Fordham Law

Schapiro Discusses Market Structure Challenges Facing the Commission

Corporate Center in Wolters Kluwer, September 27, 2010

Media Source

This story appeared in SEC Today.

SEC Chair Mary Schapiro this week spoke to the Security Traders Association about the market structure issues facing the Commission. Since the market turmoil of May 6, the SEC has implemented new circuit breakers for individual stocks, but she believes additional actions are needed. For example, Schapiro called for an examination of ways to prevent erroneous trades from triggering pauses while also allowing pauses to occur when needed. The SEC is considering limit-up/limit-down style trading parameters, she advised, in which trades would have to be executed within a range tied to the best bid and offer.
The limit-up/limit-down approach would prevent aberrant trades from occurring outside specified parameters, Schapiro explained, while allowing trading to continue within established limits. If normal trading does not resume within those parameters and within a set period of time, a formal trading pause would be triggered. This pause would give market participants time to establish a new price in an orderly fashion, she said.

Schapiro said the SEC also needs to examine whether the circuit breakers are set at levels that preserve the stability and integrity of the equity markets. During the May 6 market disruption, the SEC learned that many firms which provide significant liquidity to the market had programs that pulled back or shut down when prices moved in an atypical fashion. Schapiro said the programs acted as ad hoc circuit breakers. The SEC needs to consider how to prevent ad hoc circuit breakers from removing significant liquidity providers from the markets during extreme volatility. The SEC is considering what, if any obligations, these significant liquidity providing firms owe to the markets.
Another area under review is the trading obligations of high frequency trading firms which exert tremendous influence over trading. Given their volume and access, Schapiro said these firms have an enormous capacity to affect the stability and integrity of the equity markets, yet they are subject to few obligations relating to market stability. The SEC will consider whether these firms should be subject to a regulatory structure that governs their quoting and trading strategies.

Schapiro said the SEC’s guiding principle will be to encourage a market structure that promotes capital formation and protects investors, while being mindful of the risk of unintended consequences.The SEC will also consider whether relatively new liquidity-seeking algorithms are subject to appropriate rules and controls. These algorithms can flood the market with executable orders far beyond the normal volume for a stock, she explained, which can create sudden liquidity imbalances. A malfunctioning algorithm can cause serious losses to a firm that uses it, and can also cause severe trading disruptions that harm market stability and shake investor confidence, she said.

Market fragmentation is another concern which adds to the complexity of the markets. Investors may not be aware of the potential conflicts of interest that could affect their orders. The SEC may consider rules to enhance the transparency of trading venue practices and the practices of broker-dealers acting as agents for investors. The SEC will implement new rules under the Dodd-Frank Wall Street Reform and Consumer Protection Act, including the development of a new market structure for security-based swaps. The Act provides a comprehensive framework for the regulation of the over-the-counter derivatives market and specifies the jurisdiction of the CFTC and the SEC over the swaps market.

The Act creates new security-based swap execution facilities for trading in swaps. Market participants generally must execute security-based swaps subject to mandatory clearing on a swap execution facility or a national securities exchange. The swap execution facility must provide market participants with impartial access.

Schapiro said the details of the new facility will be worked out in greater detail through the rulemaking process. She believes that real-time reporting will have a profound and positive effect on the market. The SEC will seek to embed into the security-based swap market the same broad principles that have provided important benefits to the equities markets, she said.