After agreeing to pay $1 million to settle charges brought by the Securities and Exchange Commission, Pipeline Trading Systems is reaching out to its customers, attempting to retain their business in spite of the fact the company admitted it was not forthcoming about how its dark pool operates.
According to the SEC, Pipeline failed to disclose that the vast majority of orders in its alternative trading system are 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.
Meanwhile, the trading industry is abuzz with chatter about Pipeline’s long-term prospects, as the settlement came as a shock, since few knew the affiliate even existed. In addition, many are wondering if this news will be a blow to the reputation of dark pools in general.
To stem the tide, Pipeline is now scheduling in-person meetings with customers in an attempt to explain how the affiliate provides liquidity and to emphasize the execution quality its dark pool provides.
“We recognize that we should have been more forthcoming about the critical role of our affiliate and sincerely regret that we were not,” Pipeline said in a statement to customers. “We believe—and can show you in detail—that you have benefitted in the past from our affiliate’s ability to provide liquidity in the Block Market, and you can benefit in the future.”
The big question is whether customers will stick around after seeing regulators chastise Pipeline for misleading people about its business. Even sources sympathetic to Pipeline have called its past marketing deceptive and inappropriate.
In spite of numerous claims that Pipeline provided natural liquidity, the company’s affiliate, Milstream Strategy Group, sought to predict the trading intentions of dark pool customers and then trade elsewhere in the same direction as those customers before filing their orders on Pipeline, according to the SEC.
Yet Pipeline specifically instructed its sales force to tell customers that there was “no prop desk at Pipeline attempting to game your block orders,” the SEC said.
One veteran broker who asked not to be named said that in his opinion the affiliate clearly was acting as a prop desk.
“Milstream was a prop shop,” the broker said. “That’s a fact.”
In its defense, Pipeline has claimed it has a patented mechanism to align the interests of Milstream’s traders with those of customers. Under the system, traders are supposed to be penalized if they make trading profits at a customer’s expense.
In fact, Milstream has shown a cumulative net operating loss since it was launched along with Pipeline’s dark pool in 2004. Though in recent years Milstream has made trading profits, including $18.4 million in 2008, it is currently operating at close to breaking even.
Pipeline maintains the purpose of the affiliate was to provide liquidity, not to make a profit. Still, for many in the industry, the issue comes down to a question of trust.
“People were using that pool with an expectation that it was natural liquidity,” said Garrett Nenner, managing director of global markets for Momentum Trading Partners. “Maybe Pipeline thought what they were doing was fair, but it’s disappointing.”
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.
The revelations could have repercussions beyond Pipeline, as market participants take a closer look at dark pools in general. Some dark pools have their own prop desks, which they do disclose, and in the wake of the Pipeline disclosure, 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.
