Buy-side firms are stepping up their due diligence of broker dark pools following legal action against Barclays for allegedly misrepresenting details about its crossing network to users.
The case against Barclays, which has been accused by New York attorney general Eric Schneiderman of providing misleading information about the extent of high-frequency trading (HFT) in its LX dark pool, has also increased concerns among end-investors.
Recent events have led to further ratcheting of buy-side scrutiny of broker dark pools and order routing decisions, according to Ben Springett, head of electronic trading at Instinet Europe.
"We've seen a steady increase in the number of order routing and dark pool questionnaires from clients over the past couple of years, but this has intensified since both the publication of [Michael Lewis book] ‘Flash Boys’ and now the case against Barclays in the US," he said.
"In the past, buy-side firms would typically ask very open, general questions, which would make it difficult for them to directly compare different broker offerings and enabled the brokers to potentially omit important details. Today, they are asking much more direct, ‘yes/no’ questions which give them a very consistent and complete view of the practices brokers are undertaking."
Barclays is accused of hiding the fact that Kansas-based HFT firm Tradebot was the biggest liquidity provider in LX
Adrian Fitzpatrick, head of investment dealing at Kames Capital, says long-held concerns about the amount of HFT in dark pools have caused the buy-side to seek more detail from brokers. “In the last few years, we’ve known that brokers have been opening up their dark pools to HFT. You only have to look at average fill sizes, which have fallen considerably since 2008, to realise there is too much toxic flow in these pools,” he said.
While many already active funds avoid pools suspected of including large HFT volumes, Fitzpatrick warned that passive funds may be unknowingly losing out when orders are routed to pools with high concentrations of HFT participants.
As well as asking for more information from their brokers, buy-side firms are also increasingly looking at options to conduct their own independent research into pools to discover hidden HFT activity.
LiquidMetrix, a data analytics firm which specialises in dark pool execution performance, has also seen increased interest from institutional investors.
“Buy-side firms are most interested in which brokers are routing to which pools, levels of toxicity and indicators that HFT is present, as well as best execution outliers,” explained Sabine Toulson, managing director of LiquidMetrix.
Springett said that while specific recent events have intensified interest in the quality of dark pools, these trends are being driven by longer-term changes in the demands placed on the buy-side.
"Investment managers are themselves facing higher levels of scrutiny from their clients and from the regulator, as such they need to have robust due diligence in place," he said.