A headline:

Barclays is scandalously lying about a Dark Pool 

New York Attorney General Eric Schneiderman has sued Barclays over a Dark Pool and some High-Frequency Trading and generally being an all-out naughty bank.

Allow me to give you the basic background (and I’m going to start far from my ending point – so bear with me).

Imagine that you’re a small-time investor, with some interest in buying an Apple share. But when you chat to your broker, he’s seeing on his screen that Blackrock (that giant institutional investor) is currently in the market, selling off a batch of Apple shares in order to pay out a large investor. Because it’s such a large batch, they’re having to do it in small lots: trying not to drive the share price too low by flooding the market with shares for sale.

So the broker suggests that you throw in a really low buy bid to see if Blackrock take it. If they don’t, it’s no loss – you can just re-bid a bit higher later in the day.

Now imagine all the traders in the market noticing that, and trying to do the same thing. In particular, imagine all those “high frequency traders” that are actually super-fast computers running complicated algorithms that allow them to trade in and out of a stock in microseconds to take advantage of the buy/sell movements of giant institutional investors…

There is a commonly-used descriptive word for me and my HFT friends, were we to engage in such a thing. We would be called “predatory traders”.

And in the end, what you have is whole lot of highly annoyed institutions, who are losing out because they’re so big in the market, and some pleased-with-themselves predatory traders.

Given that, what the big institutional investors would really prefer is a place where they can make their trades without anyone seeing that they’re making trades until after they’ve made them.

Enter: the Dark Pool

The Dark Pool is an off-the-exchange trading venue where traders can trade anonymously. And it’s the kind of shady establishment that keeps the riff-raff (ie. the badly-behaved predatory traders) out. The big banks own/run these dark pools, and they stand outside like bouncers, making promises to their exclusive clientele about who they’ll let in and who they’ll boot to the curb.

Enter: Barclays

The Dark Pool run by Barclays is one of the largest of its kind. And Barclays busily shopped itself around to its institutional clients by making large claims about how well-behaved all the traders were in its Dark Pool. It showed the institutional investors this chart (which I have re-posted from this AMAZING Bloomberg Article by Matt Levine):

If you’re looking at this and wondering what’s going on: the green circles represent high-frequency traders (ELPs, or electronic-liquidity providers), and the blue circles represent institutional investors, and everyone is sort of batting in the same playing field all over.

Only, as it turns out (and as Matt Levine points out), the key to this chart is the use of the word “Sample” in the title – which in Barclays-speak, means “completely falsified”. The largest ELP trader in the pool is Tradebot – and their trades were excluded from the diagram because it looked bad.

An extract from the complaint that Eric Schneiderman filed:

41. In a response email, one employee objected to the modified chart, stating that removing Tradebot from the analysis was a falsification of the data.

42. In response to this objection, a Director in the Equities division wrote that “the point of the chart is not to show what’s in the pool. The point is to market our capability . . . to monitor individual participants in the pool.”

43. A Vice President responsible for selling the dark pool to clients disputed that explanation, replying to the group that “[m]y point when selling that picture was always: ‘here is a snapshot of the participants in [Barclays’ dark pool] as an accurate view of our pool.’ I was never using it like an ‘illustration’” of Barclays capability to monitor the pool. “I had always liked the idea that we were being transparent, but happy to take liberties if we can all agree”.

44. Barclays’ Head of Product Development (who was also the second in command within Barclays’ Equities Electronic Trading division) agreed. He responded, “I think the accuracy [of the chart] is secondary to [the] objective” of showing clients that Barclays monitors the trading in its dark pool, and “so if you want to move/kill certain bubbles, it doesn’t really matter.”

45. Barclays’ Head of Equities Sales responded, “Yes! U smart.”

So to quote Matt Levine:

The naive reading of that chart is: “We have a lot of institutional investors and very limited predatory trading in our dark pool.” But the correct reading of the chart is: “We have software that allows us to produce this chart.” The chart is a perfectly self-referential object, demonstrating only that the chart exists. The chart is a chart of how much chart there is.

Which is amazing.

The Awkward Irony

At the same time that Barclays was running around and punting its Dark Pool to its institutional investors as a place without too many predatory traders; it was also running around and schmoozing up to the high frequency traders to try and get them to play in the Dark Pool.

Why?

Well that’s actually an excellent question. Some facts about the pricing of trades:

1. High Frequency Traders are charged virtually nothing to make trades. As in: they pay nothing when they post a trade. And they pay between $0.0002 and $0.0005 per share to take an available order (ie. when they sell a share).
2. Institutional Investors are the ones that actually pay money to buy and sell shares.

Given that, why on earth would Barclays do what it did?

I mean – allowing predatory traders into the pool earned them less than a rounding error, and jeopardised their real revenues.

Here’s the theorised explanation:

1. Institutional investors might like to trade with each other, and only each other, in a Dark Pool.
2. But the trouble is that all Institutional Investors kind of want the same thing – to trade for the long-term.
3. Which makes it a bit difficult to trade – because there is no one to trade with.
4. So the institutional investors actually need the ELPs (and/or predatory traders) to meet the other side of their trades.

Think of it this way: institutional investors are a bit like young married couples with children, and the ELPs are their single friends that are still leading the high life. The young married couples might think that they’d prefer to party with people that “understand” – but those parties are extraordinarily boring. Mainly because, as it turns out, married couples with children only really have one topic of conversation: their children. So you need the singletons because they’re the ones with interesting lives.

So Barclays had two choices:

1. Run a Dark Pool that was so pristine that no one would be able to swim in it; or
2. Run a Dark Pool that everyone could use.

Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.