Don’t fear the dark side

Much coverage of recent innovations in the financial markets seems to have a simple message: “beware of the dark side”. Like some bizarre offshoot from the Star Wars franchise it evokes a dimly lit world inhabited by a new, dangerous species.

First, there are the “dark pools”. These are private trading venues, typically housed inside big investment banks, which match buyers and sellers anonymously. Only after trades are made is the identity of institutional investors who use these entities revealed. For such investors the advantage is they can trade large blocks of shares without moving the market.

Clearly the term “dark pools” can itself, whether rightly or wrongly, be taken to imply something underhand is going on. There are certainly suspicions on the part of the authorities. For instance, in June New York state’s attorney general filed a complaint against Barclays for alleged fraud and deceit in its dark pool. In response Barclays has asked a court to dismiss the complaint arguing in a memorandum that it “fails to identify any fraud” or establish any “actual harm”.

This brings us to the new alien species in the franchise: the high frequency traders. These are individuals who use computer algorithms to make markets. Such players often attempt to “trade ahead” of the market by buying available shares before investors. A tiny fraction of a second later they then sell the shares at a slightly higher price.

Michael Lewis, one of America’s leading financial writers, claimed in his book Flash Boys that such traders have in effect rigged the market against the interests of ordinary investors. High frequency traders counter that they are reducing trading costs by using computers rather than overpriced humans. Such traders contend that it is the mainstream asset management firms that charge excessively for their services.

Finally, there are shadow banks. These are institutions that act like banks, in that they play a role in the provision of credit, but are technically not banks. For example, money market mutual funds can act in this way. Yet shadow banks are not subject to the tight rules that regulate the banking industry.

Concern about the dangers of shadow banking is widespread. For example, Mark Carney, the governor of the Bank of England, has argued in the Financial Times that they played a central role in the financial crisis. Many others have claimed that the burgeoning shadow banking sector in China threatens global financial stability.

What all the critics have in common is that they look to what they see as the dark side of finance as a key source of instability bedeviling markets and the economy beyond. They fail to understand that if companies fail to use capital for productive investment it tends to flood the financial markets.

The kneejerk demands for ever-more rules provide no solution. Indeed the tighter regulation of banks helped supply the impetus for the rise of shadow banking. As long as high levels of surplus liquidity are circulating around the economy it will find its way into the markets.

The solution is not to shine light on the supposed ”dark side”. Instead it is to find ways to encourage firms to harness capital productively in the real economy.

This blog post was first published today on Fundweb.