When allegations of abuse in Barclays LX, the second-largest dark pool in the nation, splashed across the markets on a Wednesday morning in late June, Craig Jensen wasn’t shocked at all. He was frustrated.
Jensen, principal and head of trading at Armstrong Shaw Associates, an investment advisor in New Canaan, Conn., with about $1 billion in assets under management, had complained bitterly for several years to many of the bulge bracket-run dark pools his firm would use, protesting the pools’ lack of transparency and seeking answers about how his trades were handled.
In fact, Jensen had become so frustrated with the dark pools’ opaque operations and the pool operators’ unwillingness to address his concerns that he began going over reams of captured fill data himself in an effort-if not to fully understand what was happening in the pools-to at least be able to demonstrate to his clients that he was aggressively pursuing the best pricing.
Now, as Jensen heard the salacious details-outlined in a civil lawsuit filed by New York Attorney General Eric Schneiderman-of how Barclays’ dark pool allegedly promised its customers they would be protected against predatory high-frequency traders (HFT) while at the same time allowing HFTs access to the pool and customers’ order flow, he could only shake his head. “This case is just everyone’s suspicions coming to light,” he said. “It wasn’t because of our questions and complaints, but it has come to light.”
The allegations of the Barclays case-rampant front-running of large institutional orders by high-frequency traders, done with the complicity of the dark pool operator-constitute perhaps the biggest nightmare that institutional buyside traders face in using dark pools. Little wonder they flock to dark pools run by the most reputable Wall Street banks, like Barclays, which had promised them that those pools would be safe.
And Jensen isn’t the only buysider whose early suspicions about dark pools were confirmed by the Barclays case. “We barely use dark pools because we don’t trust them,” said Jaffray Woodriff, co-founder and CEO of Quantitative Investment Management (QIM), a $3 billion hedge fund based in Charlottesville, Va. Woodriff added that dark pool avoidance has been “the case for at least five years” at QIM and “is not a reaction to the recent media firestorm.”
Flash Boys’ Second Chapter?
Indeed, that firestorm, erupting in June and July, proved as brutal for operators of dark pools as April and May were for high-frequency trading firms following the publication of Michael Lewis’ book Flash Boys. (Interestingly, dark pool trading volume dropped a stunning 13 percent in May after a 1 percent drop in April, according to a study from the TABB Group, showing perhaps the “Michael Lewis Effect” on the markets. All eyes are on the June numbers, due out in early this month, which may show the impact the Barclays case could have on dark pool activity.) As with the HFT frenzy, the past several weeks have seen dark pools become the subject of announced regulatory proposals, revealing data dumps and shocking enforcement actions. Underpinning this all, however, is a question of whether dark pools-secretive and murky by their very nature-still add value to the markets, or are now simply a venue that allows abuse to go on when the lights go out.
“For investors, especially large investors, there is always a need to be anonymous in some cases, but dark pools now have become the preferred trading venue for really any reason,” said Chris Nagy, founder and CEO of KOR Group, a market structure-focused lobbying and consulting firm.
The first volley in this most recent battle was fired on June 2, when the Financial Industry Regulatory Authority (FINRA) released trading activity data from alternative trading systems (ATSs), including the roughly 40 operating dark pools. It was the first time that the investing public and many financial professionals had a look at those numbers, which previously had been provided only to traders and had been based on voluntary reporting from some, but not all, dark pools on an aggregated, monthly basis. Now, FINRA was promising a weekly aggregate volume tally from all ATSs, published on a two-week delay. (Some dark pool operators, like Goldman Sachs and Credit Suisse, took the cue from FINRA and released details about their operations, too.)
What the FINRA data showed was that the dark pools owned by the five largest banks-Bank of America, Barclays, Credit Suisse, Morgan Stanley and UBS-accounted for about half of all ATS trading volume, and that the average trade size in the top five dark pools in the FINRA report was a paltry 187 shares. That number alone undercut dark pools’ purported raison d’etre-that they existed as a venue for large institutional block trades of tens or hundreds of thousands of shares that would otherwise roil the markets.
The market already knew that total ATS volume had reached about 40 percent of all stock trades, compared to just 15 percent in 2008, according to TABB. That knowledge, coupled with the FINRA data, seemed to make many market pros look at dark pools with renewed urgency.
“Forty percent of volume? What does that do to quotes in the marketplace?” Nagy asked. “It’s just too much volume, and it creates a rising cost for institutional investors or any investors who continue to use lit markets.”
As the market was still digesting the FINRA numbers, Securities and Exchange Commission Chair Mary Jo White offered more to chew on. In a widely watched speech before bankers, exchange executives and traders just three days after the FINRA data release, White offered pointed criticism of high-speed trading and dark pools, citing both as examples of technology-driven change that may not always have the most positive impact on the market. “Technology can and has greatly increased the efficiency of our markets, but it can also allow severe problems to develop very quickly,” White said to the crowd, promising the SEC would be examining rule proposals to curb some of these perceived excesses.
Addressing dark pools, White said transparency is a hallmark of U.S. markets and she was troubled by “the lack of it in these dark venues.” She said the SEC would work to expand on the trading data disclosures from ATS began by FINRA, and would also consider requiring brokers to detail their routing decisions for institutional orders. White also said the SEC would be launching a pilot program to look at tick sizes in trades, and the program would include a “trade at” feature that would give some insight into how dark pools handle orders (see sidebar).
W. Hardy Callcott, a partner at Sidley Austin in San Francisco who previously served in the General Counsel’s Office of the SEC as assistant general counsel for market regulation, said in some ways, the market has been having the same discussion for months, and all of it driven by Flash Boys. “Even if the book’s initial splash was about high-frequency trading, the book brought up a whole group of market structure issues, including dark pools,” Callcott said.
Nagy agreed, saying he also understood why White was addressing both HFT and dark pools in the same harsh tones. “As far as market structure, they are the two overriding issues right now, and they are linked in nefariousness,” he said. While Nagy said he is cautious about how tentatively regulators are approaching the issue-he noted that a set of SEC dark pool rule proposals crafted in 2009 were never acted upon and have been gathering dust ever since-he is encouraged even by the incremental movement. “The SEC may start treating dark pools like SROs,” Nagy said. “And that would be a good thing.”
Going Dark for the First Time
David Downey remembers the days before the dark pools came.
Downey, chief executive of OneChicago, a registered securities futures exchange, began his career on the floor of the American Stock Exchange (ASE) in the mid-1980s. He remembers instances when traders would be sitting around, talking and reading the newspaper, when a floor broker would come in, whistling and making hand signals. The other traders would immediately snap to attention and try to decipher what the trader’s manic gesticulations meant as to what stock was being traded and how big the order size was.
“After a while, people could read these hand signals, and the big traders knew their orders were getting exposed,” Downey said. “So, they needed a way to stop the negative market impact on their trades-and this was when we were trading in 10-cent to 30-cent increments!”
And thus, dark pools were born. Initially, the venues were used by large institutional investors who wanted to place a whale-sized order but didn’t want every little fish in the ocean to take a bite out of their trade’s profitability. As in Downey’s day on the ASE, a big order would attract traders who wanted to get in front of it, buy up the targeted stock and get the bump when the institutional investor’s larger order went through. It’s really the same thing that happens to large orders today, but in a small fraction of the time.
While this new arrangement worked for a while, and early dark pools like Instinet’s Crossing Network, POSIT and Liquidnet thrived, a funny thing happened with this relatively logical and simple solution to a basic market problem. Slowly over the 1990s, and then more quickly into the 2000s, traders started realizing that if big institutional investors could hide their activity in a dark pool, they could, too. Suddenly, dark pools became a choice venue for equity trading and, more recently, futures and foreign exchange trading for all types of traders-large and small, institutional and retail.
“Dark pools have morphed-it’s become a way of keeping market activity from being out in the open,” said Downey, adding that he was stunned at the ATS numbers released by FINRA, especially the average trade size of 187 shares. “Now, looking at the average share number-that’s not block trades, that’s not institutional size!” he said. “So, if this isn’t institutional activity, let’s examine why we allowed this to happen.”
KOR’s Nagy agreed. “The reasons to go dark, for anonymity and to keep your large trade from roiling the markets, don’t hold water when average trades are so small and dark pool volume is so large,” he said.
Finding Your Way in the Dark
Several days after the Barclays news broke, another shoe dropped when FINRA fined Goldman Sachs for pricing rule violations in its Sigma X dark pool, saying the pool had executed almost 400,000 trades at inferior prices. Goldman Sachs agreed to pay an $800,000 fine and settle the case, without admitting or denying guilt.
This second dark pool abuse case, coming so close after the Barclays disclosures, was troubling because it validated what many had feared was going on in the dark for so long. “Certainly, Barclays raised eyebrows and may have confirmed many people’s worst fears about what was going on in some dark pools,” said David DeVito, head of trading at Madison Investment Advisors, a money management firm based in Madison, Wis., with $15 billion in assets. “But I think it’s also true that Barclays may not be the only one, and this is the first shot across the bow.”
Since the Barclays news broke, DeVito said he has heard from concerned clients, fielding questions from boards of directors and due diligence professionals about how his firm deals with dark pools. For his part, DeVito said his firm will use dark pools that have demonstrated a consistently high average execution size. He also monitors as best he can what is happening in the pools he uses. “But for a smaller firm, that is a tremendous allocation of cost and time.”
Even the dark pools themselves are finding that buyside users are more wary over the past several weeks and want more information about what’s happening to their orders in the pools. “The buyside is being more cautious-they want more verification,” said Adam Sussman, head of market structure and liquidity partnerships at dark pool operator Liquidnet, noting he’s fielding more questions about all aspects of trading. “They have more questions on algorithms and smart routers-really from top to bottom, it’s the whole process of order handling.”
DeVito said he hopes the end result of all this concern is that buyside firms will recognize they need to step up and peer into the shadowy waters of the dark pools they use. “The buyside cannot rely on the sellside to police this activity-they are not doing it well,” he explained. “The buyside needs to do more of its own due diligence about what is happening in these pools.”
To some extent, that is already happening. Dennis D. MacKee, spokesman for the Florida State Board of Administration (SBA), which oversees $180 billion in state pension funds, said the board doesn’t try to direct how its external managers use brokers, but it does keep an eye on things. “As a matter of policy, the SBA does detailed trade analysis for managers down to the trade level, which provides us the insight needed to discuss trading processes and costs, when appropriate, with our managers,” MacKee replied in an email.
That only makes sense, several buysiders claimed. This fear of the dark, and especially of front-running, can make some money managers cautious about every move they make in the market. “There have been times I’ve placed a market order in a very liquid stock and watched it sit there for 30 seconds or so, so I know my order is winding its way through the sausage factory, and everyone in the world is taking a look at it-and there’s only one way the price is going to go for you at that point,” said Armstrong Shaw’s Jensen. “Other times, I put in a limit order and it’s filled in an instant.”
These tense situations leave Jensen frustrated at times over the market’s complexity and fragmentation, and dark pools’ lack of full transparency. “Are things illegal? No. Are they unethical? Maybe,” he explained. “But you just know there are better ways of doing things, and so you search for those ways.”
Turning on the Light, Turning Back the Clock
One of the biggest old saws that HFT firms trotted out to counter the criticism of their activity in the markets was that you can’t turn back the clock. HFT, and the evolving technology that birthed it and continues to make it faster every day, cannot be undone-at least without irreparable harm to the markets, to trading volume and to liquidity.
But can the same be said about dark pools? If somehow the SEC could manage to stuff dark pools back into the box from which they sprang-make them a venue solely for institutional investors wanting to move large blocks of stock without roiling the markets-would that be a benefit to the markets and investors?
Some think it would. “It can be achieved, if we have people who know the technology,” said OneChicago’s Downey. “And one solution is to push back to what dark pools were originally, what they were created for.”
Whether the dark pool genie can be put back into its bottle is a big question, but as more trading abuse comes to light, the buyside is starting to realize that it may be up to them to take the lead. “I think the buyside needs to vote with its feet with some of these dark pool operators,” said Madison’s DeVito. “And I think we should be rewarding other people for doing business the right way.”
