Monday, 14 January 2013

Dark pools – good or evil?

“The limitation of the ethical phenomenon to its place and time
 does not imply its rejection but, on the contrary, its validation. 
One does not use canons to shoot sparrows.” 
Dietrich BonhoefferEthics

To me, the biggest problem with dark pools is simply their name.  Dark pools of liquidity, hidden orders, trading in the dark, come over to the dark side… Can’t be good, can it?

Now, if they had a ubiquitous rather than occasional name like Price Improvement Pool, or PIP, would there really be as much fuss?

Algorithmic trading has similar PR problems thanks to algorithms, especially dark specific ones, with names like Predator, Stealth, Dagger, Guerilla, Sniper, Sniffer.  Not nearly as friendly as “My Little Pony”.  Would the financial press be so scathing of the “friendly bear and gentle bull” algo?

The dilemma with the PIP structure is that it subverts price discovery by design.  It is parasitic to market structure, but in a good and healthy way.  The elephant in the room is that because it undermines price discovery there must be a natural limit to the size of the parasite otherwise it will destroy the host. 

Price improvement, good. Subverting price discovery, bad.

I kind of like to think there is an interesting parallel to index funds here.  Imagine every investor just invested in index funds.  No relative change in size for any stock.  Bizarre.  A weirdly static market lacking any accountability.  Stupid, huh?  However, it’s hard to argue with the John C. Bogle line of reasoning that index funds are a good idea for the average investor, but they too are kind of parasitic in that they subvert price discovery.  I don’t think a sane regulator would ban index funds.

We seem to have yet another case of all things in moderation including moderation itself.

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