CS Credit Suisse Group

By Scott Patterson 

The latest round of penalties over "dark pools" highlights how reliant banks and exchange operators have become on business from high-frequency traders--even on platforms that promised to blunt their advantage.

Dark pools were advertised to mutual funds and other traditional money managers as a place where they could trade in secret and avoid giving away their moves to computer-driven traders. New settlements with two of the biggest dark-pool operators, Credit Suisse Group AG and Barclays PLC, showed that the banks were quietly catering to high-frequency traders at the same time.

The reality beneath those practices is that high-frequency traders account for the bulk of bids and offers that keep the market running--about two-thirds of the total--a source of business that can be hard to pass up. Credit Suisse and Barclays catered to them by concealing the role of speedy traders on their platforms and going back on promises to protect clients from predatory trading, according to the settlements with the Securities and Exchange Commission and New York Attorney General.

The often opaque ties between exchanges, dark pools and high-speed firms have been one of the most perplexing issues facing investors and regulators. In recent years, firms accused of masking their links to superfast trading outfits have been hit with a series of escalating fines.

In 2011, the Securities and Exchange Commission fined Pipeline Trading Systems LLC $1 million for failing to disclose to clients that they were often trading with an in-house high-speed firm. BATS Global Markets Inc. last year agreed to pay $14 million to settle allegations that two exchanges it ran failed to disclose certain details about their markets that the SEC said gave advantages to some high-speed traders. UBS Group AG a year ago agreed to pay $14.4 million to settle allegations that it failed to inform all clients about advantages its dark pool gave to some firms, including high-frequency traders. Pipeline, BATS and UBS didn't admit or deny the allegations.

The emergence of dark pools and high-frequency trading went hand in hand as trading increasingly shifted from floor-based open outcry models to one largely controlled by computers.

Trading on dark pools, which, unlike exchanges don't publish buy and sell orders, took off about 15 years ago. Dark pools largely were used by institutional firms hoping to trade large chunks of stocks without alerting the broader market to their activities.

At about the same time, trading by high-frequency firms also took off. Large traders such as mutual funds grew concerned that high-speed traders were hurting them by detecting their orders on exchanges and trading ahead of them. Many of the firms turned to dark pools, hoping the opaque venues would protect them from such activities.

The problem was that most dark pools also catered to high-frequency firms. Some weren't entirely forthcoming to their clients about their reliance on high-speed traders, regulators have found. Worse, they told clients they would protect them from predatory high-speed trading while hiding how much of their order flow depended on the firms' frenetic activities.

Credit Suisse and Barclays this week agreed to pay a combined $154.3 million to settle allegations that they misled investors about high-frequency trading activities on their dark pools.

Barclays told clients that its dark pool, called LX, protected them from predatory trading using its "Liquidity Profiling" system, which it said could detect such activity, according to the SEC. Trades were categorized in buckets ranked from zero to five, with zero the most predatory, and clients could elect to not trade with low-ranked firms.

But Barclays often shifted traders assigned a low ranking into a higher ranking, the SEC said. Because of that, certain clients traded with firms ranked "in the most aggressive categories," the SEC said. Barclays also presented marketing material describing the types of clients on LX that omitted its largest subscriber--a high-frequency trader.

Credit Suisse, meanwhile, told clients its dark pool would give predatory traders a negative score, a program "intended to address certain subscriber concerns about interacting with high-frequency trading firms," the SEC said.

Clients could choose not to trade with firms with a bad score. But the systems didn't perform as Credit Suisse said it should since it included "significant subjective elements," the SEC said.

The Swiss bank also didn't disclose that it ran a trading system that alerted two high-frequency firms about the existence of orders placed by other clients, the SEC said.

(END) Dow Jones Newswires

February 01, 2016 19:18 ET (00:18 GMT)

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