Dark Markets

In Criticism, Financial, Fresh on April 28, 2014 at 11:37 AM

Imagine that you’re buying property in Toronto. You know the exact neighborhood that you want to live in, but your real estate agent has told you there are no homes listed for sale in that area. Secretly though, every home in that neighborhood is owned by one real estate kingpin. The kingpin wants to take advantage of the high real estate prices as soon as he can, but he needs to do this discreetly. He understands that if he were to list all of his property at once publicly, then he wouldn’t get as much money for his property. He needs to make buyers like you believe there is a limited supply of homes, when in fact there is an abundant supply. To do this, he uses dark markets.

Sometimes, he lists a property publicly and lets people in Toronto outbid each other for it. Other times, he lists it privately to a group of investors on the other side of the world – a listing you have no access to. What helps the kingpin keep his plans secret is his access to dark markets. These “dark pools” of buyers that provide him cash in exchange for his assets (liquidity) let him make transactions without the public knowing. Using publicly available information, you can’t deduce what the kingpin is up to, because the information you have is incomplete.

These dark pools of liquidity are becoming a concern for the financial markets. According to this article in the National Post, roughly 40% of all American stock trades take place in in dark markets, also referred to as “over-the-counter” exchanges. Ultimately, dark markets aren’t required to have the same level of transparency as public or “lit” markets. Dark markets have always existed, but their prominence as a place where stocks can be bought and sold has proliferated. Many other types of financial instruments, such as derivatives or bonds often trade in “dark” or “over-the-counter” markets. Dark markets are not inherently bad, but they present a fundamental conflict between investor privacy and public transparency.


Transactions that take place in dark markets and don’t get reported to the public will affect that asset’s price. Transparency in market prices is important for well-functioning capital markets. Price efficiency helps us transact with confidence. It protects us from being ripped off. As more information gets reported and aggregated, the more efficient prices become. An efficient market price is the convergence of many independent transactions. If a large chunk of those independent transactions aren’t reported and aggregated, we no longer have the same confidence in market prices.¹


But that is one side of the argument. Let’s take a look at the same issue from the view of an institutional investor. “Big players” include the likes of our large pension plans, investment companies, hedge funds, mutual funds, and insurance companies. Being such large investors, they own very large blocks of company bonds or stock. When an pension plan wants to unload a large block of shares, it can prove difficult. Selling it all at once on a public exchange means you’ve tipped your hand. Other players in the market can take advantage of this information. These big players would have to absorb losses when selling. Instead, they look to benefit from the use of dark markets. By using dark markets, they can sell the entire block of shares quietly, one little bit at a time. This is the most important reason why dark markets exist – so that big players can transact with privacy. They want to execute these transactions as if they were not a big player, but rather, a bunch of little players.


There’s a broader issue here. Should big players be allowed to pretend like they are little players whenever it suits their needs? Of course, we play a large part in these big players existing in the first place. We pool our money together to save costs and gain leverage through size. In doing so, we gain access to investments that we could not participate in otherwise. We save on transaction costs too. Our big pools of money can swoop in and take advantage of distressed companies by purchasing control over that company at a low price. In doing so, they are using both their size and their identity to execute the transaction on our behalf. Dark markets allow them to switch from being big and visible to being small and private.

What rules allow for stable and sound functioning of financial markets? There are no good guys or bad guys. The Canadian Pension Plan benefits from this Jekyll & Hyde routine just as much as Goldman Sachs. The current system has created an incentive for investment companies to become bigger, because there’s no real disadvantage. But should there be some balance here? Should all market exchanges have some level of basic transparency so that there are no truly dark markets? It would mean the big players would lose some of their flexibility in that they may not pretend to be small when it’s convenient.

Who’s playing God?

The answer to this question will come from market regulators, although it won’t come easy. Dark markets were a big problem during the 2008 financial crisis because companies were trading very risky credit default swaps in the dark, which meant regulators had no clue what kinds of risks they were taking. Now dark markets are being used to move common stock, which means market prices may not be efficient. If we expect regulators to be omniscient and advise governments when and how to act, they must have knowledge of all trades. Regulators don’t want dark markets. If a big player wants to make a bunch of small transactions anonymously, it should be able to do so but once those transactions are executed we need post-transaction transparency. In other words, the information about the transactions should be available publicly, once it’s completed.

When we go back to our Toronto real estate kingpin, it would be nice to know all the recently closed deals in the neighborhood. Post-transaction transparency achieves that. It may be that the kingpin is selling homes privately for less than what he’s selling when he lists it publicly. Wouldn’t this information affect how you might bid for the next property when it comes up for sale?

Dark financial markets will continue to pop up unless regulators around the world create some basic principles that outline minimum transparency requirements for securities exchanges. Until then, we must live with imperfect information on market values and hope we’re not getting ripped off.

¹ Consider further, that all our banks, insurance companies, mutual funds, pension plans and really any company that hold stocks rely on market values. In valuing their respective stock portfolios, these companies presume an efficient stock market has informed the prices they use. The accounting rules demand this practice. The concern with trading happening in dark markets is that it would force accountants to use fragmented market prices to come up with values. Potentially, this has serious consequences. For example, assets that a bank holds in its reserves determine how much it can lend. Almost all of those assets are financial products, like company stock, traded in capital markets. The value of those assets stems from supposedly efficient market prices. If those prices are not reflective of what these assets are actually worth, then banks may be lending too much and over-extending themselves (or too little, and contracting the money supply). 

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