On June 5, 2014, Mary Jo White gave a speech at a conference on the topic of the structure of equity markets, the entire text of which is available on sec. gov. The speech was very high-level and broad-based with few specific initiative announcements. However, it does provide some insight into the direction of planned market structure initiatives and rule releases. This blog is a summary of her speech.
Ms. White began her speech by acknowledging that the SEC agrees with the basic premise that “investors and public companies benefit greatly from robust and resilient equity markets.”
Ms. White announced that she is recommending additional measures to “further promote market stability and fairness, enhance market transparency and disclosures, and build more effective markets for smaller companies.” In addition, she will request that the SEC create a new Market Structure Advisory Committee of experts to review specific initiatives and rule proposals.
Current Market Structure
As noted in Ms. White’s speech, today’s markets are computer-based, with algorithms providing the backbone for trading and monitoring of such trading activities. The SEC believes that today’s electronic system provides a level of stability, trustworthiness (Ms. White asserts that today’s markets are not “rigged”) and reduced costs, and Ms. White gave a few interesting facts to support this view. In particular:
- For institutional investors, the costs of executing large orders, measured in terms of price, were more than 10 percent lower in 2013 than in 2006. This is true even though fundamental volatility was slightly higher in 2013 than it was in 2006.
- The level of intraday volatility also has returned to low levels after spiking during the financial crisis. Intraday volatility of the S&P 500 Index was nearly the same in 2013 as it was in 2006 — for both average and maximum volatility.
- The spreads between bid and ask prices for the broader market also are as narrow as they have ever been. These narrower spreads are particularly important for retail investors because they reflect the cost of trading immediately at the best prices, which is generally the objective of retail investors.
However, despite these positive facts, the small cap market has not seen the bulk of these benefits and continues to have high costs, large spreads, and both long- and short-term volatility. In that regard, Ms. White briefly addresses the topics of market instability, high-frequency trading, fragmentation, broker conflicts, and the quality of markets for smaller companies.
Ms. White points out the recent rule changes and initiatives that the SEC has taken to help maintain market stability including the “limit-up-limit-down” rule which went effective February 2013. This rule prevents trades in individual exchange-listed stocks from occurring outside of a specified price range.
In addition, also in February 2013, the SEC enacted updated market-wide circuit breakers. The market-wide circuit breakers will halt trading completely on an exchange in response to market declines of 7%, 13% and 20% from the prior day’s closing price based on the S&P 500 Index. The halts last for 15 minutes if triggered before 3:25 p.m. and for the remainder of the day if triggered after 3:25 p.m.
The SEC is “vigorously enforcing” its Market Access Rule, which requires brokers to implement risk controls as a precondition to market access. The rule is designed to prevent unfiltered market access, including the risk of erroneously submitting a single large order or flood of small orders that could disrupt trading.
The SEC is working on final rules related to its proposed Regulation SCI which will further regulate technology used by exchanges, large alternative trading systems, clearing agencies, and securities information processors (SIP’s).
High-Frequency Trading and Promoting Fairness
As market participants are aware, and Ms. White points out, “algorithmic traders, which include high frequency trading firms and a large percentage of institutional trading, likely represent well over a majority of trading volume.” These computer-generated trading systems, although a sign of the technologically advanced times, can put regular investors at a disadvantage in the marketplace. Although today the SEC does not have a definitive plan to address these issues, they are considering various rule initiatives including rules “tailored to apply to active proprietary traders in short time periods when liquidity is most vulnerable and the risk of price disruption caused by aggressive short-term trading strategies is highest.”
Importantly, Ms. White disclosed that the SEC is currently working on rules that will subject unregistered active proprietary traders to SEC rules as dealers.
Further, the SEC and FINRA are working on rules and systems to minimize consolidated data delays. The exchanges and FINRA have an obligation to provide data to the SIPs in a way that is not unreasonably discriminatory. They are not allowed to transmit data to direct customers any sooner than they transmit data to the SIP, and the technology used for transmitting data to the SIP must be on a par with what is used for transmitting data to direct feeds. The SEC is looking into several initiatives in this regard including additional time stamping of feeds, and further disclosure by traders on the use of feeds.
Enhancing Market Transparency and Potential Trading Venue Regulation
“Order flow in exchange-listed equities is divided among many trading venues — 11 exchanges, more than 40 alternative trading systems, and more than 250 broker-dealers.” Although in many aspects multiple order flow venues is a benefit including increased competition, checks and balances, and alternative routes in the event of malfunctions or disruptions, there are also added risks and concerns. In particular, multiple venues allow for an arbitrage of these venues and trading on what the SEC calls “dark venues.”
Ms. White explains, “dark trading venues generally reference the quoted prices displayed by the lit exchanges and do not publicly display quotes or otherwise provide pre-trade transparency of the prices at which they will execute orders.” Today, dark trading accounts for approximately 35% of all market trading. Ms. White points out that “Although the trades of dark venues are reported in real time, the identity of participants in the dark venue is not disclosed to the public. And dark venues generally only provide limited information about how they operate. ATSs, for example, file a form with the SEC on some aspects of their operations, but the forms are not publicly available under current rules.”
Ms. White’s speech offers no particular solutions to issues created by market fragmentation and multiple trading venues and platforms, other than to point out that the issue is on the SEC’s radar and that together with FINRA, market effects and possible solutions are being examined. The SEC has not conducted an in-depth review of trading alternatives for 20 years and is proceeding to do so now with a view towards comprehensive changes in the regulations.
Investors rely on their brokers to figure out how and where to execute orders on their behalf for the best result. Ms. White states, “The cost to the broker for executing in different venues can vary widely. Some venues make payments directly to brokers as a means to attract particular types of order flow. These payments include the liquidity rebates paid by exchanges that use a ‘maker-taker’ fee structure. They also include payments offered by off-exchange market makers to retail brokers for the marketable order flow of their customers.”
The conflict is obvious: a broker may be motivated to execute an order on a venue that provides kickback-type payments, to the detriment of the customer/investor. The SEC is considering rules that would enhance order routing disclosures.
View on Smaller Companies
Ms. White’s speech points out that the number of domestic companies listed on U.S. exchanges has dropped by half from the highs of more than 7,000 in the 1990s, and that a large part of this decline has been from a reduction in the number of IPOs, particularly IPOs of smaller companies. However, other than the current initiative related to wider tick sizes, Ms. White does not offer any current ideas or plans to help smaller companies.
As an attorney representing these smaller companies on a daily basis, I see many areas that could use improvement. For example, the SEC and FINRA could offer assistance to smaller companies being damaged by the shorting of their stock. Although naked shorts are not allowed, it is the overwhelming belief in the small cap industry that naked shorting is rampant and masked by the use of offshore accounts and trading platforms, and cross covers among clearinghouses.
The small and micro-cap industries are still awaiting final rules related to Regulation A and A+ and Title III Crowdfunding under the JOBS Act, which are anticipated to assist in access to capital markets.
Further initiatives towards reducing costs, such as simplifying the use of the EDGAR system and reducing or eliminating XBRL requirements for small reporting companies, would be welcome.
Finally, the deposit and clearing of penny stocks has become an overwhelming problem in the industry. I understand the view that there are risks in trading in low-priced penny stocks, but there are also risks in trading in high-priced entities and in fact, when there are problems in the large cap industry, those problems have a much greater impact on the national economy and business industries as a whole. FINRA and the SEC should be looking at initiatives that provide for a system of checking the veracity of deposited penny stocks, without penalizing the industry as a whole and clearing firms that cater to these entities and their shareholders.
Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
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