Dark Markets

Donald MacKenzie

‘Dark pools’ are private, electronic share-trading venues in which a participant can bid to buy shares or offer to sell them without those bids or offers being visible to the market at large. For most of their history – they’ve been around for nearly thirty years – they have attracted little attention, but that has changed fast in the last couple of years. This is doubtless partly because of the name, which resonates with a widespread sense that financial markets are opaque, at least to outsiders, and a place where murky deals are done; the Wall Street Journal reporter Scott Patterson called his recent book on automated trading Dark Pools, even though it isn’t really about dark pools. But a more specific reason for their higher profile was the announcement on 25 June 2014 by Eric Schneiderman, attorney general of New York, that he was filing a securities fraud complaint against Barclays Bank. Barclays, Schneiderman said, claimed that its dark pool protected ‘institutional investors such as mutual funds and pension funds holding the savings of millions of New Yorkers’ from ‘the predatory high-frequency trading tactics that are seen on public exchanges’. High-frequency trading, or HFT, is the fast, entirely automated trading of large numbers of shares or other financial instruments.[1] Schneiderman is an outspoken critic of it. In reality, he alleged, there was ‘no protection for any ordinary investor’ in Barclays’ dark pool, which was ‘full of predators who were there at Barclays’ invitation’. Schneiderman is also said to have launched investigations of the dark pools run by Credit Suisse, Deutsche Bank, Goldman Sachs, Morgan Stanley and UBS.

Schneiderman isn’t the first New York attorney general to show his unwillingness to leave the policing of financial markets to federal bodies such as the Securities and Exchange Commission. Eliot Spitzer, who was elected attorney general in 1998 and went on to become governor of New York, took on Wall Street using an old, largely forgotten legal weapon that Schneiderman is now using against Barclays: New York’s 1921 securities fraud law, the Martin Act. The act grants the attorney general wide-ranging authority to subpoena documents, and action under it does not require proof of scienter (knowingly fraudulent intent); it seems too that the attorney general may not even have to show that losses were caused by the bank’s behaviour. Nicholas Thompson, writing in Legal Affairs in 2004, reported that those questioned under the Martin Act have no automatic right to have a lawyer present and that the Fifth Amendment right not to incriminate themselves did not apply. In the years before Spitzer turned to the Martin Act, these draconian powers had mainly been used against small-time fraudsters. There was, Thompson said, ‘an unspoken gentleman’s agreement’ that it shouldn’t be used against major financial institutions.

Dark pools were originally set up in the US in the late 1980s as an alternative to the main trading venue at the time, the New York Stock Exchange. Suppose you were a portfolio manager at an institutional investment firm in the 1980s who wanted to buy a block of shares in a corporation traded on the NYSE. You, or (if the firm was a large one) a trader working on your behalf, would typically phone up an investment bank or another ‘broker-dealer’ firm that was a member of the NYSE. There were essentially three things the broker-dealer could do with your order. First, so long as the order wasn’t too big, they could submit it electronically to the NYSE. It would then arrive at a trading post in one of the five large rooms that made up the NYSE trading floor. There, the order would no longer be handled entirely automatically. Each stock traded on the NYSE had a ‘specialist’. He (they were nearly all men) was both an auctioneer and a trader on his firm’s own account. If his ‘book’ (his list of orders that had not yet been executed) contained offers to sell shares at a price that matched that of the incoming buy order, he or his clerk could execute the trade, charging a commission for doing so. If that wasn’t the case, the specialist could trade on his own account, selling the shares himself; or he could put the incoming order into the book to be executed at some later point. Only he and his clerks could see the full book, which was a valuable, private source of information.

The second thing that a broker-dealer firm could do with an institutional investor’s order was to telephone its booth on the NYSE trading floor, whose staff would in turn page a ‘floor broker’, usually also employed by the firm. After receiving the order at one of the many yellow telephones in the five trading rooms, the broker would walk over to the specialist responsible for trading the shares in question. If the specialist was already surrounded by a crowd of other brokers, all of them bidding to buy shares and/or offering to sell them, the broker could join the action. If there was no crowd, he could simply leave the order for the specialist to execute, but instead would often have a brief chat with him. Two sociologists of finance, Daniel Beunza and Yuval Millo, witnessed some of these conversations in 2003, at which point the NYSE trading rooms hadn’t yet been fully automated. They describe following a floor broker around, noticing ‘how he addressed, backslapped and saluted with nicknames the people he met on his way. Everyone on the floor was Johnny, Jimmy or Bobby; there were no Johns, James or Roberts.’ It wasn’t just masculine clubbiness: good personal relations were important for business. Beunza and Millo watched another broker, who had an order to buy a large quantity of shares, ask the relevant specialist about the book. ‘I think it’s a little heavy,’ the specialist said: there were lots of existing bids to buy, so the broker might do better by his firm’s customer if he held on to his order until a little later.

The third thing that a broker-dealer firm could have done with the order was to pass it not to a floor broker but to one of its ‘upstairs’ brokers, whose job was to keep in regular touch with big market participants who might wish to buy or sell the shares for which he was responsible. When he received a customer buy order, he would then phone his contacts or use a private computer network, AutEx, to seek out in a discreet manner an institutional investor or broker-dealer firm that might be prepared to sell the shares in question. If he were successful in executing the order this way, it would never circulate on the trading floor.

The NYSE’s interpersonal way of trading shares had its virtues. If a customer needed to sell a block of shares in difficult, volatile market conditions, a skilled broker could reduce what’s called ‘market impact’: the tendency to drive prices down while executing the sale. An experienced specialist could keep trading going in an orderly fashion through temporary panics or frenzies. One specialist told Beunza and Millo how he practised ‘crowd control’ when surrounded by floor brokers all frantically trying to sell shares on behalf of their customers, telling them: ‘OK, let’s calm down, let’s see if we can find some buyers, let’s see what happens at various prices, let’s talk this thing out, let’s do business.’

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[1] Donald MacKenzie wrote about high-frequency trading in the LRB of 11 September 2014.

[2] John Lanchester wrote about the flash crash in the LRB of 5 June 2014.

[3] The terminals were computers directly linked to the Bloomberg mainframe; these days the physical terminals have been replaced by Bloomberg’s proprietary software.