June 30 (Bloomberg) -- While money managers don’t always like what happens in the $23 trillion U.S. stock market, they’re too fond of dark pools to let them go extinct, according to a professor whose research was presented to the Senate.
“Dark pools have existed forever,” Robert Battalio of the University of Notre Dame said in a phone interview last week. “You can shut down these dark pools and just new forms will arise somewhere else.”
Brokers and mutual funds disconnected last week from one of the private trading platforms, owned by Barclays Plc, after New York’s attorney general said the London-based bank lied to customers and masked high-frequency traders in its LX dark pool. The migration doesn’t mean dozens of others aren’t providing a useful service to investors reluctant to use public exchanges, Battalio said.
“There are bad dentists out there, there are bad store clerks, so you’ve got to separate the structure from the bad apple,” Battalio said. “Order flow will always have multiple venues to execute on -- upstairs markets -- because one size doesn’t fit all.”
New York Attorney General Eric Schneiderman’s probe into stock trading practices led to a complaint against Barclays that alleged the London-based bank hoarded trades at the expense of brokerage clients who may have gotten better deals on other venues. Schneiderman alleged a pattern of “fraud and deceit” starting in 2011 in which Barclays assured investors they were protected while aiding predatory tactics.
The best way for investors to avoid mistreatment is to analyze the performance of their brokers to make sure they’re getting a fair shake, Battalio said.
“That’s what we would argue needs to happen,” he said. “The buy-side’s become empowered, and they’re doing a much more vigilant job of watching.”
Battalio told a U.S. Senate hearing on June 17 that his research found brokers favor their own needs over customers’, often sending stock orders to exchanges that pay the most. The system of public exchanges paying traders for some orders, known as maker-taker, was criticized by lawmakers at the hearing, held to examine conflicts of interest in the market.
By sending clients requests to buy or sell shares to markets that pay the most, rather than those offering the best price, brokers get a bad deal for their customers, Battalio said in his testimony. He called on the government to consider forcing more transparency of market data and broker incentives.
Dark pools and other forms of off-exchange dealing account for almost 40 percent of U.S. equity volume. Detractors point to a lack of transparency, saying it’s impossible to know whether investors are treated fairly on the systems, an argument supported by Schneiderman’s revelations. Defenders of the platforms say they help large investors trade big blocks of shares in private, minimizing their impact on prices.
In a paper published in April, BlackRock Inc., the world’s largest asset manager, said dark pools are an “invaluable execution tool” for large orders and stocks that may be more difficult to trade because of wide spreads or low liquidity. Dark pools should be required to provide more information, such as how they prioritize orders and fees, the firm said.
Investors are exerting more control over where their trades get sent following Schneiderman’s suit, said Niamh Alexander, an analyst at Keefe, Bruyette & Woods in New York.
“We don’t know that this was the case everywhere else, but naturally people in the industry are cautious, and they’re going to ask the question of their brokers,” Alexander said in a phone interview. “Clients already are being a lot more cautious and careful and asking more questions about where their order flow is going, exactly where it’s been executed, how it’s been executed.”
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