Category: Research

“Dark Pools” can improve price discovery in open exchanges

When big investors want to execute trades but fear the size of the transaction could move the market, they often go to dark pools—alternative trading systems where orders are not publicly displayed. These opaque trading venues, now accounting for about 12 percent of equity trading volume in the United States, have sparked concern among regulators and in the financial press. With so many transactions occurring out of public view, critics warn that price discovery, the accurate determination of asset prices, will become more difficult.

Professor Haoxiang Zhu

But despite their sinister sounding name, dark pools can actually improve price discovery in open exchanges, I have found in my research, “Do dark pools harm price discovery?” Open a dark pool alongside a ‘lit’ pool, such as the New York Stock Exchange or Nasdaq, where orders are visible to all, and pricing can become more accurate on the open exchange.

To understand why this happens, it helps to consider investors to be divided loosely into two groups: informed and uninformed. Informed investors examine balance sheets, study analyst reports, read company press releases, and use advanced technology to monitor the market. When informed investors decide to execute a trade, they hope to profit from the information they gathered–and quickly.

Uninformed investors trade mainly for liquidity reasons. They may need to get cash to meet an obligation, or they may have cash they need to invest. They want to make their transaction regardless of a company’s fundamentals.

A dark pool presents different execution risks to informed and uninformed investors. This risk arises because a dark pool relies on matching, rather market makers, to execute trades. For example, if a dark pool has 300 shares to buy and 200 shares to sell, then only two thirds of each buy order is executed. Failure of execution is costly. (On an open exchange, those extra 100 shares to buy would be executed by market makers or liquidity providers). Informed investors have a high execution risk in the dark pool because they tend to trade in the same direction. Uninformed traders have a lower execution risk because their orders tend to be balanced on either side of the market.

This difference in execution risk tends to drive a greater proportion of informed investors to the open exchange and a larger share of uninformed investors to the dark pool. Having more informed investors trading on an exchange improves price discovery in the exchange and yield more accurate asset prices—precisely the opposite of what critics of dark pools fear.

While having non-displayed orders can help price discovery, dark pools are opaque in other, potentially harmful, ways. For example, dark pools typically do not disclose how they operate, and investors and the public often don’t know how the venues set execution prices or process orders. Increased oversight and closer scrutiny of dark pools could well be a very good thing for financial markets. But not displaying orders in itself needs not threaten price discovery in transparent venues. Instead, it could help.

Haoxiang  Zhu is Assistant Professor of Finance at the MIT Sloan School of Management

What is the true cost of government-backed credit?

The U.S. government is arguably the largest financial institution in the world. If you add the outstanding stock of government loans, loan guarantees, pension insurance, deposit insurance and the guarantees made by federal entities such as Fannie Mae and Freddie Mac, you get to about $18 trillion of government-backed credit. Through those activities, the government has a first-order effect on the allocation of capital and risk in the economy.

Professor Deborah Lucas

The question of what those commitments cost the public is important; accurate cost assessments are necessary for informed decisions by policymakers, effective program management, and meaningful public oversight.  My research and that of others has shown that if one takes a financial economics approach to answering that question — one that is consistent with the methods used by private financial institutions to evaluate such costs — it leads to significantly higher estimates than the approach currently used by the federal government.

At the core of the problem are the rules for government accounting, which by law require that costs for most federal credit programs be estimated using a government borrowing rate for discounting expected cash flows, regardless of the riskiness of those cash flows. That practice systematically understates the cost to the government because it neglects the full cost of risk to taxpayers, who are effectively equity holders in the government’s risky loans and guarantees.

An alternative approach to cost estimation — a fair value approach based on market prices — would fully take into account the cost of risk. Fully accounting for the cost of risk makes a significant difference:  An estimate of the official budgetary cost of credit programs in 2013 shows them as generating savings for the government of $45 billion, whereas a fair value estimate suggests the programs will cost the government about $12 billion.

The understatement of cost has important practical consequences. For example, it may favor expanding student loans over Pell grants because student loans appear to make money for the government. It also creates the opportunity for “budgetary arbitrage,” whereby the government can buy loans at market prices and book a profit that reduces the reported budget deficit, as it did in several instances during the recent financial crisis.

That perspective on how credit program costs should be measured is widely shared by financial economists, although until recently the issue has not received much attention by academics. That changed last month when the Financial Economists Roundtable (FER), of which I am a member, issued a statement on this matter, writing: “The apparent cost advantage of government credit assistance over private lenders is, in the opinion of the FER, primarily due to [government] accounting rules, rather than to any inherent economic advantage of the government.”

According to the FER’s statement, the solution to this undervaluation is to amend current accounting rules to require an approach to cost estimation that fully recognizes the cost of risk in the government’s credit programs. The group maintains (and I agree) that such a change “would make the true budgetary implications of credit assistance more transparent to program administrators, policy makers and the public.”

Prof. Deborah Lucas is the author of “Valuation of Government Policies and Projects.” She previously served as assistant director and chief economist at the Congressional Budget Office. 

Risk, price, and catastrophe

At inaugural Sussman lecture, former Goldman risk manager calls for global agreement on emissions tax

A collaborative global decision on carbon dioxide emissions pricing must be made soon, or the risk of a catastrophic incident linked to the warming of the earth will rise.

That is the word from Robert Litterman, chairman of the risk committee at Kepos Capital. Litterman, who recently retired from a 23-year career in risk management at Goldman Sachs Group, Inc., gave his warning—and his prescription—in a public lecture at MIT Sloan Sept. 20.

Litterman is the inaugural recipient of the S. Donald Sussman Award, presented to individuals or groups who best exemplify the career of Donald Sussman, a successful investor in quantitative investment strategies and models. Recipients receive a $100,000 cash prize and share their insights on quantitative finance and the financial industry in public lectures at MIT Sloan.

Robert Litterman delivers lecture at MIT Sloan

Litterman called the Earth’s atmosphere a reservoir, one that fossil fuel emissions are filling toward an unknown overflow point. That overflow is disaster, and he recalled the devastating Johnstown Flood of 1889 as a metaphor for risk, catastrophe, and responsibility.

Governments must recognize the inherent risk in emissions, determine the cost of that risk to society and price that risk accordingly, Litterman said.

“To this day, governments are not pricing climate risk appropriately, and elected officials should be held strictly accountable for this failure,” he said.

“By some irrational convolution of logic, the…United States government fails to recognize that if $20 [per metric ton of carbon dioxide] is the appropriate credit for reducing emissions, then $20 is also the appropriate tax for those creating those same carbon dioxide emissions,” he said. “And although it now recognizes the cost of emissions in regulatory policy, through tax policy the U.S. government continues to incentivize our economy to fill the atmosphere with emissions.”

But even as scientists and environmental advocates warn of the potential danger, no single country will volunteer to lead the way on pricing carbon emissions, Litterman said. He argued for a global agreement to set an admissions price based on science and economics, and free from political motivation. A common atmosphere, he said, requires a common price.

Taxing emissions is not regulation, he argued. He appealed instead to a free market philosophy that recognizes increasing risk should come with a price. Once that price is set, he said, governments should get out of the way.

Litterman is also a board member at the World Wildlife Fund. That organization and a group of economists—including five Nobel Memorial Prize winners, two MIT economists, and MIT Sloan Dean Emeritus Richard Schmalensee—are urging the U.S. government to participate in setting a global price on carbon dioxide emissions in aviation.

Meanwhile, society moves forward with blinders on, he said, with no idea of when, where, or how a catastrophe might occur. Any delay in setting an emissions price will inevitably mean a higher price, should one ever be set, he said.

“Human society has not slammed on the brake,” he said. “It is not braking at all. The government foot is still pressing hard on the fossil fuel accelerator.”