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On Dark Pools, Price Discovery, and a Level Playing Field

Courtesy of Marla Singer

I heard an incredible thing yesterday. Apparently, mutual funds are being stolen from by algorithmic traders.

Late in the day “The Narrator,” one of our dedicated public relations gurus, spoke for almost an hour with a reporter who called in to talk about high frequency trading, dark pools and topics of similar ilk. I talked with The Narrator for a couple of hours after the encounter. I paraphrase: What, the reporter asked, do we make of the argument that “predatory algos” (a brand of algorithmic trading) cost large mutual funds billions a year by sniffing out “iceberging” (the practice of breaking up of large orders into smaller blocks to avoid swinging the price significantly in response to a large block of demand or supply)? What did we make of the TABB Group’s estimate that $20+ billion in profits stem from certain algorithmic trading strategies. Are algorithms evil?

In a word: no.

In more detail: the very orientation of the discussion has been shrewdly manipulated by large market players to demonize algorithmic trading. The current discourse on the subject is entirely backwards and while many aspects of what I will broadly call “High Frequency Trading” are disturbing, algorithmic trading, in general, strikes me as fairness-neutral.

Consider the haunting plea of “Mr. Mutual,” a poor, starving mutual fund trying desperately to scrape by with assets under management of $10 billion:

I need iceberging. I often need to purchase large blocks of stock and the mere whiff of my interest will send the price up costing me hundreds of thousands of dollars. These predatory algos are killing me by pumping up (pulling down) the price I pay (get) for stock and eating into my profits.

Sounds sympathetic, yes?

It’s a lie.

What our mutual fund friend has managed to do with the rhetoric (“predatory algos” for instance) in this woeful tale is hide the fact that what is really going on when he icebergs is that he is enjoying the windfall that results from a myopic market. Unless you believe price discovery an unimportant function of markets, it is easy to see that Mr. Mutual is getting artificially low execution on his stock purchases when he icebergs successfully. True demand (his large order) is hidden from the market by his trading tactics. That’s fine. He’s entitled to be as coy as he can. That’s a given. That’s America. But it is quite a leap to say he is entitled to successful coyness. That, however, is the essence of his current claim. By calling the higher price he pays when he fails to conceal his massive hunger for AIG shares “cost” he turns the discussion on its head. (Note, however, that he went ahead and bought the shares at the higher price anyhow- it’s not like his demand wasn’t real, and price-insensitve… extending up as his volume pressed price northward).

The reality is that the market has gotten sophisticated enough to deploy icebreakers. It is not a simple matter to hide demand from the market any longer. If you were depending on tiny fractions of share price you scraped out with iceberging to make your living, you have been outgunned and its time to move on to another profession- preferably without insulting the rest of us by complaining to your congressmanofleisure that you are being “stolen from.” This is what markets are supposed to do: Provide efficient price discovery and execution. The fact that the success or failure of iceberging is typically measured against the issue’s VWAP (Volume Weighted Average Price) is a clue that efficient price discovery is the bane of the practice.

When you view the issue in this light, dark pools start to look a little less benign too. Their purpose is, after all, to fool the market and frustrate true price discovery by hiding real demand and supply. That’s fine, to a point: Until these pools grow to a substantial portion of market volume. We are way past that threshold. Time to level the playing field and return transparency to the market.


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