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Gazing Into 'Dark Pools,' the Tool that Enables Anonymous Insider Trading

Steven A. Cohen, Founder and CEO of SAC Capital.
Rhonda Churchill | Bloomberg | Getty Images
Steven A. Cohen, Founder and CEO of SAC Capital.

While federal authorities aggressively pursue individual insider stock trading cases — including an ongoing investigation of Wall Street titan Steven A. Cohen's SAC Capital hedge fund — financial regulators remain years away from being able to peer into "dark pools," the high-tech mechanism that insiders use to conduct secret, advantageous transactions.

Federal prosecutors have been circling Cohen, 56, the founder and owner of one of the largest and most profitable U.S. hedge funds and one of the richest men in America, since at least late last year, when an indictment was unsealed against former SAC employee Mathew Martoma. He was the fifth SAC employee accused of insider trading while at the firm; four others have pleaded guilty.

The complaint, which alleges that Martoma used inside information about a clinical drug trial to help SAC earn profits and avoid losses of $276 million in 2008, indicates that Martoma told Cohen about the results of the trial. SAC then sold stock in the Elan company and purchased options, a calculated and well-informed gamble that the stock would plummet once the news was announced, according to the complaint.

Martoma, 38, pleaded not guilty to insider trading charges this month. His lawyer said he expects his client to be "fully exonerated."

Cohen has not been charged with any crimes. A spokesman for Cohen said, "The firm and Steve Cohen are confident he acted appropriately."

The complaint also offered a look at how "dark pools" allowed Cohen's firm to trade millions of shares and hundreds of millions of dollars of stock virtually undetected.

Dark pools are essentially private stock exchanges reserved for the largest traders, including hedge funds, major institutional funds, pension funds, and big banks. The pools use computers to match buyers and sellers of a particular stock, drawing pricing data from public stock exchanges like the New York Stock Exchange or NASDAQ.

While all exchanges have a degree of anonymity, dark pools have an increased level of secrecy because neither the size of the trade nor the identity of the participants are revealed until a trade is filled. It's like the childhood pool game of "Marco Polo," except all the players are blindfolded rather than just one. As a result, there is no way of knowing if just one broker, one trader or one firm doing all the buying or selling.

That means institutions trying to unravel or rapidly accumulate large positions in a company can avoid the large increases or decreases that often occur when a major trader begins acquiring or dumping a stock. Essentially, without knowing who is doing the buying or selling, other investors can't recognize a sudden large increase in supply or demand, experts on the pools tell NBC News.

In the complaint against Martoma, investigators cite an email from a "senior trader" at SAC Capital explaining how trading in dark pools and using algorithms enabled the company to avoid detection, and potential losses on its sale of Elan stock:

"This process clearly stopped leakage of info from either in (or) outside the firm and in my viewpoint clearly saved us some slippage," it said.

The secret trades are perfectly legal. Only if they are coupled with inside information and used to give buyers or sellers an improper advantage do they cross the line.

Investors who have filed a class-action lawsuit against Cohen and SAC Capital say that's exactly what happened with the trades in the Elan pharmaceutical company initiated by Martoma. They allege that they were at a distinct disadvantage as SAC profited from insider knowledge.

"I had a million dollar home, now I'm in a manufactured home," said one of the plaintiffs, Howard Kreier of North Carolina. Today, he said, he's ashamed to talk to his friends who also bought the Elan stock on his recommendation and lost big too.

What surprises many investors is that the Securities and Exchange Commission, the regulator of the dark pool exchanges, also is in the dark, with no way of quickly determining who is trading what, according to its website. Only through historical forensic analysis of trades — and sometimes by subpoenaing trading records — can the SEC find suspicious patterns indicative of insider trading.

The regulatory agency is putting together a system, called the Consolidated Audit Trail (CAT), capable of tracking trades in near-real time. But that is at least three years away according to the bid schedule. It is unknown if such a system could have detected the huge moves by SAC Capital in July 2008.

The SEC declined requests for comment from NBC News, but pointed to the agency's website for the information on CAT as well as the SEC's charter, which requires it to "protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation."

That mandate puts the agency in the difficult position, observers note, because it has to encourage innovation — such as the use of dark pools — while simultaneously protecting investors from being at a disadvantage as a result of such systems.

Insider trading by all hedge funds has been under scrutiny since August 2009, when Preet Bharara took over for the U.S. Attorney's Office for the Southern District of New York.

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Since then, 76 people have been charged with the illegal act of buying and selling stock based on information from insiders, with 71 convicted, according to the U.S. Attorney 's Office.

While the toll of insider trading is difficult to establish, plaintiffs in the class-action lawsuit against Cohen and SAC say their case shows that the practice punished both ordinary investors and other institutions that aren't in the know.

In going after Cohen and SAC, they are targeting one of Wall Street's savviest traders.

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Cohen is worth nearly $9 billion, according to published reports. Despite his massive art collection, 36,000 square foot home, and enormous wealth Cohen maintains a relatively low profile, rarely granting interviews.

"In speaking to Steve Cohen you wouldn't necessarily know that he has one of the greatest track records as an investor over the last 15 or 20 years and that he's one of the richest men in the country, said CNBC's David Faber, "He's fairly understated, he's far from a recluse, he has plenty of friends and is extraordinarily competitive."

But Kreier, one of the plaintiffs in the lawsuit, said he has no compunctions about going after such a prominent player, given the high price he paid for his investment in Elan. Because he had no idea SAC Capital was dumping hundreds of millions of dollars of stock and even short-selling Elan through the dark pools, he said his confidence in the stock market is shot.

"You don't stand a chance," he said. "You buy a stock, you're better off buying a lottery ticket."

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