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Market Structure Rules Should Be Examined In Light of Evolving Marketplace, Reed Says

Friday, September 21, 2012
By Maria Lokshin

Sen. Jack Reed (D-R.I.), chairman of the Senate Banking Securities Subcommittee, said Sept. 20 that rules governing market structure should be examined in light of the rapidly evolving marketplace and recent high-profile computer-generated trading snafus.

“It is not clear that our rules have kept up,” Reed said at a hearing on the issue. “In … light of the enormous growth of high-frequency and algorithmic trading, there is a growing consensus that the entire regulatory scheme surrounding high-frequency trading firms and their algorithms should be assessed.”

The hearing, Reed said, was a “first step” to look at automated and high-frequency trading, saying he wants to do “a lot more work” to address the issues, including additional hearings on the topic.

“This is not a one-stop, quick fix,” Reed said. “This is an issue that will not go away.”

Trading Errors
He called the hearing in the wake of several recent trading errors attributed to computer glitches. Last month Knight Capital Group lost about $440 million due to what it termed a technology “issue” (150 SLD, 8/6/12). In May, Nasdaq Stock Market LLC experienced technical problems in connection with trading in Facebook Inc.'s initial public offering (100 SLD, 5/24/12).

The hearing also comes less than two weeks before the Securities and Exchange Commission is slated to hold a market technology roundtable Oct. 2 to focus on computer-generated trading errors--an event SEC Chairman Mary Schapiro announced after the Knight incident. Schapiro also spurred staff to accelerate work on a proposal that would require exchanges to have programs ensuring the “capacity and integrity” of their trading systems.

In 2010, the SEC issued a concept release to address multiple issues related to the equities markets, including high-frequency trading (08 SLD, 1/14/10). The release came just months before the so-called flash crash of May 2010.

Though the SEC has not proposed regulations based on the release, a Trading and Markets Division official recently said that high-frequency trading remains a key focus (113 SLD, 6/13/12). However, the division likely will conduct more data analysis before moving forward.

Witnesses Wrestle With Solutions
Meanwhile, witnesses at the hearing wrestled with ways to address issues connected with the computerized marketplace and high-frequency trading--an ultra-fast type of automated trading that now accounts for the majority of equity trading volume in the United States.

“Our fully automated markets are overly complex,” said Larry Tabb, chief executive officer of the TABB Group, a research firm focused on the capital markets.

While computerized trading is “efficient, cheap, and fairly effective,” Tabb told lawmakers that such trading has reached a “point where the market is too fast.”

According to Dave Lauer, a former high-frequency trader and now a consultant for advocacy group Better Markets Inc., high-speed trading plus an overly fragmented marketplace are the chief culprits for what has become an “excessively fragile market.” Currently, trading takes place on 13 exchanges and dozens of dark pools.

“We are truly in a crisis,” he said.

Lauer suggested that regulators take several steps to address these issues, including unifying rules for exchanges, alternative trading systems, and dark pools; assigning a “unique identifier” to “supervisory individual[s]” that would be attached to every quote to better pinpoint potential problems; and trying, on a pilot basis, a 50 millisecond quote life. Lauer added that the SEC needs a “pretty dramatic improvement” in its technological capabilities to effectively regulate high-speed trading.

Chris Concannon, executive vice president of electronic market maker Virtu Financial LLC, said the industry is “currently exploring” so-called kill switches as a risk management tool to be used as a “secondary defense” in the event of a technological failure. Such backstops, Concannon said in prepared remarks, “have operated effectively on futures exchanges in the US for many years” and could translate well to equity exchanges.

“Such a kill switch would have severely limited the damage” from the Knight Capital trading incident, he said. “We will never get rid of the bugs … but it's how we respond to them [that] is more critical.”

'Hide Not Slide' Questioned
Sen. Mike Crapo (R-Idaho), ranking member of the subcommittee, meanwhile, questioned a practice known as “hide not slide,” an order type sometimes used by high-frequency trading firms that, he said, allows them to get a head start on trades at the expense of less savvy investors.

The order type, Concannon explained, involves placing an order that “locks the market” but can only be used by sophisticated firms, not retail investors.

For Lauer, the “hide not slide” order type represents a larger issue.

“I think that hide not slide and many other order types are great examples of complexity in the marketplace,” he said. “I think that the bar for approving the order types needs to be revisited, and I think that it would be a great service … if it [were] easier for the average person to get their head around what these order types mean.”

By Maria Lokshin

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