MONEY

What Do Wall Street’s “Dark Pools” Mean for Regular Investors?

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New York's AG wants to know what's going on beneath the surface. iStock

What you need to know about the latest allegation against another big investment bank

Yesterday New York Attorney General Eric Schneiderman announced a civil lawsuit accusing the investment bank Barclays of fraud related to its operation of a “dark pool” for stock trades. What does it mean for regular investors? Here’s what you need to know:

What are dark pools?

They’re essentially private electronic stock trading markets, separate from the main public stock exchanges. Many are run by investment banks. They’re called “dark” because, unlike on public exchanges, buy and sell orders are invisible to other traders.

Are they as sinister as the name suggests?

Actually, the pitch for dark pools is that they are supposed to make trading less costly. When a big investor, like a mutual fund, tries to buy or sell stock on a public exchange, other traders on the market may see that trade and try to move ahead of it. That means the fund will end up paying a little more for a stock it’s buying, or get a little less for a stock it’s selling. By cloaking such orders, a dark pool is supposed to keep other traders from taking advantage of the fund’s moves.

So what is the New York AG saying Barclays did wrong?

Scheiderman says Barclays’ dark pool exposed investors to the very kind of front-running trades they wanted to get away from. Although the bank’s marketing materials said it would protect dark pool participants against “predatory traders,” the New York AG says Barclays didn’t do enough to remove such traders from its pool. In fact, the complaint alleges that Barclays sought the business of some of those traders, and provided them with “detailed information regarding the structure and composition of its dark pool” that may have given them an edge.

High-frequency traders, which use computer programs to make programmatic trades in fractions of second, were allowed to trade in the pool for virtually nothing, the complaint says. High-frequency traders can use their speed advantage to get ahead of other trades.

In a statement, Barclays has responded by saying it is co-operating with the AG and federal Securities and Exchange Commission.

Anything else?

Yes. The AG alleges that because Barclays was eager to grow its dark pool business, its brokerage routinely routed client orders through its own dark pool regardless of whether it was the best place to execute a given trade.

So how might any of this affect me?

The kind of predatory trading Schneiderman is talking about isn’t a serious concern if you are buying 100 shares of Apple. As the complaint notes, it’s the big institutional investors whom aggressive, fast traders are going after. But those big institutions may include mutual funds and pensions funds, which you do have stake in.

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