Barclays allegations and inside the murky world of dark pools

Bad Bonus Pool

What is a dark pool?

Banks in the US and Europe created these pseudo exchanges to carry out transactions on behalf of big clients who wanted to conduct huge buy or sell deals without the price moving as the deal was done. The term "dark pool" was coined to sum up the opaque nature of these privately run platforms, which have become one of the main devices banks use to match buyers and sellers away from the main exchanges.

They are computer-driven, and cheaper than sending buy and sell orders through the US's 13 public exchanges. Around 45 dark pools are in operation. The biggest are understood to be run by JP Morgan, Morgan Stanley and Credit Suisse.

Who benefits?

There are several selling points. The trades tend to be large slugs of shares that would attract the attention of other large shareholders, either spooking them into selling their shares of encouraging them to buy more. Dark pools only report data after a trade has occurred. At that stage, information about the trade has little influence on the price.

In the past investors who wanted to process a big trade would break it up into a number of smaller transactions – but algorithmic traders used computers to spot these trading patterns and prices were effected as they moved in to buy and sell at the same time.

There was also a promise that high frequency traders – dubbed the great white sharks of the investment business in Michael Lewis's new book Flash Boys: A Wall Street Revolt – and algorithmic traders would also be prevented from participating and incorporating dark pool trading in their computer-driven dealings.

Lastly, there was the price tag. Banks promised to process trades at cheaper, bulk rates compared with rival big exchanges. This price promise has now attracted many smaller investors in search of a cheap transaction.

Why are they a problem?

Critics say dark pools are parasitic, largely unregulated and open to abuse. Parasitic because they price trades using data off the main exchanges. Unregulated because while banks must submit detailed accounts to regulators about their reserves and liabilities, dealing in client funds has been, to a great extent, a private affair – at least until there are complaints (see Barclays). They are open to abuse when the balance of information is uneven between the client and the matchmaker. The dark pool operator is in possession of very big, market-moving information on trades which they, or their staff, might front-run (ie deal in advance with inside knowledge).

Are they a threat to existing exchanges?

According to Reuters, dark pools now account for up to 40% of shares traded in the US, up from around 16% six years ago.

Are regulators doing anything about it?

John Ramsay, a former head of the US Securities and Exchange Commission's (SEC) trading and markets division, told reporters in February that dark pools were "a real concern".

Without saying when regulators should intervene, he said: "We have academic data now that suggests that, yes, in fact there is a point beyond which the level of dark trading for particular securities can really erode market quality."

Since then, and with added pressure of Lewis's book – in which he says the markets are effectively rigged in favour of banks and high frequency traders – it appears the SEC has been digging around to see what goes on.

Why are Barclays in the firing line?

The UK bank is accused of ushering in the high-frequency traders to its secretive LX Liquidity Cross alternative trading system and letting them run riot. Or more precisely, let them bid on trades with clients without their knowledge.

The New York attorney general, Eric Schneiderman, said Barclays told customers who chose to trade in its dark pool that they would be protected from these "predatory traders", which use their speed advantage – processing trades through superfast fibre-optic cables – to deprive other investors of small profits on every trade. The bank courted high-frequency traders in part by charging them virtually nothing, Schneiderman claimed.

What happens next?

In the months after the financial crash, regulators have worked to put exotic derivatives trading behind the sub-prime mortgage crash through open exchanges, where it can be monitored. Now it looks like the trading of shares, which has drifted away from the main exchanges in London, New York and Tokyo into dark pools,may need to be forced back onto the main exchanges.

The New York Stock Exchange and Nasdaq exchange have allowed brokerages to place dark pool-style orders on their platforms, with the trade hidden until after it is executed. This practice could be tackled by regulators.

Powered by Guardian.co.ukThis article was written by Phillip Inman, for The Guardian on Thursday 26th June 2014 19.37 Europe/London

guardian.co.uk © Guardian News and Media Limited 2010

 

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