Dancing in the Dark: Fraud Shapes Dark Pools

Publication date: 05/2016

Aggelos Andreou looks at three key fraud investigations that have gone a long way to shaping the dark pool landscape into what it is today.

In the post-financial crisis era, the stereotype of corrupt bankers and executives who make money on the back of other people’s savings has been widely accepted, and when exposed, the news is enthusiastically greeted by the public. But not everyone in the financial services industry shares that sentiment, especially dark pool providers.

Depending on the source, there are now upwards of 40 execution venues, comprising independent, broker-dealer-owned, consortium-owned and exchange-owned dark pools. These venues, now responsible for approximately 15 percent of all orders executed across the US markets, were established ostensibly to facilitate block trading by institutional investors worried about moving market prices by executing large orders on lit—or traditional—venues.

But the reality is that dark pools—an unfortunate moniker if ever there was one—provide the perfect platform from which the media can elicit sensational news when it comes to fraud, not necessarily because of the large number of cases to have emerged from this market, but due to the lack of transparency in the trading process.

Transparency Is the Enemy

There are indeed reasons why dark pools are under scrutiny, not only from journalists but also from regulators. As has been reported before, it is their very trading nature that raises concerns about the circulation of securities and the intentions of traders.

In Flash Boys, Michael Lewis describes the main concerns with dark pools: “Their internal rules were a mystery, and only the broker who ran a dark pool knew for sure whose buy and sell orders were allowed inside,” Lewis writes. “The amazing idea the big Wall Street banks had sold to big investors was that transparency was their enemy.” Transparency, Lewis maintains, is the key.

While large financial institutions insist that this is a fundamental aspect that keeps lit markets safe and unaffected, regulators are concerned about them not disclosing any information on who buys or sells securities and the volumes being traded. Although this method of trading is anything but new—dark pools have been part of the US securities landscape since the 1980s—it is clear that in recent years with the introduction of high-frequency trading, dark pools have become a center of attention.

“This whole frenzy with regulating dark pools kicked in when traders and brokers were able to use algorithms and trade in zero time,” explains Haoxiang Zhu, assistant professor of finance at the MIT Sloan School of Management. As we will see in the three cases below, high-frequency trading was the common basis and the regulators’ starting point to investigate and impose sanctions. High-frequency traders have always been regarded as the “villains” of the market, due to their algorithms being able to predict market moves and trade in zero time.


But transparency and high-frequency trading are not the only problems related to dark pools. As the Seven Pillars Institute for Global Finance and Ethics points out in its Shining a Light on Dark Pools paper published in 2013, there are a number of issues that need to be addressed before the market can be considered free and fair. Price discovery is the number one concern, according to the Institute, as the lack of information and transparency surrounding the trading process can double- or triple-count trading volumes, making it hard to quote an accurate price for a given security. “It is imperative to know the price when you’re making a trade. If there is no information on that, then you can set whichever price you want, and this can create problems,” MIT’s Zhu explains.

Furthermore, the fact that dark pools are designed to cater to certain institutions and not to all traders in the market is a major factor in creating inequality in the markets. “And for those who have access to a dark pool, they usually compete for exclusive information, such as indications of interest (IOIs),” adds Zhu. These issues are by no means the only instances contributing to what many see as an ongoing battle between regulators and dark pool providers—a battle that in recent times has claimed a number of casualties in the form of investment banks Barclays, Credit Suisse and UBS.

The Barclays Case

It’s fair to say that 2014 was not a good year for Barclays: In April the bank reached a $280 million settlement with the US Federal Housing and Finance Authority (FHFA) after it was found guilty of misleading lenders Fannie Mae and Freddie Mac during the 2008 financial crisis, while only a month later it was fined £26 million ($37 million) by the UK’s Financial Conduct Authority (FCA) for “failing to adequately manage conflicts of interest between itself and its customers as well as systems and controls failings, in relation to the Gold Fixing.”

Then, in late June 2014, New York Attorney General Eric Schneiderman filed a lawsuit against Barclays alleging that the bank had provided preferential treatment to US-based high-frequency trading firms, while simultaneously claiming to protect its other clients specifically from “predatory” and “aggressive” traders in its Liquidity Cross (LX) dark pool. And while such allegations might have been nipped in the bud had Barclays managed the situation better through acknowledging its wrongdoing, official statements from the bank in the wake of the scandal were thin on the ground.

At the time, there were only sporadic leaks of internal emails from the firm’s upper management, which failed to deny the accusations and added further fuel to the developing fire. “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. The success of our business depends crucially on our clients being able to rely absolutely on our honesty and integrity,” wrote Anthony Jenkins, Barclays’ then CEO, in a leaked memo to staff published by Reuters on June 26, 2014.

owever, given the magnitude of Barclays’ impending fine, it appears Jenkins’ comments were too little too late. No Misconduct Some eight months later, in February 2015, Barclays, by way of a 42-page motion, argued that the New York State Supreme Court should drop the case, officially denying any misconduct on its part. “We don’t believe that the lawsuit is justified,” said Barclays in an official statement, claiming that its clients would not rely on a brochure to proceed with their trades.

The judge presiding denied the request, although the bank achieved something of a small victory when Schneiderman was ordered to provide better evidence to support his case. Eventually, approximately a year later, in January 2016, Barclays capitulated and agreed to a settlement: The bank was forced to pay a fine of $70 million, split evenly between the Securities and Exchange Commission (SEC) and the New York Attorney General’s office, in addition to admitting publicly that it had violated New York State laws and agreeing to independently monitor its LX venue.

“The problem is that institutional investors worry that if they are forced to move big orders to the market, the price will move away from them. They do have a need to make transactions without disclosing much information. So dark venues from that perspective are useful for investors,” adds MIT’s Zhu.

The Credit Suisse Case

Following the Barclays case, Credit Suisse became Schneiderman’s second victim in his quest to clear the shadows surrounding dark pools. However, the marked difference between the Credit Suisse and Barclays cases is that the Swiss bank held up its hands and admitted its wrong-doing once the lawsuit became public.

On July 27, 2015, Fox Business reported that Schneiderman was in the process of preparing a lawsuit against Credit Suisse—similar to the case against Barclays—relating to irregularities in its Crossfinder dark pool, the largest dark pool in the US capital markets by volume. Later that month, The Wall Street Journal wrote that the Swiss bank was in negotiations to settle the case, paying “tens of millions of dollars,” without providing any specifics in terms of allegations. Schneiderman officially filed a lawsuit against Credit Suisse in August 2015.

As with Barclays, Credit Suisse was charged with a series of regulatory breaches: publishing misleading brochures, which falsely promised an investment environment safe from high-frequency traders; favoring certain clients by providing trading-related benefits; and most importantly, violating regulations around its pricing of stocks.

A few months later—in January 2016—the Swiss bank settled a fine of $60 million, again split between the New York Attorney General’s office and the Securities and Exchange Commission. In addition, it agreed to pay a total of $24.3 million to the SEC for a separate case relating to 117 million illegal sub-penny orders executed in its Crossfinder pool. Contrary to the Barclays case, however, Credit Suisse was released from having to publicly admit to any of the allegations, sticking to a policy of not commenting on the case to the press.

One would have thought that two banks and $154 million in fines would have sent a clear and unequivocal message to other dark pool operators to play by the rules, although misconduct leading to the third case—that of Swiss bank UBS—had already been ongoing for some time.

The UBS Case

The UBS case, which cost the Swiss bank a total of pay $14.4 million, involved fraud over an extended period from 2008 to 2011, although news of the violations only came to light in early 2015 when the SEC announced that the bank had been engaged in a series of regulatory breaches relating to its dark pool.

According to the SEC, UBS “failed to properly disclose to all subscribers the existence of an order type that it pitched almost exclusively to market-makers and high-frequency trading firms. The order type, called PrimaryPegPlus (PPP), enabled certain subscribers to buy and sell securities by placing orders priced in increments of less than one cent. However, UBS was prohibited under Regulation NMS from accepting orders at those prices. By doing so the firm enabled users of the PPP order type to place sub-penny-priced orders that jumped ahead of other orders submitted at legal, whole-penny prices.”

It is worth noting that UBS’ dark pool is the second largest in the US by volume and hosts some of that market’s most prominent players. Even though the news didn’t receive the level of publicity one might have expected, the bank didn’t deny any of the accusations and declared that it is was “happy” to settle the charges.

What is interesting about this case is that it is likely that the SEC knew what was going on in the UBS dark pool between 2008 and 2011, although it was not in a position to intervene until regulations pertaining to dark pools had been hammered out. According to a Bloomberg article published on January 15, 2015, the SEC had been aware of what was going on in UBS’ dark pool during the specified period, but at that time the function of dark pools was treated primarily as a “technical” issue where regulators could only provide a warning to “fix” irregularities.

More to Come

According to a Reuters news story published on February 22, 2016 pertaining to the SEC’s increased focus on dark pools, SEC chair Mary Jo White confirmed that she expects more providers to fall afoul of the US market’s regulations. “I think you’ll see more dark pool cases,” she said. “It’s enormously important they be strongly complied with and so we pay a lot of attention to any violation of any of those rules and requirements.”

White’s comments appear to be consistent with European expectations, where regulators are keen to follow the US lead. A source from London Stock Exchange, who asked not to be named, confirmed that the exchange group expects new directives from UK and European regulatory bodies before the end of 2016 that will force providers to modify how their dark pools are run. “We are expecting major restrictions and they will definitely affect the way dark pools work,” the source says.

There are two lessons venue operators can learn from the cases of Barclays, Credit Suisse and UBS. First, if you’re engaged in any illegal activity, the regulators are likely to get wind of it sooner or later, even if it is a number of years after the behavior/market abuse ceased, as in the UBS case. Second, if you’re caught with your hand in the cookie jar, the best course of action is to admit your wrong-doing, cooperate with the regulators, and accept your punishment.

That much is common sense.