The Securities and Exchange Commission (SEC) has prevented Nasdaq OMX from offering benchmark algorithmic strategies, citing competition concerns and the potential for market risk.
The US regulator's refusal, believed to be the first relating to algo trading strategies, will again fuel debate on the role of exchanges' as self-regulatory organisations (SRO).
Under the proposal first revealed last May by Eric Noll, executive vice president, transaction services, US and UK, Nasdaq OMX, the exchange sought to offer its US members VWAP, TWAP and percentage of volume strategies through a new set of order types.
The strategies were similar to execution algorithms that brokers already offer institutional investors and aim to execute orders to a pre-defined benchmark price. Upon announcing the plan, Noll said the order types were not a ploy to compete with top tier algo offerings.
"This is not intended to compete with the high-end, highly sophisticated algo providers, but is instead addressed to the largest part of the market… and says, 'we can do this for you better, faster, cheaper than you can do it for yourself'," he said.
The SEC pointed to issues raised by broker trade body, the Securities Industry Financial Markets Authority (SIFMA), related to the self-regulatory nature of exchanges.
SIFMA argued that as an SRO, Nasdaq OMX could enjoy immunity if any liability were to arise from the benchmark order plan, given that its initial filing suggested the new strategies would be a functional, rather than a commercial, offering.
"It would be an incongruous result if Nasdaq were permitted to use regulatory immunity as a shield against liability, while competing algorithm providers offering the same services may assume unlimited liability [without an] arms-length agreement," read a letter SIFMA filed with the SEC in protest.
Whether or not exchanges should retain their SRO classification has been a hot debate since Nasdaq OMX was considered by some market participants to use its SRO status as a way of avoiding liability after the botched Facebook IPO last May. Nasdaq OMX initially stated that "the risks associated with system malfunctions should be allocated among all exchange members, rather than being borne solely by the exchange".
Despite an eventual remedies proposal by the bourse which included cash compensation, some brokers, including UBS and Citi, are pursuing legal action to cover losses they believe are far greater than the total US$62 million package offered by Nasdaq OMX.
The SEC's rejection of Nasdaq's algo offerings plan suggests regulators are beginning to take note of the industry's concern regarding SROs.
At a senate hearing on 18 December entitled 'Computerised trading venues: What should the rules of the road be', Dan Mathisson, head of US equity trading at Credit Suisse, suggested the role of an exchange as SRO was incongruent with their roles as for-profit entities.
"We believe that this new model for the markets has proven itself to be costly to investors, unfair to broker-dealers, and rife with conflicts for the exchanges themselves," said Mathisson. "We suggest that ending exchanges' status as SROs and transferring those regulatory responsibilities to [independent exchange regulator] FINRA or the SEC would put all market players on a level playing field and would benefit the average investor by creating markets that would be simpler, less vulnerable to disruptions, and less expensive to operate."
During the same hearing, Noll pointed out SRO status could only be achieved after undergoing a "rigorous, public process".
"SROs supply the SEC and other regulators vital information about the trends and performance of US capital markets. The SEC is our partner in protecting investors," Noll said.
In assessing Nasdaq OMX's algo proposal, the SEC also considered the naked access rule, which requires brokers to conduct risk checks on all orders before they hit the market. While a broker entering the initial trade through one of Nasdaq's proposed order types would be subject to the checks, the subsequent child orders generated by the exchange for the purposes of meeting the desired benchmark would not.
Although Nasdaq had stated that child orders would be subject to the relevant pre-trade risk checks, the SEC decided that the point had not been adequately addressed by the exchange.
Nasdaq OMX declined to comment on whether it would appeal against the SEC's decision.