The US securities market is braced for conflict over the ”trade-at' rule, proposed as one of a number of recommendations made by a committee established by US regulators to report on the 6 May flash crash.
The proposals, which would primarily affect brokers that internalise trades and high-frequency trading (HFT) firms, include the imposition of the trade-at rule, which was first suggested by the Securities and Exchanges Commission (SEC) in its January 2010 concept release.
“This caught a lot of people off-guard. The troops are already getting organised from the retail brokerage side to the HFT side; they don't want the trade-at rule,” said Joe Saluzzi, co-head of the trading desk at agency brokerage Themis Trading. “The internalisation guys are going to go nuts about it.”
In a paper entitled ”Recommendations regarding regulatory responses to the market events of May 6 2010' the Joint Commodity and Futures Trading Commission- Securities and Exchanges Commission Advisory Committee on Emerging Regulatory Issues made 14 proposals aimed at making the market more secure in light of the ”flash crash' of 6 May 2010.
The trade-at rule would require venues that do not display the national best bid-offer (NBBO) to either offer price improvement or route the order on to a venue that does display it, rather than crossing at the NBBO.
Regulators consider this one way to prevent trades occurring in the dark when they could be executed in displayed pools at no disadvantage. This is intended to increase the overall level of liquidity in the lit market, which was highlighted as a cause of the crash on 6 May as market makers withdrew from trading.
In addition to the trade-at rule, the committee's recommendations included: imposing obligations on firms that internalise flow to either make markets during volatile periods or offer price improvement; a fee structure that would punish excessive cancels made against orders placed; incentives for market makers to operate in all conditions; and fees that limit supply and demand at ”peak load' periods.
Although regulators are well intentioned, Alison Crosthwait, director, global trading strategy at agency broker Instinet, says they should be cautious. “I don't think that the rule is the right thing, but I know what they are trying to accomplish,” she says. “I hope they consider potential unintended consequences.”
Market participants have previously argued that the introduction of the trade-at rule could challenge the model for electronic market makers who pay for order flow from retail brokers and match it against HFT flow. This business equates to around 15% of the US market volume.
Crosthwait believes some of the recommendations – such as restrictions on certain algorithmic trading functions, the extension of the time delay for circuit breakers operating on derivatives markets beyond five seconds, and the fees introduced for ”peak load' limits – may face strong opposition from market participants. “The committee is looking at how markets would be structured in a perfect world – they are certainly not looking at revenue impacts,” she said.
Heavy-handed enforcement of rules that challenge business models could prove counter-productive, adds Kevin McPartland, senior analyst at research firm TABB Group. “They motivate firms to change their behaviour rather than out-right banning practices,” he said. “The more that they ban, the more it will force the market to work out ways to run strategies or manage risk in a way that would mimic what they were doing before.”
The report was presented at a meeting of the committee on 18 February and is now to be taken under consideration by the two regulators. Its proposals are advisory in nature and will be used as one source document for regulators as they consider regulatory proposals. There is no official timeline under which they must react and with so many regulatory changes already under way, it seems unlikely that regulators will be in any hurry to implement these recommendations.
“The same morning as this report came out, SEC chairman Mary Schapiro said she can't enforce Dodd-Frank without more money,” said Crosthwait. “They have such a constraint on resources right now. I think that they will look again at the 2010 concept paper in Q3, incorporating what is in here, but I would be surprised if anything happened before that.”
This period of respite will give concerned market participants the opportunity to lobby regulators, and potentially soften the proposals' effects. “The final product will be somewhat tempered, as we have seen with the Dodd-Frank Act and how those rules are being written,” adds McPartland.
However Saluzzi has a warning, “If something bad happens between now and any implementation, the committee will ask the regulators ”What did you do since we made these 14 recommendations?' and if the answer is ”Nothing' then there will be hell to pay.”