SEC Vote Shows Scope of High-Frequency Trading Rules (Update2)

Jan. 13 (Bloomberg) -- High-frequency traders, whose lightning-fast stock and options tactics have been called unfair by senators, will learn how far U.S. regulators may go to rein them in.

The Securities and Exchange Commission is asking brokerage firms, traders and exchanges to weigh in on the practice, which describes strategies that depend on high-speed executions, usually less than a millisecond.

SEC commissioners voted 5-0 today to publish a so-called concept release on high-frequency trading, dark pools and the structure of markets. The document lays out the agency’s concerns and begins a process of soliciting and reviewing feedback that will last months before any rules are approved.

“In recent years, the equity markets have undergone extraordinary change,” SEC Chairman Mary Schapiro said at a meeting in Washington. “Trading has accelerated from seconds to milliseconds. At the commission, we must continually assess how changes in the market are affecting investors.”

High-frequency trading accounts for as much as 70 percent of U.S. stock volume, according to data compiled by New York- based financial services consultant Tabb Group LLC. New regulations may make the practice less profitable for trading firms and trim revenue U.S. exchanges, which generate revenue based on the number of transactions executed.

‘Populist Sentiment’

The SEC is “going to put out some positions that the commission either feels strongly about or wants to feel people out on,” said Sean O’Malley, a former attorney in the agency’s division of trading and markets who’s now a partner at Goodwin Procter LLP in New York. “If you’re a compliant high-frequency trader, your concern is that there is this populist sentiment that these guys are getting away with something.”

The SEC is reviewing high-frequency trading after lawmakers including Senator Ted Kaufman, a Delaware Democrat, questioned whether the practice is benefiting Wall Street at the expense of individual investors. Proponents of the technique say it has lowered fees, boosted liquidity and increased volume.

Questions the SEC will ask include whether it should impose new rules on high-frequency trades, whether “highly automated, high-speed” trades hurt investors and what metrics regulators should use to determine the effects of new trading strategies on “long-term investors,” the agency said in a statement today.

Co-Location

The SEC will also ask about co-location, where traders and securities firms place computers close to exchange data centers to shave time off orders. The agency wants to know whether co- location gives traders unfair advantages and whether firms that place computers near data centers should face regulations, according to the statement.

Once the SEC publishes its release, the agency will seek comment for 90 days before deciding whether to propose rules.

It’s “a big laundry list of stuff they would like to hear opinions on,” said Justin Schack, director of market structure analysis at Rosenblatt Securities Inc. in New York. “It’s the beginning of a process that could ultimately result in new regulations, but it would be many months and possibly years before you’d see the end of that.”

Under pressure from Kaufman and fellow Senator Charles Schumer, a New York Democrat, the SEC in September proposed banning flash trades, or orders displayed for less than a second to a segment of a market center’s customers to get an execution at the industry’s best price on that venue. Schumer and Kaufman said the practice was giving an unfair edge to investors with the fastest computers.

Increasing Transparency

The SEC in October proposed rules to address concern that dark pools, private trading venues operated by brokers that don’t display prices, were growing too rapidly and drawing volume away from regulated exchanges.

SEC commissioners today proposed rules that would ban so- called naked access, in which brokers let clients execute unsupervised trades on exchanges and market centers without risk controls. The practice helps trading firms execute orders faster than competitors. The SEC has said inadequate monitoring may lead to manipulation or trading errors that damage markets.

The agency’s proposal requires securities firms to implement controls that are “reasonably designed” to prevent orders that exceed “pre-set credit or capital thresholds.”

Baseline Information

Schapiro said in October her staff is also working on a proposal to require that high-frequency traders give the agency “better baseline information.” The rule may attach identification codes to market participants who exceed a certain volume threshold so the SEC can monitor their trades, according to people familiar with the matter who declined to be identified before the proposal is public.

Lawrence Harris, a former SEC chief economist, said the agency should wait for market participants to respond to its concept release before pursuing piecemeal regulations.

“A concept release provides an opportunity for the expertise of practitioners and academics outside the SEC to be brought in on important questions before the agency,” said Harris, who’s now a business professor at the University of Southern California in Los Angeles. “At a time when the SEC’s technical competence has been found wanting, the use of outside expertise is particularly important.”

To contact the reporter on this story: Jesse Westbrook in Washington at jwestbrook1@bloomberg.net.