Internal Dark Pools—Into Darkness?

It was probably just a matter of time following the publication of Michael Lewis' Flash Boys earlier this year that regulatory scrutiny would rise, legal actions would follow, and finally, definitively, volume at an object of suspicion—in this case Barclays' LX dark pool—would taper. As the FT notably reported this week, even light-trading upstart venue IEX—which purports to thwart HFT sharks through a number of technical and physical measures—saw more volume than LX, according to data provided by Finra.

The debate about HFT's technical advantage on one hand, and dark pools' anonymity on the other, has been well-hashed—and to be clear, this kind of news spells the end of neither.

It does, however, display just how skittish the buy side has become when even a mere hint of manipulation arises. Sure, the major sell-side firms pulling out of LX (for now) might be doing it to protect themselves—or stick in the craw of a competitor—but the better bet is that most are doing it because their phones are ringing off the hook with furious clients, wondering if their trades are being front-run or gamed.

Of course, reading the actual allegations from New York Attorney General Eric Schneidermann—one half, along with New York State Department of Financial Services chief Benjamin Lawsky, of an enforcement tandem that has become quite a thorn in foreign investment banks' side the last few years—gets more interesting.

When it comes down to it, this appears to have been a problem with poorly worded marketing materials misstating the venue's rules—and still poorer timing. If there was any intent in that or not, it doesn't seem to matter at this point. The volumes, so far, speak for themselves.

Countermeasures at a Premium
Whether those numbers pop back up, or remain this far back of their average for good, will be critical as the broader debate about equities market structure moves forward.

Surely no one involved wants an enforcement action of this variety to so quickly, so comprehensively—and maybe so permanently—demolish what had been one of the industry's most effective off-exchange venues. If this is the case, then soon enough there won't be many dark pools left, period.

Those that stick around—and the agency-only types now might well be at an advantage—will do so by offering as many protective options as possible, whether anti-HFT order routing techniques or other algorithmic tools that can make passive trading strategies more sophisticated in their execution. Clearly there is demand for these tools.

Clients aren't off the hook, though. To reference Lincoln's classic and once-famously butchered expression, this is now a case of being fooled twice, and buy-side firms that aren't actively engaged with their preferred intermediaries and venues to know—before the Attorney General does—exactly how things work on a technical level and the risks incumbent in that, should really get to work. 

Whatever happens with LX, the takeaway here shouldn't be that all dark pools are imperiled; it's that marketing materials, in 2014, are no substitute for due diligence.

Better to know and never route to a pool at all, than collectively leave a gaping hole where there once was reliable—if perhaps in some instances, vulnerable—liquidity.

In the short term that might be a safe move. But just like allowing HFT shops to run amock, it's no way to maintain a market.