SEC May Extend Planned Rule to Brokers

(Bloomberg) — The U.S. Securities and Exchange Commission may include large brokers and dark pools in a planned rule aimed at ensuring that regulated securities markets have adequate technology systems, an SEC official said.

The SEC is working to turn policies on how exchanges manage their automated systems into regulations in the wake of a $440 million Knight Capital Group Inc. trading loss triggered by a software malfunction last month.

The commission’s so-called automation review policy program was established after the 1987 market crash to ensure exchanges and clearing agencies have the capacity to handle sudden surges in trading. The initiative evolved to encompass the security of automated systems and make sure the technology wouldn’t fail during or after a crisis, according to David Shillman, associate director in the SEC’s division of trading and markets.

The aim now is “to codify that, to make the standards clearer, perhaps expand them a bit,” Shillman said yesterday at a Futures Industry Association conference in New York. Minimum standards for automated systems, which currently cover exchanges and clearinghouses, “could be applied to other market participants” including brokers and dark pools, he said.

SEC Chairman Mary Schapiro said on Aug. 3, two days after the Knight error, that she had asked her staff to hasten work on the rule. Knight’s loss, which drove the company to the brink of bankruptcy before it shored up its finances by selling shares to a consortium of investors, was the latest damage to confidence in a market infrastructure following the botched initial public offerings of Facebook Inc. and Bats Global Markets Inc. this year.

SEC Roundtable

Shillman said he expects the automation review policy, or ARP, program to be discussed during a roundtable meeting about technology the SEC is holding in Washington on Oct. 2. That dialogue will focus on the “ways in which technology can be used to prevent errors” and address mistakes when they occur, he said.

Schapiro said in a March 2011 speech that compliance with the ARP program should be made mandatory. The Government Accountability Office urged that action in 2004, she said.
While the SEC’s focus in the ARP program has been on trading systems, that’s likely to broaden following the recent technology mishaps, Shillman said.

‘Enforceable Rule’

“We recognize that other technologies are important to the markets as well, including market data provision, routing services, issuer services and the like,” Shillman said. “The main goal of the initiative is to see whether objective industry-wide standards can be devised that are appropriate for the securities industry and to have an enforceable rule to buttress that,” he said.

The SEC’s project to update the ARP guidelines is one of several initiatives to improve the securities industry’s ability to manage automated trading. The agency is now conducting reviews stemming from its so-called market-access rule, adopted in 2010 to reduce the risk of trading disruptions and improper and manipulative activity, Shillman said. The rule, which went into effect last year, requires brokers to employ risk checks on orders before they’re sent to markets to make sure they aren’t erroneous and don’t exceed preset capital and credit levels.

The commission is “getting a sense of best practices and looking for weaknesses in the controls as well as looking for potential violations of the rule,” Shillman said. He declined to comment on Knight’s trading activity on Aug. 1, saying that regulators are “still looking into the Knight incident.”

Improper Reporting

The Financial Industry Regulatory Authority, which oversees about 4,400 brokers, has uncovered problems through its reviews of brokers’ trading practices following the implementation of the market-access rule, according to Gene DeMaio, senior vice president for market regulation at Finra.

Finra has seen a “real uptick” in brokers improperly reporting the positions of so-called large traders in options, DeMaio said at the futures conference yesterday. This is part of a “whole host of misreporting issues,” he said.
The regulator is conducting reviews to

look for instances where orders are coded as coming from customers even when they’re from a broker-dealer, he said. The codes affect how the orders are executed by options exchanges and the trading fees they’re charged.

Potentially manipulative activity is another area receiving greater scrutiny after an increase in complaints, DeMaio said. These may involve efforts to move the price of a stock to affect an options position and attempts to manipulate the volatility of an options contract, he said. He added that these are “hard cases to prove.”