Pipeline Settles With U.S. SEC Over Dark Pool Claims

Pipeline Trading Systems LLC, the seven-year-old dark pool operator specializing in block trades, will pay $1 million to resolve U.S. claims it failed to provide the confidentiality and liquidity it advertised to customers.

Fred Federspiel, the nuclear physicist who founded Pipeline in 2004, and Alfred Berkeley III, a former Nasdaq Stock Market Inc. president who is Pipeline’s chairman, both agreed to pay $100,000 to settle the claims, the Securities and Exchange Commission said today in an administrative order.

The trading platform advertised by New York-based Pipeline was billed as a “crossing network” that matched customer orders with those from other clients, providing what’s called “natural liquidity,” the SEC said. Those claims were misleading, because Pipeline’s parent company owned a trading entity that filled the vast majority of customer orders, according to the order.

“It’s really shocking,” Larry Tabb, founder of research firm Tabb Group LLC in New York, said in a phone interview. “Here’s a firm that’s built a brand around executing large blocks and doing it in an unconflicted manner and here they are, taking the other side of many of these trades and not being forthcoming,” he said. Pipeline’s executives “are going to need to talk with their clients to reinstill confidence in the platform,” he said.

80% of Trading

The affiliate, Milstream Strategy Group LLC, sought to predict the trading intentions of Pipeline’s customers and trade elsewhere ahead of those orders before filling Pipeline clients’ requests, the SEC said. From the launch of the Pipeline dark pool in 2004 through the end of 2009, Milstream participated in about 80 percent of the volume on the platform, the SEC said.

The settlement “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,” Pipeline said in a statement e-mailed by managing director Tom Corddry.

Pipeline was started in 2004 as an SEC-registered dark pool, or privately operated platform to trade securities away from exchanges. Dark pools, which display little or no information about customer orders, are used by asset managers and brokers to hide their trading intentions and avoid moving the market with large orders.

‘Accurate Information’

“However orders are placed and executed, be it on an exchange floor or in an automated venue, whether dark or displayed, one principle remains fundamental -- investors are entitled to accurate information as to how their trades are executed,” SEC Enforcement Director Robert Khuzami said in the statement. “Pipeline and its senior executives are being held to account because they misled their customers about how Pipeline’s dark pool really worked.”

Pipeline traded about 3.1 million shares a day in September, down from about 7.5 million a year earlier, according to estimates in a Rosenblatt report on Oct. 19. The dark pools Rosenblatt tracks handled almost 11 percent of total U.S. trading that month.

According to the SEC order, Milstream had some advantages over other users, including special access to information about the dark pool’s operations and to data connections that made it easier to track activity on the platform. Pipeline also failed to protect customers’ confidentiality by allowing the research director at Pipeline’s parent company to access certain trading information, the SEC said.

Los Alamos

Pipeline, Federspiel and Berkeley settled the claims without admitting or denying wrongdoing, the SEC said. Before getting into finance, Federspiel, who holds a doctorate in nuclear physics, worked at Los Alamos National Laboratory in New Mexico. Berkekey was Nasdaq’s president until 2000.

“I’m amazed and shocked,” Justin Schack, managing director for market structure analysis at Rosenblatt Securities Inc. in New York, said in a phone interview. “Judging from what the complaint said, it’s a pretty serious violation of customer trust. Customers were trading with an automated proprietary shop that Pipeline owns.”

The problem Pipeline faced, the difficulty in matching blocks when investors want to trade, is one many operators of dark pools deal with as they build their venues and seek more orders. Brokers running dark pools often address this by enabling a stream of orders from their own firm’s market-making units or by allowing outside automated traders or high-frequency firms to fill that role within their system, Tabb said.

Trading Algorithms

The bulk of these orders supplied on most broker-operated dark pools are for several hundred shares at a time. They often trade against orders from institutions that are funneled through algorithms, or computerized strategies that break bigger buy and sell requests into smaller pieces.

“The issue isn’t that they had proprietary capital in their liquidity pool,” Tabb said of Pipeline. “It’s more that they didn’t disclose who was behind the proprietary capital.”

Pipeline misled investors by marketing itself as a venue free of high-frequency traders and incorrectly said that users on its system could find “natural liquidity in mega-block size for stocks that otherwise trade in bits and pieces,” the SEC said. The agency also said the pool’s rising volume at times resulted from the affiliate’s activity and not more trading by the venue’s institutional investors. The affiliate was formed to provide liquidity on Pipeline’s platform, the SEC said.

Losing Money

The affiliate didn’t make money for Pipeline, the SEC order said. From 2004 through 2006, it lost about $19.7 million on its trading. While it made $32.2 million in trading profit from 2008 to 2010, expenses including compensation exceeded the gains, the SEC said.

Pipeline created an incentive system for traders at the affiliate to address conflicts of interest. A bonus system was instituted to encourage traders to buy and sell profitably “while at the same time reducing their incentive to trade to the detriment of Pipeline’s customers,” the SEC said.

Bloomberg News parent Bloomberg LP also owns Bloomberg Tradebook, which runs a trading platform that offers the ability to route orders to dark pools.

Garrett Nenner, managing director for global markets at Momentum Trading Partners LLC in New York, which handles large equity orders for clients through human traders, said Pipeline breached the trust of its users.

“What’s extremely worrisome is that when you put your orders into a dark pool, you expect them to be dark -- private orders matching against other private orders,” he said in a phone interview. “The whole point of a dark pool is to maintain secrecy. There’s a trust here that’s been impacted.”

(Corrects description of Bloomberg Tradebook in third-to-last paragraph.)
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