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Dark Pools & Lit Pools: A Financial Morality Tale?

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AP

Welcome to the light.

Credit Suisse has launched a new "lit pool"—in contrast with the "dark pools"—which are periodically vilified for their absence of transparency.

Here's the thumbnail summary.

Exchanges provide price transparency to buyers and sellers.

If buyers and sellers have the ability to view the open bid/ask data in a limit order book, they can get a sense of market depth—as opposed to merely looking at the historical prices at which a given security has traded. In an exchange traded scenario, traders are able to see the price and quantity at which other traders are willing to buy and sell.

By way of contrast, in a dark pool prices are only printed after an order is executed. This significantly reduces the transparency of the transactions in a dark pool.

Why would anyone want to do business without price transparency, you might ask?

The answer is that high-frequency traders—using sophisticated algorithms and computers that are co-located near the exchanges for better execution speed—are able to step in front of a trade and profit from the information contained in the order book.

In short, the price transparency is used against long-term investors—especially institutional investors, who trade in large blocks. (This is because large block trades are particularly vulnerable to the kind of opportunistic practices discussed above, because as far as is large volume of the trade telegraphs the direction market will be moving in.)

Credit Suisse is implementing a new ECN that seeks to provide the advantages of price transparency without the downside of having your pocket picked.

In the new lit pool, trades will get executed with the transparency of an exchange.

But Credit Suisse will ban "opportunistic traders" from directly accessing their new ECN.

The opportunistic traders, of course, are the high-frequency players discussed earlier.

High-frequency traders will only be able to access the Credit Suisse network indirectly, through other intermediaries.

Forcing high-frequency traders to place orders through a third-party eliminates the structural advantages they now enjoy the marketplace, through using cutting-edge hardware, sophisticated algorithms, and prime location.

The Credit Suisse plan appears to be a very good solution: I wonder what I'm missing?

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