'Dark Pools': Are Hidden Trades Undermining the Stock Market?

bell of the New York Stock Exchange After the closing bell rings, whether it's the physical bell of the New York Stock Exchange or the virtual bell of the Nasdaq, you may believe that trading activity has ceased for the day and the shares of the companies you trade in are sitting quietly until the markets open again the following day. That's not necessarily true.

Behind the scenes, your companies may be seeing trading action in so-called "dark pools," secondary stock markets that operate out of sight of the average investor and beyond the reach of regulators.

The Yin and Yang of Trading

In financial jargon, "dark" is the opposite of "displayed." Displayed pools are regulated, public stock exchanges, examples of which include the NYSE and the Nasdaq. In a displayed pool, anyone who wants to buy or sell a particular equity has an equal view of all the activity going on with that company's available shares, including the volume being traded.

Dark pools are private exchanges that are used by institutional investors. In dark pools, brokers are typically trading large numbers of companies' shares, shares the average investor has no access to. Private operators of dark pools include Liquidnet and Pipeline, as well as broker-run operations like Credit Suisse's (CS) CrossFinder and Goldman Sachs' (GS) Sigma X.

Why trade in dark pools at all? If an institutional investor tried to move a large block of a company's shares on a traditional public exchange, that investor would likely find that the large volume moved the market, with a resulting price distortion. By trading in dark pools, institutional investors can trade at the enormous volumes they need to without automatically putting themselves at a disadvantage.

The People's Market

According to Financial Times, there are about 50 dark pools operating in the U.S. Counting the big broker-run operations, the newspaper estimates that nearly 40% of equity trading volume now occurs outside the traditional stock markets and in these dark pools. That's a lot of trading being done outside the view of the average investor.

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The stock market has its origins as a people's market, a way for middle-class citizens to get a share in the world's burgeoning commercial activity beyond what they did to earn a living. The Dutch East India Company was famous for being one of the first public companies to let anyone off the street buy a share.

But maybe more important, the stock market has been the primary capital creator for companies in the U.S. as well as the U.K. While German companies were more likely to turn to the banks for funding, and Japanese companies bought large blocks of stock in one another's companies to support growth, in America and Britain, companies rose on their ability to attract a larger volume of small investors.

Keep Investors Invested in the System

Dark pools are an invention of the marketplace, and serve a purpose. For big investors that need to move enormous numbers of shares around, dark pools offer a more level playing field. From the individual investor's perspective, one could argue that keeping these big trades off the public exchanges is also useful because of the price distortions they can inflict.

10 Stocks for the Next 50 Years
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'Dark Pools': Are Hidden Trades Undermining the Stock Market?

10 Stocks to Buy, Hold and Prosper

Betting on companies that are not only profitable but also have a long history of increasing their dividend payments to shareholders is as good a strategy as you'll find for increasing wealth without exposing yourself to outsize risk.

Each of these 10 businesses has been issuing ever-higher checks to their investors for at least half a century, according to the dividend-tracking site The Dynamic Dividend.

1. Diebold (DBD). This maker of safes and other security equipment yields 3% and pays out 50% of its profits as dividends. Management has increased the average payout by 5.4% annually over the past five years.

2. American States Water (AWR). This company pays a 3.1% yield as of this writing, with 45% of profits committed to dividends. This California water utility was founded in 1929 and has increased its average payout by 3.9% annually over the past five years.

3. Dover (DOV). Shares of this industrial machinery supplier yield 2.1% as of this writing, paying out 26% of profits as dividends. Management has increased the average payment to shareholders by 11% annually over the past five years.

4. Northwest Natural Gas (NWN). It pays a 3.9% yield as of this writing, with 73% of profits earmarked for dividends. This Pacific Northwest gas utility celebrated its centennial two years ago and has increased its average payout by 4.7% annually over the past five years.

5. Emerson Electric (EMR). Another member of the 100-plus club, this supplier of industrial electronics yields 3.2% as of this writing. Roughly 46% of earnings are committed to dividends. Management has raised the payout 9.1% annually over the past five years.

6. Genuine Parts Company (GPC). Yielding 3.1% as of this writing, this auto parts wholesaler pays 50% of profits back to shareholders as dividends. Management has increased the payout by 6% annually over the past five years.

7. Procter & Gamble (PG).You already know P&G -- it's one of the world's most popular consumer products companies, maker of such items as Tide detergent and Pampers diapers. What you might have missed is the company's 3.3% yield, paid from 60% of annual earnings. Management has increased its spending on dividends by 11.2% annually over the past five years.

8. 3M (MMM). Originally known as Minnesota Mining and Manufacturing when founded in 1902, 3M -- the creator of Post-It Notes -- yields 2.7% as of this writing. Management pays out 37% of profits as dividends, and 3M has increased the per-share cut by 3.6% annually over the past five years.

9. Vectren (VVC). Founded in 1912, this central U.S. utility funds a 4.9% yield by paying 80% of earnings back to shareholders as dividends. Management has increased the payout by 2.4% annually over the past five years.

10. Cincinnati Financial (CINF). The riskiest bet in the lot, this property casualty insurer pays out more than 150% of its annual profits as dividends. So while the history and current yield -- 4.6% as of this writing -- are no doubt enticing, management may be forced to curtail payments to shareholders in the coming years.

Should you invest in any of these stocks? That depends on whether you have an interest in learning more about the underlying businesses. And again, don't invest with money you'll need in the next five years. Stocks are wonderful at creating long-term wealth, but they're as dangerous as dynamite over the short term.

And for any commodity, there have always been wholesale and retail markets. Buyers and sellers who can deal in large quantities have always had pricing advantages over the average end-of-the-line consumer.

But just as an income gap can get so wide that those at the bottom lose faith in the system and stop participating in it, or worse, start to work against it, the perception of an overly tilted playing field on the trading floor can cause the average investor to lose faith in the equities market. And that trust is something regulators should look to preserve. Millions of nest eggs and college funds depend on it, as well as all the companies and jobs that nest-building creates.

John Grgurich is a regular contributor to The Motley Fool, and owns no shares of any of the companies mentioned in this column. Motley Fool newsletter services have recommended buying shares of Goldman Sachs.

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