Financial Suicide – Privatizing Social Security

The clatter is starting up again over the privatization of Social Security. With this plan, the individual gets to decide how to invest their Social Security funds, something akin to a public 401k program. The bulk of this new-found investing activity, however, will go towards Wall Street and the stock exchanges.

The idea of being able to select one’s own investments sounds all well and good, but Americans may want to start asking themselves just what is at stake. In fact, if you’re investing in stocks, stock-driven mutual funds or a 401k, you stand no better chance in redeeming these investments at retirement from a privatized Social Security plan as you do from an increasingly at-risk public Social Security plan.

Originally writing on the topic of shadow markets in 2009, I then noted the increasing influence of high-frequency trading and ‘dark pools’ on stock markets. Three years later (this morning in fact), the Financial Times reports:

Trading of US equities on “dark pools” has grown by almost a half in the past three years to account for nearly a third of total market volume, according to research that underscores the challenge facing international regulators.

The shift from transparent public exchanges has highlighted growing concern among asset managers and global regulators about off-exchange trading, where prices are reported only after deals are executed.

Dark pools are venues where stock trades are hidden from public view, lowering the quality of publicly available information. Dark pools allow major traders, those holding large blocks of stock, to hide their identities and intentions, to avoid moving share prices. Dark pools have gained traction over the last decade as the average size of trades dramatically decreased on the transparent exchanges.

The United States has some 40 such venues dealing in dark pools and high-frequency trading, including Goldman Sachs, Getco, and Credit Suisse.

Reuters quoted Mary Schapiro, chairperson of the U.S. Securities and Exchange Commission (SEC), as saying dark pools are not dark to all participants but transmit electronic messages to select individuals that could convey valuable information about their available liquidity, leading to significant private markets that exclude public investors. In the fall of 2009, the SEC announced it was considering placing tougher limits on the amount of anonymous trading carried out in dark pools. The SEC understood shadow markets were increasing volatility in the public markets.

In 2009, Rosenblatt Securities estimated about 7% of all stock transactions occurred in a dark pool but the Tabb Group estimated that dark pools at Credit Suisse’s Crossfinder and Goldman Sachs’ Sigma X alone accounted for 9.4% of all US equity volume from 2006 to 2009.

Fast forward, this morning’s Financial Times‘ article reports that a “survey by the London-based CFA Institute found that trading of U.S. equities on dark pools had risen 48 per cent since the start of 2009 to account for about 31 per cent of total consolidated volume, as of March (2012).”

Dark pools, the Financial Times goes on to report, “have grown popular with asset managers as they minimize the risk of the market moving against them when executing a large order, or of seeing their order sliced up by high-frequency traders.”

High-frequency trading, in case you’re wondering, involves “powerful computers, some housed right next to the machines that drive marketplaces like the New York Stock Exchange,” Charles Duhigg reported in a late July 2009 article of the New York Times,”(that enables) high-frequency traders to transmit millions of orders at lightning speed and, their detractors contend, reap billions at everyone else’s expense.”

In the wake of the May 6, 2010 “Flash Crash,” connections were being made between high-frequency trading and market volatility. And the proprietary trading desks of the Wall Street banks – which oversee high-frequency trading as part of their responsibilities – were thought to be disappearing in response to financial-reform regulations (a step eventually taken by Bank of America), but simply reappeared as wholly owned hedge funds, using the same threat with a different name.

The existence of shadow markets goes against everything we expect when investing: Shadow markets such as dark pools create private markets, asymmetrical information, unfair advantage, and certainly go against the grain of transparent markets.

Just understanding the basic workings of high-frequency trading and dark pools compels the small investor to question the wisdom of investing in stock-driven mutual funds and 401k programs when the cards are severely stacked against the small investor. It also raises serious questions about the recently renewed drive to privatize Social Security.

Sadly, high-frequency trading and dark pools may never be banned, as these two-edged swords have proven useful to banks, large investors and governments in manipulating stock markets during selloffs and rallies.