Bridging the Week by Gary DeWaal

Heads of both the US Securities and Exchange Commission and the UK Financial Conduct Authority expressed similar concerns about market structure and low latency trading but with different tones before the annual Sandler O’Neill exchange and brokerage conference last week in New York City, while a public discussion was sponsored on the same topic by the US Commodity Futures Trading Commission in Washington, DC. Meanwhile, at the CFTC, a new chairman began his term. As a result, the following matters are covered in this week’s Bridging the Week:

• Heads of Financial Regulators from the UK and US Express Similar Concerns About Market Structure and Low-Latency Trading But With Different Tones Before Sandler O’Neill Conference;
• CFTC TAC Also Discusses Low-Latency Trading and Futures Market Structure; Timothy Massad Begins Tenure as Chairman;
• CFTC Extends Transaction-Level Requirements Relief in Certain Cross Border Situations;
• FINRA Settles With Three Firms for US $1 Million Apiece for Filing Inaccurate Blue Sheet Data; Charges Pending Against Fourth;
• Second Circuit Reverses District Court’s Refusal to Approve SEC Settlement With Citigroup;
• Broker Dealer and Two Supervisors Charged With Market Access Violations;
• SEC Cites Dark Pool With Not Safeguarding Subscribers’ Confidential Trading Information; and more.

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Heads of Financial Regulators from the UK and US Express Similar Concerns About Market Structure and Low-Latency Trading But With Different Tones Before Sandler O’Neill Conference

Two leading international regulators provided different perspectives on low-latency trading last week before the 2014 Sandler O’Neill & Partners Global Exchange and Brokerage Conference in New York City. Although Mary Jo White, Chair of the US Securities and Exchange Commission, conceded during her presentation on June 5 that US equities markets today are “not fundamentally broken, let alone rigged,” she said the Commission is embarking on a number of initiatives to address issues raised by low-latency trading and market fragmentation. On the prior day, June 4, Martin Wheatley, Chief Executive Officer of the UK Financial Conduct Authority, struck a more measured tone, stressing the importance to “…reflect on automated trading coolly and not get carried away by headlines.”

In her presentation, Ms. White acknowledged that empirical evidence demonstrates that “investors are doing better in today’s algorithmic marketplace than they did in the old manual markets.” Among other things, for large investors the costs of executing large orders (in terms of price) have declined more than 10% from 2006 to 2013; the level of intraday volatility of the S&P index is “nearly the same” in 2013 as in 2006, and spreads between bid and ask prices, including for retail investors, “are as narrow as they have ever been.” However, said Ms. White, market structure rules and practices that were principally developed to accommodate manual markets “cannot be expected to optimally address all of today’s market practices.”

As a result, Ms. White revealed a number of initiatives the SEC and the industry have adopted or are considering adopting to address various contemporary equity markets issues. These include previously implementing “limit up-limit down” rules to prevent trades from occurring in specific equities outside designated price bands and circuit breakers to militate against excessive market-wide volatility. The SEC also has adopted a market access rule that requires brokers to enhance certain of their risk controls to help avoid manipulation, and has proposed Regulation SCI that, if adopted, will require enhanced controls around technology used by exchanges, large alternative trading systems, clearing agencies and securities information processors. Overall she is calling for the creation of a new market structure advisory committee of experts to assist the SEC consider potential new initiatives and rules.

Ms. White did not identify any specific abuses attributable to low-latency traders. However, she indicated that the SEC is looking at trading practices that “may be working against investors rather than for them.”

Specifically, the Chair indicated she has directed SEC staff to develop an anti-disruptive trading rule, as well as recommendations to enhance “…firms’ risk management of trading algorithms and to enhance regulatory oversight over their use.” She also suggested that trading speed may have “passed the point of diminishing returns” and that she is considering measures to slow trading down:

"I am personally wary of prescriptive regulation that attempts to identify an optimal trading speed, but I am receptive to more flexible, competitive solutions that could be adopted by trading venues. These could include frequent batch auctions or other mechanisms designed to minimize speed advantages. They could also include affirmative or negative trading obligations for high-frequency trading firms that employ the fastest, most sophisticated trading tools.”

In her presentation, Ms. White also raised concerns regarding the large number of trading venues including so-called “dark venues” that lack transparency, as well broker conflicts that arise because of the large number and types of orders “designed to deal with the maker-taker fee model.”

The prior day, Mr. Wheatley also discussed issues that arise from low-latency trading, but, in a tongue and cheek manner, pointed out that these issues have been around since the time of the first high-frequency trading (HFT), which he claimed occurred on the London Stock Exchange on June 19, 1815. These issues are, he said, “the link between speed, market fairness and safety.” On that day in 1815, Nathan Rothschild used a relay of faster horses to obtain and trade on information regarding the Battle of Waterloo prior to the news becoming generally available. According to Mr. Wheatley,

 “[Mr. Rothschild] employed faster horses with more frequent changeover points – superior communications and technology; he ‘co-located’ himself on the floor of the Stock Exchange; and (shockingly) he initially short sold small parcels of gilts to create a downward market (momentum ignition) before proceeding to buy-up – before the position news reached the market.”

Mr. Wheatley called for a measured review of low-latency trading that he said he’s “not sure has yet been honestly assessed by all players.” He also pointed out that issues may not be the same from jurisdiction to jurisdiction and argued against a “one-size-fits-all” regulatory response. That being said, he pointed out how the European Securities and Markets Authority (ESMA) already has “detailed expectations around systems and controls for both trading venues, as well as firms using these [HFT] techniques.” He noted also that when MIFID II and MIFIR are rolled out in Europe in 2016, there will be new requirements for low-latency trading.

In conclusion, however Mr. Wheatley cautioned it is important to consider low latency trading dispassionately:

“We do not want to be in a position where acting in haste precedes repenting at leisure. Innovation will always bring with it some risk. Sometimes too much risk. But it also creates serious possibilities to explore. Finding the balance between those two poles is one of the great financial challenges of our time, with the most far-reaching consequences for the many billions of investors, savers and pension holders around the world.”

(For further coverage regarding Ms. White’s speech, access the article in last week’s Katten Muchin’s Rosenman’s Corporate & Financial Weekly Digest entitled “SEC Chair Gives Speech on Equity Market Structure” by clicking here. All quotations in this article are from the speakers’ prepared remarks.)

And briefly:

• CFTC TAC Also Discusses Low-Latency Trading and Futures Market Structure Too; Timothy Massad Begins Tenure as Chairman: On June 3, 2014 -- the same day that a spirited discussion was held at the Technology Advisory Committee (TAC) of the Commodity Futures Trading Commission regarding low-latency trading -- the US Senate confirmed the appointment of three new commissioners to the agency, including its new chairman, Timothy G. Massad, who began his tenure at the Commission on June 5. The Senate also confirmed Sharon Y. Bowen and J. Christopher Giancarlo who are expected to join the Commission within the next two weeks. The TAC, chaired by Commissioner Scott O’Malia, held sessions on developing a twenty-first-century surveillance program and increasing buy-side participation on swap execution facilities, in addition to exploring the impact of low latency trading on derivatives markets. (For more details regarding the June 3 TAC meeting, see the Between Bridges article “Three New CFTC Commissioners Approved by US Senate on Same Day CFTC Technology Advisory Committee Considers Low Latency Trading Issues” by clicking here.)
   
• CFTC Extends Transaction-Level Requirements Relief in Certain Cross-Border Situations: The CFTC extended until December 31, 2014, the date by when non-US based swap dealers registered with the CFTC must begin to comply with certain transaction-level requirements in connection with swaps arranged, negotiated or executed by US-based personnel or agents. This relief initially was granted on November 14, 2013, and only applies when swaps are entered into between such non-US based swap dealers and non-US counterparties. (For details, see the Bridging the Week article regarding the initial relief entitled “CFTC Issues Advisory Related to the Arrangement of Swaps Involving Non-US Swap Dealers by US Persons,” by clicking here. For additional information on the current extension, click here to access the Corporate & Financial Weekly Digest article entitled, “CFTC Extends No-Action Relief for Certain Transaction-Level Requirements for Non-US Swap Dealers.)
   
• FINRA Settles With Three Firms for US $1 Million Apiece for Filing Inaccurate Blue Sheet Data; Charges Pending Against Fourth Firm: The Financial Industry Regulatory Authority filed cases against four broker dealers and settled with three for allegedly not providing to the SEC, FINRA and other regulators complete and accurate information about certain trades arranged by the firms and their clients. The information is commonly known as “blue sheet” data. The three firms settling their charges by each paying fines of US $1 million were Barclays Capital Inc; Goldman, Sachs & Co; and Merrill Lynch Pierce Fenner & Smith Inc. The firm not settling at this time was Wedbush Securities. According to FINRA, each of the firms has had prior issues with providing inaccurate blue sheet data. Barclays’ alleged failures occurred between August 2012 and April 2013: Goldman, Sachs’ from 2004 to 2013; Merrill Lynch’s from March 2006 through January 2014; and Wedbush’s from 2012 to 2013.
   
• Second Circuit Reverses District Court’s Refusal to Approve SEC Settlement With Citigroup: A federal appeals court in New York reversed a district court’s refusal to approve a 2011 settlement agreement entered into between the SEC and Citigroup Global Markets Inc. The settlement came about in response to the SEC’s complaint that Citigroup had “negligently misrepresented its role and economic interest in structuring and marketing a billion dollar fund” where the fund’s assets were mostly secured by subprime securities tied to the then faltering US housing market. Citigroup agreed to resolve the SEC’s action by disgorging US $160 million (which the SEC claimed was Citigroup’s net profit), paying prejudgment interest of US $30 million, paying a fine of US $95 million and instituting certain internal changes, among other sanctions. The Hon. Jed S. Rakoff, the judge handling this matter for the lower court, had rejected a proposed consent order necessary to implement the settlement, claiming that its terms compared unfavorably with resolutions of other equivalent SEC enforcement actions. However, the appeals court rejected this analysis, claiming the district court should solely have considered whether the proposed settement terms were “fair and reasonable” and that the “public interest would not be disserved.” The district court may not consider whether a settlement is adequate. As a result, the appellate court said that the lower court had “abused its discretion” in not approving the settlement. The appellate court required the district court to reconsider the settlement by applying the standards it articulated in its decision. Citigroup also did not admit to any liability as part of its proposed settlement. This was not relevant to the lower court's refusal to approve the settlement, however, acknowledged the appellate court: “[t]he decision to require an admission of liability before entering into a consent decree rests squarely with the SEC. As the district court did not condition its approval of the consent decree on an admission of liability, we need not address the issue further.”
   
• Broker Dealer and Two Supervisors Charged With Market Access Violations: The SEC charged Wedbush Securities, a broker dealer, along with Jeffrey Bell, an executive vice president and Christina Fillhart, a senior vice president, with violating the Commission’s market access rule (Regulation MAR) from July 2011 to at least January 2013. This rule, which mostly became effective on July 14, 2011, requires broker dealers to ensure that all trades that pass through their connections with exchanges and other trading venues be subject to certain risk filters to help avoid manipulative conduct. The SEC claimed that during the relevant time, Wedbush allowed anonymous foreign traders to send orders involving “billions of shares every month” directly to trading venues without being subject to the required risk filters. According to the SEC, these problems occurred even after SEC staff advised Mr. Bell and Ms. Fillhart of certain concerns regarding one of Wedbush’s largest sponsored access clients just prior to the effective date of Regulation MAR. The SEC also claims that Wedbush did not have appropriate written supervisory procedures over its market access business, and violated other rules, including Regulation SHO as well as an obligation to preserve certain communications regarding trading instructions. In addition, Wedbush failed to file suspicious activity reports pursuant to the SEC’s anti-money-laundering requirements, claims the Commission.
   
• SEC Cites NY Dark Pool With Not Safeguarding Subscribers’ Confidential Trading Information: Liquidnet, Inc. agreed to pay a fine of US $2 million to settle SEC charges that it failed to safeguard its subscribers’ confidential trading information between 2009 and 2012. During that time the company maintained two alternative trading systems (ATS), commonly known as “dark pools.” According to the Commission, the firm shared information regarding its customers’ intentions to buy or sell securities with corporate issuers and control persons of corporate issuers, as well as private equity and venture capital firms, contrary to an SEC rule requiring ATS subscribers’ confidential information to be protected. At all times, says the SEC, “Liquidnet held itself out to [subscribers] as a trading venue that offers anonymity and minimal information leakage.” In agreeing to the settlement, the SEC noted Liquidnet’s prior remedial acts, including the implementation of functionality to provide subscribers with direct control over the use of their data within the Liquidnet system.

And even more briefly:

• ESMA Sets Dates for MIFID II/MIFIR Public Hearings: ESMA has scheduled three public hearings in Paris on MIFIDII/MIFIR: July 7 regarding markets issues; July 8 on investor protection issues; and also on July 8 regarding commodity derivatives.
   
• FINRA Begins to Shed Light on Certain Dark Pool Data: Last week FINRA began publicizing data regarding activity levels in each alternative trading system (dark pools). The information made available includes the total number of shares traded by each security in each dark pool.

For more information, see:

CFTC Extends Transaction-Level Requirements Relief in Certain Cross Border Situations:
http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/14-74.pdf.

ESMA Sets Dates for Public Hearings on MIFID II and MIFIR:
http://www.esma.europa.eu/news/ESMA-announces-three-open-hearings-MiFID-II?t=326&o=home

FINRA Begins to Shed Light on Certain Dark Pool Data:
https://ats.finra.org.

FCA Head Argues for Measured Approach to Regulate Low Latency Trading:
http://www.fca.org.uk/news/regulating-high-frequency-trading.

FINRA Begins to Shed Light on Certain Dark Pool Data:
https://ats.finra.org.

FINRA Settles With Three Firms for US $1 Million Apiece for Filing Inaccurate Blue Sheet Data; Charges Pending Against Fourth Firm:
http://www.finra.org/web/groups/industry/@ip/@enf/@ad/documents/industry/p521301.pdf.
http://www.finra.org/web/groups/industry/@ip/@enf/@ad/documents/industry/p521302.pdf.
http://www.finra.org/web/groups/industry/@ip/@enf/@ad/documents/industry/p521303.pdf.
http://www.finra.org/web/groups/industry/@ip/@enf/@ad/documents/industry/p521304.pdf.

SEC Chair Calls for New Anti-Disruptive Trading Rule and Reflection on Whether the Agency’s Own Rules Have Caused Excessive Market Fragmentation:
http://www.sec.gov/News/Speech/Detail/Speech/1370542004312#.U5DNShbXrRo.

SEC Cites Liquidnet With Not Safeguarding Subscribers’ Confidential Trading Information:
http://www.sec.gov/litigation/admin/2014/33-9596.pdf.

Second Circuit Reverses District Court’s Refusal to Approve SEC Settlement With Citigroup:
http://www.ca2.uscourts.gov/decisions/isysquery/52b75f87-28d3-41b9-a305-09846b4e3bf5/3/doc/11-5227_opn.pdf#xml=http://www.ca2.uscourts.gov/decisions/isysquery/52b75f87-28d3-41b9-a305-09846b4e3bf5/3/hilite/.

See also SEC Statement:
http://www.sec.gov/News/PublicStmt/Detail/PublicStmt/1370541993346#.U5CEARYrfnc.

Wedbush Securities and Two Supervisors Charged With Market Access Violations:
http://www.sec.gov/litigation/admin/2014/34-72340.pdf.

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of June 7, 2014. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law for any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP and/or Gary DeWaal may represent one or more entities mentioned in this article.  Mr. DeWaal is a member of the CFTC TAC referred to in this article.

Circular 230 Disclosure: Pursuant to regulations governing practice before the Internal Revenue Service, any tax advice contained in this article is not intended or written to be used and cannot be used by a taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer.