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Ah the “R” word. Gracing front pages, blogs, shop windows and “75% Off!” flyers everywhere. But what exactly is a recession and what causes one? Unfortunately, the answer to that is a relatively contentious one and different economists will probably tell you different things. One thing is for certain though; recessions are a natural part of the economic life cycle. They have happened before and will certainly happen again.

According to the widespread technical definition, a recession is a period of reduced economic activity, or negative growth, which lasts for at least two quarters. It is usually marked by a rise in unemployment, reductions in retail sales and a slowing of demand for big purchases like houses and cars. Simply put, it is a contraction – a bit like breathing. In order to have life you have to breathe, to expand and contract. In the same way, in order for the economy to have life, money has to expand and contract too. While recessions are clearly unpleasant, they do tend to spring clean and reboot the economy, and this makes for a healthy economic environment over the long run.

A wide variety of things are often linked to recessions, from inflation and interest rate changes, to wars or financial crises. It is thought that the main cause of the recession the world is currently experiencing was kicked off by the “credit crisis” that erupted in 2007 and has still not been stabilized.

Roll back a couple of years and life was good. Business was booming and people were spending; but, it was a false prosperity, as they were spending more than they actually had and borrowing more than they could actually afford.

In early 2007, banks in the US – the world’s largest housing market – found that they were confronting the so-called subprime crisis, due, in part, to their leniency in who they gave credit to. In the line with the old adage, “what goes up must comes down,” after the boom levelled off house prices started to fall. All of a sudden, these bank-owned “assets” were worth far less than the debt borrowed to buy them in the first place – which of course still needed to be repaid – and banks found themselves having to write down huge losses. As these losses mounted they in turn led to frozen banking functions and failing banks, and what followed is the worst financial crisis the world has seen since the 1930s; and it wasn’t long before the crisis spread to the economy and businesses started to fail too.

Understandably, banks suddenly got a lot stricter with who they gave credit to, meaning fewer people could buy houses and prices began to fall even further. The high energy prices which characterized 2007 and early 2008 weren’t helping either, reducing disposable incomes which were already growing smaller as businesses were closing or scaling back. Things were getting expensive, there was a total collapse in confidence and banks had stopped lending to each other, too. Finally, after the US investment bank Lehman Brothers failed in September 2008, the banking system was vulnerable to a total collapse, credit dried up, and the global economy experienced a sudden contraction that was the sharpest downturn for over 75 years. And with that, we found ourselves plunged into a deep recession.

Now, the question on everyone’s minds is when will it all end? According to some UBS economists, the slow climb towards normality could begin towards the end of this year, with a slightly stronger economy being seen midway through next year.

Many now hope that bailouts, government spending, and improvements in the banking industry will eventually cause banks to give out more credit under less strict terms. But ‘eventually’ may take a long time and governments will have to find a solution to the problem of the trillions of dollars of bad assets that banks are sitting on before we can all take a big breath and watch the economy expand once more.

With the markets in their current unpredictable state, hedge funds, in particular, have recently been thrown into the limelight, receiving more publicity than they usually do – most likely a little unsettling for this notoriously secretive bunch. Perhaps that’s why, though we recognize the term, few of us actually know what a hedge fund is or does.

To understand what a hedge fund is, let’s first take a look at what it’s not: a typical mutual fund. While these types of funds can generally only buy and sell stocks and bonds, a hedge fund can do a lot more. They typically have far more freedom when it comes to what they can invest in and how they do it, as the majority remain largely unregulated by any official body – for the moment at least. Investing in a hedge fund, therefore, can lead to a whole lot more money because they can use more varied and aggressive strategies.

The primary aim of most hedge funds is to reduce your investment’s risk and volatility – or the amount of uncertainty about a change in the value of whatever you’re investing in – while attempting to preserve or make money no matter what state the market is in.

There are two basic reasons for investing in a hedge fund: to seek higher returns and/or to seek diversification for your investment portfolio. If you have a wide range of investment options, and one doesn’t work out, at least you have a variety of others, so the impact on your financial return – the amount you make or lose – is somewhat minimized.

It’s for this reason that hedge funds are so lucrative – and yet so secretive. Come up with the winning strategy and you make a lot of money. Let someone figure it out and, by copying you, they’ll cause you to lose your unique selling point to investors, as well as your unique grip on the market.

Last week we announced the expansion of the UBS Price Improvement Network (UBS PIN) to Australia, providing clients there with access to off-exchange, non-displayed – or “dark pool” – liquidity for the first time. It’s a kind of liquidity we’ve already made available in the US, Europe and, most recently, Hong Kong – but what exactly is a “dark pool” anyway?

Essentially, a dark pool is a network of order flow collected together in a single venue for the purpose of crossing orders against each other without a visible quote or order book. Crossing occurs when two orders execute against each other, without a public quotation, off the Exchange. By keeping their order non-displayed, or “dark”, the client has less chance of information leakage and/or market impact, a reaction to visibility that “moves the price” away from you. Though sometimes viewed as controversial because of its rather menacing connotation, “dark” became a popular term for this kind of liquidity since it quickly conveyed the idea that these orders were not visible.

If, instead, you sent that Acme order to a dark pool, your interest in Acme would not have been visible, so your order might have anonymously matched with Acme sell orders at a much lower price.

In markets such as these, saving a fraction of a basis point on your trades over the course of time can mean the difference of millions, or tens of millions of dollars, pounds or euros to large investment managers. The effect on performance can be significant – which in turn has a direct impact on the ability of an investment manager to retain client assets.

Dark pools can be independent structures, an “alternative trading system”, (ATS – the US regulatory structure) or a “multilateral trading facility” (MTF – the European regulatory structure), providing trading executions that occur outside of the local exchange. There are also internal crossing networks that are broker-owned facilities, such as our own UBS PIN or Goldman Sachs SIGMA, which are designed to cross client flow with internal orders.   
  
No matter the structure, though, trading anonymity is what “dark liquidity” is all about. It also explains why dark pool liquidity has become such a key factor in today’s equities environment. By making dark liquidity available to our clients, UBS is assisting them in protecting their orders from market impact, and potentially improving their price performance – which is the cornerstone of best execution.