by Securities and Exchange Commission
The Securities and Exchange Commission today charged a Citigroup business unit operating an alternative trading system (ATS) with failing to protect the confidential trading data of its subscribers.
New York-based LavaFlow Inc. has agreed to pay $5 million to settle the SEC’s charges, including a $2.85 million 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. Said Andrew J. Ceresney, director of the SEC’s Enforcement Division:
Operators of alternative trading systems must protect confidential subscriber data and take steps to ensure that affiliates do not improperly use order information. 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 percent 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 $1.8 million 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 $1.8 million in disgorgement of money earned by Lava Trading while unregistered plus $350,000 in prejudgment interest and a $2.85 million penalty. The order also censures LavaFlow and requires the firm to cease and desist from committing or causing these violations.
The SEC’s investigation was conducted by Market Abuse Unit staff including Jason Breeding and Mandy Sturmfelz. The investigation was supervised by Mr. Hawke, Robert Cohen, and Diana Tani. The SEC’s National Exam Program and Division of Trading and Markets provided substantial assistance with the case.