Demand grows for more regulation, transparency to insulate investors
A lawsuit filed by New York state against Barclays PLC was the latest hit to the image of dark-pool trading, providing yet another prod to increase trading venues' transparency while also potentially opening up dark-pool operators to broader legal action from governmental agencies.
“Nobody needed this,” Kevin McPartland, principal and head of market structure research, Greenwich Associates, Stamford, Conn., said of the lawsuit filed June 25 by Eric Schneiderman, New York state attorney general.
The suit, combined with SEC Chairwoman Mary Jo White's announcement last month that the Securities and Exchange Commission would review rules on dark-pool transparency, should show the need to make dark-pool operations more open, Mr. McPartland said.
In addition, the SEC might be spurred into filing civil charges against dark-pool operators. Some experts see parallels between the Barclays lawsuit filed by Mr. Schneiderman and legal action brought in 2003 against Putnam Investments LLC, Boston, claiming the money manager did not disclose improper market timing by its portfolio managers.
A year later, Putnam agreed to pay a total of $110 million to settle accusations by the SEC and Massachusetts regulators.
“If the past is any guide to the future, I think this raises the potential that the SEC will feel some motivation to move ahead with a civil case (against Barclays),” said Todd Cipperman, founder and managing partner of Cipperman Compliance Services LLC, Wayne, Pa. “I wouldn't be surprised first if Massachusetts followed suit with its own case against Barclays. But I would be surprised if the SEC didn't do the same.”
One source who asked not to be identified said: “Back then (with market timing), shareholders were harmed; now it's both shareholders and investment clients. ... Traditional mutual funds had no reason to do market timing other than to game the system. It's the same with dark-pool manipulation; it's not best execution, it's gaming the system for individual gain.”
False statements alleged
Mr. Schneiderman's lawsuit in New York State Supreme Court claims Barclays increased the market share of its dark pool through false statements to clients and investors about how, and for whose benefit, the bank operates its dark pool.
“We take these allegations very seriously,” said Mark Lane, Barclays spokesman. “Barclays has been cooperating with the New York attorney general, and the SEC and has been examining this matter internally.”
“Dark pools were supposed to insulate institutional investors from predatory moves by high-frequency traders,” said Avi Josefson, partner and securities fraud litigator at Bernstein Litowitz Berger & Grossmann LLP, Chicago. “The deceit by Barclays, according to the New York attorney general's lawsuit, is that those pools were marketed as safe when they were not.”
Several sources said the issue is not whether dark pools are inherently bad, but rather how they're used and how aware investors are of how they operate.
Institutional investors “need to understand the kind of pool they're swimming in,” said Rebecca Healey, senior analyst, The TABB Group LLC, London, who would not comment on specifics of the Barclays lawsuit. “It's a myth to accuse dark pools of including predatory traders. There's always a trade-off. Those using very safe pools are unlikely to get the immediate liquidity they want. To find that match (for a trade), those pools need more time. It's a utopian call to get both the liquidity and security they want. ... It's not so much if a pool is risky or risk free; it's about understanding the pool and what you expect from the pool, how your trading behavior will interact with the pool. It's a two-way street.”
Greenwich's Mr. McPartland agreed, saying the more investors know about the operation of the dark pools they and their brokers use, the fairer the pools will operate. “It's all alleged, but the story to me is about transparency, letting users know how trades are made,” Mr. McPartland said.
“It's not that dark pools are bad. Across the board, all markets, whether in equities or fixed income, are looking for transparency,”Mr. McPartland added.
Mr. Cipperman said some benefits of the increased exposure dark pools have received of late are that institutional investors will do more monitoring, more operational and compliance due diligence in selecting trading venues.
“You'll see more questions in RFPs specifically about trading in dark pools. Do they allow high-frequency trading? And the big plans will want to see as much data as they can about the dark pools,” Mr. Cipperman said. “This will be tough on compliance people; they need to know the trading venues, know the algorithms used.”
What institutional investors probably won't do, Mr. Cipperman said, is file their own lawsuits. “There will be a wave of regulatory actions, but not a lot of civil suits. (In those suits) you need to show intent. Barclays was more a compliance breakdown. It will be like the next "market-timing' issue in terms of regulatory response.”
As for dark-pool operators, Mr. McPartland's wish is that all of them — including the large banks — be proactive in making their trading rules clear and understandable, and that they not wait for the SEC to act. “My advice is that all of the (dark-pool) operators make all of their rules public. Independent operators generally provide this already; I'm hoping the bank-owned platforms do this, too. We're all better off that way.”
Still, Mr. Cipperman thinks such transparency will be difficult for dark-pool operators to pull off. “Dark pools inherently are non-transparent — that's why they're "dark' pools — but obviously their operators see what's happening in them. The big issue for Barclays (in the New York state suit) is they told clients that they wouldn't allow predatory traders in the pools and then let them do it. The particularly egregious behavior was that they marketed this as a protected dark pool.” n
This article originally appeared in the July 7, 2014 print issue as, "Barclays suit another black eye for dark pools".