“It’s just not an efficient market if a fair amount of orders never see the light of day,” [Kevin Cronin, the top trader at the mutual fund provider Invesco,] said. “We should all be concerned about this.”
So ends ‘As Market Heats Up, Trading Slips Into Shadows’, an important New York Times article by Nathaniel Popper on the rise of off-exchange equities trading to nearly 40 percent of the total US volume on some days.
…trading has increasingly migrated from established bourses like the New York Stock Exchange to private platforms, including dark pools, that are largely hidden from public view. The shift is helping big traders hide what they are doing in the markets, and regulators are worried that the development could obscure the true prices of stocks and scare away ordinary investors.
Three Grounds for Concern
‘We should all be concerned about this’ for three reasons.
• Dark pools reverse 80 years of efforts to make markets information available to all.
• Secrecy begets more secrecy. The rise of dark pools for equities has coincided with efforts to conceal public funds’ investments in alternatives, such as hedge funds.
• The Efficient Markets Theory, the bedrock of contemporary money management, assumes securities prices reflect all the information available to investors. Price = Value. If a significant portion of pricing information isn’t accessible, the Theory and all built on it seem questionable.
Hence, I pass on Mr. Cronin’s alert and amplify it.
Rejecting Securities Regulation
History tells us securities trading in the shadows, in ‘dark pools’ as they’re called today, leads inevitably to abuses. That experience led to the Securities Acts of 1933 and 1934 and 70 years of ever-brighter sunlight disinfecting markets. Says Popper of this:
The trend has bucked the government’s broad effort in recent years to move more of the financial industry out of the back rooms and into the light. The increasing opacity of stock trading in the United States, long the most transparent place in the financial world, is troubling for investors and regulators.
The jolts to investor confidence in markets and market-makers beginning with Enron have led to scepticism about the fairness and honesty of securities markets unknown since World War II.
‘Transparency’ & Hypocrisy
Few words have become so meaningless as ‘transparency’ when invoked by institutional investors and managers. Dark pools make that point. Popper writes:
Often run by big banks, dark pools do not require buyers and sellers to publicly announce their intention to trade stocks, allowing traders and investors to hide behind a veil that only the operator of the pool can penetrate.
That appeals to a pension fund that wants to buy a million shares of Ford stock, for instance, because it allows the fund to avoid tipping off competitors who could push the price of the stock up.
Like ‘that pretended patriotism which so many, in all ages and countries, have made a cloak for self-interest’, so, too, demands for corporate transparency from buyers and sellers in dark pools.
Spreading Pools of Darkness
The logic and benefits of dark pools, once the concept is unleashed, become compelling in markets beyond equities. Consider this report from Pensions & Investments for Feb. 28:
California Assemblyman Kevin Mullin, a Democrat, introduced a bill that would shield real estate investments from public records disclosure.
The bill would also exempt the California counties and their agencies, including pension funds, from disclosing private equity, venture capital, hedge fund or absolute-return fund information. The $253.2 billion California Public Employees’ Retirement System, $157.8 billion California State Teachers’ Retirement System and University of California have been exempted from doing so since 2006, said Ben Turner, Mr. Mullin’s legislative director.
[P]ublic pension funds are losing out on real estate investments because state law requires them to make that information public. Public pension fund real estate managers are concerned that information on deals and properties could be revealed to their competitors, [Mr. Turner] said.
In essence, Assemblyman Mullin’s bill – which has no visible opposition – would shield the bulk of public pensions’ alternative investments from disclosure. Why he chooses to reduce the protections of disclosure instead of seeking ways to impose it on the pensions’ competitors eludes me.
And, consider the pensions’ and other institutions’ ‘competitors’. Why are they competing? Has the world changed so much from an institutional perspective since 1976 when Peter Drucker identified ‘the revolution no one noticed’: ‘the attainment of pension fund socialism’?
I can’t conceive of a return that would compensate the public for the risks secrecy imposes. Have we truly learnt nothing from the mortgage-backed securities debacle? Have we forgotten the pre-1929 market and why we regulate securities?
Information & Market Efficiency
Secrecy and pension-fund competitors returns me to Nathaniel Popper and a third reason to be concerned about dark pools. It lies in what Kevin Cronin told him: ‘It’s just not an efficient market if a fair amount of orders never see the light of day.’
The key phrase here is ‘efficient market’, a term of art in finance. Indeed, it is the bedrock, discovered by 1991 Nobel-laureate Ronald Coase 75 years ago – on which the superstructure of Modern Portfolio Theory has been built.
In 2004, the consultancy, Watson Wyatt Worldwide (now Towers Watson), described the Efficient Market Theory:
…security prices reflect all the relevant information that is available about the fundamental value of securities. The reasoning is as follows:
• To forecast prices, investors comb all sources of information.
• They then buy securities with higher-than-average expected returns and sell those with lower-than-average expected returns.
• The prices of securities then adjust until all the expected returns (adjusted for risk) are equal.
• Therefore, prices reflect the market’s best forecast of future discounted cashflows. In other words, price and value are the same.
In this framework, the only factors that can change the price of a security are external … events which cannot be known in advance. Examples include economic news and geopolitical events. Hence prices follow a random walk (in other words, they are equally likely to move up or down) as the market adjusts to this unpredictable news.
Why are blind pools and non-disclosure legislation devastating to the Efficient Market Theory? Because they bar knowledge essential to forecasting prices. So, the model doesn’t work, can’t work.
Efficient Markets: Theory & Practise
In his prescient book, An Engine not a Camera: How Financial Models Shape Markets (2006), Donald MacKenzie identifies an essential element of the Efficient Market Theory’s visceral appeal:
To say of a financial market that it is “efficient” – that its prices incorporate, nearly instantaneously, all available price-relevant information – is to say something commendatory about it….
“Efficient,” in the sense in which the term is used in financial economics, does not equate to “desirable”; one could, for example, imagine a market in human kidneys that was efficient in the speed with which prices incorporate available information, but that does not imply that it would be good to construct such a market. Nevertheless, that our wider culture’s most authoritative source of knowledge of markets has declared financial markets to be “efficient” – a word with almost entirely positive connotations in ordinary speech – has surely been of some importance.
‘Positive’ is an understatement, for ‘efficient’ has assumed a moral dimension.
Finance theorists believe that markets were made efficient by the actions of arbitrageurs and other knowledgeable investors, so there was no contradiction in those theorists seeking to take these actions themselves. Nevertheless, that they did so shows that they did not construe market efficiency as an already-achieved fact. Rather, the achievement of efficiency was a process – perhaps an endless process – in which they could themselves sometimes take part and from which they could profit. Similar ambivalence – the capacity both to be committed to a model and, simultaneously, to doubt the extent of its empirical validity – can be found in regard to more specific models.
‘Ambivalence’: far stronger words come to mind. But MacKenzie, an Edinburgh University professor specialising in the sociology of financial services firms, wrote before the 2008 crash.
Faith & Action
Our present-day faith in ‘markets’ also rests on the quicksand of the Efficient Markets Theory. Its apparent neutrality conceals default positions on social justice. As Robert Kuttner has written:
There is a good reason why economics used to be called political economy. Nearly all the difficult economic issues are not just questions of the efficient allocation of scarce resources by the price system in an institutional vacuum, but profoundly political issues involving property rights, ground rules, and strategies to deal with market failures that can only be settled by recourse to values and to politics.
‘We should all be concerned about this.’ Kevin Cronin is right. All we lack is the will to bring to bear our values and politics.
Correction 4/4/13: Altered headline to ‘dark’ from ‘blind’.
1. James Boswell, Life of Johnson  (Oxford: Oxford Univ. Press, 1970), p. 615 (April 7, 1775).
2. Peter Drucker, The Pension Fund Revolution (originally The Unseen Revolution ) (New Brunswick, NJ: Transaction Publishers, 1996), p. 1.
3. Watson Wyatt Worldwide [now Towers Watson], “Changing Lanes – Doing Risk Better” (Reigate, Surrey: Watson Wyatt Worldwide, Dec. 2004), p. 19. http://www.watsonwyatt.com/europe/services/ccg/media/BDG-15744_Changing_lanes_FINAL_Jan_05.pdf
4. Donald MacKenzie, An Engine, Not a Camera: How Financial Models Shape Markets  (Cambridge Mass.: MIT Press, 2008), p. 251.
5. Id., p. 248.
6. Robert Kuttner, ‘Of Economists and Liberals’, American Prospect, Nov. 1996, p. 16.