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June 1, 2011

New Checks Unlikely to Satisfy SEC

By Peter Chapman

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Whether or not a single large order caused the "flash crash" in May 2010, as the Securities and Exchange Commission has alleged, brokers are under pressure to make sure they don't toss any oversize or out-of-control orders into the market.

Neal Goldstein, Nomura

A recent report produced by a joint advisory committee of the SEC and the Commodity Futures Trading Commission urged the SEC to work with the Financial Industry Regulatory Authority and the exchanges "to develop effective testing of sponsoring broker-dealer risk management controls and supervisory procedures."

The concern from Washington prompted a group of 12 brokerages to collaborate on a set of risk guidelines intended for adoption across the industry. Working under the aegis of FIX Protocol Limited, the group recently published a checklist of 13 risk controls it hopes will deter the acceptance of orders that might disrupt the marketplace.

FIX Protocol is a pan-industry group that promotes and supports electronic trading through the ubiquitous FIX communications standard. The guidelines devised by the members of the FPL Risk Management Working Group focus strictly on algorithmic and direct-market-access orders for cash equities. The members include the nine largest trading firms, which account for the vast majority of industry orders.

See Chart: FPL Risk Guidelines

The hope of those involved in the FPL initiative is that the guidelines will represent the gold standard of order handling. Those broker-dealers that adhere to them would be deemed best in class, and would, presumably, stand out in the eyes of the buyside.

Pressure from the money managers would eventually force all brokers to adopt the guidelines, which would reduce the likelihood of disruptive orders making their way into the markets. Such an industry-based solution would, in turn, make the SEC happy, and perhaps forestall any new rules the regulator was considering.

That may be wishful thinking. Although there is a good chance the guidelines will be accepted by brokers-they already have similar checks in place-the SEC may want even more. Some sources say the guidelines lack teeth and are unlikely to dissuade the SEC from taking action.

Sources tell Traders Magazine that some committee members wanted the brokers to incorporate hard numbers into the guidelines. One possibility was automatically rejecting orders with a notional value of at least $500 million. Another was to reject any single order equal to 10 percent of the security's average daily volume. This idea of hard numbers, however, didn't fly with others, who protested that it would reduce their flexibility.

"Unfortunately, there was almost universal push-back on that," one committee member said. "They said, 'We need the freedom to up those numbers when it makes sense.' Because of the push-back, this has become just a rough framework. I don't think the SEC will accept this."