Analysis: Barclays dark pool lawsuit raises technology and compliance questions

The lawsuit filed by the New York Attorney General against Barclays this week has raised questions over the technology and processes used by the bank to protect investors against “aggressive” traders in dark pools.

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The lawsuit filed by the New York Attorney General against Barclays this week has raised questions over the technology and processes used by the bank to protect investors against “aggressive” traders in "dark pools".

Barclays runs one of the world’s largest dark pools, an anonymous market which allows large chunks of trades to be made without providing trading information to participants until completion. However, while Barclays’ LX dark pool was marketed as providing investor clients with protection against 'predatory' high frequency traders, the Attorney General’s 30-page lawsuit claims this was inaccurate.

“Barclays grew its dark pool by telling investors they were diving into safe waters. Barclays’ dark pool was full of predators – there at Barclays’ invitation,” New York attorney-general Eric Schneiderman claimed.

A major part of Barclays claims of transparency of its dark pool is the LX Liquidity Profiling system. This “sophisticated surveillance framework” enables Barclays’ ATS team to monitor and police the behaviour of traders using data visualisation tools, allowing the bank to move quickly to provide corrective action when trading became overly aggressive.

However, the lawsuit makes the case that this was not the reality. Among the allegations is the claim that the number of high frequency traders in the dark pool was significantly higher than claimed by the bank - at 25 percent rather than 10 percent stated in its marketing materials.

Barclays declined to comment on whether the inaccuracy was due to any specific failings within the surveillance system itself or purely due to the actions of staff, due to the sensitivities on the ongoing legal case. 

What is evident though is that the bank’s marketing efforts were successful in the aim of becoming the largest dark pool in the US, which is likely to have been aided by the liquidity provided by enabling HFT firms - including its own trading desk - to quietly enter the market without scaring off other participants.

This raises the question of why senior staff were not alerted to the levels of ‘aggressive’ trading through the use of the dark pool surveillance system, and why HFT firms were accepted in the first place.

According to the Attorney General lawsuit, one of the reasons HFT firms such as Tradebot were able to trade in the LX pool was due to the ability of Barclays staff to ‘override’ systems aimed at blocking unwanted participants. This meant assigning ‘safe’ Liquidity Profiling ratings to certain traders that should have been rated as toxic.

It appears that, at many points, compliance systems should have been able to detect that the dark pool, and the data derived from Liquidity Profiling system, was being used improperly.

Such controls are not always effective in recognising errant behaviour. For example, UBS claims that adequate systems were in place that should have detected a rogue trader losing the bank approximately $2 billion (£1.26 billion) in 2011, with Kweku Adoboli able to circumvent controls in place. Also, SocGen was hit with significant losses due to an employee's "in-depth knowledge" of fraud monitoring systems. 

Ultimately, regulation and compliance controls can only go so far to preventing questionable activity, and the culture with an organisation should be considered too.

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