Call For SEC To Regulate High-Frequency Traders

by Glen Shapiro, LawAndTax-News.com, New York

20 August 2010

While the United States Securities and Exchange Commission (SEC) is considering measures to counteract a recurrence of the May 6 “Flash Crash”, it has received letters from two senators, Charles E. Schumer and Edward E. Kaufman, suggesting ways to control the effect on the markets of high frequency trading firms.

The Flash Crash, as it is called, was a stock market crash on May 6, 2010, involving US corporate stocks, followed by an almost immediate rebound. It was the biggest point decline, almost 1,000 points, on an intraday basis in the Dow Jones Industrial Average’s history.

Schumer said in his letter to the SEC that “one of the most important new developments, and one that many observers and market participants think contributed to the market’s volatility on May 6, is the role that high frequency traders now play as de facto liquidity providers. The traditional definition of bona-fide market makers developed to describe the upstairs specialists of the old trading floors is now largely irrelevant.”

“During the May 6 Flash Crash many high frequency traders pulled out during the freefall, leaving a dearth of liquidity and exacerbating market volatility,” he added. “This disappearance of high frequency traders and their withdrawal of liquidity reveal a serious problem with our market regulation. The players in our markets have changed but our regulations have not kept pace.”

He urged the SEC to place high-frequency trading firms under a uniform set of rules to prevent them from pulling out of markets en masse. He suggests an updating of its 17-year-old “market maker” definition so that more of those traders have affirmative obligations when it comes to providing liquidity to the markets.

Schumer therefore proposed a number of new obligations that would be imposed on all traders who are dealing in 25 or more stocks. These include a best price obligation that would require market makers to quote between the highest bid and lowest offer price for a minimum amount of time during each trading day, and require that market makers' quotes be reasonably related to the market price, which would effectively ban so-called “stub quotes”.

He said that many of these obligations are currently imposed on designated market makers by the New York Stock Exchange, but not all trading venues have designated market makers or impose affirmative market-making obligations on market participants. Schumer also said the proposed obligations should apply uniformly across all trading platforms to ensure a level playing field and avoid the kind of disorderly markets experienced on May 6.

Kaufman, in his letter, pointed out that “several areas of current market structure lead me to be concerned about the performance of the markets for investors and companies seeking to raise capital.” Amongst those are the substantial rise in volume executed internally by broker-dealers or in dark pools, excessive messaging traffic, and the dissemination of proprietary market data catering to high frequency traders. All, he said, “may be combining in ways that cast doubts on the depth of liquidity, stability, transparency and fairness of our equity markets.”

He agreed with Schumer that, as high frequency trading volume is now responsible for as much as 70% of average daily trading volume, and as such traders have emerged as the dominant source of liquidity and largely taken the place of traditional specialists and market-makers, the SEC should impose some liquidity provision obligations on high frequency traders.

Furthermore, however, he also proposed that the SEC should, in addition to collecting data and analyzing it for manipulative trading patterns, issue guidance on what trading patterns and practices constitute unlawful manipulation; require all high frequency traders who exceed a certain volume threshold to register with the SEC; and necessitate the chief executives of applicable high frequency trading firms to certify that their algorithms do not manipulate market prices.

Again in agreement with Schumer, he asked the SEC to “determine whether we have gone from too few market centres – a duopoly of the New York Stock Exchange and Nasdaq – to too many. Today, there are more than 50 trading venues in addition to over two hundred broker-dealers who can execute order flow internally.” As trading continues to become faster and more dispersed, he felt that it is that much more difficult for regulators to perform their vital oversight and surveillance functions.

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