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1 Securities and Capital Markets January 23, 2013 BATS Exchange Glitch Highlights Complexity Concerns For U.S. Equity Markets Structure On January 9, 2013, BATS Global Markets, Inc., the operator of two BATS electronic stock exchanges (BZX Exchange and BYX Exchange), reported that a system issue resulted in more than 400,000 transactions over a four-year period being executed at prices that violated Securities and Exchange Commission (SEC) rules intended to ensure that purchases and sales of equities are done at the best prices available across all markets. As part of a National Market System regulatory structure first mandated by Congress in 1975, and which has since evolved on the foundation of creating and maintaining open and competitive securities markets for the benefit of investors, securities exchanges like BATS, and all other trading centers as they are defined today, must have procedures in place that are reasonably designed to assure that transactions are done at the best available bid or offer -- the National Best Bid and Offer (NBBO) -- then available across all trading centers. During the four-year period involved here, the BATS system issue, in contravention of SEC National Market System rules, allowed trades to be executed at prices inferior to the NBBO. The total estimated loss to investors because of the BATS glitch was $420,000, which, though small in relative terms, and miniscule at an individual investor level, carries far greater significance for investor perceptions of fairness in a U.S. market system fragmented across 13 stock exchanges and many more electronic venues that qualify as trading centers as part of a national market system and its regulatory requirements. What happened at BATS, taken in context with other wellpublicized breakdowns in the computer-driven infrastructure of severely fragmented U.S. securities markets that now include such daunting elements as dark pools, predator algobots and AI (artificial intelligence) trading systems, draws attention to the evolution of a market structure quite different than that envisioned by Congress in 1975 in its National Market System mandate. Moreover, as reported by The New York Times in the wake of the latest BATS glitch, confidence-shaking technology mishaps have been an almost daily occurrence in U.S. stock exchanges so far in the new year. The Times noted, for example, that just a day ahead of the reported BATS issue, the trading software used by the Continued on Page 2 The total estimated loss to investors, though small in relative terms, and miniscule at an individual investor level, carries far greater significance for investor perceptions of fairness in a U.S. market system fragmented across 13 stock exchanges and many more electronic venues that qualify as trading centers as part of a national market system and its regulatory requirements. For additional information and discussion on this topic, please contact this Securities and Capital Markets attorney or your regular Calfee contact: Robert N. Rapp rrapp@calfee.com Chiquita Center, 15th Floor, 250 East Fifth Street Cincinnati, Ohio

2 Alert continued Page 2 National Stock Exchange stopped functioning properly for nearly an hour, forcing other exchanges to divert trades around it. As also reported by the Times, the New York Stock Exchange has had two similar, though shorter-lived breakdowns since Christmas, and two separate problems with its data reporting system. And on Jan. 3, the trade reporting system for stocks listed on the Nasdaq Stock Market broke down for nearly 15 minutes. BATS and the National Market System BATS Global Markets, Inc. is today the third-largest stock exchange operator in the United States. Its two stock exchanges handle 11 percent to 12 percent of all U.S. equities trading volume. The BATS Exchange model is an all-electronic automated trading system, accessible to members, who are securities brokerdealers meeting basic qualifications of membership in a securities industry self-regulatory organization other than the BATS Exchange itself, and who are connected with a clearing firm. Individual investors have no direct access to BATS Exchanges, although through broker-dealer intermediaries, their trades may be executed on BATS, which competes on pricing, speed of execution and cost against other trading centers also accessible by those intermediaries. Orders flow to and among accessible trading centers by computerized routing systems, with time measured in milliseconds or microseconds. BATS operates two national securities exchanges registered with the SEC under provisions of the Securities Exchange Act of The BATS exchanges represent the new generation of stock exchanges in the United States, leaving behind the historic centralized, physical floor auction models exemplified by the New York Stock Exchange, which itself more recently morphed into a more modern demutualized hybrid marketplace. BATS, which formerly operated as an alternative trading system (more commonly known as an ECN -- electronic communication network), in recent years became a full-fledged stock exchange along with several other electronic markets, most notably the Nasdaq Stock Market, and the National Stock Exchange, mentioned above. Today there are 13 stock exchanges (including modern iterations of former regional stock exchanges) operating in the United States, along with three options markets that are also registered as national securities exchanges. There are many other non-exchange trading venues that continue to operate as alternative trading systems, as largely unregulated dark pools, broker crossing networks, or other proprietary platforms for internalization of trading. As national securities exchanges, the BATS exchanges are trading centers, as that term is defined by the SEC for purposes of a series national market system rules adopted in 2005 collectively under the heading of Regulation NMS -- National Market System. Under Regulation NMS, trading centers include not only registered national securities exchanges like BATS and the Nasdaq Stock Market, but also alternative trading systems and other trading facilities or platforms, as for example, broker-dealers that execute customer orders for the purchase or sale of securities internally by trading as principal or by crossing orders as agent of the customers. The central element of Regulation NMS is the Order Protection Rule, intended to ensure that transactions in every trading center are executed at the best available price across all markets. Under Regulation NMS, this means that a trading center must have and enforce written policies and procedures reasonably designed to prevent transactions from being executed in that trading center at prices that are lower or higher than what is known as the national best bid or best offer (NBBO) displayed among all trading centers and continuously reported through a consolidated data stream. Under Regulation NMS, trading centers must, except in very limited circumstances, assure that trade-throughs, i.e., prices away from, the NBBO, do not

3 Alert continued Page 3 occur. BATS acknowledged that its computer system inadvertently allowed trades to occur over a four-year period that were not at the NBBO, thus depriving investors of the best prices available. Disadvantaged investors will ultimately be compensated, but the BATS system issue fuels growing concern of all market participants over the fairness and integrity of equity markets given the highly fragmented, technology-driven equity market structure that now exists in the United States. An Incredibly Fragmented Market Structure In 1975, when Congress mandated the creation of a national market system for securities, it did so with specific objectives for the protection of investors and the maintenance of fair and orderly markets to assure: Economically efficient execution of securities transactions; Fair competition among brokers and dealers, among exchange markets, and between exchange markets, and markets other than exchange markets; The availability to broker-dealers and investors of information with respect to quotations for and transactions in securities; The practicability of brokers executing investors orders in the best market; and An opportunity for investors orders to be executed without the participation of a dealer. Equity market structure in 1975 was fairly simple. Centralized, floor-based stock exchanges, primarily the New York and American Stock Exchanges, but also several regional exchanges, dominated trading. The decentralized, dispersed dealer market represented by then-emergent NASDAQ, and the generalized over-the-counter (OTC) market structurally evolved alongside, although events in October 1987 showed how slowly that evolution was taking place. Structural evolution also saw the creation of the so-called Third Market developed by broker-dealers, including pioneering work of the disgraced Bernard Madoff, for trading in exchange-listed securities away from the exchanges. The electronic Intermarket Trading System (ITS) likewise evolved alongside, for the first time enabling participants in one market to send orders to another, and automated trading systems were created to allow virtually instantaneous execution of orders in the exchange and NASDAQ markets. The sea change in equity market structure came with technological advances, and the emergence of a new breed of electronic marketplace -- the subscriber-based ECN, or noted earlier as technically labeled, Alternative Trading Systems. Qualifying as what we now define as trading centers, these ECNs proliferated as obstacles to trading in exchange-listed stocks away from the exchange were eliminated. Well-known ECNs such as Island, Archipelago, Instinet, REDIBook, Bloomberg Tradebook and others attracted increasing order flow, bypassing the exchanges and NASDAQ, and presenting the opportunity for investors to obtain better prices at lower cost. The proliferation of ECNs gave rise to regulatory concerns, and in general, to concern over what was then characterized as the Balkanization of securities markets. This concern in the 1990s led the SEC to undertake its Market 2000 study, and ultimately in 1999 to adopt Regulation ATS, which imposed certain regulatory requirements on any system that constitutes a marketplace or facility for bringing together

4 Alert continued Page 4 purchasers and sellers of securities or which otherwise performs the functions commonly performed by a stock exchange. ECNs must register with the SEC as broker-dealers and comply with several meaningful requirements relating to access, order display, automated systems and ongoing regulatory reporting. The Balkinization of securities markets feared in the 1990s became a reality, and is today the fragmentation structural reality. Market consolidation through acquisitions resulted in several of the most prominent ECNs being integrated into the New York Stock Exchange hybrid market, the Nasdaq Stock Market or, as exemplified by BATS, becoming a registered national securities exchange in their own right. Other ECNs continue to operate as such, and more than 50 different trading venues exist today, including more and more dark pools -- opaque, private markets that grew in a very short period of time to account for some 40 percent of all U.S. stock trades, and which present new questions and national market system regulatory challenges. The original fear over Balkinization of markets that drove regulatory concerns two decades ago was eventually addressed through the umbrella regulatory structure of SEC Regulation NMS, coupled with huge advances in computerized order routing and trading systems, fed by a constant stream of data reported in and from all trading centers that allowed now incredibly fragmented markets to function in theoretical conformity with national market system key objectives. That said, the BATS four-year system issue that permitted trades away from the NBBO in violation of Regulation NMS has led to criticism of the SEC itself, questioning whether the agency can effectively enforce Regulation NMS in today s fragmented market environment. Some argue that the U.S. market structure has simply become too complex, and that with the multiplicity of trading centers and the dominance of high-speed trading, for which time is measured in milliseconds and microseconds, the SEC cannot detect and address such errors as occurred at BATS, and that the BATS error demonstrates that trading center software breakdowns are possible across all markets. In simplest terms, however, the criticism in the wake of the BATS error is that Regulation NMS has failed because the SEC has no effective means of monitoring compliance. Beyond BATS In his 2012 book Dark Pools, Wall Street Journal reporter Scott Patterson characterized trading in securities markets today as a cloak-and-dagger game of hide-and-seek, of spymaster tricks, feints and dodges embedded in mysterious algos dueling in dark pools. Markets are, to be sure, scary, and the plumbing of the market as put by Patterson, is dangerously fragile. The May 2010 flash crash, when in approximately eight seconds, more than 20,000 trades across more than 300 securities were executed at prices more than 60 percent away from their values just moments before -- some at prices of a penny or less, or some as high as $100,000 per share before returning to precrash levels -- opened eyes to the prospect, and effect, of technology run amok. In March 2012, BATS was forced to cancel its own initial public offering, on its own exchange, after a trading glitch caused shares to collapse to less than a cent in value in seconds. The BATS technology glitch allowing execution of trades at prices away from the NBBO seems tame in comparison. It did, however, undermine the central tenet of the national market system over a four-year period, and it raises the question whether ever more complex routing and trading systems among ever

5 Alert continued Page 5 more fragmented markets catering to high frequency trading threatens the quality of markets and has already undermined the confidence of regular investors. BATS likely faces administrative action by the SEC. Going forward, however, the question remains whether the national market system regulatory structure launched in 1975, augmented by SEC Regulation NMS, can maintain pace with a vastly different market structure. Bob handles financial market regulatory and complex litigation matters for a wide range of market participants and financial intermediaries. He is a noted author and teacher on law, theory and practice in financial markets.