US SEC sets market review, high-frequency probe

January 13, 2010

By Rachelle Younglai and Jonathan Spicer

WASHINGTON/NEW YORK, Jan 13 (Reuters) – U.S. securities regulators took their first stab at deciding whether rules are needed to curb high-frequency traders, whose lightning-fast computer programs now dominate equities markets.

In a move that could overhaul how markets function, the Securities and Exchange Commission voted on Wednesday to seek public comment on the rapid trades, the anonymous trading venues known as dark pools, and other market developments that have blossomed over the last decade.

The SEC will publish a so-called concept release asking whether the current structure of markets is fair to investors and whether they have the tools to protect their interests.

“The equity markets have undergone extraordinary change,” said SEC Chairman Mary Schapiro. “At the commission, we must continually assess how changes in the market are affecting investors.”

The 60-page document asks whether high-frequency traders — the proprietary firms, banks and hedge funds that use sophisticated algorithms to make markets and profit from tiny imbalances — present systemic risk.

Some lawmakers have pressured the SEC to speed up its review of the markets and are concerned that the changes have created a system that benefits computer traders and sophisticated players.

The rapid trading, estimated to account for some 60 percent of all U.S. equity trading, was one of the most profitable lines of business throughout the financial crisis.

Its defenders say there is little evidence that some are gaining an unfair advantage and say high-frequency traders add liquidity that allow markets to function.

The SEC’s much-anticipated paper asks whether high-frequency strategies are beneficial or harmful, whether the traders should be saddled with trading obligations, and whether dark pools harm the quality of price discovery.

“Obligations sound good in theory; they sound like they benefit the (individual) investor, but it’s exactly the opposite — they would entrench a select few players,” said Manoj Narang, chief executive at Tradeworx, a New Jersey-based hedge fund that runs high-frequency trading strategies.

“It harkens back to the days of designated market makers … We know what that’s like, and the regulators were the ones that changed the rules because it wasn’t good enough,” he said.

The regulator also questions whether the ultra-fast trading strategies need new rules and whether co-location — when trading firms rent space near an exchange’s trading system — give those trading firms an unfair advantage.

A concept release can be a precursor to rulemaking but does not always result in new rules. It will be open for a 90-day comment period.

The SEC’s examination into the country’s market structure comes as the White House and U.S. Congress try to revamp the way the financial system is supervised.

Under some pressure from lawmakers, the SEC proposed a ban on flash orders that stock exchanges send to a select group of traders before revealing them publicly.

The SEC has also proposed ways to shed light on dark pools by revealing the electronic trading messages that are sent to a limited group of market participants. (Reporting by Rachelle Younglai and Jonathan Spicer; editing by John Wallace and Gerald E. McCormick) ((; +1 202 898 8411))

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