What Goes On Inside Those Dark Pools?

The WSJ published another article scathing yesterday on a murky area of our broken market. This time Scott Patterson and Jenny Strasburg revealed more details from the Pipeline Trading scandal that broke last year. There are so many disturbing pieces of information in this article that it’s hard to know where to start, so we’ll just list a few:

– The Pipeline Trading affiliate, Milstream, was setup in 2004, with the goal of making sure orders got filled by first executing for its own account in the open market.

– Milstream was headed up by an employee named Gordon Henderson. Henderson was proud of the fact that every trader he hired had no prop trading experience and he trained them all.

– Henderson was quoted on the article as saying “I love nepotism” and he even hired his own step son who was paid $1.5 million per year from 2007-2009

-Henderson regarded Milstream as an independent trading desk. He is quoted as saying: “I didn’t care about the customers”

-Milstream had a special electronic link installed by Pipeline alerting them to when an order was placed and certain price information (think data feeds here)

-Milstream had $32 million in trading profits from 2008-2010 yet was only fined for $1 million by the SEC for front-running their own clients.

The Pipeline case is an example of what can go wrong in our non-transparent, fragmented equity market that is not being properly supervised. With over 50 market centers, there are so many points of information leakage in the post Reg-NMS equity market that is nearly impossible for the regulators to police them all. This type of information leakage is no different from insider information. Material, non-public information is being disseminated ahead of time to a subset of the market creating a high tech, insider trading ring. While the head trader at Galleon was locked up and fined millions of dollars, this new high tech insider trading seems to be just getting a slap on the wrist.

Tabb Group has estimated that 37% of trades are now being executed on off-exchange venues (13% in dark pools and 24% via broker internalization). These dark venues are pinging each other and sending out IOI’s at a furious pace. Does the SEC know what’s in these IOI’s? Is there another Milstream type trading desk taking the other side of trades in other dark pools? Is volume being distorted due to these middlemen inserting themselves in the trading process? Has the price discovery process been distorted due to artificial arbitrage opportunities being created from these microsecond timing differences between different venues?

We have heard time and time again that competition in the equity market is great and has driven down transaction costs. But with over 50 for-profit trading destinations all competing for the same dwindling order flow, operators of venues that lack liquidity may be tempted to do more unscrupulous things like Milstream did in order to get their volumes up. Is this competition really helping the market or is it distorting the true supply/demand pricing equation? We think the latter.