SEC Charges Another Dark Pool

Dark pools are one of the issues which have been debated at least since Michael Lewis published Flash Boys and Scott Patterson put out Dark Pools. To date the SEC has brought two actions involving the trading venues. One was In the Matter of Liquidnet, Inc., Adm. Proc. File No. 3-15912 (June 6, 2014) which centered on the improper use of customer information and was resolved with a cease and desist order based on Securities Act Section 17(a)(2) and certain rules, a censure and the payment of a $2 million fine. The second was In the Matter of UBS Securities LLC, Adm. Proc. File No. 3-16338 (Jan. 15, 2015). That action focused on improper order types and certain disclosure failures. It was settled with a cease and desist order based on Securities Act Section 17(a)(2), and certain rules, a censure and the payment of about $14.2 million — $2.2 million in disgorgement and a $12 million penalty.

Now the agency has settled its third action involving a dark pool. In the Matter of ITG Inc., Adm. Proc. File No. 3-16742 (August 12, 2015). Respondents in this action are ITG Inc., a subsidiary of Investment Technology Group, Inc., and a registered broker-dealer, and AlterNet, also a subsidiary of ITG Group and a registered broker-dealer.

This action centers on the improper use of proprietary customer data and a failure to follow published policies and procedures. ITG has historically operated as an independent agency-only brokerage firm. The firm did not engage in proprietary trading for its account. Rather ITG focused on providing brokerage services to buy-side customers and more recently those on the sell-side. Those services also included an alternative trading system or ATS called POSIT which was a dark pool, a private execution venue for ITG customers and subscribers which represented that it maintained the confidentiality of orders. Customers included investment advisers such as asset managers, pension funds and hedge funds on the buy-side and broker-dealers on the sell-side.

In late 2009 and early 2010 ITG explored initiatives to increase diversification and revenue. Eventually the board of the parent company approved the creation of a proprietary trading desk as a trial. It was known as Project Omega and was managed by Liquidity Executive. A team was assembled that had significant experience in algorithmic trading design and writing computer code but no experience in proprietary trading. Initiation of Project Omega was kept on a need to know basis even within the firm.

When Project Omega began in early 2010 the ITG compliance department issued written policies to the Liquidity Executive detailing the operating parameters. Those included policies regarding financial risk limits and information barriers which prohibited accessing customer order and execution information. Those restricts applied to POSIT. Those limits were reiterated in a subsequent memo.

Despite the limitations imposed by compliance the Liquidity Executive was not walled off from confidential trading information. To the contrary, he did not relinquish any of his existing management responsibility regarding POSIT and ITG algorithms. He continued to have access to confidential trading information. Other team members who had been drawn from various areas of the firm were not restricted from their prior areas within the firm.

The strategies for Project Omega were directed by the Liquidity Executive, a former programmer. The two primary trading strategies were called Facilitation Strategy and Heatmap Strategy. Both focused on making small profits on the spread by purchasing and selling NMS stocks within the best bid/ask spread.

The Facilitation Strategy was designed to capture the full bid-ask spread by opening and then closing positions. It was based on a feed of information from open orders routed by sell-side subscribers to ITG’s trading algorithms. The feed included client trading information. During the period of its operation the Omega team had access to the identities of POSIT subscribers and used this information to identify sell-side subscribers to trade within POSIT. Based on a profit and loss analysis the team made decisions about whether to stop trading with a small number of subscribers and continue trading with others. Subscribers were not informed.

The Heatmap Strategy centered on trading on markets other than POSIT. It used a live feed of confidential information relating to customer executions in external dark pools other that POSIT. The system aggregated customer executions in the external dark pools and generated “probability scores” tied to the possible liquidity in the venues. The goal of this strategy was to capture half of the spread between the bid and ask.

In December 2010 senior management and compliance learned that Project Omega was improperly accessing subscriber order information. After a review the Liquidity Executive was reprimanded for violating ITG policy and placing the firm at risk. After certain changes were made to the trading strategies, the Project resumed. The Facilitation Strategy no longer had access to the live feed. The Heatmap Stragety restarted without direct access to its feed. Nevertheless, Project Omega continued to have improper access to information identifying POSIT subscribers and it coordinated with the dark pool’s development team to identify the sell-side subscribers. From about April 2010 to July 2011 Project Omega traded about 1.3 billion shares, traded 262 million shares with subscribers of POSIT and had gross revenues of just over $2 million.

The Order alleges violations of Securities Act Sections 17(a)(2) and (3) and Rules 301(b)(2) and 301(b)(1)) of Regulation ATS. To resolve the action Respondents admitted that they violated the Federal securities laws. ITG Inc. consented to the entry of a cease and desist order based on the Sections and rules cited in the order. Both ING Inc. and AlterNet consented to the entry of a censure. In addition, Respondents will pay disgorgement of $2,081,304, prejudgment interest and a penalty of $18 million.

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