The Securities and Exchange Commission charged Wednesday that the operator of the LeveL ATS failed to protect information about unexecuted orders in its dark pool.
The regulator said eBX LLC, which operates the LeveL alternate trading system, did not “protect the confidential trading information of its subscribers,” allowing an outside technology firm to use information about LeveL subscribers’ unexecuted orders, for its own “business purposes.”
The violations of Regulation ATS lasted from at least 2008 through early 2011, the SEC said in its complaint. eBX agreed to pay $800,000 to settle the charges. eBX also was censured and ordered to avoid violations of this nature in the future.
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 its own order routing business.
For example, the SEC said in its complaint, if the router knew that a buy order had been routed to LeveL, the service provider would use that information to route a sell order to LeveL to obtain an execution.
Conversely, if the provider of the smart order router, Lava, knew that no buy order had been routed to LeveL, its system would likely route any sell order it subsequently received to another destination.
Lava has a retained memory function that, according to LeveL, is a “commonplace” feature of smart order routes.
That “memory feature,” the SEC said, enabled the Lava router to retain a record of any order submitted to various market centers, and to use that information to make automated routing decisions. The feature retains the symbol, side, source, quantity, and received time for these orders; and can be turned on or off.
In a letter to customers, LeveL chief executive Whit Conary said Lava confirmed in April 2011 that it no longer was using the feature when it involved LeveL subscribers.
But he defended the use of memory functions in smart order routers, like that marketed by Lava.
“We believe retained memory functions benefit ATS subscribers by delivering contraside trading interest to subscribers while avoiding both blind ‘pinging’ and the information leakage inherent in sending out indications of interest,” he said.
While not naming Lava, the SEC said the router involved “was aware of the prices and pricing attributes of orders resting in LeveL, and was programmed to use that information in determining whether to send an order to LeveL as opposed to another venue based on where it knew it might get a better price for its own customers’ orders.”
That gave the service provider’s order routing business an information advantage, the SEC said, because it could increase the execution rate of its own customers’ orders by knowing about the LeveL subscribers’ unexecuted orders.
Even so, the SEC also noted “there is no evidence that information about LeveL’s unexecuted orders was displayed, or otherwise communicated to, clients of the Order Routing Business or other third parties.” The SEC also said actual execution prices were not affected by the use of the memory feature.
Nonetheless, eBX had “insufficient safeguards and procedures to protect subscribers’ confidential trading information,” the SEC said.
In his letter to customers, Conary said LeveL settled to “avoid the cost and attendant distractions of litigation.”
“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, in a statement. “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.”
LeveL confirmed Wednesday that it will continue to use Lava’s ColorBook order router.
SEC spokesman Kevin Callahan declined to discuss whether the SEC was considering any action involving the technology provider. Citigroup, on Lava’s behalf, declined comment.
“The fact that LeveL has apparently violated these rules and the promised conduct by which they operate is a grave misstep. Customers have to trust their brokers and ATS operators,” said Matt Samelson, principal at capital markets consulting firm Woodbine Associates. “Operators need to establish and maintain trust. This means outlining the rules of engagement and following them.”
Last year, the operator of the largest venue for institutions to trade large blocks of shares anonymously in a dark pool acknowledged to its customers that it failed to fully guard information about them.
In that case, Liquidnet chief executive Seth Merrin said his firm “screwed up” in failing to guard customer data properly.
The errors involved an internal sales tool for marketing a new equity capital markets business known as Infrared.
InfraRed and was launched in 2009, in conjunction with NYSE Euronext.
That service allows corporate treasurers, finance officers and the like to reach into Liquidnet’s “dark” pool of mutual funds and other institutions to see what kind of activity there is in the shares of their stocks and tap into it.
Separately, Pipeline Trading Systems this year closed down, after the Securities and Exchange Commission determined that the company failed to disclose that more than 97 percent of orders in Pipeline’s 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 ended up paying agreed to pay a $100,000 fine for their involvement, as well.
Berkeley is a former president of Nasdaq.
According to the SEC’s order, Pipeline described its trading platform as a “crossing network” that matched customer orders with those from other customers, providing “natural liquidity.”
Pipeline’s claims were false and misleading because its parent company owned a trading entity, Milstream Strategy Group, that filled the vast majority of customer orders on Pipeline’s system, the SEC found.
“Like last year’s Pipeline scandal, this (case) highlights issues of trust regardless of the magnitude of economic impropriety,” said Woodbine’s Samelson. “Investors need to have confidence that their brokers and trading venues are playing by the rules and doing business as it is presented.”
