By Michael Lewitt, Editor, The HCM Market Letter*

The world outside Wall Street has finally discovered the world of dark pools and high frequency trading. The question we would like to pose is whether these latest twists on Wall Street's proclivity for opacity and speculation will be the next black hole that swallows the markets and the economy along with them?

Dark pools are electronic trading networks that allow institutional investors to buy and sell stocks anonymously. These networks allow investors to conceal their identities as well as the number of shares they are buying or selling. Readers may have heard of some of these networks - Goldman Sachs operates one called SIGMA X, for example, and there are others called Liquidnet, BATS and Direct Edge.

According to The Economist, there are currently forty dark pools operating in the United States that account for an estimated 9 percent of traded equities. Other sources estimate the volume to be higher, which highlights the question of how anybody can know exactly what is going on in these hidden corners of the investment universe when their very raison d'être is to conceal information from the eyes of regulators and investors. Wall Street loves these private trading networks, where business is booming and profits are growing.

HCM will go on record as saying that dark pools are a singularly bad idea from a systemic standpoint because they suppress the very transparency that builds confidence in markets. High frequency trading is a phenomenon that often takes place on these dark pool exchanges. Actually the correct term is "high frequency algorithmic trading" since it is a trading strategy based on using algorithmic formulas to analyze market data and then predict and exploit likely market movements. It is another manifestation of the quantitative trading strategies of which HCM has been critical before. HCM's view of this type of investing is well-known - quantitative trading is nothing more than mere speculation and adds nothing to the productive capacity of the economy.

Moreover, in recent years we have seen the deleterious effects that these strategies can have on the markets by increasing volatility and causing securities prices to move without any connection to fundamental changes in the underlying company's financial condition. Proponents of these activities argue that dark pools enhance market liquidity, but liquidity without transparency is a sure-fire recipe for disaster. Add higher volatility to the mix and you have a singularly bad idea in our view. Why can't these trades be done with full disclosure and in the full light of day? How does hiding these trades in the shadows enhance liquidity or market stability?

No less than Paul Wilmott, a highly respected figure in the quantitative investing world (and founder of the quantitative finance journal Wilmott), warned of the dangers of high frequency trading in a recent opinion piece in The New York Times: "Thus the problem with the sudden explosion of high-frequency trading is that it may increasingly destabilize the market. Hedge funds won't necessarily care whether the increased volatility causes stocks to rise or fall, as long as they can get in and out quickly with a profit. But the rest of the economy will care."

The economy will care because the financial markets do not simply provide an outlet for financial speculation; like banks, they also provide a public utility function whereby they serve as a source of growth capital for companies. Dark pools are private playgrounds that hedge funds and investment houses use to trade in secret; allowing them to operate is singularly bad public policy. As we saw last year, when the markets fail and can no longer perform their public utility function because of damage caused by excessive speculation, the economy suffers severe damage. One of the best ways to insure the healthy operation of markets is to require them to operate transparently, and high frequency trading on dark pool exchanges are designed to do precisely the opposite.

High frequency trading recently attracted attention when the media-shy senior Senator from New York, Charles Schumer, threatened to introduce legislation banning the practice of "flash orders" if the Securities and Exchange Commission (SEC) didn't take immediate steps to outlaw the practice. Flash orders are a particularly noxious Wall Street invention in which dark pool exchanges allow traders to briefly see and react to certain orders ahead of the rest of the market. This is commonly referred to as "front-running" in financial markets where the securities laws are enforced.

As we have come to learn with laws governing abusive practices such as naked short selling, however, sometimes the securities laws in the United States are enforced, and sometimes they aren't. As The Wall Street Journal matter-of-factly stated the matter, "[t]he SEC is looking into the practice and is widely expected to ban it, according to people familiar with the matter." Oh really? The SEC is behind the curve and needs to catch up quickly.

The very name "dark pool" says it all - these off-market exchanges are antithetical to the transparency that should be the basis of financial markets. HCM has long marveled at the ability of these exchanges to proliferate under the noses of regulators without any investigation or opposition, particularly in view of the repeated disasters that off-balance sheet or hidden entities or activities have inflicted on the financial markets and the economy. We would say we were surprised, but how could we be surprised in view of the abject regulatory failures of recent years.

This time, however, the regulators have a chance to prevent a potential train wreck before the train gets much further down the tracks. In order to do so, however, the Obama Administration is going to have to stand up to some very powerful financial interests on Wall Street and give the lie to the arguments that trading will flee to less regulated jurisdictions that will allow this kind of opaque activity.

One can only hope that after the lesson of Enron (a company concealed material information from investors in off-balance sheet entities), which had to be learned all over again with the demise of SIVs (entities whose very purpose was concealing $400 billion of risky assets from regulators, credit rating agencies and investors), that the Administration will give its regulators the necessary backing to reign in these secret trading exchanges.

In an era in which corporate bond trading has been forced into the open through the introduction of the TRACE system, which requires broker-dealers to report all public bond trades within a few minutes of execution, it makes absolutely no sense to permit large parts of the equity markets to retreat into the shadows. It would be an important step on the part of the Obama Administration to end the intellectual Balkanization of financial regulation by treating debt and equity markets the same and forcing trading in both markets into the open. How many times are we going to tempt fate?

(*Excerpted with permission from The HCM Market Letter, August 2009.)