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'Dark Pool' Settlement Shines Light on Potential Abuses

Tuesday, October 25, 2011



Regulators dragged a "dark pool" trading platform into the light, settling charges that the firm was running a secret affiliate that sought to trade ahead of customers' orders before filling "a vast majority" of them on the private market.

Pipeline Trading Systems LLC and two executives agreed to pay $1.2 million in fines to settle charges that the firm withheld the fact that nearly all of its clients' trades on the company's private electronic markets were facilitated by a Pipeline-owned entity, according to Securities and Exchange Commission officials. In a statement, a Pipeline spokesman said the firm was "pleased" to resolve the matter, in which it didn't admit or deny wrongdoing.

The case is the SEC's first enforcement action involving dark pools—private markets for institutional traders where large blocks of stock are bought and sold anonymously—and stems from a deeper SEC probe into potential abuses in private share dealing, according to regulators.

Regulators continue to consider stricter rules for off-exchange trading in shares, which could require dark pools and other alternative trading platforms to provide better prices to customers, among other ideas under discussion.

"Judging from what's in the SEC allegations, this was a grave violation of customer confidence and trust," said Justin Schack, managing director of market structure analysis for Rosenblatt Securities Inc., which researches dark-pool trading.

According to the SEC, New York-based Pipeline enlisted traders of its own to make its platform look more attractive to institutional clientele—but kept the arrangement hidden from customers, who believed they were doing business with other institutions.

The complaint from the SEC on Monday said that clients of Pipeline's private market nearly all the time wound up trading with an entity called Milstream Strategy Group LLC, an affiliate of Pipeline.

Milstream, according to regulators, tried to predict what shares Pipeline's customers might buy or sell, and made similar trades on other markets before filling customer orders on the Pipeline platform.

The firm also traded with an edge over other participants on the market, the SEC charged, getting access to system operations and data connections that helped the entity track activity. The Milstream relationship also left confidential customer information unprotected, according to the SEC.

The set-up created a conflict of interest, according to the SEC, although traders working for Milstream were paid using a formula that rewarded them for offering favorable prices to Pipeline's customers.

Pipeline agreed to pay a $1 million fine to settle the matter without admitting or denying the findings. Pipeline Chief Executive Fred Federspiel and Chairman Alfred Berkeley, a past president of the Nasdaq Stock Market, each agreed to pay fines of $100,000, also without admitting or denying the findings.

"The agreement will enable us to continue to provide our customers with the excellent trade execution quality and access to sources of liquidity which they have come to trust over the years," the Pipeline spokesman said.

The Pipeline case is the first major action taken by the SEC against a dark-pool platform and emerged from broader efforts by regulators to scrutinize off-exchange share dealing, which accounted for 28.6% of all trading through the first half of October, according to data from Raymond James Financial.

Dark pools are electronic markets set up for institutions like mutual funds and pension plans to avoid alerting the broader market to a big stock trade. If faster-moving traders discover that a major purchase is in the works, they can move the market against the institution and raise the price, making the trade more expensive.

"As dark pools have become the medium for execution of a steadily increasing volume of security trades, we have sought to step up our scrutiny of the market and its participants through both examination and enforcement probes," said George Canellos, director of the SEC's New York regional office.

Pipeline is a relatively small player among the private markets that compete with U.S. exchanges for stock trade. Rosenblatt Securities estimated that in September an average 3.1 million shares traded per day on Pipeline's systems, down 59% from September 2010.

Credit Suisse runs the busiest such venue, where 158 million shares traded per day last month, according to Rosenblatt figures.

The episode may raise questions among institutions over how their business is handled by alternative trading systems but is unlikely to deal lasting damage to the business, according to Jamie Selway, head of liquidity management for Investment Technology Group.

"This type of thing speaks to the actions of particular individuals and firms rather than the industry more broadly," said Mr. Selway, whose firm runs one of the oldest dark-pool platforms. "Block-crossing is an area that has conducted itself pretty well because it's client-focused by design."


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