SEC puts the light on dark pools

October 25, 2011, 7:35 PM UTC

FORTUNE — If you own 10 million shares of a company, it’ll be pretty obvious if you want to sell them all. For that reason mutual funds like to divvy up their trades among what are known as dark pools. Dark pools are private trading networks where big institutions buy and sell stocks anonymously. Or so they think.

Turns out that isn’t always the case. On Monday, the SEC announced a settlement with one of the major dark pools, Pipeline Trading, on charges that it failed to protect the confidentiality of its customers and also misled them about how liquid its network is. Pipeline, while “neither admitting or denying wrongdoing” as the boilerplate goes in these actions, will pay $1 million in fines and its founder and CEO Fred Federspiel and Chairman Alfred Berkeley III each will pay $100,000 in personal fines, also neither admitting or denying they screwed their customers. Market watchers may find Berkeley’s name familiar — he was president of the Nasdaq Stock Market  from 1996 to 2000 and vice chairman from 2000 to 2003. (He’s not the first former Nasdaq chairman to run into trouble. Bernie Madoff was chairman of Nasdaq before Berkeley arrived.)

Considering how Pipeline positions itself as the champion of mutual funds, this is ironic.

According to the SEC release, the head of research at Pipeline’s sister company Milstream Strategy Group had access to certain trading information that likely allowed sellers to be identified, or at least allowed them to trade on knowledge of pending customer trades. This is a big deal, for two possible reasons. One is the front-running of trades, a practice in which someone makes a trade for their own benefit ahead of a client order, knowing the client order will affect the price of the security. This has happened to mutual funds before on Wall Street and is a reason why funds use dark pools like Pipeline.

An even bigger reason is that many traders use computer algorithms to try and determine who is selling based purely on trading patterns. If you can determine what patterns means a large manager like Fidelity Investments is selling, you could both profit from the information without actually front-running and then perhaps even predict when big mutual funds will sell.

The SEC also found that a lot of the liquidity Pipeline claimed to have was actually provided by Milstream, not other mutual funds. In its defense, Pipeline said it paid Milstream incentives to provide favorable prices for its customers. Whether that’s enough to make up for the apparent deceit is beside the point — the SEC says customers should have known about that compensation arrangement.

It’s not clear what funds may have lost money with Pipeline. As recently at April, Harris Investments, which manages over $14 billion mainly for high net worth individuals, had been counted as a client and even given endorsements.

Even as dubious actions such as these are exposed, traders on the buy-side are worried that front-running may become more common due to a pending rule change on the NYSE (NYX) that means brokers would be more free to front-run their buyside clients, ultimately costing individual investors money. At a time when investor confidence needs to be reinforced, this isn’t a positive development.