By Karen Freifeld and John McCrank
NEW YORK (Reuters) - The New York Attorney General on Wednesday filed a securities fraud lawsuit against Barclays PLC for misrepresenting the safety of its U.S.-based alternative trading system, or "dark pool," to investors.
The lawsuit alleges that in order to increase business in its dark pool, Barclays has favored high-frequency traders and has actively sought to attract them by giving them systematic advantages over other investors trading in the pool.
"Barclays grew its dark pool by telling investors they were diving into safe waters," said Attorney General Eric Schneiderman. "According to the lawsuit, Barclays' dark pool was full of predators - there at Barclays' invitation."
Barclays declined to comment.
Broker-run trading systems known as dark pools, where participants are anonymous and trading information is hidden until after the trades are completed, are a key focus of Schneiderman's sweeping investigation into the U.S. stock market.
His office is looking into whether dark pools operate in a way that is consistent with how they market themselves, that they have the interests of investors in mind and that brokers directing trades to their own dark pools do so in a way that does not present conflicts of interest.
The probes have been going on for up to a year, but scrutiny has intensified in recent months following the release of best-selling author Michael Lewis' new book, "Flash Boys: A Wall Street Revolt." In the book, Lewis contends that high-frequency traders have rigged the stock market, profiting from speeds unavailable to others.
The Barclays complaint, which is based on internal communications provided by former employees, says while the firm told its clients it would keep high-frequency traders that engage in "predatory" trading practices out of its dark pool, it never actually prevented any trader from participating. In other words, Barclays underrepresented the concentration of high frequency trading.
For instance, Barclays falsified marketing material it said showed the extent and type of high-frequency traders in its dark pool by not including high-frequency trading firm Tradebot Systems, the complaint said. Barclays had already identified Tradebot, which at the time was the largest participant in the dark pool, as having been engaged in aggressive trading behavior.
A spokeswoman for Tradebot, of Kansas City, Missouri, said the firm had no comment.
Barclays actually courted high-frequency trading firms by disclosing detailed, sensitive information to major such firms to help ensure their aggressive trading strategies were effective, the complaint said. HFT accounts for around half of all U.S. trading volume.
NO AIRBAG, NO BRAKES
Barclays also told its clients it does not favor its own dark pool when routing client orders to trading venues, when in reality it was doing just that, the complaint said. One former Barclays employee told the Attorney General's office that based on the high amount of client orders Barclays was sending to its own dark pool, better trading opportunities may have been missed elsewhere.
There was a lot going on in the dark pool that was not in the best interests of Barclays clients, one former director said. "The practice of almost ensuring that every counterparty would be a high-frequency firm, it seems to me that that wouldn't be in the best interest of their clients . . . It's almost like they are building a car and saying it has an airbag and there is no airbag or brakes."
The U.S. Securities and Exchange Commission has also taken an increased interest in issues surrounding dark pools and high-frequency trading. SEC Chair Mary Jo White earlier this month said her agency is developing a series of rules that would seek to make markets more transparent and fair for all investors.
One potential measure would require dark pools and firms that match customers' orders internally to tell regulators and the public how they operate. The SEC has also stepped up enforcement actions, including a civil lawsuit filed in early June against dark pool operator Liquidnet for allegedly improperly using its subscribers’ confidential trading information to market its services.
The SEC declined to comment on the lawsuit.
(Additional reporting by Herb Lash)