Even stock markets see the evils of ‘dark pools’

Not too many years ago, if you decided to sell your shares of IBM stock, the trade eventually went through the Exchange specialist charged with “making a market” in IBM stock. Whether you were selling 100 shares or 100,000, the transaction and its pricing were transparent. In a normal orderly market, if IBM was selling for $88.75 at the time your trade was made, you could be confident that other sellers, no matter how large, were getting something very close to that price.

That’s not how it works anymore. Back in the 1980s, the first of what we now call “dark pools” was created to give large institutional investors a venue in which big trades could be made anonymously without affecting market prices. For years, trading in dark pools represented a very small percentage of overall stock trading and didn’t really threaten the transparency of our markets.

That changed in 2007, when the Security and Exchange Commission made a number of rulings that cut back on the government’s regulatory role. Among them was a ruling that allowed just about anyone to start a black pool. Within a year, 16 percent of all stock trading was done in dark pools. By last March, that had grown to 36 percent, according to a Rosenblatt Securities analysis.

There is simply no way right now for an individual investor to know if she is buying or selling at the same price as Wall Street insiders.

The good news is that our three largest stock exchanges recently called on the SEC to take a hard look at its 2007 decision to free the dark pools. The New York Stock Exchange, Nasdaq and BATS Global Markets argue that the shift of so much volume from public exchanges to dark pools is distorting real pricing and increasing . The trend has weakened investor confidence in the integrity of our markets and threatens the reputation of U.S. markets as the most transparent and open in the world.

FINRA, the financial industry’s major self-regulator, has also been looking into the operations of dark pools. FINRA has requested information from pool operators, mainly big banks, on whether customers are receiving preferential treatment, if there are conflicts of interest, and how they are paid for their services.

One of the most vexing problems you confront when trying to change things like dark pool rules, or fixing some of the things that caused the financial meltdown of 2008-2009, is what I came to think of as the “no snitch” culture on Wall Street. I made a lot of visits to New York in 2009 and 2010 as a senator trying to gather information and ideas for the Dodd-Frank Wall Street Reform Act. I sat in dozens of private meetings with insiders who were quite open about what Wall Street had done wrong, and what needed to be done to avoid another crisis. But the conversations were nearly all “off the record.”

I remember, for instance, a meeting in my office with one of the top people at one of our biggest banks. He had come to talk about credit card reform. But as he was leaving, he paused at the door and said, “By the way, I love what you are doing to bring back the uptick rule.”

Repeal of the uptick rule on short selling in 2007 was a large contributing factor in the crashes of Bear Stearns and Lehman Brothers stock. I thanked him and asked if I could quote him. He grimaced, shook his head, and said, “No, no. They’ll just come after us.”

“They” is Wall Street-speak for all of the traders, money managers and hedge fund operators who are doing very well in the current system, thank you, and aren’t above taking revenge on any of their own who want to change it. Omerta may be on the wane in the Mafia, but in our interconnected financial industry, it is alive and well.

The only hope we have is that the SEC will act to restore and enact new rules governing things such as dark pools. A lot of good people on Wall Street would be happy to see that happen. They too want to restore the transparency and fairness that made our markets the envy of the world.

Ted Kaufman is a former U.S. senator from Delaware.