A three-hour shutdown of the Nasdaq Stock Market marks the first test of Securities and Exchange Commission Chairman Mary Jo White’s ability to push through stronger technology safeguards for electronic trading.
White, a former prosecutor who lacks a background in market regulation, responded to the failure by vowing to finish a rule proposed in March to require exchanges to test the reliability of their technology. Exchanges want to limit the number of systems covered by the rule and how much information they have to report about glitches.
The SEC has grappled with how to improve market stability since the May 2010 flash crash, when $862 billion in equity value was erased in 20 minutes before share prices recovered.
“White needs to be convinced these guys, all of them, take this with the utmost seriousness,” said Andrew M. Klein, a former director of trading and markets at the SEC and now a partner at Schiff Hardin LLP. “Nasdaq is starting to look like you can’t be stopped from having these problems, and it needs to stop.”
White signaled in her Senate confirmation hearing in March that she would scrutinize the “high-speed, high-tech and dispersed marketplace, so that it can be wisely and optimally regulated.”
The regulator has invoked new rules, improved its data- mining abilities, and fined exchanges such as Nasdaq for faulty systems in connection with the botched initial public offering of Facebook Inc. in May 2012. The SEC said it accelerated drafting the rule White cited after automated trading errors by Knight Capital Group Inc. cost the firm more than $450 million and led to its sale to Getco LLC.
Nasdaq said its failure stemmed from “a connectivity issue between an exchange participant” and the network, called a securities information processor, that provides data about quotes and prices.
Such systems, or SIPs, are owned by the two major exchange operators — The Nasdaq OMX Group Inc. and NYSE Euronext.
The SEC’s rule proposal, known as Regulation SCI, would require exchanges, SIPs and clearing firms to adopt policies to prevent failures, stress test their systems to ensure trading continues through a disruption, such as a software glitch or natural disaster, and report the disruptions to the SEC. The rule also would cover exchange competitors known as alternative trading systems, including dark pools. The SEC has said 10 dark pools are large enough to be subject to the regulation, based on data from 2012.
The SEC warned in its March proposal that SIPs could be vulnerable to glitches because “there is virtually no competition” among market-data feeds provided to the public, which “could lead to little incentive in ensuring a high- quality product with minimal disruptions,” the SEC wrote.
“If you are thinking about investing in your budget for technology, you are going to invest in things that bring in revenue, not necessarily things that are infrastructure or shared services across the industry,” David Easthope, a San Francisco-based research director for the securities and investment group at consulting firm Celent, said in a phone interview. “It’s not necessarily Nasdaq’s chief concern as a publicly traded company.”
Software failures have mounted as stock trading becomes more dispersed across 13 U.S. equity exchanges and multiple alternative trading venues. The demand for faster dissemination of market data has forced exchanges to accelerate the movement of the information through high-speed proprietary data feeds and the SIPs, said Larry Tabb, chief executive officer of Westborough, Massachusetts-based financial-market consultant Tabb Group LLC.
“The way you wind up getting software to speed up is you take out all the protection,” Tabb said in a phone interview. “In the attempt to go faster, they continuously remove every bit of non-critical software.”
Exchanges are resisting Regulation SCI because they worry it will be used to fine them for software glitches that are impossible to eliminate, Tabb said. The rule would replace a voluntary program created after the stock market crash of 1987 and would expand the SEC’s oversight to more systems, including those that support regulatory compliance and surveillance.
“Reg SCI basically gives the SEC the ability to ding any exchange for any problem,” said James J. Angel, a finance professor at Georgetown University’s McDonough School of Business in Washington.
White said on Aug. 22 that she would work to advance the proposal, which passed the SEC unanimously on March 7. She also said she would convene a meeting of exchange executives and other market participants to “accelerate ongoing efforts to further strengthen our markets.”
SEC Commissioner Michael Piwowar, who joined the agency this month, yesterday advised caution on advancing the regulation. He said that while recent market disruptions, including errant options trades involving Goldman Sachs Group Inc., demand attention, the commission should should ensure that any new rule fits the facts learned from recent failures.
“Regulation SCI may or may not have contemplated what ultimately caused these disruptions,” Piwowar, a Republican economist, said in a phone interview. “Therefore, we should re- evaluate the assumptions underlying the Regulation SCI proposal before moving forward with further rulemaking.”
Exchanges said last month the SEC “significantly underestimated” the cost of compliance with the proposal. The agency calculated initial costs could be as much as $242 million for organizations subject to the regulation, with another $191 million in annual costs.
The exchanges also want the SEC to limit the rule to systems that support trading, clearance, settlement, order routing and market data in real time. They also say the commission should adopt a “materiality threshold” to limit the number of compliance failures or system intrusions that must be reported to the regulator.
Some of the rule’s critics have questioned whether the SEC’s oversight authority allows it to impose technology standards on self-regulatory bodies, which enjoy a special status under federal law.
“Striking to me has been the kind of collective resistance by the self-regulatory organizations to much of what is in the release,” Klein said. “The problem is finding a device to prevent this and recognize the the truth of what the industry- based message is, that you can’t have this kind of technology- based elaborate system and expect no failures.”
–Editors: Anthony Gnoffo, Michael Shepard