The Deep End of a Dark Pool

There was some speculation that the financial markets in this country would suddenly stagnate after the most recent downturn. The innovation of products that used an ever-increasing and more complicated methodology to make money would stop, paving the way for dull and boring, over-regulated markets that offered so much oversight as to slow the growth of the country. To hear some Wall Streeters talk, the end of an era was upon us.

Not so fast.
Financial markets and those that look for ever smaller ways to extract a decimal from these tough times have rediscovered a product called dark pools. These are ways to trade electronically using the money from a bank, doing so without publicizing the trade until well after it had been executed and even more sinister, allowing traders to see in advance what orders are being placed.

In other words, while we rely on live quotes, these dark pool traders are able to purchase an equity without needing to publicize what the actual quote was. These types of pools have been around for over a decade but were largely underused. There were simply too many other tools of the trade to be utilized while the Bush administration's crippled S.E.C. looked the other way. As long as the market escalated, there was little or no need to decimalize each trade.

But that has changed and the numbers of large and institutional traders that now tap this type of trading platform has increased at a frightening rate of 17% over the last year (from 58% to 70%). While you may say to yourself, what mutual funds, pension funds and hedge funds do to enhance their return is okay by you, some of which you may have an interconnected interest in, the idea that the equity markets may not be fair to all players is not right.

Individual investors have known of these disparities for some time. Beginning of the day and end of the day volumes and volatility have increased to the point that many people could never predict where the market is going to end the day. (Exchange Traded Funds have been to blame for frenzied trading as well.)

Now this subject of who and how these dark pools are being used seems to be getting a little light shed on it from the new chair of the S.E.C. Mary Shapiro. In a recent keynote address at the 2009 SIFMA Market Structure Conference, James A. Brigagliano Co-Acting Director, Division of Trading and Markets U.S. Securities and Exchange Commission wondered if "there is any compelling reason for dark pools to object to improved post-trade transparency." Acknowledging the need for these trades to be dark prior to execution as part of the success of these pools, he couldn't see why "some form of improved post-trade transparency would be likely to interfere with their business models."

The Downside of Speed.
This darkness is however not complete, coming in different shades. Often called indications of interest, these so-called messages done in advance of the trade itself, offering a look to other traders of a trade about to happen, whether it be executed or canceled may resemble a quote too closely.

Because these trades are able to get done very quickly, these "actionable order messages could create the potential for significant private markets to develop that exclude public investors" according to Brigagliano suggesting that because of this "the public does not have fair access."

Mr. Brigagliano has no real beef with the huge block trades that are conducted between institutional investor, often trading in excess of 50,000 shares. But smaller order systems could make the general investing public less likely to want to trade if they feel as though some select individuals get orders processed at a better price based on a quote the general public was unable to see. If that were to happen, the markets would essentially freeze.

He is correct in assuming that "any practice that significantly detracts from the incentives to display liquidity in the public markets could decrease that liquidity and, in turn, harm price discovery and worsen short-term volatility."

At the heart of this reform is a newly energized SEC. So far, they are looking at regulation with a realization that too much regulation would have long-range effects that we would have to live with for years to come and the lack of regulation they inherited needs revamping. Cleaning up the dark pools is one of the ways they hope to do this. Expect Wall Street to resist.

Any transparency is better than none and Ms. Shapiro is making this a focus of her approach to getting the investor’s trust in the US equity markets back on track. The "gaps" in regulation have allowed too many innovators to slip through with products that might make money for some, but threaten the long-term goals of some investors and challenging the trust of others.

A Stern Warning From the SEC - Just in Time

In a recent address at the Mutual Fund Directors Forum Ninth Annual Policy Conference, Mary Shapiro, SEC Chairperson announced her problems with target date funds. As you know from previous posts here, at the previous address of this blog, on my website and on our retirement blog, these funds are not as yet advisable alternatives to a portfolio built on your own. And even if the temptation to allow these types of funds, which in short look to some far-off future date that you pick for your retirement and readjust your risk and holdings to make sure that you grow increasingly conservative with your investment dollar, turn out to be what they sy they will do, there are far too many issues right now.

In her address to these fund managers, the much tougher than the previous eight years of SEC chairpersons told them of her concerns. She said: "Growth in target date fund assets is likely to continue since these funds can be default investments in 401(k) retirement plans under the Pension Protection Act of 2006. More than 60 percent of employers now use target date funds as a default contribution option, compared with just 5 percent in 2005.

"However, target date funds have produced some troubling investment results. The average loss in 2008 among 31 funds with a 2010 retirement date was almost 25 percent. In addition, varying strategies among these funds produced widely varying results. Returns of 2010 target date funds ranged from minus 3.6% to minus 41 percent."

This single acknowledgment should send alarms ringing throughout the mutual fund world. No longer is business as usual, I'll-turn-my-head-and-let-you-do-what-you-want-to type of enforcement. No longer is this simply the wishes of Wall Street over the fiduciary responsibility of those managers, who lobbied mightily for the Pension Protection Act of 2006, which more or less mandates the use of these funds.

She offered a clear cut objective instead for her agency "that SEC staff is closely reviewing target date funds’ disclosure about their glide paths and asset allocations. The staff also is examining whether the same target date funds underlie both retirement and college savings plans. The staff has been working closely with the Department of Labor in light of target date funds’ prevalence in participant-directed retirement funds. This important issue has also been an area of focus for Chairman Kohl and the Senate Special Committee on Aging."

As I have mentioned before, many of these funds lack clear transparency of just how they plan on achieving their promised results. I have accused the industry of dumping orphan and unwanted funds into the portfolio of these funds to keep some investor's money on the table while sacrificing others in the process. The fees are still much higher than they need to be. Ideally, they should be closer to the index level, charge no 12b-1 fees, and offer more succinct projections of what is to come. Mae West once suggested that “An ounce of performance is worth pounds of promises.” Ms. Shapiro, to her credit wants more.

Her final warning: "While you do your part, we at the SEC will do ours. We will consider whether additional measures are needed to better align target date funds’ glide paths and asset allocations with investor expectations. Among other issues, we will consider whether the use of a particular target date in a fund’s name may be misleading or confusing to investors and whether there are additional controls the SEC should impose to govern the use of a target date in a fund’s name. As we pursue this analysis, we will have a special focus on the expectations of the millions of everyday Americans who use target date funds to invest for retirement and educational needs."

Good luck Ms. Shapiro but I believe the wind is at your back on this one.