Dark-pool operator eBX LLC agreed to pay an $800,000 penalty to settle charges that it failed to protect customers’ confidential trading information, the Securities and Exchange Commission said.
The payment also settles allegations that eBX, which runs the Level ATS dark pool, failed to tell subscribers that it allowed a technology firm to use data about unexecuted orders, the SEC said today in a statement. The outside company was identified as Lava Trading, a unit of Citigroup Inc. (C) that built the dark pool, in a letter from Level ATS to clients that was obtained by Bloomberg News.
“Dark pools are dark for a reason: buyers and sellers expect confidentiality of their trading information,” Robert Khuzami, the SEC’s director of the division of enforcement, said in the statement. “Many eBX subscribers didn’t get the benefit of that bargain.”
The SEC has penalized exchanges and brokerages at least three times in the last month for rule violations. NYSE Euronext was ordered to pay $5 million to resolve claims that the New York Stock Exchange gave certain customers a head start on quotation and transaction market data, and the SEC charged a New York-based brokerage for allowing overseas clients to run a scheme aimed at distorting stock prices.
One of the key features of dark pools is that they don’t identify the brokers and institutions that buy and sell on their systems and give out no information about their orders. The platforms are designed to avoid the market impact of trading requests by keeping them out of public view until the moment a transaction is completed.
EBX allowed the technology company access to information about unexecuted orders for its own business purposes, according to the statement from the SEC. The outside firm was able to use the knowledge to make routing decisions for its own customer orders in a separate business, the SEC said. Lava’s so-called smart order router, which decides how and when to send trade requests to different venues, is known as ColorBook.
Level ATS, a dark pool or alternative trading system that doesn’t display price quotes to the public, began operating in October 2006. Boston-based eBX was formed by Citigroup, Credit Suisse Group AG, Fidelity Investments, Lehman Brothers Holdings Inc. and Merrill Lynch & Co.
Level accounted for 0.7 percent of U.S. equities volume, or a daily average of more than 37 million shares, in August, according to data compiled by Rosenblatt Securities Inc. Credit Suisse’s Crossfinder, the largest U.S. dark pool, traded more than 90 million shares a day, the Sept. 24 report said.
“At the end of the day, a lot of the securities business is based on trust,” Sang Lee, managing partner at Boston-based research firm Aite Group LLC, said in a telephone interview. “Nothing good will come out of the fact that they wound up sharing information with a technology vendor. It gives an advantage to one client over others.”
The SEC said the outside firm’s order-routing business “received an information advantage over other Level subscribers because it was able to use its knowledge of their orders to make routing decisions for its own customers’ orders and increase its execution rate.” Armed with pricing information about orders at Level, the firm could send trade requests to Level or elsewhere based on where it could get a better price, the SEC said.
Lava Trading, which built and operates Level, has provided technology to the venue since it began trading in 2006, Whit Conary, chief executive officer of Level ATS, said in the letter to clients today. The firm was required to keep Level’s order information private. In 2008, Lava asked Level if it could use data about the dark pool’s orders to improve its own decisions about where to send buy and sell requests from its customers and received permission, Conary said in the letter.
The SEC’s administrative order against Level did not mention Lava by name and didn’t say the technology company did anything wrong. Scott Helfman, a spokesman for Citigroup, declined to comment.
The regulatory sanction follows the disclosure by Liquidnet Holdings Inc. in June that the SEC was investigating the dark- pool operator for shortcomings in how it guarded private information about firms using its platform. Pipeline Trading Systems LLC settled government allegations in 2011 that it failed to provide the liquidity and confidentiality it advertised to customers of its dark pool.
Level, which had declined requests by other dark pools and exchanges for information about orders at the venue, decided that Lava’s plan wouldn’t give the firm data it didn’t already possess as a technology provider and that the data wouldn’t be disclosed to ColorBook users or other parties, Conary wrote. Lava stopped using the feature in April 2011, the letter said.
Level violated Regulation ATS, a set of rules for alternative trading venues, from at least 2008 until early 2011, according to the SEC. The regulator said it found no evidence that information about Level’s unexecuted orders were shown or sent to clients of the technology firm’s order-routing business or other parties. It also said the firm didn’t get better prices at Level than it would have received without employing the “memory feature” that gave it information about orders at Level.
The dark pool operator didn’t admit or deny wrongdoing in settling with the SEC.
“Lava has always been obligated to maintain the confidentiality of customer information,” Conary said in an e- mail. “As the SEC itself stated in the order, at no time was customer information displayed to any customer placing orders or making trading decisions. Lava’s smart router was permitted to use the customer information resident within our trading system solely to make routing decisions.”
The technology company’s order-routing business benefited by being able to send buy requests to Level when it knew a sell order was waiting or vice versa, the SEC said. It filled between 30 percent and 70 percent of orders that had to be completed immediately or canceled that were sent to Level from about May 2008 through June 2009, compared with 1 percent to 2 percent for other subscribers, the commission said.
The company accounted for between 4 percent and 11 percent of shares traded in Level during that period, the SEC said.
The broker affiliated with Level’s technology provider also enabled a stock market it ran to make routing decisions based on order information from the dark pool, the SEC said. Citigroup operates LavaFlow ECN, an electronic communications network.
“The fact that Level has apparently violated these rules and the promised conduct by which they operate is a grave misstep,” Matt Samelson, principal at Woodbine Associates Inc., a research firm based in Stamford, Connecticut, said in an email. “Customers have to trust their brokers and ATS operators. This means outlining the rules of engagement and following them.”
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