High Frequency Trading Is Hosing You: Part 2

This is the second post based on Michael Lewis' excellent book, Flash Boys, which exposes how High Frequency Traders (HFTs) use technological advantages to obtain informational advantages that amount to learning about upcoming equity transactions fractions of a second before the rest of the market becomes aware of them. They employ these advantages to exploit less technologically sophisticated investors for profit, as I described in a preceding post.

Today we'll explore dark pools, a private financial exchange that exploits the ignorance of average investors in order to profit both the banks those investors entrust as their financial representatives as well as the HFTs that pay princely sums to those banks to perpetuate their advantages.

While dark pools may sound like some sort of sinister torture intended for comic book super heroes, they refer to private, in-house exchanges that large banks (as well as other entities) created for trading securities outside of public view (and beyond the oversight of regulators) to serve large institutional investors.

Banks defend their use by saying that when a large institutional investor wishes to trade a significant chunk of stock, doing so in a public exchange can impact the markets so significantly that the institutional investor ends up either paying an excessively high price or selling for an excessively low price because the sheer volume of shares traded floods the market all at once. Even Vanguard, with a reputation as the protector of small investors, has gone on the record with the SEC in supporting exchanges that provide such dark liquidity.

For example, it is hard for Warren Buffett to make large trades for Berkshire Hathaway via public exchanges - news of the trade itself alters the market and adversely affects the prices Berkshire Hathaway obtains. Making big trades in public becomes a liability.

Let's consider that Buffett wants to sell a million shares of XYZ. He has a choice of either placing the order through a floor trader, splitting it up into smaller sell orders over several days, or selling small orders as possible until a large purchaser buys the balance on offer. Since the identity of the seller and the intent to sell is revealed on public exchanges, it is likely to impact market prices. Furthermore, the second and third strategies place the order at high risk of obtaining a reduced sale price as the order is gradually fulfilled.

Dark pools, banks argue, remove these risks by protecting the identity of the seller and reducing the chances that their order will impact the market by virtue of its size alone.

The drawbacks, however, are numerous. Let's highlight the most concerning form of dark pools, those run by broker-dealers. An example is where a large bank creates a dark pool ostensibly for clients looked after by brokers at the bank, while simultaneously allowing proprietary traders (a separate group of bankers within the bank that tries to earn money for the bank, often by using information derived from their inside access to bank activity).

This pits the interests of the bank against the interests of the investors represented by the bank - creating a scenario where the bank trades for itself at the expense of its customers.

Because trades are done opaquely, an investor can never know if their trade was executed at the best price available. For example, if Bank A has a relationship with a large institutional investor (such as a mutual fund) looking to sell of shares of XYZ, it might sell them entirely within the bank's dark pool to private individual investors who use brokers from Bank A. The institutional client gets a good price on XYZ, while the individual investors (who pay significantly less in fees and are likely to be less sophisticated) will pay a higher price than they might have paid on a public exchange.

Banks making trades within their proprietary dark pools save money by avoiding payment of exchange fees they would otherwise pay to access public exchanges, creating a conflict of interest where matching buyers and sellers in their dark pools at unfair prices is more lucrative than seeking fair prices on public exchanges.

Large banks often have institutional bankers whose interests are directly in conflict with private brokers for smaller, individual investors. As described above, small investors may be used as easy marks to offload investments at unfair prices, all to retain the business of more lucrative clients.

There is decent evidence that banks preferentially trade within their dark pools even though they might get better prices on public exchanges. This is reflected in the fact that banks with small overall market shares of certain stocks will trade those stocks internally via dark pools far more often than they will trade them on a public exchange, suggesting banks are responding to incentives for gain that come at the expense of their clients.

Banks are able to charge high fees to sell access to their dark pools. HFT firms gladly pay these fees and then use the access to discover large trades about to happen. As described in a prior post, HFTs set lures by placing small orders to buy and sell stocks within dark pools. When an order comes in, sophisticated HFTs learn to interpret the order as if they were reading the cards of an opposing poker player on the cusp of making a large trade. HFTs then employ their technological advantage to front-run orders and profit at the expense of the trader.

So contrary to the bank's arguments, by allowing HFTs access to their dark pools in order to profit from high fees banks charge for the access, the net effect does not protect the bank's institutional investors from impacting the market. Instead, it confers important information asymmetry to HFTs who use technological advantage to profit by that knowledge.

From the perspective of HFTs, dark pools allow banks to gather big fish into a private fishing hole that HFTs pay a fee to access, in exchange for which the predator is provided private access to a collection of desirable prey.

The bank plays a morally dubious role as both fee-collecting intermediary and nonlethal parasite, collecting fees from the institutional prey (who are led to believe that the dark pool is protective), allowing their own in-house proprietary traders to feed on the prey (placing the bank's financial interests above those of the bank's clients), preferentially conducting client trades within the dark pool even when better prices may be found at outside exchanges, and finally selling access to the highest bidding predator by allowing HFTs to enter their private fishing hole.

When weighed against the considerable conflicts of interest and potential for abuse, it would seem dark pools are very much instruments of the dark side.

Interest piqued? Check out a copy of Flash Boys by Michael Lewis from your local library or buy a copy to support quality journalism in finance.