Pipeline Trading: Rise Like a Phoenix or Burn to the Ground?

The revelation several weeks ago that Pipeline Trading and two senior managers have been found in violation by the SEC of several securities laws caught many in the institutional trading business by surprise. In a flurry of press and analyst related releases in the days following the news, commentators forecasted impact on the market - ranging from significantly greater oversight and reporting requirements for dark pools to a flurry of buy-side demands for execution information to another "nail in the coffin" of Main Street trust in Wall Street.

While these assertions are colorful, they are also far-reaching. In reality, the Pipeline fiasco is an unfortunate firm-specific event unlikely to have any meaningful systemic impact on trading, dark pools, or regulation.

Pipeline Was Wrong. Pipeline management was clearly wrong by not disclosing the operations and characteristics of its dark pool and for mishandling client information. No question about it.

According to the SEC release, Pipeline's trading entity traded ahead of and behind client orders to accumulate or divest contra positions. In effect, the entity added liquidity to the pool that was anything but "natural" as Pipeline had claimed. Furthermore, their proprietary trading entity received preferential dark pool access and information about client trading practices for positioning purposes.

Whether the violations were found to be massively egregious with nine-figure fines, or completely inconsequential with a slap on the wrist, the fact of the matter is that there were indeed clear violations, and the company was indeed at fault. It seemed Pipeline's objective was to service their clients by supporting their dark pool, yet they also chose to see if they could add trading profits for themselves along the way. The only conclusion is that those profits must have come at the expense of their clients, regardless of the measurement Pipeline chose to certify a quality execution for those clients. Yet Pipeline, in their settlement with the SEC (whereby the firm and its principals admit no wrongdoing), was fined were a mere $1 million for the firm and $100,000 each for the chairman and chief executive. Yet these numbers, which are rather miniscule in today's financial world, are likely to weigh mightily on the future of Pipeline.

It's About Trust. The negligible financial impact in this situation highlights the importance of trust in the broker-client relationship.

Certainly, all things being equal, consistently poor trading performance (either via an algorithm or human trader) will likely not be tolerated. Yet the broker-client relationship is often enhanced where the rationale for particular actions can be explained - even in instances when performance is lacking. In other words, it is quite important that the institutional client understand how orders are handled and have confidence in their brokers even if performance is occasionally substandard.

As normal course of business, we expect that Pipeline sales and relationship management personnel had regular contact with their clients. No doubt, the range of Pipeline services was discussed and active Pipeline clients would have been comfortable with the nature of the service and relationship as they understood it. Imagine the sense of betrayal when news was released indicating operations were not as described. As a result, many firms suspended operations of all types with Pipeline regardless of whether value was provided by trading through the Pipeline block market or algorithmic products.

No Industry Impact. Yet, the Pipeline transgressions are likely to have very little impact on the industry as a whole. These events haven't shaken institutional trading: institutions haven't suddenly substantially reduced or stopped their use of non-displayed venues. Nor have the Pipeline transgressions changed the value proposition of non-displayed venues or internalization. We also don't believe it has greatly soured public opinion any further against Wall Street: we doubt most of Main Street has ever heard of Pipeline Trading or news of the violations.

We don't believe that the transgressions in any way -- as set forth by others -- increase regulatory scrutiny on non-displayed venues. Nor should there be a threat to the structure of dark pools, or the value they provide to the trading world. This was a violation of the way Pipeline chose to conduct their business, not a denouncement of the business itself. So don't expect drastic industry-wide changes of any sort. Apart from some limited institutional due diligence, no one is doing anything differently.

We, like most of the industry familiar with Pipeline Trading, continue to scratch our heads and wonder how former Pipeline senior management -- individuals with formidable reputations within the industry -- could stray as they did to the point of breaking the law. But make no mistake -- these events are firm-specific and not systemic in any way.

Implications for Pipeline. Pipeline Trading must not only deal with fallout from the recent breach in trust with its clients but also considerable cultural and related issues that have very likely confounded the firm's growth and operation since inception. Pipeline must deal with issues that considerably pre-date the release of the damning information and very likely contributed to the scandalous activity.

The company has replaced senior management at the center of the scandal with new leadership. The new executive chairman is an industry veteran with significant expertise in several disciplines. Yet, he is currently unproven at the executive leadership level. In addition to being challenged to get his sea legs in his new role, he finds himself forced to do so in a situation that simultaneously requires crisis management. Only time will tell if he will succeed.

As far as the corporate culture issue, we believe that Pipeline is subject to challenges not uncommon at firms that offer complex, quantitative trading services. In many instances, it is extremely difficult to effectively articulate the value of the offering to potential clients due to differences in skill sets between sales and product teams. In many instances, elements of the value proposition, features, functional aspects, and specific benefits of complex products and services get lost between the two teams which can result in missed opportunities for new clients and can therefore limit expansion. We are not privy to insider information, but our collective experience tells us that these are issues that have challenged Pipeline since inception. To correct these issues, Pipeline needs to ensure the correct personnel are in both positions with their roles and responsibilities clearly defined, and razor sharp business and sales strategies in place.

On the issue of offering, there are questions of breadth, differentiation, and existing competition. An agency broker, Pipeline is subject to competing for a larger share of a continuously shrinking pool of discretionary order flow. As the smallest of its immediate competitors (generally considered to be Investment Technology Group, Instinet, and Liquidnet) and perhaps the most challenged in terms of service offering and scope of offering, Pipeline can least afford to close its block market. New management appears adamant about saving the block market, but the immediate move to divest the proprietary entity to mollify clients in the wake of the scandal may prove to be the block market's undoing which, in turn, would further narrow Pipelines product scope. While the firm has some impressive algorithmic related offerings such as the Alpha Pro and the algorithmic switching engine designed to facilitate trading, obscure user's intentions, and protect users from informed liquidity on the opposite side of the market, the products are few and the distinguishing features not so pronounced to assure the firm substantial business. The firm's new leadership must move decisively to broaden and distinguish the brand if the firm is to remain independent.

Pipeline has taken a decisive, though predictable, step to attempt to remedy the trust issue -- management change. They did not seem to have a choice but to do such, but the move hardly rectifies the situation. The challenges that confront management are considerable. Extensive change in culture, personnel, and offering -- a virtual full-scale overhaul -- will be necessary for the firm to have a chance to continue operating independently.

Conclusion. The Pipeline event is an unfortunate, puzzling, firm-specific occurrence that has the most limited systemic implications. It is sensational in that one of the basic tenants of the client broker relationship -- trust -- was violated. Yet the potential impact on the firm itself is likely to be considerable despite the fact that the financial impact resulting from clandestine activities was far from egregious in aggregated dollar terms. The challenges for Pipeline run deep and will be considerable in maintaining the firm's independence.

Matt Samelson is principal for Woodbine Associates, the financial markets research firm.