CURRENT ISSUES IN THE EQUITY TRADING MARKETS // February 9, 2010

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CURRENT ISSUES IN THE EQUITY TRADING MARKETS //
February 9, 2010
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Presented by Jerry Citera February 9,
2010 Buffalo University Law School New York City
Program

• CURRENT ISSUES IN THE EQUITY TRADING MARKETS

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Topics

• Requirements for a National Market System
• Overview of Current Market Structure
• Key Regulatory Developments in the Equity Trading
  Markets
• Evolution of the Equity Trading Market
• SEC Announces Broad Review of Equity Trading
  Markets
• SEC Concept Release on Equity Market Structure
• SEC/Nasdaq Sponsored Access Rules
• SEC Proposed Rule Regarding Flash Orders
• SEC Proposed Rule Regarding Dark Pools
• Short Sales
• Use of Customer Information
• Securities Lending
• Glossary of Market Structure Terms

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Requirements for a National Market System

• Exchange Act Requirements for National Market
  System
• In 1975, Congress found that it is in the public
  interest and appropriate for the protection of
  investors and the maintenance of fair and orderly
  markets to assure five objectives
• Economically efficient execution of securities
  transactions
• Fair competition among brokers and dealers, among
  exchange markets, and between exchange markets
  and markets other than exchange markets
• The availability to brokers, dealers, and
  investors of information with respect to
  quotations and transactions in securities
• The practicability of brokers executing
  investors orders in the best market and
• An opportunity, consistent with efficiency and
  best execution, for investors orders to be
  executed without the participation of a dealer.
• Congress also found that these five objectives
  would be fostered by the linking of all markets
  for qualified securities through communication
  and data processing facilities.

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Overview of Current Market Structure

• Trading Centers
• Registered Exchanges (11 Exchanges)
• Electronic Communication Networks (ECNs)
• Dark Pools
• Broker-Dealer Internalization
• Linkages
• Consolidated Market Data
• Trade-Through Protection
• Broker-Dealer Routing Services
• Drivers of Change
• Technology Manual Trading Market to Electronic
  Market
• Regulatory Reform

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Key Regulatory Developments in the Equity Trading
Markets

• Enactment of the Securities Act Amendments of
  1975 Mandating National Market System
• Evolution of the Third Market and repeal of NYSE
  Rule 390
• Limit Order Protection Rules Adopted (NASD
  Manning Rule and NYSE Rule 92)
• Introduction of SuperSoes automated Trading
  Capacity
• Enforcement Actions Against OTC Market Makers in
  1996
• Antitrust
• SEC
• NASD
• Adoption of the Order Handling Rules (Display
  Rules) in 1996
• Adoption of Regulation ATS in December 1998
• Decimalization 2000
• Adoption of Rules Requiring Disclosure of Order
  Execution and Routing Practices 2001
• Adoption of Regulation NMS in June 2005
• SEC Concept Release and Related Rule Proposals
  2009-10

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In US equities, technology-based trading has
completely redefined the landscape . . .
Market Share, US Equities
NYX
TRF (ex BATS, DE)
NDAQ
Direct Edge
BATS
EDGX
Source BATS Exchange, Inc.
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. . . with off-exchange venues (i.e., dark pools)
steadily gaining market share in the last 2 years
. . .
Percent of Consolidated Volume
VIX Average Close
Source Rosenblatt Securities
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. . . leading to the emergence of some big
players in the equity execution business that
arent exchanges
Breakdown of Dark Pool volume (8.6 of total
volume)
Source Rosenblatt Securities, August 2009
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Europe has experienced similar changes
Source Federation of European Securities
Exchanges
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High Frequency Trading in the US is rumored to
account for than 70 of equity volumes . . .
Source Tabb Group, August 2009
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. . . with a select few players accounting for
most of the volume
Percent of US trading firms with a high frequency
strategy
Percent of US equity volume driven by high
frequency strategies
Source Tabb Group, August 2009
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SEC Announces Broad Review of the Equity Trading
Markets

• In late 2009, the SEC announced that it is
  undertaking a broad review of market structure
  issues. Topics include
• Flash Orders (Difference between IOIs and
  orders)
• Dark pools (including the use of indications of
  interest)
• Regulation ATS thresholds (Appropriate
  Disclosure Levels)
• Post-trade transparency of alternative trading
  systems
• Sponsored market access (Broker-dealers must be
  gatekeepers)
• High frequency trading (Volatility)
• Colocation (Fairness in access)
• Short Sales
• Consolidated Audit Trail
• Inter-Market Surveillance System
• Large Trader Reporting Requirement

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SEC Announces Broad Review of the Equity Trading
Markets (cont.)

• In a speech on October 27, 2009, Chairman
  Schapiro announced the SEC intent to conduct a
  broad review of the equity trading markets and
  identified the key market structure issues that
  the SEC concept release would cover.
• On October 20, 2009, Senator Schumer sent a
  letter to the SEC calling for action on a variety
  of topics affecting the equity trading markets
  including establishment of a consolidated market
  surveillance authority across trading venues
  various rules regarding approval and requirements
  for ATSs and treating actionable IOIs as firm
  quotes.
• On October 28, 2009, the Senate Banking Committee
  on Securities, Insurance and Investment held
  hearings on Dark Pools, Flash Orders, High
  Frequency Trading and Other Market Structure
  Issues.
• On January 21, 2010, Jamie Brigagliano, Deputy
  Director of the Division of Trading and Markets
  of the SEC gave the keynote address at the SIFMA
  Dark Pool Symposium in which he summarized the
  outstanding proposals and identified two
  additional initiatives SEC consideration of a
  larger trader reporting proposal and the
  implementation of a consolidated audit trail to
  facilitate intermarket surveillance efforts.

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Why now?

• In light of the major regulatory reforms before
  Congress and on the plate of the SEC, why focus
  on these equity market structure issues at this
  point in time?
• Regulation NMS baked in and new issues and
  concerns are now crystallizing
• Easy Target definable problem shows progress
  and action by regulators
• Political Pressure Key Players (NYSE) fighting
  competitive battle supported by Senate Schumer
  and others
• SEC fighting for life and relevance as a result
  of the financial crisis
• Pent up initiative on SEC staff level to address
  these issues
• Other areas of reform are still being considered
  by Congress and will take legislative reforms

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SEC Concept Release On Equity Market Structure

• On January 14, the SEC published a broad concept
  release that will be the cornerstone of its
  review of equity market structure. SEC Release
  34-61358 (Jan.14, 2010).
• The 74-page concept release seeks comment on a
  broad range of issues, many of which have arisen
  since the implementation of the Commissions
  Regulation NMS.
• In the concept release, the SEC requests public
  comment on literally hundreds of questions on
  equity market structure performance (in
  particular for long-term investors), high
  frequency trading, and undisplayed liquidity.
  Many of the questions raise issues that could
  have significant potential impact for
  broker-dealers, proprietary trading firms,
  exchanges, and other market participants.
• The concept release is part of an ongoing SEC
  review of the equity markets. As noted in the
  following pages, the SEC has already issued four
  major rule proposal addressing perceived risks in
  the equity trading markets.
• We await proposals regarding enhanced
  large-trader reporting and an intermarket
  surveillance plan, as well as a final short-sale
  price restriction rule, which Chairman Schapiro
  has said will be brought to a Commission vote as
  soon as February.

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Dark Pools

• The primary regulatory concerns expressed by
  Concept Release regarding dark pools include
• Fragmentation
• The SEC is concerned that trading in dark pools
  is siphoning orders away from displayed markets
  in a way that harms public price discovery.
• Dark pool trading volumes may be passing the
  fragmentation tipping point.
• Are long term investors abandoning the lit
  markets to the machinations of the high frequency
  traders?
• Transparency
• The SEC is concerned about the reliability of
  public information regarding dark pool trading
  activity, and the lack of a uniform methodology
  for determining trading activity metrics.
• The SEC is concerned that dark pools are using
  actionable indications of interest to attract
  order flow without the concomitant quoting
  obligations of a displayed market.
• Fair access
• The SEC is concerned that dark pools routing of
  indication of interests to selected market
  participants unfairly disadvantages market
  participants that do not have access to these
  indications of interest.

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Dark Pools

• Proposed responses include
• Better execution quality statistics
• Trade-at rule
• Depth of book protection

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High Frequency Trading

• Broad policy question
• Do high frequency traders add value to the
  market by increasing liquidity and certainty of
  execution at various execution prices and thereby
  justify the profits they take from the market
  (passive liquidity providers arbitragers)
• OR
• Do high frequency traders harm markets by
  stepping in front of legitimate customer orders
  and long term investors causing rapid increases
  in the prices of securities, increased
  volatility, and making those customers pay more
  for the securities (order anticipators momentum
  igniters).
• Proposed responses include
• Market maker obligations
• Broker-dealer registration
• Regulation of manipulative strategies

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Colocation

• Broad policy question
• Does co-location create two tier market giving
  increased access to a limited group of market
  participants to the disadvantage of other
  participants in the market
• Proposed responses include
• Fair access for exchanges
• Treatment of colocation facility as a facility of
  the exchange
• Regulatory parity with respect to leased and
  owned data centers
• Reliability and redundancy standards
• Latency disclosures

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SEC Proposal On Sponsored Access

• On January 19, 2010, the SEC proposed a new rule
  that would effectively prohibit unfiltered access
  to equity trading markets by requiring
  broker-dealers to maintain risk management
  controls and supervisory procedures to manage
  customer access to such markets. SEC Release
  34-61379 (Jan. 19, 2010)
• Proposed Rule 15c3-5 would apply to
  broker-dealers with access to trading in
  securities on an exchange or ATS as a result of
  being a member or subscriber of the exchange or
  ATS (market access), or that provide this
  market access to others.
• These broker-dealers would be required to
  establish, document, and maintain a system of
  risk management controls and supervisory
  procedures reasonably designed to manage the
  financial, regulatory, and other risks, such as
  legal and operational risks, related to the
  market access business activity.
• By requiring such controls and procedures to be
  under the broker-dealers direct and exclusive
  supervision, the proposal mandates that customer
  orders under these arrangements pass through
  systems controlled by the sponsoring
  broker-dealer.
• The proposal would also mandate an annual review,
  and a CEO certification, of the effectiveness of
  these controls and procedures.

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NASDAQ Sponsored Access Rule

• On January 19, 2010, the SEC simultaneously
  approved a more limited Nasdaq sponsored access
  rule change, which would require additional
  controls but not ban direct access.
• Amended Nasdaq Rule 4611
• Permits members to provide access to Nasdaq by
  passing orders through the members own systems
  or through other means.
• If the member provides market access other than
  through its own system, it must contractually
  require customers to comply with applicable laws,
  trade within agreed limits, and grant access to
  their books and records. Special requirements
  apply where access is provided through a third
  party provider.
• Mandates controls reasonably designed to prevent
  trading in excess of credit thresholds or of
  restricted products, submission of
  erroneous/duplicative orders and regulatory
  violations.
• Prescribes audit trail, reporting and supervisory
  review standards.

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Sponsored Access (cont.)

• The SEC and SROs have raised the following
  concerns about Sponsored Access
• Risk issues
• Lack of risk controls over, or pre-trade
  monitoring of, sponsored participants
• Potential for a domino effect meltdown caused by
  one erroneous algorithm or errant trade
• Enforcement issues
• Manipulative behavior by sponsored participants
• Spoofing
• Marking the close
• Wash sales
• Frequent cancellations
• SRO rule violations including market on close
  orders and odd lot order execution
• Need for involvement of legal and compliance
  personnel in the algorithm creation and oversight
  process

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SEC Proposed Rule Regarding Flash Orders

• The SEC proposed eliminating the use of flash
  orders. SEC Release 34-60684 (Sep. 18, 2009).
• The widely anticipated proposal eliminates an
  exception from Rule 602 of Regulation NMS the
  quote rule for orders that are withdrawn or
  cancelled if not executed immediately.
• Notable points in the proposal include
• The SEC continues to view immediate or cancel
  orders and price improvement auctions as
  permissible order types.
• The SEC cited the Regulation ATS adopting release
  discussion regarding indications of interest.
• Questions posed for public comment include
• Whether trading floors should be permitted to
  continue manual flashing of orders if
  electronic flashing is prohibited and what, if
  any, conditions should apply.
• Whether there should be a distinction in approach
  between listed options and cash equities.
• Whether requiring broader dissemination of flash
  orders, such as in the consolidated quote stream,
  or providing flash orders free of charge to
  anyone, would address concerns about a two-tiered
  market.
• Comments to the proposal were due by November 23,
  2009.

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SEC Proposed Rule Regarding Dark Pools

• The SEC issued its formal proposal on Regulation
  of Non-Public Trading Interest on November 14.
  SEC Release 34-60997 (Nov. 14, 2009).
• In essence, the proposal requires
• Post-trade reporting of ATS activity
• Trade reporting that identifies the dark pools,
  as opposed to a generic OTC label
• Trade-by-trade disclosure versus summary
  statistics
• Exception for large trades of 200,000 in value
• Indications of Interest
• Actionable versus nonactionable
• Expansion of Regulation ATS adopting release
  discussion of firm quotes
• Effect on public price discovery
• Regulation ATS thresholds for fair access and
  quoting
• .25
• All stocks once an ATS crosses the threshold in a
  percentage of its stocks
• Exception for large trades of 200,000 in value

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Short Selling New Rules

• Misrepresentation of Locates
• Reg SHO requires brokers to obtain a locate prior
  to executing a short sale for a client.
• Customers, however, may also be liable under the
  SECs anti-fraud rules if they misrepresent the
  availability of a locate to the broker executing
  a short sale.
• Rule 10b-21 (eff. October 17, 2008)
  emphasizes/amplifies prohibitions against
  misrepresenting locates.
• Rule 204 (eff. July 27, 2009) amended Reg SHO
  with the intention of helping to further the
  SECs goal of addressing naked short selling
  in all equity securities. Rule requires a fail to
  deliver position to be closed out by the
  beginning of regular trading hours on the next
  trading day following the day on which the fail
  first occurred.
• Todays actions demonstrate the Commission's
  determination to address short selling abuses
  while at the same time increasing public
  disclosure of short selling activities that
  affect our markets.
• SEC Chairman Mary Schapiro, announcing Rule
  204 and other related initiatives, July 27, 2009

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Short Selling New Rules (cont.)

• Price Test Restriction Proposals
• First set of proposals was released in April,
  followed by an additional proposal in August.
• Significant issues
• Circuit breaker v. all stocks, all the time
• Exception for market makers (including
  derivatives market makers)
• Absolute prohibition versus policies and
  procedures
• Short Sale Marking Issues
• In August, Trading and Markets staff released new
  FAQs regarding short sale marking.
• Marking multiple orders in flight
• Marking mixed long/short orders
• Treating all foreign broker-dealers (including
  Canadian brokers) as customers for purposes of
  the rule
• Trading and Markets staff have said that they are
  listening to market participants reactions on
  the FAQs.
• Big challenge by some firms that the SEC
  overstepped its boundaries by changing
  substantive trading rules without following
  proper administrative process
• No definitive indication of an inclination to
  revise the FAQs

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Short Selling New Rules (cont.)

• Pre-borrow Requirement
• The SEC hosted a roundtable on September 29-30,
  2009 on securities lending and shorts sales that
  discussed the concepts of pre-borrow, arrange to
  borrow and hard locate requirements.
• Concern about non-decrementing locates
• Balance sheet implications
• Disclosure issues
• Daily Publication of Short Sale Volume
  Information  SROs began publishing on their Web
  sites the aggregate short selling volume in each
  individual equity security for that day.
• Disclosure of Short Sale Transaction
  Information  SROs began publishing on their Web
  sites on a one-month delayed basis information
  regarding individual short sale transactions in
  all exchange-listed equity securities, excluding
  any identifying information.
• Enhanced Disclosure of Fail to Deliver
  Information The Commission enhanced the
  publication on its Web site of fails to deliver
  data so that fails to deliver information is
  provided twice per month and for all equity
  securities, regardless of the fails level.

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Use of Customer Information

• Regulators are tightening standards for trading
  for large customer orders.
• FINRA and NYSE proposed to harmonize their Rule
  92 and the Manning Rules (March 2009).
• The proposals would require affirmative written
  consent before entering into terms and conditions
  with institutional accounts.
• FINRA proposed to broaden its front running
  policy (December 2008)
• The proposal extends the scope beyond certain
  options and security futures to other types of
  derivatives, financial instruments and financial
  contracts.
• The comment period closed on February 27, 2009.
• OCIE Top Five Issues include front running of
  customer orders.
• Regulators also are focusing on handling of small
  customer orders.
• The FINRA and NYSE Rule 92/Manning Rule
  harmonization proposal applies to all customer
  orders.
• The proposals would merge limit order and market
  order protections and apply them to all equity
  securities.
• The proposals allow walling off market maker
  desks with information barriers bolstered by
  supervisory procedures.
• NYSE/FINRA are conducting an ongoing sweep of
  algorithmic trading.
• This sweep specifically is examining interaction
  of algo orders with proprietary trading desks.

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Securities Lending

• The SECs recent roundtable also focused on
  securities lending issues.
• The SEC seems to view securities lending as a
  part of its broader review of opaque markets
  (e.g., dark pools).
• Chairman Schapiro has said that, securities
  lending is an area that perhaps has not received
  the level of regulatory attention that is
  necessary to ensure the fair and
  investor-oriented operation of a multi-trillion
  dollar market.
• Key issues discussed at the roundtable include
• Securities lending market structure
• Progress toward an automated and transparent
  market
• Extent of public information available to
  beneficial owners
• Whether a central counterparty is useful for the
  securities lending market
• Short sale related issues
• Does the securities lending market preclude more
  stringent pre-borrow/arrange to borrow/hard
  locate requirements?
• Is a hard borrow rule necessary in light of the
  success of the hard delivery rule in reducing
  naked short selling?
• Do structural issues in the current market (i.e.
  disconnect of actual borrow from affirmative
  determination particularly in the area of prime
  brokerage) preclude any such changes?

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Glossary Of Selected Market Structure Terms

• ATS refers to an alternative trading system
  that acts as a venue for trading securities and
  is subject to regulation under Regulation NMS.
  Alternative trading systems are typically
  electronic trading systems involving multiple
  parties (although manual interdealer broker
  systems are also ATSs). ATSs are required to
  register with the SEC as broker-dealers and as an
  alternative trading systems, and are subject to
  requirements for quoting, fair access, systems
  reliability and information confidentiality at
  differing thresholds of market share. They also
  cannot call themselves exchanges.
• Co-location refers to the practice of exchanges,
  ATSs or third parties providing space for the
  servers of market participants in the same data
  center housing the matching engines of the
  trading center. Co-location is favored by high
  frequency traders because it affords lower
  latency in the transmission of the order from the
  trader to the market center.
• Dark Pools refers narrowly to ATSs that do not
  display bids and offers in the public quotation
  stream. More broadly, Dark Pools refers to
  sources of liquidity not reflected in public
  quotes, such as dark orders on exchanges and
  internalization of orders by a broker-dealer.
• Decimalization refers to the transition from
  quoting stock prices in 1/16ths or 1/8ths of a
  dollar to quoting in pennies, or decimals. The
  transition to decimal pricing occurred in 2000.

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Glossary Of Selected Market Structure Terms

• Direct Market Access refers to the practice of a
  broker-dealer providing its client with the
  ability to route orders directly to a market
  using the broker-dealers market participant
  identifier, or MPID. Direct Market Access
  sometimes refers only to orders that are routed
  through a broker-dealers systems for credit and
  regulatory checks before routing on the market
  in this context, orders that are not routed
  through the broker-dealers systems are referred
  to as sponsored access or naked access.
• ECN refers to an electronic communications
  network, which is an ATS used in part by market
  makers that displays orders within its system.
  ECNs do not include dark crossing systems or
  over-the-counter market makers trading as
  principal with customers.
• Exchange refers to a national securities exchange
  registered with the SEC. Examples include the
  New York Stock Exchange and Nasdaq. Exchanges
  are subject to greater regulatory oversight than
  ATSs.
• Flash Orders refers to a practice whereby a
  trading center will for a few milliseconds show
  to subscribers customer buy orders priced at the
  national best offer, or customer sell orders
  priced at the national best bid. Subscribers
  with fast electronic connections can then execute
  the orders at the flash price. If the order is
  not immediately executed, it is withdrawn without
  exposure to the entire marketplace, or is routed
  to other exchanges. Flash orders are only
  tangentially related to high frequency trading.

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Glossary Of Selected Market Structure Terms

• High Frequency Trading refers to automated
  trading by complex algorithms that enter and
  often cancel orders frequently, often thousands
  of times a minute. Many firms that engage in
  high frequency trading seek to end the day with
  little or no exposure to the market. Various
  strategies are used, including statistical
  arbitrage, market making and event-based
  strategies. In general, the term is vague and
  probably has different meanings to different
  people.
• Indication of Interest refers to an order that
  requires further agreement before it can be
  executed. There is significant debate as to the
  point at which an Indication of Interest, or IOI,
  should be treated as actionable, i.e. as a firm
  order, thereby requiring a facts and
  circumstances analysis in many cases.
• Limit Order refers to an order to execute a
  transaction at a specified price. Marketable
  limit orders are buy limit orders at or above the
  national best offer to sell, and sell limit
  orders at or below the national best bid to buy.
  Non-marketable limit orders are buy limit orders
  below the national best offer, and sell limit
  orders above the national best bid.
• Locked and Crossed Market refers to a national
  best bid to buy that is at the same price as the
  national best offer to sell (Locked Market) or at
  a higher price than the national best offer to
  sell (Crossed Market). Exchanges are required by
  Regulation NMS to have rules to deter and correct
  locked and crossed markets. Locked and crossed
  markets occur when a quote is temporarily
  inaccessible, or when the quotes have access fees
  that discourage hitting the quote.

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Glossary Of Selected Market Structure Terms

• Naked Short Sale refers to a short sale where the
  seller does not borrow or otherwise have
  available to deliver the shares that are sold
  short.
• Sponsored Access usually is synonymous with Naked
  Access.
• Spread refers to the difference in price between
  the national best bid to buy and the national
  best offer to sell.
• Trade-through refers to transacting an order on
  one market center when a more advantageous price
  is available at another market center, i.e.
  trading-through the order. The order
  protection rule of Regulation NMS requires a
  trading center to establish, maintain, and
  enforce written policies and procedures that are
  reasonably designed to prevent trade-throughs,
  subject to numerous exceptions. Rule 611(a)(1).
• Upstairs Market refers to the market for trades
  executed internally by a broker-dealer or
  over-the-counter with another broker-dealer
  rather than on an exchange. Dark Pools have been
  analogized to the upstairs market for block
  trading that was prominent in the era of stock
  exchange dominance.

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Gerard S. Citera
212 450 4881 tel gerard.citera_at_davispolk.com

• Mr. Citera is counsel in our Financial
  Institutions Group and a senior lawyer in the
  firms Broker-Dealer and Market Regulation
  practice. He has extensive experience
  representing broker-dealers, banks, investment
  banks, investment advisers and other financial
  institutions in a wide range of legal, compliance
  and regulatory matters. His advisory practice
  focuses on the full scope of broker-dealer
  regulatory issues, including compliance,
  supervision, trading, sales, market structure,
  derivatives and technology. Mr. Citera has
  managed implementation of major regulatory,
  technological and market structure changes. He
  also structures and implements supervisory and
  compliance programs and procedures, conducts
  internal investigations and compliance reviews,
  and represents clients in SEC and SRO
  examinations, investigations and enforcement
  proceedings.
• OF NOTE
• In 2007, Mr. Citera received the Excellence in
  Alumni Service Award from the University at
  Albany
• Since 2006, he has served as a guest lecturer and
  project manager for the SUNY Buffalo Law School
  New York City Program in International Finance
  and Law
• Since 2004, he has served as a member of the
  Rockefeller College Advisory Board at SUNY Albany
• Mr. Citera is one of the founders of and serves
  on the on Executive Committee for the Advisory
  Council of the Center for Financial Market
  Regulation at SUNY Albany
• Mr. Citera has published numerous articles and
  practice outlines on various securities law
  issues and is a frequent speaker at industry
  conferences on broker-dealer regulatory issues
• PROFESSIONAL HISTORY
• Counsel, Davis Polk, 2008-present
• Executive Director, UBS Securities, 2000-07
• Deputy General Counsel, PaineWebber Securities,
  1994-99
• Counsel, Broker-Dealer Regulatory Group, Wilmer,
  Cutler Pickering, 1985-94
• Attorney, Division of Market Regulation and
  Office of General Counsel, SEC, 1982-85

• Bar Admissions
• State of New York
• District of Columbia
• Education
• B.A., Magna Cum Laude, SUNY Albany, 1977
• J.D., Magna Cum Laude, SUNY Buffalo Law School,
  1980