Cracks Open in Dark Pool Defense With Barclays LawsuitSam Mamudi and Doni Bloomfield
Last October, managers told an employee in Barclays Plc’s trading unit to keep from clients a report showing the bank routed most of their dark pool orders to itself, according to the New York attorney general.
He refused, Eric Schneiderman said, and was fired the next day.
The state’s top law-enforcement official released the account, which he said he got from the former Barclays senior director, in a 30-page document that portrayed the London-based bank as bilking its own customers to expand its dark pool. Schneiderman cited a pattern of “fraud and deceit” starting in 2011 in which Barclays hoarded orders for stocks and assured investors they were protected from high-frequency firms while simultaneously aiding predatory tactics.
“The behavior described in this complaint would put a bank’s financial interest in marketing its dark pool and profiting by providing access to predatory high-speed traders ahead of the interests of investors,” Senator Carl Levin, the Michigan Democrat who leads the Permanent Subcommittee on Investigations, said in a statement. “Action is needed to end conflicts of interest in the U.S. stock market.”
Barclays declined as much as 5.6 percent in London trading and was down to 217.9 pence at 1:25 p.m. The stock is at its lowest price since November 2012.
Barclays LX is the second-largest U.S. dark pool, trailing only Credit Suisse Group AG’s Crossfinder, according to data from the Financial Industry Regulatory Authority. Along with misrepresenting who traded there, the bank sent too many orders to its own venue, according to the complaint.
In a statement, Mark Lane, a spokesman for Barclays, said: “We take these allegations very seriously. Barclays has been cooperating with the New York Attorney General and the SEC and has been examining this matter internally. The integrity of the markets is a top priority of Barclays.”
Scrutiny from law-enforcement authorities is increasing as concern grows that America’s fragmented and computerized market structure enriches professional traders at the expense of individuals. U.S. Securities and Exchange Commission Chairman Mary Jo White proposed changes to the market this month, and the regulator this week announced it wants to test a curb on dark pool trading. Last week, Levin’s panel held hearings focused on where brokers send their customers’ orders.
Schneiderman’s case is the boldest initiative and may open fissures in the decade-old defense of U.S. equity markets that has been championed by brokerages and traders. In their version of the story, dark pools serve as havens for institutional investors tired of seeing orders to buy and sell stocks front-run on public exchanges. According to Schneiderman, institutions may not have been much safer on Barclays’ platform.
“We are talking about pension fund money,” Schneiderman said on CNBC today. “The average citizen who wants to be in the market is trading through large institutional investors, and we found specifically that there was fraud committed against large institutional investors.”
Part of the selling point of dark pools is that by keeping orders to transact securities private, they are less likely to be prowled by speed traders looking to beat investors who are slower to react to new information. Barclays, according to Schneiderman, sought further to soothe money managers by saying high-frequency firms were policed on its platform. Allegations that they weren’t could cause mutual funds and other big investors to wonder if any corner of the market is safe.
“This is obviously a breach of confidence, a breach of trust,” said Joe Saluzzi, co-head of equity trading at Themis Trading LLC in Chatham, New Jersey. “It’s pretty obvious at this point that the SEC needs to come in, it needs to know what’s going on actually inside these boxes. Barclays -- are they the only ones? We don’t know. I don’t know.”
Barclays was so bent on lifting its private trading venue to the upper ranks of Wall Street dark pools that it falsified marketing materials to hide how much high-frequency traders were buying and selling, the complaint said.
Seeking to reassure customers that their stock orders wouldn’t be picked off by predatory counterparts, Barclays touted a system designed to keep that from happening called liquidity profiling, according to the complaint. Marketing material including charts purported to show that very little of the trading within the dark pool was “aggressive” and that operating there was safe for institutions.
“The representations were false,” according to the complaint. The chart and accompanying statements obscured the trading taking place in Barclays’ dark pool. Senior Barclays personnel de-emphasized the presence of high-frequency traders and left out reference to one of the largest and most toxic participants, it said.
“Internally, Barclays acknowledged that it was ‘taking liberties’ with the truth by suppressing the disclosure of this high frequency trading firm, but decided to falsify the analysis in order to ‘help ourselves,’” according to the complaint.
Expanding its dark pool to one of the biggest in the country “was a principal goal” of Barclays’ electronic trading division in its quest to drive profits, according to the complaint. Attracting orders was important to building market share, reducing commissions paid to other venues and increasing fees collected from firms using the venue, it said.
Yesterday’s action may force other regulators to act more decisively, according to Todd Cipperman, a lawyer who consults on compliance with securities regulations. In a June 5 speech, SEC Chair White said dark pool owners would have to provide the regulator with their rules for matching buyers and sellers. She may have to do more than that now, he said.
“It’s hard for the SEC to sit back and say, ‘Well, nothing’s wrong’ when the state attorney general has already brought some kind of lawsuit,” said Cipperman, the managing principal of Cipperman Compliance Services LLC in Wayne, Pennsylvania, and former general counsel at SEI Investment Co.
Schneiderman’s action is reminiscent of cases brought by Eliot Spitzer, Cipperman said. As New York attorney general from 1999 to 2006, Spitzer invoked state laws to prosecute abuses in industries that other regulators may have missed.
“I was at SEI when Eliot Spitzer was engaging in his prosecutions, and it put a lot of pressure on firms, and people wanted to settle, wanted to settle quickly and get out of there,” he said. “You’re going to see a lot of that here.”
Spitzer exposed conflicts of interest at investment banks whose stock analysts ridiculed companies in private while publicly recommending them to help win business. That helped spur Wall Street firms to agree to reorganize their research departments.
In yesterday’s complaint, filed in New York state Supreme Court in Manhattan, Schneiderman describes how closely Barclays worked with high-frequency trading firms even as it was telling other clients that its dark pool was a haven. The document quotes one former senior director saying the bank “was doing deals left and right with high-frequency firms to invite them into the pool to be trading partners for the buy side,” referring to long-term investors such as mutual funds.
Barclays “would invite the high frequency firms in,” the former employee said, according to the suit. “They would trade with the buy side. The buy side would pay the commissions. The high frequency firms would pay basically nothing. They would make their money off of manipulating the price.”
Barclays made money from the fees longer-term investors paid, said the former director.
“And the buy side would totally be taken advantage of because they got stuck with the bad trade,” he said, according to the complaint. “This happened over and over again.”
Barclays shared information with speed traders, contradicting what it said publicly, Schneiderman alleged. For example, even though marketing materials said aggressive traders made up 6 percent of its dark pool’s activity, one high-frequency firm concluded Barclays venue was “50 percent good, 50 percent aggressive,” the complaint said.
Barclays shared “detailed, sensitive information” with high-frequency firms -- including details of trades by various types of investors, according to the complaint. Notwithstanding its marketing, Barclays didn’t police its dark pool to get rid of predators, it said.
Schneiderman said that Barclays processed market data in the dark pool “so slowly as to allow latency arbitrage,” which is when speed traders at a venue with slower pricing data take advantage of other participants thanks to direct feeds from stock exchanges.
Internal documents from the bank show that Barclays believed the value of growing LX into a leading dark pool would be between $37 million and $50 million a year, according to the complaint.
Schneiderman quoted a former senior Barclays director as saying that the dark pool’s design and contrasting marketing claims were akin to “building a car and saying it has an airbag and there is no airbag or brakes.”