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December 1, 2011

Pipeline Fine Shocks Trading World

Top 10 Stories in 2011

By James Armstrong

Traders were shocked this year when Pipeline Trading Systems agreed to pay $1 million to settle charges brought by the Securities and Exchange Commission. Regulators alleged the company failed to disclose that, at times, more than 97 percent of the orders in its dark pool were filled by a trading operation affiliated with the firm.

The SEC also reached settlements with Pipeline founder Fred Federspiel and company chairman Alfred Berkeley, who each agreed to pay a $100,000 fine for their involvement. Berkeley is also a former president of Nasdaq. Under the agreement, neither man admitted nor denied wrongdoing.

Pipeline launched its alternative trading system in 2004, billing itself as a crossing network that matched orders to provide natural liquidity. But the SEC claimed Pipeline's liquidity was anything but natural.

The company owned a trading entity that has gone by multiple names, most recently Milstream Strategy Group. Milstream sought to predict the trading intentions of the dark pool's customers, the SEC said. Milstream allegedly would then trade elsewhere in the same direction as those customers before filing their orders on Pipeline.

In the first four months after Pipeline launched, the affiliate, initially known as Exchange Advantage, was a party to 97.5 percent of all transactions in the dark pool, the SEC said. From the launch until the end of 2009, the affiliate allegedly participated in a total of about 80 percent of all trades.

Pipeline told users that they were being treated the same, but in reality provided its affiliate with advantages over other users, according to the SEC. Those advantages allegedly included special access to certain information and data connections that made it easier for the affiliate to track activity in the dark pool.

The company responded to the charges by reaching out to its customers, attempting to retain their business in spite of the revelations. Pipeline scheduled in-person meetings with customers to explain how the affiliate provides liquidity and to emphasize the execution quality its dark pool provides.

"We recognize that we should have been more forthcoming about the critical role of our affiliate and sincerely regret that we were not," Pipeline said in a statement to customers. "We believe-and can show you in detail-that you have benefited in the past from our affiliate's ability to provide liquidity in the Block Market, and you can benefit in the future."

In its defense, Pipeline has claimed it has a patented mechanism to align the interests of Milstream's traders with those of customers. Under the system, traders are supposed to be penalized if they make trading profits at a customer's expense.

In fact, Milstream has shown a cumulative net operating loss since it was launched along with Pipeline's dark pool in 2004. Though in recent years Milstream has made trading profits, including $18.4 million in 2008, it was operating this year at close to breaking even.

Pipeline maintains the purpose of the affiliate was to provide liquidity, not to make a profit. Still, for many in the industry, the issue comes down to a question of trust.

"People were using that pool with an expectation that it was natural liquidity," said one veteran broker. "Maybe Pipeline thought what they were doing was fair, but it's disappointing."

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