SEC on Market Structure: The Chair Speaks and Enforcement Acts

SEC on Market Structure: The Chair
Speaks and Enforcement Acts
Morris Simkin, Esq.
Simkin Law Office
212 455 0476
[email protected]
June 18, 2014
Equity Market Structure: the Chair
Speaks and Enforcement Acts
• June 5, 2014 speech by SEC Chair Mary Jo
• Settled Administrative Proceeding of June 6,
2014 against Liquidnet
• Order Instituting Proceedings against
Wedbush Securities Inc. on June 6, 2014
Mary Jo White Speech
• June 5, 2014 Speech by Mary Jo White, SEC
Chair, at the Sandler O’Neill & Partners, L. P.
Global Exchange and Brokerage Conference
Mary Jo White Speech
• Current Market State—It isn’t broke but may
need some fixing:
• Institutional investor costs to execute large
orders is more than 10% less in 2013 than in
• Intraday volatility of S&P 500 nearly the same
in 2013 as it was in 2006
• Spreads between bid and ask prices as narrow
as they have ever been
Mary Jo White Speech
• But there are some issues:
• Improved technology has lead to excessive
• Institutional investor costs to trade small-cap
stocks relatively high in contrast to large
declines in costs for the broader market;
• Market structure rules and industry practices
were developed with manual markets in mind.
Mary Jo White Speech:
• High Frequency Trading
• Develop a recommendation to the SEC for
anti-disruptive trading rule– apply to active
proprietary traders when liquidity is most
vulnerable and risk of price disruption
• Clarify status of proprietary traders to subject
them to dealer rules
• Eliminate exception from FINRA membership
for BDs that trade only with other BDs
Mary Jo White Speech
• Recommend to SEC to improve BDs risk
management of trading algorithms and
enhance regulatory oversight over their use;
• Asks SROs to include a time stamp on data
feeds to SIP;
• Ask SROs for recommendations to deal with
increasingly expensive search for speed--e.g.
rules like 11(a)(1)-1(T).
Mary Jo White Speech
• Market Fragmentation– 11 exchanges, more
than 40 Alternative Trading Systems and more
than 250 broker-dealers, proliferation of dark
trading venues:
• Is dark trading volume at levels that risks
undermining quality of price discovery;
• Has Regulation NMS trade through rule
contributed to fragmentation?
Mary Jo White Speech
• Broker-dealer conflicts:
• Maker-taker fees and payment for order flow do not
flow through to the customer
• Staff to recommend rule to amend NMS Rule 606 to
enhance order routing disclosure- e.g. cover large
orders, and disclose customer specific information to
institutional investors on request;
• Large number of complex order types- usually due to
maker taker fees- Asks exchanges to consider rule
changes to clarify these rules and how they affect fair,
orderly and efficient markets.
Mary Jo White Speech
• Tick Size
• Asked staff to recommend a pilot program for
wider tick sizes for smaller companies’ stock
Mary Jo White Speech
• Ask to establish an SEC Market Structure
Advisory Committee – comprised of experts
with different backgrounds and viewpoints,
review specific initiatives and rule proposals
Secondary Market– Enforcement
• Two administrative proceedings on June 6,
• Liquidnet, Inc. Release No. 34-72339
• Wedbush Securities Inc. and 2 individuals
Release No. 34-72340
Liquidnet, Inc.
• It is a registered broker-dealer and an Alternative Trading System
• Regulation ATS, Rule 300(a) defines an ATS as one that provides a
market place to bring together buyers and sellers of securities, and
does not have conduct rules or discipline subscribers.
• Regulation ATS Rule 301 imposes obligations upon an ATS. These
– File Form ATS with the SEC, and periodically update it;
– If within 4 of the last 6 months it had average daily trading volume of
5% or more of an NMS stock, make its best bids and offers available to
the exchanges and other broker-dealers (go light);
– Have adequate safeguards and procedures to protect subscribers’
confidential trading information.
Liquidnet, Inc.
• Subscribers gave Liquidnet electronic access to
their Order Management Systems. The OMS
showed what securities they were planning to
buy or sell, quantities and prices. Where
Liquidnet detected a potential match, it
notified the two subscribers and, on an
anonymous basis, they could negotiate a trade
through Liquidnet. When they reached
agreement the buyer and seller were
identified to each other.
Liquidnet, Inc.
Liquidnet wanted to expand its subscriber base to issuers, control persons and
venture capital and venture equity firms.
It formed a new unit called Equity Capital Markets (ECM).
It launched an application for issuers called InfraRed. InfraRed was given to
corporate executives, and showed the ratio of buys to sells of that issuer’s stock in
the Liquidnet system.
InfraRed also identified to ECM personnel what subscribers were interested in
buying and selling, and the number of shares.
In presentations to corporate issuers ECM staff described subscribers with buying
and selling interests.
ECM staff reached out to issuers with reports of recent activity in their stock on
Liquidnet, often including detailed trading data- buys, sells, quantity and price.
They also reported to 13F reporting companies on average daily trading volume in
those securities, and information as to liquidity depth.
They gave corporations information as to interests in their stock by firms the
corporation was planning to meet with.
ECM staff gave corporations advice as to when to buy or sell, and if subscribers had
particular interests in their stock.
Liquidnet, Inc.
• Liquidnet developed “Ships Passing” alerts. These
alerts notified its Relationship Managers (RMs)
about missed execution opportunities between
subscribers’ algorithmic orders and subscribers’
indications of interest.
• It also developed “Aqualytics.” This identified
stocks where Liquidnet’s recent trading made it a
dominant force in the market for the security.
This report was used to by RMs to contact
subscribers to alert them to this fact.
Liquidnet, Inc.
• These actions were found to be violations of
Regulation ATS’s obligations to establish adequate
safeguards and procedures to protect
subscribers’ confidential trading information and
to amend its Form ATS prior to implementing a
material change to its operations.
• Liquidnet was censured, ordered to cease and
desist, and fined $2,000,000. (The gross revenue
from the expanded issuer and VC/PE marketing
was $1.66 million.)
Wedbush Order Instituting
• This is the second case brought under Rule
15c3-5. The first was against Knight Capital
because on August 1, 2012 its order entry
system generated multiple orders that were
not authorized due to failures in its operating
• Rule 15c3-5 was adopted in 2010 and became effective July 14, 2011. It
applies to brokerage firms that allow others to use its access to trading
markets of which it is a member (stock exchanges) or subscriber (ATSs) to
place trades using the broker’s member proprietary identification.
• Rule 15c3-5(b) requires the firm providing market access to have a system
of risk management controls to mange the financial, regulatory, and other
risks of this business activity.
• Rule 15c3-5(c)(1) requires the broker to have risk management controls
and supervisory procedures to limit the financial exposure of the broker
that could result from market access– e.g. orders exceeding pre-set credit
or capital threshold, or the entry of erroneous orders.
• Rule 15c3-5(c)(2)requires the broker to have supervisory controls designed
to assure compliance with all regulatory requirements. This includes the
pre-order entry rules (Regulation SHO), and to restrict access to only
personnel pre-approved by the broker.
• Rule 15c3-5(d) requires that this system of management controls must be
under the direct and exclusive control of the broker.
• The SEC charged the firm and two senior
personnel in its Correspondent Services
Division with violating Rule 15c3-5.
• Wedbush provided sponsored market access to
some 50 customers through its correspondent
services business. These customers generated
monthly average trading volume of 30 billion
shares. Several had more than 1,000 traders, and
one had more that 10,000 traders. These
customers could direct their trades directly to an
exchange or ATS under Wedbush’s identity.
• The correspondent services business was
Wedbush’s most profitable operation.
• Wedbush was familiar with Rule 15c3-5.
• A Latvian sponsored access customer used the service as
part of scheme to intrude third party accounts and engage
in market manipulation.
• Another customer used the service as part of its activities
as an unregistered broker-dealer.
• The SEC Office of Compliance Inspections and Examinations
sent Wedbush an Examination Deficiency Letter on May 17,
2011. Among other things the letter cited repeated
violations of Reg SHO because of dependence on an access
customer’s claimed ability to locate shares being sold short.
• Wedbush representatives met with the SEC on July 5, 2011
to discuss the impending effectiveness of Rule 15c3-5.
• Alleged violations: Control
• Most of Wedbush’s customers used third party trading
platforms that Wedbush could not control. Even if
Wedbush set controls and limits on these customers
through their platforms, the customer could override or
revise whatever controls or limits Wedbush had set.
• Wedbush did not receive any demonstrations of the actual
risk controls that were in effect for a customer, had no
physical ability to prevent the customer changing the
settings on the platform. Wedbush had no contractual
relationship with the operators of these platforms that
would give it access to a customer’s platform.
• Short Sales (pre-order entry rules)
• Reg SHO Rule 203(b)(1) requires a firm entering a
short sale to either have borrowed the security,
entered into an arrangement to borrow the
security or have reasonable grounds to believe
that the security can be timely borrowed (easy
borrow list).
• Wedbush relied on its customers or the trading
platforms that they used to comply with this rule.
• AML and Suspicious Activity Reports
• Broker-dealers are required to file Suspicious Activity Reports if
they know or reasonably believe that there have been violations of
law by themselves or others.
• Wedbush learned from stock exchanges of suspicious wash sale
and/or pre-arranged trading by some of its correspondents.
• Correspondents allowed their traders to use more than one
identification. Several of these same user identifications traded
with another identification of the same trader- wash sales.
• Layering is the entry of large number of non-bona fide orders on
one side of the market, and promptly cancelling them in order to
obtain a favorable execution of an order on the other side of the
market. Wedbush learned from exchanges that traders in the same
customer account were engaging in layering.
• Unauthorized traders. Rule 15c3-5(c)(2)(iii)
requires that Wedbush limit access to its system
to persons and accounts pre-approved by it.
• The firm’s practice was to review and approve the
principals of a correspondent for use of its
services. In cases where it did get the names of
the traders, it ran their names against OFAC’s list
of SDNs. It did not pre-approve all of the traders
that these customers had. In many cases it did
not know who were these traders.

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