SEC Reviewing U.S. Trading Practices After Decade-Long Shift to Automation
The U.S. Securities and Exchange Commission is examining equity trading practices that gained dominance in the past decade amid a shift to automation, according to an official in the agency’s enforcement division.
Daniel Hawke, head of the market-abuse unit, said at an event yesterday that the SEC is looking into techniques such as co-location, in which exchanges let traders place computers close to the market’s systems to shave time off executions. He said other practices under examination include the rebates that venues pay to spur transactions, direct market access where brokers let investors send orders to venues themselves, and whether the types of orders exchanges offer are being misused.
Regulators are evaluating U.S. markets after rules since the 1990s boosted competition and spread stock trading across 13 exchanges and dozens of private, broker-run venues. While the shift cut investors’ costs, it made trading more complex, and scrutiny increased after a May 2010 rout erased $862 billion from equities in less than 20 minutes. Several practices Hawke highlighted are used by firms engaged in high-speed trading.
“No one’s been able to prove whether high-frequency trading is good or bad,” Larry Tabb, chief executive officer of research firm Tabb Group LLC in New York, said in a telephone interview. “They don’t have a consolidated audit trail, clean access to good data or the quantitative analysts to really analyze data, so they’re doing it through the resources they have -- which is through enforcement.”
Majority of Market
About 55 percent of U.S. equities volume comes from firms using high-frequency trading strategies, Adam Sussman, a partner and director of research at Tabb Group, said in December. More than half of that -- 32 percent of total stock volume -- is from market makers supplying bids and offers, he said.
“Given a large enough regulatory staff and deep forensic analysis, the SEC can find anything,” Tabb said yesterday. “Will this completely change the way market making or liquidity provision is done? I don’t know.”
SEC Chairman Mary Schapiro said yesterday that plans for a marketwide surveillance system, called a consolidated audit trail, are being finalized. She added that the system should ultimately include markets such as fixed income and futures.
The SEC also is examining whether the self-regulatory organizations that operate exchanges are complying with and enforcing their own rules, Hawke said. Alternative venues that aren’t exchanges are operated by broker-dealers and must register with the agency. These include dark pools, or private venues that match orders without displaying order information.
Richard Adamonis, a spokesman for NYSE Euronext (NYX), owner of the New York Stock Exchange, declined to comment on Hawke’s statements, as did Robert Madden of New York-based Nasdaq OMX Group Inc. (NDAQ), Randy Williams of Bats Global Markets Inc. in Lenexa, Kansas, and Jim Gorman of Direct Edge Holdings LLC in Jersey City, New Jersey. The four companies own 10 of the 13 U.S. stock exchanges, and five options markets.
Bats, the third-largest U.S. exchange operator, said on Feb. 23 that it got a request from the SEC for information on how different types of orders were developed for its venues. Hawke said at the event yesterday that possible industry misuse of order types is being reviewed.
Several of the SEC’s investigations developed from the agency’s review of the May 6, 2010, crash in which the Dow Jones Industrial Average (INDU) plunged 9.2 percent, said Hawke, who commented at a securities-law conference in Washington where Schapiro also spoke. A mutual fund company’s automated sale of futures without regard to price set off the drop, according to a report from the SEC and Commodity Futures Trading Commission.
Some automated trading firms, which execute orders in fractions of a second, widened the difference between their bids and offers or withdrew from the market entirely during the decline, the SEC and CFTC said. The report said that exacerbated losses.
The enforcement division appears to be focusing on practices related to high-frequency trading, Edward Fleischman, a former SEC commissioner, said in a phone interview yesterday.
“The high-frequency traders who make a big virtue of their adding volume and liquidity to the market can simply walk away as quickly as they came,” Fleischman said. “This reflects the SEC’s concern with practices that they’re still trying to understand and get under control.”
The SEC’s focus raises the “philosophical question of whether regulators should be able to control markets,” Fleishman said.
Since the rout almost two years ago, U.S. regulators have banned unsupervised trading, or “naked” access to markets that brokerages offered clients who wanted to trade faster, and required securities firms to conduct credit and other checks on all orders before they’re sent to exchanges. They also banned so-called stub quotes, which were placeholder bids and offers at prices far from prevailing levels.
The SEC has also approved plans to track activity by large traders through identification codes, enacted circuit breakers that stop trading in individual stocks when their prices move too quickly, and created a uniform system for canceling errant transactions.
Bats said Feb. 23 that the request from the SEC’s enforcement division, which the company disclosed in a regulatory filing, sought information about how order types have evolved at the firm. Bats said regulators asked for documents “related to the development, modification and use of order types, and our communications with certain market participants,” including some of company’s owners.
The SEC is also examining the level of order cancellations, or buy and sell requests that are withdrawn before they execute, Hawke said. The ratio of canceled orders to completed trades, particularly for New York Stock Exchange-listed companies, began increasing at a faster pace about five years ago in the run-up to new SEC rules.
The commission said in January 2010 that proprietary trading firms may use strategies in which more than 90 percent of submitted orders are canceled.
David Shillman, associate director at the SEC’s division of trading and markets, said in September that regulators were considering whether to urge exchanges to impose a fee on brokers when their orders exceed a ratio to executions, or for sending messages including quotes, updates, cancellations and executions. Higher message traffic imposes a cost on brokerages and other participants by requiring them to be able to process more data, he said.
Restrictions around the level of canceled orders would affect the prices market makers publish when they provide orders against which investors can trade, James Overdahl, a vice president at NERA Economic Consulting and a former chief economist at the SEC and CFTC, said in an e-mail yesterday. The reduction of the bid-offer spread enables investors to purchase shares for less and sell at higher levels, he said.
“The ability to quickly cancel and replace orders in response to new information is an essential tool for electronic market makers to manage their open order risk,” wrote Overdahl, who is also an adviser to the FIA-PTG, the Futures Industry Association’s Principal Traders Group, which includes 36 U.S. proprietary trading firms. Inhibiting their use by market makers “means that the open order risk will be managed instead by widening bid-ask spreads,” he said.
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