CURRENT ISSUES IN THE EQUITY TRADING MARKETS // February 9, 2010 - PowerPoint PPT Presentation

1 / 35
About This Presentation



CURRENT ISSUES IN THE EQUITY TRADING MARKETS // February 9, 2010 CURRENT ISSUES IN THE EQUITY TRADING MARKETS Topics Requirements for a National Market System ... – PowerPoint PPT presentation

Number of Views:62
Avg rating:3.0/5.0
Slides: 36
Provided by: dalu151


Transcript and Presenter's Notes


February 9, 2010

Presented by Jerry Citera February 9,
2010 Buffalo University Law School New York City

  • Requirements for a National Market System
  • Overview of Current Market Structure
  • Key Regulatory Developments in the Equity Trading
  • Evolution of the Equity Trading Market
  • SEC Announces Broad Review of Equity Trading
  • 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

Requirements for a National Market System
  • Exchange Act Requirements for National Market
  • 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
  • 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.

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
  • Regulatory Reform

Key Regulatory Developments in the Equity Trading
  • 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
  • Enforcement Actions Against OTC Market Makers in
  • 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

In US equities, technology-based trading has
completely redefined the landscape . . .
Market Share, US Equities
Direct Edge
Source BATS Exchange, Inc.
. . . 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
. . . 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
Source Rosenblatt Securities, August 2009
Europe has experienced similar changes
Source Federation of European Securities
High Frequency Trading in the US is rumored to
account for than 70 of equity volumes . . .
Source Tabb Group, August 2009
. . . with a select few players accounting for
most of the volume
Percent of US trading firms with a high frequency
Percent of US equity volume driven by high
frequency strategies
Source Tabb Group, August 2009
SEC Announces Broad Review of the Equity Trading
  • 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
  • Dark pools (including the use of indications of
  • Regulation ATS thresholds (Appropriate
    Disclosure Levels)
  • Post-trade transparency of alternative trading
  • Sponsored market access (Broker-dealers must be
  • High frequency trading (Volatility)
  • Colocation (Fairness in access)
  • Short Sales
  • Consolidated Audit Trail
  • Inter-Market Surveillance System
  • Large Trader Reporting Requirement

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
  • 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
  • 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.

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

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.

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
  • 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.

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

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
  • Proposed responses include
  • Market maker obligations
  • Broker-dealer registration
  • Regulation of manipulative strategies

  • 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

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
  • The proposal would also mandate an annual review,
    and a CEO certification, of the effectiveness of
    these controls and procedures.

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
  • Prescribes audit trail, reporting and supervisory
    review standards.

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

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
  • Comments to the proposal were due by November 23,

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
  • 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
  • .25
  • All stocks once an ATS crosses the threshold in a
    percentage of its stocks
  • Exception for large trades of 200,000 in value

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

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
  • 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

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.

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
  • 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
  • The proposals would merge limit order and market
    order protections and apply them to all equity
  • 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.

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
  • 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?

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.

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
  • 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.

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
  • 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.

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
  • Sponsored Access usually is synonymous with Naked
  • 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.

Gerard S. Citera
212 450 4881 tel
  • 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
  • In 2007, Mr. Citera received the Excellence in
    Alumni Service Award from the University at
  • 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
  • Counsel, Davis Polk, 2008-present
  • Executive Director, UBS Securities, 2000-07
  • Deputy General Counsel, PaineWebber Securities,
  • 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,
Write a Comment
User Comments (0)