Barclays Tries 'Sophisticated Client' Defense to Justify Dark Pool Fraud

According to a securities fraud complaint filed by New York Attorney General Eric Schneiderman, Barclays has allowed high frequency traders (HFT) to operate inside its dark pools. The bank has done this despite promising that HFTs couldn’t interfere with dark pool trades. In response to Schneiderman’s complaint, Barclays argued that dark pool clients are too sophisticated to actually believe them. In other words, it’s okay for a bank to lie because sophisticated clients should know better.

In his bestselling book “Flash Boys: A Wall Street Revolt,” author Michael Lewis shed light on a practice called high frequency trading. It’s a practice that, according to some analysts, rigs the stock market against ordinary investors. Throughout the history of economic crime and fraud, profiled here by an MBA in Fraud Management and Economic Crime program, criminals have leveraged technology to stay ahead of both victims and law enforcement. No one is calling HFT a crime just yet, but attorneys general like Schneiderman have started to look askance at the practice.

If an ordinary investor or hedge fund decides to buy 10,000 shares of Apple, the HFT detects the trade and buys the shares before the investor can execute the trade. The investor expects to receive a certain price when he clicks the “Buy” button. However, because HFTs interfere with the trade, he has to pay more than he anticipated.

HFTs invest heavily in Internet infrastructure that enables them to execute trades milliseconds before the ordinary investor’s trade reaches an exchange. Lewis highlights a company called Spread Networks that invested $300 million to run a fiber optic cable from the Chicago futures market to New York. The new cable only shaved three milliseconds off of the current signal route, but those three milliseconds provide enough time for HFTs to execute a bait-and-switch on investors. An investor’s trade request might arrive at one exchange ahead of an HFT, but the HFT can beat the investor to all of the other stock exchanges.

Investment banks and brokerages create dark pools to allow investors to trade away from public stock exchanges. The concept was originally designed to protect institutional investors that needed to make big transactions. For instance, if a mammoth pension fund wanted to sell a large number of shares without disturbing the market, dark pool brokers would match the pension fund with buyers who were willing to purchase their shares at a quoted price. The shares wouldn’t have to be sold piecemeal on the open exchange, where they would be subject to price fluctuations.

Dark pools are controversial because they affect stock price transparency. No dark pool trade is reported on the exchanges until the trade is already executed, so everyday investors have no heads-up when a major transaction is about to happen. Dark pools now make up 12 percent of all securities sales in the U.S., which means that they significantly influence stock prices without regulation or transparency. Also, brokers are allowing more than just institutional investors into their dark pools. They’re also lowering transaction size requirements, allowing dark pool investors to execute smaller trades.

According to Schneiderman, Barclays marketing materials claimed to protect dark pool investors from HFTs. In reality, Barclays executed trades over HFT systems that maximized its profits instead of looking for trades on exchanges, which might have offered better prices to investors. By allowing HFTs into its dark pools, Barclays subjected institutional investors to the same bait-and-switch that ordinary investors have experienced on the open exchange.

Barclays says that its investors knew what it was doing despite what marketing materials said, and it isn’t the first Wall Street firm to try this tactic in court. Jesse Litvak, a former managing director at Jefferies & Co., was convicted of misstating the prices of mortgage-backed securities sold by his firm. At his sentencing hearing, when he argued that his clients knew he was lying, Judge Janet C. Hall of New Haven’s District Court was unsympathetic. “You lied,” she said. “Maybe that’s what people do every day on Wall Street. That doesn’t make it legal.” If precedent holds, Barclays’ sophisticated client defense will turn out to be a legal dead end.