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December 6, 2011

$1.2 Million Settlement Sheds Harsh Light on Dark Pools

The SEC’s recent settlement with a dark pool operator should prompt fund directors to review their advisers’ use of alternative trading systems, according to fund experts.

The operator of the dark pool, Pipeline Trading Systems, billed itself as providing a refuge from “predators” seeking to exploit investors’ large trades, but the venue failed to disclose that the vast majority of orders were filled by an affiliate that had access to specialized information about trades, according to the Securities and Exchange Commission’s order. Pipeline and its top executives paid $1.2 million to settle the charges, without admitting or denying wrongdoing. The two top executives at the venue’s parent company, Pipeline Financial Group, stepped down shortly after the settlement was announced in October, and a new chairman has promised to restore investors’ trust.

Dark pools aim to allow investors to make large trades without giving away their identity or the size and nature of their position and thus causing prices to move against them. Boards have a responsibility to oversee advisers’ efforts to get an optimal mix of price, speed of execution and likelihood of execution, both in public stock exchanges and in dark pools, according to the SEC.

Directors should ask advisers how and why they choose the dark pools they work with, what type of diligence they conduct in making their selection and how comfortable they are with the firms they use, says Andrew “Buddy” Donohue, a partner at Morgan Lewis & Bockius. The advisers should review the dark pools’ disclosure documents, although the allegations about Pipeline seem to indicate there is no guarantee those are always wholly accurate, Donohue adds. Directors can also consult the SEC’s 2008 proposed guidance on overseeing advisers’ efforts to get best execution, he notes.

At the very least, Donohue says, dark pools “should do what they’re saying they’re doing. They shouldn’t use an affiliate without saying they’re using an affiliate.”

But there’s a more fundamental concern, says Dennis Kelleher, CEO of Better Markets, a Wall Street watchdog group. “The real question is, why are we in dark pools in the first place?” Kelleher says. “The only reason you have dark pools is because trading is being driven from the open exchanges almost exclusively because of the predatory behavior of high-frequency traders and computer-driven traders.”

Alternative trading systems such as dark pools began to grow in popularity in the mid-1990s, in response to technological advances that allowed broker-dealers to more easily match buy and sell orders, according to 2009 Senate testimony by an SEC official. They have been credited with reducing institutional investors’ commission costs and allowing them to obtain better prices than they could on public exchanges. However, some investors have raised concerns about dark venues’ lack of transparency and their potential vulnerability to abusive practices.

Rise of high-speed trading

Dark pools made up nearly 12% of consolidated U.S. equity trading volume in October, up from less than 4% in January 2008, according to Rosenblatt Securities, which tracks dark pool activities. Pipeline, one of the 18 dark pools tracked by Rosenblatt, handled an estimated 0.0034% of consolidated volume in October, according to Rosenblatt.

Dark pools’ increase in popularity has coincided with the rise of high-frequency traders, who use supercomputers to make trades in microseconds, racking up gains off even the smallest movements in the markets. Regulators have expressed concern that high-frequency traders can use technology to game the system and profit at the expense of other investors, while proponents argue the traders provide valuable liquidity.

“The net effect of high-frequency trading has been positive, and it doesn’t make a lot of sense to avoid trading with high-frequency traders,” says Justin Schack, managing director at Rosenblatt, which estimates that high-frequency firms account for between half and two thirds of U.S. stock-market volume. “One way or another you’re going to be interacting with these guys.”

As for dark pools, the alleged abusive practices at Pipeline are “extremely rare” and shocked the industry, Schack says. “People need to take the appropriate lessons from that to try to protect themselves,” he says. However, he adds, given Pipeline’s alleged lack of disclosure about its affiliate’s role in the pool, “I don’t know how this could have been stopped.”

Though markets are more complex than they were before the rise of high-frequency traders and dark pools, they deliver better trading outcomes, Schack says. Nonetheless, he says the allegations have led to searching questions on the part of traders and directors alike.

There are potential pitfalls to using alternative trading venues, he acknowledges. Brokers can face conflicts of interest when deciding which venue to use; one venue, for example, may charge a commission for a certain trade while another would issue a rebate, Schack says. The brokers’ rebates or fees are not passed through to the institutional client, so the broker can have an incentive to choose the least expensive venues, not necessarily the ones with the most liquidity or the best prices, Schack says.

“A lot of head traders we deal with are calling us and saying, ‘My board is asking me about this, my CIO is asking me about this – what do I need to know about this? What do I need to do differently?’” Schack says.

‘This has got to stop’

Investors’ interest in keeping their trading intentions secret is nothing new, says Tim Mahoney, CEO of dark pool operator BIDS Trading. Institutional investors have always had access to “dark” liquidity through traders who would keep the details of orders hidden.

“Hidden liquidity has been around as long as people have been trying to buy and sell stock,” Mahoney says. “Most people see the wisdom of using dark liquidity to trade size.”

Pipeline appeared to be running a market-making operation inside its dark pool, according to the SEC order, which is acceptable as long as everyone knows that’s the case, Mahoney says. “I just think they had to disclose that,” he says. “If you’re a buy-side trader, you want the ability to know that and decide whether or not to use that venue.”

In light of the Pipeline allegations, fund directors should ask their adviser about the process for seeking best execution, says David Hearth, a partner at Paul Hastings. “The responsibility is to ask the questions and review the materials sufficiently to give the board comfort that the manager is satisfying its best execution responsibility,” he says.

He adds, “This does not necessarily mean that managers or funds were hurt. It’s very likely the case that the trades that were executed through Pipeline were done at very favorable commission rates and for very favorable and very competitive prices, better than what could have been done through a more open market transaction. It’s not so much whether funds could have gone elsewhere and gotten more favorable prices. The real issue is whether the price through Pipeline could have been more favorable.”

But Better Markets’ CEO argues there is a deeper problem.

Mutual funds that use dark pools because they are concerned about being exploited on public exchanges are like a person who gets pick-pocketed every day in broad daylight deciding to walk down a dark alley; the victim should simply call the cops, Kelleher argues. Fund directors and other industry insiders should demand that regulators such as the SEC curb abusive practices, whether they occur in public or dark venues, he says.

“Nothing is going to happen to the high-frequency traders until the big market participants on the buy side say, ‘This has got to stop,’” Kelleher says.

Those advocating for increased safeguards should proceed with caution, Hearth warns.

“People all the time are suggesting different ways to restrict and regulate the markets through exchange rules,” he says. “It’s not obvious to me how you do that in a way that’s fair to everybody. I agree superficially. Certainly the high-frequency trading and the resulting volatility seem not to be a healthy influence on the market, I see that, but I think you have to be really careful putting in more constraints on the market because sometimes the side effects can be not what you intended. The devil is in the details.”

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