Is Barclays Unique?

The New York State Attorney General filed a civil suit Thursday, accusing Barclays of securities fraud for misrepresenting its LX Liquidity Cross dark pool. From the complaint:

contrary to Barclays’ representations that it “treat[s] all venues the same based on execution quality,” essentially all client orders were routed to Barclays’ dark pool first, regardless of the probability that a given trade would execute there, would execute at a favorable price, or would cause information leakage.

Any time a firm is accused of wrongdoing, people wonder whether the alleged incident represents an isolated event or suggests an industry-wide problem. Although Barclays allegedly took things to a different level in misrepresenting its routing and darkpool policing practices to clients, all algorithmic brokers who operate major dark pools have intractable conflicts of interest that are not aligned with clients’ goals of achieving the best order execution.

Conflicts of interest for agency brokers around venue fees and maker-taker have been highlighted in recent years in a variety of forums from academic papers and Pragma’s own research to the recent senate hearings.

But the complaint against Barclays rounds out this picture by illustrating the conflicts around other kinds of “value extraction” that can affect the profitability of a big broker’s equity-trading businesses. According to the AG’s complaint, an internal Barclays document instructed employees that:

“[A]ggregating [order] flow into Barclays LX has strategic and economic value for the entire Equities business,” including the savings Barclays would realize by not having to pay commissions to execute trades on other venues; fees gained from firms paying to trade in the dark pool; and the “internal trading P&L [profit and loss] opportunities” available to internal Barclays trading desks that trade in the dark pool against brokerage client order flow. Barclays also identified the “market share value of attracting more [order] flow” into its dark pool…

In other words, Barclays could monetize client order flow by trading its own funds against that flow, by selling access to outside proprietary traders and other liquidity seekers, and by evading exchange fees or other venue fees.

Through their agency trading algorithms and smart order routers, brokers control the timing, pricing, and routing of each order placed on behalf of their clients. These decisions can make the order flow more or less profitable for the broker, and these financial benefits for the broker are totally decoupled from the effect they have on the client’s execution quality.

Wall street has proven itself to be well structured to reward people for generating short-term profit for their firms.

For this reason, rather than trusting their brokers to defy the incentives, or relying upon regulators to protect their interests, the buy side may be best served by avoiding giving control over their orders (algorithms and smart order routers) to agents with conflicts.

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