Know your role

The furore surrounding the industry’s handling of the Facebook IPO just refuses to die down, and has now turned to the framework that governs exchanges in the US.

Industry debate has thus far been rife on the role of underwriters, whether exchange technology is tipped too heavily in favour of high-frequency traders (again) and whether the IPO process as a whole needs a facelift.

Brokers in particular seized the opportunity to stick the boot into Nasdaq OMX – and in particular its plans for compensation – but are now using the incident to call for a more fundamental reassessment of exchanges’ role generally.

Initially, what riled brokers was Nasdaq OMX’s first compensation plan comprising cash and discounted execution fees for members that had trouble figuring out if, and at what price, they executed trades in Facebook. Most regarded this as a sly attempt to win market share off the back of a bungled listing.

In a submission to the Securities and Exchange Commission (SEC) on Nasdaq’s revised all-cash reimbursement plan, Citi remained unsatisfied, and vented its fury further by proclaiming, “the era of market self-regulation has passed”.

“Nasdaq no longer regulates its market participants; they are regulated by FINRA. Nasdaq's rulebook is not posted on the home page of its website. The vast majority of its market-related rules have been deleted,” continued the Citi statement.

The role of exchanges as self regulatory organisations (SROs) has been altered dramatically since the creation of the Financial Industry Regulatory Authority (FINRA) in July 2007 from a merger of the enforcement arms of Nasdaq and NYSE.

FINRA essentially handles oversight of exchanges’ members and allows investors to seek arbitration for claims against brokers.

In their self-regulatory capacity, exchanges are required to establish standards that prevent fraud and market manipulation, and have the power to take action against members who violate federal securities law.

This leaves the SEC to approve rules proposed by SROs – such as recent post-flash crash initiatives like the limit up/limit down circuit breakers and the consolidated audit trail – and ensure that SROs adequately meet their regulatory responsibilities.

Leaving exchanges with this oversight of their listings and trading businesses create clear conflicts of interest according to many industry observers.

Asides from committing to a review of the issues related to the Facebook IPO, the SEC has so far remained quiet on both Nasdaq’s compensation plans and possible sanctions against the bourse for its handling of the issue.

“If Nasdaq is under no threat of liability as a result of its actions that led to this harm, Nasdaq has little or no incentive to behave differently in the future,” posited Citi.

Citi and UBS are two brokers that have publicly declared their intention to pursue legal action against Nasdaq in order to recoup losses that they say are far in excess of total US$62 million currently offered by the bourse.

Knight Capital – which probably has a few more pressing priorities than chasing Facebook losses right now – supports Nasdaq’s cash only offer, but urged regulators to hold a separate enquiry on the liability limitations and regulatory immunity US exchanges enjoy due to their SRO status.

“As exchanges have evolved over the years, with greater and greater emphasis on profits and business expansion, the time is right for a more fulsome discussion on this issue,” wrote Knight’s general counsel Len Amoruso in the recently rescued market maker’s letter to the SEC.

This appears to get to the heart of the issue.

The risks posed by exchanges that continue to seek high-speed order flow at the risk of market stability suggest that the SRO role should at the very least be redefined.

One possibility that has lingered since the flash crash in May 2010 is the compulsory compliance with Automation Review Policies, which would require all market participants to test the systems necessary to run their operations annually.

Alternatively, we could go back to a time when exchanges were member owned.