If the Securities and Exchange Commission expected a year of thoughtful reflection pondering market structure, it got a rude awakening on May 6.
The industry’s top regulator began the year publishing a Concept Release covering what it believed to be the major issues facing the markets and packed with hundreds of questions. The idea was to start a dialogue with industry participants and the public that might lead to changes in the way the market operated. Best execution, dark pools and high-frequency trading were all on the list.
An intellectual idyll was not in the cards, though. On May 6, the S&P 500 dropped by 5 percent in four minutes, before rebounding just as quickly, prompting agonized screams for the SEC to do something. The regulator spent the next five months analyzing the "flash crash," pushing any other market structure concerns to the side.
The regulator quickly went into attack mode. It prodded the nation’s exchanges to adopt single-stock circuit breakers that would complement existing marketwide circuit breakers. Any stock that rose or fell 10 percent or more in a five-minute period would be halted for five minutes. That would give the market time to catch its breath, the SEC believed.
Meanwhile, it spent the ensuing months analyzing reams of data, interviewing hundreds of people and holding joint meetings with the Commodities Futures Trading Commission to try and get at the cause of the market’s flip-flop.
In early October, it laid the blame on a $4 billion futures trade and began pondering its next move. It has charged the exchanges to come up with a plan to improve on the circuit breakers, which have been criticized for going off too regularly. The exchanges are now working on a plan to import the limit up-limit down functionality in use by the Chicago Mercantile Exchange.
With the flash crash issue largely under control, many in the industry hoped the SEC would be able to get back on the market structure track. Besides the Concept Release, the commission has several rule proposals outstanding, including those covering dark pools, high-frequency traders, flash orders and a much touted consolidated audit trail.
In November, the SEC did put to bed two outstanding issues: "naked" access and stub quotes. In a unanimous ruling, the commission voted to forbid brokers from sending orders to the markets without first risk-checking them. The commission was concerned that too much flow was being pushed through brokers "naked," or without the appropriate vetting for such details as size of trades and ability to settle.
Stub quotes are market maker quotes that don’t come close to the prevailing market price. Stub bids may be a penny and stub offers may be in the thousands of dollars. They are used by dealers to fulfill their obligations to quote when they don’t particularly want to.
Because on May 6 many trades were executed against these placeholders, investors got bad fills and the SEC ordered the exchanges to close the loophole. The exchanges proposed that dealers keep their quotes within 8 percent of the NBBO and the SEC approved the measure.
Still, how quickly the SEC will be able to resume its "normal" agenda remains to be seen. It is faced with rule-making deadlines associated with the Dodd-Frank financial reform bill that many expect will sideline the SEC’s market structure deliberation once again. For their part, SEC officials have made conflicting statements about their capacity to dive back into the thorny subject.
If there is a delay, it will disappoint all concerned: exchanges, brokers and money managers. Exchanges are waiting for rule-making on the both the dark pool and flash-trading fronts. Some brokers are also clamoring for the SEC to tackle issues of fragmentation and transparency in the dark pool space. Almost everyone in the industry wants to see the regulator get a handle on the HFT phenomenon.
Anyone trying to divine the future of SEC rule-making probably need not look much further than Nov. 2. The Republican rout in Congress is expected to make the rule-making body less confrontational toward Wall Street. Republican leaders have publicly stated they would adopt a more conciliatory tone–in direct contrast to the past two years, when Democrats held the House of Representatives.
More specifically, the whispers from Washington hold that Spencer Bachus, R-Ala., or Jeb Hensarling, R-Texas, will assume control of the powerful House Financial Services Committee. Bachus is a ranking member of the committee. Hensarling is a ranking member of the subcommittee on financial institutions.
Based on a long letter the two sent to SEC chairman Mary Schapiro this summer questioning much of the regulator’s market structure agenda, their leadership could result in a less active SEC. Bachus and Hensarling questioned the need to ban flash orders, regulate high-frequency traders, impose obligations on market makers and require a large trader reporting system.
The two also wondered how frequently SEC staffers got out of their offices and visited exchange executives and traders. "Rather than prohibiting practices that have a positive market function, it is our hope that the SEC will seek to better understand the market and become a more sophisticated and thoughtful regulator," the two wrote.
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