Matt Levine comments:  Coincidence or not, ever since “Flash Boys” came out four months ago, alleging that U.S. equity markets are rigged by high-frequency traders and crooked dark-pool operators, there’s been a whole lot of regulatory attention paid to high-frequency traders and crooked dark-pool operators in U.S. equity markets.¹ New York Attorney General Eric Schneiderman has been on quite a tear.  The Securities and Exchange Commission has upped its game, fining Liquidnet for using dark-pool customer data to pitch issuer business. Even Finra has gotten involved.

The SEC settled for 5 million dollars with LavaFlow Inc., a big stock trading venue owned by Citigroup. LavaFlow is not a dark pool; it’s an electronic communications network (ECN) that displays orders. (Basically: It’s a stock exchange within Citigroup.) But it allows subscribers to submit various sorts of non-displayed orders,²which are, you know, not supposed to be displayed. And the problem was with those non-displayed orders.

LavaFlow had an affiliate called Lava Trading,³ whose main business was running a smart order router called ColorBook. An excerpt from the LavaFlow order::

Lava Trading’s flagship product was ColorBook, which was software that provided smart order routing services to over 100 registered broker-dealers that principally used ColorBook to route their customers’ orders to execution venues. … An “order router” is an application that generally allows an end user to submit an order to an execution venue. A “smart order router” applies preprogrammed analytics that carry out an execution strategy for order flow provided to the smart order router.

The point here is that, if you just want to buy some stock, that’s a weirdly hard thing to do. You can’t just go to the New York Stock Exchange and say “buy 100 shares of IBM,” because IBM shares are traded on a bunch of different exchanges and ECNs and dark pools, and you want to buy them at the lowest price offered on any of those venues. Or maybe you don’t — maybe you prefer convenience to getting the lowest price.

A human trader at a big bank, Brad Katsuyama, had trouble buying shares because he was a human, and the price kept moving. So he built a smart order router (and named it “Thor”). Smart order routers are (1) computers, so they’re fast, and (2) smart, so they break up your order and send it to the places where it’s most likely to execute quickly at the best possible price.⁵ Some brokers have their own order routers; others will rent someone else’s, because building one is hard. ColorBook is an order router that Citi uses, and that other brokers can rent.

One thing that made ColorBook smart was that it remembered where it sent orders. So not only could it see all the displayed orders on all the displayed exchanges and ECNs, but it also could see all theundisplayed orders — dark pool orders, or hidden orders sent to exchanges or ECNs — that it had sent there. So if you came to ColorBook asking to buy 100 shares of IBM, and the best offer for IBM displayed anywhere was $195, but ColorBook remembered sending an undisplayed order to LavaFlow to sell at $194.95, then ColorBook would route your buy order to LavaFlow to get the better price. As the SEC puts it, “ColorBook considered its historical knowledge of non-displayed resting orders to make future routing decisions.”⁶

If you used ColorBook, that was part of the deal: It would remember your secret orders and use them to route its future orders, though it wouldn’t tell anyone about them.

But as it turns out, if you just used the LavaFlow ECN without using ColorBook — as a “direct subscriber” — then ColorBook remembered and made use of your orders anyway:

From March 2008 until March 2011, LavaFlow allowed ColorBook to access and use its knowledge of the LavaFlow ECN direct subscriber non-displayed order flow when making smart order routing decisions for those smart order routing customers who also were subscribers of the LavaFlow ECN.

What ColorBook did with the hidden orders is route its customers to those hidden orders. What it didn’t do was tell them about the hidden orders.⁸ So the ColorBook customers couldn’t use the hidden orders to make pricing decisions, or to decide whether or not to trade, or to “front-run” the hidden orders. All they could do was trade with the hidden orders: Once they submitted an order to buy X shares at Y price, ColorBook would send it toward the hidden orders. That’s exactly what you want when you submit a hidden order! That’s not bad! If you’re a LavaFlow direct subscriber, you might be annoyed that ColorBook used your data without telling you, but I don’t think you were harmed by it. You might even have been helped: Your orders were more likely to execute, and more quickly.⁹

The victims were the LavaFlow direct subscribers, who did not use ColorBook, and who left hidden orders on LavaFlow. Who subscribes directly to Citi’s ECN, without using Citi’s order router? I think the answer is basically:

• other big broker-dealers (and their routers), who feel obligated to connect everywhere, and who do their own routing, and
• high-frequency traders, who want to trade everywhere, and who also do their own routing.

Other banks and brokers probably subscribe to LavaFlow, but it seems unlikely that they’d leave a lot of hidden orders there. (Why leave orders with your competitor?¹⁰ ) The LavaFlow direct subscribers who were actually leaving hidden orders there were … probably mostly high-frequency traders?

So this case looks a lot like: Citi took information from high-frequency traders and used it to improve the outcomes of regular customers.