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Dark Forces in Dark Pools |
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12 July 2011 |
Justin Urquhart Stewart is one of the most recognisable and trusted market commentators on television, radio, and in the press. Originally trained as a lawyer, he has observed the retail market industry for 20 years whilst at Barclays Stockbrokers and developed a unique understanding of the market's roles and benefits for the private investor.
Justin Urquhart Stewart is one of the most recognisable and trusted market commentators on television, radio, and in the press. Originally trained as a lawyer, he has observed the retail market industry for 20 years whilst at Barclays Stockbrokers and developed a unique understanding of the market's roles and benefits for the private investor. Justin provides financial advice to clients of Kester Cunningham John Financial Planning LLP.
There has been much talk about the issues surrounding certain types of Exchange Traded Funds (ETFs) and especially those which are known as "synthetic" ones which are backed by "swaps" or contracts that replace the need for actual physical holdings of stock with alternative assets acting as collateral. ETFs of this nature are often over-collateralised (which we would insist on if we were to use them in a 7IM portfolio). These are indeed more sophisticated ETFs than the simple stock tracker ones but this different approach serves a useful purpose. Physical holdings in a broad index can be difficult and expensive to achieve - as with some of the Emerging Market indices - and a synthetic ETF can provide a good solution. The key issue is the due diligence which is necessary to distinguish the good ones from those that may be less attractive - but this applies equally with any investment carried out for a client on any fund or portfolio. However there are always parties looking for the latest scare story - even to the extent that they imply such ETFs could become a "systemic risk to the banking system". However, undermining the scaremongers is the very fact that they are being evaluated in such light should negate any such occurrence, as the regulators can now see this as an area to monitor.
For me however one initiative that does have potential to create a systemic risk could be the effects of High Frequency Trading (HFT). People always ask "where do you think the next problem will occur?"(As an aside, in personal finance I would suggest that the questionable practice of borrowing against your pension is fraught with danger - but more on that another time.)
In the investment world though, the development of HFT has come about from the computer driven trades feeding off the actual trades being put through in the marketplace. In effect every trade that is put through normal channels could well be being automatically evaluated by the automated computer programmes that have been set up and create multiple and fractional trades that take place hundreds of times a second.
This has always been a concern to me, partly due to my own ignorance, but also out of a concern over the lack of transparency in such trading systems. If we can't see the trading, we can't fully measure the risk, and then we could be building up a silent and invisible trading risk hidden from the normal running of the markets.
This HFT is often linked to what have become known as "dark pools". The dark pools term refers to transactions where prices are only posted after the trades have been completed. Thus this trading is in effect off market and outside the scrutiny of the main exchanges. These dark pool trades have grown in popularity as institutional investment houses and fund managers seek to try and match larger orders in a single trade, rather than having to go to the extra cost and effort of slicing them into smaller pieces or shapes for general consumption.
Now it is being proposed that retail trades could not only be linked to these dark pools to match any untraded bargains, but potentially also linked to HFT. The concept is that if you link the HFT with broker dealer trading and the retail market you create more liquidity - and with more liquidity you have a better chance of more efficient price creation - which in English is better prices. There has always been a concern that the retail client got the nominal "best" available price, while institutions actually got the real best prices. The concept is exciting and better prices are (usually) to be welcomed - however I would raise the concern of transparency of price creation and trading, both in terms of risk but also manipulation by less scrupulous forces that may be operating in these dark pools. How appropriate in the week when the last Harry Potter film comes out that we already see ideas for the new franchise - The Dark Lord Voldemort Goes Stock Trading.
If the regulators can monitor what is going on and actually do so, then I will be comforted - however for the present I will need some persuading, reassurance and most importantly, evidence that this is the case.
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So the next round of quarterly earnings starts this week and on them rests the hopes of the bulls that the corporate sector is still seeing healthy profits and cash build up. The story so far has been one of recovery, with costs cut and inventories rebuilt; that however, can only go on for a certain period after which we are going to start having to look for some real underlying demand. One indicator to be looking for will be the levels of new investment being planned - or at least considered. If this starts to rise then (whisper it) confidence is returning; if not, then we may be looking at a lower and slower corporate world. The indications so far are positive, but let's wait for the actual figures.
Have a good week.
Justin A. Urquhart Stewart
Director
Seven Investment Management Limited
This article represents a personal and lighthearted view from Director, Justin Urquhart Stewart of Seven Investment Management Limited, and is based on current financial news and events around the world. Its content should not be used for investment purposes and you should contact an independent financial adviser before making any investment or financial decision. Seven Investment Management Limited is authorised and regulated by the Financial Services Authority. Member of the London Stock Exchange. Head office: 23 Austin Friars, London EC2N 2QP. Telephone 020 7760 8777.
Registered in England and Wales number 4092911. Registered office: 3 More London Riverside, London SE1 2AQ. |
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