The lawsuit, which relates to Barclays' LX Liquidity Cross 'dark pool' alternative trading system, alleges that the bank promised to get the best possible prices for customers looking to buy or sell shares but instead took steps that maximized the bank's profits and executed nearly all of its customers' stock orders on LX instead of on exchanges or other venues that might have offered better prices.
The New York Attorney General's action is the highest profile case yet to emerge in the U.S. authorities' efforts to ensure that dealers are not ripping off investors in increasingly automated stock markets.
These probes have been progressing for up to a year, but took on additional urgency in recent months, after best-selling author Michael Lewis released the book "Flash Boys: A Wall Street Revolt" which contends that markets were rigged.
Dark pools were originally created to allow investors to execute big trades without tipping off the market. But ever-larger volumes of trades have been shunted into dark pools and their critics say the opacity of the markets may be resulting in more and more investors getting ripped off.
Barclays' London-listed shares were down 4.5 percent at 219.65 pence by 0753 GMT(3.53 a.m. EDT) on Thursday, their lowest level since November 2012 and extending their fall this year to 20 percent.
The lawsuit delivers another blow to Chief Executive Antony Jenkins' efforts to restore the bank's reputation after a series of scandals. He has said its culture, which has been criticized as high-risk, high-reward, had to change and that systems and controls are improving, but the emergence of past sins are hampering his efforts.
New York Attorney General Eric Schneiderman said Barclays told customers who chose to trade in its dark pool that they would be protected from "predatory traders," which use their speed advantage to deprive other investors of small profits on every trade. But in fact customers were not protected at all, and the bank in fact courted predatory high-frequency traders in part by charging them virtually nothing, Schneiderman alleged.
"Barclays grew its dark pool by telling investors they were diving into safe waters," Schneiderman said. "Barclays' dark pool was full of predators - there at Barclays' invitation."
"We take these allegations very seriously," Barclays said in an emailed statement. It added that it was cooperating with the authorities, looking at the matter internally, and that the integrity of markets was a top priority for the bank.
Schneiderman is looking at dark pools, which are typically owned by brokers, including all of the big banks, and where participants are anonymous and trading information is hidden until after the trades are completed.
The U.S. Securities and Exchange Commission has also taken an increased interest in issues surrounding dark pools and high-frequency trading. SEC Chair Mary Jo White earlier this month said her agency was developing a series of rules that would seek to make markets more transparent and fair for all investors, and the agency has also stepped up enforcement actions against dark pool operators.
Banks have admitted to bad behavior in other markets, after probes showed collusion in currency trading and short-term interest rate products, among other areas.
NO AIRBAG, NO BRAKES
Jenkins took over as Barclays chief executive in August 2012, replacing Bob Diamond who was ousted after the bank was fined for the alleged manipulation of Libor benchmark interest rates.
Jenkins is trying to improve profitability by cutting costs, including the axing of around a quarter of investment bank jobs, while pushing for the change in culture.
But the bank continues to be dogged by issues around past conduct, however, and last month it was fined 26 million pounds ($43.8 million) for past failures in internal controls that allowed a trader to manipulate the setting of gold prices.
The New York Attorney General's complaint against Barclays, which is based on internal communications provided by former employees, says while the firm told its clients it would keep high-frequency traders that engage in "predatory" trading practices out of its dark pool it never actually prevented any trader from participating.
For example the complaint alleged that Barclays falsified marketing material it said showed the extent and type of high-frequency traders in its dark pool by not including high-frequency trading firm Tradebot Systems. Barclays had already identified Tradebot, which at the time was the largest participant in the dark pool, as having been engaged in aggressive trading behavior.
A spokeswoman for Tradebot, of Kansas City, Missouri, said the firm had no comment.
Barclays wooed high-frequency traders by disclosing detailed, sensitive information about other customers to the firms to help ensure their aggressive trading strategies were effective, and by charging them almost nothing, the complaint said. HFT accounts for around half of all U.S. trading volume.
The complaint did not specify the amount of damages being sought from Barclays.
Barclays also told its clients it does not favor its own dark pool when routing client orders to trading venues, when in reality it was doing just that, the complaint said. One former Barclays employee told the Attorney General's office that based on the high amount of client orders Barclays was sending to its own dark pool, better trading opportunities may have been missed elsewhere.
There was a lot going on in the dark pool that was not in the best interests of Barclays clients, one former director said, according to the complaint. "The practice of almost ensuring that every counterparty would be a high-frequency firm, it seems to me that that wouldn't be in the best interest of their clients ... It's almost like they are building a car and saying it has an airbag and there is no airbag or brakes."
The SEC is considering forcing dark pools and firms that match customers' orders internally to tell regulators and the public how they operate. In early June, the SEC filed a civil lawsuit against dark pool operator Liquidnet for allegedly improperly using its subscribers’ confidential trading information to market its services.
The SEC declined to comment on the lawsuit.
(Additional reporting by Herb Lash)
By Karen Freifeld and John McCrank