Dodd-Frank might be turning the US financial markets upside down, but it isn’t the only new set of rules reshaping the trading and reporting processes of institutional investors and their broking counterparts.
In July 2011, the US Securities and Exchange Commission (SEC) adopted a new regulation, Rule 13h-1, that imposes new reporting requirements on ‘large traders’, defined as market participants – based in the US or not – that trade US exchange-listed securities at levels above two million shares or US$20 million per day or 20 million shares or US$200 million.
The rule is designed to help the SEC monitor the impact of large traders on the US securities markets by enabling officials to reconstruct trading patterns following periods of unusually high market volatility.
"The SEC will be able to back track in close to real time to identify traders involved in a market incident to find out whether their trading activity was legitimate," says Jennifer Wood, partner at international law firm Dechert.
Caught in the net
The new regime was expected to mainly impact large-volume market participants such as firms that use high-frequency trading (HFT) strategies, but the regulation’s thresholds mean the SEC can cast its net far wider.
"The rule affects firms much further down the scale than the largest global investment institutions, but ultimately it will depend on whether you're a buy-and-hold investor or you turn over your book more frequently," adds Wood.
Investment institutions that trade above the volume threshold must file a 13h form with the SEC and provide their US broker-dealers with their large trader identifier (LTID). Any changes to the details of the filing must be presented to the SEC 10 days before the end of the relevant calendar quarter and updates must be submitted annually (45 days after calendar year end) even if no changes are necessary. In their filings, non-US investment managers must report the US-registered broker-dealers with which they maintain accounts. US-registered broker-dealers must regard non-US affiliates as customers for the purposes of the rule and may need to inform them if they exceed the large trader threshold. Wood said non-US investment managers captured by the new rule could expect the local affiliates of their US broker-dealers to inform them of their need to register for an LTID. As such the rule imposes additional systems development, data capture and record-keeping requirement on US broker-dealers.
Though partially a response to the 6 May 2010 flash crash, the rule was actually tabled a few weeks prior to the incident, on 23 April. The flash crash was not caused by HFT activity, but the reaction of some electronic market makers to a rogue large order initiated by a long-only investor exacerbated the market dislocation and highlighted the potential systemic risks posed to the US equity market infrastructure from high volumes of automated, low-latency trading.
The new reporting requirements for large traders is just one of a number of measures proposed to bolster US equity market stability. In the aftermath of the flash crash, the SEC fast-tracked Rule 15c3-5, originally proposed in January 2010, which ended the practice of ‘naked’ market access, under which broker-dealers would permit clients to send orders direct to exchange, without submitting to pre-trade risk controls that could increase trading latency.
Drop the pilot?
The regulator also introduced single-stock circuit breakers in June 2010 to halt trading in any stock for five minutes in the event of a fall or rise in its value by 10% or more in the preceding five minutes. This pilot regime, which covers stocks in the S&P 500 index and Russell 1000 index, is due to be replaced with a limit-up / limit-down framework that prevents trades from being executed at 5% above or below a stock’s average price in the previous five minutes. For stocks currently outside the pilot, the threshold proposed by the exchanges and the Financial Industry Regulatory Authority (FINRA) would be 10%. But the SEC has delayed the adoption of the limit-up / limit-down proposal because of concerns about how the new mechanism would interact with existing market-wide circuit-breakers that halt trading in the event of the market falling 10%, 20% and 30% below the previous closing value of the Dow Jones Industrial Average. Earlier this year, FINRA applied for the single-stock circuit-breaker pilot programme to be extended to 31 July 2012, from its 31 January 2012 expiry.
The SEC attracted criticism from parties within and beyond the financial markets for the delay and depth of its 1 October 2010 report into the flash crash. “The SEC decided to institute one of its existing options to capture more detailed market data in light of the lack of information available when investigating the flash crash,” Wood notes.
As well as confirming the SEC’s existing plans for large trader reporting requirements, difficulties identifying the causes of the flash crash also led the watchdog to propose a consolidated audit trail on 27 May 2010, which will require exchange members to send quote and order information in near-real time to a purpose-built central repository. While the market has been broadly supportive of the large trader reporting requirements, laid out by the SEC in July 2011, the cost of the consolidated audit trail – estimated by the regulator at US$4 billion up front and US$2 billion per annum subsequently – has made it a more controversial measure. The SEC has acknowledged market concerns but last week chairman Mary Schapiro confirmed that staff recommendations for the new monitoring framework would soon be under consideration by commissioners.