SEC Puts Exchanges on Notice Over Computer-Driven Trades
More than five months before a software error ruined Bats Global Markets Inc. (BATS)’s initial public offering, U.S. regulators put exchanges on notice that they need to do more to protect investors from technology gone awry.
The missive came in the form of a prologue to a Securities and Exchange Commission case against Direct Edge Holdings LLC in October over claims the exchange operator had weak internal controls that caused its trading system to fail.
The agency, working to avoid another event like the May 6, 2010, rout that erased $862 billion from equities in 20 minutes, decided to use the Direct Edge case to create a blueprint for actions against other exchanges, according to a person with direct knowledge of the decision. While the SEC didn’t fault exchanges in the 2010 crash, the event magnified pressure on the commission to show it can ensure the fragmented marketplace of high-speed, computer-driven trading is safe for investors.
“The consequences of a big failure are so severe that the SEC should be paying close attention to these issues,” James Angel, a finance professor at Georgetown University’s business school in Washington, said in an e-mail. “No human system is perfect and eventually something will happen, so they also want policies and procedures in place for catching problems quickly and cleaning up the mess afterwards.”
The 2010 “flash crash,” as it has come to be known, spawned about 20 separate SEC investigations encompassing a dozen areas of possible securities law violations, according to the person, who spoke on condition of anonymity because the probes aren’t public. One involves types of orders used on Bats and Direct Edge, according to another person who declined to be named because the matter isn’t public.
Focus on Disruptions
While some of the investigations involve possible illegal trading practices, those that focus on exchanges revolve around whether the venues have the right compliance structures to address trading disruptions that could spiral out of control.
Typically, the SEC’s trading and markets division and exam staff work with exchanges to ensure their internal policies and procedures are adequate. The Direct Edge case, which was a rare joint effort by those two offices and the enforcement division, showed that the agency is ready to impose sanctions on exchanges that don’t have proper systems in place.
Daniel Hawke, chief of the SEC enforcement’s market abuse unit, said “exchange conduct and compliance is an area of renewed enforcement interest.”
‘Risk of Harm’
“The risk of harm to investors and their confidence in the fairness and integrity of the markets increases when exchanges fail to follow or enforce the rules that are applicable to them or to the member firms they regulate,” Hawke said in an e-mail.
Bats, in a statement last week, said that it responded appropriately to a computer malfunction in its IPO auction process, which triggered problems with its quotations and forced a halt in Apple Inc. (AAPL) Still, the public nature of the company’s March 23 debacle has cast fresh light on the complexity of modern markets and how regulators are grappling with a proliferation of electronic trading platforms.
The SEC has asked Bats for information about types of orders used by some of the fastest automated trading firms, who attempt to be first in line when supplying bids and offers, according to a person with knowledge of the matter. The agency, interested in orders with so-called price-sliding features, is also making inquiries about Direct Edge, the person said. Bats disclosed the matter in an IPO filing in February.
The request from the SEC’s enforcement division sought information about how order types have evolved at the third- largest owner of U.S. equity exchanges by volume, according to the filing. 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 Bats’ owners.
The SEC probe, which asked for information about automated trading firms Tradebot Systems Inc. and Getco LLC, may lead to guidelines from the regulator about how exchanges communicate with customers, the person said. Tradebot and Bats were founded by the same person, Dave Cummings. Getco owns a stake in Bats, and so does Tradebot.
Sophie Sohn, a spokeswoman for Chicago-based Getco, said the company doesn’t comment on legal or regulatory matters. Cummings declined to comment.
“All exchanges have different order types and they’re designed to incentivize or facilitate trading on that market venue,” said Adam Honore, research director at Boston-based Aite Group LLC. “The SEC may want to know if some people have an unfair understanding of how the market operates that’s not available to everyone.”
The SEC has approved price-sliding order types at Bats and Direct Edge. Versions are also available on Nasdaq Stock Market and NYSE Arca. Nasdaq’s offering has been available since at least 2007, according to rule filings sent to the SEC.
Technology and speed have become more important as trading has become fragmented across 13 U.S. stock exchanges, several alternative venues and a few dozen private broker-run markets. Rival exchanges and venues are tied together through data linkages and regulations and form a national marketplace that gives investors a unified view of prices and where shares are available to buy or sell.
Many of the newer exchanges started as technology-focused trading platforms. Regulators are concerned that these firms have less experience with the obligations associated with being an exchange, including writing and enforcing trading rules, according to a person with knowledge of the matter.
While technology or system outages “inevitably will occur” and don’t always violate the law, weak controls can exacerbate problems and inflict harm on investors, the SEC said in the order against Direct Edge in Jersey City, New Jersey.
The Direct Edge order spelled out what the SEC considers the exchanges’ responsibilities: “National securities exchanges are obligated to ensure that their order quoting, routing, and execution systems, compliance infrastructures, and communications platforms are developed, maintained, and governed to avoid material failures, outages, and other significant contingencies that could pose material risk to the National Market System and to the public interest.”
To resolve the SEC’s claims, Direct Edge, without admitting or denying wrongdoing, agreed to implement policies and procedures to improve its controls. The firm, which had already paid back $2.1 million to harmed customers, said in October that it had “vigorously executed” its plan to enhance technology, personnel and processes.
The New York Stock Exchange and Nasdaq now account for less than 26 percent of trading in the corporations they list, down from 80 percent in 1997, as new trading venues emerged, such as Direct Edge and Lenexa, Kansas-based Bats. Direct Edge accounts for 9.3 percent of U.S. equities volume, according to data compiled by Bloomberg.
“It used to be that exchanges would never go down,” said Larry Tabb, chief executive officer of research firm Tabb Group LLC in New York. “Today the exchanges focus a lot more on speed and cost. What the SEC wants is for them to not forget about resilience and process.”
Larry Harris, a finance professor at the University of Southern California Marshall School of Business in Los Angeles, said exchanges’ interests as for-profit corporations can be at odds with their duty to put market stability first.
Conflict of Interest
“The exchanges have a conflict of interest that should be of concern to any regulator,” Harris said. “They want to stay open and take order flow and they don’t want to be perceived as being a problem. But when they have problems, they can’t be allowed to gum up the system.”
Before trading became predominantly electronic, market makers could use judgment to stop activity while a problem was sorted out, Angel said. Computers, on the other hand, are “mechanical drones.” Since trading can rapidly become disorganized without proper curbs, the SEC must ensure the exchanges have effective emergency controls, he said.
Trading disruptions of various sizes occur with some regularity. In April 2011, Nasdaq voided trades in 84 securities after a system malfunction produced “invalid and stale” quotations over 35 minutes, the company said at the time. In February, NYSE Amex Options canceled 14,000 of more than 31,000 accidental executions in 27 seconds, and a computer error at the Tokyo Stock Exchange (TOPIX) disabled trading of 241 companies for two and a half hours.
First of Its Kind
In the Direct Edge case, the first of its kind, the SEC said an untested change to a computer code in November 2010 caused its two exchanges to execute about $773 million in unwanted trades. In another instance, an administrator inadvertently stopped the exchange’s ability to process orders. It took Direct Edge 24 minutes to remove its quotations from the processors that publish market data to the public, a move that should have happened “immediately,” the SEC said.
Exchange operators must show they can fulfill their responsibilities as markets and be able to “avoid material failures, outages and other significant contingencies” that could disrupt trading, the agency said in the October order.
“This is not a technology problem where you have to spend more money,” Aite’s Honore said. “This is standard stuff for anyone with mission-critical applications. It’s a process problem where you have to spend more time.”
Direct Edge submitted new policies to the SEC on March 22, including procedures to cancel orders at its routing broker in the event of an outage or technical problem. The exchange company said it would also use a third-party broker to liquidate positions acquired in the account and institute new controls.
Michael T. Dorsey, an attorney at the SEC from 1986 to 1994 later general counsel of Knight Capital Group Inc. (KCG), said that regardless of their cause, trading disruptions mean investors could make decisions based on bad information.
“If people are induced to trade based on quotation or last-sale information, the data had better be reliable,” Dorsey said.