naked capitalism

One of the primary lessons we are learning from the current financial debacle is that the lack of transparency in the OTC derivatives markets is one of the big reasons for the complete breakdown of those markets. Furthermore, the lack of appropriate oversight into those markets allowed problems to fester rather than being noticed and dealt with sooner.

I, along with others in the blogosphere and the MSM have called for greater regulation of these OTC markets as a means to prevent the disasters that have befallen such instruments as CDOs, CDSes, ABSes, etc. While the exact type of regulations required is certainly being fiercely debated, President Bush, Secretary Paulson, Fed chief Bernanke, and indeed, even many Wall Street heads have all admitted the need for more regulation and oversight of some type.

Well, some lessons are never learned. Just as the nation’s policy makers are discussing how to bring new and unwieldy instruments such as credit derivatives under appropriate regulation, a consortium of investment banks has proposed creating a private market for plain equities, a market which does not currently seem to be suffering from its current regulatory apparatus.

Behold, Project Turquoise (Hat tip Mara for mentioning it in the comments):

Project Turquoise, the share trading system backed by a group of the world’s largest investment banks, will allow transactions both on-exchange as well as in “dark liquidity” pools, where firms offer to buy and sell large blocks of shares away from public sight.

Speaking at an Exchange Forum conference in London, Phillip Hylander, co-head of European equities at Goldman Sachs (NYSE:GS) , set out for the first time the broad outlines of the business model that has promised to bring more competition to European share trading.

“Turquoise is to be a hybrid that will incorporate a public order book and a non-public order book,” Mr Hylander told the conference. “Turquoise will be an aggregator of ‘dark pools’.”

Project Turquoise was apparently initially dreamed up as an alternate stock exchange that would compete with European exchanges such as the LSE, thus leading to lower trade commisions. This would have been a welcome development. However, in addition to its public exchange facilities, Project Turquoise now aims to enable private placements of large lots of stock without the need for public disclosure of those trades as would be required if they were executed on a public exchange. While firms engaging in such trades may view such disclosure requirements as “burdensome regulation”, it’s that disclosure that forms the basis for policing against such illegal practices as pump-and-dump and insider trading, while ensuring that for any given time, there is only one best bid and offer which is freely available to anyone who wants it.

Furthermore, it’s precisely those types of private deals that contributed to the current collapse of OTC markets by hindering the normal market processes of price discovery and aggregation of liquidity.

These “dark liquidity” pools are already casting a long shadow on the traditionally open American equities market. According to Reuters last year:

Top IPO underwriter Goldman Sachs Group Inc. (GS.N: Quote, Profile, Research, Stock Buzz) this week launched a platform allowing an exclusive club of big investors to trade unregistered, privately placed securities, in the latest challenge to U.S. equity markets.

Private placements have become a big deal on Wall Street, another alternative for companies who want to raise capital but don’t want the regulatory and disclosure requirements that come with a public listing.

. . .

Last year [2006], according to Nasdaq, $162 billion of capital was raised through unregistered private placements compared with $154 billion through IPOs, which are registered with the Securities and Exchange Commission.

. . .

Under SEC rules, companies can sell securities without registering them as long as issues are limited to qualified institutional buyers, investors with at least $100 million of assets, and there are no more than 499 stockholders.

By easing the ability to trade through essentially unregulated and unreportable pools of money, Goldman Sachs and the rest of the i-banks are weakening the public equity markets that have served as the foundation for much of the world’s financial systems. While I’m all for creating new exchanges to allow competition to lower trading costs, and I’m all for bringing in new sources of liquidity to fund investments, doing so without the safeguards of public disclosure and oversight is a prescription for disaster. A disaster that we’re already seeing unfold in other markets.

So is Project Turquoise the bearer of doom and destruction to public equity markets? Conversely, will it strengthen equities markets by bringing in new sources of liquidity? Or is it really nothing more than a way to lower trading costs through competition? We’ll know soon. Project Turquoise is scheduled to start trading this month…