In an industry dominated by speed, where short-term success is dependant on decisions made faster than the blink of an eye, getting traders to focus on the long-term impact of regulatory changes is like trying to get a world class sprinter to think like a marathon runner.
Sure, both pursuits involve the simple act of placing one foot in front of the other, but winning at either discipline requires completely different approaches. Day-to-day, the buyside sprinter is focused on the short-term – reacting to market signals, identifying liquidity, testing prices, and monitoring execution quality. In contrast, successful firms adapt to the ever-changing regulatory environment using a marathoner’s mindset. Marathoners study their route months in advance, know where the hills are, know where the water stops are, and plan a strategy for miles twenty-four through twenty-six as much as they do miles one through five.
More than anything else, marathoners prepare months in advance, mile after mile, to make sure that when race day comes, they already have the miles in their legs.
The Long Road Race
Preparing for regulatory changes requires the long-term planning of the distance runner. Regulators signal their intentions months or years in advance. The more complex or controversial a proposal, the longer the lead time. Last month at the Sandler O’Neil Global Exchange and Brokerage Conference, SEC Chair Mary Jo White laid out the agency’s equity market structure roadmap. She first identified three “core principles” grounding the Commission’s approach to equity market structure issues: (i) the best interest of investors and facilitation of capital formation; (ii) accounting for the varying nature of companies and products; and (iii) comprehensive testing of past assumptions. Chair White then highlighted the Commission’s initiatives to address five broad issues: market instability, high-frequency trading, fragmentation, broker conflicts, and market quality for smaller issuers.
Even with the relatively low volatility of recent memory, the wild gyrations caused by the financial crisis still loom large. Market instability is therefore still a major concern of the Commission. In the near-immediate aftermath of the financial crisis, the Commission promulgated both limit up/limit down and market access rules. Today, the focus is on what Chair White referred to as “single points of failure,” such as the securities information processors or “SIPs.” Proposed Regulation Systems Compliance and Integrity (SCI) is designed to provide the Commission with better information about disruptions, intrusions, and systems compliance issues for exchanges, clearing agencies, SIPs and certain alternative trading systems (ATSs). Initially proposed in March 2013, the staff currently is digesting numerous comments received, and a final proposal to the Commission is still months away. For the industry, the key question for the final Regulation SCI proposal is whether it is just another mandate that calls for the collection and reporting of more data, or whether it will establish more definitive protocols to address data and processing interruptions as they happen in real time?
HFT remains in the news, and therefore remains a Commission priority. While appearing to rule out any hard “speed limit,” Chair White has instructed the SEC staff to review what she calls “aggressive, destabilizing trading strategies” that could “seriously exacerbate price volatility” in “vulnerable market conditions.” This “anti-disruptive trading” rule, she says, “will need to be carefully tailored to apply to active proprietary traders in short time periods when liquidity is most vulnerable and the risk of price disruption caused by aggressive short-term trading strategies is highest.”
In a rulemaking idea aimed at proprietary traders, the SEC is considering subjecting unregistered active proprietary traders to regulation as “dealers” under the Exchange Act. Alongside this proposal, the SEC would potentially eliminate an exception from FINRA membership for certain dealers that trade in off-exchange venues. These proposals, still in the most embryonic of regulatory development, are aimed squarely at bringing within regulatory reach significant market participants who, until now, have been on the outside looking in. Buyside, meet FINRA. FINRA, meet the buyside.
In addition to these significant proposed expansions of the SEC’s regulatory reach, Chair White also identified several nuts and bolts measures, including instructing the staff to prepare recommendations related to the use of trading algorithms, and, especially, to promote rules that force firms to pay a high price for poorly designed or supervised algorithms. Also on the menu are continued efforts to address latency issues between the SIPs and proprietary data feeds. This effort would include potentially asking FINRA to include certain timestamps in the consolidated data feed indicating when displays of orders and executions are processed.
In her speech in July, White appeared to question whether “the increasingly expensive search for speed has passed the point of diminishing returns.” But rather than have the Commission set a mandatory “speed limit,” she has instead instructed the staff to consider proposals for market-based “competitive” solutions any problem that speed creates. While not quite wishing the industry back to the days of bike messengers running paper certificates from brokerage house to brokerage house, White indicated that the Commission would be evaluating market-based initiatives to “deemphasize speed as a key to trading success” that may be similar to “ones historically applied to the proprietary traders with time and place advantages on manual trading floors.”
Today’s Word Is Transparency
The watchword for the Commission’s ongoing concerns regarding fragmentation is transparency. Or, as Chair White puts it, the lack of it. “Transparency is one of the primary tools used by investors to protect their own interests, yet investors know very little about many trading venues that handle their orders.” Part of the solution to this lack of transparency, according to the Chair, includes FINRA’s dissemination of aggregate ATS trading information.
But, since ATS’ account for less than half of all unlit volume, the SEC supports FINRA’s efforts to expand this aggregate information to include all off-exchange market makers and broker-dealers. This push comes close on the heels of recent enforcement actions against dark pools run by major broker dealers where a lack of transparency, and a failure to follow their own guidelines, has opened the door for more top-down regulatory action.
As part of this overall review of market fragmentation, expect the SEC to take a hard look at Regulation NMS and the order protection and trade-through rules. Regulators also will no doubt re-examine Regulation ATS, as twenty years have passed since its first adoption.
The maker-taker model is also now front and center, with Chair White noting that there were “serious questions” about whether conflicts related to these rebates and incentives offered by exchanges to attract volume could be effectively managed. To address this conflict, the Chair has asked the staff to review Rule 606 of Regulation NMS, which requires disclosure of some order routing practices, but does not always capture large institutional orders. Chair White suggested that while some brokers already provide this wider swath of information, she would like to see this practice expanded.
Finally, in an effort to improve the quality of the equity markets for smaller companies, the SEC is pushing forward with plans to implement a pilot program that would allow wider tick sizes for the stocks of smaller companies. The SEC, on June 24th, approved an order requiring the exchanges and FINRA to submit a pilot plan by the end of August. Under the order, the pilot would last one year and would include securities with (1) market capitalization of $5 billion or less; (2) average daily volume of one million or less; and (3) a share price of $2 or more. The pilot will include a control group that will continue to trade under the current rules, and three test groups: (1) securities quoted in five cents minimum increments with trading at any currently-permitted price increment; (2) securities quoted in five cent minimum quotes with trading at five cent increments with certain exceptions; and (3) securities with quotes and trading at five cent increments, but subject to certain rules to prevent price matching by trading centers not displaying the national best bid or offer. While the SEC’s order sets out parameters, detailed implementation schemes and effective dates are still a ways away.
These regulatory initiatives are not like typical market data, able to be quickly analyzed, digested and traded on in a nanosecond. Evaluating and preparing for these changes, and changes are coming, require that firms set aside their reactive and instinctive sprinter’s mindset, and prepare for a longer, slower, and more grueling race.
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Mark D. Knoll is a partner at Bressler, Amery & Ross, P.C., a New York City law firm that specializes in financial regulations and compliance.
The views represented in this commentary are those of its author and do not reflect the opinion of Traders Magazine or its staff. Traders Magazine welcomes reader feedback on this column and on all issues relevant to the institutional trading community. Please send your comments to Traderseditorial@sourcemedia.com
