Bloomberg News

SEC Faults Direct Edge For Weak Controls That Caused Losses

October 14, 2011

Oct. 14 (Bloomberg) -- Direct Edge Holdings LLC and two electronic exchanges it operates were faulted by U.S. regulators for having weak controls that led to about $2.8 million in trading losses and a systems outage.

In November 2010, an untested change to a computer code caused the EDGA and EDGX exchanges to execute more orders from three members than what they wanted, totaling about $773 million in unwanted trades, the Securities and Exchange Commission said in an administrative order yesterday.

While Direct Edge and the exchanges returned $2.1 million in customer losses, they were faulted for having done so in violation of rules prohibiting exchanges from trading their own capital. The firms, which didn’t pay any fines, agreed to implement new risk-management policies and train employees about securities laws.

In a second instance in April, a mistake from an administrator who the SEC said was granted inappropriate access to the system shut down connections to an EDGX database. That stopped its ability to process orders and forced other trading centers to declare they were bypassing the exchange through a “self-help” rule. That remedy, used repeatedly during the May 6, 2010, market plunge that wiped away $862 billion in equity value within 20 minutes, lets trading centers bypass quotations from an exchange that isn’t immediately responding to orders.

“Direct Edge was required to police not only its members’ conduct, but its own conduct as well,” SEC Enforcement Director Robert Khuzami said in a statement. “Despite those responsibilities, it violated the principal obligations of self- regulatory organizations and national securities exchanges to put the public interest first by ensuring the strength and security of their systems.”

Customer Losses

The exchange reimbursed about $668,000 in customer losses resulting from the second instance.

In settling the matter, Direct Edge and the exchanges didn’t admit or deny wrongdoing.

“Several months ago, we developed a comprehensive plan to ensure the fulfillment of our obligations in a sustainable, repeatable and demonstrable way,” Direct Edge said in a statement. “We have vigorously executed this plan, with significant investments made to enhance our technology, personnel and processes.”

Alison Crosthwait, managing director for global market structure research at New York-based Instinet Inc., said the current fast-paced trading environment requires exchanges to have stronger controls.

Hewlett-Packard

“If I were Direct Edge, I’d be concerned about the SEC sanctioning me but I’d be more concerned I was able to execute that many overfilled trades,” she said in a phone interview.

Direct Edge drew attention last year when it miscategorized trades of Hewlett-Packard Co., causing the firm’s Aug. 6, 2010, closing price to be misreported. The error made it appear that the shares tumbled prior to the announced resignation of its chief executive officer, Mark Hurd. On some late transactions, Direct Edge failed to assign the “Form T” code that shows they happened after hours, automatically shifting the market-wide closing price to $41.85 instead of its end-of-day value of $46.30, according to data compiled by Bloomberg.

“Left unchecked, dark pools and other alternative trading platforms could pose inherent dangers to the stability of the markets,” U.S. Senator Charles Schumer, a New York Democrat, said in an e-mailed statement yesterday. “Regulators need to step up their policing of trading platforms like Direct Edge that seek to cut regulatory corners at every possible turn.”

--With assistance from Nina Mehta in New York. Editors: Lawrence Roberts, Maura Reynolds

To contact the reporter on this story: Joshua Gallu in Washington at jgallu@bloomberg.net

To contact the editor responsible for this story: Lawrence Roberts at lroberts13@bloomberg.net


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