The Financial Industry Regulatory Authority (FINRA) announced that they may impose fines on broker-dealers in response to the May 6, 2010 ‘flash crash’. The reason for the fine is stated as a failure to have proper risk-management control over firms they allow direct or sponsored access to the markets.
I was intrigued by these reports, primarily because there was no announcement on the FINRA website (that I was able to locate). I was also intrigued because the language was so vague and confusing. It seemed to me impossible that the broker-dealers (BD’s) did not know WHO they had given access to. Moreover, the flash crash has, from the beginning, been attributed to high-frequency, or computer/algorithmic trading, which to my knowledge does not violate any FINRA or NASDQ rules. It all seemed like more gobbledee-gook from the policy-wonks so I did a little looking into the rules. It produced some mildly interesting information.
In January of this year, the SEC in the US approved a NASDAQ stock market rule change to Nasdaq Rule 4611. This rule governs electronic access to the Exchange’s order execution system. Basically it is designed to ensure that participants in the Nasdaq Market Center are all knowable, monitored and that those giving access are responsible for those they give access too. Ultimately, the SEC is concerned with the protection from systemic risk and integrity of the marketplace. OR they are seeking additional fees in some way.
Participation in the Nasdaq Market Center is limited to Nasdaq market makers, Nasdaq ECN or Order Entry Firm with current registration with Nasdaq. Such participants are permitted to allow access to the Trading Center-Nasdaq or otherwise-to other firms or persons by allowing use of the member firms market participant identifier (MPID). Access is provided through a Sponsored Access System or a Member System. The first allows access directly to the markets while the latter filters orders through the member’s system first and then to the market. NASDAQ Rule 4611(d)(1-5) requires this arrangement to be supported by member firm supervision and monitoring to ensure that all users comply with federal securities laws and Exchange rules. The new rule does not become effective until January 2011.
This rule change approval came together with an SEC rule proposal. Proposed rule 15c3-5 would also require brokers providing access to the market to create financial risk management controls to prevent order entry exceeding credit limits, establish, document and maintain a system for reviewing the effectiveness of risk management controls among others. High-frequency traders may be the target of these new rules but the broad effect is to increase transparency full stop.
Currently, some market participants are able to access the exchanges and alternative trading systems (ATSs) without pre-trade risk assessments and no visibility to regulators or sponsoring firms. The new rules require these firms to be subject to self-regulatory organization regulations.
On the other hand, while transparency is good there is the argument that HFT’s provide much needed liquidity. Also, these new rules with be have a cost to implement. Some firms who made comments during the rule proposal period suggested that the rule be tested for several years before it is formally adopted.
There are several other interesting nuances to these rules regarding ATS’s and the like. I do not have time to learn about them just yet. I think the new rules and the regulators attempts to get on top of HFT’s is needed. HFT’s account for at least 40% of the daily volume of equities traded in the U.S markets and most likely much more than that on any given trading day. They are a significant market participant and should be understood and regulated…but not killed.