October 26, 2011

Outrage in the Dark

Observe. Orient. Decide. Act. OODA.

This is how Pipeline Trading describes its predictive analytics for helping buyside customers identify large-block trading opportunities.

For those of you who missed the news that rocked The Street this week, Pipeline, a dark pool, was fined $1 million by the SEC for misleading clients about the nature of its liquidity.

Were you harmed? Check to see if your shares trade at Pipeli—

Oh. You can’t. It’s a dark pool. You don’t know if your shares trade there unless Pipeline’s orders route to your listing exchange.

Of Pipeline, SEC Enforcement Director Robert Khuzami said in a statement: “Investors are entitled to accurate information as to how their trades are executed.”

Pipeline offers a platform where institutional customers like mutual funds can find “natural liquidity,” or real orders from other buysiders. What’s more, Pipeline provides execution algorithms that mimic how high-frequency traders try to project price and volume in order to place profitable trades ahead of moves. If the buyside can beat HFT at its own game, then instead of being victimized, it can also generate alpha – market-beating returns on trades.

In a dark pool, you’ll recall, there are no displayed prices. You don’t walk in looking to see what lettuce sells for here. You come because you want to keep secret your interest in a truckload of lettuce. Maybe Pipeline with its predictive algorithms and natural lettuce liquidity can fill your truck at a price midway between Safeway’s and Kroger’s, whose prices will still set yours but without your walking into either store and creating a run on lettuce.

Turns out, Pipeline was filling nearly 80% of orders with its proprietary trading subsidiary, Milstream Strategy Group. Which was also using Pipeline OODA analytics to front-run orders at other markets.

Yup. That’s bad. By the way, Pipeline matches about seven million shares of about seven billion daily at present across all US equity venues. Drop in the bucket. But it earned a big fine.

Because accurate information matters.

Two takeaways for the IR chair. First, the line between what Pipeline did and what the big listing exchanges do is fine and gray, frankly.

Exchanges sell circuits and colocation services that give good customers fractionally better information, the same as predictive analytics. See our piece some weeks back about Burstream.

Further, exchanges present themselves to their public-company customers as impartial venues with displayed prices. But they pay around fifteen cents per hundred shares for DARK liquidity. Exchanges, which vilify dark pools for distorting price-discovery, incentivize dark orders with rebates and encourage it with order types.

In fact, liquidity often advertised to you as proof that your listing exchange is doing you service is paid to be there. Well, isn’t that what Pipeline was in form and function doing? Those brokers the Nasdaq lists as liquidity providers? Lots of that is incentivized order flow that earned thirty cents per hundred shares. Incentivized volume is not investment; it’s fleeting, artificial. It’s hoping to profit from the act of intermediation.

And why do exchanges pay for that? Because the act of intermediation generates data, the revenues from which are shared by exchanges under the SEC’s quote and tape plans. What drives data? High-speed trading. Who consumes data? High-speed traders. What is the majority of your volume? Do the math.

Do they tell you? You’re a customer entitled to accurate information about how your shares trade. I don’t mean to criticize our friends at the exchanges. But has the exchange ever explained to you precisely how they match trades in your shares?

Which brings us to Key IR Takeaway Number Two: If investors deserve accurate information about how trades are executed, on pain of fines, what about public companies?

In the past ten years, all the exchanges have become for-profit entities. Regulators have instituted a vast host of rules fragmenting markets and fundamentally restructuring how trades are intermediated, matched, monetized and compensated.

Do you know what changes have been made to data for public companies during that time? Exactly NONE.

This is why you know less about your trading activity than any generation of IROs. Permit me to be blunt: Regulators have not considered public companies worth the time to modernize data rules to reflect the market structure they fostered.

A year ago we thought it would take an act of Congress to redress this inequity. We now know that FINRA can fix it with a rule-filing.

All it takes is some of your CEOs asking FINRA: Why are investors entitled to accurate information, but public companies are not?

Editorial Note: Don’t miss the IR Magazine Think Tank next week in NYC.  Hope to see you there!

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