to eat tons of organic waste. Now the pigs are gone and the rotting food piles up on the streets... What started out as an impulsive response to the swine flu threat has turned into a social, environmental and political problem for the Arab world's most populous nation." Though pigs had been considered pariahs, it turned out they were a valuable part of the ecosystem, providing a service that few understood or appreciated.

If dark pools were suddenly forced by a confused public to lose their darkness, what would the consequences be? Well, it would be much the same as in Cairo. Instead of food rotting in our streets, we'd have illiquid positions rotting in our portfolios. Dark pools play an important and underappreciated role in the trading ecosystem: They allow buyers and sellers to find each other without signaling to the entire world that a new player has entered the marketplace. Big long-term investors, like mutual funds and pension funds, rely on dark pools to trade some of their most sensitive orders.

Dark pools represent about 8 percent of U.S. volume, admittedly just a small niche, but enough to draw the ire of the major for-profit exchanges. The exchanges have been aggressively fighting the pools in Washington by creatively pushing the need for "transparency." In an article on Nov. 6, The Wall Street Journal quoted the CEO of a major exchange referring to dark pools on his quarterly earnings call: "We're comfortable that the regulatory discussions going on [in Washington] will be a significant net positive [for us]."

"Transparency" in dark pools is a "significant net positive" for exchanges because it strikes at the very heart of what the pools do. The whole point of dark pools is to hide sensitive order information, so that short-term traders can't sniff out big orders and trade ahead of them. It's hard to argue against increasing transparency on a delayed basis, say by disclosing dark pool volumes at the day's end, but doing it in real-time? Ask yourself who would be more likely to benefit from millions of new real-time trading data points: short-term quantitative traders, or long-term fundamental investors?

While relatively clean already, the rules under Regulation ATS do allow dark pool operators a little room to roll around in the mud by allowing dark pools to create private networks of traders. Dark pools sometimes shut off access to other broker-dealers for competitive reasons. Mandating fair access to all dark pools could clean out this last pigpen of exclusiveness.

But fair access doesn't have to mean open access. Restaurants can refuse to serve patrons based on their behaviors, for example by requiring shoes, but they can't refuse patrons for arbitrary reasons, like the color of their hair. Similarly, there is nothing wrong with dark pools excluding based on behaviors--for example, requiring that clients maintain a certain average order size, or a low frequency of order placement, or mandated average holding periods. But excluding clients for arbitrary reasons is unfair. By determining access to their pools based on objective behavioral criteria, the pools can do something much better than cleaning up their name--they can clean up their only significant flaw, leaving no remaining logical arguments for opponents.

Would the lack of logical arguments from opponents save the dark pools? Before the pig-killing decree, the Egyptian health authorities did not do much homework. A United Nations health organization called the slaughter "scientifically unjustified," which is an understatement. Had the authorities done the slightest bit of reading, they would have learned that pigs have nothing to do with the virus. But most likely, the authorities deliberately failed to check, because pigs were unloved by most Egyptians for religious reasons, and the swine flu panic served as a convenient excuse to sweep them away.

So this is where the analogy breaks down, and we can breathe a sigh of relief. Because in America, we don't have to worry about public prejudice against traders, right? In America, traders have always been allowed to freely trade dark or light, long or short. As the old Wall Street expression goes, "Bulls and bears make money. Pigs get slaughtered." Oh, wait--maybe the dark pools are screwed after all.

 

Dan Mathisson is the head of AES at Credit Suisse, which operates Crossfinder ATS. He testified about dark pools before the U.S. Senate Banking Committee on Oct. 28. The opinions expressed in this column are his own, and do not necessarily represent those of the Credit Suisse Group.

 

(c) 2009 Traders Magazine and SourceMedia, Inc. All Rights Reserved.

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