Asia-Pac Traders React to Barclays’ Dark Pool Case
On 25 June 2014 the New York Attorney General, Eric Schneiderman filed a summons to Barclays, the UK-headquartered broker, alleging that it had misrepresented its dark pool activities to increase its market share. The allegations – which Barclays is contesting – specifically claim that the broker had misled its clients about the amount of predatory behaviour taking place in the dark pool.
Dark pools are trading venues that disclose little or no pre-trade information, which in theory prevents large orders from being spotted. As a large order takes time to fill, any firm gaining insight into its size and price range can use that information to find buyers/sellers elsewhere trading at a another price and arbitrage the difference. Where that difference is taken in profit by the arbitrageur, it is a cost to the trader placing the block order, typically a long-only buy-side trader. By concealing that information, a dark pool can prevent arbitrageurs from spotting large orders.
“Dark pools are easy political targets but they can be very efficient for institutional clients in cases where the trader wants to trade in size, within the spread, or at the mid-price,” says Kent Rossiter, head of Regional Asia-Pacific Trading for asset manager Allianz Global Investors.
In Asia Pacific, dark trading is only conducted in a few markets, such as Japan, Hong Kong and Australia. As a consequence, the region does not have the same scale of trading in the dark that the US or European markets experience. Nevertheless the proportion can be significant.
According to the Australian Securities Exchange on average around AU$1.05 billion (US$982 million) of daily turnover, or 21% of the AU$5.010 billion (US$4.67 billion) in average total turnover was executed in the dark between 11 and 15 August 2014, the latest data available at the time of going to press. An average of 5.6%, included in that 21%, was being traded on the exchange’s own dark pool.
The average daily turnover on ToSTneT, part of the Japan Exchange which dark pools are required to connect to, was ¥192 billion (US$1.8 billion) for the five working days up to 26 August, representing 9.3% of the ¥2.052 trillion (US$19.7 billion) in average daily equity turnover for that period.
Hong Kong is said to trade around 3% of average daily volume via dark pools, according to market data provider Morningstar, which would be approximately HK$1.8 billion (US$232 million) of the exchange’s HK$63 billion (US$8 billion) daily turnover for the first seven months of 2014.
Comparatively, Bloomberg has reported data shows that off-exchange trading in the US, which equates to dark pool operations, broke the 40% barrier on 10 June 2014, its highest level since hitting the all-time peak of 41.7% on 22 June 2012.
The scale of the business in the US has led to growing political pressure to investigate dark trading practices. Since the Barclays case was announced Credit Suisse, Deutsche Bank and UBS have also acknowledged they are speaking to authorities about their own dark pool operations in the US. The greatest disclosure was given by UBS which noted in its Q2 2014 Report, “UBS is responding to inquiries concerning the operation of UBS’s alternative trading system (ATS) (also referred to as a dark pool) and its securities order routing and execution practices from various authorities, including the Securities and Exchange Commission (SEC), the New York Attorney General and Financial Industry National Regulatory Authority (FINRA), who reportedly are pursuing similar investigations industry-wide.”
The SEC investigation is said to have opened in 2012 but these investigations have been hurried along by the very public allegations made in Michael Lewis’s ‘Flash Boys’ book released on 31 March 2014. It detailed brokers’ exploitation of long-only buy-side client orders by allowing high-frequency trading (HFT) clients to interact with block orders. HFT firms use high speed data feeds and trading connections with trading engines that can make place orders in microseconds based upon available data.
Although electronic trading engines and algorithms are used by the majority of institutional equity traders, when such firms invest long they are capturing alpha over a period of years. As a result they do not have a business case i.e. daily, low-risk profit, to source the equipment and low-latency telecom connections necessary to process data and trading decisions at such high speeds. Intraday volatility is managed by traders whose platforms seek to avoid any impact on price while sourcing liquidity effectively.
Some HFT strategies, such as latency arbitrage, actively try to arbitrage large block trades and therefore add cost to the buy-side. By feeding and processing data faster than other firms they are able to interact with the market more rapidly, effectively getting a look at the book that other traders cannot get.
It is precisely these strategies that Schneiderman fears Barclays’ clients were exposed to. However these risks are not new to buy-side traders or regulators.
In 2012, when the SEC was reportedly starting its investigation, ASIC set up two task forces, one to investigate HFT and another to investigate dark pools in the Australian market. The task forces found that it was in fact dark pools, rather than high frequency trading which were its chief source of concern.
In a March 2013 paper, the regulator reported that “some crossing systems allow, or have previously allowed access to their crossing systems by clients that the industry widely considers to be high- frequency traders while maintaining there is no high frequency trading in their crossing system.”
In August 2013 a paper written by Will Psomodelis, head of trading Australia at investment management firm Schroders, and Stuart Baden Powell, then-executive director at brokers RBC Capital Markets detailed proprietary research by the two firms which indicated that in certain dark pools “there were persistent losses in certain venues more consistent with arbitrage.”
As a result of its own findings, ASIC released a series of new regulations; the first issued in May 2013 required dark pools to deliver meaningful price improvement on trades while re-categorising block trades as AU$200,000, AU$500,000 or AU$1 million depending on a stock’s liquidity. Further rules were put in place over a nine-month period from August 2013 to deliver better transparency and execution to the users of dark pools.
As one Australian-based buy-side trader puts it; “ASIC have been on top of this for years.”
In Hong Kong, a consultation on the regulation of alternative liquidity pools (ALPs) was concluded in April 2014 by the special administrative region’s market regulator, the Securities and Finance Commission (SFC). The main proposals were to introduce a harmonised set of rules across all market operators, where before firms were assigned a set of operating parameters along with their automated trading licence and to ban retail order flow from dark pools. These are added to a requirement that came into effect 1 January 2014 that any intermediary takes responsibility for the operation of electronic trading systems, which has required firms to revisit their use of order routing platforms and trading venues.
As a consequence of these provisions, many vigilant buy-side traders feel that the risks in the US are not a threat to wary firms in Asia-Pac.
Emma Quinn, head of Asia Pacific Trading at asset manager Alliance Bernstein says, “We’ve always paid a lot of attention to dark pools and with the Hong Kong electronic trading rules and Australian Securities Investment Commission (ASIC) rules about trading at midpoint, for a lot of people this had been taken care of.”
However Japan, which has seen a significant level of market fragmentation across both proprietary trading systems, such as SBI Japannext and Chi-X Japan, and dark pools, has been less responsive than the other markets.
The Financial Services Agency, Japan’s regulator, published a report on dark pools in May 2013 authored by Yoko Shimizu, special research fellow, at the FSA’s Financial Research Center, however this only reported on US and European market regulatory approaches at the time.
Tetsuya Wakabayashi, head of trading, Invesco Asset Management, Japan, says, “Revision of dark pool usage is not happening both on the FSA/Japan Exchange Group (JPX) side. FSA/regulators may consider regulating dark pools in Japan but in the short-term, we see no action to be taken from regulators or the exchanges.”
Despite the varied efforts of market regulators to manage the risks created by broker dark pools, the alleged deliberate misleading of clients by Barclays has made many buy-side firms nervous.
Schneiderman’s case notes report one former senior-level director within Barclays’ Equities Electronics Trading division, saying “Barclays was doing deals left and right with high frequency firms to invite them into the pool to be trading partners for the buy-side. So the pool is mainly made up of high-frequency firms… [T]he way the deal would work is [Barclays] would invite the high frequency firms in. They would trade with the buy-side. The buy-side would pay the commissions. The high-frequency firms would pay basically nothing. They would make their money off of manipulating the price. Barclays would make their money off the buy-side. And the buy-side would totally be taken advantage of because they got stuck with the bad trade … this happened over and over again.”
A Singapore-based head of trading at a regional asset manager, who spoke on condition of anonymity, said that using FIX tags can help, because they allow the dealer to track how trades are progressing in venues once they leave a dark pool, however the technology does not make orders visible while they are still in a pool.
“The question has now been raised, how do I know that a broker is doing what they say they are doing?” he says. “There has been a lot more doubt cast on dark pools. We insist that brokers either fill out a very extensive survey which is signed off by compliance and distribution or we get third party verification that confirms the broker is doing what is says that it is doing.”
Wakabayashi believes that a raised level of caution is reasonable as long as that leads to prudent and proportional action.
“Here in Japan, after the incident in US, more clients do their due diligence, maybe even turning off the dark pool functionality or have put on more additional features like no HFT or proprietary crosses,” he says. “Clients also ask more questions about how a specific dark pool might work. The important thing to remember is how to use dark pools after understanding its characteristics. I believe that dark pools are beneficial venues and view the sell-side as partners.”