US Senator Asks SEC for Broad Review of Structure of Market Regulation

Senator Ted Kaufman (D-DE) has urged the SEC to conduct a broad comprehensive review of the structure of the financial markers in order to ensure a level playing field for all investors. In a letter to SEC Chair Mary Schapiro, the senator suggested that conflicts of interests may be leading to failures to protect retail order flow from being taken advantage of by high frequency traders, that dark pools are undermining public price discovery and are not being adequately surveilled, and that disparities in execution speed may have made the national best bid or offer (NBBO) "questionable as a benchmark of execution fairness." Sen. Kaufman noted in his proposal that the study should include independent outside experts from across the United States, including representatives of the retail investor community and small business.

The senator is concerned that questionable practices threaten to further erode investor confidence in the financial markets and that regulatory capacity has not kept pace with those changes. In his view, actions taken by the SEC over recent decades have, perhaps unintentionally, encouraged the development of markets which seem to favor the most technologically sophisticated traders. The current market structure appears to be the natural consequence of regulatory structures designed to increase efficiency and thereby provide the greatest benefits to the highest volume traders. The implications of the current system for buy-and-hold investors have not been the subject of a thorough analysis. He believes that SEC rules have effectively placed increased liquidity as a value above fair execution of trades for all investors

He asks the SEC to undertake a comprehensive, independent "zero-based regulatory review" of a broad range of market structure issues, analyzing the current market structure from the ground-up before piecemeal changes built on the current structure exacerbate potential execution unfairness.

Sen. Kaufman further suggested that flash orders should be banned and high frequency trading strategies that take advantage of market structure latencies should be subjected to a searching examination and in some cases possibly prohibited. Further, liquidity rebates should be reconsidered. Importantly, the co-location of servers at execution venues should be regulated by the SEC to ensure fair access, he emphasized, and auditing of execution at all market centers should be uniform and improved.

Markets have become so fragmented, he averred, and the rise of high-frequency trading that can execute trades in milliseconds has been so rapid, that the SEC should review and quantify the costs and benefits of these market structure developments to all investors. Specifically, he noted that Regulation NMS appears to have had many unintended consequences, driving order flow into dark pools when it was intended to strengthen public order display. Moreover, Regulation ATS has permitted execution venues to flourish, and competition generally has been beneficial. More than 50 execution platforms now exist. While this has led to increased competition for market share, he acknowledged, this also includes questionable practices such as liquidity rebates, flash order offerings, co-location of servers and other inducement arrangements with broker-dealers and other market participants.

Moreover, market structure developments have taken place so quickly, that the SEC rule-making process is applying principles and precedents based on floor-based trading to electronic environments. For example, he noted that, in May 2009, the SEC staff permitted two exchanges to introduce flash-order offerings, even though both admitted that the practice was of dubious value and that they simply were being driven to adopt it by the loss of market share to competitors. Instead of simply applying precedent from an obsolete business practice to a particular electronic order type or technological development, he said, there needs to be a comprehensive evaluation of each proposal's direct and indirect costs to the average investor.

The senator asked the SEC to improve the reporting of execution quality for all trading venues in Rule 605. The SEC should also make brokerage firms produce better and usable execution quality statistics in Rule 606. He also asks if the national best bid and offer (NBBO) truly reflects the quotes consolidated from the various venues at current execution speeds. Otherwise, NBBO is questionable as a benchmark measure of execution fairness.

Liquidity, speed and the role of arbitrage functions cannot be the end of the discussion, he said, adding that this conversation is only now beginning to take place, as recent questionable market practices, which few previously understood, are only now coming to light.

He urged the SEC to ban selectively displayed orders and indications of interest that are the functional equivalent of orders. In addition, he said that the SEC needs to ensure fair access by pro-actively determining a method of allocation of co-located capacity. The Commission must also insure that such closeness is consistent with its plans for protection against terrorist attacks in the various business continuity directives.

Further, the senator said that fees for co-locating servers should be approved by the SEC. Agreements should offer the same terms and conditions and be transparent to regulators. Also retail investors should have adequate choice of co-located execution by wholesalers. Finally Sen. Kaufman said that the use of liquidity rebates (payment for order flow) to attract market share should be reconsidered. In this context, he noted that the London Stock Exchange has decided to end liquidity rebates by replacing them with a flat fee beginning September 1.

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