Fragmented markets, alternative trading systems and dark pools are increasingly a focus of discussion in the wake of repeated market outages. Interest in these venues has been intensified by the publication of Flash Boys and Dark Pools. To date only a few cases have been brought. See, e.g. In the Matter of Liquidnet, Inc., Adm. Proc. File No. 3-15912 (June 6, 2014)(ATS dark pool where confidential customer data used for marketing); In the Matter of eBX, LLC, Adm. Proc. File No. 3-15058 (Oct. 3, 2012)(informational edge given to another); In the Matter of Pipeline Trading Systems, LLC., Adm. Proc. File No. 3-1460 (Oct. 24, 2011)(concealed conflict re order filling process).
On Friday the Commission added to its increasing number of cases in this area, filing an action against a unit of Citigroup, In the Matter of LavaFlow, Inc. Adm. Proc. File No. 3-15985 (July 25, 2014). Respondent LavaFlow, Inc. is a registered broker-dealer which is an indirect subsidiary of Citigroup Global Markets, Inc. It operates LavaFlow ECN, an electronic communications network which is a particular type of ATS. Generally, it functions as a marketplace for buyers and sellers of securities. LavaFlow ECN displays the top of its order book which is the best bid and best buy in the national market system. Other orders are not displayed.
In 2006 Lava Trading, a subsidiary of Citigroup, acquired the ECN which became known as LavaFlow ECN. Prior to that time Lava Trading had functioned as a technology services company. Its flagship product was ColorBook, software that provided smart order routing services for over 100 registered broker-dealers that used it to route their customer orders to execution venues. As a smart order router, ColorBook applied preprogrammed analytics that carried out an execution strategy. This distinguished ColorBook from an order router which generally allows an end user to submit an order to an execution venue.
When LavaFlow ECN was acquired, Lava Trading personnel believed they could use ColorBook to improve important functions of the ECN. Nevertheless, the services that ColorBook provided to customers remained distinct from those provided by LavaFlow ECN.
Initially, LavaFlow did not permit ColorBook to access and use information from the ECN direct subscriber non-display order flow when determining how to smart route orders. Beginning in March 2008, and continuing for the next three years, LavaFlow did permit ColorBook to access that information and use it for smart order routing decisions for customers who also were subscribers of the ECN. Thus if an ECN customer placed an order that would match a non-displayed order in the venue, ColorBook would route the customer order to the LavaFlow ECN with the expectation that the two orders would match.
LavaFlow did not obtain meaningful consent from its ECN subscribers to allow ColorBook to have access to direct subscriber non-displayed order flow information or to use it. While marketing materials indicated that ColorBook would be “exposed” to non-displayed order flow data, there was no procedure in place to ensure that subscribers reviewed this material. There is no indication that non-displayed orders were communicated to customers of the smart order routing business.
In June 2008 Lava Trading, which had been a registered broker-dealer since 2005, withdrew its registration. The next year Lava Trading entered into an agreement with LavaFlow under which the latter would receive all income associated with contractual arrangements that previously existed between Lava Trading and its customers. From August 2008 through February 2009 Lava Trading received transaction-based compensation for broker-dealer services, including about $1.8 million for orders handled by the smart order router.
The Order alleges willful violations of Rules 301(b)(2) and (10) of Regulation ATS and Exchange Act Section 15(a). Rule 301(b)(10) requires an ATS to establish adequate safeguards and procedures to protect subscribers’ confidential trading information and to have adequate oversight. This rule was violated by permitting ColorBook to have access to the direct subscriber non-displayed order flow information and use it to make routing decisions. Rule 301(b)(2) requires an ATS to amend its Form ATS before implementing a material change to its operation. That form was not amended here regarding the access of ColorBook.
To resolve the proceeding LavaFlow consented to the entry of a cease and desist order based on the Rules and Section cited in the Order and to a censure. It also agreed to pay disgorgement of $1.8 million, prejudgment interest and a civil penalty of $2,850,000.