Schapiro Signals SEC Plans Scrutiny of High-Frequency Trading
May 07, 2011, 4:58 AM EDTBy Nina Mehta and Jesse Hamilton
May 7 (Bloomberg) -- Securities and Exchange Commission Chairman Mary Schapiro gave the strongest signal yet that she plans to increase scrutiny of high-frequency traders blamed for exacerbating the May 6, 2010, stock market crash.
The SEC is considering whether to impose trading obligations on the firms, which can submit hundreds or thousands of orders every second and typically don’t hold positions overnight, Schapiro said in Washington yesterday. A reassessment of the “entire regulatory structure” surrounding the firms is needed, in part to determine whether the algorithms or strategies used to generate and send orders are “programmed to operate properly in stressed market conditions,” she said.
“High-frequency traders turned what was a very down day for many investors into a very profitable one for themselves by taking liquidity rather than providing it,” Schapiro said about the rout on May 6, 2010, that erased $862 billion in value in less than 20 minutes before rebounding. “Their activity that day should cause us to thoroughly examine their current role.”
The SEC and Commodity Futures Trading Commission said in an Oct. 1 report that the activity of high-frequency firms they examined fueled price moves and didn’t help stem the decline of the E-mini version of Standard & Poor’s 500 Index futures and shares of individual companies.
“Tremendous harm” was done to public companies and individual investors by the crash, which spurred volatility that increased the “perceived risk” of investing in stocks, she said at an Investment Company Institute event yesterday. Investors lost money when their orders traded at prices that were deemed unreliable and later canceled, she said. She added that the agency is exploring “what level of volatility is appropriate” for stocks.
‘Appropriate Benefits’
Quoting requirements for firms that act as market makers is one of a broader set of changes to equity trading rules the SEC is considering, David Shillman, associate director of the SEC’s division of trading and markets, said May 5 in an interview at a Georgetown University conference in Washington.
“It’s a complex issue because of the balancing. Appropriate benefits must be given to offset any obligations we may decide to impose,” Shillman said. Consistency in exchanges’ rules for market makers registered on their venues is important, he added. “If there’s an SEC initiative, the requirements would apply broadly to all exchanges just as we did with stub quotes.”
Canceled Trades
More than 20,000 transactions representing 5.5 million shares were voided by stock markets hours after they executed at prices 60 percent or more away from levels before the May 6 crash, the SEC and CFTC said last year. Investors and brokers criticized stock exchanges that May for adopting what they viewed as an arbitrary threshold for busting trades.
High-frequency trading is a style of buying and selling that comprises strategies such as market making, statistical arbitrage tactics that seek to profit from price differences between related products, and momentum trading. It accounts for more than half of U.S. equities trading, according to the SEC.
The securities agency is considering whether new requirements should be imposed on market makers and what if any benefits they should get for meeting those obligations. Schapiro said last year that market makers can’t be required to put their businesses at risk by providing liquidity in a plunging market, especially when a confluence of events including potentially faulty market data and delays in the transmission of that information may cause confusion about why prices are falling.
Lower Profit
Regulatory changes over the past 15 years designed to boost competition and lower trading costs for individual investors reduced profit for market makers and specialists, forcing exchanges to recast rules that curtailed the obligations imposed on those firms. Automated high-frequency traders helped fill the void left when firms exited the business, providing bids and offers to investors who want to buy or sell shares.
“This is a public policy issue,” said Alfred Berkeley, chairman of Pipeline Trading Systems LLC in New York and president of Nasdaq Stock Market from 1996 to 2000. Pipeline runs a U.S. dark pool, or private venue that allows investors to execute blocks. “How do you have a liquid market with unregulated liquidity providers who can go away when something happens?” he said. “We haven’t answered that.”
The exchanges and Financial Industry Regulatory Authority worked with the SEC last year to ban stub quotes, or placeholder buy and sell orders used by market makers to meet a regulatory obligation to submit both bids and offers. The rule required market makers to supply orders within 8 percent of the national best bid or offer to help meet trading demand if a surge of orders overwhelms the available bids or offers at better prices.
Penny Trades
Unlike many trading rules written to meet the needs of specific markets, the policy was uniform across venues to ensure consistency. Stocks such as Accenture Plc plunged to 1 cent on May 6, 2010, when investors’ orders traded against stub quotes, regulators said last year. Obligations on market makers have traditionally focused on the number of shares they must provide at the best prices, the percentage of time they must quote at those levels, and requirements that they supply liquidity and damp volatility.
The NYSE Euronext’s New York Stock Exchange requires traders known as designated market makers to meet quoting and market-stabilization requirements, giving them trading and pricing benefits unavailable to others. The DMMs oversee the trading of the NYSE stocks they’re assigned and run the auctions at the start and close of the day.
Nasdaq Stock Market
On venues such as New York-based Nasdaq OMX Group Inc.’s Nasdaq Stock Market, market makers compete with one another without facing quoting requirements that are as strict. They also don’t get cheaper rates than those available to other traders and investors.
Exchanges and Finra established circuit breakers last year to curb price swings across about 50 equity venues and adopted uniform rules on when to cancel transactions.
They last month proposed shifting from price curbs that halt trading for five minutes when shares drop 10 percent in five minutes to a so-called limit-up/limit-down mechanism that prevents executions outside a moving price band. If approved, the curbs would eventually apply to all securities and not just stocks in the S&P 500 and Russell 1000 Index as well as more than 300 exchange-traded funds.
The “easy fixes” are done, Richard Repetto, a New York- based analyst with Sandler O’Neill & Partners LP, said on April 27. “What’s left undone is the SEC’s attitude toward high- frequency trading.”
--Editor: Nick Baker
To contact the reporters on this story: Nina Mehta in New York at nmehta24@bloomberg.net; Jesse Hamilton in Washington at jhamilton33@bloomberg.net
To contact the editors responsible for this story: Nick Baker at nbaker7@bloomberg.net; Lawrence Roberts at lroberts13@bloomberg.net
