High-frequency traders, whose lightning-fast stock and options tactics have been criticized by senators, are about to learn how far U.S. regulators may go to rein them in.
The Securities and Exchange Commission is poised to ask brokerage firms, traders and exchanges to weigh in on the practice, which describes a range of strategies that depend on high-speed executions, usually less than a millisecond.
SEC commissioners vote today on publishing a so-called concept release on high-frequency trading, dark pools and the structure of markets. The document will lay out the agency’s concerns and begin a process of soliciting and reviewing feedback that will last months before any rules are approved.
High-frequency trading accounts for as much as 70 percent of U.S. stock volume, according to data compiled by New York- based financial services consultant Tabb Group LLC. New regulations may make the practice less profitable for trading firms and hurt U.S. exchanges, where revenue hinges on the number of transactions executed.
The SEC is “going to put out some positions that the commission either feels strongly about or wants to feel people out on,” said Sean O’Malley, a former attorney in the agency’s division of trading and markets who’s now a partner at Goodwin Procter LLP in New York. “If you’re a compliant high-frequency trader, your concern is that there is this populist sentiment that these guys are getting away with something that is unfair to the rest of us.”
Wall Street Edge
The SEC is reviewing high-frequency trading after lawmakers including U.S. Senator Ted Kaufman, a Delaware Democrat, questioned whether the practice is benefiting Wall Street at the expense of individual investors. Proponents of the technique say it has lowered fees, boosted liquidity and increased volume.
Questions the SEC will ask include whether it should impose new rules on high-frequency trades, whether “highly automated, high-speed” trades hurt investors and what metrics regulators should use to determine the effects of new trading strategies on “long-term investors,” the agency said in a statement today.
The SEC will also ask about co-location, where traders and securities firms place computers close to exchange data centers to shave time off their orders. The agency wants to know whether co-location gives traders unfair advantages and whether firms that place computers near data centers should face regulations, according to the statement.
‘Big Laundry List’
It’s “a big laundry list of stuff they would like to hear opinions on,” said Justin Schack, director of market structure analysis at Rosenblatt Securities Inc. in New York. “It’s the beginning of a process that could ultimately result in new regulations, but it would be many months and possibly years before you’d see the end of that.”
Under pressure from U.S. Senator Charles Schumer, a New York Democrat, and Kaufman, the SEC in September proposed banning flash trades, or orders displayed for less than a second to a segment of a market center’s customers to get an execution at the industry’s best price on that venue. Schumer and Kaufman said the practice was giving an unfair edge to investors with the fastest computers.
Increasing Transparency
The SEC in October proposed rules to address concern that dark pools, private trading venues operated by brokers that don’t display prices, were growing too rapidly and drawing volume away from regulated exchanges.
SEC commissioners today will consider new rules for sponsored access, or arrangements by which brokers allow their customers to trade directly on exchanges and market centers. The practice gives some trading firms an edge in executing orders faster than competitors. The SEC is concerned that inadequate risk controls may lead to manipulation or trading errors that damage markets.
The SEC proposal would require brokers to implement “risk management controls” over their clients’ transactions before the trades are made, according to the agency’s statement. The controls must be “reasonably designed” to prevent orders that exceed “pre-set credit or capital thresholds,” the SEC said.
SEC Chairman Mary Schapiro said in October her staff is also working on a proposal to require that high-frequency traders give the agency “better baseline information.” The rule may attach identification codes to market participants who exceed a certain volume threshold so the SEC can monitor their trades, according to people familiar with the matter who declined to be identified before the proposal is public.
Lawrence Harris, a former SEC chief economist, said the agency should wait for market participants to respond to its concept release before pursuing piecemeal regulations.
“A concept release provides an opportunity for the expertise of practitioners and academics outside the SEC to be brought in on important questions before the agency,” said Harris, who’s now a business professor at the University of Southern California in Los Angeles. “At a time when the SEC’s technical competence has been found wanting, the use of outside expertise is particularly important.”
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