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December 1, 2011

Traders Wary After Pipeline Case

Traders Wary After Pipeline Case

By By James Armstrong

In the wake of Pipeline Trading Systems' settlement with the Securities and Exchange Commission, many people are wondering if dark pools will be able to retain the trust of traders given the misrepresentations made by such a well-known venue.

According to the SEC, Pipeline failed to disclose that the vast majority of orders in its dark pool were filled by an affiliate of the firm. Though Pipeline billed itself as providing natural liquidity, it has now admitted that, over the course of its history, its affiliate took the other side of the trade about 80 percent of the time.

Pipeline did disclose in most of its subscriber agreements that unspecified affiliates could be trading in the dark pool, but it did not disclose the vital role its affiliate played in providing liquidity, the SEC said.

The revelations could have repercussions beyond Pipeline, as market participants take a closer look at alternative trading systems in general. Some dark pools have their own prop desks, which they do disclose, and in the wake of the Pipeline scandal, those desks could draw greater scrutiny.

"It points up the general opaqueness of how ATSs disclose how they handle orders," said David Mechner, chief executive officer of Pragma. "The lack of transparency about details raises questions."

Mechner said he hopes the revelations about Pipeline don't translate into a general backlash against dark pools, but added the case should be a wake-up call to the industry that transparency and disclosure are important.

Joe Gawronski, president and chief operating officer of Rosenblatt Securities, noted that many customers of Pipeline used the company's dark pool because they thought it would help them avoid gaming by high-frequency traders. Yet the Pipeline affiliate allegedly employed many HFT strategies, such as placing a large number of orders and then canceling them immediately afterward.

Rosenblatt built a name for itself by being the first firm to track dark-pool volume, but Gawronski said he would happily cede that part of his firm's business if it meant dark pools started being more transparent without firms like his.

"The industry should demand transparency," Gawronski said. "We live in a much more complex world than before."

Dave Johnsen, head of U.S. liquidity strategy for Goldman Sachs Electronic Trading, said many customers have become paranoid in the wake of the Pipeline scandal, wondering if other dark pools might also be behaving in ways contrary to what they have disclosed.

Johnsen said that today's complex market structure will not go back to where it was decades ago, in spite of wishful thinking from some on the buyside. Instead, firms have to construct algorithmic trading strategies to protect themselves, even in dark pools, he said.

Among other things, dark pool participants need to be prepared to deal with HFT, said Dmitri Galinov, head of liquidity strategy for Credit Suisse Advanced Execution Services.

"You need to understand what kind of strategies they're using, and then you need to design algos to prevent information leakage," Galinov said.

Meanwhile, the trading industry is abuzz with chatter about Pipeline's long-term prospects. The settlement in October came as a shock, since few knew the affiliate even existed. Even sources sympathetic to Pipeline have called its past marketing deceptive and inappropriate.

The company's block trading activities in the U.S. only amount to about 30 percent of its total business, according to knowledgeable sources. Pipeline's analytic tool Alpha Pro actually accounts for a larger portion of its business, but with a shadow cast over the firm's dark pool, other units could lose customers as well.

Several sources in the industry expressed doubts that firms would be eager to work with Pipeline on any of its ventures, even those not touched by the dark pool scandal.