Barclays Probe Casts Ugly Light on Dark Pools

Photograph by Asim Hafeez/Bloomberg

In a 30-page complaint (PDF) against Barclays last week, New York Attorney General Eric Schneiderman levels accusations of fraud in its private “dark pool” trading venue called Liquidity Cross, or LX.

The complaint lays out what Bloomberg News’ Sam Mamudi and Doni Bloomfield describe as a “market structure nightmare”: Barclays executives allegedly hoarded client trading orders to funnel them into the dark pool and mislead clients about the amount of high-frequency trading that goes on there. Barclays also allegedly removed evidence of its largest high-frequency customer from a presentation, and Schneiderman accuses executives of pressing a senior director to withhold data that suggested the company favored itself over its clients.

If Schneiderman’s right and this sort of thing happens in other private-trading venues, then dark pools are pretty much the exact opposite of what they claim to be.

The whole point of dark pools was to provide a haven for institutional investors to buy and sell stocks without letting other traders know what they’re up to. The big banks and brokerages that run most of the 40 or so dark pools in the U.S. can limit who is able to trade inside their pools. Initially that meant no high-frequency trading. But as dark pools handled more volume, they attracted more HFT firms, taking more volume off public exchanges.

The ultimate promise of a dark pool, however, was that no matter who was invited inside, prices weren’t immediately reported—in theory, at least, limiting the impact a large trade can have on the market. In public exchanges, by contrast, bids and offers are displayed (often at varying speeds depending on which feeds you buy) and prices are reported immediately after a trade is executed. This information can create ripples across the market, allowing faster firms to trade ahead of a big order and make a profit.

This was the problem that dark pools sought to fix. By keeping orders in the dark, effectively blinding traders to what was happening around them, there were no ripples. Or if there were, they went unnoticed.

The picture Schneiderman paints is much worse. There’s still a room filled with blindfolded traders buying and selling to each other. But now there’s a speed trader or two lurking in the corner, secretly watching everything that’s going on. In a memo to employees, Barclays Chief Executive Anthony Jenkins said, “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.”

There was already growing unease over dark pools. Michael Lewis’s book Flash Boys kicked up controversy around the entire topic of electronic market structure. Last month the Securities and Exchange Commission fined Liquidnet, another dark pool operator, $2 million for not keeping its clients’ trading data secret enough. And Credit Suisse last year stopped reporting information on its dark pool, Crossfinder, considered at the time to be the biggest in the U.S.

Public exchanges have been complaining about dark pools for years. Even though dark pools operate in a way similar to public exchanges, they are run by brokerages and so can discriminate when it comes to whom they let in. Access is granted only to certain firms that are charged different prices. Dark pools are also not subject to the same level of regulatory scrutiny as exchanges. As trading has migrated off public exchanges, dark pools have captured more trading volume and now account for about 15 percent of all trades.

Ironically, some of the public exchanges got permission from the SEC to roll out trading venues in 2012 that were similar to dark pools, hoping to better compete for retail order flows they had pretty much lost. NYSE went first with its Retail Liquidity Program. BATS followed a few months later. It’s worth watching to see if the added scrutiny toward dark pools will have any positive effect on the public exchanges. One indicator: Shares of Nasdaq are up 1.6 percent since the Barclays complaint was announced.

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