Pipeline's Bombshell Hurts All Dark Pools

Trust in dark pools takes a hit as the SEC charges Pipeline with filling customer orders via an affiliated trading entity rather than by matching them against other customer orders, as advertised.

Related article: Pipeline Shakes Up Management Following Scandal

Buy- and sell-side firms are wrestling with the revelations that dark pool operator Pipeline Trading Systems filled the vast majority of customer orders through an affiliated trading entity that it owned -- and not by matching against other customer orders, as advertised. The controversy not only raises questions about Pipeline's operating model, but also about the routing and business practices of dark pools in general, which match buy and sell orders away from the public markets.

"What's affected here is trust in dark pools," says Garrett Nenner, managing director of global markets at Momentum Trading Partners, an independent agency broker-dealer that provides high-touch executions to institutions. "Unfortunately, there was a chink in the armor. Regulators at the SEC found it. It's unfortunate that it existed."

Indeed, on Oct. 24, the SEC announced that Pipeline Trading Systems would pay a $1 million penalty to settle charges that the broker and two of its top executives failed to disclose to customers that the majority of orders (about 80 percent) sent to the firm's dark pool were filled by a wholly owned trading affiliate, most recently known as Milstream Strategy Group. Yet Pipeline had aggressively marketed its alternative trading system (ATS) as a way to avoid information leakage and to protect institutions against interaction with predators, such as high-frequency trading firms.

"The whole issue is disclosure that the dark pool did not conform to what they had put in the Regulation ATS form," according to Larry Tabb, CEO of Tabb Group. "The other issue is that Pipeline marketed it as natural flow against natural flow -- they did not purport to have crossing with internal flow."

Pipeline In the Beginning

Founded by Fred Federspiel, a neurophysicist who previously worked at the Los Alamos National Lab in New Mexico, and Alfred Berkeley, a former president and vice chairman of The Nasdaq Stock Market, Pipeline sought to differentiate itself from other block trading venues by setting minimum order size limits of 10,000, 25,000 and 100,000 shares, depending on the stock, to prevent predators from risking a small amount of capital on small orders to sniff out large institutional orders. And to reduce the chances of information leakage, Pipeline leveraged automatic executions. To further protect buy-side customer orders against information leakage, Pipeline created a proprietary graphical interface, known as Pipeline Block Board, that displayed the stock symbol in a small orange box on clients' computers; when a customer placed a buy or sell order for that security, the orange light turned on, but it did not indicate the order's side, price or size.

But Pipeline didn't disclose to its customers that a few months after launching the ATS on Sept. 9, 2004, it also created an affiliate to provide some of the liquidity against which orders would be matched. That affiliate participated in approximately 80 percent of the trading volume on the Pipeline platform, from the ATS's launch in late 2004 until Dec. 31, 2009, the SEC has charged. According to the SEC, the affiliate's traders sought to trade ahead of customers' orders; they would predict on which side of the trade the customer orders resided and would then trade on the same side as those orders in other trading venues before filling them on the Pipeline ATS.

Pipeline agreed to pay the $1 million fine to settle the matter without admitting or denying the SEC's findings, including that Pipeline failed to adequately protect customers' confidential trading information. In addition, Federspiel and Berkeley each paid $100,000, the SEC reported. But the controversy has left institutions with a sour view of Pipeline, and there is speculation over whether the company can recover from the fallout.

"They've completely blown the business with us," exclaims one head equity trader at a traditional asset management firm on the East Coast who spoke with Advanced Trading only on the condition of anonymity. "After that, who would do business with them?" After learning the news, the head trader adds, his asset management firm wasted no time severing ties with Pipeline. "We disconnected everything."

A Dim View of Dark Pools: Guilt by Association?

In addition to questioning their relationships with Pipeline, immediately following the disclosures of the SEC charges against the company, buy-side firms began to investigate the practices of other dark pools -- or at least to seek assurances that they were not shipping trades off to an automated prop trading desk. The East Coast asset manager's head equity trader says he called other dark pool operators -- including Liquidnet, Pulse Trading and Bids Trading -- to clarify their operating practices.

On Oct. 25, the day after the SEC announced the settlement with Pipeline, Investment Technology Group informed its customers that in the previous 24 hours it had received client inquiries about its standards and practices, according to a letter obtained by Advanced Trading. In the letter, ITG assured clients that it does not engage in proprietary trading, market making, capital commitment or establishing directional positions. "We strictly enforce the order handling and execution rules of Posit, which are clearly set forth in Form ATS on file with the Securities and Exchange Commission," wrote Bob Gasser, ITG's CEO and president. Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio