The next step in the discussion about high frequency trading leads logically to the topic of dark pools. I'm constantly mind-boggled to see the same people who were railing against high frequency trading proceed to dark pools as their next target. Why is this so surprising to me? It's simple: dark pools are the antidote to high frequency trading. They're where you go to hide from the computer algorithms who are making lightening fast trades in reaction to the bids and offers you post in the marketplace.
Let's take a quick step back. One component of high frequency trading is what I'll call "pattern mappers" - algorithms that try to deduce how stock prices are going to move based on the bids and offers that are lining up in the marketplace on open books. For example, if XYZ normally trades one million shares a day, and there is a bid posted for 100,000 shares, it might be reasonable for a high frequency trading algorithm, or any other market participant for that matter, to assume that there is more demand for shares than there is supply, and that the price of XYZ will go higher. Of course, there is no guarantee that this will happen, and the person buying 100,000 XYZ may not ever change his limit. So, the algorithm, we'll call her Patty Pattern Mapper, buys stock in XYZ hoping to sell it to the buyer at a higher price. The big buyer, we'll call him Donnie Dark Pool, has other options though. Instead of exposing his bid to Patty's pattern mapping algo on the NYSE, he can enter his order in a dark pool, where no one can see the order. If, and only if, there is someone on the other side of his trade willing to sell shares to Donnie, the stock will trade.
Now, there are some key facts about dark pool trades that lots of people either ignore or fail to understand. First, all dark pool trades, like any other trades, are required to be reported to the tape within 90 seconds. Second, all dark pool trades, like any other trades, in accordance with Reg NMS, are required to take place within the inside market - the NBBO - national best bid/offer. So, no matter how much Karl Denninger would like to construct an example where a stock is trading at $10 on the "open exchange" and there is a seller in a dark pool willing to sell shares at 9.90, which are instantly snatched up by Goldman Sachs for $9.90 to resell to the open market at $10 - that simply does not happen. The dark pool either routs the seller's order to the open $10 bid, the stock trades at $10 or better in the dark pool, or no trade takes place.
Third, and most importantly, trades in a dark pool, or in any other marketplace, only happen when there are matching supply and demand for shares at a given price. One misconception is that dark pools somehow unfairly allow buyers to buy large blocks of stock without moving the price. Huh? Yeah - they can buy large blocks of stock if there is someone willing to sell large blocks of stock. Otherwise, they can either raise their bid in the dark pool until they find liquidity, or not buy shares. It's impossible to buy "large volumes of shares" at "small volume prices."
An erroneous critique related to this third point is that "large supply of stock should make prices go lower in an open market." David Weidner's column on Marketwatch gives an example of this common thought error:
"The problem, of course, is that bulky trades move markets. If I'm at Merrill Lynch and I need to unload 500,000 shares of XYZ, I can place the order in dribs and drabs -- through the multiple public markets out there including the Nasdaq, EDGE and Arca. But that order still is going to pressure XYZ's share price. Also, I'm going to be giving myself away. It also means that XYZ's share price should be lower because there are more shares for sale than buyers. That's how free markets are supposed to work, right?"
Is that how free markets are supposed to work? If I want to sell stock at $15, large amounts of it, then the stock should trade lower? No - I don't think that's a requirement of good, free, efficient markets at all. Although, it is one area of market inefficiencies that the high frequency pattern mappers are experts at implementing. The truth is that if I want to sell 1mm shares of stock at $15, the price need not go down at all. The price goes down only when there is no one willing to pay $15 and I lower my limit to $14.95. Then, when I exhaust the demand at $14.95, the price goes down again when I lower my price to $14.90. Supply of stock at a given price (say $15) does not make a stock go lower. Supply of stock at increasingly lower prices without a corresponding match in demand makes a stock go lower - this is a key point, and is not semantic nitpicking. We're so accustomed to trading off of what we think other traders are going to do that it requires some philosophical forethought to understand this concept.
In the ideal market, I believe that the entire marketplace would be dark - we need not even see bid and ask prices - just one last price. Everyone can enter their bids and offers - their supply and demand - into this one big dark pool, and trades would print as matches were made, with no one worrying about being out-traded by Patty Pattern Mapper.
I believe it's totally consistent to have the view that both dark pools and high frequency trading algorithms which exploit the bids and offers they see on open exchanges are ok. However, I think it's logically impossible to be against both these pattern mappers and the dark pools which enable other traders to hide from them. Furthermore, I believe its clear that individual investors are not disadvantaged by dark pools, and elimination of dark pools would result in higher execution costs.