SEC plans to ban flash trading - will dark pools be next?

Chalk this one up to the power of the blogosphere. Sen. Charles Schumer of New York stated today that he had received a personal guarantee from Mary Schapiro, head of the Securities and Exchange Commission, that a ban on "flash trading" was in the offing, according to Bloomberg News. The practice had allowed stock exchanges and specialized trading shops to sell advanced-notice of stock orders, providing customers with an extra split-second to trade before pending stock orders.

Critics charge that flash trading allowed sophisticated Wall Street players -- Goldman Sachs (GS), Credit Suisse (CS) -- to pocket billions of risk-free profits through computer algorithms that probe flash orders to determine actual prices that buyers and sellers are willing to pay, and then instantly pushing the actual market price to those levels. A number of leading financial blogs, including ZeroHedge, had been agitating for an end to the practice since early this year.
The next logical step for the SEC would be to shut down "dark pools": large groups of stocks connected to "crossing networks" that let traders move very large amounts of shares without announcing the transactions on the open market. The dark-pool operators sometimes break up the large orders into numerous smaller orders that can trade on the open market without causing as much disruption. (If a large hedge begins unloading a significant stake in a company, shares of that company might plunge if the broad market noticed the transaction, and sentiment rapidly swung against the company.)

However, dark pool operators get an advanced preview of the intentions of larger institutional investors. And these pools' opacity make it impossible for their customers to know who they're trading against, and whether those parties are using the order size information to profit on their own.

ZeroHedge reports that the largest dark pool, Sigma X, is operated by Goldman Sachs, which maintains enormous proprietary trading operations. That's a clear conflict of interest.

In its dark pools, Goldman supposedly provides neutral, customer-friendly execution. In its proprietary trading operations, Goldman attempts to gather and benefit from as much market information as possible and grab profits by outsmarting the very customers who are entering into dark pools. A big conflict.

To be fair, Morgan Stanley (MS) and Credit Suisse operate dark pools as well, and so do other major Wall Street firms. But Goldman's Sigma X is the biggest player in this market.

The media and blogosphere's recent illumination of the subject prompted Sen. Edward Kaufman of Delaware to request last week that dark pools be banned, and that full market transparency be restored. If the dark days of dark pools are numbered, good riddance. But if Goldman and other Wall Street titans made the vast majority of their profit last quarter in trading, how much came from trading against customers using high-frequency trading, flash orders, and dark pools?

It's hard to tell, but it's possible the big banks could see a huge profit squeeze, as transparency forces them to give up these lucrative moneymakers and to abandon the unfair trading strategies that dark pools and flash orders allowed.
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