Financial Regulatory Forum

US SEC review expected to stir market controversies

By Reuters Staff
January 12, 2010

By Jonathan Spicer

NEW YORK, Jan 11 (Reuters) – Regulators are set to stir old controversies this week when they meet to release a paper on high-frequency trading and the broader U.S. equity markets, expected to review myriad changes over the last decade.

The U.S. Securities and Exchange Commission will vote Wednesday on whether to issue the concept release on everything from placing traders’ computers next to exchange computers, known as co-location, to the value of anonymous venues known as dark pools.

The SEC, under pressure by some lawmakers and others to do the comprehensive review despite no serious problems in stock markets, said this month the paper would look at “the performance of equity market structure in recent years,” and solicit public comment.

Industry sources said they expect the SEC to raise thorny questions such as the possibility that high-frequency traders’ lightning-quick algorithms prey on less-sophisticated investors, and whether to saddle them with new obligations.

The regulator is also expected to ask whether changes are needed to the sweeping Regulation National Market System (Reg NMS), which in 2005 forced exchanges to route orders to the venue with the best price — a move that connected U.S. markets like never before, and set them apart from other regions.

“I think we’ll have to sort through all of the existing regulations again in 2010,” said Sang Lee, managing partner focused on market structure at Boston consultancy Aite Group.

Staffers will present the concept release to SEC commissioners at the 10 a.m. EST (1500 GMT) meeting. The paper would be published shortly or within days after the vote, an SEC spokesman said.

A concept release can be the first step in the SEC’s rulemaking process. However some papers have been abandoned with no action.

Traders, analysts, and exchanges said they expected no significant market structure changes, if any, until 2011. Few would comment on record due to the sensitivity over the paper.

‘PREPOSTEROUS CLAIMS’

High-frequency trading muscled onto regulators’ already cluttered radar last year during concerns about manipulation and market stability, and with news that the trading practice was involved in an estimated 60 percent of U.S. equity volumes.

An official at one large fund management company, who requested anonymity, said he thinks some high-frequency algorithms “might be less genuine than markets would hope for.”

Senator Ted Kaufman, a Democrat from Delaware, has been a particularly vocal critic of lightning fast trading strategies, concerned it is creating a two-tier system of investors and could lead to market chaos.

The trading firms, many of which are proprietary, submit thousands of orders per second to make markets and profit from tiny price imbalances. They provide much liquidity, and argue there is little if any evidence of wrongdoing.

The SEC “will look at the various criticisms and allegations of high-frequency trading because they have to, regardless of how preposterous some of the claims are,” said a high-frequency trader who requested anonymity.

“We’re hoping they’re not pejorative in their approach and that they do not presuppose that we’re doing something wrong,” he said. “But I think they’ll do their best to be fair.”

Regulators will also consider on Wednesday proposing new risk management rules for the practice of “sponsored access,” where brokers give trading firms degrees of direct access to markets in exchange for a fee.

THE QUESTION OF ‘TRADING AT’

More broadly, the SEC could ask whether Reg NMS’s “trade through protection” is adequate, and whether a “trading at” ban is also necessary, said a source familiar with the SEC’s thinking.

Trade through protection bars exchanges and the dozens of alternative venues from executing orders at a worse price than exists on another venue. But they can keep that order in-house if there is an undisplayed, or “dark,” order willing to match it at the best national price — a move known as “trading at.”

A “trading at” ban could further heighten exchange competition, and put the time orders are received in sharper focus. It would also likely hurt dark pools, which already face a crackdown in separate SEC proposals.

It is unlikely the SEC is serious about adopting a “trading at prohibition,” the source said, noting Reg NMS was decided after about a five-year study of markets. “They’d propose it (as a question) because they’re under a lot of pressure on dark pools,” he said. (Reporting by Jonathan Spicer; Editing by Tim Dobbyn) ((jonathan.spicer@thomsonreuters.com; +1-646-223-6253; Reuters Messaging: jonathan.spicer.reuters.com@reuters.net))

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