Dark pools: What's going on inside the secret stock exchanges?

Barclays is accused by New York regulators of fishing in some unethical waters. But this time the bank is holding its course

Barclays’ New York office is being pursued by state prosecutors who say it failed to police its dark pools (AFP/Getty Images)

It sounds like something George Lucas would have thought up for his Star Wars franchise. But “dark pool” trading is, in fact, at the centre of yet another financial scandal in which US regulators want hundreds of millions of dollars in fines, starting with Barclays.

And this time, in stark contrast to a string of other scandals, the banking empire is striking back and squaring up for a fight that has already reached a courtroom and is set to do so again this year.

New York Attorney General Eric Schneiderman has upped the stakes in his attempt to penalise Barclays over its dark pool share trading exchange after an initial complaint was lodged last year, by filing a renewed series of allegations.

The initial claim was that “predatory” high-frequency traders (HFTs) were allowed into Barclays’ dark pool without the knowledge of users, who had turned to the facility and others like it in part to protect themselves against the “toxic” and “aggressive” practices HFTs have allegedly engaged in. The subject of Michael Lewis’s best-selling Flash Boys, HFTs trade rapidly in and out of shares, often holding them for less than a fraction of a second, and seeking advantage through cutting-edge IT hardware and software.

Dark pools were designed to allow big institutional investors to trade large blocks of shares before investors in the broader market could see what they were up to and bet against the trades. As such, they can be considerably cheaper to use than regular stock exchanges for offloading sizeable investments in big companies.

The root of Mr Schneiderman’s argument is that Barclays, whose dark pool was aggressively expanded from the back of the pack to second in the market to Credit Suisse, did so on the back of HFTs, the type of market participant users would prefer to avoid.

Indeed, he claimed that Barclays used its dark pool to give an unfair edge to high-frequency traders and that its staff did so in an attempt to boost its revenues and (naturally) their bonuses.

The Attorney General suggested Barclays “did not police” the pool, and that it told investors that between 6 per cent and 9 per cent of trading activity within it was “aggressive” when it knew the amount was closer to between 25 per cent and 30 per cent. He claimed that this was in violation of his state’s Martin Act, an anti-fraud law.

In his latest court filing, Mr Schneiderman further claimed Barclays’ alleged wrongdoing went beyond a few isolated incidents and was “a broad course of conduct involving numerous Barclays employees”.

The ambitious prosecutor named 14 Barclays employees although he did not describe them as defendants. But he further claimed that the bank had refused to allow two of the most senior ones, William White and David Johnsen, to talk to him.

In his amended complaint, Mr Schneiderman also said Barclays falsely told clients from 2012 to last year that algorithms used by the system gave no advantage to any particular trading venue.

A hearing on whether to let Schneiderman pursue his amended complaint is scheduled for February 11 in the New York State Supreme Court in Manhattan.

Usually, one might expect that, when faced with this sort of thing, a financial institution would pay up and settle to make it go away. After all, Mr Schneiderman has already published several embarrassing-looking statements culled from emails and marketing material, and a court case could add fuel to the fire.

What makes this case markedly different is that Barclays is unmoved. It’s response to the latest claim was: “Although we continue to seek to co-operate with the New York Attorney General in this matter we will continue to defend vigorously against these allegations.”

The bank previously argued that users of the pool were sophisticated professionals and were well aware of the pool’s characteristics. This time around, it accused Mr Schneiderman of re-hashing “the same flawed arguments” with his latest broadside.

In court, it has already claimed that the embarrassing fragments of communications quoted by Mr Scheiderman in his first filing were set out to make it look bad. The bank is still waiting on a motion to dismiss filed at Christmas, and while these rarely succeed, it shows no sign that a reversal will stop its battle.

People with knowledge of the situation say the two executives were made available before the suit was filed, with an appointment scheduled for last summer. But the interviews never happened.

Now the lawsuit has moved beyond discovery and into the preliminary courtroom skirmish phase, the bank sees no reason to give them to Mr Schneiderman for a fishing expedition. Sources close to the bank say that when it has done wrong it will pay up, as it did with the Libor interest rate fixing scandal, and as it will do over the foreign exchange rate fixing scandal.

This case, it argues, is different because it has no merit. The bank has taken the stance after an exhaustive internal review. The stakes are high and the case is being closely watched by the wider banking industry. Taking a case as far as a courtroom is risky, and can be expensive.

If Barclays wins, however, it would represent a major victory for the banking industry, and particularly those who operate dark pools of their own. The bank does not lack for supporters. Critics of the US regulatory system already say that, at least in some cases, the industry is being soaked. And that watchdogs with political ambitions have been using it to further their careers. This, they say, is one of those examples.

Barclays, for its part, is hell-bent on proving that.

Financial glossary: Deciphering the dark side

Dark pool

Private stock exchange used by big institutional investors.

Institutional investors

Sizeable investment funds, often acting on behalf of millions of small clients.

High-frequency trading

Buying and selling shares extremely quickly with aim of getting into and out of a stock before its price moves in response to a stimulus. Requires sophisticated technology.

New York Attorney General

The highest legal authority in the state of New York, who handles legal proceedings on its behalf.

Electronic trading algorithm

Complicated series of share trading instructions that are carried out automatically by a computer.

Securities and Exchange Commission

America’s lead financial regulator with responsibilities for share trading, stock exchanges etc.

Exchange-traded funds

Type of investment fund with units that can be traded on a stock exchange.

Tracker funds

Investment funds that aim to mimic the performance of a stock market index such as the FTSE 100.