Market Structure Nightmare Comes True in Barclays Action

For years, brokers and traders have assured anyone who cast aspersions on America’s electronic stock market that the concerns don’t add up. Then came Eric Schneiderman.

New York’s attorney general has spent a year digging for dirt on two of the main features of modern market structure, dark pools and high-frequency trading. This week, he hit a vein with a 30-page complaint against Barclays Plc.

Schneiderman’s suit against the British bank alleged Barclays executives lied to customers while secretly cozying up to high-frequency firms. In doing so, he emboldened those who contend the private venues are havens for bad actors taking advantage of mutual and pension funds. The action provided ammunition to those who say the stock market’s opaque structure mainly serves insiders.

“Lots of people have suspected this kind of thing was going on, that some people had a leg up and others didn’t,” Marshall Front, chief investment officer at Chicago-based Front Barnett Associates LLC, said by phone. “The extent we’re able to air it, it is a positive, but not necessarily over the short term. I think it raises uncertainty.”

Consequences for Barclays worsened yesterday as money managers and brokers shunned the the LX dark pool, its stock fell more than 6 percent and the bank’s chief executive officer pledged an urgent inquiry. Deutsche Bank AG, Royal Bank of Canada, Sanford C. Bernstein & Co. and Investment Technology Group Inc. were among brokerages that disconnected from the platform after hearing Schneiderman’s allegations.

Fraud, Deceit

The account by state’s top law-enforcement official portrayed London-based Barclays as deceiving its own customers to expand the dark pool, one of dozens of private venues in the U.S. where investors buy and sell stocks anonymously. Schneiderman cited a pattern of “fraud and deceit” starting in 2011 in which Barclays hoarded orders for stocks and assured investors they were protected while aiding predatory tactics.

“These are serious charges that allege a grave failure to live up to our values and to the culture at Barclays which we are trying to create,” CEO Anthony Jenkins said in a memo to employees yesterday. “If there has been wrongdoing we will address it quickly and decisively.”

Among the claims was that the firm misrepresented the amount of “toxic” trading in the pool, that it removed evidence of its largest high-frequency customer from a presentation, and that executives pressed a senior director to withhold data that suggested it favored itself over its clients. The losers, he said, were American investors.

Pension Money

“We are talking about pension fund money,” Schneiderman said on CNBC yesterday. “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.”

Private trading venues such as dark pools made up 37 percent of total U.S. equity volume this year, according to data compiled by Bloomberg. The degree of off-exchange trading has drawn rebukes from both Nasdaq OMX Group Inc. and Intercontinental Exchange Inc.’s New York Stock Exchange, who say it hurts the market’s ability to price companies.

They haven’t been alone in their protests. Michael Lewis’s “Flash Boys” painted a portrait of markets rigged by insiders with advanced computers. In an April interview with Bloomberg Television, Lewis reiterated that the deck is stacked against individuals, though not just by trading firms.

Blaming high-frequency traders is “like blaming the lion for eating the antelope,” Lewis said. “They are wired that way. The system is screwed up.”

Worst Fears

Lewis’s book and Schneiderman’s complaint have the potential to confirm people’s worst fears, Randy Frederick, Austin, Texas-based managing director of trading and derivatives at Charles Schwab Corp., said in a phone interview. The firm oversees about $2.4 trillion in client assets.

“I don’t know that the typical investor knows what of his or her money is going to dark pools, but headlines about investigations could reveal to investors what they thought was suspicious already,” he said. “This is all spawned by the Lewis book, and as the investigations into these dark pools get going, I think it’s the first of many.”

Barclays actions shouldn’t be seen as representative of Wall Street, Schneiderman told Bloomberg Television’s Trish Regan yesterday.

“This is a pretty flamboyant example of out-and-out fraud against your investors,” he said. “We don’t believe that’s happening across the board.”

Discrimination OK

Schneiderman’s actions don’t amount to an indictment of dark pools and alternative trading systems, said Justin Schack, partner and managing director for market structure analysis at Rosenblatt Securities Inc.

“Keep in mind the context of what an ATS is, and how it’s different from an exchange,” he said by phone. “The very nature of operating an ATS is that you can discriminate and give people preferential treatment. That doesn’t mean you can misrepresent or lie about what you’re doing.”

The Barclays suit could help U.S. stock exchanges, said Kevin McPartland, head of market structure and research at Greenwich Associates in Stamford, Connecticut. Unlike dark pools, bids and offers for shares are visible on exchanges, which are required to accept all market participants.

“There’s a push across all of the markets for transparency,” he said by phone. “Exchanges are looked upon as the most transparent of execution venues. Whether this is all perception or reality, either way, it should benefit them.”

Exchanges Rally

ICE’s shares rose 0.7 percent to $189.25 yesterday as the NYSE was picked to host the initial public offering of Alibaba Group Holding Ltd. Nasdaq OMX climbed 1.3 percent to $38.02.

Dark pools have been opening up and could face more reporting requirements. The Financial Industry Regulatory Authority just started reporting trade data for alternative trading systems. Many operators have for the first time made their regulatory filings public. Securities and Exchange Commission Chairman Mary Jo White proposed rules on June 5 that would make dark pools reveal more details about how they work.

Allegations of wrongdoing are unlikely to help lure investors back into equities. After embracing stocks last year for the first time since the bull market began, individuals are showing signs of reverting to the skepticism that led them to pull more than $400 billion from mutual funds from 2009 through

2012. They pulled money out of U.S. equity funds for an eighth consecutive week, the Investment Company Institute reported on June 25, plowing $20 billion into bonds.

“People want to avoid the exchanges because of ‘too much information leakage,’ they want to avoid dark pools now because there could be bad routing practices, they want to avoid internalization,” said Larry Tabb, CEO of Tabb Group LLC. “So the question then becomes, where is there left to trade?”

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