Senate Panel Reviews Alternative Trading Systems with View Towards Reform of Market Regulation

Senate Securities Subcommittee hearings examined alternative trading systems and dark pools amidst a growing consensus that holistic market regulatory reforms are needed to address increasingly electronic and complex securities markets. Chairman Jack Reed (D-RI) questioned if current market regulations reflect the reality of the current market structure. He said it could be necessary to change the rules of the road. The Senator is also concerned about the complexity of the markets and the cost of that complexity. Senator Reed also fears that off-exchange trading may be hurting price discovery

Senator Reed noted that SEC Regulations ATS and NMS dramatically accelerated changes in the structure of financial markets. Regulation ATS encouraged the development of new market centers by exempting alternative trading systems from having to register as exchanges. Taken together, said Senator Reed, Regulations NMS and ATS led to a proliferation of new trading platforms and put a premium on speed, giving an advantage to firms that could place their order first.

The motivating idea behind the adoption of Regulation  NMS, in Senator Reed’s view, is to ensure that orders are sent to the trading platform with the best price regardless of where the orders originated and, he added, that does not seem to be happening with dark pool, whichs are computerized trading systems organized under Regulation ATS that do not show publicly displayed bids and offers. The order sits inside the computer waiting  for a sell order to intersect. After the trade is executed, it is publicly displayed.

Senator Kay Hagen (D-NC) also expressed concern with the dramatic increase in dark pool trading, which now accounts for 14 percent of trades. Senator Hagen perceives a lack of transparency in dark pool trading.

The Committee’s Ranking Member, Senator Mike Crapo (R-ID), was concerned about how markets perform in times of stress and what tools can be used to minimize any deleterious impact.  He noted that the use of automated switches, which the Senator called kill switches,  to turn off trading at securities firms when their volume exceeds pre-set maximums appear to be the first choice of many market participants.

Senator Crapo asked the exchanges what progress they are making in implementing kill switches. Joe Mecane Executive Vice President, NYSE Euronext, said that NYX is having an active dialogue around kill switches and is developing a framework for kill switches and should have something to report in 1Q 2013. Eric Noll, NASDAQ OMX Executive Vice President, said that the exchange is: working with the SEC to implement kill switches.

Mr. Mecane noted that there are around 63 execution venues in the US markets, including 13 exchanges and 50 dark pools.  Exchanges find themselves competing more directly with alternative trading systems, which are able to employ different practices than exchanges with far less oversight and disclosure.

In 2007, just as the technology among the trading community was becoming more sophisticated, the SEC adopted Regulation. NMS, he noted, which gave brokers the freedom to trade around markets such as the NYSE when the NYSE was in slow mode, and at the same time forced participants to access the national best bid or offer (NBBO) in the market.  Because exchanges competed by establishing the NBBO, speed among markets became the competitive differentiator based on one exchange’s ability to set the NBBO faster than a competing market.  While Reg. NMS also established the Order Protection Rule to protect visible orders and encourage displaying quotes, today more than 3000 securities have over 40%  of their volume occurring off exchange in dark markets. 

The NYX senior officer noted that technology and the rules that govern the U.S. equity markets have resulted in the creation of a trading infrastructure primarily focused on speed and a resulting complexity through which professional traders can identify and access liquidity, too often at the expense of retail investors and market integrity.  To accomplish this, exchanges, brokers, and vendors have had to build expensive networks with the capacity to keep up with the growth of messages delivered each day to market participants seeking liquidity, as well as learn how to interact in a very complex ecosystem.  

The NYX believes that the SEC is best suited to propose meaningful market structure changes. Global regulators in other markets, including Canada, Australia and Europe, are already taking action.  With Congressional oversight, the SEC should continue with the holistic review it began in 2010 with the Concept Release on Equity Market Structure

by proposing changes promoting additional transparency, fairness and long term capital formation.  This unfinished initiative needs to be completed and made a 2013 priority, emphasized Mr. Mecane.