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Dark pools and SAC Capital

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In their investigation of high-flying hedge fund SAC Capital, financial regulators have revealed an embarrassing hole in their armor that will have a profound impact on the industry as whole. They remain years away from being able to peer clearly into dark pools where many investment firms do their actual trading.

Federal prosecutors have had Stephen Cohen, the founder and owner of one of the largest hedge funds and one of the richest men in America, in their sights for the past few months. So far, five former SAC employees have been accused of insider trading at SAC, of which four have pleaded guilty. (Cohen has not been charged with any crimes.)

According to news reports, the complaint revealed how dark pools allowed Cohen's hedge fund to trade millions of shares and hundreds of millions of dollars of stock virtually undetected.

In the complaint against one of the accused, investigators cite an e-mail 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 stock.

As CNBC reports:

"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."

It continues, noting that,"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."

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