Quick Note – Barclays: Dark Pool Allegations Shocking, but Stock Trades with Substantial Margin of Safety

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The NY AG’s complaint against Barclays around alleged fraud and deceit in the operation and marketing of its dark pool is shocking, and the 5% decline in the stock price since the filing shaves GBP2bn of market cap.

The central issue is Barclay’s representations to buy-side investors that it monitored the pool for predatory behavior by high-frequency trading (“HFT”) firms and, in particular, its use of a “liquidity profile” chart showing activity by type of trader.  The complaint alleges that Barclays wilfully falsified data, including the exclusion of one of the largest participants in the pool, to downplay predatory activity by HFTs on the rationalization, seemingly endorsed by the Head of Equities, that “the point of the chart is not to show what’s in the pool; the point is to market our capability to … monitor individual participants in the pool”. There are also allegations that, contrary to marketing claims, Barclays routed transactions to favor its own interests over clients’.

While it is possible other dark pools are engaging in similar behavior, Barclays will likely lose credibility with, and business from, the buy-side across its equities franchise if not also its FICC franchise. This is unfortunate because an important element of our thesis is that Barclays has scale and technology advantages in electronic execution, and it now looks as if some of the share gains we noted (as Barclay’s dark pool moved from a top-10 position in 2009 to a top-2 position in 2013 – see Exhibit 1) may have been the result of fraudulent sales practices.

A key issue now is the extent of the customer backlash given the equities business contributed GBP2.3bn to 2013 revenue of GBP8.7bn for the “core” investment bank which, in turn, represents 40% of the equity of the core bank (see Exhibit 2) as opposed to the “non-core” bank (announced on May 15th) which will be liquidated over time. The NY AG claims Barclays put the revenue growth opportunity in the dark pool at $37-50mm per year but the reputational impact may be larger given management cites the dark pool as “an integral part of our electronic trading offering”. We will get more information on July 30th when Barclays reports 2014H1 results; meantime, Barclays has yet to answer the allegations, and there is some comfort that “the matter appears to be US specific” according to the FT.

All that said, Barclays shares now offer a substantial margin-of-safety. The core bank will have end-2014 equity of GBP38bn (assuming a 12% ROE, as in 2013, on a GBP36bn base and a 50% payout – see Exhibit 2); we value this at GBP50bn or 1.3x equity. Adding in GBP8bn as an estimate for realizable non-core tangible equity (vs. total non-core equity of GBP16bn) generates a total value of GBP58bn or  GBP3.50/share; this is equivalent to 10-11x 2016 EPS of GBX33/share, and compares with the current share price of just over GBP2.15 and current tangible book value/share of GBP2.84.

Exhibit 1 – Selected US Dark Pool Competitors with Average Daily Trading Volume (in millions of shares) for January 2014

UntitledSource: NY AG Complaint against Barclays of 6/25. Excludes BAC and Credit Suisse

Exhibit 2: The Core and Non-Core Bank at Barclays

UntitledSource: Corporate Reports. Numbers may not add due to rounding particularly equity allocations within the core bank

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