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What are "dark pools," and why are they dangerous?

Last week, Goldman Sachs (GS) said its U.S. alternative trading system has been added to the list of things governmental and regulatory bodies are investigating. While the New York-based investment bank didn't say who is investigating, New York State Attorney General Eric Schneiderman has previously said he's looking into the arrangements between these alternative systems, known as dark pools, and high-frequency trading firms.

As even the name implies, dark pools aren't exactly the most transparent things on Wall Street. So, in case you're wondering just what all this fuss is about, here are the answers to some common questions about dark pools:

What are dark pools?

They're private clubs where investors can go to execute trades without the public finding out. They were initially geared to big institutions that wanted to execute a large sale in a dark place, but they're now used by investors of many different sizes. According to Reuters, "Around 40 percent of all U.S. stock trades, including almost all orders from 'mom and pop' investors, now happen 'off exchange,' up from around 16 percent six years ago."

Who runs them?

They're run by large banks like Goldman and Barclays (BCS), which make a lot of money by having clients use their exchanges instead of the New York Stock Exchange (NYSE), the Nasdaq or other public exchanges.

Why were dark pools created?

They were started to solve the problem of high-frequency traders gaming trades on public exchanges. These traders are now referred to as "Flash Boys" because of author Michael Lewis's best-selling book about them of the same name. By using ultrafast telecom links, microwave towers and special access to the exchanges, the Flash Boys are able to gain an edge over other traders. They can buy or sell large amounts of stock in the microseconds before a regular investor does, which means that investor either has to pay more to buy or accept less to sell.

How do they work?

A dark pool is just one of several different ways that a brokerage can fulfill a customer's order. There the order is matched up with another order by a dealer. In a dark pool, fees are lower, trades are anonymous and orders don't get reported until after they've been executed.

The other ways of filling an order include "internalizing," where the firm can match buy and sell orders from its own customers, or it can send the trades to a public exchange, which charges higher fees. According to Reuters, about 45 dark pools are now operating, and as many as 200 internalizers compete with the 13 public exchanges in the U.S.

So, why are dark pools a problem?

Public exchanges, provided they're adequately regulated, create a level playing field for all investors by providing equal access to pricing information. When they receive an order, the price of the stock is adjusted and everyone with a data feed sees it. So, if a lot of people want to sell a stock, the price goes down, and if a lot of people want to buy, it goes up.

Dark pools are the exact opposite of that. They report data only after a trade has occurred. This denies investors critical information and has little impact on the price.

What's wrong with that? Why shouldn't an investor who wants to take that risk be able to make trades in a dark pool?

The problem is that so much trading is now happening in dark pools that it may be warping publicly quoted stock prices to the extent that they no longer properly represent where the market is. For example, if a lot of sell orders for stock in ABC123 Corp. are waiting to be fulfilled in a dark pool, then buyers in the pool and elsewhere don't know that the price of that stock should be lower than it is. Further, because dark pools base their prices on the prices from the public exchanges, then the prices in the dark pools will be wrong as well.

Also, dark pools have several characteristics in common with things that contributed to the financial crisis: lack of transparency, under-regulation and, because of the amount of trades they now handle, they have clear systematic links to the rest of the financial system and the entire economy.

Thus, a problem with them could have major implications for many people who couldn't tell a dark pool from a swimming pool.

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