It should not come as any great surprise that a brokerage firm, like the proverbial used-car salesman, would take a few liberties with the truth while trying to sell something. But the New York attorney general, Eric T. Schneiderman, has taken on Barclays by filing a civil suit related to the marketing of its dark pool trading platform, which the bank portrayed as safe for investors when it let plenty of sharks swim in the deep end.
The sharks are the high-frequency trading firms that have been pilloried of late, particularly since the publication of Michael Lewis’s book “Flash Boys,” which portrays them as the villains behind what he calls a rigged market. Whether true or not, those claims have become a powerful marketing tool that Barclays sought to exploit to lure investors into its dark pool by contending the investors would be protected from harmful trading practices.
There are more than 40 “alternative trading systems,” more commonly known as dark pools, that keep many of the details about the transactions executed there a secret. The systems give large investors, like mutual funds and pension plans, a place to trade large blocks of stock without revealing their strategies to others who could take advantage by front-running the trades. But the cost is a lack of transparency about prices, which makes it difficult to discern whether the trade was executed at the best price.
The premise underlying a dark pool is that investors trust whoever is operating it to provide a fair price and not misuse the information about their trading so that others can profit by trading ahead of them. Dark pools and other off-exchange venues now account for about 35 percent of the transactions in equities listed in the United States and have become quite lucrative for their owners, like Goldman Sachs, UBS and Barclays.
Profitability is driven by volume, so the temptation is strong to invite the high-frequency traders into the pool along with other investors. That sets up an inevitable clash between expanding the trading platform and adhering to the needs of investors for a safe place to trade.
For Barclays, it appears the bank tried to have it both ways: giving the high-frequency traders access to its dark pool while marketing it as safe for investors by saying the bank was limiting the access of those firms. Thus, the bank trumpeted its “liquidity profiling” system to protect against “predatory trading,” which Mr. Schneiderman contends was false because Barclays failed to provide those protections to a significant portion of the trading through its dark pool.
It is unlikely that marketing materials that contain misleading claims about a dark pool could be the basis of a federal securities lawsuit. A stock exchange does not owe a fiduciary duty to investors, so there is always a measure of risk when conducting business with a dark pool because it does not need to disclose other traders or how orders are handled.
There is no evidence at this point that Barclays violated any Securities and Exchange Commission rules about the proper execution of trades or the appropriate prices for the transactions, so investors received whatever protections to which they were entitled. A securities fraud charge also requires proof of fraudulent intent in connection with the purchase or sale of a security. Barclays was only enticing investors to use its dark pool, not misleading them about the value of the securities they were trading.
Mr. Schneiderman unsheathed a powerful tool not available to the S.E.C.: the Martin Act. Under that New York State law, a violation can be shown based on negligence, and a recent DealBook article pointed out that the “the only thing that prosecutors need to establish is a misrepresentation or omission of material fact” related to securities.
The reach of the Martin Act is broad, as shown in a 1948 case, People v. Goldsmith. The defendant was the author of a market newsletter that predicted the direction of stock prices by implying he had access to corporate insiders. This was long before the crackdown on insider trading. In fact, his predictions were based on interpretations of comic strips, which led the New York court to find that “when he failed to inform the subscribers of the purported sources of information he was concealing a material fact.” The Sunday funnies strategy is certainly novel, but telling investors one thing while doing another appears to be sufficient to violate the Martin Act.
The reaction from Barclays to Mr. Schneiderman’s suit has been telling. Rather than deny any violations, or contend that the attorney general twisted its words, a Barclays spokesman simply said that “we take these allegations very seriously.” The bank’s chief executive, Antony P. Jenkins, expressed his “deep disappointment” in a note to employees and said that “I will not tolerate any circumstances in which our clients are lied to or misled, and any instances I discover will be dealt with severely.”
This is not the first time Barclays has run afoul of the government, having agreed to a deferred prosecution agreement in 2012 over manipulation of the London interbank offered rate, or Libor, that resulted in a penalty of about $450 million. So do not be surprised if the bank seeks a quick settlement of the suit that will cost it millions of dollars in fines, perhaps even more than it had to pay two years ago.
The greatest benefit from the lawsuit may not be any penalty extracted from the bank but the reaction of investors. DealBook reported that several brokerage firms had stopped sending orders to the Barclays dark pool because of investor concerns about how their orders were being executed. There is a chance that other dark pool operators will be scared straight by the response of investors, at least for a little while.
The broader question is whether this signals the beginning of the end of dark pools, or at least a significant readjustment of the rules governing them. In a speech on June 5, Mary Jo White, the S.E.C. chairwoman, said “transparency has long been a hallmark of the U.S. securities markets, and I am concerned by the lack of it in these dark venues.” The S.E.C. initiated a pilot program last week that includes a provision designed to drive some trading from dark pools to “lit” exchanges, like the New York Stock Exchange and Nasdaq.
The reason for creating dark pools was to protect large investors from predatory trading, but what seems to have escaped notice is that building a market based on a lack of transparency is almost sure to invite abuses. Like anything else, what appeared to be a good idea at the time can morph into something that causes unforeseen harm.
There will be no quick fix, however, as the S.E.C. has to study the issue before it proposes any new rules. And substantial restrictions on dark pools are sure to draw heavy lobbying from Wall Street, which profits handsomely from letting the sharks swim in their dark pools.