Shadow Exchanges for the Shadow Financial System: Dark Pools

Here's the latest twist on market manipulation in a financial system gone completely out of control. One 'secret' market for big players to trade where they do not have to report the price or volume, and another retail market where the small players show their cards and their orders up front.

If you are not a trader the full impact of this might not dawn on you right away. But it puts the retail investor/trader at a significant disadvantage to a few insiders who can 'see' the dark pool action, and use it to front run the slower and less informed retail exchanges.

Rise in secret stock trading may be skewering share prices
So-called dark pools of liquidity help large investors hide trades; they could also be roiling markets, some say

April 21, 2008

(Reuters)—A new obsession by big investors with veiling their stock trading patterns is rewriting the rules of the stock market, but some are questioning if the trend, for all its secrecy and sophistication, has created as many problems as it has solved.

The stealthy but rapid growth of off-exchange trading venues, known as dark pools of liquidity, may be playing a bigger role in the market than some expected.

Only a few years ago, investors could count on one hand the number of places to trade stocks in, for example, U.S. companies.

But today traders must navigate a virtual ocean of more than 40 venues to find the best prices—a phenomenon that may be adding to overall volatility and possibly compromising the validity of all stock prices.

In dark pools, where buyers and sellers anonymously match large stock orders keeping details about price and volume concealed, there is no guarantee that even big investors are getting the prices they should.

“My biggest concern with dark pools is that before, when you were using the Big Board as somewhat of a standard, you were trading with some level of information, and now in dark pools you are trading without information,” said Bob Koci, a trader with Principal Global Investors.

Investors have become accustomed to knowing the quoted price on traditional stock exchanges like the New York Stock Exchange, or Big Board, and Nasdaq, is generally fair and the best available at any point in time. But as trades are increasingly fragmented across different venues, making such assumptions in the future could be dicey.

“On one hand, there are trades being executed right now that would not be executed without dark pools,” said Robert Iati, a partner at market technology consulting firm The Tabb Group in New York.

“On the other hand, you can say it’s not visible and that makes it more volatile.”

Some investors have always looked for ways to hide their cards, such as slicing a large block trade into smaller pieces, or placing a reserve order that displays a small amount of liquidity while keeping a larger amount hidden. However, recent advances in electronic trading and the 2001 switch to trading stocks in dollars and cents instead of fractions are credited with pushing traders into more secretive venues.

As investors found it increasingly difficult to trade discreetly on open markets, the average size of a stock trade on an exchange fell from close to 1,500 shares per trade a decade ago, to just 250 today, Tabb’s Mr. Iati noted. That trend developed at the same time hedge funds and institutional investors found it profitable to make riskier, more leveraged bets at faster speeds, he said.

“Indirectly, you have the market structure changing,” Mr. Iati said. “Now it is much more challenging overall for any investor to make money like they did 10 years ago in the plain-vanilla U.S. markets.”

Alternative, off-exchange trading systems, ranging from dark pools to electronic networks were set up rapidly to address demand. Some pools are sponsored by brokers like Goldman Sachs’s Sigma X, while others such as Liquidnet and BATS Trading were created independently or as joint ventures. Now even the exchanges are setting up their own pools to remain competititive.(Gee sounds great. Only Goldman Sachs sees the total market. Perfect - Jesse)

In dark pools, traders looking to buy or sell large blocks of stock get something akin to a wholesale discount.

When investors see a large buy order on a public exchange, they often jump in and bid up the price of the stock, assuming a big trader is making a strong bet about its direction. But if the trader who made the order is still trying to fill it, the price for the stock can move against him, adding to costs.

Hiding the bid from the public markets in a dark pool offers traders the ability to fill an order without suffering the impact of other traders changing the price.

Trades in dark pools are now estimated to account for some 10 to 12% of all stock trades, and consulting firm The Aite Group predicts that by 2011 dark pools will encompass more than 20% of market share in the United States.

But reaching such a critical volume of stock trades, could begin to affect the basic supply and demand equations used to price stocks, analysts say, as investors’ true feelings about how a stock should be traded are hidden.

NYSE President Catherine Kinney summarized the problem at a 2006 conference, saying every share traded in dark pools was one that did not help the markets determine an accurate price for that stock.

And while analysts cautioned recent market volatility is mostly due to economic worries and the subprime mortgage crisis, many said it is possible that hidden trades in dark pools are contributing to the storm.

“Lack of a central marketplace can add to volatility,” said Andrew Silverman, managing director of electronic trading at Morgan Stanley .

According to the Aite Group, stock trading on the NYSE and Nasdaq represented just 75% of average daily trading volume in the third quarter of 2007, down 5 percent from the second quarter of 2006.

Investors can also react more quickly in dark pools because they don’t have to splice and dice an order and trade it throughout the day. (Yes and it makes it MUCH easier to front run the retail exchanges if you know how things are moving in the dark pools - Jesse)

But on the flip side, no study has been published on whether dark pools increase volatility, or decrease it by limiting the market impact of trades.

“There’s kind of a mixed verdict on dark pools,” said Craig Pirrong, a finance professor at the University of Houston’s Bauer College of Business. “On one hand they provide competition (for exchanges), on the other they probably reduce the quality of price discovery marketplaces like the New York Stock Exchange.”

When traders meet in a dark pool, they are not necessarily looking to get the best price on their stock trade, but rather, the most efficient execution so they can limit market impact.

However, the execution price for trades in dark pools is actually derived from public quotes on exchanges, so dark pool traders are essentially “free riding” on the way public market investors price their transaction.

“If a retail customer puts in an order that is very well priced, and it becomes the best price available, all of a sudden, all these investors in dark pools have to trade off of that price,” said Bernard Donefer, Associate Director of the Subotnick Financial Services Center at Baruch College in New York. “The national best bid offer could be created by small retail investors. It used to be the opposite. It used to be that the institutional investors set the price and the retail investors got that price.” (Where is Joe Schmerky setting the price for mega-trades between Berkshire and Goldman Sachs? On Fantasy Island that's where you knucklehead - Jesse)

While some analysts say arbitrage traders would jump in and fix discrepancies between dark pool and exchange prices, it could become increasingly difficult for investors to assume the quoted exchange price takes into account all the trading information about the stock.

“The theory is if you keep it confidential you get the better price,” said Frederick Lipman, a corporate and securities lawyer at Blank Rome in Philadelphia.

“Whether that’s true or not remains to be seen.” (Its the guy who has the most and latest information that gets the best of all deals. - Jesse)

Rise in Secret Stock Trading May Be Skewering Prices

Pictures from an Exhibition of Reckless Financial Speculation

Five Banks have taken on the leverage normally reserved for hedge funds, placing the US dollar and the entire financial system at risk, and essentially holding it hostage to carry their losses while they take their profits.

They are JP Morgan Chase, Bank of America, Citibank, Wachovia, and HSBC.

JP Morgan alone is holding derivatives with a value of $84.8 Trillion. Yes they have netted that down, provided there are no significant counterparty failures in which case that netting goes to hell in a handbasket. Their credit exposure to capital ratio is 418.7. This gearing is priced to the perfection of a lossless countertrade with nothing even reasonably expected on the tails. They make LTCM almost look like grannies when to comes to being a risk-loving beta monster.

This is why their counterparty Bear Stearns had to be bailed out with public money. There are a few others to keep a close eye on including Merrill and Lehman with their derivatives exposures although they are not in the top five.

This is why its not over yet.

There are two classes of financial institutions in trouble. Those that are 'too big to fail' and those that are 'too big to mention the word failure in the same sentence.' The top five derivatives speculators are in the latter category.

This debate among deflation, stagflation, hyperinflation and disinflation ought to be expanded to include financial obliteration.

The source for these graphs is the latest report from the Office of the Comptroller of the Currency OCC Dec. 07 Report

If the Federal Reserve had taken over supervision from the OCC as Secretary Paulson recommended, do you think we would be seeing such detailed reports on the concentration of risk in five financial market players? Or would they be skulking to the Discount Window to try and hold their books together with public money without any disclosure?

Japan's Hunger: the Dark Side of Globalization and Central Planning

Food shortages in Japan?

File this one under the divergence between the world of paper and the world of reality. And perhaps under moral hazard and unintended consequences of distorted markets and the failure of markets when they are free in name only, being over-adjusted in the grasp of the central planning of bureaucrats for sustained periods of time. Japan has not had a free market in decades, being the shining example of industrial policy focused on exports of manufactured goods, to the detriment of the rest of the economy. Let them eat Toyotas.

The Age - Australia
Business, Finance and Market News
Japan's hunger becomes a dire warning for other nations
Justin Norrie, Tokyo
April 21, 2008

MARIKO Watanabe admits she could have chosen a better time to take up baking. This week, when the Tokyo housewife visited her local Ito-Yokado supermarket to buy butter to make a cake, she found the shelves bare.

"I went to another supermarket, and then another, and there was no butter at those either. Everywhere I went there were notices saying Japan has run out of butter. I couldn't believe it — this is the first time in my life I've wanted to try baking cakes and I can't get any butter," said the frustrated cook.

Japan's acute butter shortage, which has confounded bakeries, restaurants and now families across the country, is the latest unforeseen result of the global agricultural commodities crisis.

A sharp increase in the cost of imported cattle feed and a decline in milk imports, both of which are typically provided in large part by Australia, have prevented dairy farmers from keeping pace with demand.

While soaring food prices have triggered rioting among the starving millions of the third world, in wealthy Japan they have forced a pampered population to contemplate the shocking possibility of a long-term — perhaps permanent — reduction in the quality and quantity of its food.

A 130% rise in the global cost of wheat in the past year, caused partly by surging demand from China and India and a huge injection of speculative funds into wheat futures, has forced the Government to hit flour millers with three rounds of stiff mark-ups. The latest — a 30% increase this month — has given rise to speculation that Japan, which relies on imports for 90% of its annual wheat consumption, is no longer on the brink of a food crisis, but has fallen off the cliff.

According to one government poll, 80% of Japanese are frightened about what the future holds for their food supply.

Last week, as the prices of wheat and barley continued their relentless climb, the Japanese Government discovered it had exhausted its ¥230 billion ($A2.37 billion) budget for the grains with two months remaining. It was forced to call on an emergency ¥55 billion reserve to ensure it could continue feeding the nation.

"This was the first time the Government has had to take such drastic action since the war," said Akio Shibata, an expert on food imports, who warned the Agriculture Ministry two years ago that Japan would have to cut back drastically on its sophisticated diet if it did not become more self-sufficient.

In the wake of the decision this week by Kazakhstan, the world's fifth biggest wheat exporter, to join Russia, Ukraine and Argentina in stopping exports to satisfy domestic demand, the situation in Japan is expected to worsen.

Bakeries, forced to increase prices by up to 30% in the past year, are warning that the trend will continue. Manufacturers of miso, a culinary staple, are preparing to pass on the bump in costs caused by the rising price of soybeans and cooking oil. And the nation's largest brewer, Kirin, is lifting beer prices for the first time in almost two decades to account for the soaring cost of barley.

"In the past, Japan was a rich country with a powerful yen that could easily buy cheap imports such as wheat, corn and soybeans," said Mr Shibata, who directs the Marubeni Research Institute in Tokyo. "But with enormous competition from the booming Chinese and Indian economies, that's changed forever. You also need to take into account recent developments, including the damage to crops caused by drought and other disasters in exporting countries like Australia," where the value of wheat exports has tumbled from $3.49 billion to $2.77 billion in the past three years.

The situation has been compounded by a surge in demand for bio-fuels such as ethanol, made from maize, encouraging farmers around the world to divert their efforts away from wheat and barley and into maize, further driving up prices.

Arguably Japan's biggest concern, however, is its weakening ability to sustain its population with domestic produce. In 2006 the country's self-sufficiency rate fell to 39%, according to the Agriculture Ministry. It was only the second time since the ministry began keeping records in 1960 that the population derived less than 40% of its daily calorie intake from domestically grown food.

Shinichi Shogenji, dean of the University of Tokyo's graduate school of agricultural and life sciences, said Japan's meat consumption had increased by 900% since 1955, in part because expanding incomes had enabled families to supplement the sparse national diet of rice, fish and miso soup with more Western-style food.

This trend, combined with rapid ageing and declining rural populations, had placed the country's self-sufficiency at a perilously low level, Professor Shogenji said.

In view of recent predictions by Goldman Sachs analysts that commodities could experience "explosive rallies" in the next two years, many are wondering if Japan could become an example to other rich nations that have relied too much on foreign supplies to put food on their tables.

Japan's Hunger Becomes a Dire Warning

Why Gold is Not in a Bubble

A nicely done analysis by Paul Krugman, economist of Princeton, in The New York Times.

What Paul does fail to mention is the significant decline of the dollar tends to inflate the prices of all commodities and products not produced in domestic US or sold openly in world markets, and that commodities are significantly and increasingly the case, a triumph of the service economy. Further, the inputs to costs of extracting/producing those commodities are soaring because of the general inflation of energy products.

So even if the price had increased while the supply remained steady, or even increased, a case could be made for commodities priced in dollars that they are still not in a bubble because the US dollar is in a bubble of supply.

However, this brings us to the interesting anomaly. Why is metals production not increasing with the dramatic increases in prices?

Some say that gold and silver were actively priced suppressed by the paper markets in NY and Chicago for many years, with huge short positions keeping the benefits of adding sources of supply artificially low. So now we are paying the price, since it takes years to bring new supply, new mines, into production.

But that's Moral Hazard and Unintended Consequences, and we are told to ignore them, as Josef Goebbels told the German people to disregard the bombs falling on Berlin. And for now, we listen, and go forward into the night.

Moral Hazard: A dilemma that arises when government officials take steps to bail out countries or businesses that are in serious financial trouble. Although the action may help prevent widespread financial turmoil, thereby protecting innocent parties, it creates an expectation that governments will always come to the aid of failing countries and companies, potentially increasing risky behavior because there is no penalty. Webster's Dictionary

Since free markets and capitalism are based on the principle of discovering price and managing risk, the greatest hazard ultimately is that we will lose our free markets, and essentially lose that which we think we have based our market economy upon, until of course we hit the wall and collapse, in our markets or as a republic.

Commodities and speculation: metallic (and other) evidence
by Paul Krugman
April 20, 2008, 9:49 am
The NY Times

We’ve had a huge runup in commodity prices — fuels, food, metals. But why? Broadly, the debate is between those who see it as a speculative phenomenon, driven by some combination of low interest rates and irrational exuberance, and those who see it as a collision of rapidly growing demand with constrained supply.

My problem with the speculative stories is that they all depend on something that holds production — or at least potential production — off the market. The key point is that the spot price equalizes the demand and supply of a commodity; speculation can drive up the futures price, but the spot price will only follow if the higher futures prices somehow reduces the quantity available for final consumers. The usual channel for this is an increase in inventories, as investors hoard the stuff in expectation of a higher price down the road. If this doesn’t happen — if the spot price doesn’t follow the futures price — then futures will presumably come down, as it turns out that buying futures produces losses.

Which brings me to this chart, from the IMF’s World Economic Outlook:



Bubble, bubble, where’ the bubble?

As far as I can see, this creates real problems for any claim that high metal prices are speculatively driven. Food inventories are also historically low. I just don’t see how a low-interest-rate or bubble story works here.

Paul Krugman in the NY Times