Dark Pools is a page-turning, fascinating account of how computerized algorithmic high-frequency trading (HFT) and electronic platforms evolved, took over financial markets and turned the NYSE floor into a mere "puppet-show for TV." Author Scott Patterson, a reporter for the Wall Street Journal, is a consummate observer. Dark Pools is a follow-up to his New York Times bestselling, award-winning The Quants (2010). His account of what's transforming capital markets cross-references Broken Markets by Sal Arnuk and Joseph Saluzzi, which I reviewed for Seeking Alpha.com June 30, 2012.
While Arnuk and Saluzzi, as co-founders of Themis Trading, LLC, write as deeply-concerned market participants, author Patterson is a quintessential observer, also deeply-concerned as a knowledgeable researcher in the field of artificial intelligence and an investigative reporter. While Broken Markets reads like its authors' many informative letters to the SEC and testimony before expert groups, Patterson's Dark Pools explores the colorful inner workings through a cast of improbable characters: the traders, programming geniuses, eccentric electronic market-makers, aggressive "algo-warriors," high-rollers and hedge fund quants who have taken over Wall Street, London, Singapore, Tokyo, Mumbai, Sao Paulo and Shanghai. Their fiber-optic cables circle the Earth, linking all financial markets at ever-higher speeds in the global arms race of the Algo Wars. These cables are now being superseded by even-faster microwave stations relaying HFT orders and trades 3 milliseconds faster than the fastest cables.
As a worried retail investor, I have tracked these changes second-hand, in my editorials, including "Global Finance Lost in Cyberspace" (www.ethicalmarkets.com). Patterson reports that the Tokyo Stock Exchange's Arrowhead HFT platform launched in 2010 now makes up half its volume. The Singapore Exchange (SGX) launched its Reach platform in 2011, billed as the fastest matching engine, with order speeds below 90 micro-seconds, and aggressively courting all the high-speed traders now flocking to Asia. India's National Stock Exchange (NSE) back in 2009 made 35 co-location servers available which were snapped up by Goldman Sachs, Citigroup and Morgan Stanley, leaving local Indian firms in the dust. The BATS Chi-Ex Europe now handles 25% of all stock trading in Europe. GETCO, the king of speed-trading, was edged out in 2011 by Virtu Financial and a slew of A.I. firms trying to capture trading patterns in real time. London's Fixnetix claimed that it had the world's fastest microchip that processes a trade in 740 nanoseconds.
Patterson reports on the SEC's well-known dilemma: outgunned and outspent, falling further behind since the May 2010 Flash Crash. The SEC plans to build a giant machine of its own: the Consolidated Audit Trail (CAT) to capture every single order placed into the stock market: trades, cancelled orders, etc., in real time - in theory. Patterson states that insiders know the terrifying truth: the market by the late 2000s had descended into one vast pool of darkness, as the HFT gunslingers and their new partners the electronic exchanges changed the game and took over the NYSE and Nasdaq, which became for-profit and went public.
A few whistle-blowers joined Arnuk and Saluzzi, notable Thomas Peterffy, founder of Interactive Brokers and Timber Hill, one of the earliest users of Island, an iconic pioneer electronic platform, along with Instinet. In late 2010, Peterffy told the World Federation of Exchanges annual meeting in Paris: "In the last 20 years came computers, electronic communications, electronic exchanges, dark pools, flash orders, multiple exchanges, alternative trading venues, direct access brokers, OTC derivatives, high-frequency traders, Reg NMS in the USA - and what we have today is a complete mess ... to the public, the financial markets seem like a casino, except that the casino is more transparent and easier to understand."
How could so many computer geniuses like Peterffy, Joshua Levine, the brain behind Island, Jerry Putnam, founder of Archipeligo - all trying to democratize Wall Street, have been so blind to the unintended consequences? These are cultural questions, involving academia's fascination with computers and information technology combined with government's science and technology policies and their recognition of all this along with strategic satellite systems and artificial intelligence as a new source of power and wealth. Taxpayers' money was funneled to university grants, the Pentagon, DARPA, and to the creation of the internet.
The genie was out of the bottle. Applying computer power to Wall Street was a lucrative "no-brainer," as well as a dream of a few to make markets more efficient, transparent and cheaper by displacing the middlemen: the specialists and old market-makers. Misguided academics, physicists and quants flocked to hedge funds lured by the big bucks. We all know the tragic results and await the next Flash Crash, global in scale, some call the Splash Crash caused by interlinked trading centers at warp speeds juggling every kind of security (beyond quaint risk-management concepts like diversification, Value-at-Risk, models, in "a worldwide, push-button money grid").
Then there's the unraveling of economic theories which drove the financial models that helped crash the markets in 2008. Exogenous reality checks came from physics and thermodynamics: economics did not understand the 2nd Law, the Entropy Law, and thus overlooked energy as a boundary condition and the assumption of infinite substitutability. Endogenous reality checks came from psychologists who exploded assumptions of human rationality and endocrinologists who examined traders' behavior as swinging between testosterone-induced irrational exuberance, hubris, and risk-taking and cortisol's role in market downturns or bad trades producing catatonic states or depression. Former derivatives trader turned biologist John Coates tell all in his The Hour Between Dog and Wolf (2012).
As I and other retail investors seek other havens for our hard-earned savings, we learn in Dark Pools that even putting limits on our orders is futile. Limit orders, too, have become fodder for the algo-bots in today's shark-filled pools, they are the "dumb money" orders from mom and pop investors and managers of mutual funds.
As Patterson ends by describing the latest algo-bots programmed to learn investment strategies by themselves, I wonder about what ultimate mind games might turn the tide. What would be the super-contrarian strategy to turn back the game of money symbols making more money symbols - exposing at last that money is not wealth, but rather a metric to track real-world wealth and score the games we humans play? Would it be to program the bots with real information about the way our planet actually works and how its 30 million species, including humans, have survived, innovated, evolved and thrived for 3.8 billion years? Can we learn to invest according to Life's Principles by following Ethical Biomimicry Finance? We at Ethical Markets and our partners at Biomimicry 3.8 are finding out.