Barclays received a harsh lesson in ichthyology last week, learning that sharks should not be allowed to swim with smaller fishes in a dark pool tank.
The lesson, also learned by now-defunct Pipeline Trading, could be the beginning of a long dissertation by regulators which could eventually spell the end of dark liquidity.
Barclays "demonstrated a disturbing disregard for its investors" by misleading them on some of the fishier residents of its dark pool, said New York's attorney general Eric T. Schneiderman, who filed civil fraud charges against the bank on June 25.
Although Barclays assured investors that they were "diving into safe waters... the dark pool was full of predators -- there at Barclays' invitation," said Schneiderman.
[For more on how the markets need to adapt to HFT in different ways, read: Mind the Gap Between Innovation and Regulation.]
The predators were high frequency trading firms, the same firms that many investors -- and some regulators -- consider sharks in the fish tank.
Is it safe to go back in the water?
A relatively new phenomenon, dark pools were originally synonymous with safety, having been invented to cross customer and internal trades within the cozy confines of a bank or brokerage.
Not only would the dark pool save the bank/broker/customer money by lowering costs (exchange fees), it would also ensure that customers' larger deals would have a lesser impact on the market -- as the deals would not be seen until completed.
But Barclays isn't the first company to lure investors into a shark-infested dark pool. About three years ago, the Securities and Exchange Commission announced a million dollar settlement with Pipeline Trading systems for misleading investors.
Pipeline billed itself as a big-block crossing network that did not allow HFT players, but this was only part of the deception. Pipeline was funneling the majority of its customers' orders through a trading company that it owned.
The double deception cost Pipeline, founded by a nuclear physicist, Fred Federspiel, and a former Nasdaq president, Alfred Berkeley, its company. After rebranding itself as Aritas, Pipeline had to close down only a few months later.
So, are dark pools a benefit to investors or merely a convenient money-making scheme for banks and brokers -- away from the prying eyes of regulators? According to The New York Times: "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."
The dark pool bandwagon, upon which some 40 alternative trading systems have jumped, may have had its heyday. Part of SEC Chairman Mary Jo White's new 13-step program is to make HFT and off-exchange trading more transparent. Shining light into dark pools is not exactly what the operators had in mind when they started them, and it may not agree with their business models.
It could also be a case of "be careful what you ask for" if investors, happy that the sharks have headed for the dark pool exit, are unhappy with the remaining liquidity.
If that is the case, there could be some major consolidation of dark pools, and many will simply close.
To paraphrase Emily Dickenson, we have grown accustomed to the dark, and when the regulators hold the lamp the darkness may have to alter.Dr. John Bates is a Member of the Group Executive Board and Chief Technology Officer at Software AG, responsible for Intelligent Business Operations and Big Data strategies. Until July 2013, John was Executive Vice President and Corporate Chief Technology Officer at Progress ... View Full Bio