Some Thoughts On The Shadow Market
The "shadow market" is a broad-based moniker with both positive and negative connotations. It can refer to: the confluence of power between wealthy individuals and sovereign nations, housed in secret jurisdictions and sovereign wealth; dark pools to promote more effective trading; the black market for goods and services, where items can be had on the cheap for anyone willing to pay with much-needed hard currency; and shadow banking, financial intermediaries that are not banks. Here is a basic discussion of each.
Littoral Jurisdictions
Offshore is onshore is offshore. Any region in which an individual does not make as his or her primary residence is considered offshore. The notion of offshore as a distant subequatorial venue, typically an island, is only partially true. Ireland, the United Kingdom and the United States are offshore jurisdictions, as are places such as Jersey and the Cayman Islands. These locations afford individuals and corporations tax havens that enable them to skirt rules and regulations of the jurisdiction where they are domiciled.
While corporations may claim avoidance of double taxation as a legitimate claim to use these jurisdictions, governments could accomplish the same result through tax treaties, yet fail to do so, precisely because the havens themselves do. The result is that corporations often end up paying little, if any, tax. Tax avoidance such as this on a grand scale is considered free riding, as it often deprives the local economy of tax revenue needed to pay for infrastructure, education and other endeavors for the public good. Additionally, tax havens provide potential escape routes for despots looking to hide ill-gotten gains, beyond the reach of law enforcement.
Governmental Brokerage Accounts
A sovereign wealth fund is, effectively, a government-managed investment portfolio funded by foreign exchange reserves earned through exports, or other sources of revenue, and invested in accordance with stated objectives. Seers have looked at such vehicles with approval and suspicion alike: with approval when they acted as saviors to some of the banks brought down by the 2007-2008 financial crisis; and with suspicion when they make large investments in companies with what would appear to be veiled attempts at political influence or market manipulation.
Behavior of these funds is watched closely, given the enormity of the assets they control. Such concerns prompted the formation of the Generally Accepted Principles and Practices (GAPP), also known as the Santiago Principles. These call for clearly-stated objectives, rules of operation, transparency and acting in the fund's best interests. Compliance is voluntary, however, and some funds have adhered to these principles with greater rigor than others.
SEE: An Introduction To Sovereign Wealth Funds
Dark Pools
Dark pools are relatively new alternative trading systems, designed to preserve anonymity and liquidity, provide lower execution costs and minimize market impact. They are most applicable for odd-type orders (e.g., oversized, small and block orders, and illiquid securities), accommodating trading needs outside of conventional systems. Private contract law, rather than stock exchange law, governs transactions in this space. Different types of pools exist to accommodate different types of market participants.
Black Market
A black market in goods and services exists when purchasers and sellers exchange them at a rate that is at significant variance from the normal marketplace. During the Cold War, Eastern Bloc (Warsaw Pact) countries' currencies were soft, i.e., not readily exchangeable at market rates the way that Western governments' were. Starved for hard currency, merchants would exchange a quantity of Hungarian forints or Polish zlotys for far greater amounts of dollars or pounds, based on the economic fundamentals policy decisions driving the hard currency markets.
SEE: Getting Started - What Moves A Currency?
Non-Bank Financial Institutions
Coined by former PIMCO managing director Paul McCulley, the phrase "shadow banking" refers to the body of financial institutions that operate outside of the traditional, regulated banking system. These include non-bank mortgage lenders, money market funds, hedge funds, independent broker-dealers and structured investment vehicles (SIVs or conduits) that invested in illiquid mortgage derivatives, such as Collateralized Debt Obligations (CDOs).
Prior to the 2007-2009 financial crisis, none of these enjoyed safety nets such as lender of last resort (LOLR, read: central bank) or federal deposit insurance. The opacity of their funding sources, abetted by the rating agencies, gave a false impression of their creditworthiness , the true state of which was revealed during the market collapse of 2008.
SEE: The Fall Of The Market In The Fall Of 2008
The Bottom Line
"Shadow," "dark" and "black" all typically connote activities outside of conventional channels. One should take care not to paint all such activities in a negative light. Shadow banking activities are not illegal, but providers' and users' expectations of the economic environment occasioned greater reliance upon them, until many of them unwound with disastrous consequences. Sovereign wealth funds' activities often take place in the public realm and for legitimate purpose. With their size comes economic power on which policymakers need to remain focused for any unwarranted forays into industries and currencies where national interests and national security could be jeopardized. Finally, dark pools afford the potential for more efficient and cost-effective trading. By contrast, some activities, such as secret jurisdictions and black markets, have few positive attributes.
