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Market Surveillance 2.0: Beyond the Crisis

26 June 2014

Barclays Claims Don’t Need to Signal Dark Days for Dark Pools

Allegations that Barclays misled investors and provided informational advantages to HFT firms over institutional investors on its internal dark pool LX are damning. But they could offer a golden opportunity for the industry. Now more than ever, the focus should be on improving the quality and standardization of post-trade data to gain greater clarity on dark pool activity. But it will be the analysis of all routing activity, not just fill analysis, that will provide the greatest transparency.

Bold accusations make great headlines. But just as with the Michael Lewis “Flash Boys” story, the industry should not fear the truth.

Concerns over dark pools are nothing new. Rather than getting hung up on the accusations, however, we now have the opportunity to address substandard behavior as well as the speculation and dispel the myths surrounding all dark pools. As TABB Group discussed almost a year ago (see: “European Dark Trading: A Question of Clarity),no two dark pools are the same; similarly, whether order flow is viewed as toxic is subjective. What is the underlying fund manager looking to achieve? What available liquidity exists at the time of the order? What is the time horizon required to execute the trade and under what parameters?

Dark pools serve a purpose. Despite arguments that dark pools may not be needed at all, darktrading has always existed; what we are now witnessing now is a shift from ownership of execution from the sell side to the buy side as voice trading shifts to automation. If New York attorney general Eric Schneiderman’saccusations 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. 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.

The decline in bilateral voice OTC trading coincided with the rise of automated dark trading, enabling institutional traders to become more autonomous from brokers in their endeavors to maximize returns for investors. But with this autonomy comes responsibility. Buy-side traders have to ensure they are armed with the facts to ask the right questions of their broker s – and question the answers that they are given. As a result of the increased usage of FIX protocol tagging, venue analysis and TCA (Transaction Cost Analysis), buy-side firms in Europe can now obtain enhanced post-trade transparency to achieve this analysis. This analysishas been more prevalent in Europe than in the US for one clear reason: Reg NMS. Whereas in the US, venue selection was the responsibility of the broker, in Europe, the buy-side trader has had the ability to self-select the venue of choice for a number of years now.

[Related: “No, Michael Lewis, the US Equities Market Is Not Rigged”]

As retail investors continue to outsource their wealth to institutional managers through mutual funds and ETFs, the concentration in asset managers and resulting homogeneity in trading decisions, partly driven by benchmarking, will continue to result in fewer, but larger and more challenging, trades to be executed in an environment of declining turnover – overall European volumes in 2012/3 were roughly one-third of those in 2008. Thin volumes expose trading intent and impact performance. Hence, European buy-side traders will continue to push for greater knowledge of venue and broker behavior, as well as independently verify the answers they have been given.

This will be a dynamic process. Just as no two dark pools are the same, venue performance can fluctuate according to external market conditions as well as the individual order being executed. The underlying activity of individual pools needs to be understood and continually reassessed. Buy-side traders have to educate themselves as to what is happening, where. If the buy side abdicates measurement responsibility, it becomes much harder to take its claims of incredulity seriously– you can’t have your cake and eat it too.

Now thelatest accusations maynot relate per se to all dark poolsbut rather to the methods of disclosureof the US team of Barclays LX. Whether we agree with Mr. Schneiderman’s position,no buy-side tradershould be taking any brokers marketing material as fact-based evidence upon which to trade; but this will also depend on the full and accurate provision of full routing data by brokers. It is not only where a trade was filled, but where it was not filled that also provides the true picture of activity.

Only through greater education and the ability to independently verify a broker’sperformance will confidence rightly be restored tothe markets. As trading becomes further divorced from the research process and the buy side becomes more autonomous from the sell side, the requirement to demonstrate best execution will facilitate greater broker transparency as well as increasedknowledge and education on the buy side – and that can only be a good thing for the equities markets as a whole.

Spotlight-white-trans For more stories in the Market Surveillance 2.0: Beyond the Crisis Spotlight Series click here.

Comments | Post a Comment

25 Comments to "Barclays Claims Don’t Need to Signal Dark Days for Dark Pools":
  • Anon_avatar
    Anonymous

    27 June 2014

    Sadly, this all goes back to the fundamentals of client service and the best interests of the clients.

    For too long, intermediaries have used complexity to obfuscate what should be a simple client / broker relationship.  And the buyside has been too willing (or just lazy) to trust their brokers.  The heavy weighting of commission allocation as payment for non-execution services has also provided an excuse not to look too hard at broker execution performance.

    It is a nonsense to believe that brokers cannot provide more detailed info for buyside analysis, particularly when so many of them boast about how good their systems are compared to others.  It is about asking the right questions, as the brokers will only give you what you ask for (which is not acting in the client's best interest).

    As for the concept of FIX tags / messages indicating where an order has been routed prior to execution, are there any details on how that will work?  Presumably this is tied back to the parent level order, so every single order generated from the parent is reported back to the client (every sweep and post in dark pools, every unfilled FOK / IOC).  That's an awful lot of data to analyse!  And a complete set of strategy behaviour.........  Perhaps the buyside could sell the data to the HFTs to hit back at brokers selling their order flow?

  • Anon_avatar
    Anonymous

    27 June 2014

    I personally believe, the Barclays case is only the tip of an iceberg. Broker dark pools do not generally deliver on promises of better execution and less price impact, in fact, it is usually the opposite. At the end of the day, dark pools are, once again, just tools for intermediaries to optimize revenue for themselves.

  • Missing
    shamlet76

    27 June 2014

    it is not just that dark pools are lacking credibility today.  it is also that HFT are lacking credibility for requesting advantages and using advantages.  we don't need to examine each dark pool or each HFT to figure out that these entities are disadvantaging the retail investors/institutional buyers.  the NY attorney general just laid it out.

    and the SEC and FINRA should not only be embarrassed for allowing themselves to be mislead.  they should quit writing rules that allow illegal/immoral entities to continue trading in the markets, taking $ out of the capital markets.  the SEC should refer to their mission statement.

  • Anon_avatar
    Anonymous

    27 June 2014

    all good points.  needs to be more transparency and accountability.  The 606 report is competely useless not to mention I don't even think firms are reporting correctly based on some of the few I've reviewed.  Where the heck are the auditors and regulators when reviewing these?  So, while I agree we need some new type of routing report that shows where all routing is done (not just where executions take place), how are we going to ensure that they are accurate?

  • Comment_230146_210851315613283_100000652474653_678322_2285980_n
    crammond1964

    28 June 2014

    there were /are  alot   of supporters who both agreed and defended "dark pools "  before they were really tested . Sadly  traders like myself  smelt a rat  and realized exactly what the hosts were up to ; it took a while but eventually they have been found out .

          Yet again the retail investor has been pick pocketed and denied a fair and honest fill ; perhaps now regulators need to not only fine the guilty parties but suspend them from trading  as it appears the warnings have not worked !  The question I would like to know is  can we trust the defenders of the "pools" anymore ?

  • Missing
    shamlet76

    28 June 2014

    no, we cannot.  we never could.  the financial industry is not deserving of trust.  i saw that the SEC had a press release about some people who are no longer in their positions yesterday and i wonder if this was related to the NY attorney general action.  the NY attorney general has a superior tool that can be used - he doesn't have to prove intent.  nonetheless, his investigation concluded with prosecution for barclays.  the SEC and FINRA seemed unable to come to a conclusion about anything and you might wonder why.  when they did come to a conclusion, punishments were light by design.  the department of justice also stayed away from conclusions.  

    we know that HFT is wildly profitable, but where is the $ coming from?  it is not faceless $ to the investors.  the $ in wall street comes from somewhere.  it is a question of whether the investor should be pickpocketed because they invest.  capital markets exist because of the formation of capital.  do we have to allow people to be fleeced by speed or tricks or fraud?

    worse, should the whole financial industry be allowed to collude to fleece the investor?

    this has ended up with the financial industry lying to the investors and the regulators believing the financial industry.  black marks for everyone.

    we don't need all this "liquidity" or volume.  but some people are dedicated to providing it because they benefit from doing so, in the short term.  the perpetrators will deny investors and regulators information.  this is like juggling and keeping all the balls in the air.  they will all fall at some point and this occurrence will be devastating for everyone.  i predict that many books will be written after the devastation becomes clear.

  • Missing
    peroniriserva63

    30 June 2014

    Why would any institution want to be operating in a dark pool with any involvement of HFT. And why would they not audit and get concrete assurances from the operator of that being the case.  Dereliction of duty?

  • Missing
    John Harris

    30 June 2014

    Why shouldn't customers be able to to rely on representations made by their brokers, Rebecca?

  • Comment_rebecca-healey-tabb-group
    rhealey2

    30 June 2014

    Thank you for all your comments. I agree that Barclays may not be the only case on Wall Street but this does go back to the original basis of my argument

    1. No two dark pools are the same; just as no trading intentions in any given market conditions will be alike. 
    2. For example you can’t put Liquidnet or ITG’s Posit Alert into the same category as a DP aggregator.  There is a trade-off between waiting for the “right” liquidity vs speed of execution and this will dictate what type of participant you want to interact with.
    3. A very crude analogy would be a swimming pool with a shallow end.  Less liquid (water) means that you have greater transparency (you can see the bottom of the pool).  If you choose to swim in the deep end, you need to understand how the pool is filled (water from my tap as to opposed to sewage).  A single pool with a high number of controls over participants  is less likely to have immediate natural matches.
    4. Dark pools could get shut down and everyone forced onto the lit exchanges but this does not benefit institutional investors – they are the market participants who have been most vocal in their demands for better policed broker dark pools (using the OTF category in MiFID II – which was rejected by Trilogue in Europe last year)
    5. Dark activity has not just been created – it has always existed but as OTC bilateral voice broking.  As trading as become automated, dark pools and FIX tagging have provided the institutional buy side with greater knowledge of order behaviour (more so than phone based trading)
    6. There are European dark pools now who offer robust policed dark pools which institutional investors verify with third party providers to demonstrate that they are receiving best execution.  Incidentally as it stands, these pools are benefiting from the Wall Street reaction.

     

    Finally in answer to the last quote – there are institutional participants who choose to participate with HFT – again this goes back to the same debate.  Is this toxic flow or electronic market makers who have replaced the risk business large globals have restricted? 

    It is more critical to know what is happening in any given pool (through third party verification preferably) to establish whether this is the right liquidity for the investment strategy at any given time – not all dark pools are the same, neither are all HFT strategies.

  • Comment_rebecca-healey-tabb-group
    rhealey2

    30 June 2014

    Apologies John I missed your comment when posting.  Customers can rely on representations by their brokers but in order to demonstrate their fiduciary responsibility to their end clients, increasingly European institutions are choosing to confirm the information they are being given is correct rather than take it at face value.  The fiduciary responsibility to the end client is what is driving this need for greater education - which as mentioned in the article can only be good for the industry overall.

  • Missing
    John Harris

    30 June 2014

    No worries, Rebecca. Thank you. Agreed, due diligence is recognition that representations may be false or misleading and taking action to protect against such representations. But just because investors will or should be engaged in due diligence does not excuse deceptive representations. If Barclays was saying one thing but doing another, then hopefully it will be held to account for doing so.

  • Comment_rebecca-healey-tabb-group
    rhealey2

    30 June 2014

    Completely agree John - and that holds true for any  individual or firm

  • Comment_230146_210851315613283_100000652474653_678322_2285980_n
    crammond1964

    30 June 2014

    sadly it looks as if all "dark pools "  have been extremely economical with the truth and its regulation ; obviously it will be rectified but the damage to trust & confidence will not be forgotten or forgiven  .

      Even more reason for regulators to demand "lit markets " and zero tolerance supervision .

  • Comment_rebecca-healey-tabb-group
    rhealey2

    01 July 2014

    Always love the debate Neil - still fail to see how you can put all dark pools into the same category.  Set up for institutional only order flow will be different to that for an SI or an MTF for that matter.  Plus each broker will have individual routing logic which will be adapted according to client requirements. 

  • Comment_230146_210851315613283_100000652474653_678322_2285980_n
    crammond1964

    01 July 2014

    I hope your are right ; however its quite obvious why "dark pools " were invented and especially who benefits !  The interesting twist will come when /if the others are found at fault and mis leading their clients ; sadly even then their defenders will have to admit defeat . My argument is simple "dark pools " do not do what it says  in the instructions  and I apologise for complaining but its easy to see "cheetahs !" 

  • Comment_rebecca-healey-tabb-group
    rhealey2

    01 July 2014

    Ah - so then you would be in agreement with me - if it Is "easy" for you to see the "cheetahs" surely it would be better for that knowledge to be spread amongst buy side traders so they can bring any brokers to task who are not above board.  The whole episode underlines the need for greater education as to what dark pools do and who should use them.

  • Missing
    peroniriserva63

    01 July 2014

    Goldman Sachs Fined $800,000 by Finra Over Dark-Pool Pricing

    Ahem!   :)

  • Comment_rebecca-healey-tabb-group
    rhealey2

    01 July 2014

    Yes here is the CNBC story - http://www.cnbc.com/id/101803933#.

  • Missing
    peroniriserva63

    01 July 2014

    Rebecca auditing the dark pools should have been a pre-requisite for any institution entering a dark pool, but the buyside sleep walked its way into this situation because it did not foresee the damage that the ill thought out regulatory changes brought upon the industry. The buyside failed to fight its corner effectively due to the impotence of the IMA and the unwillingness of trading's major figures to stand alone and argue on behalf of its client base.

  • Comment_main-thumb-3378195-200-eeqk8jvi8vsk38mxx85ssngsoii7elay
    biancamano

    02 July 2014

    Neil, once again you paint all dark pools with a much too wide a brush.  Dark pools were never "invented" they have existed just as long as latent liquidity has.  The NYSE specialist system was essentially a dark pool whereas the Specialist acted as a conduit aware of all order flow as well as hidden interest. (as a matter of fact one of the reasons in my opinion that the 2009 SEC Dark Pool proposal was never enacted as written is because if they outlawed actionable IOIs, they would have also impaired Specialist ability to represent buyer and seller hidden interests) Brokers have always been able to cross flow upstairs, finding naturals by cold calling other desks. It was only the creation of crossing systems in the 90's, specifically Instinet and ITG's POSIT where the first off the floor agency crossing occurred, leading to what is now known as "dark Pools".  Many people also don't realize that POSIT was not initially designed as a Block Crossing system, but was in fact designed for small orders for Portfolio Trades, POSIT is an acronym  for "POrtfolio System for Institutional Trading".   Finally the term Dark Pool didn't crop up until around ~2006 or so, when the rise of Broker owned crossing systems occurred.  They have a vital role, for both large and small orders.

  • Missing
    justinamos

    03 July 2014

    Dark Pools have always existed, they were called blotters. As trading moved away from phones and pits and became electronic the liquidity moved from an instituions paper blotters to data pools.

    I agree with Rebecca ,  it boils down to what the client is expecting in terms of service. As long as the service proivders deliver what they say they are going to do then there should be no reason for complaints.

  • Comment_230146_210851315613283_100000652474653_678322_2285980_n
    crammond1964

    03 July 2014

    justin  "As long as the service proivders deliver what they say they are going to do then there should be no reason for complaints. "  ..............this is the issue as we knew they were not honouring this . Therefore yet again we have allowed our retail clients to be pick pocketed again ; may not be an issue for you or  Rebecca but  it stinks and we have again ignored this abuse and pretended  it was not happening ! 

  • Missing
    justinamos

    03 July 2014

    Here is a question though - who should be policing and at what frequency ? - Should we see the emergence of business compliance function or the extention in the role of Audit ?

  • Comment_230146_210851315613283_100000652474653_678322_2285980_n
    crammond1964

    03 July 2014

    market supervison within  "pool" would  suffice ; but they have to be allowed to !  

  • Missing
    shamlet76

    03 July 2014

    i am not in the industry but i have observed the industry for a long time.  as far as i can see, best information has become the primary advantage for the financial industry.  whether the retail/institutional market is disadvantaged by dark venues, display-only orders, post-only orders, non-reported transactions, self-reported easy-to-borrow locate-stock claims, renting marketmaker identification by placing orders directly on the exchange floor, delayed settlement, HFT taking the best price and giving the worst price, it is all the same.  the way i see it, the financial industry plays catch-me-if-you-can, and any penalty is viewed as a small transaction tax.  the retail/institutional market has no choice but to make a contract with a broker for trading execution even though all of the brokers are advantaging other financial entities to your disadvantage.

    brokers audits should at least reassure the clients that the broker has their portfolios and that the retail/institutional clients are not funding speculation and debt to the market.  when a retail/institutional customer wants to buy some stock, they are not wanting to buy an IOU while paying a market price for the impaired title.  this shortselling turns the stock sold into a futures contract, which is not the contract that the retail/institutional customer was seeking.  some of the problem is "netting" the customers' investments against the shortselling.  well, if this is the way to fund shortselling, this can produce a maximum of entire customers' portfolios sold short.  quarterly inventory/brokers audits can mitigate this.

    i think the SEC needs to mandate that rebates are not paid for order flow (whether at the exchange level or the broker level), that all pools are regulated for best execution and fair practices.  i think there are too many financial actors in the industry trying to make $ and the industry will have to contract as the financial industry is reformed.  i don't think the regulators should worry about damaging bad business models nor licensing fraud.

    further, i am not sure that the financial markets need marketmakers anymore, since the retail/institutional customer has electronic access to the order book and time/sales data.   it is my feeling that marketmakers have abused their trust by 1) confusing marketmaking functions with HFT "services", 2) promoting order types and exchange procedures that are predatory practices 3) withdrawing "liquidity" just when the market needs "liquidity".  the financial industry defends all practices, whether they are predatory or just disadvantage non-financial traders.  in this way, the financial industry is functioning like a conspiracy.

    i might have more belief in the industry if the industry would help clean itself up. instead, the financial industry defends all bad practices and refuses to identify the perpetrators.  the financial industry tries to supply as little information as possible to regulators or to market participants.  so i view this topic as just part of the inability of the industry to identify a problem or suggest a solution/if there is a problem.

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