New York Attorney General Shines a Light on Dark Pools

September 1, 2014

Dark pools are trading venues where securities trades are executed anonymously outside national exchanges. Dark pools have grown in popularity in recent years, particularly among institutional investors, as a way to trade large blocks of shares without alerting the market or revealing trading strategies. 

There are at least 40 dark pools operating within the United States, and some of the largest dark pools are operated by notable Wall Street banks, including Barclays, Morgan Stanley, Goldman Sachs, and J.P. Morgan. Despite the increased popularity of dark pools, recent events have confirmed that dark pool participants must be careful to protect themselves against aggressive trading practices that have become increasingly common in these venues.

Recently, regulators have subjected several major dark pools (and their operators) to fines and lawsuits. For example, on July 1, 2014 the Financial Industry Regulatory Authority (“FINRA”) fined Goldman Sachs $800,000 and ordered it to return $1.67 million to harmed customers because it executed customer trades in its SIGMA-X dark pool at prices inferior to the best bids on the market at the time. Another dark pool, Liquidnet Inc., recently paid a $2 million penalty to the Securities and Exchange Commission (“SEC”) for allegedly improperly sharing information about its customers with outside parties in order to expand its business operations. Finally, on June 25, 2014 the New York State Attorney General, Eric Schneiderman, filed a lawsuit against Barclays PLC and its United States affiliate Barclays Capital, Inc. (collectively, “Barclays”) alleging that Barclays operated its dark pool, Barclays LX, through “fraud and deceit” by hiding the level of predatory trading conducted in the dark pool by high-frequency trading (“HFT”) firms who use complex computer algorithms and fast electronic connections to impose an artificial fee on legitimate trades. Although HFT strategies vary, HFT firms generally extract these “fees” by front-running purchasers of stock and selling the stock to those purchasers at slightly higher prices. This generates pennies or fractions of a penny in profit for the HFT firm per trade, but is repeated at a high frequency.

Using evidence from whistleblower testimony, internal emails, and Barclays’ marketing materials, the Attorney General’s complaint (the “Complaint”) alleges that Barclays sought to make its dark pool the largest by trading volume “through a series of false statements.” According to the Complaint, Barclays touted its dark pool to investors as a safe haven against predatory HFT firms, while allowing predatory HFT firms access to its dark pool and its clients’ trades. As set forth in more detail below, the Complaint alleges that Barclays’ marketing materials misrepresented: (1) the extent of HFT and the amount of aggressive HFT activity in its dark pool; (2) the lack of protection actually offered by its “Liquidity Profiling” service against HFT tactics; (3) the manner in which it routed its client orders to favor Barclay’s trading venues; and (4) the fact that Barclays catered its dark pool to HFT firms.

1.    Type and Extent of HFT Activity

In its marketing materials, Barclays often included graphic charts analyzing the “liquidity landscape” of its dark pool. These charts, which represented each firm trading in the dark pool as a circle on a scale roughly corresponding to the aggressiveness of that firm’s trading, purportedly showed that the dark pool was a safe trading venue with few HFT firms and very little aggressive trading. In fact, internal emails revealed that Barclays had intentionally “de-emphasized the number of [high frequency traders]” in the charts by obscuring certain HFT firms behind other HFT firms on the scale. Emails also revealed that Barclays completely removed one aggressive HFT firm from a chart, thereby skewing the representation of risk to investors.

2.     Barclays’ “Liquidity Profiling” Service

Barclays created its “Liquidity Profiling” service purportedly to insulate investors from predatory trading by quickly responding with corrective actions when it detected adverse behavior. It claimed that its Liquidity Profiling service has the ability to analyze “each interaction in the dark pool” so that Barclays could “restrict HFTs interacting with our clients.” According to the Complaint, however, the Liquidity Profiling service “offers little or no benefit to Barclays’ clients.” In fact, the Attorney General’s investigation revealed that Barclays: (1) never prohibited a single HFT firm from participating in its dark pool no matter how toxic or predatory its activity was deemed to be; (2) did not regularly update the ratings of traders monitored by the Liquidity Profiling service, meaning traders were often categorized in ways that did not reflect their aggressive trading activity in Barclays’ dark pool; (3) applied “overrides” to a number of traders in the dark pool, assigning safe Liquidity Profiling ratings to certain traders that should have been rated as toxic; and (4) did not apply its Liquidity Profiling service to a significant portion of the trading activity in its dark pool.

3.    Barclays’ Routing Practice

Barclays’ marketing materials claimed that it routed client orders in a manner that did not favor any particular trading venue. The Attorney General’s investigation found, however, that almost all client orders were routed to Barclays’ dark pool first, regardless of the probability that a given trade would execute there, would execute at a favorable price, or would cause information leakage.1 Barclays admitted as much in emails to a select group of HFT firms in March 2014, telling them that approximately 90% of all orders “are first directed into the dark pool.”

4.    Barclays Catered to HFT Firms

According to the Attorney General’s Complaint, while Barclays represented to clients that it was working to keep them safe from predatory HFT tactics, the bank supplied HFT firms with advantages over traditional investors in its dark pool. Specifically, it allowed HFT firms to connect directly to its servers, it processed orders slowly enough to allow HFT firms an opportunity for latency arbitrage,2 and it charged high-frequency traders little or nothing to trade. One former senior-level Director stated that, “Barclays was doing deals left and right with high frequency firms to invite them into the pool to be trading partners for the buy side. So the pool is mainly made up of high frequency firms.”

In relation to the above allegations, the Attorney General asserts in his Complaint that Barclays committed securities fraud in violation of New York’s Martin Act (General Business Law §§ 352 et seq.) and persistent fraud and illegality in violation of New York Executive Law § 63(12).

Although dark pools serve as a useful venue for many investors seeking to make legitimate trades, certain dark pools are also frequented by HFT firms who make executing trades more expensive for other investors. As such, investors who wish to execute trades in a dark pool may wish to avoid certain venues so as to protect themselves against these aggressive trading practices.


1Information leakage occurs when an investor’s trade order is revealed to other investors, brokers, or HFT firms, thereby defeating the purpose of trading in the dark pool.

2Latency arbitrage refers to an HFT firm’s ability to take advantage of the fact that certain traders receive market information more quickly than others.
Latency arbitrage is an essentially zero-risk trading method.