Industry analysts are wondering what’s going on at Goldman Sachs. One of the biggest global investment banking and securities management firms has been exhibiting some unusual behavior. It seemed to have started after the release of Flash Boys: A Wall Street Revolt. In the tome, author Michael Lewis claimed the equity market is rigged by powerful traders. Discreetly, Goldman supported the allegation. This even after the book directly placed Goldman in the middle of the dark pool private exchange, accusing the equity broker of utilizing its proprietary traders to exploit the trend. That didn’t bode well for Goldman, a banker considered the investment bank with the most political clout that never really took a stand on its reputation for long term greed as long as there was profit down the road. Not long after Flash Boys, the bank announced it was exiting the NYSE and selling Spear, Leeds & Kellogg, a broker it bought for $6.5 billion in 2000.
Over the last ten years, equity trading has evolved with Europe’s Mifid directive and the Regulation NMS in the states. New exchanges and dark pools exploded across the investment industry. Market makers and floor traders were replaced by software that generated high speed fiber optic exchanges. This increased market competition. As described in Flash Boys, it led to the speed rush of every investment institution wanting to get to the finish line first.
A number of HFT trading firms came out on top, including Knight Capital, Citadel and Getco. On the losing side were institutional investors unable to trade at quoted prices. Many moved their business to dark pools. Here they were less susceptible to arbitrage. Despite initial foreboding, these dark pools started out as a good plan in theory. PositAlert and Liquidnet were excellent alternatives for selling 100,000 shares of General Electric before an institutional investor was victimized by algorithms.
The director of CFA Institute’s capital markets policy, Rhodri Preece, believes investors are aware of the goings on in the dark pools. “There is a lot of high-frequency trading and they are not being used for their original purpose.” The insider term for much of the trading that transpires in dark pools is “toxic liquidity.”
Today, dark pools don’t provide what they originally promised. This might be okay with investors if they were making money. The fact is high frequency trading is not the money machine it was. The market is sitting smack in the middle of a classic Wall Street boom and bust. When edgy traders discover a profitable business, they will rush in. Of course, other investors eventually catch up and margins get eroded. In time, there’s isn’t enough return to make a worthy investment.
Meanwhile, risks are clear. The 2010 flash crash was a major high frequency pile-up, the first of its kind. Former winner Knight Capital saw a loss of $460 million in 2012 and was taken over by Getco. One firm, Tabb Group, admitted to a devastating loss in revenue when it peaked in 2012 with $1.2 billion. This was after they showed $7.2 billion on the books in 2009. In August, Goldman lost $50 million under similar circumstances.
One Wall Street executive close to the dilemma says the market structure isn’t sound and created poor incentives and bad behavior. In the current low investor confidence market, it wouldn’t take much for regulators to step in with solutions that won’t make anyone happy. On the European end, there are already attempts to correct excesses in the Mifid and Mifid II directives. In the U.S., reform is on the table. A sharp investment bank might see this as a good time to get ahead of the backlash and profit squeeze by draining any dark pools, minimizing NYSE trading exposure. Getting a step up on the moral high ground could be the only high road to take.