New York The US Securities and Exchange Commission is investigating Liquidnet Holdings for shortcomings in how the dark-pool owner guarded information about firms using its platform, according to a letter the company sent clients yesterday.
SEC staff has requested information about Liquidnet’s equity capital markets business, the operator of two stock trading venues said in an email obtained by Bloomberg News. Liquidnet said it corrected the issues the SEC identified and no longer provides “descriptive characteristics” about member firms to corporations using its services.
Federal regulators have stepped up scrutiny of stock trading practices that gained dominance in the past decade amid a shift to automation, Daniel Hawke, head of the market-abuse unit in the agency’s enforcement division, said in February. Dark pools, broker-operated private venues that don’t display quotes publicly, rose to prominence as a way for institutions to buy and sell without moving share prices. More than 40 such pools now exist to trade US equities.
“While the inspection revealed some shortcomings with this business, we do not believe that any member was ever disadvantaged in any trade,” according to the email from Liquidnet Chief Executive Officer Seth Merrin. “Nevertheless, we take these issues every seriously and have taken steps to address them.”
Block trades
Melissa Kanter, a Liquidnet spokeswoman, confirmed that Merrin sent the message to clients on Friday. Merrin has spoken to some of the company’s member firms and will continue to do so, Kanter said. Liquidnet, which began trading US stocks in 2001, has about 700 asset-management clients, including hedge funds and pensions, and operates in 39 countries, she said. About 400 clients are in the US.
“It doesn’t sound like a systematic abuse of trust,” Sang Lee, managing partner at research firm Aite Group LLC in Boston, said in a phone interview. “It sounds like internally they had a bad process in place. But it’s not clear if it was intentional or accidental and my guess is Seth is going to have to spend a lot of time talking to their membership, especially in light of what happened to Pipeline.”
Pipeline Financial Group settled government allegations in October that it failed to provide the liquidity and confidentiality it advertised to customers of its dark pool. The New York-based company agreed to pay $1 million (Dh3.67 million) to resolve US claims it misled clients by deploying a trading entity, Milstream Strategy Group LLC, to buy and sell shares on its venue while telling customers their orders were being matched with other clients. The firm’s founder and CEO resigned and its chairman retired the next month.
Block trades
Liquidnet traded 23 million US shares a day on average through its two dark pools in April, according to data compiled by Rosenblatt Securities. The company’s main venue had an average trade size of more than 43,000 shares, over 10 times larger than the firm in second place, Rosenblatt’s data show.
One of the key features of dark pools is that they don't identify the firms that buy and sell on their systems and give out no information about their block orders. The platforms are designed to eliminate the market impact of trading requests by keeping them out of public view until the moment a transaction is completed.
At Liquidnet, the SEC is focused on a unit started three years ago in which the company allows mutual funds and other money managers to trade blocks directly with companies that are buying back or issuing their own shares. As part of the business, Liquidnet provides data on aggregated institutional buying and selling demand for shares within the dark pool to executives such as chief financial officers and treasurers.
Not excluded
One of the issues identified by the SEC involves a feature that lets buyers and sellers have their data excluded from the service, known as InfraRed. Nineteen firms asked Liquidnet not to include their information in the offering to issuers. At four of those firms, requests from subsidiaries weren’t heeded. Liquidnet said only one firm had “significant” US volume.
“We have since opted out these affiliates and have added steps to our opt-out process to ensure that firm’s affiliates are opted out at the same time as the firm,” Liquidnet said in the email.
The other focus of the SEC inspection was a tool created by Liquidnet in February 2011 for its staff to use when communicating with companies issuing or buying their own stock. The tool displayed “aggregate and member-level liquidity and execution information,” according to Merrin’s email.
Market depth
“The ECM team used this tool to present issuers with opportunities to interact with member liquidity,” including providing data on the depth of the market and guidance on when to submit orders, Liquidnet said. “In some instances, the ECM team provided descriptive characteristics to members involved in that issuer’s stock,” it said.
Merrin told asset managers in his letter that Liquidnet has ceased giving “any type of member characteristics to issuers”.
Liquidnet filed to go public in 2008. It shelved the plan during the financial crisis following the collapse of Bear Stearns and Lehman Brothers Holdings.
“Liquidnet has to make sure their member firms are comfortable staying in the network,” Lee said. “It’s not a positive thing for Liquidnet or dark pools. There’s already a lot of public scrutiny over what’s going on in those markets.”
