The U.S. Securities and Exchange Commission rejected Nasdaq Stock Market’s request to offer clients trading algorithms that would enable them to execute buy and sell orders according to predetermined guidelines.
Nasdaq failed to specify in its proposal how it would ensure that orders generated under its plan would comply with rules requiring risk checks on buy and sell requests before they are sent to markets, the SEC said in a Jan. 11 notice. It also didn’t respond to criticism by the Securities Industry and Financial Markets Association that the offering would compete unfairly with algorithms supplied by brokers, the SEC said.
“It’s a surprise,” Bruce Weber, dean of the Alfred Lerner College of Business and Economics at the University of Delaware, said by phone. “There’s nothing particularly new or innovative about the offering except that it’s coming from an exchange rather than a broker-dealer. I think the SEC is very gun-shy about approving rules that could potentially lead to anything that could have a destabilizing influence on the market.”
Algorithms for trading are a brokerage tool used to execute client orders. Nasdaq’s proposal to offer them follows 20 years in which the line between exchanges and their members has faded. The blurring began when brokers, frustrated by the speed at which equity markets ran in the 1990s, set up their own venues. More recently exchanges have added technology offerings tailored to brokers such as systems to route buy and sell requests to other venues and a growing selection of order types to negotiate automated markets.
Most algorithms are designed to buy or sell stock within parameters that ensure their users get the price they want while allowing them to fine-tune executions based on variables such as volume, volatility and how urgently they want to trade. Nasdaq asked the SEC for permission in May to provide benchmark orders that seek transactions aimed at achieving a stock’s volume- weighted average price, time-weighted average price or percentage of volume traded over a specific period, similar to services offered by brokers.
A decade ago, algorithms were “quite innovative, but now there are a number that are quite routine,” Nasdaq OMX Group Inc. (NDAQ) Chief Executive Officer Robert Greifeld said on a July 25 conference call. “We filed to be able to do some of these routine algos.”
In delaying action on the proposal in August, the SEC said Nasdaq hadn’t made clear how pre-trade risk and capital checks would be conducted on parts of its algorithms known as child orders, which are pieces of the larger buy or sell request that is submitted for execution. The SEC approved a regulation known as the market-access rule in 2010 mandating risk checks on any order sent for execution.
In addition, Nasdaq didn’t respond to concerns raised by Sifma, the broker-dealer trade group, that allowing Nasdaq to offer algorithms would place “undue burden” on competitors given rules that limit exchanges’ legal liabilities, the SEC wrote in the rejection notice. Nasdaq’s assertion that its rule proposal is consistent with the securities laws isn’t sufficient, the SEC said.
Sifma criticized Nasdaq’s proposal in October, telling the SEC that the offering would create “regulatory disparities” with algorithms provided by brokers, according to a letter by Theodore R. Lazo, associate general counsel at Sifma. The orders generated through Nasdaq’s plan wouldn’t be subject to risk filters required by the market-access rule that went into effect in 2011, he said.
“Sifma questions whether it is appropriate for Nasdaq, as a national securities exchange, to offer the proposed benchmark order functionality,” Lazo, who previously was general counsel at NYSE Regulation, a unit of New York-based exchange operator NYSE Euronext, wrote in the letter. “The commission should disapprove the proposal unless Nasdaq explains how its proposed benchmark order functionality would make markets more transparent and efficient, and how the proposal would not be at the expense of Nasdaq’s other functions.”
Sifma also challenged Nasdaq’s plan by saying it sought to offer a commercial service that would benefit from the exchange’s limitation on financial liability. Exchanges are SEC- registered self-regulatory organizations immune from civil lawsuits for activities conducted as part of their regulatory duties. Brokers don’t have that privilege, Sifma said.
“I view this as part of the natural evolution of exchange functionality,” James Angel, a finance professor at Georgetown University in Washington and a member of the board of exchange operator Direct Edge Holdings LLC, said by phone. “I can see why Sifma’s members aren’t so happy. Many of their firms offer competing algorithms. But why shouldn’t an exchange be able to offer what competitors are offering?”
The concern that Nasdaq’s algorithmic products could gain an advantage unavailable to brokers because of the exchange’s immunity is a “legitimate” complaint, Angel said.
Exchanges and brokers already compete in trading businesses such as routing and execution, an industry development that the SEC recognized in the late 1990s, Nasdaq said in a Dec. 17 letter by Deputy General Counsel Jeffrey S. Davis.
Nasdaq told the SEC in the letter that its benchmark orders were similar to existing order types it offers users and that differences shouldn’t impede approval. The exchange provided a list of risk checks it would conduct on benchmark orders submitted to its own venue or other platforms to ensure compliance with the market-access rule and avoid disorderly trading, according to the letter.
Orders submitted by the benchmark strategies it planned to offer would be treated the same way as those sent by other brokers, Nasdaq told the SEC. It also said the external provider of the application that managed the algorithms wouldn’t receive preferential treatment by Nasdaq.
Dan Mathisson, head of U.S. equity trading at Credit Suisse Group AG, told a Senate banking subcommittee last month that exchanges shouldn’t offer complicated order types, in part because it’s a service brokers normally provide and the financial costs of errant trading will be borne by the securities firms employing them, not exchanges.
“The line between algorithms that broker-dealers do and the line between order types that exchanges offer is blurry and there are a lot of similarities between the two but I think that the broker-dealer is the right place to have that complexity,” Mathisson said. “The broker-dealer is a fiduciary to the client, the broker-dealer has an error account and the broker- dealer has liability. And complex orders are more likely to fail than simple matches.”
Eric Noll, executive vice president for transaction services at Nasdaq OMX, told senators at the hearings that order types are approved by the SEC and allow “what used to be done manually to be done electronically with technology.”
“They need to be applied fairly, they need to be made available to everyone and they have to be used so they’re not favoring one type of party over another in an unfair way,” he said.
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