Current, Former Members Call For Sweeping Review of SEC's Reg NMS

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By Yin Wilczek

Oct. 3 --Securities and Exchange Commissioner Daniel Gallagher and former SEC member Paul Atkins Oct. 3 called for a comprehensive re-examination of the commission's Regulation NMS--National Market System--a set of market structure rules adopted in 2005.

“I think it's a prime candidate for retrospective review,” Gallagher told an industry gathering. The SEC should look at the regulation “holistically,” and use empirical data to determine its impact and whether changes are necessary.

Critics have charged that the SEC's adoption of Reg NMS led to market fragmentation and the growth of alternative trading systems.

Atkins, who was one of the two commissioners that did not support the regulation in 2005, said Reg NMS was, and continues to be, a “disaster.” Among other problems, the rules “exacerbated” the “atomization of liquidity,” Atkins said. He added that at the time, SEC staff also had no hard evidence that the “trade-through” rule was necessary. The trade-through rule mandates that exchanges put in place policies and procedures to ensure that customer orders will be traded at the best price posted and available for automatic execution.

“What was adopted just didn't work,” Atkins said. So the SEC “had to dodge and weave just to make sure the market didn't collapse.”

Gallagher and Atkins spoke at the Security Traders Association's market structure conference in Washington. Gallagher said he voiced his own views, which did not necessarily reflect those of the commission or other members. 

Reg SCI Proposal

In other comments, Gallagher told the audience that he found proposed Regulation SCI--Systems Compliance and Integrity--“troubling” in certain respects.

The proposed regulation, issued unanimously by the SEC in March , would require that so-called SCI entities, including self-regulatory organizations, alternative trading systems, and certain clearing agencies, put in place policies and procedures around their technology systems, quickly fix any potential errors, and review their compliance with the rule, among other points.

Gallagher said the proposal was presented to him as a “codification” of the SEC's voluntary Automation Review Policy Inspection Program. However, it was “anything but” a simple codification of the policy, he said. The original proposal recommended by the staff was “too prescriptive” and “heavy handed,” and he and former SEC Commissioner Troy Paredes spent a lot of time making changes, Gallagher said.

The commissioner also said the proposal would make the exchanges strictly liable for any system failures, which is an impossible standard under which to operate. Accordingly, there must be a safe harbor within the rules that would protect good faith efforts, he said.

“I hope we can” compromise on a workable rule going forward, Gallagher added. He said there is consensus within the commission to move forward on the proposal, but “as to substance, I'm not sure what it ultimately will look like.” 

SRO Model

At the panel, Gallagher also reiterated his call for a comprehensive review of the SRO model, an issue he has raised in prior speeches . Any review of market structure issues would be incomplete without examining the supervisory role of SROs, he said.

Gallagher, citing the SEC's recent enforcement activities against the exchanges, said one of his concerns is that the commission is treating SROs as for-profit organizations rather than as regulators. The fact that most of the exchanges have outsourced their market monitoring functions to the Financial Industry Regulatory Authority and are paying to do it shows that they take those responsibilities very seriously, he said.

SEC Chairman Mary Jo White, speaking at the same conference Oct. 2, agreed that the SRO model should be reviewed in light of evolving market conditions .

Meanwhile, Gallagher said the SEC's market access rule for the most part is “working pretty well,” according to industry feedback, even though technological problems--including those experienced by Knight Capital Group that cost the firm $440 million in losses --have occurred after the rule's adoption. He told the audience that regulations do not “stop glitches.”

Rule 15c3-5 under the 1934 Securities Exchange Act--adopted by the SEC in November 2010--requires firms with market access, including those that offer customers sponsored access arrangements, to implement risk management controls and supervisory procedures to prevent market errors and other problems. 

Rules of the Road

Some observers appear to think there would be systems errors “all over the place” without an SEC rule, Gallagher continued. However, the “skin in the game of market participants is stronger than any rule” the SEC can promulgate, he said. “So the commission should set general principles” and “police egregious activities” but let market forces do their work.

Atkins said that ideally, the government should set “general rules of conduct and general traffic rules” that allow investors and markets choice, and market participants to compete. “To have some kind of government central planning attitude never works,” he said.

Gallagher also told the audience that the SEC's consolidated audit trail will get built, although he could not predict its ultimate form . The SROs now are developing a plan for the CAT system--a data repository that will collect and identify orders, cancellations and executions for all exchange-listed equities and options across all U.S. markets. There is “too much support within the building and elsewhere” for it not to be established, Gallagher said.

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