Rule Fragmenting Trading Worth Review, Gallagher Says

U.S. regulators should reconsider the 2007 rule change that helped disperse stock trading among more than 50 different platforms and caused complexity that critics say increased malfunctions, Securities and Exchange Commissioner Daniel Gallagher said.

The SEC’s Regulation NMS, named for National Market System, mandates that U.S. stocks must trade on the venue that has the best price at any time, helping private trading platforms and upstart exchanges take business from the incumbent public markets, NYSE Euronext and Nasdaq OMX Group Inc.

“It’s a prime candidate for a retrospective review,” Gallagher told the Security Traders Association market structure conference yesterday.

The commissioner, one of five members of the SEC, also said the agency should re-examine other market-structure rules, including the move to quoting all stocks in 1-cent increments and the self-regulatory role played by exchanges, Gallagher said. SEC Chairman Mary Jo White said Oct. 2 that the exchanges’ business models and regulatory roles should be “fully evaluated in light of the evolving market structure and trading practices.” She has not publicly endorsed a review of Regulation NMS.

While NYSE Euronext and Nasdaq OMX Group still run the exchanges serving as the home markets for all U.S. stocks, the importance of listing venues has dwindled since Reg NMS took effect in 2007. Shares now change hands on more than 50 trading systems, including 13 public exchanges as well as private venues and internal platforms at brokers.

‘Extraordinary’ Shift

The rule brought about an “extraordinary” shift in market share for NYSE-listed stocks, pushing transactions onto other venues, the SEC said in its 2010 concept release that solicited public input on the structure of equity markets.

An examination of Reg NMS would be welcomed, said Christopher Concannon, a principal at New York-based trading firm Virtu Financial Inc. and Nasdaq’s former executive vice president for transaction services. He was an SEC attorney in the 1990s.

“It’s time for a full review of Reg NMS,” he said during an interview at yesterday’s event. “A holistic review of Reg NMS would be appreciated by the industry.”

Risks stemming from the market’s fragmentation were underscored on Aug. 22, when Nasdaq’s system for distributing prices broke, prompting a three-hour halt for thousands of companies.

SIP Malfunction

While trading takes place on multiple venues, Nasdaq and NYSE are still responsible for publicly disseminating prices for the stocks they list. Nasdaq’s malfunctioning securities information processor, or SIP, prompted the company to freeze transactions everywhere for all its companies.

White called exchange executives to Washington on Sept. 12 to discuss the breakdown and order the industry to collaborate on preventing future technology errors. Improvements under consideration at NYSE and Nasdaq include acting as each other’s SIP backups, two people briefed on the matter said last month.

Gallagher also said that the SEC has moved too far toward treating exchanges like any other investment company by punishing them for technology glitches and mishandling market-data duties, he said.

Under federal law, exchanges perform some of the functions of a regulator by policing trading on their marketplaces. Some brokers that run competing trading venues have asked Congress and the commission to remove the exchanges’ special status, saying it’s an advantage that shields them from legal liability against private claims.

A ‘Burden’

Exchanges’ self-regulatory duties actually are a “burden” for them, Gallagher said, because SEC enforcement actions show the agency no longer treats them as though they have any special status. The commission should conduct a wholesale review of equity market-structure rules, including the self-regulatory nature of exchanges, Gallagher added.

“What I worry about at the commission now is this trend toward treating these exchanges as investment banks,” Gallagher said. “There has been this notion over the last four years that these are for-profit entities, just profit-seeking entities that totally disregard their self-regulatory obligations. I personally don’t believe that’s true.”

Over the past two years, the SEC has penalized NYSE Euronext, Nasdaq OMX Group, and CBOE Holdings Inc. for regulatory failures. Nasdaq agreed in May to pay $10 million to settle SEC claims that its mishandling of Facebook Inc.’s initial public offering last year was a violation of securities laws. Direct Edge Holdings LLC was faulted without a fine by the SEC in October 2011 for having weak controls that led to about $2.8 million in trading losses and a system outage.

(Corrects last paragraph of story published on Oct. 4 to report that Direct Edge was not fined by SEC.)
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