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What Caused the 1000 Point Drop

Panic was a good word to describe how most of us felt on last Thursday afternoon as news began to spread that the Dow Jones Industrial Index plummeted 1000 points, seemingly in just a few minutes.

Stocks such as Procter & Gamble (NYSE:PG) were cited as the drivers in the index’s fall, as that stock dropped by more than 50 percent – again, just in minutes – all with not a shred of fundamental news.

As I began to track all sorts of potential issues behind the moves on my Bloomberg terminal, I quickly became aware that this wasn’t related to any specific company issues, market woes, or even political disasters in occurring in Washington, Athens or Brussels.

Instead, the root cause comes down to a threat that no one is talking about on television or in the financial pages.

It’s a risk that I’ve been following, writing about and speaking about for years – one that market regulators have ignored – including all of the folks supposedly working on financial market regulations in the White House and up on Capitol Hill.

Dark Pool Liquidity

Dark pools are private market exchanges that trade stocks, bonds, options and a host of other securities – without reporting their trades, prices and volumes to the public.

They have various names such as Turquoise (owned by the New York Stock Exchange) and operate in various parts of the globe’s markets. What they all have in common is that they are outside of existing securities regulation – and this won’t be fixed with anything currently being debated in Washington.

Dark Pools were set up as a way for institutional traders – ranging from prime brokers to hedge funds and pension funds – to buy and sell securities without showing their trades to the market.

The idea is to prevent losses for big investors who seek to capitalize on major market orders, or movements caused by larger scale stock trades. In the old days, big funds would use intermediaries, including specialized institutional brokerage companies, to camouflage these trades – but that meant slowing down execution as well as paying additional brokerage commissions.

Dark Pools give instant access to these traders, so they don’t have to worry if a market like the NYSE or London is open or not. And they don’t have to worry about borrowing shares to short – as naked trading is normal for Dark Pools.

The growth in trading in Dark Pools has gone viral over the past few years. And in fact, if you look at some of the trading reports released by exchanges such as the NYSE – the majority of trades in listed shares gets done not on the public exchange, but increasingly off-exchange on these private trading networks.

The trouble comes when volume imbalances occur. A few orders to buy or sell can get out of whack on one trading platform, and be sent to alternative platforms as they seek liquidity for execution. When they eventually hit reported and tracked markets such as the NYSE or Nasdaq’s National Market, prices that show up can be wildly off.

This is what happened last week with Procter & Gamble, among others.

I have no problem with folks wanting to make markets in over-the-counter fashion. The simple solution to the Dark Pool issue is to mandate that publicly listed securities trade on public exchanges. This would allow markets to pause, if necessary, to make orderly trades – as well as enforce short-sale rules, including the actual settlement and delivery of shares.

Simple to reform – but don’t expect Washington to go along with such simplicity.

More Dark Pool Threats to Your Portfolio

Other issues related to last week's mess aren’t being discussed, but perhaps should be. These include behind-the-scenes actions of the Fed, as well as a much more dire threat: terrorists.

The dramatic move in Procter & Gamble set off major impacts in indexes such as the Dow Jones. But while that index was cratering – along with its related derivative securities, such as many exchange traded funds (ETFs) – all of a sudden billions of dollars of index futures and other derivatives were being bought in massive wholesale fashion.

And while the buyers might have been some astute institutional traders, my fear is that it was done by the Fed with its own Dark Pool of assets – in the hope of stopping the market fall.

While it might initially seem a good thing to have the Fed step in to buy stocks or stock index derivatives, consider what that would mean: having the government not only be responsible for 90 percent of mortgages and trillions of dollars of public debt, but also billions of dollars of stock. That rubs me the wrong way.

And – with or without the Fed – the other thing to consider might be a trial run by a hostile government or terrorist group.

With Dark Pools running around the planet, it wouldn’t take much for a threatening group to get trades done to manipulate various networks – resulting in price action exactly like we saw this past week.

Just one more reason to get publicly traded securities on public markets...But again, don’t look for Washington to do the prudent thing.

My solution for all of this is to continue to rely more and more on investments in your retirement that are focused on paying you well to own them – the same investments that tend to be overlooked by traders and market abusers.

This is why so many of the stocks, funds and minibonds inside my Pay Me Strategy don’t get traded every day. And when the market takes a big hit, as it did this week – these are the securities that bounce back first, all while continuing to pay you safe and secure dividends.

Staying low-key and getting big dividends has worked during the past market craters and will keep working throughout the next ones yet to come.

Disclosure: No Positions