TOP STORIES 2012: Policing of Dark Pools Escalates

When the year rolled in, one dark pool went down the tubes for failing to disclose that it fed customers’ orders to an affiliate to fill-and profit from. And it ended with another fighting to escape the same fate, after being charged with failing to properly protect information about its customers, all of whom want to trade anonymously.

Welcome to the fine line between bad and good behavior in these trading venues, which try to protect their institutional clients from being identified by sophisticated, algorithmically driven trading firms when moving large blocks of shares.

LeveL ATS is rebounding as 2012 comes to a close. It says clients are returning since its parent firm, eBX LLC, paid an $800,000 fine and settled charges that LeveL failed to properly safeguard information on customers’ unexecuted orders, which were stored and allegedly reused in a smart order router.

Whit Conary, chief executive at LeveL, told Traders Magazine that 75 percent of the alternative trading system’s customers were sending order flow as of the end of October. The firm is working to get back 100 percent of the clients it had prior to the settlement’s announcement, he said.

LeveL’s difficulties followed the more eye-catching case involving Pipeline Trading, which stopped taking orders after it was revealed that the firm was sending order flow to an affiliate without disclosing that fact. Clients never came back to the firm’s dark pool, though its algorithmic switching engine and AlphaPro trading system have managed to retain users.

The two cases differ decidedly, according to industry pros. In the Pipeline case, the settlement was based on fraud and resulted in direct charges against individuals. Pipeline failed to disclose that more than 97 percent of orders in its dark pool at times were filled by a trading operation affiliated with the firm.

The company agreed to pay a $1 million penalty. Two top Pipeline executives, founder Fred Federspiel and chairman Alfred Berkeley, each agreed to pay a $100,000 fine for their involvement as well.

LeveL’s case, on the other hand, “is about information sharing, and to the best of my knowledge no one gained a price advantage on any trade,” said the head of one brokerage desk. In the LeveL case, the Securities and Exchange Commission said in its complaint that the smart order router of LeveL’s technology provider, the Lava Trading unit of Citigroup, kept in its memory information about LeveL subscribers’ unexecuted orders. The router then used that information to make routing decisions for the benefit of Lava’s own order-routing business.

According to an industry executive familiar with the operations of the alternative trading system, only 4 percent of all LeveL’s executed trades were processed by the order router that came into question.

In any event, large trading firms going forward will take greater steps to watch what is happening in dark pools with their orders.

Using sophisticated monitoring and analysis techniques, bulge bracket brokers are starting to build profiles of who is trading in their dark pools. Then, they can confront “toxic” participants and ask them to change their behavior or face expulsion.

They can also present the information to their customers-without disclosing identities-and allow them to decide whether to trade with certain sharpshooters. Finally, they can inject the information into their algorithms, and let technology make the decision.

Bulge firms taking the approach include Morgan Stanley, Barclays Capital, Deutsche Bank and Bank of America Merrill Lynch in the U.S., and Credit Suisse in Europe.

Another answer: the Light Pool, created by Credit Suisse. The alternative system classifies users by how they trade. The venue categorizes participants, helping mutual funds, hedge funds, pensions and endowments trade only with parties they are comfortable with.