Barclays Not Smart

http://www.bloombergview.com/articles/2014-06-26/barclays-not-smart

by rgarcia • 12 years ago

169 82 12 years ago

tptacek8• 12 years ago

To sum this up:

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.

scrumper5• 12 years ago

This is a good summary of a typically rational article by Matt Levine. His entire commentary on the industry post-"Flash Boys" is similarly enlightening and balanced.

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.

rayiner• 12 years ago

I've been quite impressed with Matt Levine's articles. Also, while I realize that Bloomberg probably exerts zero editorial control over View, I've been quite happy with Bloomberg's Wall Street coverage as of late.

danielweber• 12 years ago

Levine has very very quickly become one of my favorite writers, because of 1) his ability to say "Here is an animated picture of a stoned Wall Street bull pouring Doritos into his mouth next to a pink bong because why not"[1] in the middle of an article, and 2) his pointing out of incredibly obvious things that most commenters seem to miss. (Why was Barclays lying about the existence of the HFTs in the dark pool to the institutions who make it orders of magnitude more money than the HFTs? Because they need the HFTs to service the institutional investors.)

[1] http://www.bloombergview.com/articles/2014-06-20/levine-on-w...

rs• 12 years ago

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.

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.

tankenmate• 12 years ago

However a number of futures markets used to have rules that the size of the market positions of speculators weren't allowed to exceed the size of the market positions of the buyer / sellers; this was to prevent the speculators driving the market rather than the buyers / sellers. The most famous of these is probably the position limits imposed by the Commodity Exchange Commission (forerunner of the Commodity Futures Trading Commission) in 1938 on the commonly traded grains. In most countries these limits have been removed over the last 20 years or so. The debate on the necessity of such limits is still ongoing...

Marazan• 12 years ago

Their original role was to help farmers hedge their risk of bad harvests by setting a fixed price for future delivery of foodstuffs.

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.

bradleyjg• 12 years ago

That doesn't really put Barclay's actions in a much better light. Is it any better to promise something impossible* and not deliver it than to promise something possible and not deliver it? Either way you are engaging in fraud.

*Although per footnote six it looks like at least some trading along those lines is possible and Liquidnet is in that business.

tptacek8• 12 years ago

Nobody is trying to put Barclays in a better light! They did something bad. But that bad thing probably wasn't "selling out their dark pool to the HFTs".

OrwellianChild• 12 years ago

I have a hard time feeling bad for companies who choose to be "taken in" by a pitch like Barclays'.

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.

smsm422• 12 years ago

Virtually every ad you see on TV promises something impossible (like scantly clad beautiful women instantly falling in love with you as soon as you consume particular product or you solving all your life's problem, becoming rich , healthy and content with your life by making one phone call). They can't all be crazy there - maybe there's a reason why promising something impossible and giving something possible works better than brutal uncompromising honesty of "if you use our product you probably won't smell as bad as you do now but otherwise your chances for attracting a mate and living a happy life wouldn't change much whether you buy it or not, and you probably are wasting money as there's much cheaper product that does exactly the same".

joe_the_user2• 12 years ago

That argument is equivalent to: "the wild animal dealers were told their client wanted a zebra that could pull a horse cart and since that's impossible, they did the rational and upstanding thing. They painted stripes on a horse. Surely you can't call them [edit]"predators"[/edit] for doing the one thing that could make their client happy" (and that's accepting the facts as given).

scott_s• 12 years ago

No, it is not. You're assuming the "surely you can't call them fraudsters" part. No one is saying that. Matt Levine was quite clear:

'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."

elecengin2• 12 years ago

I struggle to feel bad for these institutional investors. These investors are mostly fund managers who make on the order of 1% of assets under management yearly... Arguably, their jobs are composed of two functions: decide on investment decisions, and execute on those decisions. Yet - they are unable to do their own analysis of execution quality.

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...

scrumper5• 12 years ago

Who's money do you think they are managing?

tptacek8• 12 years ago

I'm not sure how the answer to that question is relevant to the comment you're replying to.

chollida12• 12 years ago

Dark pools didn't start off as a bad idea.

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.

tptacek8• 12 years ago

Wait, you had me until the last 2 paragraphs.

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.

chollida12• 12 years ago

Ok, a few points.

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:)

create_acct3• 12 years ago

Are there any services out there that allow automated trading, but as a game? There are many services that let you do manual trades as a game, but I've never seen automated ones.

izyda• 12 years ago

http://www.quantopian.com let's you paper trade using algorithms if that's what you're after

create_acct3• 12 years ago

quantopian looks nice. I'm glad someone is in this niche.

ddeck• 12 years ago

Interactive Brokers also offer a paper trading account that can be traded via their API just like a regular account, although you need to have an account with them.

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...

create_acct3• 12 years ago

I've looked at them before, but I don't have $10k to tie up on what is just me playing around.

alphagenerator• 12 years ago

There is no substitute for the real thing. Get an account, build the algo, do the best you can to minimize maximum damage, and run with it.

api• 12 years ago

"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."

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.

smsm422• 12 years ago

With the correction that the only way the "public" can swim is by riding the "alligators".

>> 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.

mathattack2• 12 years ago

Matt Levine is awesome. Thanks for sharing. He's also the world kingpin of footnotes. It's almost as if he's a frustrated academic who needs to hide his humor in citations.

anonymousDan• 12 years ago

Personally I find an abundance of footnotes to be bad style. If it's important enough to say it then say it in the main text, otherwise don't bother.

mathattack2• 12 years ago

It's part of his personal style.

jerf2• 12 years ago

I don't know enough to have an opinion on HFTs and whether they actually provide liquidity. However, creating sub-markets that are illiquid if you remove them, but become liquid if you add them back in, strikes me as a pretty powerful bit of evidence in HFT's favor. Rebuttals? (Serious question.)

pfortuny• 12 years ago

Well, those markets are not fully informative so they are "markets" in some sense not in the "common meaning of the word." Hence the "opaque" adjective. I would not like all markets to be of this kind.

bkeroack• 12 years ago

The whole point of this article is to present a pro-HFT viewpoint. I don't have an opinion either way (yet), but this is clearly written by someone with an HFT bias.

jerf2• 12 years ago

I like to look at the objective facts that are very hard to spin. There aren't many of them, but you can make a lot of hay with them. "We tried not including this thing, and it didn't work, and then we put them in, and it did work" is a very powerful argument, since I value reality and real things over any amount of handwaving and theory. That's something that can't so much be spun as rebutted, hence my phrasing. (For instance, perhaps it's simply a lie. I don't know.)

(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.)

tptacek8• 12 years ago

It is? What's your evidence of his bias?

sbov• 12 years ago

I don't know a lot about this either, and my understanding might be incorrect, but the comparison seems very different to me. These dark pools are full of slow moving, like minded institutional investors that tend to buy and sell the same thing at the same time. In this scenario, my understanding is that HFTs are providing them access to a market that is not as homogenous (the public market).

dreamweapon• 12 years ago

From the article:

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.

Yunk• 12 years ago

Yes, I had the same problem with the article. The lawsuit just seems to be cherry picking which part of Barclay's paradoxical claims to trust, not creating its own self referential problems.

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.

JumpCrisscross• 12 years ago

Let's ignore the fact that Barclays manipulated the data underlying the chart in Figure 1. Think about what the chart is intended to convey.

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.

minimax2• 12 years ago

I think what they are saying with the chart is that if they see anyone who is trading in that upper right quadrant (high one second alpha, high take percentage), they can kick them out of the pool, or at least that institutions can set some flag on their order entry port that will prevent them from matching against those parties.

lmm3• 12 years ago

If you're buy-side you know you're a clown on the execution side - it's not your core competency, it's just a cost center that you vaguely want to keep as low as possible while you make your real money through long-term value investing or serving your fundamentals-trading clients. You'd rather trade in the pool full of clowns, where the sharks get kicked out, and execution will be basically a wash rather than a transfer of money from you to the HFTs whose core competency is execution.

tptacek8• 12 years ago

Yes, you would rather trade in the clown pool. But isn't the problem that the sell-side doesn't just fleece the clowns, but also enables the clowns to trade at the rate they expect to trade at?

drawkbox• 12 years ago

Amazing info and article.

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.

suprgeek• 12 years ago

Is this not a clear case of Fraud & Mis-representation? If a person had pulled this kind of stunt you would see criminal chrges flying all over the place ..Why are bank executives at Barclays not going to jail over this?

dabeeeenster• 12 years ago

Because money is power.

barclay• 12 years ago

I resent the title of this article.

slantview• 12 years ago

I believe it's a pun on the "U smart" comment made by one of the VPs.

richardw• 12 years ago

There seems to be a false dichotomy here - free-for-all or no automated traders. Automated firms are included in the diagram, so Barclays wasn't hiding them. It was, however, claiming to remove those it considered bad actors, and then wasn't actually doing so. Surely allowing HFT firms but removing those (specifically, Tradebot) that didn't follow the rules would still have left enough trade flow to enable the buy-side to get value? If it's bad enough to warrant removal from the diagram, it's bad enough to be removed from the pool, leaving every other participant to continue as before.

mrow844• 12 years ago

I have a couple of questions for the people on here who actually understand all this stuff.

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

friendzis• 12 years ago

I want to add to the argument: quite many people seem to be convinced that liquidity created by HFTs is almost a necessity for a pool/exchange to exist. What about pre-HFT times then? Did HFTs change the way we trade to the extent that it is impossible to trade without them now?

consz2• 12 years ago

Liquidity is a measure of how much you can execute/trade immediately at any one moment in time. You can think of the fair price as the midpoint of the best bid and best offer -- but nobody can trade at this, so if you want to buy or sell, you have to buy slightly above the fair price or sell slightly below the fair price. And if you want to buy or sell a lot, you have to buy or sell standing bids/offers at prices worse than the best bid/offer, e.g. MSFT has best bid at 36.60 and best offer at 36.61 with 30,000 shares at every price. If you wanted to buy 100k shares immediately, you'd have to buy 30k at 36.61, 36.62, 36.63, and 10k at 36.64, for some average price slightly higher than 36.62.

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.

mrow844• 12 years ago

Ok, I think I understand what you're saying in principle, but I still don't really understand how HFT, or indeed anyone who is only trading on prices, adds liquidity as you have defined it, beyond the addition of their initial capital: it's not having quick trades that makes a market liquid, just having available trading partners with enough capital to complete the trade you want. It strikes me that, if you roughly assume that price-based trading is random, then all that fast trading "really" does is speed up the process by which some people randomly lose their money and others are randomly given that money (those people generally being the price-based traders themselves, presumably, because they will be the ones involved in the majority of the trades).

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.

jackgavigan• 12 years ago

I dug up the original chart, before Tradebot was removed: http://jackgavigan.com/2014/06/30/barclays-smoking-chart/

davidhunter• 12 years ago

Some thoughts on this as the former head of electronic trading product management at Deutsche Bank

http://dave-hunter.com/why-barclays-lied

Barclays Not Smart

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