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David Hunter, Fintech Start-up
07 July 2014
Why did Barclays let predatory HFTs into LX if it knew it wasn’t in the best interests of its
institutional clients? Money, market share, and more money.
As the former head of electronic trading product management and quantitative strategies at Deutsche Bank,
responsible for the firm’s dark pool in Europe, I wanted to add my own 2 cents to the noise surrounding
Barclays and its dark pool, LX.
Eric Schneiderman, New York Attorney General, has some serious beef with Barclays because it filled its dark
pool, Barclays LX, with high-frequency traders (HFTs) and then lied about the highly predatory nature of the
trading strategies to its institutional clients. Barclays reportedly erased key data from marketing material and
gave private, sensitive information to HFTs about other participants in the pool.
[Related: “The End of Dark Pools? Trade-At, Not Barclays”]
As we Brits would say: “A rather silly move.”
What were Barclays’ clients afraid of?
Institutional investors have a regulatory duty to prove best execution to their clients. They don’t understand –
nor can they truly measure – the effects of HFTs on their trading performance. There are too many unknown
unknowns. Furthermore, HFTs are highly secretive in nature, and everything that is said about them tends to be
Tradebot was (and possibly still is) one of the largest HFTs in LX. The firm features in Schneiderman’s
complaint because Barclays deliberately removed it from a graph that profiled the participants in LX before
presenting it to institutional clients. Barclays knew Tradebot operated toxic trading strategies. Tradebot’s
homepage says the following:
“The stock market is tough. It owes us nothing. It punishes our mistakes. Others have more money,
more power, more connections. We are underdogs. We keep learning. We innovate. Every day is a
new fight. Technology is our weapon. We make millions of small trades. We cut losses. We identify
opportunities. We focus. The market can be beaten. We love the game.”
Does that sound like the kind of friendly individual that you would choose to trade your apples and pears with?
How about your hard earned retirement funds?
If Barclays’ clients knew the extent and nature of HFT activity in LX, a lot of them would have opted
out of trading in the pool.That is not to say that all HFT trading is “bad.” I would argue there are “good” HFT
strategies and “bad” HFT strategies. It’s much easier to be safe than sorry, though, isn’t it?
So why did Barclays let predatory HFTs into LX in the first place if it knew it wasn’t in the best interests of
its institutional clients?
And why did Barclays lie to stop its institutional clients from opting out of trading in the pool?
Bloomberg’s Matt Levine suggests that:
The commission paid by HFTs to access LX made virtually no impact to the revenue of
Barclays’ equities division, so Barclays didn’t do it for the extra cash.
Given the unidirectional trading nature of institutional clients, HFTs were needed to provide
opposing liquidity within LX.
Without opposing liquidity from HFTs, there would be far less trading activity within the
pool, meaning the orders of institutional clients would not get traded and Barclays would
therefore get less commission.
I only partly agree with Matt on this one.
Barclays pursued this strategy for 3 reasons:
Reason 1: Money
If HFTs were not allowed access to LX, then it’s true that there would be considerably less trading activity.
However, most of the institutional orders within LX are placed there by execution algorithms that are using LX
as a first port of call before sending the order out to external, lit exchanges such as NYSE or BATS. If there
was less liquidity within LX, then those algorithms would simply have traded more externally. The client
would still have executed its order, and Barclays still would have received its commission.
However, when trading on external exchanges, Barclays has to pay a fee. Aggressive trades on NYSE cost
$0.0026 per share. And they will be trading against many of the same HFTs that are already present in LX
(passive orders on NYSE receive a $0.0015 per-share rebate, which is a major incentive for high-frequency
market makers). By inviting those HFTs to trade passively in LX for free, Barclays saves $0.0026 per share in
execution fees on aggressive trades.
For passive trades, when trading in LX, Barclays loses the $0.0015 per share rebate it would get trading on
NYSE, but it makes up for some of that by charging HFTs $0.0002 to $0.0005 per share for aggressive trades.
If you assume that the ratio of passive orders to aggressive orders is 50:50, then Barclays saves approximately
$0.0014 per share by trading institutional orders against HFTs in LX versus trading on NYSE.
$0.0014 per share cost savings doesn’t sound like a lot. However, with client commissions for electronic
orders in the order of $0.01 to $0.02 per share, this can have a significant impact to the bottom line of an
electronic trading business. LX matches 285 million shares per week. This equates to approximately $20
million a year in cost savings. Not a huge amount compared to the $4 billion in equities revenue in 2013, but,
due to constant client pressure to reduce commissions, equities is an incredibly low-margin business, and this
is certainly enough to incentivize a heavily siloed electronic trading business.
Reason 2: Market Share
By opening the doors of LX to HFTs and other brokers, Barclays now has the second largest dark pool in the
US by traded volume. This was Barclays’ plan the whole time. It wants(ed) to create the world’s largest dark
pool. This is down to old skool thinking, still popular amongst the ranks of investment banks, which says:
Create the perception that we have the biggest market share of client orders and our competitors’
clients will want to trade with us in the hope of finding more natural, opposing liquidity from our
other institutional clients. Net result: We make more commission dollars.
The banks with the largest dark pools use it as a major marketing tool to attract more business, talking
endlessly about their huge market share to clients. The banks without the largest dark pools try to grow their
dark pools. Banks themselves have defined ‘size of dark pool’ as a standard measure of market share,
and they are all competing to create the biggest. Correlation is different to causality, but perception trumps
Funny thing is, it worked. Clients believed it because their own, old skool thinking told them the same thing.
In the pre-electronic-trading days, the more internal block trading a broker did, the more likely it was to reduce
the market impact of your orders and deliver superior trading performance. Dark pools are the direct,
electronic interpretation of block trading. Therefore, a larger dark pool must equal superior trading
performance. Happy days!
[Related: “US Dark Pools to Recede in Year Ahead”]
The difference here is that Barclays was not crystal clear with its institutional clients about the sources of
liquidity present in LX.
Reason 3: More Money
Barclays has its own, profitable, in-house HFT operation.
Barclays Is In a Vulnerable Position
In many areas, banks have focused too much on competing for the sake of competing and on short-term
profitability, without stopping to questioning why. Instead of innovating and creating real customer value,
they’ve reduced value and trust. This has led to some bad decisions. We’ve seen this before with the LIBOR
scandal and the FX fixing scandal.
In this case, Barclays has actively destroyed customer value and broken regulatory standards.
Clients know this. Regulators know this.
The thing to keep remembering though is, amongst all this short-sightedness, there is opportunity. Institutional
clients still have huge, trading-related problems and needs that they are desperate to solve and that they are
willing to pay for. They are just waiting for someone to deliver a great solution. Recent events have done
damage to the loyalty of customers and have opened the door a little bit further for innovative competitors.
This commentary originally appeared on Dave Hunter’s blog. Dave currently is building a fintech start-up. He
is the former head of electronic trading product management and quant strategies at DB. Living in London.
3 Comments to "Why Barclays Lied: Thoughts from a Dark Pool Operator":
08 July 2014
Regulators were given assurances by owners of "dark pools " of providing "fair & orderly markets
BUT their main aim was to make monies therefore by providing cheaper commissions they could both
pick pocket their clients and fool them into believing they were being looked after . Strangley block
trades also offered this poor service . A question Ive asked before is who made "dark pools " legal and
are we shocked now that Barclays and others have been found out ?
08 July 2014
In the 'old days' Instinet used to match buy and sell side flow on the blue and green screens. If you
took all the volume pumped through the system, matching trades were less than 10% of total flow.
And that was with user friendly functionality like block negotiation, trading mid-point and being able
to access expired activity or interest.
So when LX (and others) started saying that they were getting 25%+ matching rates, any sensible
person should have asked how?? That matching rate just doesn't happen on exchanges and agency
There are good liquidity providers and the market structure reform should focus on the exchanges
significantly lowering the fees they charge for accessing liquidity. That alone will remove one of the
biggest incentives that Barclays (and others) have had to run their own matching systems.
The second reform should be that rebates should be restricted to market makers with clear, measurable
and non-gameable liquidity obligations. All market participants can then decide whether they want to
access market maker liquidity or not. This is the same decision they made in the old phone days - do I
call a market maker for a price or do I trade with an agent?
08 July 2014
Dave is spot on. Market share and TCA are back in favour. Banks desperately need to remain
profitable, but with high margin / high ROE business in decline, the focus shifts to high volume
electronic execution where commission income is the key driver.
Could this have happened to any other dark pool operator? Probably yes. Is this coincidence that it
happened to Barclays again (after Libor and FX issues)? Probably not. Ambitious plans - to create the
one of largest pools in a competitive environments are always tough to fulfil, so it does not come as a
surprise that some corners were cut and rules softened.
While this is not the good news for already badly hit industry, it brings some positive connotations
and ways for revival. One for sure will be more honesty and openness in the pools operation. This, in
the end, will boost investors confidence and we may see more stable liquidity.
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