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Liquidnet Says SEC Investigating Dark-Pool Disclosures

Seth Merrin, chief executive officer of Liquidnet. Photographer: Patrick Fallon/Bloomberg
Seth Merrin, chief executive officer of Liquidnet. Photographer: Patrick Fallon/Bloomberg

June 22 (Bloomberg) -- The U.S. Securities and Exchange Commission is investigating Liquidnet Holdings Inc. for shortcomings in how the dark-pool owner guarded private information about firms using its platform.

SEC staff requested information about Liquidnet’s equity capital markets business, the operator of two stock venues said yesterday in an e-mail to clients obtained by Bloomberg News. Liquidnet said it corrected the issues identified by the SEC and no longer provides “descriptive characteristics” about member firms to corporations using its services.

Federal regulators have stepped up scrutiny of stock trading practices that gained dominance in the past decade amid a shift to automation, Daniel Hawke, head of the market-abuse unit in the agency’s enforcement division, said in February. Dark pools, broker-operated private venues that don’t display quotes publicly, rose to prominence as a way for institutions to buy and sell without moving share prices. More than 40 such pools now exist to trade U.S. equities.

“If we screw up, we have to tell people we screwed up,” Liquidnet Chief Executive Officer Seth Merrin said in a phone interview today. “It’s very important for us to maintain credibility. These were oversights. They were errors of omission, not commission. Still, they’re issues we had to correct and we corrected them.”

Trader Information

One of the key features of dark pools is that they don’t identify the firms that buy and sell on their systems and give out no information about their block orders. The platforms are designed to eliminate the market impact of trading requests by keeping them out of public view until the moment a transaction is completed.

In Liquidnet’s case, the SEC found the company may not have gone far enough in safeguarding private information about the orders on its platform. While Liquidnet isn’t accused of revealing the identities of institutions buying and selling, according to Merrin’s letter, it may not have lived up to its responsibilities to its users by providing potential customers with “descriptive characteristics” of the institutions’ orders.

Any information about supply and demand or the types of firms operating in a marketplace could be valuable to company that is considering buying or selling shares. For example, if a seller knows a large mutual fund is purchasing stock, he might be more confident that his own actions wouldn’t drive the price down.

‘Bad Process’

“It doesn’t sound like a systematic abuse of trust,” Sang Lee, managing partner at research firm Aite Group LLC in Boston, said in a phone interview yesterday. “It sounds like internally they had a bad process in place. But it’s not clear if it was intentional or accidental and my guess is Seth is going to have to spend a lot of time talking to their membership, especially in light of what happened to Pipeline.”

Pipeline Financial Group Inc. settled government allegations in October that it failed to provide the liquidity and confidentiality it advertised to customers of its dark pool. The New York-based company agreed to pay $1 million to resolve U.S. claims it misled clients by deploying a trading entity, Milstream Strategy Group LLC, to buy and sell shares on its venue while telling customers their orders were being matched with other clients. The firm’s founder and CEO resigned and its chairman retired the next month.

Liquidnet’s law firm is conducting a review of the equity capital markets unit, which seeks business from corporate issuers, Merrin said.

SEC Inspection

While the SEC’s inspection “revealed some shortcomings with this business, we do not believe that any member was ever disadvantaged in any trade,” Merrin wrote in the e-mail to asset managers yesterday. “Nevertheless, we take these issues very seriously and have taken steps to address them.”

Melissa Kanter, a Liquidnet spokeswoman, confirmed that Merrin sent the message to clients yesterday. The SEC also received a copy of the letter, she said. Liquidnet, which began trading U.S. stocks in 2001 and now operates in 39 countries, has about 700 asset-management clients, including hedge funds and pensions, according to Kanter. About 400 are in the U.S.

Liquidnet discovered the problems involving the use of customer information during an SEC audit and is cooperating with the investigation, Merrin said in the interview. He started speaking to some of Liquidnet’s member firms about the disclosure of information last week and will continue talking to them to explain what the company did and what remedies have been put in place.

‘Very Supportive’

“This is the first type of this call I’ve had to make in 12 years,” Merrin said. “Most of the calls were very supportive and very positive. There were some obviously who were disappointed.”

Liquidnet traded 23 million U.S. shares a day on average through its two dark pools in April, according to data compiled by Rosenblatt Securities Inc. The data count completed transactions the way exchanges tally their volume, instead of recording buy and sell sides separately, which is how dark pools calculate their figures.

The company’s main venue had an average trade size of more than 43,000 shares, Rosenblatt’s data show. Investment Technology Group Inc.’s Posit Alert system, which lets asset managers trade with similar firms, had an average size of 33,000 shares in the first quarter, according to the data. Unlike block venues, dark pools run by most large brokers including Credit Suisse Group AG and Goldman Sachs Group Inc. trade less than 300 shares on average, comparable to what occurs on exchanges, the Rosenblatt data show.

Market Secrecy

At Liquidnet, the SEC is focused on a unit started three years ago in which the company allows mutual funds and other money managers to trade blocks directly with companies that are buying back or issuing their own shares. As part of the business, Liquidnet provides data on aggregated institutional buying and selling demand for shares within the dark pool to executives such as chief financial officers and treasurers.

One of the issues identified by the SEC involves a feature that lets buyers and sellers have their data excluded from the service, known as InfraRed. Nineteen firms asked Liquidnet not to include their information in the offering to issuers. At four of those firms, requests from subsidiaries weren’t heeded. Liquidnet said only one firm had “significant” U.S. volume.

Opting Out

“We have since opted out these affiliates and have added steps to our opt-out process to ensure that firm’s affiliates are opted out at the same time as the firm,” Liquidnet said in the e-mail. Asset managers must allow their information to be included in the InfraRed product to trade with issuers using Liquidnet to buy or sell shares, Merrin said today.

The other focus of the SEC inspection was a tool created by Liquidnet in February 2011 for its staff to use when communicating with companies issuing or buying their own stock. The tool displayed “aggregate and member-level liquidity and execution information,” according to Merrin’s e-mail.

“The ECM team used this tool to present issuers with opportunities to interact with member liquidity,” including providing data on the depth of the market and guidance on when to submit orders, Liquidnet said. “In some instances, the ECM team provided descriptive characteristics to members involved in that issuer’s stock,” it said.

Member Characteristics

Merrin told asset managers in his letter that Liquidnet has ceased giving “any type of member characteristics to issuers.” This was done in late 2011, he said in the interview. The company also altered the internal tool so employees can no longer see that data. The system now shows them only the ratio of buy and sell demand available on InfraRed, Merrin said in the e-mail. That change was made a few weeks ago, he said today.

Liquidnet filed to go public in 2008. It shelved the plan during the financial crisis following the collapse of Bear Stearns Cos. and Lehman Brothers Holdings Inc.

“Liquidnet has to make sure their member firms are comfortable staying in the network,” Lee said. “It’s not a positive thing for Liquidnet or dark pools. There’s already a lot of public scrutiny over what’s going on in those markets.”

News of the SEC’s investigation came a day after the U.S. House Committee on Financial Services heard testimony from executives at exchanges and brokers about market structure changes over the past decade and a half. NYSE Euronext CEO Duncan Niederauer urged legislators to change rules to help it compete more with dark pools and other venues that execute trades away from stock exchanges without offering benefits such as larger transaction sizes.

Trading Speed

The SEC and Commodity Futures Trading Commission have examined the practices and advantages of high-frequency trading firms as the speed of trading has increased in recent years. These firms have recently drawn scrutiny from U.S. regulators seeking evidence that they may be distorting market prices by conducting transactions with themselves, said two people with knowledge of the matter.

So-called wash trades, in which a party buys a contract from itself, could be executed inadvertently by firms with multiple algorithms, or trading strategies, that are active in the same stock or derivative, said the people, who requested anonymity because the review isn’t public. Such trades, which can alter the price of shares if they are executed above or below market rates, would be illegal if deemed intentional efforts to manipulate stocks.

Merrin said he’d be surprised if Liquidnet is the only firm with problems uncovered during an SEC audit of its trading business. To maintain trust and credibility among clients using the block trading platform, Liquidnet wanted to tell them about the issues turned up in the SEC review itself, instead of waiting for the investigation to be completed, Merrin said.

“What Wall Street needs to do to establish some trust is to be upfront, be transparent, be honest about what people are doing,” Merrin said in the interview. “I hope we’d set an example for other firms to do the same thing.”

To contact the reporter on this story: Nina Mehta in New York at

To contact the editor responsible for this story: Nick Baker at

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