Pipeline Trading Systems, a US-based operator of block crossing systems, and two of its senior executives have been fined by the Securities and Exchange Commission (SEC) for failing to disclose that a high proportion of orders executed on behalf of buy-side customers in its US dark pool were filled by an affiliated trading firm.
Pipeline has been fined US$1 million, while CEO Fred Federspiel and chairman Alfred R. Berkeley III have been fined US$100,000. In settling the matter, Pipeline, Federspiel and Berkeley did not admit to or deny the SEC’s findings.
According to the SEC, Pipeline failed to disclose to customers that the “vast majority of customer orders” on its system were filled by Milstream Strategy Group, an entity trading entirely owned and funded by the dark pool operator and managed by Federspiel between 2004 and 2006.
The regulator added that claims by Pipeline that its alternative trading system (ATS) provided institutional clients with “natural” trading opportunities and prevented “pre-trade information leakage” were “false and misleading” given the presence of a trading affiliate on the other side of most trades. Pipeline insists that clients have not been disadvantaged by the use of Milstream and the firm now intends to offer clients the option of trading with the affiliate via an initiative called Pipeline Liquidity Pro.
The SEC said breaches of the US Securities Act and Regulation ATS took place between August 2004 and March 2010 relating to trades conducted on Pipeline’s Block Board, a desktop trading tool that notifies traders when there is trading interest in a particular stock. The SEC states that Milstream Strategy Group was created by Pipeline several months before its US launch in September 2004 (then known as Exchange Advantage) to help build liquidity on its platform.
Milstream traded in front of the orders placed by institutional investors in Pipeline by sourcing the required liquidity from other trading venues and then selling or buying the shares to the Pipeline member. Although the Block Board does not indicate the size, direction or price of an order, Milstream traders used market conditions, recent trading history, and test orders in Pipeline and other dark pools to determine the liquidity it needed to fill an order. This means Pipeline occasionally provided Milstream with information about client trades.
In the first four months after launch, the entity that later became Milstream was the counterparty to 97.5% of transactions executed on Pipeline, dropping to 87% in 2005. From launch to 31 December 2009, Milstream is understood to have participated in 80% of Pipeline’s trading volume.
The SEC said that use of Milstream was inconsistent with Pipeline’s claims to customers that its flow emanated from “natural” counterparties. Moreover, the regulator points out that in press releases and interviews, Pipeline executives regularly positioned the service as protecting institutional clients against proprietary trading flow that sought to exploit buy-side orders. Milstream traders were apparently paid using a formula that rewarded them in part for giving favourable prices to Pipeline’s customers.
Pipeline also failed to disclose to the SEC – as is required under Regulation ATS – that Milstream was involved in the operation of its dark pool, and sent out misleading marketing information. By giving Milstream access to the orders in its system, Pipeline was also charged with failing to safeguard customers’ confidential trading information, although the SEC order acknowledges that the firm was not seeking to take advantage of customers.
“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. Pipeline and its senior executives are being held to account because they misled their customers about how Pipeline’s dark pool really worked,” said Robert Khuzami, director of the SEC’s Enforcement Division.
In a prepared statement, Pipeline said it would provide greater clarity to customers in future. “We are pleased that the agreement we have entered into with the SEC resolves allegations that Pipeline made certain untrue or misleading statements regarding its block trading system and the role of its trading affiliate, and failed to properly disclose to clients or the SEC the role played by this affiliate in the operation of the Block Market. 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 statement read.
According to a monthly dark pool liquidity tracking service from US brokerage Rosenblatt Securities, Pipeline traded approximately 3.1 million shares – or 0.04% of total consolidated liquidity – in September 2011, 38% lower than August’s total of five million shares.
While Pipeline expects to continue to provide off-exchange crossing services to institutional investors, a number of observers have suggested that the damage to its reputation caused by the SEC ruling will be hard to overcome.
“It’s difficult to see how Pipeline can maintain its credibility with institutional investors after this. The firm held itself out as a guardian of buy-side orders against short-term gamers. But if the SEC allegations are true, Pipeline’s business model was highly dependent on information leakage,” said Justin Schack, managing director, market structure analysis at Rosenblatt.
In Europe, Pipeline Financial Group operates the multilateral trading MTF known as the Pipeline European Block Board.
In a statement, the company said the European operation does not and never has allowed any affiliate company to trade on its own account with, or provide liquidity to the European Block Board.
“Neither Pipeline nor any affiliate undertakes any form of proprietary trading, market making, capital commitment or establishment of directional positions on behalf of clients in relation to the European Block Board,” the company.
Pipeline operates the European Block Board on a common access policy and common rules whereby all users receive exactly the same level of system information in all respects according to the system rules when undertaking trades on the European Block Board.
The European Block Board was launched in May this year and in September saw record growth in terms of client order flow.