Wednesday, April 9, 2014

Are "Dark Pool" Probes Pending?

Banks' so-called "dark pool" trading venues are all the rage these days.

The media jumped when dark pools were cited in federal authorities' and investor class action complaints against SAC Capital and its executives. The focus was on how the anonymity associated with dark pools, and the levels of secrecy they provide, allowed SAC and/or its members to avoid detection and potential losses on its sale of stock. (See also Gazing into 'dark pools,' the tool that enables anonymous insider trading)

One quote from a complaint reads:
“We executed a sale of over 10.5 million ELN for [various portfolios at CR Intrinsic and SAC LP] at an avg price of 34.21. This was executed quietly and efficiently over a 4 day period through algos and darkpools and booked into two firm accounts that have very limited viewing access.”
Next Goldies brought its dark pool, Sigma X, to the fore.  Having discovered pricing errors within the opaque pool, Goldman reportedly decided to send refund checks to customers to compensate them for the mistakes.

Michael Lewis didn't make matters any easier for Goldman or dark pools, giving them a hard time in his new book, Flash Boys.  Among other things, he casts doubt on whether investors got "best execution" through the dark pools:
“A broker was expected to find the best possible price in the market for his customer. The Goldman Sachs dark pool—to take one example—was less than 2 percent of the entire market. So why did nearly 50 percent of the customer orders routed into Goldman’s dark pool end up being executed inside that pool—rather than out in the wider market.”
That quote, alone, might not be altogether convincing: it's not clear whether he's looking at scenarios in which Goldman's clients have requested execution through the Sigma X, or whether Goldman's clients, requesting best execution, were oddly quite regularly executed through Sigma X, despite the potential for sub-optimal execution through that platform.  It's probably fair to say that those requesting execution through the dark pool would agree that they were foregoing "best execution" in the market - which is something one typically foregoes even with "hidden" orders submitted to an (open) exchange.

But now Goldies is back in the spotlight.  According to today's WSJ, they're considering shutting down their dark pool.

But why?

According to the Journal article, Goldman executives are weighing the benefits of the revenues it produces, against the burdens dealing with trading glitches and negative press.  Some burdens those must be, given Sigma X is purportedly one of the largest bank dark pools, and is likely producing significant flow.

Perhaps there's another theory...

Consider these stories:

In January 2014 Barclays decided to shut down its retail / margin Foreign Exchange business, Barclays Margin FX; in February, NY regulator Lawsky opened a currency markets probe.

In January 2014 Deutsche Bank AG (DBK) announced that it will withdraw from participating in setting gold and silver benchmarks in London;  in March, the CFTC announced that it is looking at issues including whether the setting of prices for gold—and the smaller silver market—is transparent. 

In July 2013, the CFTC put metals warehouses on notice of a possible probe. By November 2013 Goldman was resuming talks to sell its metals warehouses and seeking a buyer for its uranium trading unit; and by March 2014 we had various notices of JP Morgan's intent to sell its physical commodities divisions.

Probe and Sale

We could go on and on, but ultimately these are all anecdotal and we aren't wanting or looking to prove statistical significance at this stage.  We're also not too concerned about what comes first: the probe or the sale.  There's certainly no one-to-one mapping.  Not every regulatory probe is followed by a sale, or vice-versa.  We're only wondering if there's a pattern. And if there's a pattern, could there be an explanation as to why there's a pattern?

Here's one theory.  (We welcome yours.)  Might it be that, pending a likely or imminent (and embarrassing or expensive) enforcement action, banks may take preemptive action in selling "problematic" divisions ... to enable the negotiation of a more lenient settlement as they're (now) less likely to be repeat offenders of whatever activity was the subject of the probe?

In other words, is a dark pool probe pending?

Friday, April 4, 2014

High Frequency (Non) Trading

This week's release of Michael Lewis' new book, Flash Boys, has renewed focus on a little understood area of the market, an area that has garnered the recent attentions of market regulators, New York's Attorney General, and more recently the FBI -- but never as much attention as it garnered from Michael Lewis' interview on 60 Minutes on Sunday, with his book pending release the following day.

Without going into too many specifics, one of the central themes that Lewis discusses is the potential for high frequency traders (or HFTs) to take advantage of certain market information -- like bids and offers -- that are unknown to many other market players.

Defenders of HFTs have come out aggressively, with claims that HFTs increase market activity and liquidity, and have lowered trading costs.  The WSJ published an extensive opinion editorial by hedge fund guru Cliff Asness and his colleague Michael Mendelson of AQR, which energetically claims that much of what HFTs do is "make markets" and that they do it best because "their computers are much cheaper than expensive Wall Street traders, and competition forces them to pass most of the savings on to us investors."

Of course this sounds altogether too convincing.  Unfortunately, Asness and Mendelson provide little or no evidence (although their business as long term traders relies heavily on evidence, and they claim in the article to spend considerable energies looking into their trading costs) and they admit that they actually don't have too much conviction in the premise of their exposition:
"We think it helps us. It seems to have reduced our costs and may enable us to manage more investment dollars. We can't be 100% sure. Maybe something other than HFT is responsible for the reduction in costs we've seen since HFT has risen to prominence, like maybe even our own efforts to improve." (emphasis ours)
But this aside, no doubt all forms of HFTs bring liquidity.  They're a good thing.  Let's focus our attention elsewhere.  

Or not?

Might there be another type of HFT, that doesn't always bring liquidity for the greater good of the market ...  perhaps a type that uses obscure mechanisms to change the look and feel of the market -- to make people think there is a bid, think there is an offer, without there being one?  

This is what Flash Boys, and the interest it has invigorated in HFTs, really concerns itself with -- understanding market maneuvers like spoofing or pinging: the submission of phantom orders, immediately cancellable, that have the potential to create a false impression of market levels.

Are we creating a whole lot of (potentially fictitious) orders, but not a whole lot of activity?  Are there high-frequency non-traders?  Are we mis-marking our portfolios as a result? We continue to investigate.  But we couldn't help but bring you back to a 2013 chart from Mother Jones, which highlights the growing contrast between actual trades (in orange) and quotes/orders (in red).