New York-based LavaFlow Inc. has agreed to pay $5m to settle the SEC’s charges, including a $2.85m penalty that is the agency’s largest to date against an ATS.
An ATS is a venue that executes stock trades on behalf of broker-dealers and other traders. LavaFlow operates a type of ATS known as an electronic communications network (ECN), which unlike a dark pool displays some information about pending orders in its system, such as best bid or best offer. Under federal rules, an ATS must have safeguards to protect the confidential trading information of its subscribers.
According to the SEC’s order instituting a settled administrative proceeding, LavaFlow allowed an affiliate operating a technology application known as a smart order router to access and use confidential information related to the non-displayed orders of LavaFlow’s ECN’s subscribers. The order router was located outside of the ECN’s operations and LavaFlow did not have adequate safeguards and procedures to protect the confidential information that the order router accessed. While LavaFlow only allowed the affiliate to use the confidential trading data for order router customers who also were ECN subscribers, the firm did not obtain consent from its subscribers to use their confidential information in this way, nor did LavaFlow disclose the use in its regulatory filings with the SEC.
According to the SEC’s order, LavaFlow eventually discontinued this practice, but not before the smart order router executed more than 400 million shares in a three-year period based in part on the subscriber information contained in the ECN’s unexecuted hidden orders.
'Operators of alternative trading systems must protect confidential subscriber data and take steps to ensure that affiliates do not improperly use order information', said Andrew J. Ceresney, director of the SEC’s Enforcement Division. 'We will continue to hold accountable firms that fail to follow the rules applicable to off-exchange venues'.
Daniel M. Hawke, chief of the SEC Enforcement Division’s Market Abuse Unit, added, 'LavaFlow’s subscribers trusted and expected that knowledge of their hidden orders would not escape the ATS. Because much of today’s equity trading is automated, firms must protect sensitive information within computer networks just as aggressively as they police against the misuse of information by people'.
Alternative trading systems currently execute approximately 12% of the U.S. equity trading volume. According to Financial Industry Regulatory Authority data, LavaFlow is estimated to be a top 10 ATS when measured by share or trade volume. LavaFlow is owned by Citigroup Financial Products.
In addition to the Regulation ATS violations, the SEC’s order finds that LavaFlow aided and abetted a violation by the same affiliate that operated the smart order router, Lava Trading Inc., which continued to provide broker-dealer services for several months after it deregistered in August 2008. Lava Trading, which also was owned by Citigroup Financial Products, earned approximately $1.8m in broker-dealer business during this time period, and LavaFlow provided operational and administrative support while also responsible for a website that claimed Lava Trading was a registered broker-dealer.
The SEC’s order finds that LavaFlow violated Rule 301(b)(10) of Regulation ATS, which requires an ATS to establish safeguards and procedures for protecting confidential trading information of its subscribers. LavaFlow also violated Rule 301(b)(2) of Regulation ATS, which requires that an ATS file certain amendments on Form ATS with the SEC. LavaFlow aided and abetted and caused Lava Trading’s violation of Section 15(a) of the Securities Exchange Act of 1934, which requires broker-dealer registration. The SEC’s order, to which LavaFlow consented without admitting or denying the findings, requires the firm to pay $1.8m in disgorgement of money earned by Lava Trading while unregistered plus $350,000 in prejudgment interest and a $2.85m penalty. The order also censures LavaFlow and requires the firm to cease and desist from committing or causing these violations.