Barclays' "Dark Pool" Trading Scandal Sounds Bad, Because It Is Bad

Fitted to excite pity and sympathy, state and federal agencies have begun filing lawsuits against financial services juggernaut and arguable maîtres du monde Barclays PLC over allegations of fraud at Liquidity Cross: the British firm's "dark pool" trading venue. Yes. Fraud. In a dark pool.

Like the warm, amniotic fluid of a womb, dark pools are private trading venues that, in theory, are meant to protect large institutional investors (and others) by not publicly reporting their buy-and-sell orders until those incubating trades have fully formed. They first arose around the 1970s as phone-based services, archetypal Wall Street guys shouting "Buy! Sell!" into handsets, but by the 1980s — and this is very 1980s — electronic platforms with names like Instinet and Posit began cropping up, automating the field. For decades, these discreet trading platforms remained an acquired taste, floating under 4 percent market share, consolidated volume, until around 2008. What changed (and you probably know this already) was the untrammeled growth of high-frequency trading by algorithms.

Suddenly, it became very easy, plus lucrative, to jack-rabbit around these monumentally large institutional trading orders, skimming off profit by quickly placing one's own orders before the institution's purchase altered the market price.

But, somewhere between 2008 and today, as the dark pools swelled, now covering 15 percent of market share, they transformed from shelters for institutional investors — like mutual funds, pensions, and (sure) hedge funds — into feeding chambers for select high-frequency traders.

Barclays' "Dark Pool" Trading Scandal Sounds Bad, Because It Is Bad

According to data from the Financial Industry Regulatory Authority, Barclays' dark pool, often shortened to LX, was nearly the largest in trading volume, second only to Credit Suisse's dark pool, Crossfinder. So, it was something of a serious matter when, two weeks ago, New York state's Attorney General Eric Schneiderman filed what the New York Times called "a scathing lawsuit" against Barclays over "demonstrated persistent fraud" and repeated violations of the Martin Act.

"The particularly egregious behavior was that they marketed this as a protected dark pool," Todd Cipperman of Cipperman Compliance Services told Crain's Pensions & Investments (an excellent gift for grandma or grandpa).

Integral to this deception, according to the suit, was a complete misrepresentation of Barclays' "Liquidity Profiling" service which promised to police "each interaction in the dark pool" to "protect [clients] from predatory trading" but in practice, well, didn't do shit. The suit alleges that Barclays "granted liberal 'overrides' to high-frequency trading firms and to Barclays' own internal trading desks (which themselves employ 'aggressive' trading strategies), in order to make them appear less 'toxic' than they really are."

Citing internal emails between senior executives of Barclays' Equities Electronic Trading division, Schneiderman's office states that the firm intentionally "de-emphasized" high-frequency traders in a promotional chart of the pool's liquidity landscape. They also altogether removed data about Tradebot Systems, an ominously generic firm that "had historically been, and was at that time, the largest participant in Barclays' dark pool, with an established history of trading activity that was known to Barclays as 'toxic.'"

As described by one former senior-level Director within the division:

Barclays was doing deals left and right with high frequency firms to invite them into the pool to be trading partners for the buy side. So the pool is mainly made up of high frequency firms. [...]

[T]he way the deal would work is [Barclays] would invite the high frequency firms in. 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 would make their money off the buy side. And the buy side would totally be taken advantage of because they got stuck with the bad trade [...] this happened over and over again.

Phenomenally lurid, containing prose written with great clarity and momentum, the 31-page civil suit against Barclays makes for excellent beach reading, full of serious misdeeds that teeter between mere compliance breakdown and full-on criminal conspiracy.

In advance of this suit, this past spring, Schneiderman's office issued subpoenas to six high-speed trading firms seeking to determine whether those firms were given preferential treatment in certain dark pools. In early June, the Senate's Permanent Subcommittee on Investigations announced plans to hold hearings focused on potential conflicts of interest between dark pool operators and some of their clients. And this week the Wall Street Journal reported that the SEC is now quietly planning to launch its own probe into Barclays' LX dark pool. Cumulatively, a pretty clear indication that utterly heedless and/or malicious behavior may have been the norm in Wall Street's off-exchange trading venues.

Just before Independence Day, in front of a Sandler O'Neill + Partners conference, SEC Chair Mary Jo White said her agency will be examining whether the current volume of off-exchange trading in dark pools, and wherever else, "risks seriously undermining" the entire U.S. stock market.

Stock-exchange executives, who would likely benefit from a dark pool crackdown (in particular, given that off-exchange operators are believed to be using their knowledge of large private trades to their benefit out in the open market), naturally applauded the speech.

"If you make that statement and you believe it," Robert Greifeld, chief executive of Nasdaq OMX Group, reportedly said during a Q&A session, "it's a call to action."

Barclays' "Dark Pool" Trading Scandal Sounds Bad, Because It Is Bad

So, it's a troubling case — though you wouldn't know it from certain sectors of the business press.

At Forbes, Tim Worstall has decided that the Barclays case "isn't serious" based on the fact that Goldman Sachs only had to pony up a trivial $800,000, or so, in a recent case against their dark pool, SIGMA-X. Why he selected the Goldman case and not, say, the SEC's recent $2 million settlement with New York dark pool Liquidnet, or the $110 million settlement against Putnam Investments pursued jointly by the SEC and Massachusetts state regulators, is sort of anyone's guess. Then again, Worstall wrote a trollishly contrarian op-ed last year praising the NSA's PRISM program. So, perhaps he is not a representative example of the financial pundit class.

And yet, his core belief that few bad trades or price-gougings took place in the dark pools "precisely because none of the customers [came] out complaining" is a weirdly common one.

"If these brokers and trading houses were that badly effected by this practice, the first thing that I'd be looking for would be private suits by the aggrieved people who were put into these dark pools without their knowledge or who were given so-called 'more predatory counter trades' than they thought they were getting [...]" Charles Griffin Intelligence managing member Philip Segal told Bloomberg's Street Smart, continuing:

I think the people who would have the best idea of what it would cost are the people that were put into these pools, the people that the Attorney General was supposedly protecting. It's not a "Let's protect the small investor" lawsuit; it's "Let's protect the poor innocent hedge funds and the Blackrocks of the world who are very good at getting lawyers, and analysts, and expert witnesses, and figuring out very quickly how much it cost them." So, I want to hear from them now.

It's certainly surprising that a guy with 13 years as a business reporter and an 8-years-and-counting career in business intelligence and due diligence investigations can't seem to figure out that the "large institutional investor" category includes really small-time victims, like the clients of pensions and mutual funds. It's also surprising that someone with a law degree, like Segal, doesn't seem to know that private suits would have to prove intentionality in court, a prohibitively high bar compared to the government's civil suits under the Martin Act.

Plenty of other financial observers seem to have understood that the victims weren't exclusively white-shoe hedge funds and investors, or that, as the Times pointed out, "banks should not be entitled to operate increasingly in the shadows, where even large and savvy clients can get mugged."

But whatever.

Perhaps the most generous appraisal of these dark pool apologists, would be to point out that in the face of Wall Street's total graft and corruption take, in a grand assessment of world finance's scary intractable problems, these dark pool scandals may simply be (somehow) small potatoes.

Last June, institutional investors including BlackRock Inc., and Allianz SE's Pimco sued a phalanx of their largest bond trustees — U.S. Bank, Citibank, Deutsche Bank, Wells Fargo & Co., HSBC, and Bank of New York Mellon — for failing to adequately supervise over $2 trillion in mortgage-backed securities before the 2008 financial crisis. They are suing them for $250 fucking billion in damages.

These are Greek Gods doing battle outside our sad necropolis. Kaiju monsters left fighting each other within city limits, while regulators watch helplessly from their giant broken robots, or opt instead to noodle around in the rubble chasing down pick-pockets.

Barclays' "Dark Pool" Trading Scandal Sounds Bad, Because It Is Bad

There's a narcotic fatalism that comes very organically from following this sort of news story: a shared True Crime titillation between writer and reader that's mutually gratifying, chic yet pornographic, and maybe not entirely productive. The problem is that the options beyond it are thorny.

Would you like to donate to Eric Schneiderman's 2014 political campaign, shore up his war chest for what surely promises to be a vicious battle against Wall Street-larded New York Republicans? I think that's a swell idea, frankly — despite the fact that I have only minimal confidence that it will change a damn thing.

Perhaps you want to go back to Zuccotti Park and Occupy Wall Street all over again? Or throw some tea into Boston Harbor? (Are you a time traveler from the past?) Sure. That seems fine too. Or a full-blown post-post-Structuralist Marxian-materialist revolución that dares to push for rhizomatic utopian structures? Sounds good to me, so long as everyone gets course credit.

OR: Would you like to preserve an aura of jocular detachment from all this? Give it the horse-race speculation treatment? What's your take: Will Barclays get hit harder because it is a foreign bank and thus easier to attack politically than the well-connected boys back home? Does that mean Credit Suisse or UBS (who incidentally has the third largest dark pool) will be next in regulators' crosshairs?

Will Eric Schneiderman's political career survive this aggressive pursuit of white collar criminality? Or will embarassing facts miraculously emerge, as it did for his predescessor Eliot Spitzer, inciting a Client 9-style scandal just in time to derail him, and preserve the raucous, disruptive virtues of our free market society?

One thing is certain: Roger Stone, the veteran GOP operative who took credit for exposing Elliot Spitzer's prostitution habit (almost assuredly without earning it) is totally gunning for Eric Schneiderman:

For the record, Eric Schneiderman is older than Eliot Spitzer by four years.

That H. L. Mencken quote, "No one in this world [blah, blah, blah] has ever lost money by underestimating the intelligence of the great masses of the plain people," you might have heard it before?

Everyday, you should wake up endeavoring to prove it wrong.

[Barclays office photo via Reuters]

To contact the author of this post, email matthew.phelan@gawker.com, pgp public key here. In the interest of full disclosure, the author owes Barclays PLC over $2000 in credit card debt.