In an exclusive interview about the Pipeline controversy, Jamie Selway, managing director at ITG, tells AT that, according to the SEC, Pipeline "violated Reg ATS." "They didn't describe in the Form ATS everything they were doing with their affiliate," says Selway, whose firm competes with Pipeline in the block-crossing market. "Moreover, they aggressively spoke about things that weren't true."
According to Tabb Group's Tabb, "The key issue is that Pipeline leveraged internal capital and they told everybody that it was natural flow." But in reality, he says, virtually all dark pools -- especially the broker-operated dark pools -- have some sort of liquidity source beyond customer orders.
"There is someone making markets in the dark pool -- it's either internal capital that is being used or, in some cases, it's external liquidity providers," Tabb explains. "For the larger dark pools, the only way to have enough order flow to match up is to have market-making facilities," he contends, noting that some dark pools offer electronic liquidity provider (ELP) programs and others broadcast indications of interest (IOIs) to build liquidity.
However, an executive with a block-crossing network who spoke on the condition of anonymity asserts that Pipeline's usage of the affiliate to provide liquidity crossed the line between agency brokerage and proprietary trading. "Prepositioning is prop trading, whereas with agency block crossing, there's a pairing off of clients' order flow," he maintains. There are cases in which an agency broker operates as a riskless principal, acquiring a security for a short time, and then passing it on to a customer, the executive acknowledges. But with agency brokerage, the firm is making money on the commission, not trading gains and losses, he points out; Pipeline's affiliate was taking on risk.
"The story is about a company that lied, ... that misrepresented its liquidity to cheat," ITG's Selway says. "It's hard work to build a block-crossing liquidity pool, and they cheated." But the agency block-crossing model works, Selway insists. "There is nothing wrong with the agency crossing model. By design it's fundamental purpose is to get away from things that Pipeline was doing, which is to remove the intermediary," he says. "Pipeline cheated. We don't cheat."
How Much Transparency Is Enough?
Meanwhile, the Pipeline revelations also reignited a simmering debate around dark pool transparency, particularly into how they route and match trades. "It raises awareness and it's part of a fine-tuning process to have the dark pools run as effectively and fairly as possible," Mark Kuzminskas, director of equity trading at Robeco Investment Management in Boston, says of Pipeline's impact on dark pool routing and reporting parctices.
"The first logical step is for everybody to police it," he continues. "Currently, we on the buy side are asking questions of the sell side on how they operate, while the sell side is investigating their own methodology, and that should hopefully root out any other improprieties. Otherwise, if we can't get it done, then we're going to be subject to greater regulatory scrutiny, and at the end of the day we might not like the outcome."
According to ITG's Selway, the buy side already has enough data to judge dark pool executions. Tags via the FIX protocol provide "complete visibility into the executions," he insists. "Pipeline lied about who is in Pipeline. I don't think there is much need for more data or consultants," Selway says, suggesting that the role of the SEC and FINRA should be to ensure that firms are doing what they say in Form ATS.
And there may be little anyone can do to save Pipeline, industry sources believe. "It's going to be hard for Pipeline to get over this because it's lost the trust of its clients," observes Tabb Group's Tabb.
According to the East Coast buy-side head equity trader, Pipeline offered to sit down with his firm to prove that it did not disadvantage client orders. But, he says, it's too late. "Quite honestly, the train has left the station."