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Fraud Charges Against Barclays Rock the Dark Pool World

New York State's lawsuit alleges that Barclays marketed the safeguards of its surveillance system to buy-side customers but actually favored high-frequency traders in its dark pool.

Truth in advertising will soon be coming to dark pools, if it isn’t there already.

Barclays heavily marketed an LX Liquidity Profiling surveillance technology to provide a safe environment for buy-side traders in the firm's LX dark pool.

One problem is that Barclays didn’t use the robust capabilities of profiling order flow that it advertised. A lawsuit filed this week by New York State’s top enforcement official accuses the firm of a pattern of “fraud and deceit” in advertising that its dark pool LX protected institutional investors from interaction with predatory traders.

In reality, institutions that traded in Barclay’s LX, the second largest dark pool in US equities, were swimming in shark-infested waters, according to a lawsuit filed Wednesday by New York Attorney General Eric Schneiderman. His office conducted an investigation aided by a number of former employees of Barclays’ Equities Electronic Trading division along with emails obtained from the bank.

While the firm heavily marketed its LX Liquidity Profiling surveillance technology to create a safe environment for buy-side traders, behind the scenes Barclays grew its market share by inviting aggressive HFT shops to trade in the dark pool.

In addition, Barclays was falsifying information in reports to show that HFT was a smaller percentage of the dark pool than it was. The firm told institutions that aggressive order flow was 6% of the pool, while it was as much as 50%.

Starting in 2011 Barclays launched an effort to grow the market share of its dark pool into one of the largest in US equities, aiming to surpass rival Credit Suisse, which operates Crossfinder, the biggest private trading venue. Schneiderman alleges Barclays took liberties in the way it marketed and operated the dark pool.

"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," said a Barclays spokesman.

Overriding surveillance system
In a March 2013 article, an executive for Barclays' electronic trading product told Wall Street & Technology that dark pools often provide some degree of classification for participants in the pool. “Institutions had the option of interacting with all of the liquidity, just the broker dealers, just the institutions, just the high frequency traders,” the executive explained. “You could opt in or opt out based on this classification.”

Despite these representations, Barclays' Liquidity Profiling service "offers little or no benefit to clients -- because Barclays does not police or punish bad trading behavior,” the lawsuit contends.

What’s more, the complaint alleges that Barclays failed to update the profiles of traders in the dark pool, altered the rankings of certain proprietary traders when it benefited the firm, and didn’t apply the Liquidity Profiling service to the bulk of the orders in the dark pool.

To assure clients that the pool was safe, Barclays’ senior personnel falsified a chart to de-emphasize their exposure to high-frequency traders in the pool. It removed the analysis of one major participant, Tradebot, a high-frequency trading company that dominated the pool, to reduce the presence of HFT in the pool.

“I think the accuracy [of the chart] is secondary to [the] objective” of showing clients that Barclays monitors the trading in its dark pool, and “so if you want to move/kill certain bubbles, it doesn’t really matter,” the head of product development allegedly said at a meeting when information was being removed

In addition, Barclays “overrode” certain liquidity ratings for its own internal trading desks that practiced high-frequency trading to make them look less toxic than they were in reality.

Though Barclays told clients that it routed orders to other alternative trading venues, the suit found that Barclays routed 90% of orders to its own dark pool first. The firm fired one employee who objected to keeping this information out of a report.

Industry impact
The high-profile case is likely to strengthen the hand of regulators who are examining how dark pools operate and their relationships with HFT firms. Schneiderman has been investigating dark pools as part of his "Insider Trader 2.0" investigation. SEC Chair Mary Joe White announced a sweeping review of market structure on June 5, which mentioned the need for more transparency into how dark pools operate.

 “This is going to blow open the entire argument about where do you do your business,” said Manus Cranny, a European markets editor for Bloomberg Television in a video interview. “This will really push the argument back to exchange-traded products, exchanged-traded trading in equities. You are going to see people want transparency. Transparency is available on the equities exchanges.”

According to one analyst, it’s up to the buy-side to verify the dark pool's performance numbers, and they shouldn’t be relying on marketing materials from brokers.

“If New York Attorney General Eric Schneiderman’s accusations are accurate, the behavior of Barclays’ US employees is indeed damning; but no buy-side firm should be relying on broker marketing material to ensure effective venue selection,” wrote Tabb Group senior analyst Rebbecca Healy, in a commentary published on Thursday.

“In today’s market, all institutions need to take greater responsibility to better understand market behavior and the interaction of their order flow -- tough to achieve in a fragmented marketplace, but not impossible, and something I would argue we have seen greater advances in Europe than in the US,” wrote Healy, who is based in London.

Healy points out that “the latest accusations may not pertain to all dark pools but rather to the methods of disclosure of the US team of Barclays LX,” and urges the buy side to educate themselves and not abdicate the responsibility for performance analysis.

Even so, buy-side traders seeking to buy and sell equities anonymously in dark pools to avoid predators are likely to question the marketing materials of various dark pools and their surveillance systems more closely than ever before.

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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Becca L
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Becca L,
User Rank: Author
6/30/2014 | 2:12:49 AM
Shaking the confidence
These are some serious allegations, and I can't help but hope they are grossly exaggerated. From what I can tell, none of Barclay's accused activities are illegal on their own, just grossly misrepresented. Among other parts of this article I could quote for reference, "The firm told institutions that aggressive order flow was 6% of the pool, while it was as much as 50%" - this is terrible! If one of the largest players is lying to this degree, how are traders supposed to regain any trust in the market?

Schneiderman's push for transparency is much appreciated, and although Healy makes a strong point about not blindly trusting the marketing materials, let's be honest - it's unethical that there's such a need to question them to such a degree in the first place.  It's a bit like food labels - sure, the nutritional information is a bit fudged and we all know the cereal is not as "healthy" as it claims, but we naturally assume it's in the ballpark.
Greg MacSweeney
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Greg MacSweeney,
User Rank: Author
6/30/2014 | 6:14:35 AM
Stong arguments
The charges seem strong, and a number of experts have said that this is a pretty solid case. However, ghow many 'strong' cases have we seen fall apart under cross examination, or by presenting mountains of evidence to a court. We'll have to see how this plays out.
IvySchmerken
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IvySchmerken,
User Rank: Author
6/30/2014 | 9:53:51 AM
Re: Shaking the confidence
Becca, I agree wholeheartedly with your comments. Financial markets are based on trust and confidence  and clearly both were lacking in Barclay's representation of its dark pool, that is if what's in the lawsuit from Schneiderman is accurate.  Clearly, if Barclays had told institutional traders that high frequency traders made up 50% of the pool, they would have run for the hills. On the contrary, they needed HFT to add liquidity to the pool so they could match trades. The issue to me is mispresenting the composition and also marketing the surveillance system without using it to punish any bad behavior. Your food analogy is fitting. Some cereals have almonds and granola in the box but also contain 20+ grams of sugar. Can they really be healthy?
Becca L
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Becca L,
User Rank: Author
6/30/2014 | 10:27:59 AM
Re: Shaking the confidence
Ivy, great point about the obligation of surveullance systems to also deal out punishments. We often report on the overlap of security and complaince... what happened here? I'd be interested to see how many departmetns were involved and keeping quiet. And if they are already doing that, what other things are they hiding on this scale? This is a case of be careful what you wish for, as a thorough investigation by could dig up some shattering information, breaking down the trust that has been slowly building post-08.
Becca L
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Becca L,
User Rank: Author
6/30/2014 | 10:37:42 AM
Re: Stong arguments
Legally, this could get very interesting. A recent article on WS&T Consider Yourself Served: The Rules Haven't Changed, But Technology Has explained entire court cases have been thrown out because of a single misdocumented facebook post. I'm curious to learn the kind of information called for of Barclays, and its ability to deliver the in a timely manner.
IvySchmerken
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IvySchmerken,
User Rank: Author
6/30/2014 | 11:01:15 AM
Re: Stong arguments
The complaint by NY AG Schneiderman is "scathing," as the New York Times put it in an ediorial [See, The Dark Pool Iceberg]. The way the evidence is presented in the lawsuit makes the case seems very strong, especially since ex-employees who had senior roles in the equities electronic trading division have cooperated with the attorney general. 

However, I agree no legal case is a slam dunk. It's possible that other dark pool operators are also favoring high-speed traders to a greater extent than they are divulging to the buy side. Clearly, more scrutiny is coming to dark pools. I saw a headline this morning that dark pools (ATSs) might register as ECNs which display bids and offers.
IvySchmerken
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IvySchmerken,
User Rank: Author
6/30/2014 | 11:10:49 AM
Re: Shaking the confidence
Becca, this is an excellent point! Was Barclays compliance department aware that the firm was not policing the activity in the dark pool with its surveillance system? I assume that the compliance department was aware that it had been marketing Liquidity Profiling Framework as a surveillance system. I thought compliance departments looked at marketing materials vs. operations of a dark pool?
Jonathan_Camhi
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Jonathan_Camhi,
User Rank: Author
6/30/2014 | 11:24:02 AM
Re: Stong arguments
There's definitely a strong incentive though for Barclays to settle this quickly with the regulators. If this turns into a long process they will just keep getting their name dragged through the mud.
Becca L
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Becca L,
User Rank: Author
6/30/2014 | 11:33:19 AM
Re: Stong arguments
Thanks for the link. According to the author, "There is no reason to believe that this kind of wrongdoing is limited to Barclays." Adding, most banks run dark pools and it wouldn't be a shock if other dark pools were serving their own interests ahead of clients, although perhaps not to the extent of Barclays.

This case would not be possible without the aid of whistle-blowers and former executives. I wonder if, in response to Barclays and in fear of similar investigations, we'll see a wave of people coming forward from other major banks with dark pools.
Becca L
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Becca L,
User Rank: Author
6/30/2014 | 11:35:43 AM
Re: Stong arguments
Good luck to them on that front. It is still getting smeared for manipulation of interest rates. Even though it wasn't the only players doing so, Barclays was the face of the scandal. If it comes out that banks are misrepresenting their darkpools across the baord, Barclays will still be the unwilling lead of the scandal.
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