SEC Says Big Regulatory Initiatives Coming This Fall

Traders Magazine Online News, September 21, 2009

Nina Mehta

The Securities and Exchange Commission is engaging in a broad reassessment of equities market structure against the backdrop of an increasingly automated trading environment. This comes on the heels of a rule proposal last Thursday that would ban flash orders on equities and options exchanges.

“The securities market has experienced extraordinary changes over the last few years in trading technology and practices,” James Brigagliano, co-acting director of the SEC’s Division of Trading and Markets, said last Thursday at one of the Commission’s regular open meetings. “Some of these changes have led to serious concerns about whether the regulatory structure remains up to date.”

Broadly, the SEC is looking at how technology and automated trading have altered the landscape in the wake of Regulation NMS, which was implemented for exchanges in March 2007, and whether that has led to unfair trading practices. Reg NMS forced the New York Stock Exchange to become electronic, ending the Big Board’s monopoly over trading in its listed stocks.

As a result of Reg NMS and Regulation ATS, which became effective in 1999, the overall equities market has become more competitive as well as more fragmented. These big rule changes produced a bevy of alternative trading systems that do not display quotes publicly. Some of these ATSs are crossing platforms for block orders. Most, however, are broker-operated dark pools whose average execution size is several hundred shares.

Brigagliano on Thursday laid out many of the trading issues currently on the SEC’s plate. The SEC, he said, is “looking at the threshold levels of Reg ATS, looking at post-trade transparency for some of the dark venues so that investors can assess the relative levels of volume and liquidity [in particular securities in those venues]. We’re looking at the use of IOIs, which can have analogous features to flash orders, DMA, co-location, and high-frequency trading.” The comment about IOIs referred to automated indications of interest sent by some ATSs to one another to search for liquidity.

Brigagliano noted that several SEC initiatives “may be in form of proposals where we think prompt action is warranted.” He added that high-frequency trading is an issue that would most likely fuel a “big picture discussion,” rather than an immediate policy initiative.

SEC Chairman Mary Schapiro has said several times over the last six weeks that market and trading practices with “opaque features” are coming under greater regulatory scrutiny. Last Thursday, at the SEC’s open meeting that discussed flash orders, she said the SEC “is continuing to review other forms of dark trading that lack market transparency, and I expect that initiatives in this area will be considered in the near future.”

Flash orders are orders that enable a market center that is not quoting at the best price to execute that order by soliciting contra-side interest at the market’s best quoted price from its participants. The SEC said last week that flash orders unfairly give select market participants information that is not available to the broader market.

Larry Tabb, founder of research firm TABB Group, has thought for a while that a broad market structure reassessment is warranted. “Pretty significant changes in the structure of the markets are happening because of changes in the dynamics of trading,” Tabb told Traders Magazine last month. “Some of it is the result of decimalization, some of it is the result of advanced technology, and some of it is because of who’s provisioning liquidity and how. I think the SEC is thinking about all of these changes, how market structure impacts this ecosystem, and how that affects trading costs.”

Tabb said he didn’t know how extensive the regulatory changes this fall might be. “If the whole Rube Goldberg thing actually works and provides good executions for both individuals and institutions, you leave it alone, even if it is complicated,” he said. “But if we can determine that there’s a large group of people taking advantage of information, then we need to do something.”

At last Thursday’s meeting, Kathleen Casey, one of two Republicans among the five SEC commissioners, said she considers an overarching review of trading issues necessary. “I would like to see the Commission engage in a comprehensive review of the current structure of U.S. securities markets,” she said. “We are several years past [Regulation] NMS and, given the rapid change in technology and the market, I believe it is an appropriate time for a broad-based review of market structure issues.”

Elisse Walter, one of the Democratic commissioners, said flash orders were just the “initial step in a series of actions” the Commission would likely take in the coming months. She stressed the need to address dark pools and the automated IOIs they send one another, as well as “Regulation ATS thresholds.” The latter referred to both the display and fair access requirements for ATSs. In addition, Walter highlighted sponsored access, high-frequency trading and co-location as topics needing greater regulatory focus.

“The Commission is looking closely at all of these matters to determine whether they raise policy concerns that are analogous to flash orders or otherwise may be detrimental to the fairness and efficiency of the national market system,” Walter said.

The recent demand for a review of market structure developments has come from several sources. Senators Chuck Schumer of New York and Ted Kaufman of Delaware, both Democrats, urged the SEC to ban flash orders over the summer. Sen. Kaufman has also called for a wide-ranging review of a number of trading practices, including the growth of high-frequency trading and co-location. In addition, there has been a broad public discussion in the mainstream media and on blogs about how the equities market is evolving.

Robert Colby, a veteran regulator who left the SEC’s Division of Trading and Markets earlier this year and is now counsel at law firm David Polk & Wardwell, observed that the chief criticisms the SEC is currently facing are concerns about the potential lack of fairness in the markets, the fragmentation of trading centers and allegations of manipulation in the markets. He commented on these issues in a speech at a mini-conference sponsored by research firm Aite Group last Wednesday.

Colby addressed some of the public discussion that trading issues have generated over the last two months. Some of the fervor behind the widespread outrage, he said, amounts “to a kind of muddled jumble of important concerns and a misunderstanding of what trading markets are really like today.”

He stressed that there are serious regulatory concerns about some of the trading issues that have developed. A form of sponsored access called “naked access” or unfiltered access, he said, “raises really important and significant risks for the entire equities market.” At the same time, he suggested, some issues have been magnified in recent public discussions. “Flash orders have been added to the perp walk,” he said, noting that the internalization of customer orders by broker-dealers has existed for a long time, so “the concept is not new.”

On Friday, in a speech at Georgetown University about global finance, SEC Chairman Schapiro suggested that disclosure and transparency are the guideposts that will help the SEC update rules and practices in a range of areas, from oversight of credit ratings agencies to municipal securities and equities trading. She went on to note that the SEC’s decision to propose a ban on flash orders fits into the Commission’s “disclosure regime, because it’s about letting all investors have equal access to information.”

Many of the changes in the equities market now under consideration could affect trading volume as well as competition between market centers. Brian Hyndman, an executive at Nasdaq OMX Group, said last Wednesday at the Aite conferencee about high-frequency trading and other issues that his company worried about the unintended consequences of “some of the regulatory changes that have either come out or will come out.” Representatives of NYSE Euronext, BATS Exchange and Direct Edge, who were also on the panel, agreed with him.

For more information on related topics, visit the following channels:

• Exchanges and ECNs
• Crossing Networks/ATSs

Inquiry Stokes Unease Over Trading Firms That Shape Markets

I would like to extend a welcome to all of our past members from Wall and Broad.  As you all may recall, the Alliance of Floor Brokers has always been a group that has fought for the integrity of the marketplace.  I invite you to read the articles I have found from various sources.  Most of these focus around the much publicized topic of High Frequency Trading.  Currently the SEC is reviewing the practice of flash orders types, and the NYSE is on the right side of the argument.  Please feel free to comment on our blog.  Your years of service to the exchange can provide us with valuable input, as we continue to represent the floor community.

Patrick Armstrong

Co-President AFB

On The Cover/Top Stories
The New Masters of Wall Street
Liz Moyer and Emily Lambert 09.21.09, 12:00 AM ET

Daniel Tierney and Stephen Schuler share a lot of traits with many other enigmatic traders populating the financial world. Their firm, Global Electronic Trading Co., is tucked behind a nondescript door on the second floor of the Chicago Board of Trade’s art deco building. Until this summer, when it added some company specifics, its Web site contained little more than a reading list with recommendations like Reminiscences of a Stock Operator. Not a single photo is publicly available of either of its principals.

What distinguishes Tierney and Schuler is that Getco, as their firm is known, currently buys and sells 15% of all the stocks traded in the U.S., ranking it among the likes of Goldman Sachs and Fidelity Investments. Getco was reportedly valued at $1 billion two years ago and is rumored to have earned roughly half as much as that in net profit last year alone. Tierney, 39, and Schuler, 47, are among Wall Street’s super-nouveau-riche.

“We translate technology innovation into making financial markets more efficient,” Tierney says in a carefully worded interview.

Getco earns its outsize profits buying and selling securities up to thousands of times a second. This frenetic profession has come to be known as high-frequency trading, and in recent months it has emerged as the hottest ticket on Wall Street. Even as financial markets collapsed last year, high-frequency traders collectively enjoyed $21 billion in gross profit, according to Tabb Group. On the NYSE, daily volume surged 43% through June from a year earlier to 6.2 billion shares; high-frequency traders are believed to account for 50% to 70% of the activity and similar proportions in electronic futures and options markets.

In the process they have ushered in the most wrenching, and controversial, transition in the history of U.S. securities markets. For decades the New York Stock Exchange towered over U.S. equity trading, with its market share rarely dipping below 80%. Nasdaq and other electronic rivals slowly chipped away at it. But the real shakeup has come very recently at the hands of high-frequency traders and the band of scrappy exchanges that have popped up in their orbit. In the past two years they have collectively cut, from 50% to 28%, the share of equity volume controlled by the NYSE, even as it has sacrificed its iconic floor to the whims of the electronic crowd.

With their emergence as the predominant source of activity and profits, high-frequency traders have become the new masters of the Wall Street universe, reshaping financial markets in their image, just like the junk bond kingpins, corporate raiders and private equity powerhouses who reigned before them. High-frequency traders and their offshoots–the public trading venues that cater to them and the private “dark pools” that seek to shut them out–have become lightning rods for criticism among frazzled individual investors and grandstanding politicians who are shocked–shocked!–to find Wall Street trying to make a buck at a time like this.

Senator Charles Schumer (D–N.Y.) has demanded that the Securities & Exchange Commission prohibit the high-frequency gang from using something called flash quotes. SEC Chairman Mary Schapiro warned the lack of transparency in dark pools has “the potential to undermine public confidence in the equity markets.” Nasdaq’s Robert Greifeld has called for banning them outright. “America is destroying its capital market structure,” frets Thomas Caldwell, chairman of Caldwell Asset Management, an NYSE investor.

Here’s another viewpoint: All these scolds are missing the bigger picture. High-frequency trading adds liquidity, speeds execution and narrows spreads. This contrary view comes from, among others, George (Gus) Sauter, who oversees $920 billion in investments for the Vanguard Group. “We do think [high-frequency trading] enhances the marketplace for all traders,” he says.

Getco’s story parallels the changes afoot. Tierney, a cerebral economist and philosopher, began trading options on the floor of the Chicago Board Options Exchange in 1993. Schuler, a gregarious futures broker, started out in 1981 on the floor of the Chicago Mercantile Exchange and eventually opened his own firm. Acquaintances from the clubby world of Chicago’s financial markets, they started talking about going into business together in 1999 and set up Getco that year as part of a vanguard of floor traders migrating from the pits to “upstairs” computerized trading rooms.

Early on the firm operated out of space in Schuler’s firm barely big enough for a couple of desks and computers. For trading talent the partners scoured nearby Illinois Institute of Technology in search of skilled videogamers. As Getco grew, they bought gear from dying Internet companies and coded it to operate with ever less human intervention.

Sidebars:
High Frequency Who’s Who�
Trading for Dummies

Special Offer: Free Trial Issue of Forbes

From the get-go the strategy was to trade fast, furiously and electronically. Getco’s first point of attack was futures, which went electronic early. Tierney and Schuler programmed their computers, and the people manning them, to offer quotes and execute trades more quickly than rivals. Then, when the market moves, to do it again. By posting bids and offers for the same securities simultaneously, they are able to scoop up a spread of a tenth or a hundredth of a penny per share thousands of times a day while limiting the capital at risk. What Getco gives up by capping its risk it makes up for in volume. The company currently trades an estimated 1.5 billion shares a day with 220 employees and offices in Chicago, New York, London and Singapore.

Computerized trading is hardly new nor is the demonizing of its effects. The era of floor-based markets started drawing to a close with the popularization of Nasdaq’s electronic system in the early 1980s. Program traders were the early electronic whiz kids until critics pinned the blame on them for the 1987 crash and circuit breakers limited their influence. A decade ago people working the Small Order Execution System, a.k.a. SOES bandits, began minting money by arbitraging spreads created by lags in the speed at which disparate Nasdaq marketmakers updated their prices; the dot-com bust eventually laid them low.

Others have shown impressive stamina. Former math professor and code cracker James Simons founded algorithmic trader Renaissance Technologies in 1982. But his firm came to true prominence only with the hedge fund boom of the past decade. Last year its flagship Medallion fund (assets: $9 billion) was up 80%. Simons ranked 55th on FORBES’ 2009 list of the world’s billionaires.

Dissatisfied with the duopoly the NYSE and Nasdaq enjoyed, then SEC Chairman Arthur Levitt (now an advisor to Getco and Goldman Sachs) in 1998 pushed through Regulation Alternative Trading Systems. Reg ats gave rise to a plethora of so-called electronic communications networks that made markets in stocks, or simply matched buyers with sellers. Two years later the exchanges began quoting prices in decimals instead of fractions. Overnight the minimum spread a marketmaker stood to pocket between a bid and offer was compressed from 6.25 cents, or a “teenie,” down to a penny.

In classic Wall Street fashion traders set about finding new ways to earn a living. Some were nefarious. In 2004 seven NYSE specialist firms paid a quarter-billion dollars to settle charges of front-running clients.

Others viewed electronic markets as legitimate opportunities. The big wire houses hedged their bets by taking stakes in the various electronic communications networks that emerged in the 1990s. In 1999 Goldman Sachs paid $550 million for Hull Group, which used computer-based algorithms to trade equity options. “An unsustainable model” is how Duncan Niederauer described floor trading to forbes a year later. A Goldman derivatives trading exec at the time, he now runs the NYSE.

The final structural move that set the stage for the current electronic trading revolution was Regulation National Market System, put in place in 2005. Previously brokerages were, in theory, obliged to offer clients the best possible execution of stock orders. But it was left up to each firm to determine whether “best” meant the fastest or at the most favorable price. That left brokerages plenty of wiggle room to match buy and sell orders internally and pocket the spread, or send them to exchanges that paid kickbacks for order flow.

Under Reg NMS, by contrast, the SEC decreed that market orders be posted electronically and immediately executed at the best price available nationally. To Getco and its high-frequency brethren, Reg NMS was like catnip. Many began posting continuous two-sided quotes on hundreds of stocks. Some sought to arbitrage the tiny price spreads that existed at any given moment between buy and sell orders. Others, known as rebate traders, profited from payments for order flow the exchanges offered. Latency arbitragers, like the SOES bandits before them, sought to scoop up price differences resulting from momentary time lags between exchanges.

Today hundreds of firms are vying for a piece of the high-frequency action–huge ones like Goldman and Barclays Capital, hedge funds like Citadel and lesser-knowns like Getco and Wolverine Trading. Lime Brokerage, housed in chic lower Manhattan digs with a rooftop garden, handles trades for 200 high-frequency trading firms and individuals. Like hedge funds in the mid-1990s, high-frequency traders are popping up practically every day and attracting leading talent. Vincent Viola, who headed the New York Mercantile Exchange, recently opened Virtu Financial and lured away Christopher Concannon, former head of Nasdaq’s transaction services. Private equity money is rushing in, too. General Atlantic reportedly paid $200 million to $300 million for 20% of Getco (Tierney, Schuler and employees own 80%) in 2007. Last year ta Associates acquired a stake in RGM Advisors and Summit Partners bought into Amsterdam’s Flow Traders; deal terms were not disclosed.

Sidebars:
High Frequency Who’s Who�
Trading for Dummies

Special Offer: Free Trial Issue of Forbes

With so many players, high-frequency trading has morphed into a technology arms race. In a well-publicized case, the FBI arrested former Goldman employee Sergey Aleynikov in July for allegedly stealing trading algorithms. Separately, Citadel claims in a lawsuit that Aleynikov’s new employer, Teza Technologies, may have got illicit access to trading software it spent hundreds of millions of dollars developing. Teza has not been accused of wrongdoing by the government.

Making it in high-frequency trading these days requires the latest technology. Lots of it. Getco won’t talk details, but others will. Infinium Capital is the biggest marketmaker in natural gas futures and runs its computers in 100,000 square feet near the Chicago River. The core of its operation is 40 racks of servers overseen by quant traders who man up to a dozen screens each.

Infinium’s operation runs on a piece of the public electricity grid backed up by two separate power substations and 196,000 pounds of batteries. Not safe enough. Infinium is paying to install a 2,000-kilowatt diesel generator just in case. Infinium taps into the CME Group’s computers, housed on the same floor of a data center, via dedicated fiber-optic lines capable of transmitting up to 5,000 orders per second with a lag time of no more than 10 milliseconds. Infinium has other servers strategically situated near exchange computers in New Jersey, London and Singapore.

The high-frequency boom is reshaping securities markets everywhere. Four years ago 13 people from TradeBot, a Kansas City trading outfit, left to form a new ECN called Bats Trading. Getco, Wedbush Morgan, Lime and seven big banks are now investors. Bats was granted full exchange status last year, adding a level of legitimacy and eliminating a time lag in reporting trades through another exchange. It now handles nearly 12% of daily U.S. stock trades. Direct Edge, a rival backed by Goldman, Citadel and Knight Trading, handles another 14%.

What’s not to like? From a narrow perspective, the robot traders seem to be enjoying an unfair physical advantage over other investors. One eyebrow-raising reality is that a big chunk of high-frequency profits derive from jumping into markets before small investors can. In the high-frequency world, the 20 milliseconds it can take quotes to travel from Chicago to Nasdaq’s market site in New Jersey (the flashy Times Square one familiar to the public is a TV prop) is an unacceptable lag. So interminable, in fact, that it gave rise to the entire strategy known as latency arbitrage.

The need for speed, in turn, has led to a rush for real estate as close to securities exchanges as possible. In Chicago 6 square feet of space in the data center where the big exchanges also house their computers goes for $2,000 a month. It’s not unusual for trading firms to spend 100 times that to house their servers, says Scott Caudell of 7ticks, which manages dozens of firms’ servers there. Now even the tradition-bound NYSE plans to open a 400,000-square-foot tech center in New Jersey and is taking orders for server stalls.

Does this institutionalize an unlevel playing field? It does and it doesn’t. Small-fry investors are cut out of the business of making 0.1 cent markups. But this isn’t what the fellow buying 1,000 shares of ExxonMobil should be worried about. For him, the risk is that he pays 5 cents a share too much, only to see the quote fall back a nickel a few seconds later, perhaps because brokers in the middle could see what he was doing but he couldn’t see what they were doing.

For years the regulators have tried to make trading fair by putting bids and offers out in the open. When Levitt took over the chairmanship of the American Stock Exchange 31 years ago, the talk was of a “composite limit order book” that would make it harder for middlemen to pocket undeserved spreads. That idea didn’t fly, but variations of it lived on in all sorts of rules designed to force transparency on the market. The trouble with such rules is that they can’t force anyone to really show his hand. A reg can mandate that a 10,000-share order be put on the tape within a certain number of seconds. It can’t mandate that the hedge fund trader placing it reveals his intentions for his other 90,000 shares.

No surprise that today’s order books are filled with feints and parries, made and withdrawn in a blink of the electronic eye–1,000-share bids and offers that are stalking horses for million-share moves. Unfair to the little guys? Not necessarily. Their salvation comes from volume. If enough shares move every second, it is less likely that they will be gouged out of a nickel spread.

Another controversial offshoot of high-frequency trading is sponsored access, which already accounts for 15% of Nasdaq activity. In the old world traders were required to send every order to a registered broker-dealer who passed it along to an exchange or executed it themselves. With sponsored access, traders send orders directly to exchanges. This has raised concerns that a lack of oversight could lead to the sort of disaster that overtook derivatives during the financial crisis.

Some high-frequency traders are sending out 1,000 orders a second. In the span of the two minutes it typically takes to rectify a trading system glitch, a careless trader could pump out 120,000 faulty orders. On a $20 stock that represents a $2.4 billion disaster. Without better controls, “The next Long-Term Capital meltdown will happen in a five-minute time period,” warned Lime Brokerage in a June letter to the SEC.

While many market centers have adapted to cater to high-frequency traders, dark pools have adapted to evade them. Seth Merrin founded Liquidnet in 1999 as a place where professional money managers can swap large blocks of stock anonymously. It’s the successor to the brokerage work that used to keep block traders at Weeden & Co., Goldman and First Boston busy decades ago, when the NYSE ruled Wall Street but a fair amount of its trading took place upstairs. The goal of Liquidnet is to avoid tipping off the market, including high-frequency arbitragers, that a big order is in the market and moving prices.

Merrin, even as he battles a bad market for new offerings and a legal dispute over patent infringement, aims to take Liquidnet public. The firm already handles 61 million shares a day, and Merrin views himself as something of a crusader who is enabling mutual funds, pension plans and other investors to trade at the best possible prices. All told, crossing systems like Liquidnet and Credit Suisse’s Advanced Execution Services (300 million shares a day) handle about 8% of stock trades and are expected to control 10% by year’s end.

The problem with such liquidity pools is that they are in fact “dark,” meaning they conceal their orders from public markets. What’s more, they piggyback off publicly displayed bids and offers rather than adding to the liquidity pools that determine them. That, in turn, has led to charges that they are depriving investors in both lit and dark markets of the best possible prices. Thus the calls for heavy-handed regulation or an outright ban.

Proponents of Big Brotherism should stop hyperventilating. The high-frequency engineers are already on the case, sniffing out when dark pools are trading at the midpoints between public bids and offers and posting their own prices around them (and, in turn, forcing the dark pools to come up with countermeasures to the countermeasures).

As this cat-and-mouse game plays out, trading is getting ever faster and spreads ever thinner. This probably isn’t the market that securities market overseers envisioned, but it’s working just fine.

Flashpoint of Controversy

High-frequency trading helps small investors by narrowing spreads and speeding execution. The same can’t necessarily be said for flash orders. Market center Direct Edge uses them to give a small group of clients a one-tenth-of-a-second crack at incoming orders before others get one. The practice has been criticized for favoring insiders, and the Securities & Exchange Commission may ban flash orders.