I dragged out the soapbox not too long ago to highlight some of the hypocrisy and ignorance surrounding algorithmic trading, and particularly high frequency trading. Today, it’s time to shine the light on dark pools. While we’re at it, it seems a good time to look at the real responsibility politicians hold for economic outcomes.
I firmly believe AT and HFT are simply modern expressions of time-honoured market practices, sped up by technology – “jobbing” and “arbitrage” with computers. As such, they offer no threat to orderly markets. The same cannot be said for dark pools, or the paradox of policy impacts on markets.
Knowledge is power. Perfect knowledge is the equivalent of that young traders’ dream – getting tomorrow’s prices today. However, for those of us in the real investment world, we must learn to live with uncertainty.
Nassim Taleb dealt with the “unknown unknowns” in his insightful and provocative “Black Swan”, a terrific read offering valuable insights to the nature of markets. That leaves us with known unknowns, and unknown knowns – and dark pools and policy effects are good examples.
Known unknown – dark pools
The term “dark pools” refers to the practise of matching bids and offers away from the “lit” markets on exchanges. We know there is trading going on – we simply don’t know what or where – a known unknown. Usually involving trades over $1,000,000 in value, large buyers “find” large sellers, and a trade is agreed. Depending on the “finding” process, the trade may be then reported through an exchange as a “special trade”, or in the darkest of pools the transaction occurs “off market”, with the trade coming to light only on the share register after settlement.
The arguments in favour of dark pools are usually made by large traders of stock and their broking representatives. The buying and selling intentions of the largest brokers are often communicated to their largest clients – the idea is to find an opposing interest, so that the broker may “cross” the trade, and receive brokerage on both sides of the transaction. The brokers’ interest in trading in a dark pool is obvious.
The arguments from clients tend to revolve around liquidity and execution. Fund managers transacting lines of stock that are larger than an average day’s turnover face challenges in completing their order without significantly moving the market. The potential to trade in size without impact is a clear advantage to these biggest of players.
Secondly, there is a tendency to under-estimate the impact of such transactions. Clients often blame the resultant price slippage on poor execution, or at the extreme, front running of their orders. Placing an interest to trade in size without impacting the price of a stock is usually the main argument of fund managers trading off market.
While these practises may suit brokers and their clients, there is a case that they damage the underlying market. The two main market disadvantages are a splintering of liquidity and a market that is less informed. Less liquid markets impose higher trading costs as spreads widen. Additionally, imagine you are buying shares a tick below a large sell order that you can’t see, only for the market to crumble after you’ve bought. It’s an unhappy situation, and a blight on the market.
Unknown knowns – the economic power of politicians
Harder to pin down are the unknown knowns – the assumptions we make about markets that are not true. These unconscious understandings shape our trading and investing behaviour – yet there is often no reasonable reason for them.
Taking credit, sharing blame
Politicians of all parties are guilty of “privatising good news, and socialising bad news” when it comes to economics. That is, according to politicians, good employment numbers, healthy national growth and debt reduction are a direct result of good policy, but poor trade numbers or a failing manufacturing sector are the result of “evil” external forces over which the government has no control.
This is not only nonsensical, it’s wrong on both counts. The government is not solely responsible for either economic success or failure.
It’s true that policy can directly affect companies – Telstra and the NBN are a recent example. It’s also true that government regulation can dominate a sector – energy wholesalers and retailers are a case in point. However, when it comes to the broader economy, the government can push levers, but it cannot control outcomes – there are simply too many variables.
Any government must make its best assessment of the variables, and set policy direction accordingly. It is an estimate, based on further estimates. The government of the day deserves neither all credit or total blame – and we should be sceptical whenever we hear these claims.
In fact, it’s a step towards better investing and trading. Be sceptical, question and check everything, call it rubbish if it is…good in life as well as markets.
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Published direct from the trading desk of 30-year market veteran Michael McCarthy, the Market Mint provides smart stock selections and timely market strategy before the Australian market open three times each week. Click here to take a no obligation 21-day trial to the Market Mint or visit www.marketmint.com.au/. |
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