The Securities and Exchange Commission is engaging in a broad reassessment of equities market structure against the backdrop of an increasingly automated trading environment. This comes on the heels of a rule proposal last Thursday that would ban flash orders on equities and options exchanges.
"The securities market has experienced extraordinary changes over the last few years in trading technology and practices," James Brigagliano, co-acting director of the SEC’s Division of Trading and Markets, said last Thursday at one of the Commission’s regular open meetings. "Some of these changes have led to serious concerns about whether the regulatory structure remains up to date."
Broadly, the SEC is looking at how technology and automated trading have altered the landscape in the wake of Regulation NMS, which was implemented for exchanges in March 2007, and whether that has led to unfair trading practices. Reg NMS forced the New York Stock Exchange to become electronic, ending the Big Board’s monopoly over trading in its listed stocks.
As a result of Reg NMS and Regulation ATS, which became effective in 1999, the overall equities market has become more competitive as well as more fragmented. These big rule changes produced a bevy of alternative trading systems that do not display quotes publicly. Some of these ATSs are crossing platforms for block orders. Most, however, are broker-operated dark pools whose average execution size is several hundred shares.
Brigagliano on Thursday laid out many of the trading issues currently on the SEC’s plate. The SEC, he said, is "looking at the threshold levels of Reg ATS, looking at post-trade transparency for some of the dark venues so that investors can assess the relative levels of volume and liquidity [in particular securities in those venues]. We’re looking at the use of IOIs, which can have analogous features to flash orders, DMA, co-location, and high-frequency trading." The comment about IOIs referred to automated indications of interest sent by some ATSs to one another to search for liquidity.
Brigagliano noted that several SEC initiatives "may be in form of proposals where we think prompt action is warranted." He added that high-frequency trading is an issue that would most likely fuel a "big picture discussion," rather than an immediate policy initiative.
SEC Chairman Mary Schapiro has said several times over the last six weeks that market and trading practices with "opaque features" are coming under greater regulatory scrutiny. Last Thursday, at the SEC’s open meeting that discussed flash orders, she said the SEC "is continuing to review other forms of dark trading that lack market transparency, and I expect that initiatives in this area will be considered in the near future."
Flash orders are orders that enable a market center that is not quoting at the best price to execute that order by soliciting contra-side interest at the market’s best quoted price from its participants. The SEC said last week that flash orders unfairly give select market participants information that is not available to the broader market.
Larry Tabb, founder of research firm TABB Group, has thought for a while that a broad market structure reassessment is warranted. "Pretty significant changes in the structure of the markets are happening because of changes in the dynamics of trading," Tabb told Traders Magazine last month. "Some of it is the result of decimalization, some of it is the result of advanced technology, and some of it is because of who’s provisioning liquidity and how. I think the SEC is thinking about all of these changes, how market structure impacts this ecosystem, and how that affects trading costs."
Tabb said he didn’t know how extensive the regulatory changes this fall might be. "If the whole Rube Goldberg thing actually works and provides good executions for both individuals and institutions, you leave it alone, even if it is complicated," he said. "But if we can determine that there’s a large group of people taking advantage of information, then we need to do something."
At last Thursday’s meeting, Kathleen Casey, one of two Republicans among the five SEC commissioners, said she considers an overarching review of trading issues necessary. "I would like to see the Commission engage in a comprehensive review of the current structure of U.S. securities markets," she said. "We are several years past [Regulation] NMS and, given the rapid change in technology and the market, I believe it is an appropriate time for a broad-based review of market structure issues."
Elisse Walter, one of the Democratic commissioners, said flash orders were just the "initial step in a series of actions" the Commission would likely take in the coming months. She stressed the need to address dark pools and the automated IOIs they send one another, as well as "Regulation ATS thresholds." The latter referred to both the display and fair access requirements for ATSs. In addition, Walter highlighted sponsored access, high-frequency trading and co-location as topics needing greater regulatory focus.
"The Commission is looking closely at all of these matters to determine whether they raise policy concerns that are analogous to flash orders or otherwise may be detrimental to the fairness and efficiency of the national market system," Walter said.
The recent demand for a review of market structure developments has come from several sources. Senators Chuck Schumer of New York and Ted Kaufman of Delaware, both Democrats, urged the SEC to ban flash orders over the summer. Sen. Kaufman has also called for a wide-ranging review of a number of trading practices, including the growth of high-frequency trading and co-location. In addition, there has been a broad public discussion in the mainstream media and on blogs about how the equities market is evolving.
Robert Colby, a veteran regulator who left the SEC’s Division of Trading and Markets earlier this year and is now counsel at law firm David Polk & Wardwell, observed that the chief criticisms the SEC is currently facing are concerns about the potential lack of fairness in the markets, the fragmentation of trading centers and allegations of manipulation in the markets. He commented on these issues in a speech at a mini-conference sponsored by research firm Aite Group last Wednesday.
Colby addressed some of the public discussion that trading issues have generated over the last two months. Some of the fervor behind the widespread outrage, he said, amounts "to a kind of muddled jumble of important concerns and a misunderstanding of what trading markets are really like today."
He stressed that there are serious regulatory concerns about some of the trading issues that have developed. A form of sponsored access called "naked access" or unfiltered access, he said, "raises really important and significant risks for the entire equities market." At the same time, he suggested, some issues have been magnified in recent public discussions. "Flash orders have been added to the perp walk," he said, noting that the internalization of customer orders by broker-dealers has existed for a long time, so "the concept is not new."
On Friday, in a speech at Georgetown University about global finance, SEC Chairman Schapiro suggested that disclosure and transparency are the guideposts that will help the SEC update rules and practices in a range of areas, from oversight of credit ratings agencies to municipal securities and equities trading. She went on to note that the SEC’s decision to propose a ban on flash orders fits into the Commission’s "disclosure regime, because it’s about letting all investors have equal access to information."
Many of the changes in the equities market now under consideration could affect trading volume as well as competition between market centers. Brian Hyndman, an executive at Nasdaq OMX Group, said last Wednesday at the Aite conferencee about high-frequency trading and other issues that his company worried about the unintended consequences of "some of the regulatory changes that have either come out or will come out." Representatives of NYSE Euronext, BATS Exchange and Direct Edge, who were also on the panel, agreed with him.
