SEC Enforcement - $12 million against Citi dark pool

SEC Actions: In September 2018, the SEC found that:

Citigroup violated an antifraud provision of the federal securities laws and that Citi Order Routing and Execution (“CORE”) failed to register as an exchange.  Without admitting or denying the findings, Citigroup and CORE have agreed to be censured.  Citigroup will pay disgorgement and prejudgment interest totaling $5,437,475 and a penalty of $6.5 million.  CORE will pay a penalty of $1 million.[1] The order found, among other things, that Citigroup misled users with assurances that high-frequency traders were not allowed to trade in Citi Match, a premium-priced dark pool operated by CORE, when two of Citi Match’s most active users reasonably qualified as high-frequency traders. The order also found that Citigroup failed to disclose that over a period of more than two years, close to half of Citi Match orders were routed to and executed in other trading venues that did not offer the same premium features as Citi Match.

Credit Suisse Securities (“CSS”) made misrepresentations and omissions in connection with its now-closed Retail Execution Services (“RES”) business’ handling of certain customer orders.  The settlements require Credit Suisse to pay $5 million to the SEC and $5 million to the NYAG for a total of $10 million.  CSS created the RES desk to execute orders for other broker-dealers that handle order flow on behalf of retail investors.  The SEC found that although RES promoted its access to dark pool liquidity to customers, the firm executed an exceedingly minimal number of held orders (orders that must be executed immediately at the current market price), in dark pools in 2011 and 2012. The order also found that CSS touted “robust” and “enhanced” price improvement on orders. However, RES’s computer code treated orders for which execution quality is required to be publicly reported differently from orders for which execution quality is not publicly reported.  The SEC found that retail customers did not receive any price improvement from RES on their non-reportable orders.  RES’ non-reportable orders disproportionately used a routing tactic that generally caused market impact and resulted in less favorable execution prices for customers, despite claiming to benefit RES’s customers.  The use of this routing tactic provided RES an opportunity to profit from its execution of the final portions of those customer orders internally.

Best Execution: Typically, best execution does not require an investment adviser to obtain the absolute lowest price for their clients, but it does require that advisers seek the most favorable terms reasonably available under the circumstances.

According to the SEC, an adviser with the responsibility to direct client trades has an obligation to seek best execution.  For a broker dealer, best execution typically focuses on the price at which an order is executed.  An adviser’s standard of care is much broader, as advisers’ fiduciary obligation has a much higher level of accountability.  An adviser must evaluate the capabilities and quality of a broker’s services, including transaction costs, execution capabilities, value of research and the firm’s financial solvency.[2]

The SEC has also stated that, “when a service provider is utilized, the adviser still retains its fiduciary responsibilities for the delegated services. As a result, advisers should review each service provider’s overall compliance program for compliance with the federal securities laws and should ensure that service providers are complying with the firm’s specific policies and procedures. [3]

The oversight of broker dealers and best execution is not always a simple task. Particularly when advisers may choose from multiple execution venues. When a trading venue, such as a dark pool, violates the participants trust by routing orders to other trading venues or allowing certain “prohibited” participants such as high–frequency traders to use the service, it puts the user in an awkward situation. How can the adviser be confident that their order is handled appropriately and in its client’s best interest?  For a process built, in part, on trust, the adviser as a fiduciary to its clients, should closely evaluate the services and the execution that a trading venue is marketing when it has been disciplined by the SEC for trading related violations.

Competition can encourage innovation, improvements, and ultimately better solutions.  However, competition can also lead to corners being cut.  Reg ATS, which spawned the dubious term “dark pools,” opened the door for competition in the secondary market execution business, mostly in equities.  Dark Pools have developed a bit of a reputation as a place where unsuspecting novices get fleeced and some dark pools achieve this by cutting regulatory corners.  This does not mean all dark pools are cutting corners.  The Alternative Trading Systems (“ATS”) that have survived over time have done so largely because they offer a product that provides value to multiple types of users.  In most cases, the value is minimizing information leakage.  Ironically, information leakage and asymmetry is how the more odious dark pools make their money.

How is one to determine if using an ATS helps or hinders their cause in achieving Best Execution?  There is no litmus test.  There are some red flags, though.

• Speed Kills: If the dark pool is selling speed, there are most likely participants that have invested much more in speed and are thus faster. If you are at a poker game and you are not sure who the mark is within five minutes, it is probably you.
• Control: hope is not a strategy. Being asked to place your order in the dark pool and wait for another order to pair yours off tends to be no better than executing on the “lit" market.
• Revenue: if a dark pool relies on outbound messages or a “maker/taker” model, then there is a good chance the rebate you receive may not be not worth the lower quality execution.
• Sniff test: if you notice that placing an order on a dark pool coincides with a market move against your order, you may not just be paranoid.

ATSs have their place and if they facilitate liquidity without impacting price, then the argument can be made that they satisfy Best Execution.