FULL TEXT Barclays and Credit Suisse SEC Dark Pools Settlement

[T]he Financial Industry Regulatory Authority (FINRA) has named Joseph M. Mecane as the Floor Member Governor on FINRA's Board of Governors. Mr. Mecane is currently a Managing Director of Electronic Equities and Credit Products at Barclays. Mr. Mecane recently joined Barclays to assist in the further development of the firm's electronic product offering, with a particular focus on the equities and credit markets.

. . .

"On behalf of the Board, I would like to extend a warm welcome to Joe. Joe's valuable expertise and depth of experience in market structure issues will help FINRA's Board move forward as we advance our mission of protecting investors and ensuring the integrity of our markets," said Richard Ketchum, FINRA's Chairman and Chief Executive Officer.

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In the Matter of Barclays Capital Inc. Respondent (Order Instituting Administrative And Cease-And-Desist Proceedings, Pursuant To Section 8a Of The Securities Act Of 1933 And Sections 15(B) And 21c Of The Securities Exchange Act Of 1934, Making Findings, And Imposing Remedial Sanctions, Securities and Exchange Commission, '33 Act Rel. No. 10010; '34 Act Rel. No. 77001; Admin. Proc. File No. 3-17077 / January 31, 2016) (the "OIP").

Summary 

1. Off-exchange trading of NMS stocks1 has increased significantly in recent years. Off-exchange trading can offer many benefits to market participants, but also highlights the necessity of transparency between the entities that operate off-exchange venues and their clients. Barclays is the owner and operator of Barclays LX ("LX"), an alternative trading system ("ATS") 

2 that operates as a "dark pool."3 LX accepts, matches, and executes orders from clients (subscribers that access LX through Barclays' trading algorithms or order router only) and direct subscribers (subscribers that access LX directly, or in combination with Barclays' algorithms and/or order router) (collectively, "LX subscribers" or "subscribers") to buy and sell NMS stocks. As of May 2014, LX was the nation's second largest NMS stock ATS. 2. From December 2011 through June 2014 (the "relevant period"), Barclays violated the federal securities laws and regulations arising from its operation and marketing of LX as set forth in Section V. below. In particular, Barclays made materially misleading statements and omitted to state certain material facts necessary to make statements made not misleading concerning a) the operation of an LX product feature called Liquidity Profiling, which Barclays described as a "powerful tool to proactively monitor LX" and as a "sophisticated surveillance framework that protects clients from predatory trading" and b) the market data feeds that it used in LX. In addition, Barclays violated the federal securities laws and regulations related to its market access and its operation of LX, including by failing to establish adequate safeguards and procedures to protect subscribers' confidential trading information, and to adopt and implement adequate procedures to ensure that such safeguards and procedures are followed. 

3. In December 2011, Barclays developed a product called Liquidity Profiling to differentiate it from other dark pool operators. Barclays designed Liquidity Profiling to categorize LX subscribers and their order flow into various "buckets" numbered 0 through 5 (0 representing the most aggressive order flow, and 5 representing the least aggressive order flow), and then to allow LX subscribers to block trading with other subscribers that were assigned to certain categories. For example, an LX subscriber that did not want to trade with other subscribers that Liquidity Profiling rated as most aggressive could choose not to interact with LX subscribers that were rated as type 0 or 1. 

[Ed: Note that "Figure 2" in the OIP has not been reprinted here but may be viewed on the PDF file noted below]

4. In addition to providing LX subscribers with the ability to avoid interaction with subscribers that were assigned to certain categories, Barclays marketed Liquidity Profiling as a "sophisticated surveillance framework that protects clients from predatory trading," and that "utilizes robust visualization tools [referencing Figure 2 below] that synthesize and graph large amounts of data and allow the Barclays ATS team to continuously police the trading activity in LX."

5. Barclays also claimed that it ran "surveillance reports every week to make sure that there is no toxic flow in [LX's] book." 

6. In fact, from December 2011 through June 2014, Barclays did not "continuously police" LX for predatory trading through the use of "visualization tools" as depicted above. Nor did Barclays generally run surveillance reports on a weekly basis during the relevant period to ensure that there was no "toxic flow in [LX's] book."

7. Barclays also failed to disclose adequately its practice of overriding the Liquidity Profiling tool's categorization of subscribers (hereinafter, "Overrides"). During the relevant period, the majority of these Overrides moved LX subscribers from less aggressive buckets to more aggressive buckets. However, at times during the relevant period, Barclays overrode the Liquidity Profiling tool's categorizations of certain LX subscribers (including its own market making desk) by manually moving these subscribers from the most aggressive buckets (e.g., 0 and 1) to the least aggressive buckets (e.g., 4 and 5). Barclays overrode these subscribers' categorizations to increase the likelihood that these subscribers' orders would be executed in LX. This likelihood increased because being categorized in buckets 4 and 5 resulted in these subscribers interacting with all flow in LX, even orders placed by subscribers that chose not to interact with subscribers assigned to the most aggressive Liquidity Profiling subscriber categories. As a result, the subscribers that elected to block trading against the aggressive LX subscribers still interacted with aggressive LX subscribers whose categorizations had been overridden even though they had specifically opted not to trade with subscribers that engaged in this level of aggressive trading. 

8. In addition, from October 2012 through May 2014, Barclays distributed a PowerPoint presentation ("Pitchbook") concerning LX that contained a bubble scatter plot chart that purported to represent the "top 100 participants" in LX and to show the size and "aggressiveness" of each subscriber's order flow. The size of each bubble corresponded to the size of each subscriber's order flow at a static point in time, and placement of each bubble on the chart corresponded to the aggressiveness of that subscriber's trading flow. In October 2012, however, Barclays removed from this chart the bubble that corresponded to its largest subscriber with aggressive trading characteristics ("Subscriber 1"), and then continued to use this same chart in its marketing material through May 2014. 

9. Although in October 2012 Barclays removed from the chart the bubble corresponding to Subscriber 1, Barclays continued to include a footnote in the Pitchbook stating: "This chart represents the top 100 participants in LX (~86% of total flow). The analysis spans more than 11.3 million trades." Moreover, in April 2014, Barclays amended the footnote to then state that the source of the data for the chart, which still did not include the bubble that corresponded to Subscriber 1, was Barclays data from 2014. 

10. Barclays also at times misrepresented the type and number of market data feeds that it used to calculate the National Best Bid and Offer ("NBBO") in LX. Barclays used the NBBO to determine the price of pegged orders in the ATS and as a basis for certain compliance decisions. 

11. Market data feeds-and trading latencies potentially created by the use of particular market data feeds-have been a major focus in the securities industry over the past few years. Debate has ensued over the possibility that certain high frequency traders gain advantages by using faster, direct feeds from exchanges while some trading venues, including some dark pools, use slower feeds from the Securities Information Processors ("SIPs") for pricing pegged orders within the venues and as a basis for certain compliance decisions. 

12. Barclays misrepresented that it used more direct feeds than it actually did. During the relevant period, Barclays calculated the NBBO in LX using a combination of data from 1) SIPs and 2) direct feeds from only the BATS, ARCA, and NASDAQ exchanges. At no time during the relevant period did LX subscribe to a direct market data feed from the New York Stock Exchange ("NYSE"). 

13. However, Barclays responded to a question from an LX subscriber about which data feeds it used to construct its NBBO in LX by saying, "Combination of SIP (for regional venues) and direct feeds (for major exchanges)." 

14. Additionally, on April 9, 2014, in response to LX subscriber inquiries generated by the publication of Michael Lewis's book, Flash Boys, Barclays sent a marketing piece by email to LX subscribers that said that Barclays "utilize[s] direct feeds from exchanges to deter latency arbitrage." This piece omitted any reference to Barclays' use of the SIPs. 

15. As a result of the materially misleading statements and omissions of fact described above, Barclays violated Section 17(a)(2) of the Securities Act, an antifraud provision of the federal securities laws. 

16. Barclays also violated Exchange Act Section 15(c)(3) and Rules 15c3-5(c)(1)(i) and 15c3-5(b) thereunder by failing to have the necessary risk management controls and supervisory procedures in place related to its market access. Specifically, Barclays did not have controls reasonably designed to prevent the entry of orders that exceeded the pre-set credit and capital thresholds Barclays had in place. 

17. Barclays also violated provisions of Regulation ATS. Barclays violated Rule 301(b)(2) by failing to file, at least 20 days before it implemented a material change, an amendment on Form ATS4 that disclosed Barclays' Override process. Barclays also violated Rule 301(b)(10), which requires that an ATS "establish adequate safeguards and procedures to protect subscribers' confidential trading information," including "[l]imiting access to the confidential trading information of subscribers to those employees of the alternative trading system who are operating the system or responsible for its compliance with these or any other applicable rules." 

18. During the relevant period, certain Barclays personnel who did not operate LX and were not responsible for compliance had the ability to access confidential subscriber trading information if they knew the relevant computer language and had the ability to navigate through Barclays computer systems. As such, Barclays violated Rule 301(b)(10) by not having adequate safeguards and procedures to protect subscribers' confidential trading information, including by limiting access to confidential trading information of subscribers to those employees of the ATS who were operating the system or responsible for compliance, or by not implementing adequate oversight procedures to ensure that the safeguards and procedures established pursuant to Rule 301(b)(10)(i) were followed.

FOOTNOTES

1 "In general, the term ‘NMS security' refers to exchange-listed equity securities and standardized options, but does not include exchange-listed debt securities, securities futures, or open-end mutual funds, which are not currently reported pursuant to an effective transaction reporting plan." SEC, Responses to Frequently Asked Questions Concerning Large Trader Reporting (Aug. 21, 2014), www.sec.gov/divisions/marketreg/large-trader-faqs.htm; see Rule 600(b)(46) of Regulation NMS, 17 C.F.R. § 242.600(b)(46). The term "NMS stock" means any NMS security other than an option. Rule 600(b)(47) of Regulation NMS, 17 C.F.R. 242.600(b)(47).  

2 Rule 300(a) of Regulation ATS promulgated under the Exchange Act provides that an ATS is "any organization, association, person, group of persons, or system: (1) [t]hat constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange within the meaning of [Exchange Act Rule 3b-16]; and (2) [t]hat does not: (i) [s]et rules governing the conduct of subscribers other than the conduct of subscribers' trading on such [ATS]; or (ii) [d]iscipline subscribers other than by exclusion from trading." Regulation ATS, Rule 300(a), 17 C.F.R. § 242.300(a). Rule 301(a) of Regulation ATS provides that an ATS must comply with Rule 301(b) of Regulation ATS, unless the ATS is registered as a national securities exchange or qualifies for another enumerated exclusion. During the relevant period, Barclays was not registered as a national securities exchange and did not qualify for an enumerated exclusion. Therefore, it was required to comply with Regulation ATS, including Rule 301(b) thereunder, to benefit from the exemption from the definition of "exchange" provided by Rule 3a1-1(a)(2) under the Exchange Act. 

3 Dark pools are a subset of ATSs that, as a general matter, "offer trading services to institutional investors and others that seek to execute large trading interest in a manner that will minimize the movement of prices against the trading interest and thereby reduce trading costs." Exch. Act Rel. No. 61358 (Jan. 21, 2010), 75 FR 3593, 3599 ("Concept Release on Equity Market Structure"). More specifically, dark pools "are ATSs that . . . do not provide their best priced orders for inclusion in the consolidated quotation data," which is in contrast to another subset of ATSs, electronic communication networks ("ECNs"). Id. An ECN's key characteristic is that it "provides its best-priced orders for inclusion in the consolidated quotation data," making its trading services more analogous to those of registered exchanges. Concept Release on Equity Market Structure, 75 FR at 3599.

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