Will the New Light on Wall Street’s ‘Dark Pools’ Bring Stronger Regulation?


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Peter Conti-Brown and William Black discuss the latest regulatory actions over lapses in high-frequency trading.

Fair trading on Wall Street got a boost from the settlement announced two weeks ago between U.S. regulators and two investment banks over violations in operating alternative trading systems, known as “dark pools.” However, the fines totaling more than $154 million the two banks agreed to pay represent the cost of poor enforcement of existing laws and the failure to create precedents to act as deterrents, said experts at Wharton and the University of Missouri-Kansas City. Regulators need to increase their scrutiny of high-frequency trading, such as through dark pools, and identify systemic risks, if any, they added.

The debate on regulatory approaches over alternative trading systems ensued after the Securities and Exchange Commission (SEC) announced that Barclays Capital and Credit Suisse Securities have agreed to settle cases involving violations of federal securities laws governing dark pools. The New York Attorney General’s office announced parallel actions against the two firms.

Barclays admitted wrongdoing and agreed to pay penalties of $70 million, which will be split between the State of New York and the SEC, while Credit Suisse agreed to settle the charges by paying $84.3 million, with $60 million being split between the State of New York and the SEC and an additional $24.3 million in disgorgement and prejudgment interest going to the SEC relating to other violations. “These largest-ever penalties imposed in SEC cases involving two of the largest ATSs (alternative trading systems) show that firms pay a steep price when they mislead subscribers,” stated Andrew Ceresney, director of the SEC’s enforcement division.

Dark pools allow sophisticated traders to move large blocks of stocks without alerting traders who might be able to use such information for their benefit. They account for about 15% of overall trading volume in U.S. markets, and are designed to protect large investors in particular stocks from sudden price jumps or falls that may be caused by events unrelated to the fundamentals of those stocks, explained Peter Conti-Brown, Wharton professor of legal studies and business ethics. “The problem here isn’t so much that individual, day-trading humans are being ripped off,” he said. “It’s that the banks lied; they sold a product to their clients, whose entire virtue was eliminated through a backdoor.”

“… The banks lied; they sold a product to their clients, whose entire virtue was eliminated through a backdoor.”–Peter Conti-Brown

According to William Black, professor of economics and law at the University of Missouri-Kansas City, “This is the high cost of not enforcing the law and not creating precedents.” Black was formerly executive director of the Institute for Fraud Prevention and recently helped the World Bank develop anti-corruption measures, among other roles in combating white-collar crime. He said that instead of settling with the investment firms over violations, regulators must contest the cases, even if they ultimately lose those cases, and thereby create precedents.

“The creation of precedents is one of the geniuses of the Anglo-Saxon system that produces efficiency,” said Black. “The problem is if you are short of resources, it always looks efficient to settle, but the greatest efficiencies are often from not settling.” If regulators lose these cases because courts dispute their jurisdiction over such trading abuses, they could go to Congress “and ask them to fix it,” he added.

Conti-Brown and Black discussed the options for regulators in policing errant trading on the Knowledge@Wharton show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)

A Solution That Went Awry

“Barclays … exposed its clients to the predatory traders from whom it promised to protect them,” according to a press release from New York Attorney General Eric Schneiderman. “Barclays misrepresented its efforts to police its dark pool, overrode its surveillance tool, and misled its subscribers about data feeds at the very time that data feeds were an intense topic of interest,” said Robert Cohen, co-chief of the SEC’s Market Abuse Unit.

Credit Suisse created and operated an undisclosed platform that secretly enabled two high-frequency trading firms to trade directly with orders submitted by other Credit Suisse clients, according to Schneiderman. The bank “accepted, ranked and executed over 117 million illegal sub-penny orders” through that platform, the SEC said.

“If you are short of resources, it always looks efficient to settle, but the greatest efficiencies are often from not settling.”–William Black

“It was the worst of all worlds,” said Black of the violations. “Dark pools were supposedly the great reform that would protect regular [investors],” and they promised to protect the names of investors, and identify them only by their category, he explained. “It turns out that these dark pools that had been sold as the saviors and protectors of [small investors] were actually cutting secret deals with the high-frequency traders. You thought you were safe, which creates complacency, [but] you were lied to … by two of the largest dark pool [operators].”

Slow Development of Laws

Black lamented the slow and insufficient progress in creating laws to govern high-frequency trading, even though it constitutes more than half of all equity trading, and even more on the futures market. He noted that the development of law has steadily progressed in areas such as frauds and insider trading, but not in high-frequency trading. “We get the development of this kind of case law and rules, arguments on both sides of the bar, [and] among academic circles on what constitutes insider trading, as new facts [and] new institutions come online,” he said.

“We are not getting that with high-frequency trading and dark pools. Even by their very names, they become these mysterious unknowns as they continue to grow.” Black, a financial regulator in the Reagan administration, formerly was director of litigation at the Federal Home Loan Bank Board and deputy director of the Federal Savings and Loan Insurance Corporation.

Conti-Brown noted that the regulatory actions on dark pools took off after March 2014 when Michael Lewis wrote his book, Flash Boys: A Wall Street Revolt, which focused on high-frequency trading. “Is this the only way we can get any kind of accountability? Is it just journalism?” Conti-Brown asked. “The journalism is very good … but that’s only one end of the stick,” he said. “The other end of the stick — to explain and explore and use the power of law and government to solve these issues — doesn’t follow.”

As it happens, high-frequency trading has been on regulatory radars for several years. Prior to the two latest settlements, the SEC has since October 2011 charged dark pools and other alternative trading systems in six other cases, collecting fines totaling $43.5 million. In March 2014, Schneiderman called for tougher regulatory oversight and market reforms to eliminate unfair advantages provided to high-frequency traders. His office has since reached agreements with Thomson Reuters, Business Wire and others to end business practices that provided high frequency traders an unfair advantage.

“The rigging of the stock market cannot be dismissed as a dispute between rich hedge-fund guys and clever techies,” wrote Michael Lewis in a March 2015 article in Vanity Fair magazine. “It’s not even the case that the little guy trading in underpants in his basement is immune to its costs.”

“The creation of precedents is one of the geniuses of the Anglo-Saxon system that produces efficiency.”–William Black

What Could Regulators Do?

Black and Conti-Brown said regulators need more resources to enforce laws governing high-frequency trading, especially because of the speed at which they occur. “The SEC is not equipped to do those studies,” said Black. He also accused the Republican Party of “trying to prevent [regulators] from having the budget to get modern technology to look at these matters.”

According to Conti-Brown, there is no need for more legislation in order to give the SEC or other regulators more authority to punish errant trading practices. However, “if enthusiasm for these kinds of settlements … increases … we could see a reallocation of [the SEC’s] admittedly scarce resources towards enforcement,” he said.

“It’s a question of will as opposed to law.” Black agreed. “They lack the will to put elite bankers in prison,” he said of regulators. He described Barclays and Credit Suisse as serial felons. “They have done hundreds of thousands or millions [of violations], but nobody goes to jail.”

According to Conti-Brown, “The worry is not only about fraud, but also systemic risk.” He wondered if there is a need for a “separate federal apparatus to go after these [violations].” He also noted that regulators across the globe are cracking down on high-frequency trading, including those in Japan, Italy and Brazil.

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