As the year winds down, anticipation in the trading industry is on the rise. Why? The Securities and Exchange Commission is getting ready to signal its views with a concept release that could change the game of trading once again.
"The concept release will look at the full panoply of issues in a holistic way," said Len Amoruso, general counsel at Knight Capital Group, a financial services and market-making firm. "It will look at Regulation NMS, dark pools, how customers are faring and what areas may need improvement."
The SEC’s paper, which is expected to be published in January, will address issues relating to dark pools, high-frequency trading and co-location, according to SEC statements. Down the road, any new rules that result from the ensuing discussion could affect competition between market centers and lead to shifts in broker-dealers’ trading practices.
Robert Colby, former deputy director of the SEC’s Division of Trading and Markets, said one focus for the SEC is likely to be whether the "growth of dark venues has led to increased volatility in the markets." Colby, counsel at law firm Davis Polk & Wardwell, left the SEC earlier this year after 27 years at the agency.
Colby said he thought the SEC would use the concept release to gather more information on high-frequency trading and the trading strategies employed at firms engaged in that type of trading. The SEC, he said, might want to know "whether high-frequency trading is stabilizing or destabilizing, whether it’s surfing the waves or it’s causing the waves, whether it’s increasing volatility or it’s dampening volatility."
There will be a public comment period once the concept release is published next month. The comment period is likely to last at least 60 days.
Colby noted that the SEC’s conclusions as a result of the report and comments would be important in determining what potential new regulations the Commission may consider down the road. He spoke at a Capital Markets World event last week.
Market participants have urged the SEC to consider empirical data before making new rules in the securities markets. Several SEC commissioners have also stressed the need for data to help determine policy decisions.
"We believe the end game should be execution quality," said Knight’s Amoruso. "Are customers being provided with high-quality executions, liquidity, fast trades and price improvement? If so, we should be careful about modifying the market structure."
The SEC has telegraphed some of its intentions regarding the concept release. In a letter to Sen. Ted Kaufman, D-NY, on Dec. 3, SEC Chairman Mary Schapiro said the concept release would cover a broad range of issues. The letter was a response to concerns expressed by Kaufman about how the SEC is assessing recent trading developments such as the growth of high-frequency trading in the equities market and the usage of dark pools.
"Next month we hope to seek public comment, through a concept release or similar document, on a range of issues relating to dark liquidity in all of its forms, as well as the impact of high frequency trading in our markets," Schapiro wrote. "Among other things, we are likely to seek input on the various strategies used by high frequency traders and any special trading advantages they may enjoy, including through co-location arrangements."
Registered alternative trading systems that operate as dark pools accounted for 7.2 percent of consolidated equities volume in the second quarter of this year, according to the SEC. Entities that function similarly to dark pools but are not ATSs are not included in that figure.
High-frequency trading, which represents about two-thirds of equities market volume, includes various strategies that typically have a high turnover and require low latency to implement their trading decisions. Co-location refers to the practice of firms placing their servers near a market center’s matching engine to increase the speed of quote and order data transmission.
The SEC provided context for the upcoming concept release last month. In its proposed new rules for dark pools, the SEC in mid-November said it was engaged in a review of equity market structure "to assess its performance in recent years and whether market structure rules have kept pace with, among other things, changes in trading technology and practices."
The SEC said it would consider issues related to various forms of dark liquidity. This will include "dark pools, the order flow arrangements of OTC market makers, and undisplayed orders on exchanges," the SEC noted.
In addition, Schapiro told Kaufman in her Dec. 3 letter that the SEC plans to consider proposing two new rules next month. One of these involves the implementation of the SEC’s "large trader" reporting authority, which would provide the SEC with more information about high-frequency traders and their trading activity. The Commission has had this authority since 1990.
The other involves sponsored access. That planned rule proposal would address the risk inherent in some forms of sponsored access arrangements by requiring that broker-dealers "implement appropriate risk controls on this activity on a market-wide basis," Schapiro wrote. Sponsored access includes a range of relationships whereby firms are able to trade on an exchange or ECN using their broker’s membership or market participant identifier.
This planned rule proposal would supplement Nasdaq OMX’s proposed sponsored access rule. That rule, submitted to the SEC in December 2008, addresses a variety of financial and operational controls that would have to be in place for broker-dealers to offer their customers sponsored access to Nasdaq. Other market centers would be expected to adopt copycat rules when Nasdaq’s proposed rule, which was updated in October, is approved. That approval, according to market participants, is likely to come soon.
The SEC in its concept release may also raise other issues that have received attention in recent months. One of these involves access fees charged by exchanges and ECNs to take liquidity from their books.
At a Senate Banking Committee hearing on market structure in October, Sen. Jim Bunning, R-KY, voiced concerns about how maker-taker pricing affects trading. James Brigagliano, co-acting director of the SEC, noted that the SEC capped the access fee at 3 mils, or 30 cents per 100 shares, when it approved Regulation NMS in 2005. Reg NMS was implemented in 2007.
The argument for maker-taker pricing is that it encourages displayed liquidity by providing a rebate to liquidity providers. "Nonetheless," Brigagliano said at the Senate hearing, "as the Commission looks further at high-frequency trading in its concept release, it would make sense to look at the impact of particular market pricing models on trading behavior."
Another issue that could come up in the concept release is fair access to dark pools. Regulation ATS, which went into effect in 1999, specified the circumstances under which a dark pool must provide fair access to its order book. Credit Suisse and other brokers have urged the SEC to look anew at this issue. Block trading system have countered that broad access to their systems would hurt the institutions that use their platforms to reduce market impact costs.
