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The REAL Lesson from the Dark Pool Scandals is Buy Side Ambivalence

Traders Magazine Online News, October 1, 2018

David Weisberger

The news coverage recently on the SEC settlement with Citigroup, where the firm lied to its buy-side clients about the nature of the order flow in its dark pool, has predictably missed the most important point.  Instead of the usual fear mongering over HFT triggered by the case, the real story is how Citi was able to deliver poor execution quality for YEARS without either being detected or having its story challenged.  In this case Citi lied to their clients by telling them that they were trading against “uninformed” retail order flow, while their clients were, in actuality, often trading on other dark pools or with HFT firms as the counter-party.  This is like earlier cases against Credit Suisse, Barclays, Merrill and ITG as they were all based on misrepresentations to clients.  There is no excuse for lying to clients, and, for the record, it is good that Citi was caught and experienced consequences for their behavior.

Apart from the operators of dark pools misleading their clients, however, the blame here should not be placed on the HFT firms legally providing liquidity in those pools.   Some blame needs to be shouldered by the buy-side institutional clients that used these systems, without measuring their effectiveness or even questioning the value of trading with retail flow.

Over the past decade, one “story” told repeatedly and believed by buy side traders is that interacting with retail flow will improve their performance.  Sadly, while that could be true in rare circumstances, in most cases, waiting for such order flow incurs more in opportunity cost than is gained by so called “spread capture.”  Speaking from experience as someone who established and operated a market making business, which derived profit explicitly from trading against retail order flow, the margins in that business are very small, particularly compared to the institutional commissions paid by the buy side.  Plus, to realize those profits, the market makers portfolio’s risk needs to be quantitatively managed and positions could be held for long periods of time.  Neither of those attributes pertain to buy side trading, which generally seeks some immediacy in the establishment or liquidation of positions.  It is a well-known fact to participants in that business, that the “story” of retail flow desirability is overblown, but since some market makers operate businesses to essentially sell that story to institutions, (as Citi did during the time this case occurred) there is little motivation to set the record straight. 

I wish I could say that I am surprised by how easy the asset managers were to dupe, but sadly, I am not.  For years, I have observed the ambivalence displayed by the asset management industry over the impact of trading costs on their performance.  In fact, it is somewhat cathartic to rant on this subject, so here goes…

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