The trading industry is concerned that regulatory changes to trading rules are being driven by Capitol Hill. Executives fear that politicians could force rule changes that would harm the markets and ultimately lessen competition.
"These were not the issues that brought us to the brink" last fall, said William Brodsky, CEO of the Chicago Board Options Exchange. He said Congress should focus on the macro regulatory issues involving the over-the-counter derivatives market, instead of seeking to overhaul the equities market structure.
Lawrence Leibowitz, executive vice president for U.S. markets at NYSE Euronext, agreed. "Congress should really be examining the bigger issues," he said. Both men spoke at the Securities Industry and Financial Markets Association’s annual conference in New York last week.
Since mid-summer, a handful of senators have stressed concerns about the perception of the markets as an unfair playing field in which larger investors and faster traders get benefits unavailable to retail investors. Flash orders, high-frequency trading, co-location, dark pools and automated indications of interest have riveted the media and some members of Congress.
Last Wednesday, the Senate Banking Committee held market structure hearings about dark pools, flash orders and high-frequency trading. Sen. Ted Kaufman, D.-Del., who in July became a vociferous critic of aspects of the current marketplace, said that "liquidity as an end seems to have trumped the need for fairness and transparency."
Sen. Charles Schumer, D.-N.Y., recently urged the Securities and Exchange Commission to consider a suite of stricter regulatory requirements for dark pools. Two weeks ago, he held a conference call for reporters with Duncan Niederauer, the CEO of NYSE Euronext, to discuss what he sees as an unfair playing field between exchanges and alternative trading systems. NYSE Euronext and other displayed market centers, compete with some dark pools, which are operated by broker-dealers.
In July, Schumer scolded the SEC for what he saw as lax regulatory oversight of the markets that had allowed flash orders to evolve. Nasdaq OMX Group and BATS Exchange had introduced flash orders in their markets, joining Direct Edge and the CBOE Stock Exchange, which already offered versions of these order types. NYSE Euronext was a critic of flash orders. Schumer told the SEC and the media that if the Commission didn’t ban flash orders, he would introduce legislation to do so. The SEC last month proposed a ban on flash orders.
According to Brett Redfearn, global head of liquidity in the electronic client solutions group at JP Morgan Securities, what’s likely to be the rapid disappearance of the flash order type should raise industry concern. It was unusual, he said, for public and political outrage to "knock it out of the box within a very, very short amount of time." It is worrying, he said, to know that "the SEC is under pressure and then–boom!–something goes away overnight," perhaps without sufficient due diligence.
In Redfearn’s view, Capitol Hill’s interest in "trading practices as esoteric as an ELP order type or a flash or BOLT is something we should all be paying attention to." The industry, he suggested, should work to ensure that decisions made under political pressure yield outcomes that won’t harm trading practices. He spoke at the Security Traders Association’s annual conference last month, in Scottsdale, Ariz.
Robert Colby, counsel at law firm Davis Polk & Wardwell, and a former deputy director of the SEC’s Division of Trading and Markets, said in September that "flash orders have been added to the perp walk," joining short selling and other practices that have drawn a lot of anger and attention over the last year.
Colby noted that there are real regulatory concerns and issues with some of the market structure topics that have come up recently, but that the public response has been extreme. In his view, some of the outrage pushing particular market structure issues onto the SEC’s agenda reflects "a kind of muddled jumble of important concerns and a misunderstanding of what the trading markets are really like today."
At last week’s SIFMA conference, NYSE Euronext’s Leibowitz noted that members of Congress are speaking out about the structure of the equities market because of broad frustration in the country with the financial system and because of a "wave of angry populism" fueled by Wall Street bailouts, healthcare discussions and other issues. Congress, hesaid, is reacting to that populist anger by focusing on the equities market, even though the problems that led to the near-collapse of the financial system occurred primarily in the fixed-income and credit markets.
Eric Noll, executive vice president for transaction services at Nasdaq OMX Group, said at the same conference that he’s not sure Congress is trying to redo the equities market structure. But he noted that it’s important to figure out "what is a rational answer to the problem" instead of jumping into the fray without consideration of the fallout new rules could produce down the road.
The SEC, Leibowitz said, appears to be acting as the "common man’s ‘Hey, what are you doing in there?’" At the same time, the "public has no concept of what’s going on in the markets," he said, referring to the complexity of electronic trading and the multiplicity of venues. Explaining to investors how trading has changed over the last decade will be a difficult task, Leibowitz stressed. He added that he hopes this doesn’t give rise to "backlash that is inappropriate."
Another change investors may be unaware of, some market participants say, is the extent of competition between market centers. NYSE Euronext and Nasdaq OMX are not the behemoths they once were, and both exchange operators have hung onto what market share they’ve maintained in their own listed securities by buying smaller and nimbler competitors.
David Franasiak, a principal at Washington, D.C., law firm Williams and Jensen, emphasized the changes that have taken place in the trading industry. "There is, frankly, a lot of business model bumping and elbowing here," he said at the STA conference two weeks ago. Some of the arguments between market centers, and between exchanges and broker-dealers, he said, reflect their own interests in a competitive trading landscape.
Len Amoruso, general counsel at Knight Capital Group, highlighted the "swelling regulatory agenda" in remarks at the STA conference. Some concerns, he said, are based on "emotional-type reactions [and] hyperbole. It’s certainly quite politically charged." He suggested that rulemaking that’s not based on rigorous, thoughtful analysis "could do more harm than good."
The SEC, for its part, is now asking more questions about how technology is changing the markets and the trading industry, in the wake of the financial crisis. One of the SEC’s main concerns is the possible development of a two-tiered market in which some investors have access to information about order flow or better access to orders than other investors.
The SEC has said it is examining co-location, or the practice of placing servers near the order-matching engines of market centers, high-frequency trading, dark pools and indications of interest. The gist of all of these developments, from the SEC’s perspective, is ascertaining whether some market participants have unfair advantages over others. The Commission has also been working on a regulatory response to concerns about the impact of short selling on the markets.
Last month the SEC issued a rule proposal banning flash orders in securities markets. The comment period for this proposed rule ends Nov. 23. The SEC followed this with another rule proposal about dark pools last week. This series of potential rules, some of which are controversial, would limit the automated messages, or indications of interest, routed to and from dark pools to seek out additional liquidity. They would also add more post-trade reporting transparency for many prints.
The SEC is also working on a rule proposal concerning aspects of sponsored access, a practice that enables firms to access the markets directly through a market center’s member or participant firm. The SEC, for at least two years, has publicly stressed its concerns that some firms are able to reach the markets without adequate risk management filters or controls provided by the broker-dealer. The SEC is also aiming to release a broad concept release tackling a variety of market structure issues, including high-frequency trading, later this year or early in 2010. Senators Kaufman and Schumer have also advocated a broad review of market structure issues.
Leibowitz of NYSE Euronext and a slew of other exchange and brokerage executives have argued repeatedly at conferences and public talks over the last year that the equities markets functioned well last fall. Liquidity was available to investors, the markets operated and investors could trade. The prices across assets fell, but the markets, these industry pros said, were there for investors. That was not the case in other asset classes or, in past crises in the equities market.
Robert Greifeld, CEO of Nasdaq OMX Group, said last month at Fordham University that the industry kept up with unprecedented trading volume last year, without breaking down. He said Nasdaq in the fall of 2008 executed volumes it had only ever tested in a lab environment. Greifeld believes some changes to the market structure are now necessary, and he has done his part adding issues onto the SEC’s plate, but, he said, market participants should bear in mind that the equities markets functioned well during the financial crisis, while the credit markets did not.
