Barclays Not Smart
bloombergview.com
bloombergview.com
A "dark pool" is simply a trading exchange where orders aren't published (trades, of course, are). Huge investment banks run dark pools as a service for clients. The premise behind a dark pool is that institutional buy-side investors would use them instead of a lit exchange because they want to trade against other buy-side investors, without market-makers and aggressive, automated sell-side firms to skim off their profits. Barclays LX is a dark pool set up by Lehman.
It turns out that the idea that big buy-side investors can trade with each other without middlemen in a dark pool is probably a fiction. The premise probably doesn't hold. There are at least two big reasons for this:
1. Giant institutional investors tend to take similar positions. If one giant firm is gobbling up FCOJ, the others probably want to trade in the same direction. So when you restrict your trading partners to similarly structured and sized firms, you tend not to have counterparties to take the opposing sides of trades.
2. The timing of decisionmaking at giant firms is slow, and there aren't all that many of them relative to the market as a whole. So even if there are counterparties to match for trades, that match probably doesn't happen within the window of time that the traders actually want to trade (you want to move a block of stock in minutes or hours, but if you can only trade with other giant mutual funds, it might take days to find a match; think about the difference between filling a market order on ETrade versus trying to sell your house).
So for Barclays to make LX actually do something, rather than just acting like a frustratingly inert list of big firms, they needed to get sell-side firms to trade there too. Which they did.
The subtext of the Bloomberg post is that getting the sell-side into the LX dark pool was probably a necessity, because when you look at the revenue numbers, Barclays was making its real money from the buy-side; the HFT traders paid it a pittance compared to the mutual funds. All things being equal, it was economically irrational for Barclays to court HFT firms. Of course, in reality it was entirely rational, because without the automated traders, no trades would have happened at all.
There is a striking parallel in the futures markets: Their original role was to help farmers hedge their risk of bad harvests by setting a fixed price for future delivery of foodstuffs. That market overtly and explicitly requires that there be hedgers and speculators, otherwise - no trade. Dark pools are no different, for the reasons you nicely outline above.
You could argue that what Barclays really should have done was channel some retail flow into LX, but sources of that kind of unlimited, innocent liquidity get snapped up pretty quickly.
[1] http://www.bloombergview.com/articles/2014-06-20/levine-on-w...
You can't ask for much more than an intelligent former insider with excellent writing skills who wants to explain financial news to others. He makes other journalists look as uninformed as they are.
Not quite they were also to allow downstream businesses to fix their inventory costs, that would be the hedgers that you allude to. That is the original purpose of a futures market to allow both the suppliers and consumers to hedge risk.
Initially futures markets were restricted to individuals and businesses that dealt in the product covered by the futures contract, but over the years 'speculators': actors who at no point want to accept a delivery of the product managed to get themselves into the system. Speculators are simply middlemen between the actual producers and actual consumers of the futures product. They do not add value to the system, literally the last thing in the world they want to happen is to actually have two containers of pork bellies turn up at their door step.
Futures markets work absolutely fine without speculators as their is intrinsic value in a futures market for both producers and consumers without a revolving cavalcade of middlemen getting in the way of settling contracts.
There has also been quite a bit of academic research on the effect of speculation in futures markets, and by and large the conclusion seems to be that they help, rather than hurt these markets and rises in commodity prices have been driven mostly by external factors [1].
[1] http://www.forbes.com/2011/05/24/oil-speculators-are-your-fr...
"The upshot is that futures markets–and the speculation that occurs therein–provide a public service. Regulating, restricting, or eliminating those markets would not bring prices down or make them more predictable."
TL;DR Coal futures trader accidentally takes delivery of coal barges at his harbor district office building.
To add to this: another issue with retail flow is price and volume. Only a few really big players out there have enough of this flow to make it interesting to institutional traders.
*Although per footnote six it looks like at least some trading along those lines is possible and Liquidnet is in that business.
The complexity that exists in this small corner of the active financial markets defies simple explanation even by some of the most articulate translators of this sort of stuff (I'm talking about Michael Lewis, who wrote Flash Boys, which reads like an advertisement for IEX, one of the "dark pools" talked about here who has to let in HFTs to make markets). This level of complexity exists across all corners of the market, whether you're talking about derivatives contracts, shorts, HFTs, or any other niche.
Working in this field is not like doing your taxes, where you can hire a professional accountant, and they'll reliably produce a close-to-optimal output given clearly stated IRS rules. It is also not like doing physics or math within bounded contexts with repeatable, testable, and measurable outputs. The closest thing I can think of to doing business in high finance is building a scalable, adaptable model of a human brain - one that can predict what you'll say or think before you do so. Anyone who presumes to know how the market moves, or promises to hedge against all risk, is just blowing smoke.
If you're not ready to "read the fine print" in this industry, you're just putting yourself at risk.
I think that the issue at hand is that being effective does not make it ethical.
'Now, to be clear: While it's just a complaint, and Barclays hasn't had a chance to respond, Schneiderman makes a pretty good case that Barclays was deceiving its big institutional customers. But this is not quite the same as making a good case that Barclays was ripping off those customers. The complaint is long on evidence of false advertising, but shorter on evidence that the "predatory trading" was actually predatory. There's a certain amount of foamy fulmination at "predatory trading," but nowhere is there any evidence suggesting that Barclays's institutional clients were actually harmed by it.'
The position that "Barclays deceived their customers, and should be punished" is also consistent with "Barclays did not materially harm their customers."
Fine, I've corrected my wording above.
The passage you quoted is exactly what seems like weird apologism to me. If I sell someone something that I'm sure is just as good as what they want and lie about it being what they actually want, I'm "deceiving" but "not predatory".
The claim seems dubious.
They later thanked me for the IE upgrade and said how impressed they were at how much less malware their machine had on it.
Or: Providing somebody with what they need but selling it as if it's the thing they think they want can absolutely be deceptive and non-predatory, and the difference is important.
Consider also the way many technical decisions often have to be marketed to non-technical clients.
So to my mind, to care about the difference is sound thinking, not apologism, and I feel like you're emotionally matching 'argument that doesn't condemn a thing I want to see condemned' to 'apologism' rather than thinking it through; I'm guilty of that too on plenty of occasions.
Note that none of the above should be considered to be an opinion on whether Barclays were also predatory (I don't honestly know) or whether their behaviour was morally bankrupt (my answer to this would be longer than the existing comment, inconclusive, and unsatisfying both to right and to read :)
Their purpose was to allow big institutions to "hide" their block orders. Previously if an institution wanted to trade a big block, it had to break it up via a VWAP or POV algo and trade it over the day or to go to a sell side institution to find a buyer, in which case the broker would take a commission that is often 10x what the regular DMA commission would be.
To be fair, this is still what most buy side firms do these days. Dark pools really haven't helped much in this regard as many funds now just bypass them when they can.
> Meanwhile, Barclays was advertising LX to high-frequency traders by offering them more information, lower fees, and faster connections than it gave to institutional investors.
This is the basis of problem here.
A dark pool doesn't publish a bid/ask like other exchanges do. The idea was that everyone would be on equal footing wrt the information present. It appears as though Barclay's has been giving HFTs additional information, including the bid/ask spread in some cases, which totally defeats the purpose of having a dark pool to begin with.
The reason they did thsi is that there probably only needs to be one dark pool for the entire US, but each bank realized that it could make some serious money running their own, the only problem is that now you have the same problem as any web 2.0 market place startup does.
"How do you get the buyers and sellers"?
The HFTs started offering the banks boat loads of money to have access to the order flow in their dark pools if the bank reached certain thresholds of flow. To get to the required flow the banks started routing as many orders as the could, keeping RegNMS in mind, to their dark pools first before settling the orders on other exchanges.
I've been told with a straight face by some sell side brokers that I could not tell their SMART order routers to skip dark pools when trying to send my order to the market, again RegNMS excepted. It wasn't until we stopped trading through them that they relented and allowed us to by pass their dark pool.
The whole point of Levine's article is that HFTs did not offer the dark pool operators "boat loads of money". The dark pool operators gave the HFTs sweetheart deals to induce them to trade in their pools. They didn't do that because the HFTs paid them. They did it because without the automated traders, the dark pools wouldn't have worked at all.
By the numbers, if the big institutional investors wanted HFTs out of the dark pools, Barclays should have kicked them to the curve. Not ethically, but simply from a practical business perspective. But Barclays couldn't do that... or, they could, but then the institutional clients would have stopped trading in the LX pool, because they'd never get filled.
1) most institutional clients don't necessarily want to trade in a dark pool, their orders are just routed there by the broker's smart order routers. You would be very surprised how many huge funds don't do post trade analysis.
2) the dark pool operators make money from the HFT's not in terms of the commission, but in terms of collocating fees, market data fees, and the right to be one of only a few HFTs allowed in the dark pool via collocating, ie exclusivity.
The boat loads of money was maybe an akward of stating it. To match a trade you need people on both sides of the trade. The HFTs were the missing piece the other side of the trade. WIthout them no trades, hence no money. With them, you trade more... alot more, which leads to the boat load of money that starts following when the HFTs come in.
I may have a biased view as I'm on the buy side but not on the HFT end of things:)
> the dark pool operators make money from the HFT's not in terms of the commission, but in terms of collocating fees,
No. Dark pool don't really charge collocation fees. Barclays LX didn't. Most dark pools are in Weehawken and it's just a simple $500 cross-connect from your existing trading system.
> market data fees
It's a dark pool. There is no market data to charge a fee from.
> , and the right to be one of only a few HFTs allowed in the dark pool via collocating, ie exclusivity.
Not in the case of Barclays LX. They let every HFT in at very low rates which is the entire point of the article.
> Barclays was advertising LX to high-frequency traders by offering them more information, lower fees, and faster connections than it gave to institutional investors.
The "more information" being the key part - it sounds like the pools weren't as dark as their customers were led to believe. Your other points are spot on, though.
If I'm a market-maker, I want to trade with retail orders or slowly sliced institutional orders that are trying to rebalance a portfolio throughout the day. When I sell stock to them, the price doesn't move very much in the short-term and I have a chance to buy back on the bid to make a spread. I don't want to trade with aggressive arbitrage or stat-arb traders capturing short-term price inefficiencies, hedge funds that want to buy huge blocks of stock all at once, etc. If I sell stock to them, the price ends up moving up more than the spread very rapidly and I lose money.
When trading on a public market, I have no way to control which of these groups I trade with. I have to employ countermeasures to predict whether it's likely that I'll trade with an informed or uninformed trader and adjust my market accordingly. This is why you see market-makers rapidly flash their quotes for seemingly pointless reasons (e.g. I may adjust my prices in an airline when oil futures move) or flip out of positions aggressively when their model believes they were hit by an informed trader.
Now if I'm able to trade on a market where I know I'll only trade with long-term fundamental traders, I can quote much larger, tighter, and more stable markets. This is good for the institutions since their execution costs are lower than going to the exchanges. It's bad for arbitrage traders and hedge funds with short-term information since they effectively pay higher execution costs in a tiered market (if more "good" order flow goes to dark pools, less reaches displayed markets, and spreads on displayed markets will increase to compensate). When people want to end dark trading or internalization, they really want to have retail and institutional flow cross-subsidize fast speculators.
Ironically, it's probably HFT market-making firms who were the most impacted by Barclays giving other high-alpha HFT firms manual overrides to put them in a lower tier. If anyone would be excited at the promise of removing high-alpha traders from the pool, it would be market-makers who want to avoid being "picked off", not institutions who have a much longer time horizon.
One-second alpha, on the vertical axis, measures an "excess return" certain market participants earned over a 1-second trading interval. It represents skill in trade execution. What Barclays is saying, by pointing giddily at the bubbles in the lower-left quadrant, is that it has collected a fruitful variety of institutions particularly rotten at competently executing their trades. The customer being pitched is being told that it, being smarter than all those clowns, can now take advantage of their naïveté.
If I were an existing customer, I'd be insulted to be so portrayed. Or maybe not. Maybe I'd assume I was the lone smart bugger in the top-right. I guess that's what this chart counts on to generate, not lose, business.
The complaint is long on evidence of false advertising, but shorter on evidence that the "predatory trading" was actually predatory. There's a certain amount of foamy fulmination at "predatory trading," but nowhere is there any evidence suggesting that Barclays's institutional clients were actually harmed by it.
He then goes on to suggest that the lawsuit is therefore essentially frivolous (in his words, "a self-referential argument.")
His reasoning is flawed, of course. For one thing, commercial fraud is always harmful, even if you can't always prove that someone suffered specific losses for it. For another, the banks agreed explicitly agreed to comply with all pertinent legislation (including the Martin Act) in exchange for the privilege of obtaining a charter which allowed them to become banks in the first place. Whether one thinks the Martin Act is overly broad or gives too much leeway to prosecutors is of secondary importance.
If Barclay's could get HFTs out of their products then their situation wouldn't be much different from diet cola and they could raise a fair amount of FUD against the competition irregardless of quality of evidence. But you can't sell the same product yet claim you have removed the "harmful" component. Claiming you know it is not really harmful just means you were up to 2 fraudulent activities to deprive the market and your customers of a better arrangement.
(The Great (Psuedo-)Intellectual Temptation is to privilege theory over facts. It is not a path that leads to anything useful, but it sure is a popular one.)
The argument, as I understand it, for why it is useful to have HFTs in markets like the one in the article, is that they provide extra liquidity. My understanding of liquidity is that it is some kind of measure of how quickly an asset can be sold. I'm sure there are some formal definitions, but that has to be something like [asset value/sale time], where larger is more liquid.
It seems to me, though, that liquidity is necessarily very time-scale dependent. For example, there is basically no liquidity in any market at the picosecond (or whatever is faster than current trading) timescale, because (by definition) no-one trades that fast. So really, although liquidity can be calculated as a rate, it is more appropriate to look at the distribution of available liquidity over different time scales. In other words, being able to sell $10 of assets in 10 days is not really the same as being able to sell $1 of assets every day for 10 days.
My questions are:
1) is my understanding of liquidity as being timescale dependent correct, and if not, why not?
2) if yes, what is the social value of "faster" liquidity?
3) if "faster" liquidity has greater social value, is there any point at which the cost of maintaining that liquidity (which is what I understand HFT profits to be) exceeds the value of having liquidity at that timescale?
edit: spacing for visual clarity
So I would say that liquidity is not timescale dependent -- its a measure of the quality of your execution (relative to the fair price) if you executed everything you needed to right now. Personally, I would say no to (3) -- HFT offers liquidity at all times and only transacts when their counterparty decides to cross bid-ask spread, so if they didn't want the price HFT was offering than they wouldn't hit their bid/offer. The cost of all the ancillary infrastructure (wireless connections, backspace, hiring harvard/mit quants) is independent of the direct cost (crossing bid-ask spread) a consumer pays to the HFT, so the actual cost paid by the customer is a fraction of what the HFT has to pay to be able to display the quotes it does.
So my follow-up question is: what is the particular benefit of being able to trade as quickly as possible?
And a related, more specific, question that might be easier to target and explain: I'm sure I've heard people suggesting capping trading frequency (which might be a ridiculous idea, I don't know); how would doing so harm liquidity?
Also, just to clarify my previous question about cost, I was trying to refer to the "cost to the system", rather than direct costs. I'm not sure I can properly define what I mean by that, but I suppose it would be something like if the total revenue going to the HFT firms or similar people was greater than the return to the rest of the system of having their services. I'm not really convinced by market arguments against such cost/benefit inversions taking place, because inertia and changing circumstances can move institutions from being helpful to being unhelpful without markets being in a position to compensate.
If I've made any other bad assumptions, please point them out as well.
Capping trading frequency would lower liquidity. Simply put, the less up-to-date your view of the market is (if orders are only matched every T milliseconds, you could have a view of the market thats up to T milliseconds behind), the more uncertainty there is in your prediction, which will result in you quoting a wider bid-ask spread or quoting smaller amounts at each price. I'd say for T very small (say, T < 5ms), it will make zero difference to liquidity or HFT profits.
I suppose its tough to answer your final question. I'd say liquidity is very useful, and tighter bid-ask spreads help price discovery and help portfolio allocation (the wider the bid-ask spread, the less likely a given portfolio will be allocated in the desired way, since you can only replicate a portfolio modulo transaction costs). Anytime a transaction tax or other regulation is implemented that targets only HFT, liquidity drops, often drastically (e.g. Swedish equity markets in 90s had a relatively high transaction tax that essentially dropped all trading volume on their exchanges to zero, and trading moved to other European exchanges trading equivalent derivatives on Swedish stocks). In addition, HFT industry profits are low -- I'd be surprised if it breaks 5 billion/yr.
I think my final question about the balance between total costs and benefits is motivated by the fact that discussion about HFT and similar price-based trading always makes it sound like a lot of effort is being invested in the competition to find profit-making trades, and my wondering whether all that effort could be more productively used elsewhere.
I understand the market motivation behind doing it, which I think yours and others' explanations justify well, however, as I mentioned previously, I remain unconvinced by the allocative efficiency of markets in all situations, and these 'arms race' situations seem like good candidates for market failure (to stress, I mean failure only in terms of the societally-efficient allocation of resources, I don't doubt the local efficiency).
Your note about HFT profits obviously goes some way to addressing this by suggesting that the level of resource allocation isn't that high - I have to confess I didn't realise the profits were quite so low. I do, however, think that revenue is the more important figure, because that will capture the productive effort that we, as a society, are investing in this activity, which we can then usefully compare to the liquidity benefit we get from it.
In case you are interested, I think I have been spurred down this line of thinking by having recently read 'The Collapse of Complex Societies', by Joseph A Tainter, which I can heartily recommend if you haven't already read it. My argument is really his, just applied to the frontier of our times - finance.
And as a personal aside, if you don't mind my asking, you seem to have a good understanding of the realities of this situation, were or are you involved professionally?
I'm not saying any of this with certainty, just sharing my thoughts.
It seems possible that there is a lot of effort being put into that endeavour that is, in some sense, wasted - it is spent on competition rather than "production", and with a judicious rule change the cost of competition could be reduced. The inevitable free market counter-argument is that the market will have already selected the best balance of cost/benefit, but I don't find that convincing at all, even if only because obtaining a sufficiently free market is impossible.
Anyway, thanks for your response, it certainly seems (to a layman such as myself at least) to be a good description of the basis for HFT.
A simple determination of execution quality does not require a PhD in math - it requires comparing the price of execution to the market shortly after the execution occured (If it moved against you, you could argue there was "adverse selection"). I am not saying what Barclay's did is right. I just feel it says more about the inept behavior of institutional investors that they were not able to smell a rat earlier on.
The article rightly points out that HFT drives dark pools. If an institutional investor didn't know that, I am very confused why we pay them so much money...
Let me expand a bit: dark pools exist because of an asymmetry in the public markets caused by their fragmented structure. Those money mangers recognized that, so they sent flow to a place which was explicitly marketed as a tool to mitigate that asymmetry.
Contrary to the parent's post, transaction cost analysis is not an especially exact science and the tools available to fund managers are not particularly helpful or well-integrated. Their sell-side partners are not overly invested in helping them either, since they have their own issues (intense cost pressure, declining flow, regulators everywhere...)
Later
Sure! It's not controversial that Barclays marketing of the LX exchange was misleading. Nobody is sticking up for Barclays. But the important, subtle point is that the LX pool probably couldn't have worked the way Barclays claimed it could. It doesn't matter how they marketed it. Without market makers, with a collection of like-minded investors, it's hard to get action.
So it's not that Barclays was somehow corrupted by HFT traders. It's that they were trying to lead-to-gold alchemy to sophisticated clients, who should have known that Barclays can't turn lead into gold.
That being said, the trading desks on the buy side are, for the most part, not very sophisticated at all. They are dealing with the same evaporating liquidity as the sell side, but they have far less ability to manage it. They are utterly reliant on the tools their brokers offer - tools which are generally very good (algos, and dark pools). In this case they are guilty of naivety perhaps, but it's nativity born of desperation. Barclays did directly say, "no predatory flow." At some point, even on the street, you have to believe direct statements made by your counter parties.
Later I'm enjoying this; I have to run to a meeting unfortunately. Sorry :)
To put this into prospective, there are single buy side firms that are bigger than the entire HFT market making industry.
There's no arguing with the sophistication of the portfolio management side of institutional AM's - these are smart, well-compensated people with excellent tools and first-class support from their own companies and the street's research. Once you get to the buy side trading desk - the people responsible for implementing the decisions of the PMs, and the people who are dealing with this rapidly-changing, fragmented market - things become different.
If, as a retail investor, I could make only one call to complain, I would call my fund manager who has a _fidicuiary duty_ to me and demand an explanation.
(Note that no such fidicuiary duty exists between a sell-side broker and insititutional investor, which is why they had to use the Martin Act and there are no securities fraud charges.)
(Who, you know, still have a right not to be ripped off)
In the end, Barclays created the LX dark pool to get more fees from individual investors and smaller investors. They used HFT firms as the carrot and stick to extract more revenue from the suckers using HFT and the volatility/liquidity that it can provide.
> Meanwhile, Barclays was advertising LX to high-frequency traders by offering them more information, lower fees, and faster connections than it gave to institutional investors.
Seen from an investor who bought the marketing, this is dishonest. But seen from the Barclay's boardroom, if they make all their money off of non HFTs, they need to increase buying/selling on their smalls and institutional investors. So of course Barclays would make it really cheap for the HFTs, all the more action to extract fees and commissions from the clients/suckers that pay.
There are some limitations on specific order type/venue combinations, but most things are supported.
https://www.interactivebrokers.com/en/index.php?f=tws&p=pape...
Whether intentional or not, it sounds like they built a combination public swimming pool / alligator farm.
Marc Andressen recently penned a screed that made the rounds about how Sarbox and friends have killed the IPO. He's not wrong there. IPOs are happening much later and less frequently because of regulation.
Where he's wrong is... well... he's basically like a resident in a high crime neighborhood asking why all the shops have bars on their windows. It's driving away business after all! Let's take those bars off the windows...
But as soon as you do that, you get a smash and grab the next night. Sorry Marc, but there's bars on the windows because the neighborhood is full of thugs.
The ultimate problem -- and the ultimate thing that has killed the IPO -- is that the financial system is full of glorified white collar street hustlers who look at markets as something to bust out for short term profits.
Like the proverbial bad neighborhood I think the only solution might be to move out. I can see technologies like Bitcoin and systems like crowd funding as the embryonic beginnings of a new financial system with greater intrinsic transparency and with cryptographic authentication baked in from the get-go. Perhaps, with that added transparency, it'll be possible to engineer in a fundamentally better security model to discourage predation.
>>> Let's take those bars off the windows...
Or maybe let's fight the actual crime instead of installing thicker and thicker bars on the windows of businesses which aren't actually criminal. I'm not sure there was ever a high-crime neighborhood which was fixed and turned into a flourishing community by increasing the thickness of bars and putting more metal doors and barbed wire.