The SEC And A Dark Pool That Is Not Dark Enough

by Dorsey & Whitney LLP
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High speed trading, dark pools and similar market structure issues have become hotly debated topics. Former CFTC Commissioner Bart Chilton gave several speeches discussion the subjects and proposed that high speed traders be required to register. SEC Chair Mary Jo White discussed these questions in her recent address titled “Enhancing Our Equity Market Structure.” FINRA announced last week an initiative to disclose certain statistics on a delayed basis regarding dark pools. Authors Michal Lewis, who wrote Flash Boys, and Scott Patterson, who authored Dark Pools, both discussed these topics and called the markets “rigged.” All of this is generating studies and possibly proposed new rules.

Some issue can be resolved under existing rules as illustrated by the recent settlement in In the Matter of Liquidnet, Inc., Adm. Proc. File No. 3-15912 (June 6, 2014). The issue in this proceeding was straight forward – the dark pool was not dark enough.

Liquidnet is a registered broker dealer which operates to a block trading alternative trading system or ATS, as a dark pool. Its members are primarily large institutional investors who do not want their actions in the market place known. A key feature of the Liquidnet ATS is its “blotter-scraping” functionality under which members grant electronic access to their OMS. It contains real time information about their trading intentions.

Members of Liquidnet’s dark pool are assured of “complete anonymity.” This assurance is incorporated into the subscriptions agreement and the rules.

In 2009 Liquidnet launched a new service, its ECM initiative, which eventually developed into a stand-alone business unit. It was designed to introduce Liquidnet as an execution venue for corporate issuers and others. A key feature would permit members to execute transactions in size. Another feature was a desk top application for issuers called InfraRed. It aggregated historical data in the Liquidnet system as a smoothed ratio of “buy” liquidity to “sell” liquidity, caped at a specific ratio.

From the time ECM was launched, through 2011, its employees had access to the confidential member trading information in the Liquidnet system. This included the identity of each member who indicated interest in purchasing or selling and the number of specific shares. This violated Rule 301(b)(1) of Regulation ATS which requires that the pool operator establish adequate safeguards and procedures to protect subscribers’ confidential trading information.

ECM also used member data in marketing the service. That data was incorporated into presentations for corporate issuers. It included descriptive characteristics of pool members that had recently indicated interest in buying or selling the issuer’s stocks. ECM also contacted issuers to discuss recent trends in their stock which sometimes included member descriptive characteristics. Pool members did not consent to the use of their information in this manner which was inconsistent with the representations made to them.

Liquidnet also used confidential information about members’ indications in sales tools. In some instances Liquidnet generated alerts called Ships Passing that discussed missed execution opportunities between member algorithmic orders and member indications. In other instances members were contacted about Liquididnet’s recent dominance in certain stocks. In describing this information to a member, Liquidnet did not disclose that the decision to contact the firm was based in part on the member’s past or current indications of interest for the stock.

The Order alleges violations of Securities Act Section 17(a)(2). Rule 301(b)(2) of Regulation ATS, which requires that pool operators file amendments on Form ATS, was also violated by not filing amendments regarding ECM, a material change in operations. And, Rule 301(b)(10) of Regulation ATS, which requires the operator to establish adequate safeguards and procedures to protect subscribers’ confidential trading information, was also not followed.

In resolving the proceeding the Commission considered the prompt remedial actions of the Respondent, which included development of a program that provides members with direct control over the use of their data within the Liquidnet system. Liquidnet consented to the entry of a cease and desist order based on the Section and Rules cited in the Order and to the entry of a censure. It also agreed to pay a fine of $2 million.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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