Besieged US dark pool speaks out

The latest dark pool operator to fall foul of American regulators has said its failure to protect confidential trading information stemmed from a smart order router used by its technology affiliate.

The latest dark pool operator to fall foul of American regulators has said its failure to protect confidential trading information stemmed from a smart order router used by its technology affiliate.

Boston-based firm eBX has been fined US$800,000 by the Securities and Exchange Commission (SEC) to settle the charges which bear some similarities to allegations of lack of disclosure levelled at block trading platform provider Pipeline Trading Systems a year ago this month.

The charge concerns eBX’s alternative trading system LeveL ATS, marketed as a low cost US equity dark book trading platform. The agency maintains eBX failed to properly inform participants that their flow of orders – which was assured to be kept confidential and not shared with third parties – was being sent to an outside technology firm which used information about LeveL participants' unexecuted orders in its own order routing business.

The SEC said this gave the third-party routing business, the Lava Trading unit of Citigroup, an information advantage over other LeveL participants because it could use the knowledge to make routing decisions for its own customers’ orders and increase its execution rate.

On a conference call today, LeveL ATS CEO Whit Conary explained that Lava Trading uses a retained memory function which is a "commonplace" feature of smart order routers to help them determine where to best send orders, and that LeveL found no evidence information on orders was ever displayed or communicated.

During the call, when questioned on the firm's subsequent decision to turn off the memory function in April 2011, Conary said it was because of an "over-abundance of caution".

"We probably could have done a better job at disclosing how the functionality worked with clients," said Conary. "But at no time did we at that point, or do we now believe, that the functionality ever put the integrity of any customer confidential information at any risk."

The news has been met with a mixed response by the industry.

"This was a very different situation from Pipeline a year ago," said Joe Saluzzi, co-head at agency broker Themis Trading, who has been following the developments. "Rather than being a proprietary trading issue, this appears to be a disclosure issue."

Matt Samelson, WoodbineYet Matt Samelson, principal at consulting firm Woodbine Associates, believed the fact LeveL had apparently violated the SEC's rules and the promised conduct by which it operated, was a "grave misstep".

"Customers have to trust their brokers and ATS operators. Operators need to establish and maintain trust. This means outlining the rules of engagement and following them,” he said. “I think we have well passed the time where full disclosure and third-party validation is a necessity – which would help instil confidence in the client and help operators from any inadvertent conduct that ends up violating SEC rules.”

The agency said eBX originally hired the third-party tech company to run LeveL and signed a subscription agreement with it in February 2008. But subsequently the tech firm’s separate order routing business started using LeveL participants' confidential trading data. By November 2008, eBX signed a new agreement letting the third-party keep and use all LeveL subscriber unexecuted order information. This let the outside firm’s order routing business fill far more orders than other LeveL users and gave it an understanding of how other LeveL participant orders were priced.

“Dark pools are dark for a reason: buyers and sellers expect confidentiality of their trading information,” said Robert Khuzami, director of the SEC’s division of enforcement. “Many eBX subscribers didn’t get the benefit of that bargain – they were unaware that another order routing system was given exclusive access to trading information that it used for its own benefit.”

As well as the US$800,000 penalty, the SEC has censured eBX and ordered it to cease and desist from committing or causing further violations.

“Like last year’s Pipeline scandal, this highlights issues of trust regardless of the magnitude of economic impropriety. It appears this discretion may have actually helped LeveL customers. However, it’s simply a matter of delivering what’s advertised,” said Samelson, whose firm has recently released a report on US dark pools. “Investors need to have confidence that their brokers and trading venues are playing by the rules and doing business as it is presented.”

Pipeline was fined US$1 million last year, after the SEC found the firm failed to tell clients the vast majority of orders executed in its dark pool were filled by Milstream Strategy Group, an entity trading entirely owned and funded by Pipeline and managed by former Pipeline CEO Fred Federspiel between 2004 and 2006.