Gazing into the ‘Dark Pool’

Citadel, an asset management firm and market-maker, became the first non-bank member to clear interest-rate swaps, a special type of derivative in which a floating interest rate is switched with a fixed one. Photo courtesy of Citadel.

Written by Sashank Parigi

“The effect of the financial crisis and the ensuing regulations on financial services is no secret” said Daniel Lee, NYU Stern sophomore, “But what people don’t think about enough is: If banks are universally retreating, then who is stepping up to fill that vacuum?”

Buying and selling securities used to be a simpler process. You would call your investment bank for a quote, and, if the price was right, the bank would act as the clearinghouse or take the other end of the trade. But as markets evolved, investors demanded greater speed and efficiency — prompting, banks to create and deliver electronic trading platforms called “dark pools.” These entities compile and execute customer orders in private exchanges, rather than in the public eye through the NYSE or NASDAQ.

In his book “Flash Boys”, one of Michael Lewis’s main points is that hedge funds and proprietary trading firms should not be allowed access to the order flow of thousands of other investors.

Equities investor Jason Zhou explains why: “It’s a clear conflict of interest that breaches the standard market dynamic. If the trades on these private exchange are available only to the few who pay for access, they enjoy an unfair advantage.”

This more secretive process soon spread to other financial products. The financial industry saw the introduction of a fixed-income market, including various corporate and government bonds. This market has grown to $157 trillion, according to the McKinsey & Co’s publication “Mapping Global Capital Markets”. In stark contrast, the world equities market totals just $54 trillion.

Because the size of fixed income markets dwarfs that of equities, providing liquidity is a tougher job to handle — and more important for the Federal Reserve to monitor. Indeed, lack of liquidity in fixed income was a major contributor to the most recent financial crisis.

So why is liquidity so crucial for fixed income products? Assume you want to sell some General Electric stock. Because there are so many other traders and investors in equities, finding a buyer would be relatively quick and easy. But now imagine you’re trying to sell a very specific, esoteric fixed-income security of GE. Finding a matching buyer becomes significantly more difficult. If no buyers exist, you have no choice but to lower your asking price until someone is interested.

The mere fact that you want to sell this security affects the entire market in which it trades. Investment banks and other market- makers would typically step in as that buyer, preventing the security’s price of the security from falling too much. The bank or market- maker could then use its huge network to find a new buyer for the security. In a market with sufficient liquidity, GE’s earnings and accounts drive the prices of their securities, rather than who is buying and selling.

But, as Lee mentioned, these traditional market-makers are retreating from this space due to the 2008 financial crisis — leaving the industry wide open for different financial firms to enter. These new firms –oftentimes the same ones that some observers accused of rigging equities markets pre-crisis — are directly providing their own “dark pools” for fixed income.

Citadel, an asset management firm and market-maker, became the first non-bank member to clear interest-rate swaps, a special type of derivative in which a floating interest rate is switched with a fixed one. This means that Citadel is licensed to act as the intermediary between two parties, a role that for all of history was served by an investment bank. KCG, a similar firm, developed a fixed income “dark pool” that now deals $131 million of volume per day. Both companies simultaneously have separate arms that engage in proprietary trading, seemingly an eerie throwback to the perceived conflicts of interest in pre-crisis investment banks.

How can a firm serve its clients when a different division of the company is competing with those same clients? Currently, Citadel Securities is using its electronic trading platform to help funds buy and sell fixed income securities. At the same time, hedge funds owned by Citadel are also trading the same securities. It’s impossible to tell what the real level of interaction between these two separate Citadel entities are. But a portfolio manager who knows exactly what everyone else is buying and selling could have the same scale-tipping advantage of a poker player who knows everyone else’s hand. This is one of the major reasons why Dodd- Frank essentially ended proprietary trading at investment banks.


Banks would still argue that only they possess a large enough balance sheet to continue providing liquidity in periods of high volatility. However, smaller companies with less cash like Citadel and KCG would seem to be more likely to shut down if markets became too turbulent, arguably putting their clients and the entire financial system at risk. Citadel CEO Ken Griffin not surprisingly would disagree with this scenario. “This is a myth intended to preserve their competitive moat around what has been a very lucrative business,” he wrote.

It’s clear where many investors stand on the matter: “I’ll take the enhanced liquidity for fixed income securities wherever I can get it. I couldn’t care less if it’s coming from a bank, a hedge fund, or an egg farm.” says Krishna Sridharan, Portfolio Analyst for NYU’s Investment Analysis Group.

Where the problem arises is how to regulate this new market-making industry when the non- bank intermediaries are just as much of a force as banks. There is no clear answer to account for this new fixed-income trading environment. But one thing is certain: If there are any holes in the system, the next financial crisis will definitely expose them.

1 Comment on Gazing into the ‘Dark Pool’

  1. Great article Sashank!

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