High-Frequency Trade Rebates Questioned in SEC Review (Update2)

Jan. 22 (Bloomberg) -- The Securities and Exchange Commission will ask stock markets to explain why orders that can be placed and canceled in thousandths of seconds and rebates for high-frequency traders should be allowed, analysts said after reviewing a request for public comment.

Commissioners are seeking advice on how to balance the goals of long-term investors with professional speculators, particularly those using high-frequency strategies. The agency began a review that may result in an overhaul of market regulation before President Barack Obama proposed barring proprietary trading by banks yesterday.

The SEC wants exchange executives to justify measures they designed to attract the fastest traders, according to Adam Sussman, director of research at New York-based Tabb. While firms that use high-speed strategies are the biggest drivers of growth among U.S. markets, congressmen say they do little to improve trading and may spur volatility that results in other investors getting worse prices when they buy and sell.

“The SEC pushed for automation and making exchanges electronic because slow, manual trading gave specialists and others advantages,” said Sussman, whose firm estimates high- speed firms account for 61 percent of U.S. stock transactions. “The concern now is that speed is creating unfairness.”

NYSE, Nasdaq

Shares of NYSE Euronext and Nasdaq OMX Group Inc., owners of the largest U.S. stock exchanges, fell more than 3 percent yesterday as investors speculated Obama’s proposal will limit growth. JPMorgan Chase & Co., Goldman Sachs Group Inc. and Citigroup, all based in New York, dropped more than 5 percent after Obama said he wants to protect taxpayers who paid for last year’s bailout of the U.S. financial industry.

NYSE Euronext lost 4.1 percent to $23.62 today in New York. Nasdaq OMX slid 3.3 percent to $18.34.

Questions in the SEC’s review, which is separate from Obama’s plan, have been expected for four months in the wake of criticism by Democratic Senators Charles Schumer of New York and Ted Kaufman of Delaware that the agency isn’t doing enough to police equity markets.

Schumer and Kaufman said the traders’ technology may give them an advantage over mutual funds, pension funds and smaller investors. Proponents of high-frequency strategies say the trading increases the number of buyers and sellers in the market, improving prices and liquidity.

Long-Term Investors

The commission’s policy is to protect the interests of long-term investors, who provide capital and take the risk of owning listed companies for an “extended period of time,” according to the SEC’s so-called concept release. When their goals diverge from professional traders, the SEC will come down on the side of long-term owners, it said.

“By any measure, HFT is a dominant component of the current market structure and is likely to affect nearly all aspects of its performance,” the commission said in its 74-page document. Investors, exchanges and the public can comment on the SEC’s Web site until April 21.

Sussman said the SEC’s document shows what regulators are concerned about and offers hints about new rules. In one part of the release, the SEC asked whether orders to buy and sell stock should have a minimum duration of one second before they are allowed to be canceled.

Hundreds of Orders

Such a regulation would crimp high-frequency firms who send hundreds of orders to buy and sell stocks and then withdraw or update them in thousandths of seconds to keep changes in share prices from producing trades they don’t want. Proprietary traders say their willingness to buy or sell a share at a given price changes from millisecond to millisecond as the risk associated with the orders evolves.

“Not only is one second arbitrary, but it would require an overhaul of the basic building blocks of trading logic so there’d be a lot of pain points,” Sussman said. “It would harm certain strategies that provide liquidity to the markets.”

Ray Pellecchia, a spokesman for New York-based NYSE Euronext, which operates the New York Stock Exchange, said his company is still reviewing the SEC document and declined to comment. Robert Madden, a Nasdaq OMX Group Inc. spokesman in New York, declined to comment.

Exchanges have boosted speed and capacity in the past two years to appeal to high-frequency trading firms. Average daily trading in U.S. equities was 9.8 billion shares last year, up from 6.1 billion in 2007, according to data compiled by Barclays Capital. Sussman’s firm estimates the overall share of high- speed traders almost doubled during that period.

Technology Investments

“The question shouldn’t be, ‘are all traders equal?’” said Dan Mathisson, the New York-based head of the Advanced Execution Services unit at Credit Suisse Group AG. “Of course they’re not. Those who’ve invested more in technology and have hired smarter people will have an advantage. The focus should be on whether everyone has equal access.”

The SEC is also examining rebates paid by exchanges to entice orders from proprietary firms. The NYSE, NYSE Arca, the New York-based Nasdaq Stock Market, Bats Exchange in Kansas City and Jersey City, New Jersey-based Direct Edge Holdings LLC’s largest trading venue pay their users for so-called added liquidity, or executions that result from bids and offers they place in the trading center’s order book.

The commission asked if liquidity rebates are unfair to long-term investors because “they necessarily will be paid primarily to proprietary firms engaging in passive market-making strategies.” Rebates may reward firms for types of trading that “do not benefit long-term investors or market quality,” the SEC said.

Adding Liquidity

High-speed traders say their orders to buy and sell stock at prices that increase the depth of bid and ask quotes are a form of market making that reduces volatility. Given that claim, the SEC asked if such firms should be held to codes of conduct such as those that govern authorized market makers at exchanges.

The ability of Wall Street firms to profit from their market activity “should come with a commensurate amount of responsibility,” Kevin Cronin, the Atlanta-based director of global equity trading at mutual fund firm Invesco Ltd., said in a presentation in October arranged by the Investment Company Institute, a Washington-based trade group of mutual funds and investment companies whose members manage $11.6 trillion.

The concern, he said, is that without assurance that the firms are providing benefits to investors, “We’re allowing the U.S. equity market to become a trading market and not a long- term investment and capital-formation market.”

To contact the reporter on this story: Nina Mehta in New York at nmehta24@bloomberg.net.