Recent high-profile market disruptions-from the May 2010 flash crash to this summer’s three-hour disruption in Nasdaq trading-have demonstrated structural weakness that is an unfortunate byproduct of the financial markets’ rapid automation and the rise of alternative trading systems, dark pools and other off-exchange venues. While these disruptions are often popularly blamed on high-speed traders, U.S. regulators have recognized that the causes are far too complex to be attributed to any single group. Consequently, U.S. regulators, in contrast to their European colleagues, appear to be on the verge of implementing systemwide, principle-based rules that will ultimately impact the vast majority of market participants.
Whether it is the concern that “machines are taking over” or a worry about fundamental analysis no longer mattering, high-frequency trading has been the subject of intense public criticism over the last few years. In addition to blaming high-frequency traders for almost every market disruption, critics have suggested that HFT distorts the markets, creates “false” liquidity and fosters a multitiered marketplace with massive discrepancies in the speed of information dissemination and trade execution. Despite the public’s fascination with it, the number of players in the HFT marketplace is quite small, and although HFT still accounts for a great deal of order volume-up to 50 percent by some estimates-that number has decreased over the last two years.
While some HFT outfits have engaged in questionable conduct, such as “spoofing” (rapidly placing and canceling orders for the sole purpose of creating the appearance of market activity) and certain types of “quote stuffing” (clogging data transmissions with erroneous orders), the vast majority of HFT companies operate within the existing regulatory framework. Unfortunately, the existing rules have not always kept pace. HFT computers can and, under the right circumstances, do send millions of trade instructions in fractions of a second. Even with increasing data transmission capabilities, these instructions can overwhelm automated trading systems. The crashes, freezes and market disruptions we’ve experienced are attributable to systemic problems (a failure of data transmission capabilities or human failure to properly test new trading algorithms) as much as they are to the participation of high-frequency traders. Ultimately, it is the interconnectedness and speed of the system itself that can allow actions by individual participants to develop into cascading failures.
With this realization firmly in mind, both U.S. and European regulators have signaled that they are on the verge of imposing new regulations. Initial indications, however, are that the approaches will be very different. The U.S. has embarked on a principle-based approach, with regulations focusing on the structural integrity of the markets as a whole, while Europe appears to be focusing first on specific perceived problem areas, such as HFT.
This year, the Securities and Exchange Commission, FINRA and Commodity Futures Trading Commission all made clear statements regarding their concerns about not just HFT, but also the stability of the modern markets in general. In her remarks to the Security Traders Association Annual Market Structure Conference, SEC chairwoman Mary Jo White summed up the general consensus of U.S. regulators when she said the SEC needed to bring a “sense of urgency” to answering whether HFT, dark pools and the proliferation of complex order types harm retail investors or create an uneven playing field. She added that it is equally, if not more, important to focus on addressing the structure of the markets as a whole.
Similarly, in July, FINRA issued a Targeted Examination Letter that was ostensibly aimed at HFT but in fact touched on broader issues such as what a firm’s controls and processes were in connection with the development and use of trading algorithms. This can apply to any firm that uses computerized execution algorithms, not just high-frequency traders. The CFTC perhaps went the furthest in suggesting that a total rethink of the current regulatory environment may be in order in a September Concept Release titled “Risk Controls and System Safeguards for Automated Trading Environments.” In this release, the CFTC stated that traditional risk controls and safeguards that relied on human judgment and speed, which were appropriate for manual and/or floor-based trading environments, needed to be “re-evaluated” in light of new market structures.
Both the CFTC and SEC have released proposed regulations in line with their policy statements favoring a systemwide approach. The SEC’s proposed Regulation SCI (Systems, Compliance and Integrity) would require select SROs, alternative trading systems, plan processors and certain exempt clearing agencies to ensure their core technology meets certain standards, conducts business continuity testing and provides certain notifications in the event of systems disruptions and other events. It would replace the current voluntary compliance program with enforceable rules designed to better insulate the markets from vulnerabilities posed by systems technology issues.
The SEC has also been pushing important market participants to work together to address systemic weakness. In response to Chairwoman White’s directive that the exchanges collaborate on fixing their infrastructure, in November the exchanges announced potential improvements in five broad areas, including their main data feeds, and developed recommendations to improve “critical infrastructure items” such as communication about trading halts and initial public offerings. They also agreed to “core principles” for halting stock and options markets, established plans to reconcile procedures for canceling trades, and continued to develop a “kill switch” to stop markets.
TEST TIME
While many U.S. regulatory initiatives have been largely principle-based rather than rule-based, regulators have noted that since HFT trading often occurs without human intervention, it is especially important that there be stringent processes for the development, testing and deployment of the code used in their trading algorithms. U.S. regulators have not ignored specific rule making, but thus far seem to be letting market participants have a first chance to self-police. For example, this year the SEC oversaw the first phases of the “limit-up/limit-down” plan proposed by a group of exchanges, which revised marketwide circuit breakers and introduced a new limit-up/limit-down mechanism to pause trading when markets move too far, too fast.
The U.S. trend toward principle-based regulations, focused on strengthening the overall market structure, seems to be in contrast to Europe propagating a series of rules focused on specific areas such as HFT. For example, in October, the European Union agreed to a preliminary compromise deal on rules regarding HFT that tentatively included a binding agreement on minimum tick size, the implementation of a time synchronization system across markets and restrictions on direct market access. In September, Italy imposed a tax of 0.02 percent on all stock market transactions lasting less than half a second. France also implemented some version of such a trading tax.
It is unlikely that the new rules will change fundamentally the way trading firms do business. The signal of the regulators, thus far, is that the endgame is to make markets more stable on a systemwide basis, not interfere with healthy market activity. This may require firms to implement some new programs. Firms may have to take steps to make sure their compliance personnel are knowledgeable and numerous enough to adequately stress-test existing systems. They will need to assure that they have performed adequate regression analysis on new algorithms before they go live. They must also be prepared to allocate additional resources to upgrade and improve the robustness of their IT infrastructure.
Industry participants now have a unique opportunity to help shape the form of regulations which will govern trading for the foreseeable future. Market participants must become familiar with the proposed regulations and proactively respond to regulators’ requests for comments on these proposed new regulations. However, make no mistake that new regulations are coming, one way or another. Understanding the focus areas for regulators is key to ensuring that any industry initiatives are properly tailored to meet regulator expectations. Individual traders should pay close attention to which firms are undertaking these steps because those firms are the ones that will survive and thrive under the new rules.
Amy Bard is partner and Daniel Nelson is an associate with Bressler, Amery & Ross, a Florham Park, N.J., law firm.
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