SEC faces challenges before fast-trading reforms can go on the books
By Emmanuel Olaoye, Compliance Complete
The Securities and Exchange Commission has rolled out its intentions to regulate high-frequency trading, making stricter regulation in some form a strong possibility, but the agency faces more work and some challenging obstacles before it can put new rules in the books.
SEC Chair Mary Jo White in a speech last week outlined her goals for regulating high-frequency trading (HFT), at a time when political interest over the fairness and risks of the practice has surged in the wake of a best-selling book by financial writer Michael Lewis.
White‘s intentions for regulating high-frequency trading, which has taken a dominant role in U.S. equity markets, include registration requirements for proprietary fast-traders. Under such rules, firms registering as broker dealers would have to meet net capital requirements and establish adequate risk management controls.
The agency is also working on a rule to restrict disruptive trading rule. The rule would apply to proprietary traders in “short time periods when liquidity is most vulnerable and the risk of price disruption caused by aggressive short-term trading strategies is highest.”
The initiatives sound good on the surface but the SEC needs to work out the details, said Bernard Donefer, a professor of information systems in financial markets at Baruch College in New York. This includes learning more about the trading strategies of HFT firms before forcing them to register.
“I want them to be clear on what the strategies are before they are made to register. You can have firms that are proprietary traders using their own money, but they are not market makers. If you are a hedge fund or an asset management firm that uses similar techniques they shouldn’t have to register.”
Furthermore, the SEC should define what it means by a disruptive trading strategy, Donefer said. “What is a vulnerable trading strategy? On the surface it’s a wonderful thing. But at the end of the day what does that really mean?”
“I don’t understand how she will define vulnerable periods nor do I know what strategies will be included. The disaster next time will be different from the last one.”
Donefer said he doesn’t expect the plans to create compliance problems for the bulk of the HFT industry. He said many firms had already taken steps to improve their risk management practices and IT infrastructure.
High frequency traders use computer algorithms and sophisticated technology to buy and sell shares at fractions of a second. Lewis’ book, “Flash Boys: A Wall Street Revolt”, accused high-frequency traders of using their faster computers to rig the stock market, and his criticisms have caught on with members of Congress and other policy advocates.
Supporters defend high-frequency trading as a source of liquidity that also drives down trading spreads, saving money for market participants.
Reform advocates say HFT regulation is sorely needed.
Registration of HFT firms is “a critical first step” that has been long overdue, and rulemaking should start as soon as possible, said Dennis Kelleher, president and chief executive officer of Better Markets Inc., a public advocacy group in Washington
“It is terrific that the SEC chair has made abusive, predatory HFT practices an SEC priority. It is also encouraging that there appears to be broad support among all SEC commissioners to put an end to practices that are not only unfair and illegal, but that kill investor confidence in our markets,” he said.
The SEC has “studied these issues for a long time and already has sufficient information to take further action now,” he said.
In that vein, he said an “anti-disruptive trading rule” could take too long to write.
“A rulemaking will just give the industry more opportunity to kill or delay any meaningful, long overdue change. The markets are moving at nanoseconds and the SEC is moving in years, trying to get into the 21st century. The time for debate and industry input should be over.”
The SEC may need legislation if it wants all high frequency traders to register as broker dealers, said Jerry Markham, a professor of Law at Florida International University.
He said traders who trade solely on their own account are exempted from broker dealer registration under the Securities Act of 1934.
“I don’t know how they are going to overturn that without getting legislation,” Markham said. “They may try but they tried to do the same thing with hedge funds … They tried to have them register as advisers and they ran into a buzz saw with that.”
“If high frequency traders have to register as broker dealers you may have to bring in hedge funds, pension funds and all the mutual funds … Anybody that trades actively in the markets. I don’t see how you can pick one and not the other. I see this as being problematic.”
The challenge of writing an anti-disruptive trading rule is getting it through the rulemaking process, said Markham.
He said the process could take anything from six months to a year. Even then the HFT industry may challenge the rule in court. He noted that several Dodd-Frank rules have been thrown out by federal courts on the grounds of inadequate economic analysis.
“The courts have a tendency to throw out the SEC’s rulemaking because they haven’t considered the costs and benefits of the rule. It’s a fairly involved process. With the complexity of this high frequency trading, who knows?”
(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)