Accepting (Market) Failure

By Dylan Dellisanti ’14

This weekend’s Wall Street Journal featured an article by contributor, Scott Patterson, on “dark pools,” which are trading venues where investors are not required to post information on trades to the public. Moreover, dark pools are not subject to the same Securities and Exchange Commission (SEC) regulations that their counterpart stock exchanges are subject to. These characteristics make dark pools a risky place to invest and the Financial Industry Regulatory Authority (FINRA), a private version of the SEC, is taking steps to acquire more information about exchanges in dark pools so as to better regulate the sector. While dark pools might seem like the next big boogey man in the financial industry, their threat, and their potential to fail, should not be something to fear.

Dark pools are a classic case of the lemons problem, an idea articulated by Nobel-laureate economist George Akerloff. When sellers possess a significant degree more information about their product than the buyer, buyers will tend to lower the price at which they are willing to purchase the product. Uncertainty makes for timid buyers who won’t want to pay too high a price for a product whose quality they cannot readily discern. Recognizing that consumers will not want to pay high prices, sellers will tend to stock only low quality items since they can only acquire but so high a price. This process repeats itself until the market fails: consumers keep lowering their price expecting worse products, and sellers keep providing low-quality products in response to lower prices.

The classic example of the lemons problem is the used car market, where sellers possess a great deal of information about the history of the cars they sell, but buyers possess very little information. However, a quick look out the window reveals that the used car market does, indeed, exist. What mechanism saves the used car market from failure? Often, reputational mechanisms do. A used car dealer who habitually sells poor products might see his profits diminish as he loses customer satisfaction with his poor products. An even more effective reputational mechanism is the website carfax.com. Carfax allows consumers to see the history of used cars on the market, thus mitigating significantly the asymmetric information problem.

Dark pools are another example of the lemons problem. As the Wall Street Journal article says, dark pools are controversial because “most users, as well as regulators, don’t know what is taking place.” Investors don’t have access to information about trades and are taking a large gamble when investing in dark pools. However, dark pools have also seen increased activity in recent years as they now handle one in seven stock trades according to the Journal.

There are two likely reasons for this rise in the use of dark pools. The first goes back to the lesson on reputational mechanisms. Financial institutions will subject themselves to regulation from private regulator FINRA precisely because FINRA gives the institution credibility. The Journal article cites letters that FINRA sent to 15 dark-pool operators requesting more disclosure on exchanges, the information customers have, and how the operators’ trading systems function. Most of the letters have been returned, and with good reason: Dark pool operators recognize that to get more business they will need to mitigate the imbalance in information between them and the investor. When investors have more information about dark pools markets and are more confident they will not suffer large losses or be cheated, they will be more likely to invest.

Moreover, investors recognize that dark-pool operators can be, and have been, risky. However, risk is never taken on for risk’s sake. For instance, Felix Baumgartner, the man who skydived from 24 miles above Earth’s surface, didn’t do it simply for the value of the risk, but did it for the exhilaration of the jump and the fame he received for it. The high risk was accompanied by a high profit, which made the venture worthwhile. Likewise, investors in dark pools might recognize that the risks are great, but might also see high profit opportunities that make the ventures worthwhile.

Ultimately, dark pools could be a terrible way to invest one’s money, and there could be very little that reputational mechanisms or a high-risk/high-reward relationship could do to mitigate the problems of dark pools. However, just as profit opportunities are a necessary ingredient for markets to really get cooking, failure is also a necessary ingredient. We do not know ahead of time which business opportunities are worthwhile to pursue, and which are duds. If dark pools tend to fail, then that should be a signal to investors to avoid that particular means of investing. Obviously, there are costs to failure, but it must occur in the market so that more information can be acquired and entrepreneurs can find better means of investing.

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