Pipeline Trading Systems has agreed to pay $1 million to settle charges brought by the Securities and Exchange Commission that the company failed to disclose the fact that at times more than 97 percent of orders in Pipeline’s dark pool were filled by a trading operation affiliated with the firm.
The SEC announced on Monday it had reached the settlement with Pipeline, as well as with company founder Fred Federspiel and chairman Alfred Berkeley, who have each agreed to pay a $100,000 fine for their involvement. Berkeley is also a former president of Nasdaq. Under the agreement, neither man admits nor denies wrongdoing. The company did not immediately respond to a request for comment.
Pipeline launched its alternative trading system in 2004, billing itself as a crossing network that matched orders to provide natural liquidity. But the SEC claims Pipeline’s liquidity was anything but natural.
The company owned a trading entity that has gone by multiple names, most recently known as 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.
According to the SEC complaint in the matter, 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 role that affiliate played in providing liquidity.
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 on 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.
Traders route their orders to dark pools to avoid being gamed by predatory and high-frequency traders, but Pipeline’s affiliate allegedly engaged in many practices typically associated with HFT, such as placing a large number of orders and then canceling them immediately afterward.
In spite of this, Pipeline specifically instructed its sales force to tell customers that there was “no prop desk at Pipeline attempting to game your block orders,” according to the SEC.
Pipeline took steps to address any conflict of interest by paying affiliate traders using a formula that rewarded them for giving favorable prices to Pipeline customers, the SEC said. In fact, in the early days of the dark pool, the affiliate even lost money, which was allegedly viewed as a “marketing cost.”
Still, the company did not disclose the affiliate’s compensation formula or any of its other activities, the SEC said. Also, the affiliate has made millions in trading profits in recent years, including $18.4 million in 2008, though over the life of the affiliate, total expenses have exceeded gains from trading, the SEC added.
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.
Robert Khuzami, director of the SEC’s enforcement division, said in a statement that investors are entitled to accurate information as to how their trades are executed. Pipeline misled customers as to how its dark pool really worked, he said.
