Last week’s lawsuit from New York attorney general Eric Schneiderman against Barclays has shone a light on a murky area of trading: dark pools.
The UK bank is facing fraud charges relating to the marketing and running of its equities dark pool Barclays LX.
 |
| New York attorney general Eric Schneiderman |
Schneiderman accuses the bank of falsifying marketing material, which was supposed to show investors about how, and for whose benefit, Barclays operates its dark pool, demonstrating a “disturbing disregard for its investors in a systematic pattern of fraud and deceit”.
The complaint states Barclays purported to protect clients from “aggressive or predatory high-frequency trading” in its dark pool, but in fact actively sought them out and offered them advantages to others trading in the pool. The bank has said it is co-operating with Schneiderman and federal regulators, and is also conducting an internal enquiry.
Goldman Sachs’ dark pool Sigma X has also come under regulatory scrutiny. On Tuesday, the US bank agreed to pay the Financial Industry Regulatory Authority (Finra) an $800,000 fine for mis-pricing almost 400,000 trades in Sigma X, and it returned $1.67 million to disadvantaged customers, according to a Finra statement.
What is a dark pool?
A dark pool is a marketplace for traders to buy and sell securities in secret. There are no bids or offers, and orders are sent “into the dark”. A participant can input an order, say to buy €500 million, and that order will remain in the dark. It will not show up on the platform, and neither will the identity of the participant.
If another participant inputs an order to sell €500 million, the two orders will cross and the trade will happen. Trades can happen in microseconds or take hours to complete.
In contrast, trading on a transparent, lit venue, such as EBS or Reuters, means orders are usually displayed to all participants, who can see everyone else’s interest. Traders click on a price they like, and send an order to hit that offer.
FX trading venues have become more transparent over the years. Banks’ single-dealer platforms price off the largest platforms’ market data and, as information transmits quickly, an order placed on these large platforms are more likely to move the whole market. But therein lies the problem.
The big players in FX, typically banks, are keen to avoid the market moving against them when trading large amounts, says James Sinclair, chief executive of FX aggregation specialist MarketFactory. One solution is dark pools.
“These large banks do have large orders to trade with each other, but don’t want to be read by each other,” he says. “Dark pools have been successful for this use. The more concentrated the top end of the market is, and the lower the volatility, the more this medium would be used.”
A number of banks operate FX dark pools, including UBS, Credit Suisse and Deutsche Bank, as well as interdealer broker BGC and FX trading platform FXall.
Sinclair believes there is increasing demand for dark pools in FX, and gave a presentation to the Bank for International Settlements committee in January, in which he predicted the growth of dark pools.
Trading through dark pools already represents more than 30% of US equity volumes, according to Sinclair, and is a growing trend in FX.
Buy-side demand
At present, FX dark pools cater to the needs of the sell side, ie the top-tier banks. Arguably, these institutions are sophisticated enough to understand the drawbacks of trading with each other in a dark pool and do not require protection from regulators.
However, demand for buy-side-only FX dark pool is increasing, according to Dmitri Galinov, chief executive officer at FastMatch, a new matching system of FX.
FastMatch offers a buy-side-only dark pool called AgencyFX, which allows buy-side institutions to exchange liquidity directly with one another instead of going through a bank to trade.
This allows them to avoid paying a transaction spread to a bank and prevents information leakage, whereby the bank can influence the price offered to the buy-side client depending on what the order looks like.
The platform is still in its infancy, but already has 13 buy-side clients on board, says Galinov.
“FX dark pools will increase and a number of them will come from independent venues like FastMatch,” says Galinov. “I also see that some of the banks themselves will create dark pools.”
Is he concerned about regulators investigating the use of dark pools in FX, especially given the regulatory scrutiny facing the industry?
“No,” chuckles Galinov. “The regulators in foreign exchange have much bigger problems [right now] than dark pools.
“Practices such as last look are still very prevalent – in equities this practice was abandoned about 20 years ago. There are more egregious things going on in foreign exchange that should be addressed first.”