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SEC Says 'Dark Pool' Operator Traded Ahead of Its Customers

October 25, 2011 ( To avoid tipping their hand to other investors, institutions such as mutual and pension funds have been shunning traditional stock markets in favor of alternative arenas known as "dark pools," where they can theoretically mask their moves. The idea is to avoid driving up the price of a stock before the institutions can buy a large number of shares and to avoid driving down the price before they can liquidate a major stake.

But one of those dark pools, Pipeline Trading Systems, has been secretly trading ahead of its customers' orders, the Securities and Exchange Commission alleged Monday.

Pipeline held itself out as "a refuge from predators and front-runners" that detect big institutions' plans and beat them to the punch, but it was actually engaged in similar conduct, according to an SEC charging document.

A wholly owned subsidiary of Pipeline turns out to have been on the other side of the vast majority of trades that clients made through Pipeline, and before executing those trades the Pipeline affiliate placed its own, the SEC said.

Pipeline agreed to pay a $1 million fine for violations that included misleading customers. Two of its leaders, Fred J. Federspiel, founder and chief executive, and Alfred R. Berkeley III, chairman and former chief executive, each agreed to pay $100,000. Under their settlements with the SEC, they neither admitted nor denied wrongdoing.

Berkeley is a former president and vice chairman of the Nasdaq Stock Market. He previously worked at the investment bank Alex. Brown & Sons.

Federspiel is one of many entrepreneurs who have applied scientific or mathematical backgrounds to the business of trading stocks. He received a doctorate in experimental nuclear and particle physics and worked as a nuclear physicist at the Los Alamos National Laboratory, according to a biography on the Pipeline Web site.

The case was the first the SEC has brought against a dark pool.

The SEC accused Pipeline of failing to tell the regulatory agency about the role the subsidiary played in a required disclosure.

As part of the settlement, the firm and the two executives agreed to "cease and desist" orders - in effect, promising not to break the same rules again.

Pipeline said it was pleased that its settlement with the SEC resolves the allegations.

"The agreement will enable us to continue to provide our customers with the excellent trade execution quality and access to sources of liquidity which they have come to trust over the years," the firm said in a statement.

Dark pools have emerged as major players in the financial arena, siphoning business from conventional markets such as the New York Stock Exchange.

Regulators have expressed a variety of concerns about what happens beneath the surface of dark pools and have been studying the issue.

But conventional markets entail hazards of their own for institutions. Big buyers and sellers can be outmaneuvered by adversaries that use sophisticated, high-powered technology to sniff out impending block trades - a group known as high-frequency traders.

Promising anonymity, Pipeline catered to mutual funds, hedge funds, pension funds and insurance companies seeking the best price for big trades.

In numerous marketing statements, Pipeline described itself as a refuge for those institutions, the SEC said. The firm claimed to be "leak-proof" and "predator-proof."

"Pipeline's new technology reduces market impact by denying day traders, predatory dealers and other speculators the information they need to front run institutional investors' orders," Berkeley said in 2005, according to the SEC.

"Because your order is hidden, you can leave it in Pipeline for hours without leaking any information or moving the market," the firm said, according to the agency.

Pipeline reduced "the predatory practices that can occur in traditional trading venues . . . to the point of extinction," Federspiel allegedly said.

In fact, the SEC said, a Pipeline affiliate "commonly sought to preposition, or trade in front of Pipeline's customers' orders," the SEC said.

The affiliate was originally known as Exchange Advantage LLC, but to obscure its connection to Pipeline, the firm changed the name to Aurora Technology Partners LLC, the SEC said. The name was changed after a member of the firm's management team wrote that the affiliate "should sound like a technology firm, consulting or software," the SEC said. The affiliate later became known as Milstream Strategy Group LLC.

From its launch in 2004 through the end of 2009, the affiliate was involved in 80 percent of the trading at Pipeline, the SEC said.

Internally, Pipeline's senior managers acknowledged that its business could involve "a direct conflict of interest" with its customers, according to the agency.

Despite its advantages, the Pipeline affiliate was not a spectacular success. From 2004 through 2006, the affiliate lost $19.7 million on its trading, the SEC said. In 2008, the affiliate reaped trading gains of $18.4 million, but those declined to $9.3 million in 2009 and $4.5 million in 2010, the SEC said.

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