Last spring popular author Michael Lewis described the world of high-frequency stock trades and dark pools in his book, Flash Boys. Between then and now, the New York Attorney General (“NYAG”), a group of public investors, and two other classes of investors have filed suit against brokerages for high frequency and dark pool trading practices. Some of complaints sound in federal law and some are based on state law protections. Collectively, however, the litigation includes recurring allegations that high-frequency trading is tantamount to fraud— at least when it occurs within so-called “dark pools.” Together with mounting negative publicity, these lawsuits have reinvigorated conversations about brokerage reform and deserve further inquiry.

Flash Boys: Explaining high frequency trading

Many had not heard about—or did not understand—high-frequency trading before the publication of Flash Boys. In the book, Lewis explains how the development of electronic stock trading and the growth of public and private trading venues have resulted in small, temporary price differences between trading venues. Some traders use ultra-fast computer connections to take advantage of those price differences and gain a market advantage in a practice known as “latency arbitrage.”

In particular, latency arbitrage leverages the practices of institutional investors seeking to trade large blocks of stock. Because of the volume of these trades, no one exchange can usually handle the order. To overcome that problem, institutional investors route smaller orders through data lines to several exchanges. Often traveling via fiber optic cable, the small orders arrive at the various exchanges at slightly different times, sometimes fractions of a second apart.

High-frequency traders use this short gap to detect the large order and use other exchanges to trade against it. Lewis compared the practice to “front running”— when a broker trades securities for its own account before executing customer orders for the same securities. That practice is illegal because the broker benefits from the price change caused by the customer orders. Those opposing high-frequency trading characterize the practice as similarly fraudulent because it allows the traders to gain an edge over the institutional investor trading the large block of stock.

Dark pools illuminated

Dark pools are more private, more anonymous trading platforms than public platforms such as NASDAQ or the New York Stock Exchange. Increasingly, institutional brokerages use dark pools to trade large stock orders. Dark pools do not publish investors’ buy and sell orders and wait to publicly announce trading prices until after the trade. As a result the institutional investor can make a large trade with less risk of tipping off the market and potentially moving market prices.

Dark pool proponents claim that the trading mechanism provides desirable liquidity. Opponents argue that the growth of dark pools has exacerbated the problems associated with high frequency trading and latency arbitrage.

Dark pools + high-frequency trades = a volatile mix

Recently, some have questioned the propriety of high-frequency trades in dark pools, alleging that the practice victimizes slower investors. For example, high-speed traders could place small buy and sell orders inside a dark pool on all listed stocks to detect large orders for a particular stock. The high-speed trader could then trade that stock in the opposite direction on the public exchanges, where the prices have not yet changed to reflect the dark pool transactions.

Regulators and investors have started challenging the practice—last summer saw a civil lawsuit by the New York Attorney General (“NYAG”) and two investor class actions. In addition, shortly after the NYAG commenced its action, Credit Suisse, Deutsche Bank, and UBS disclosed that U.S. regulators were investigating their respective dark pools.  The growing awareness and heightened scrutiny of dark pools and high-frequency trading signals a trend towards more oversight, enforcement―and litigation.

NYAG civil action alleges misrepresentation amounting to fraud

Last June, the NYAG sued Barclays for misrepresentation in the operation of its dark pool. The complaint alleges that over the last three years Barclays:

• Increased the market share of its dark pool by using a series of false statements to clients and the investing public about how, and for whose benefit, it operated its dark pool.
• Attracted and favored high-frequency traders to its dark pool;
• Failed to safeguard clients; and

Barclays filed a motion to dismiss, arguing that the NYAG failed to identify any material misstatements, victims, or actual harm.  Barclays observed that its dark pool clients were highly sophisticated and based investment decisions on “detailed execution data, not on the glossy marketing brochures or quotes from magazine articles the NYAG cites.” Further, Barclays argues that the Martin Act on which the NYAG based its action does not apply to alternative trading platform. Barclays also says that, instead of NYAG, the SEC should be the body that regulates dark pool and dark pool activities.

Dark pool class actions

The NYAG suit quickly triggered two additional, separate investor class action lawsuits.

Last July brought allegations of violations of the Securities Exchange Act of 1934 (the “Exchange Act”) by a class of those who acquired Barclays ADSs and options to purchase or sell ADSs. Class members allege they suffered damage when Barclays ADSs fell 7.38% the day after the NYAG announced its suit.

Also in July, another class comprised of Barclays’ investor clients alleged concealment, unfair competition, and false advertising in violation of California law.  In this second action, class members claim they suffered damage arising from Barclays’ practice of sharing detailed information regarding orders in its dark pool with high-frequency traders. Class members allege that they received less favorable prices than they would have otherwise obtained had Barclays not enabled the high-frequency traders to trade ahead of traditional investors like those in the class.

The NYAG action and the class actions challenge high-frequency trading in dark pools, but do not raise the bigger issue of whether high-frequency trading standing alone is illegal. These lawsuits may lead to better disclosure but will not do away with the practice of high-frequency trading.

But another suit filed last April challenges the legality of high-frequency trading head on. A class of public investors—including the City of Providence, Rhode Island—contends that electronic front-running, latency arbitrage, and other high-frequency trading tactics amount to securities fraud. The complaint asserts that exchanges sold high-frequency traders special access to market data and received kickbacks in exchange for routing their customers’ orders to trading venues they knew were “rigged” in favor of high-frequency traders.

When it comes to dark pools, the City of Providence class action asserts that brokerages place and leave customer orders in dark pools, while prices on the broader market continue to change. As a result, high-frequency traders and the brokerages’ own proprietary traders wait for price changes outside the dark pool and profit by arbitraging the real-time market price against the dark pool customer’s stale order price. If successful, the City of Providence class action will have a more profound impact on stock trading practices than the outcome of other pending dark pool suits.

Conclusion

The practice of high-frequency trading— particularly that occurring in dark pools— is out from the shadows. Investors and regulators are more informed and the outrage many feel have caused some to go on the attack. The suits present evidentiary challenges to both sides, but the resulting publicity will take a toll, regardless of the legal outcomes in specific suits. Stay tuned for continued discussion, for new market reform proposals, and for more litigation from investors who claim their fortunes have been harmed by impure market forces lurking within dark pools.

[1] Michael Lewis, Flash Boys: A Wall Street Revolt (W.W. Norton & Co. 2014).

[2] According to the New York Attorney General, dark pool trading accounts for “over forty percent of all U.S. equities trades.” Complaint, Schneiderman v. Barclays Capital, Inc., No. 4511391/2014 (N.Y. Sup. Ct. July 24, 2014).  

[3] Lewis, supra at 123.

[4] Id.

[5] Max Colchester, John Letzing, & Eyk Henning, “Deutsche Bank, UBS Sucked Into Dark-Pools Trading Probe,” The Wall Street Journal, July 30, 2014.

[6] Schneiderman v. Barclays Capital, Inc., No. 451391/2014 (N.Y. Sup. Ct.).

[7] The complaint includes counts for securities fraud under New York’s Martin Act and Executive Law § 63(12).

[8] Plaintiff filed the class action against Barclays PLC, its former CEO Bob Diamond, current CEO Antony Jenkins, former Finance Director Chris Lucas, and current Finance Director Tushar Morzaria. The complaint asserted counts for violation of Sections 10(b) and 20(a) of the Exchange Act between August 2, 2011 and June 25, 2014. Strougo v. Barclays PLC, 14-cv-5797-SAS (S.D.N.Y. 2014).

[9] Plaintiff filed suit against Barclays PLC, Barclays Capital, Inc. and other unnamed defendants involved in the operation and marketing of Barclays’ dark pool. The class consisted of Great Pacific Securities and other Barclays' clients, who submitted trades from January 1, 2011 to the present for potential execution in Barclays' dark pool. The complaint alleged violations of California Bus. & Prof. Code § 17200 and § 17500. Great Pacific Securities v. Barclays PLC, 8:14-cv-01210-DDP-SH (C.D. Cal. 2014).

[10] Class members traded stock listed on a U.S.-based exchange or alternate trading venue between April 18, 2009 and the present. They asserted claims under Sections 6(b), 10(b), and 20(A) of the Exchange Act against certain high-frequency trading firms, exchanges, and brokerages. City of Providence v. BATS Global Markets, Inc., 14-cv-2811-JMF (S.D.N.Y.).

[11] Complaint at 2.

[12] Id. at 41.