I was personally shocked by the news that Pipeline, a leading dark pool, was crossing trades through a proprietary trading firms that it owned. I saw similar reactions from analysts who follow the company.
As a journalist who wrote about Pipeline many times over the past 7 years, I can't believe the firm would deceive its clients about how and where it was executing trades. If the firm was seeding an affiliated trading firm, Milstream Strategy Group LLC, to provide liquidity to its dark pool, it should have told its clients.
According to the Securities and Exchange Commission's administrative proceeding:
Pipeline held its alternative trading system or ATS as a "crossing network" that anonymously matched customers' interests in trading large amounts of stock. However, Pipeline did not disclose to its customers that the overwhelming majority of the shares traded on its ATS were bought or sold by a wholly owned subsidiary of Pipeline.
While Pipeline marketed its pool as a crossing network that matched trades internally, this was not the reality. From 2004 through the end of 2009, Milstream participated in about 80 percent of the volume on the platform, according o the SEC.
There are many layers of irony here. Pipeline went above and beyond other agency brokers in talking about the need to protect institutional orders from predators lurking in dark pools.
Pipeline was so concerned about predators pinging its dark pool that it wouldn't let algorithms into its dark pool. (Remember it kicked out Credit Suisse's dark aggregator from its dark pool).
Pipeline also developed an algorithmic switching engine - that would switch orders from one algo strategy to another. This seemed to be an over complicated, confusing product. I would argue that the firm has used complex quantitative language to mask transparency of where it's routing its trades. Here is an excerpt from an August 2010 article in Advanced Trading on TCA in which Pipeline's CEO Fred Federspiel is quoted:
"If you're not running [intraday] calculations, you're coming to a gun fight poorly armed," warns Fred Federspiel, CEO of Pipeline Trading Systems. To help traders react to real-time market conditions, Pipeline developed what it calls an Algorithmic Switching Engine that predicts the performance of algorithms under real-time conditions based on an information feedback loop.
"It takes a trader's instructions about how hard the trader would like to drive an order into the market and translates that minute by minute into a choice of an algorithm style, price limit for an algo, the control parameters on that algo and the size of the child orders sent to that algorithm, and then we send that out and let the algorithms execute it," Federspiel explains. Currently, Pipeline's switching engine reaches out to 132 algorithms and is adding about 10 more each month, Pipeline says.
The bigger message here is that institutions should question everything and demand to see routing and execution reports from dark pools. Time will tell how Pipeline's misrepresentation impacts its buy side clients. Advanced Trading will continue to follow the story.