Market surveillance for insider trading will soon be consolidated by listing market. For the first time, each listing market will be responsible for market surveillance for all trading in its listed names across venues.
Nasdaq said the impending change is the consequence of the fragmentation of listed trading. It’s “due in part to the Securities and Exchange Commission’s determination of a perceived gap largely driven by Nasdaq’s increasing market share in NYSE and NYSE Arca-listed equity securities,” Nasdaq wrote in connection with a rule filing about a related regulatory topic in February.
This change means NYSE Regulation and the Financial Industry Regulatory Authority will likely conduct all market surveillance. NYSE Reg, a not-for-profit subsidiary of NYSE Euronext, already conducts market surveillance for all NYSE and NYSE Arca trading. NYSE Euronext is in the process of acquiring the American Stock Exchange. Nasdaq outsources its market surveillance to FINRA.
“It seems logical to do this and to prevent the duplication of efforts by continuing the split-up of the regulatory responsibilities between two organizations, each of whom is capable of doing the job well,” said Andrew Klein, a partner at law firm Schiff Harden. Klein, co-leader of the firm’s securities and futures regulation group, was the director of the SEC’s Division of Market Regulation (now called Trading and Markets) during the 1970s.
FINRA and NYSE Reg “have ample tools and funds,” Klein said. “They’re looked to by the Commission as the primary guardians of the gate.”
Self-regulatory organizations are currently responsible for the intraday market surveillance of trading on their venues. However, the primary listing market has historically been the main party responsible for intraday surveillance in its listed names, according to Onnig Dombalagian, a professor at Tulane Law School who has written extensively about self-regulatory organizations. Consequently, he said, “it would probably be a modest benefit to have the listing exchange be responsible exclusively for all trading activity with respect to its listed securities.”
However, Dombalagian noted that the fragmentation of trading has recently made surveillance more complex than it previously was. “With fragmentation, surveilling trading is more difficult because the listing market doesn’t necessarily have enough information–such as the underlying details of transactions effected on other markets by nonmembers–to make inquiries of other SROs or refer cases to the SEC,” Dombalagian said.
“If Nasdaq’s automated marketplace manages to snag significant volume in NYSE-listed trading,” he explained, “NYSE Reg may not pick up, through its normal review of transaction reports and underlying execution details, anomalous trading activity [that takes place elsewhere].” Dombalagian noted that Nasdaq as an SRO has an obligation to surveil its own trading, but that it may also rely on the Big Board’s extensive efforts to surveil the market in NYSE-listed trading.
“So it makes sense that the listing exchange, to the extent it bears responsibility for surveilling the market, would want to have exclusive authority across all trading centers,” Dombalagian added.
The impending shift in surveillance responsibilities is designed to make regulatory oversight and surveillance for insider trading more uniform and efficient across displayed markets by consolidating it in the hands of the listing market. According to a November report from the Government Accountability Office, the SEC’s Office of Compliance Inspections and Examinations found last year that there was duplication of surveillance efforts by SROs and variances in the alerts generated by SROs monitoring trading in the same securities.
The NYSE, Nasdaq, FINRA and the SEC declined to comment for this article. Amex didn’t reply to an interview request.
Nasdaq told the SEC in February that it would “shortly” enter into a binding agreement concerning market surveillance with NYSE Regulation, a not-for-profit subsidiary of NYSE Euronext. The agreement, it said, would allocate “regulatory responsibility for surveillance, detection, investigation and enforcement of insider trading” by Nasdaq members in NYSE-listed and NYSE Arca-listed securities to NYSE Regulation, “irrespective of the marketplace where the trading occurred.” This delegation will take place through a Rule 17d-2 agreement–an agreement, under the Securities Exchange Act of 1934, between two or more SROs that governs the allocation of regulatory responsibilities.
Nasdaq said a separate Rule 17d-2 agreement with FINRA “will cover this for Nasdaq securities.” The exchange made these statements in connection with a December rule proposal to impose a new fee on its member firms’ registered representatives to cover regulatory expenses. Nasdaq’s statements appeared in a February response to a comment letter by the Securities Industry and Financial Markets Association that asked the SEC to abrogate the fee request because “Nasdaq’s justifications in the filing in support of the fee increase are not reasonably related to its regulatory costs and expenses.” The SEC has not yet ruled on Nasdaq’s filing. SIFMA did not respond to an interview request.
NYSE Reg currently conducts market surveillance for securities traded on NYSE and NYSE Arca. Through Rule 17d-2 agreements, FINRA conducts market surveillance for Nasdaq-listed securities in several markets, including Nasdaq. FINRA is also the primary regulator for all broker-dealer member firm regulation.
The November GAO report on SROs noted that, according to the SEC’s Office of Compliance Inspections and Examinations, the plan being hatched by the equities SROs is similar to an existing plan in options. Like that plan, in which market surveillance is delegated to the CBOE by all the options exchanges, this plan coordinates market surveillance across displayed markets.
However, unlike that plan, equities market surveillance and monitoring for insider trading will not be consolidated in a single entity. According to the GAO report, “instead of designating one SRO to conduct all insider trading-related surveillance, OCIE officials said that the current draft proposal [among the equity SROs] would require each listing market, or its designee, to conduct insider trading surveillance for its listed issues, regardless of where trading in the security occurred.” The GAO report is called “Opportunities Exist to Improve Oversight of Self-Regulatory Organizations.”
The scope of the insider trading surveillance to be conducted by the listing market, the GAO report said, would include “reviewing alerts, pursuing investigations, and resolving cases through referrals (to SEC) or disciplinary action.” According to the report, OCIE had expected the SROs to vote on the proposed plan in October and to submit the plan to the SEC by the end of last year.
It is not known whether that plan was submitted on schedule. The plan, according to the GAO, was being developed by the Intermarket Surveillance Group, an industry body created in 1983 at the suggestion of the SEC to coordinate and enhance market surveillance activities among its member SROs. The ISG currently plays a significant role in facilitating the sharing of information about potential insider trading or manipulative trading behavior. This information sharing takes place through SROs making so-called “blue sheet” requests for information from one another.
