Modify it or move on.
That’s the message Barclays Capital is delivering to traders in its LX dark pool that engage in behavior it considers detrimental to the integrity of the pool.
By using a sophisticated new surveillance system, Barclays is able to evaluate the trading practices of the participants in its pool and create precise profiles of those traders. Armed with that information, it can confront the bad actors and ask them to change their behavior. If they don’t, they may be asked to stop trading in the pool.
"We are taking an aggressive approach," said Bill White, Barclays’ head of electronic trading. "We want our clients to know we really understand what is going on inside LX and that we are watching on their behalf."
Barclays began tracking trading behavior last August, under the direction of White, a former trader, who took charge of the group in Jan. 2011. Besides using the information to reprimand bad actors, Barclays makes the data available to all LX participants, without disclosing the identities of the firms. If a participant wishes not to trade with a certain party, Barclays will block trades between the two.
Behind the initiative is concern on the buyside that trades done in dark pools can result in information leakage that negatively impacts the final price at which they trade. The buyside often blames its problems in dark pools on professional traders, particularly the high-frequency variety.
Some of the major dark pool operators, including Barclays, have taken steps in the past couple of years to categorize the players in their pools and allow their customers to bypass those groups they believed to be harmful. Mostly, those shunned were HFTs. Other groups were typically institutions, retail, and broker-dealer.
But monitoring traders’ behavior is a relatively new trend. Besides Barclays, Morgan Stanley BofA Merrill Lynch and Deutsche Bank are also tracking trader behavior in their U.S.-based dark pools.
When White took the helm of the electronic trading group, he immediately abandoned the idea that simple categorization served to protect participants from predatory behavior. Banning an HFT, for example, was ineffective because the HFT could simply re-enter the pool through another broker-dealer.
"They would leave and then come in through the back door," White said. "So we realized that these front door thresholds were doing nothing for our clients."
Moreover, White understood that smart or aggressive trading behavior was not limited to professionals. Traditional buyside trading may appear just as predatory as that of the often vilified high-frequency trader. A buysider using a top quality VWAP algorithm, for example, that takes liquidity at precisely the right moments may look just as predatory as a short-term trading professional.
When it comes time to have a chat with an overly aggressive trading firm, no single group gets more calls than any other, White says. His crew has reprimanded HFTs for abusive latency arbitrage strategies. They also have warned buysiders against using too-clever algorithms.
"There are consistent phone calls to all groups," White said, adding that some money management shops house quant groups alongside plain vanilla desks that may use sophisticated trading strategies.
White joined Barclays shortly after the bank bought Lehman Brothers’ U.S. operation in the fall of 2008, following the bankruptcy. The deal included Lehman’s designated market maker business on the floor of the New York Stock Exchange, which was being run by White.
The exec, who has spent most of his career as an independent options trader on the floor of the Chicago Board Options Exchange, originally built the electronic market-making platform for the NYSE specialist, Van Der Moolen Securities. Lehman bought Van Der Moolen in December 2007.
At Barclays, White rejoined ex-Lehman executives and headed up its market-making group, devoting most of his time to the NYSE business. Barclays is now the largest DMM, or specialist.
Within Barclays’ dark pool, volume comes from four sources. Institutional traders account for the largest chunk, contributing 40 percent. Electronic Liquidity Providers, or professional traders, account for 30 percent. Broker-dealers account for 25 percent. Barclay’s market making desks represent 5 percent of flow.
The trading behavior of each and every participant is monitored and judged. To determine whether a player is "good" or "bad," Barclays calculates two numbers for each participant. It then plots the data on a graph. Where those two variables intersect determines into which camp, or quadrant, the trader falls. They’re labeled as predatory or benign or somewhere in between.
The first variable is a "modified" take ratio, calculated by dividing the number of times a participant takes liquidity by the number of times it supplies it. In general, a higher number signifies a more opportunistic trader. A lower number signifies a more benign or "good" provider of liquidity.
The calculation is modified, meaning it is not one of simple division. The ratio takes into consideration such factors as the size of the order and the liquidity of the stock. Taking liquidity in a very liquid stock like the QQQ, for instance, does not factor into the calculation as much as taking liquidity in an illiquid name.
The second variable measures a trader’s short-term alpha. The metric is calculated by dividing the price at which the trader bought or sold stock into the price of the stock shortly after the trade. A positive short-term alpha suggests an opportunistic trader. A negative score suggests a more benign trader. He is less concerned about short-term profit and more interested in just getting the trade done.
Taken by themselves the two ratios are limited in their usefulness. Under the Barcap methodology, they must be weighed together to create a portrait of the trader.
For instance, a trader that only takes liquidity may or may not be considered predatory. If he consistently makes money on every trade, or has a positive short-term alpha, then some might consider him a dangerous trading partner. But if he generally loses money on every trade – in other words he is trading even though the market is moving against him – he may be a desirable counterparty.
Likewise a trader with a low modified taker ratio may appear to be a friendly supplier of liquidity. But if prices in the market consistently go his way after his trades, he might appear to be too "informed" for some counterparties.
The information produced by the surveillance is used by Barclays to keep the LX community in line and by some of the broker’s customers to manage their exposure in the pool. Some customers aren’t concerned about who they trade with, White explains, while others will manage their exposure on a trade-by-trade basis. Still others will block out entire groups of trading counterparties.
The trend underway by Barclays and other brokers to monitor behavior in their pools is drawing praise from traders. The thinking behind it is "insightful," Enrico Cacciatore, a senior trader at ING Investment Management, said. "It forces the brokers to dive into their pools and provide this information to their clients-to show them what is going on in the pool," Cacciatore added.
ING is likely a prime beneficiary of the trend, as it has built its own smart order router. It is intimately involved in where its trades get done. By contrast, most buysiders simply leave the routing decisions to their brokers.
At least one professional trader also approves. "I’d like to see the whole marketplace doing this," Chris Concannon, a partner at Virtu Financial, a registered market-making firm, told Traders Magazine. "It’s the next wave of change and evolution. It’s an expansion of transaction cost analysis. Now, we’re going to do TCA at the counterparty level. And I’m okay with that."
Concannon says he welcomes an analysis of the way he provides liquidity. "Tell me how I do," he said, "and I’ll adjust. We provide customized liquidity. I can go bigger. I can narrow my spread. I can do mid-point. We have very customizable liquidity. So, I want to be scored. Everyone should be scored. We are headed into a world of TCA on steroids. And it’s a good world."
For Barclays, the program seems to be bearing fruit. LX grew by about 17 percent from Feb. 2011 to Feb. 2012, outpacing all but three of the major dark pools, according to data published by Rosenblatt Securities. LX is now the fourth largest dark pool on the Street, averaging 83 million shares per day in February, according to Rosenblatt.
