On January 14, the Securities and Exchange Commission (SEC or “Commission”) published a concept release on a wide range of equity market structure issues, including high frequency trading, co-location arrangements, market data latencies, and undisplayed or “dark” liquidity.1 The Commission intends to use the public’s comments to determine whether regulatory initiatives to improve the current equity market structure are needed. Public comments are due by April 21.
This advisory summarizes key provisions in the SEC’s concept release. Given the length of the concept release and the number of questions posted by the Commission, we urge anyone interested in a particular topic to refer to the release directly or to call a Katten Muchin Rosenman LLP attorney with any questions.
I. Executive Summary
The focus of the SEC’s review is to assess whether equity market structure rules have kept pace with changes in trading technology and practices. There are three main categories of review for the Commission: (1) the performance of the current equity market structure; (2) high frequency trading; and (3) undisplayed liquidity.
Market Structure Performance. The Commission is concerned that the rise of short-term professional traders may harm the interests of long-term investors. In evaluating the effects of short-term professional traders, the Commission requests data on how to define long-term investors and how to best measure market quality for all investors and traders.
High Frequency Trading. Acknowledging that there is no one definition for high frequency trading, the Commission’s focus is on the particular strategies and tools that are used by proprietary trading firms and asks whether these strategies and tools raise concerns that should be addressed by regulatory initiatives. The Commission requests comment on whether specific strategies benefit or harm the market and the interest of long-term investors. Possible regulatory responses noted by the Commission for high frequency proprietary trading firms include:
Dark Pools and Undisplayed Liquidity. The Commission’s review of undisplayed liquidity and dark pools is focused on whether undisplayed liquidity has reached a level that harms the quality of public price discovery, market transparency and execution quality. The Commission asks whether a “trade-at” rule would be appropriate and/or whether depth of book should be protected under the SEC’s current trade-through rule. The Commission asks, as well, whether the 5% trading volume threshold that would require dark pools to adhere to a fair access standard should be lowered, and if so, by how much.
II. Market Structure Performance
A. Long-Term Investors. The Commission is evaluating how long-term investors have fared under the current equity market structure. The Commission emphasizes that between long-term investors and short-term professional traders, the Commission’s duty is to protect the interest of long-terms investors. As a threshold matter, the SEC seeks comment on the practicality of distinguishing the interests of long-term investors from those of short-term professional traders when assessing the performance of market structure. The Commission is interested in hearing how all types of individual investors and all sizes of institutional investors—small, medium and large—are faring in the current market structure. Also, recognizing that a vital function of the equity markets is to support the capital raising function, including capital raising by small companies, the Commission asks how market structure impacts stocks of varying levels of market capitalization (for example, top tier, large, middle and small).
B. Market Quality Metrics. The Commission asks for comment on what metrics should be used to assess the performance of the current market structure for both individual and institutional investors. In the past the Commission has considered the speed of execution and spread measures, including quoted spreads, effective spreads and realized spreads. Now the Commission asks if short-term volatility should be used as a metric in considering market quality. This is because the Commission believes that short-term volatility may harm individual investors if they are consistently unable to react to changing prices as quickly as high frequency traders. Further, excessive short-term volatility may indicate that long-term investors, even when they initially pay a narrow spread, are being harmed by short-term price movements that could be many times the amount of the spread. Finally, the Commission has requested comment on whether the metrics of market structure performance are correlated with the CBOE Volatility Index or other measures of volatility.
C. Rules 605 and 606. The Commission requests comment on whether long-term investors and their brokers have the tools they need to protect their own interests in a dispersed and complex market structure. Specifically, SEC Rules 605 and 606 were designed to provide useful metrics for investors and brokers in assessing the quality of order execution and routing practices. The Commission asks if the reports required by these rules have kept pace with the changes in the market structure.
III. High-Frequency Trading
Acknowledging that there is no one definition for high-frequency trading, the Commission’s focus is on the particular strategies and tools that are used by proprietary trading firms and asks whether these raise strategies and tools concerns that should be addressed by regulatory initiatives. The Commission requests comment on whether specific trading strategies benefit or harm the market and the interest of long-term investors.
A. Passive Market Making. The Commission describes passive market making as the submission of non-marketable resting orders (bids and offers) that provide liquidity to the marketplace at specified prices. The Commission notes that if a proprietary trading firm is layering the book with multiple bids and offers at different prices and sizes, this strategy can generate an enormous volume of orders and cancellation rates of 90% or more with orders of short duration. The questions posed by the Commission include: (1) whether the quality of liquidity has improved as traditional types of liquidity providers have been replaced by proprietary trading firms; (2) whether the brief duration of orders detracts from the quality of liquidity; (3) whether the orders of proprietary trading firms engaged in passive market making are properly characterized as “phantom liquidity” or whether there is a relatively stable quoted market (i.e., many quote updates but few changes in the price of the NBBO); and (4) whether liquidity rebates are unfair to long-term investors because they benefit only proprietary trading firms, or whether they benefit long-term investors by promoting narrower spreads and more liquidity.
B. Arbitrage. The Commission describes an arbitrage strategy as seeking to capture pricing inefficiencies between related products or markets. For example, a firm employing an arbitrage strategy seeks to identify discrepancies between the price of an ETF and the underlying stock components to capture the price difference. The Commission notes that in contrast to passive market making (which generally involves providing liquidity), an arbitrage strategy is likely to take liquidity.
The questions posed by the Commission relative to arbitrage strategies include: (1) whether arbitrage strategies benefit long-term investors and market quality in general; (2) whether the popularity of ETFs affects volume and trading patterns in the equity markets; (3) whether and to what extent arbitrage strategies are focused on capturing pricing differences among the many different trading centers in NMS stocks; and (4) whether arbitrage strategies depend on latencies among trading center data feeds and the consolidated market data feeds.
C. Structural. The Commission describes as “structural” those strategies that exploit structural vulnerabilities in the market or in certain market participants. Through the speed advantage that results from co-location and the use of individual trading center data feeds, a proprietary trading firm could profit by identifying stale prices. The Commission also describes how proprietary trading firms can abuse guarantees by certain firms to trade at the NBBO. For example, a proprietary trading firm could enter a small limit order in one market to set up a new NBBO, while the same firm triggers guaranteed match trades in the opposite direction.
The Commission requests comments on structural strategies, including: (1) whether proprietary trading firms are able to profitably exploit structural vulnerabilities; (2) to what extent proprietary trading firms engage in the types of strategies described; and (3) the effect of this trading on market quality.
D. Order Anticipation Strategies. The Commission focuses its questions on two types of directional strategies—“order anticipation” and “momentum ignition.” An order anticipation strategy is described as one where a proprietary trading firm seeks to find one or more large buyers (sellers) in the market and to buy (sell) ahead of the large orders with the goal of capturing a price movement in the direction of the large trading interest. The Commission distinguishes this type of strategy from a search for liquidity by long-term investors. The Commission believes that in the case of a long-term investor seeking liquidity, both the long-term investor and the large seller (buyer) benefit from the search for liquidity by long-term investors. The Commission states that, in contrast, an order anticipation strategy harms the large seller (buyer) because the proprietary trading firm seeks to trade in front of the large seller (buyer).2 Examples include the employment of sophisticated pattern recognition software to ascertain from publicly available information the existence of a large buyer (seller), or the use of orders to “ping” market centers to locate and trade in front of large buyers or sellers.
The Commission requests comments on order anticipation strategies, including: (1) whether order anticipation strategies detract from market quality and harm institutional investors; (2) whether order anticipation strategies have been more prevalent in recent years; and (3) whether there are regulatory tools that would address order anticipation strategies without interfering with other beneficial trading strategies.
E. Momentum Ignition Strategies. According to the Commission, momentum ignition occurs when a proprietary trading firm initiates a series of orders or trades to ignite a rapid price move either up or down. By establishing a position early, the proprietary trading firm attempts to profit by subsequently liquidating the position (if successful in igniting a price movement). The Commission notes that any market participant that manipulates the market has engaged in prohibited misconduct. The Commission asks whether additional regulatory tools are needed to address illegal practices, as well as other practices associated with momentum ignition strategies.
The Commission requests comments on momentum ignition strategies, including: (1) whether momentum ignition strategies are a problem; (2) whether the speed of trading and ability to generate large numbers of orders across trading centers make this strategy more of a problem today; and (3) whether there are regulatory tools that would effectively reduce or eliminate the use of momentum ignition strategies while at the same time having a minimal impact on other strategies that are beneficial to long-term investors and market quality.
F. Co-location. The Commission describes co-location as a service offered by trading centers that operate their own data centers and by third parties that host the matching engines of trading centers. The trading center or third party rents rack space to market participants that enables them to place their servers in close physical proximity to a trading center’s matching engine. Co-location helps minimize latencies between the matching engine of trading centers and the servers of market participants. The Commission believes that the co-location services offered by registered exchanges are subject to the Exchange Act and that exchanges that intend to offer co-location services must file proposed rule changes and receive approval of such rule changes in advance of offering the service to customers.
The Commission also requests comments on the fairness of co-location services, including: (1) whether co-location benefits long-term investors and market quality; (2) whether co-location provides proprietary trading firms an unfair advantage because they generally will have greater resources and sophistication to take advantage of co-location services than long-term investors; (3) whether co-location allows liquidity providers to operate more efficiently and thereby increases the quality of liquidity; (4) whether co-location services are fundamentally different from other ways market participants get latency advantages (assuming co-location services are available to anyone on terms that are fair, reasonable and not unreasonably discriminatory); (5) whether, if markets were no longer permitted to provide co-location, third parties would obtain space close to an exchange’s data center and rent the space to market participants; (6) whether it is possible for trading centers to guarantee equal latency across all market participants that use comparable co-location services; and (7) whether the Commission should require latency transparency, i.e., disclosure that would allow market participants to make informed decisions about their speed of access to a market.
G. Affirmative and Negative Trading Obligations. The Commission requests comment on whether market participants with co-location should be subject to affirmative or negative obligations on the theory that the advantages of co-location are analogous to the advantages that specialists had on the floor. The Commission’s questions include: (1) whether the wide availability of co-location services distinguish co-located market participants from exchange specialists; (2) if co-location participants should be subject to trading obligations, what should be the nature of such obligations; (3) whether co-location participants should be prohibited from aggressively taking liquidity and moving prices; and (4) whether co-location participants should ever be required to provide liquidity on an ongoing basis.
H. Latency in Trading Center Data Feeds. The Commission notes that the market data supplied through individual data feeds offered by the markets generally reach market participants faster than the data supplied in the consolidated data feeds. When it adopted Regulation NMS in 2005, the Commission did not require markets to delay their individual data feeds to synchronize with the distribution of consolidated data. The Commission requests comments on the latency between consolidated data and individual trading center data, including: (1) whether plan processor systems can be improved to reduce latency from current levels; (2) whether the existence of a latency, or the disparity in the speed of which information transmitted, is fair to investors that rely on the consolidated market data trading center data feeds; and (3) whether trading center data should be delayed to allow consolidated data to reach users first.
I. Including Odd-Lot Transactions in Consolidated Trade Data. The Commission observes that approximately 4% of trading volume may be attributable to odd lots. The Commission requests comments on the level of odd-lot volume, including: (1) why the volume of odd lot trading is so high and whether there has been an increase in odd-lot trading recently; (2) whether the Commission should be concerned about odd lots not appearing in the consolidated trade data; and (3) whether market participants have an incentive to trade in odd lots to circumvent the trade disclosure or other regulatory requirements.
J. Systemic Risks. More broadly, the Commission asks whether high frequency trading poses risks to the integrity of the current equity market structure. The Commission asks whether the high speed and enormous message traffic of automated trading systems threaten the integrity of trading center operations. The Commission also questions whether firms engaged in similar strategies could generate significant losses at the same time, placing these firms in financial distress, which could lead to large fluctuations in market prices. The Commission notes that the equity markets performed well during the worldwide financial crises in the autumn of 2008, when volume and volatility spiked to record highs. In this regard, the Commission asks the following: (1) whether all proprietary trading firms should be required to register as broker-dealers and become members of FINRA so that their operations are subject to full regulatory oversight,3 and (2) whether the current regulatory regime addresses the particular concerns applicable to the trading activity of proprietary trading firms and their trading strategies.
IV. Undisplayed Liquidity and Dark Pools
The Commission requests comment on all forms of undisplayed liquidity but presents three specific issues for comment: (1) the effect of undisplayed liquidity on order execution quality; (2) the effect of undisplayed liquidity on public price discovery; and (3) fair access to sources of undisplayed liquidity.
A. Order Execution Quality. The Commission reports that a significant percentage of the orders of individual investors are executed by OTC market makers, and that a significant percentage of the orders of institutional investors are executed in dark pools. With respect to individual investors, the Commission asks for comment on whether investor orders receive high-quality executions when their orders are routed to OTC market makers by brokers who receive payment for order flow. With respect to institutional investors, the Commission asks whether dark pools are effective for the trading strategies of institutional investors when such investors have to trade in large size. The Commission requests comments on the execution quality of institutional orders using undisplayed liquidity in dark pools or otherwise, including: (1) whether execution quality varies across different types of dark pools; (2) whether institutional investors are affected by improper practices such as placing small orders to change the NBBO and submitting orders to dark pools for execution at the new NBBO; (3) whether all dark pools employ anti-gaming tools and whether these tools are effective; and (4) whether institutional investors can trade more efficiently using undisplayed liquidity at dark pools and broker-dealers than they can using the undisplayed liquidity at exchanges and ECNs.
B. Public Price Discovery. The Commission believes a significant percentage of the orders of long-term investors are executed either in dark pools or at OTC market makers, while a large percentage of the trading volume in displayed trading centers is attributable to proprietary trading firms executing short-term trading strategies. The Commission notes that the overall percentage of trading volume between undisplayed markets and displayed markets has remained steady for many years between 70% and 80%.
The Commission requests comments on whether the trading volume of undisplayed liquidity has reached a level that detracts from the quality of public price discovery and execution quality. In this regard, the Commission requests comment on the state of public price discovery, including: (1) whether the level of undisplayed liquidity has led to increased spreads, reduced depth or increased short-term volatility in the displayed trading centers, and (2) whether there has been an increase in the proportion of long-term investor orders executed on undisplayed trading centers.
Trade-at Rule. The Commission asks whether it should propose a “trade-at” rule that would prohibit any trading center from executing a trade at the price of the NBBO unless the trading center was displaying that price at the time it received the incoming contra-side order. Under this type of rule, a trading center not displaying the NBBO at the time it received an incoming order could either: (1) execute the order with significant price improvement (e.g., the minimum price variation), or (2) route ISOs to full displayed size of NBBO quotations and then execute the balance of the order at the NBBO price. The Commission asks for comment on the benefits of a trade-at rule as well as the feasibility of implementing the rule given current systems and technologies. The Commission requests comments on whether a trade-at rule should be conditioned on there being no access fee or an access fee that is much lower than the current 0.3 cent per share cap in Rule 610(c) of Regulation NMS.
Expanding Trade-through Protection. The Commission requests comment on whether trade-through protection should be expanded to displayed “depth-of-book” quotations and asks whether it is feasible and cost effective under current conditions.
C. Fair Access and Regulation of ATSs. The Commission notes that ATSs are not required to provide fair access unless they reach a 5% trading volume threshold in a security, which no dark pool ATS currently does. In contrast, exchanges must provide fair access to all members. The Commission requests comment on whether the volume threshold for fair access should be lowered. The Commission also asks if multi-service broker-dealers offering dark pools can apply objective, fair standards to prevent predatory trading, without using such standards as a pretext to discriminate based on the competitive self-interest of the sponsoring broker-dealer.
Other topics of interest for the Commission are whether dark pools should provide improved transparency on their trading services and the nature of their participants. Also, the Commission asks whether dark pool operators contribute sufficiently to the costs of consolidated market surveillance.
1See Securities Exchange Act Release No. 61358 (January 14, 2010).
2The order anticipation strategies of interest to the Commission do not involve the violation of a duty, misappropriation of information or other misconduct.
3Proprietary trading firms that register as broker-dealers are not currently required to become FINRA members. FINRA membership generally is required when a firm engages in a customer business. It is not clear from the SEC's question in the concept release whether it would consider requiring mandatory FINRA membership for proprietary trading firms or if the mention of FINRA is simply a reference to general membership in a self-regulatory organization.