This is how Pipeline Trading describes its predictive analytics for helping buyside customers identify large-block trading opportunities.

For those of you who missed the news that rocked The Street this week, Pipeline, a dark pool, was fined $1 million by the SEC for misleading clients about the nature of its liquidity.

Were you harmed? Check to see if your shares trade at Pipeli—

Oh. You can’t. It’s a dark pool. You don’t know if your shares trade there unless Pipeline’s orders route to your listing exchange.

Of Pipeline, SEC Enforcement Director Robert Khuzami said in a statement: “Investors are entitled to accurate information as to how their trades are executed.”

Pipeline offers a platform where institutional customers like mutual funds can find “natural liquidity,” or real orders from other buysiders. What’s more, Pipeline provides execution algorithms that mimic how high-frequency traders try to project price and volume in order to place profitable trades ahead of moves. If the buyside can beat HFT at its own game, then instead of being victimized, it can also generate alpha – market-beating returns on trades.

In a dark pool, you’ll recall, there are no displayed prices. You don’t walk in looking to see what lettuce sells for here. You come because you want to keep secret your interest in a truckload of lettuce. Maybe Pipeline with its predictive algorithms and natural lettuce liquidity can fill your truck at a price midway between Safeway’s and Kroger’s, whose prices will still set yours but without your walking into either store and creating a run on lettuce.

Turns out, Pipeline was filling nearly 80% of orders with its proprietary trading subsidiary, Milstream Strategy Group. Which was also using Pipeline OODA analytics to front-run orders at other markets.

Yup. That’s bad. By the way, Pipeline matches about seven million shares of about seven billion daily at present across all US equity venues. Drop in the bucket. But it earned a big fine.

Because accurate information matters.

Two takeaways for the IR chair. First, the line between what Pipeline did and what the big listing exchanges do is fine and gray, frankly.

Exchanges sell circuits and colocation services that give good customers fractionally better information, the same as predictive analytics. See our piece some weeks back about Burstream.

Further, exchanges present themselves to their public-company customers as impartial venues with displayed prices. But they pay around fifteen cents per hundred shares for DARK liquidity. Exchanges, which vilify dark pools for distorting price-discovery, incentivize dark orders with rebates and encourage it with order types.

In fact, liquidity often advertised to you as proof that your listing exchange is doing you service is paid to be there. Well, isn’t that what Pipeline was in form and function doing? Those brokers the Nasdaq lists as liquidity providers? Lots of that is incentivized order flow that earned thirty cents per hundred shares. Incentivized volume is not investment; it’s fleeting, artificial. It’s hoping to profit from the act of intermediation.

And why do exchanges pay for that? Because the act of intermediation generates data, the revenues from which are shared by exchanges under the SEC’s quote and tape plans. What drives data? High-speed trading. Who consumes data? High-speed traders. What is the majority of your volume? Do the math.

Do they tell you? You’re a customer entitled to accurate information about how your shares trade. I don’t mean to criticize our friends at the exchanges. But has the exchange ever explained to you precisely how they match trades in your shares?

Which brings us to Key IR Takeaway Number Two: If investors deserve accurate information about how trades are executed, on pain of fines, what about public companies?

In the past ten years, all the exchanges have become for-profit entities. Regulators have instituted a vast host of rules fragmenting markets and fundamentally restructuring how trades are intermediated, matched, monetized and compensated.

Do you know what changes have been made to data for public companies during that time? Exactly NONE.

This is why you know less about your trading activity than any generation of IROs. Permit me to be blunt: Regulators have not considered public companies worth the time to modernize data rules to reflect the market structure they fostered.

A year ago we thought it would take an act of Congress to redress this inequity. We now know that FINRA can fix it with a rule-filing.

All it takes is some of your CEOs asking FINRA: Why are investors entitled to accurate information, but public companies are not?

Editorial Note: Don’t miss the IR Magazine Think Tank next week in NYC.  Hope to see you there!

Sunday, Karen and I loaded the bikes and set out with good friend Jeffrey to conquer the passage between two of Colorado’s tall “fourteeners” named Princeton and Harvard. We rode from the Arkansas Valley floor at 8,000 feet up Cottonwood Pass (which sounds like “cotton whupass”) from Buena Vista to the summit at 12,126 feet and a stunning view of the fruited plain.

Choosing a route from point A to point B had me thinking about stock trades (you do this long enough, that’ll happen to you too). Stock trades must have routes. Sometimes it happens automatically. Whether orders for shares in your stock meet their matches internally at Barclays or by dint of timing, routing, pricing and chance at Susquehanna’s dark pool, RiverCross, often is a matter of routing. Even online brokers afford ways to route trades now.

Most IR folks don’t think about routing. People buy and sell, and that’s that, we suppose. Alas, no. Routing plays a big role in the behavior of your volume. Think about driving across town in a large city. You might take the freeway or you could wander the surface streets. One may get you from point to point faster even if it’s farther, while with the other you’ll see more and maybe check off errands but hit lights.

The same applies to trades. Brokers must report how they route orders (called Rule 606). Routing decisions can change the entire nature of the volume, too. Sometimes it’s how arbitrage occurs – sending orders out on the freeway and on surface streets simultaneously to see how they impact other traffic patterns.

Orders have value too. It’s not just the buying and selling, but the act of buying and selling. Liquidity as commodity is valuable to others. Exchanges pay for it, offering the best incentives to brokers bringing them the most liquidity. Payments are called “rebates.” You can also pay more to get your orders first in line, just like at Disneyland paying extra for a FastPass slots you ahead of the line. Those are routing decisions.

Broker dealers pay for volume too, called Payment for Order Flow. If they aggregate enough volume and send it out to exchanges as what are called “non-marketable orders,” or orders outside prevailing best prices, then that liquidity can earn big payments from exchanges. The exchanges collectively pay about half their gross annual revenues in these “maker” rebates. It’s about routing.

So it’s not just that institutions buy and sell stocks. In today’s markets, decisions about how orders are routed can become investment schemes themselves. Algorithms may route loose, non-marketable volume around throughout the day just to see what it generates in rebates and payment for order flow.

If a trade routes to a broker, who matches the trade internally inside the best prevailing bid or offer, and then that volume starts routing about to generate the sellside firm returns on liquidity, and your price moves as a result, is that rational activity?

No. Rational thought did not change the price; trading activity did. And that’s why Rational Price, our measure of thoughtful investment pricing, is an important distinction from the noise of the market.

I’m moderating the discussion. The all-star panel includes Nicole Olson of storied dark pool Liquidnet; Adam Sussman of expert market-structure research firm TABB Group; and Joe Saluzzi at Themis Trading, one of today’s leading voices on the nature of trading markets. You know him from Bloomberg, 60 Minutes and CNBC.

Two weeks ago at the NIRI finale for the season here in Denver, we were indulging in the benefits of having brewery Molson Coors in the chapter. And someone was talking to me about “black pools.”

I thought, “IR folks don’t get dark pools yet.”

This afternoon an IR pro in California emailed, asking how to figure out what percentage of their shares trade in dark pools. You can’t know, exactly.

Aside: That’s reason #4,032 why you should support the Issuer Data Initiative. If 35,484 of your shares traded at Liquidnet, and 5,203 at Lavaflow today, don’t you think you’re entitled to know? You are. But rules on trades and data for public companies divided in some faded and yellowed wood, and public companies are most definitely on the road less traveled.

Which brings us back to dark pools. The term “dark pool” to me is like trying to describe a process as if it were a place. There are facilities like Liquidnet and Pipeline that specialize in matching trades without displaying prices. But we’re talking about behavior – trading at a posted price, or looking for bargains where prices aren’t shown.

Think about it. This is as old as the hills, old as human nature. You could go to the bazaar where lots of hawkers of wares would list their prices for things. You could do this in ancient Samaria or right now at Walmart.

Or you could instead negotiate with someone in private in hopes of a deal that would keep secret how much or little of the product you wanted. And you might say, “I can get it for two bucks at the market.”

The rules for trading – except for the 14-15 major exceptions and exemptions – require exchanges to display the best prices at which parties are willing to buy or sell shares. Regulations also require the many marketplaces where stocks trade to be connected so everybody always knows the best national deal. Trade there, or pass it on.

What happens when human beings are forced to behave in a prescribed manner? Right, exactly. Humans start looking for ways around it. Dark pools.

Now, dark pools can’t be outside the best bid or offer. But they can be inside it. It’s no different than saying, “I can get it for two bucks at the bazaar,” except that everybody from CFOs to retail investors thinks that the displayed stock prices are best.

But price is only one reason deals meet behind closed doors. Often it’s to keep size secret. What would happen to price if you had to tell the whole world, by rule, that you wanted ten million shares at close of business today?

Now add in one more feature. Since all these markets are required to be connected, and in fact many of the dark pools are linked too, there’s an Ethernet boulevard running through them. Fast machines can race back and forth.

Do you think there’s a wee chance that traders might, oh, display one price out there and a different one in the dark?

That would be human nature. That would also be arbitrage if matched simultaneously.

Regulators seem okay with this dichotomy. When all the different motivations and drives and purposes of many, many disparate beings running myriad mathematical calculations behind trades are forced into deciding between the displayed best price and the unknown un-displayed market lurking darkly in a pool right there beneath that 100-share surface, you are as much as flashing a neon sign that says “please arbitrage at will.”

As a result, we have remarkable machine synchronicity juxtaposed with utter value confusion. Are displayed prices better? Or are investors being gamed by arbitragers in dark pools? The truth is, nobody knows.

When rules attempt to force human beings to do things that they are naturally indisposed to do, the better idea is to get rid of those rules. Why can’t humans decide for themselves what constitutes a good deal, be it price, size, speed or slow but grand service?

Or we can beat every trade into the brick wall, which means a lot more futility from the IR chair, talking and talking to investors about your great business without changing the way your price behaves.

The NBBO stems from legislation passed in 1975 by Congress to create a national market system. If you’re already snoozing, you’ll miss the good stuff. You cannot make up stories like this.

Back in the 1900s, several cases involving the NYSE and other exchanges and their proprietary data reached the Supreme Court. In each, the Court held that exchanges possessed an undeniable right to their proprietary quotations.

In other words, where we take for granted now that quotes for stocks are as basic a right as breathing, it used to be that keeping those quotes secret was as basic a right as breathing. (Since our markets flourished then and gasp now, we’d be idiots not to wonder which approach was correct.)

When the SEC asked for comments on new rules to establish a national market system and a true, national best price for stocks, it was unsure of its legal standing to do so. In an SEC press release from 2000 is this, from what humorist Dave Barry would call the “I Swear I’m Not Making This Up” category:

“We believe it is questionable whether the SEC has proceeded properly in proposing these Rules and we have attached, as Appendix A, a legal opinion which discusses this matter. It is long-standing and clearly established legally that the Exchange has a proprietary right in its transaction data and quotation information.”

Jump forward to today. All market centers in the National Market System are required by rule to display what used to be their proprietary property: their prices. (If you tack onto this the legal implication now that using valuable information may be criminal, it’s a wonder our markets consist of more than two parties anymore.)

This dubious path culminates in the following excerpt from a ruling filing with the SEC on May 6, 2011, from the Nasdaq. Be warned: Reading it without first consulting a physician may be hazardous to your health:

“In order to provide enhanced functionality, NASDAQ proposes to adopt an additional order type known as the Midpoint Peg Post-Only Order. Like a regular Midpoint Peg Order, a Midpoint Peg Post-Only Order is a non-displayed order that is priced at the midpoint between the national best bid and best offer (“NBBO”) (as determined using the consolidated tape). However, like a Post-Only Order, the Midpoint Peg Post-Only Order does not remove liquidity from the System upon entry if it would lock a non-displayed order…”

This goes on for pages! If you want to know more, Google “post only orders.” It’s a reaction from exchanges to the movement of trading off displayed markets. And what is the SEC response? To allow exchanges to hide orders too, and to price that non-displayed liquidity at points other than the NBBO.

You must think we’re daft. Hey, we’re just relaying the facts. Grasp one thing, IR pros, about how this stuff affects trading in your stock. All through the markets, in dark pools, on trading systems, at exchanges, there is a mad, desperate effort to avoid the NBBO. Which the investing public thinks is the best price.

Decades of rule-making and legislation and scores of billions of dollars from exchanges and brokers and traders have gone into this National Market System that is, it would appear, a colossal failure. The NBBO doesn’t work. Forcing price controls and behaviors on sentient beings fosters black markets. Elementary, Watson.

How do we undo this mess? Do what Stephen King told would-be writers – kill your babies. No matter how much you love something, if it doesn’t advance the story, slash it.

What if we just…scrapped the NBBO? If the CEO of every public company wrote to congresspersons a letter that said: “Dear Sir or Madam. Please ixnay the NBBO. Thank You. The CEO,” it would happen.

Or we can live with the stock prices you see every day moving all over the place that result from a maze of stultified rules so complex that only the most advanced machines can matriculate them. Barely. Thus all the trading halts, now averaging over 100 per day.

Choices, choices.

Actually, OTC stands for “over the counter.” It describes brokers doing business directly with each other, and it’s a big reason why NYSE Euronext and the Deutsche Bourse (everybody spells it differently) are merging.

Our friend David Weild, former vice-chair at the Nasdaq and current market-structure expert at Grant Thornton said of the impending deal: “Scale, scale, scale.” Duncan Niederauer, expected to lead the combined entity, said today: “This is an industry that lends itself to scale.” It seems that what began here in 1792 under the Buttonwood Tree at the foot of Wall Street is at an end of sorts. Why?

Businesses need scale when markets are commoditized and currencies debased. But beyond that, it’s the result of monumental revitalization of the over-the-counter market. Big brokers are trading with each other, avoiding exchanges. And because they are experts at managing risk, institutions choose them not just for execution but as counterparties for transferring risk from asset class to asset class. This is fast becoming the main reason that natural liquidity – trading lingua franca for shares not driven by high-speed intermediaries – moves around.

Did any of you see Investment Technology Group’s 10-million-share block trade last month? ITG POSIT is one of the earliest and largest “dark pools” for matching up institutional buyers and sellers outside the noise of the market. It combines trade-execution with analytics to offer the buyside efficiencies. Yet ITG’s revenue, trading volumes, and profit are down versus 2009 because, according to ITG’s earnings release out Feb 3, 2011, “continued low levels of trading activity by domestic long-only institutional investors negatively impacted our client mix.”

ITG competes with both exchanges and big broker-dealers like Goldman Sachs and Morgan Stanley. So if ITG sees flat long-only institutional demand, and big exchanges are merging – the London Stock Exchange is also marrying the operator of the Toronto Stock Exchange – what’s going on?

Answer: big brokers are controlling the supply of securities liquidity. Here’s the irony. Regulators decided back in the 1990s that intermediaries – the network of broker-dealers comprising the National Association of Securities Dealers – were making too much money. Stock trades were decimalized. The Global Settlement of 2003 between Elliot Spitzer and major bulge-bracket firms effectively ended capital-formation predicated on valuable research. The aim: To “level the playing field.”

The result? The exact opposite. Instead of shrinking the power of intermediaries, these same brokers are now threatening the whole exchange construct.

Want more irony? Gigantic broker-dealers would have gone largely extinct in 2008. But governments, now desperately dependent on the very same brokers to make markets in government securities comprised of wasting fiat currencies, gave them free access to public purses and treasuries.

No surprise, they feasted. Thus, with the phrase “too big to fail,” government set in motion what now may transform the seminal emblem of American capitalism. There is a tangled web strangling the Buttonwood Tree.

I’m glad when winter solstice passes, that shortest and gloomiest of days. After that, we’ve rounded the corner from darkness toward light no matter what winter yet holds.

But in trading markets, darkness thrives. Monday in the Wall Street Journal, Jacob Bunge, who covers the exchanges, wrote that 34% of trades in December matched up off the exchanges in “dark pools,” doubling from last year. Why is money streaming off exchanges in search of darkness, and does it mean your shares aren’t priced right?

Let’s clarify “dark pools.” There are trading facilities like Liquidnet, Pipeline, ITG Posit and Aqua that offer twists on paths to more share-supply. They’re like the Millionaire Matchmakers of trading, finding liquidity love for willing parties. But these independent platforms and their broker-dealer counterparts at Credit Suisse (Crossfinder), Goldman Sachs (Sigma X) and Barclays (LX) command about 12% share.

Where’s the rest? Let’s use an analogy. In the BCS championship bowl game between Oregon and Auburn next week, the stadium will fill up with fans. That’s like an exchange, or any place including dark pools where people gather for a purpose.

The other 22% of your trades are occurring in undefined places. It’s more like online gaming, where the game flows to players who gather no particular place. The trades meet and the meeting is logged on the tape and rolled into your daily volume.

Like this: A Merrill/BofA algorithm handling a rebalance for a mutual fund flings bits across thousands of other interwoven algorithms, and a tiny dab finds the other side of a trade on Sungard’s Assent linkage platform that’s shuttling back from a rebate trade at Lavaflow. They meet, kiss, and print to the tape.

Multiply that by millions. That’s trading today. It’s a vast archipelago of mostly meaningless interactions.

In November, our clients averaged 2.1 “rational” prices. In other words, just over twice in the entire month for a given company did mathematics reveal behavior reflective of thoughtful stock-picking. The other eighteen days, price was set by other behaviors.

In December, the number of rational prices dropped 40% to 1.3 on average. Nearly 20% of clients had no new rational price at all, and 75% had none or one.

Disenchanting? No, it’s logical. Rational thought isn’t boomeranging about every few seconds. But most behaviors are programmed to respond rather than viscerally drawn.

Back at the exchanges, everything is defined and controlled by rules. While the same rules apply to dark pools including trading at the best bid or offer, at the exchanges you’re banging and jostling with everyone. You can’t fall in love with a stock here. You can get in line and try to keep up.

That’s why money loves darkness. It’s quiet in the shadows. For the players looking to score, there’s arbitrage between light and dark markets.

Bottom line, dark pools aren’t hurting your share price, structure is. Worst for issuers, the data from this loopy structure are fragmented into a million little pieces.

The answer isn’t to force behavior back to the place it’s fleeing, but to change what’s causing it to flee in the first place. Price should be set by who values something most. Not simply by being the other side of a trade, and fastest to get there.

For any who say “but we need the volume,” I refer you to our rational-price statistics and the Flash Crash: Value and volume are not interdependent.

We can change this structure. If a thousand public companies banded together and demanded that the SEC change the structure, change would occur. If not, then we have much bigger problems than machined shares.

The NYSE and Charles Schumer were talking today about rules for dark pools. The NYSE is partnered with dark-pool operator Liquidnet and is building a massive high-speed trading facility in New Jersey. The Nasdaq meanwhile plans to launch an exchange next year that will give priority to orders of size, to compete with the size advantage dark-pool operators offer.

What’s going on here? Politics, mostly. We’ve said plenty about this stuff. But the regulators – and IR folks too we fear – continue to misunderstand the central issue. The IR profession is about supporting capital formation and fostering productive, creative enterprises. At the rate we’re going, none of us will have jobs. If trading things is an end unto itself, why bother with all that work to start and run companies? Take your idea to a broker, have them issue an exchanged traded note representing your idea, hire an accounting firm to handle regulatory and financial reporting, and that’s all you need. Traders, have fun!

We’re being obtuse. But dark pools are like black markets. Black markets form in response to price controls. We can go back to the order-handling rule in 1996 in which the SEC set out to “create better pricing opportunity.”

Come forward to Reg NMS. It was a legitimate effort to minimize market arbitrage, but it in effect is a gigantic price control. It says that all trades (there are exceptions but stay with us here) must execute at the best national bid or offer. That’s like pouring Niagara Falls through a funnel. You have literally millions of different prices trying to match up for securities, but trades can only execute, simplistically, at that one best price. That supposes that all buyers and sellers have only one thing in mind: price. If that were the case with cars, we’d all drive Tata Nanos.

Dark pools formed to serve audiences that wanted something more than the best price at this split second in time without regard to supply. Who uses them? Mostly big institutions wanting to move sizeable amounts of shares without interference by parties with other objectives such as speculation, rebate-capture, high-frequency trading and risk-management.

What’s the response from regulators? To clamp down on dark pools.

We’re oversimplifying. And we have good friends running high-frequency trading platforms. We mean no offense to anyone. But the problem in our equity markets is that they’re efficient for parties that want the best price and which don’t want to commit capital and own things.

But they’re very inefficient for capital formation. In 1996, 675 companies IPO’d in US markets with prices over $5. In 2008, 21 such companies debuted here. Money has shifted to private equity by the trillions, and to international markets with fewer price controls.

This had better matter to us more than anyone else. This is our profession. Let’s defend it, rather than slice our collective noses off to spite our faces.