Exchange Regulation Needs Review, Credit Suisse Says

The botched initial offering of Facebook Inc. is the catalyst that should lead to U.S. exchanges being stripped of self-regulatory powers and their related benefits, a Credit Suisse Group AG executive said.

Nasdaq Stock Market’s claim of immunity from liability for $500 million in brokerage losses stemming from technology problems on May 18 exposes a conflict between the historical, quasi-governmental role of exchanges and their status as profit-seeking public companies, Dan Mathisson, head of U.S. equity trading at Credit Suisse, told U.S. senators in Washington last week. Those tensions can’t be managed fairly and should spur a regulatory overhaul of the securities market, he said.

Legislation that created the Securities and Exchange Commission in 1934 also deemed the main venues self-regulatory organizations, or SROs, overseeing their member firms and trading. Critics say the Facebook mishap shows how changes in the structure of markets have made old regulations obsolete and created an uneven playing field where exchanges are governed by one set of rules and their competitors another.

“We recommend that the SRO status of the exchanges be examined,” Mathisson said at a Senate banking subcommittee meeting Dec. 18. The Facebook trading breakdown highlighted a “peculiar quirk of the U.S. market structure -- that exchanges do not have material liability for their failures. It is time for policy makers to correct this mistake,” he said.

Absolute Immunity

Like the Commonwealth of Virginia and Indian tribes, exchanges have absolute immunity for actions taken as part of their regulatory duties. The doctrine arose when exchanges were not-for-profit organizations owned by their member firms. The shield protects them from lawsuits related to the exercise of powers delegated by the SEC and prevents financial losses that could jeopardize institutions seen as vital to the U.S. economy.

“The concept of being an SRO is historically based on the idea of having obligations to the market and getting certain benefits” for living up to them, Joe Mecane, head of U.S. equities at NYSE Euronext, said at the hearings. The responsibilities include providing open and fair access to all investors, publishing rules and fees, and overseeing trading, while the economic advantages include immunity “when performing certain of their regulatory functions” and revenue from the sale of quotation and transaction data, he said.

‘Sacred Cows’

SEC Commissioner Daniel Gallagher said in October that Congress should modernize laws built around the SRO framework in the current high-speed, electronic era of rival exchanges that outsource much of the oversight and surveillance they once performed themselves. He questioned whether they should remain SROs and said a broad analysis of the U.S. market and regulatory structure should tolerate “no sacred cows.”

The Facebook debacle illustrates the growing tension between public exchanges, or SROs, and their brokerage members, many of whom operate competing trading venues themselves. Friction has increased as exchanges became for-profit corporations with shareholders and the members that once owned them created private venues to execute orders.

With 13 stock exchanges, about 50 private broker-run dark pools that trade shares, and securities firms executing orders through their own systems for clients, the New York Stock Exchange and Nasdaq no longer operate monopolies or oversee the bulk of trading in corporations they list. NYSE became public in 2006 when it combined with Archipelago Holdings Inc. in a reverse merger. Nasdaq, already public, became an exchange that year. It previously operated a decentralized dealer market.

Facebook Catalyst

“Facebook is the catalyst,” said Mathisson, whose company operates the largest U.S. dark pool, before the hearings. “This issue has been burning since 2004 but it’s been burning in the background,” he said, referring to a 73-page paper the SEC published about regulatory and commercial conflicts within SROs. “What got everybody talking was Facebook because it raised questions about Nasdaq’s limited liability and raised questions about why they have this legal status that’s different.”

Four brokerage firms say they lost a combined half-billion dollars after Nasdaq mishandled Facebook’s offering on May 18, allowing its systems to be overwhelmed by order updates and cancellations just as the stock was to begin trading. Nasdaq, enjoying legal protection afforded by its SRO status, has proposed a voluntary compensation of $62 million instead of the $3 million cap its rules allow for technical problems it causes.

The SEC hasn’t ruled on the proposal. Citigroup Inc. asked the commission to reject it, saying the exchange’s decisions resulted from “high-risk, profit-oriented behavior” by Nasdaq and not actions that are part of its regulatory oversight, according to an August letter.

Making Whole

UBS AG, which says it lost more than $350 million related to technical problems with the Facebook IPO, told the SEC that brokers should be made whole. Market-maker Knight Capital Group Inc., which nearly went bankrupt after its own trading mishap in August, recommended the SEC approve Nasdaq’s proposal.

The payout proposal covers what’s “directly attributable to the system issues experienced by Nasdaq,” the exchange operator told the SEC in a Dec. 7 letter.

Facebook highlights the strained relationship between exchanges and some of the large broker-dealers that use them. While firms such as Citigroup and UBS lack the privileges afforded to NYSE and Nasdaq under their SRO status, both firms operate hidden-order venues that carved out profitable niches partly because, as brokers, they don’t face SRO duties.

Matching Upstairs

“It’s a tug of war between brokers and the exchanges,” Jerry Markham, a law professor at Florida International University in Miami and author of “A Financial History of the United States,” a three-volume account that starts in the 15th century, said in a phone interview. “Exchanges say we’re a centralized marketplace and trading will be more efficient, and broker-dealers want to match orders upstairs away from the exchanges.”

Since 1994 when the SEC last studied the underpinnings of the U.S. markets, most trading has become automated and the biggest exchanges went public, Gallagher said at a Securities Industry and Financial Markets Association conference in New York in October. Yet the rules for trading and brokers’ conduct are premised on a self-regulatory framework put in place decades ago and based on practices that existed even earlier.

Gallagher said self-regulation is at a “crossroads” and should be examined as part of a wider review of the rules that define exchanges and broker-run dark pools. The electronic markets that have risen around NYSE Euronext, which had a market value of almost $5.9 billion before announcing a takeover by IntercontinentalExchange Inc. on Dec. 20, and Nasdaq OMX are “light years” from the trading industry in 1994, he said.

Policing Themselves

Exchanges responded to potential conflicts in policing themselves while trying to earn a profit by entering agreements with the Financial Industry Regulatory Authority to conduct market oversight and surveillance, Neal Wolkoff, former CEO of the American Stock Exchange, said in a phone interview. Still, they remain responsible for trading on their venues and make decisions about when to halt buying and selling to preserve fair and orderly markets, he said.

“You need price-determining institutions with transparency to have a transparent market,” said Wolkoff, now an attorney at Richardson & Patel LLP. “There has to be some mechanism for exchanges to have a basic threshold of oversight of their own marketplace. There’s less to be done now than used to be the case, but there’s not nothing to be done.”

Big Questions

NYSE and Nasdaq have appealed to regulators for help stemming the encroachment of alternative venues such as dark pools into their business. Any discussion of the value of self-regulation should encompass other “big market structure questions” such as high-frequency trading, dark pools and competition between exchanges and brokers operating venues, Mecane said in a phone interview.

“Our position is that the status quo doesn’t work,” Mecane said. “We need to dial it back or open it up further.”

The owner of the 220-year-old New York Stock Exchange will sell itself to Atlanta-based energy and commodities market operator IntercontinentalExchange, known as ICE, in part because the profitability from facilitating U.S. equity trading has declined over the last decade as brokers and other venues siphoned away business. The Big Board now accounts for 21 percent of volume in the companies it lists, compared with 82 percent 10 years ago, according to data compiled by Bloomberg.

$464 Million

Exchanges are public markets where all investors trade according to the same rules and discrimination among customers isn’t allowed. They split revenue from the sale of public equities market data that totaled $464 million in 2008, the SEC said in 2010. They have lower financial requirements than brokers processing trades and benefit from the legislative shield against civil lawsuits for actions that are part of their oversight duties.

Their roles running transparent markets and facilitating the process of capital formation warrant the immunity they receive, Eric Noll, executive vice president for transaction services at Nasdaq OMX, told senators last week.

“Exchanges by their very definition exist to perform the price-discovery function by gathering trading interest from all participants that want to participate and conduct that activity in a fair, transparent, accessible manner,” Noll said. “No other market participant has those same obligations.”

Few Obligations

Dark pools, private venues that face few of the obligations exchanges do, came to prominence over the last five years because of changes in regulation and technology starting in the 1990s. The shift to decimal pricing in 2001 from eighths and sixteenths of a dollar led to better prices and drove firms later known as high-frequency traders. SEC rules that went into effect in 2007 gave advantages to fast electronic trading over systems that relied on human intermediaries.

A third of trading now occurs away from exchanges, up from 16 percent in early 2008, excluding platforms called electronic communication networks that compete with public markets, according to data compiled by broker Rosenblatt Securities Inc. Dark pools, which accounted for less than half the off-exchange volume two months ago, tripled their share since the first quarter of 2008, the Rosenblatt data show.

While dark pools are allowed to discriminate among users and limit access to their venues, the brokers that operate them aren’t without responsibilities. They have fiduciary obligations to get clients the best execution possible, a duty that isn’t shared by public exchanges. Carrying it out doesn’t translate into protections from civil liabilities.

Blurred Lines

“We certainly would feel that consequence if we had a failure within our system and it was attributed to our technology,” Bob Gasser, chief executive officer of broker Investment Technology Group Inc., said at last week’s Senate hearings. ITG created its Posit venue, now known as a dark pool, in 1987. Gasser urged the SEC to resume a study of equities market structure from early 2010.

Blurring lines further, many dark pools competing with exchanges are owned by the exchanges’ biggest brokers. Barclays Plc, Goldman Sachs Group Inc., Knight and automated trading firm Getco LLC, which said Dec. 19 it will acquire Knight, are the four main designated market makers overseeing trading in corporations listed on the Big Board. All run private trading venues. Morgan Stanley, Citigroup and market-maker Citadel LLC also own platforms to execute client requests.

’Exhaust’ Orders

Orders from mutual funds and brokers often seek executions by passing through multiple dark pools, with exchanges as the final destination, according to Duncan Niederauer, chief executive officer of NYSE Euronext. Instead of higher-quality orders, public markets -- which set the prices for shares -- get the “exhaust” or leftovers when buy and sell requests routed through private networks remain unexecuted, he said at a company investor-day event in April.

The estimated annual net income of about $400 million that exchanges and Finra receive from the sale of public market data is a “government-granted windfall” that comes at the expense of investors, Credit Suisse’s Mathisson said. It far exceeds the regulatory costs of SROs it’s supposed to offset, he said.

Many of Mathisson’s suggestions for changes to the SRO regime are “focused on reducing the economics for exchanges and transferring a lot of those benefits back to the investment banks,” which compete with exchanges by running their own venues, Mecane told legislators.

Richard Ketchum, CEO and chairman of Finra, said at the Sifma conference in October that while the SRO model should be evaluated, no overhaul is needed. Finra, an SRO, was formed in 2007 when NYSE Euronext’s regulatory unit for member oversight combined with the National Association of Securities Dealers, which created Nasdaq in 1971.

“It continues to make sense for exchanges to be self-regulatory organizations even though they’ve been commoditized, even though they operate in ways that are not so dissimilar from alternative trading systems,” Ketchum said. Their “collective responsibilities” toward the marketplace should remain part of their duties, he said.

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