New York Attorney General Eric Schneiderman has hit Barclays with a lawsuit, accusing the bank of fraudulent behavior in regards to dark pools and high frequency trading. The civic suit was filed on Wednesday. 

When trading within a dark pool, buy and sell orders are, in a sense, anonymous. They do not have to be reported to the public. This allows investors to keep their trading interests hidden from competition. Stocks are bought and sold extremely quickly in this scenario, with the help of highly intelligent computer systems. 

The Attorney General believes Barclays' dark pool, Barclays LX, unfairly favors high frequency traders. The filing claimed explicitly that Barclays "operated its dark pool to favor high-frequency traders." The suit also questions the routing of client orders, which the NYAG believes Barclays falsely portrayed. The NYAG's complaint goes further, claiming Barclays offered some clients more information than others, "Barclays has actively sought to attract such traders to its dark pool, and it has given them advantages over others." 

Sources familiar with the trades in question told The Wall Street Journal that "internal disputes" were mounting at Barclays, as it seemed some clients were getting better deals than others when in the presence of elite high frequency trading firms. Clients were not always receiving clear explanations, or explanations at all. Hart Lambur, a former Goldman Sachs trader and co-founder of Openfolio, told The Wire in an email interview, that this trading platform can be difficult to verbalize. "Given that so few people actually understand how high frequency trading works and what the pros and cons are, it's going to be very difficult for banks to clearly communicate to their clients what services they offer for the high frequency trading community and how it is beneficial to the market." Lambur continues, "This is something the banks don't want to talk about – it's a red flag." 

Barclays has a system which monitors the actions of their high frequency traders. This is meant to prevent bad behavior, offer insight even without verbal communication, and regulate the dark pool without unveiling the high speed trades. However, the NYAG believes Barclays traders were about to override the system, making it "essentially a sham." This meant they could make trades they would otherwise be unable to, but keep the illusion of a safe space. Schneiderman went on to say Barclays built a large dark pool "by telling investors they were diving into safe waters. In fact, Barclays' dark pool was full of predators who were there at Barclays' invitation."

The Attorney General is citing a number of internal communications as the basis of their lawsuit, including the following emails: 

AP Photo/John Minchillo

There has been a fair amount of recent discussion about high frequency trading practices, both legally and on a larger intellectual level. Clients are pushing for more information about these trades and the traders making them. The Securities and Exchange Commission is also investigating dark pools to best understand how they operate, and how much must be disclosed to even the playing field for different kinds of investors. Barclays LX is also on the list of SEC-investigated dark pools. 

Barclays LX is the second-largest alternative trading system in the country, and now, brokers are looking to cut ties with it. Deutsche Bank and the Royal Bank of Canada have already pulled out. Other brokers are seeking details of their dealings with Barclays LX before making a decision.

Experts in the field are still at odds as to how this will play out on a larger scale. A source familiar with large alternative trading systems told The Wire that while some brokers are pulling away from Barclays LX, we should not expect to see any other dark pools shut down any time soon, as the situation is not currently that extreme. Lambur thinks differently, "With all the increased regulatory scrutiny and push for more financial transparency, the whole concept of dark pools seems rather out of place." Lambur believes banks could move away from dark pools completely, "due to heightened reputational risk and concerns around being associated with the whole high frequency trading mess."

via MSN Money.

Since news of the lawsuit broke, Barclays stock has plummeted about five percent. Morale is also suffering. Two Barclays traders who spoke to the The Wire on the condition of anonymity said that the trading floor felt distinctly "awkward and uncomfortable" since the news broke. They said the matter was not being publicly discussed between management and lower level employees, and it has been made very clear they are not to discuss it outside of their firm. 

Barclays has been equally silent, issuing only one short public statement to the press: "We take these allegations very seriously. Barclays has been cooperating with the New York Attorney General and the SEC and has been examining this matter internally. The integrity of the markets is a top priority of Barclays." 

They should be taking it quite seriously. Barclays could be made an example of, as regulatory entities urge other high frequency traders to play nice. This could lead to giant fines — perhaps the largest in history — unwanted expense and shaming for Barclays. Lambur wisely reminds us, "Financial transparency is a secular trend that isn't going away." Barclays is in for a bumpy ride to becoming crystal clear.