Understanding Equity Markets An Overview. James R. Burns March 3, 2016

Transcription

1 Understanding Equity Markets An Overview James R. Burns March 3, 2016

2 Agenda I. Trading Venues II. Regulatory Framework III. Recent Developments IV. Questions 2

3 Trading Venues 3

4 A Few Key Definitions Algorithmic Trading: The use of electronic platforms for entering orders with an algorithm that executes pre-programmed trading instructions for timing, price, volume, etc. Co-Location: Where the trading venue or a third-party provides space for the server of market participants in the same location as the servers for the matching engines of the trading venue; Sought by high frequency traders to lower order transmission time Direct Market Access: When a broker-dealer provides access for a client to route orders directly to trading venue High Frequency Trading: Automated trading using algorithms designed to enter orders with exceptional frequency Maker-Taker: Trading fee structure common among exchanges and other venues; Buyers and sellers submit standing limit orders or quotes for a rebate, and those who take that liquidity by submitting immediately executable marketable orders are charged a fee by the trading venue to which the orders are routed Trade-at rule: Would force equities transactions onto lit exchanges unless dark pools or internalizers could prove meaningful price improvement had been achieved Trade-through: Executing an order on one venue when a better price is available at another; Governed by Reg NMS and Rule 611, the Order Protection Rule 4

5 Types of Trading Venues Exchanges Alternative Trading Systems (ATS) Dark Pools Electronic Communication Networks (ECN) Internalization Dark Trading Venues 5

6 Exchanges The Securities Exchange Act of 1934 ( Exchange Act ) established requirements for national securities exchanges codifying membership, trading, capital, conduct and commission requirements: Section 3(a)(1) defines an exchange as any organization, association, or group of persons... which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange as that term is generally understood... Section 5 prohibits any broker, dealer or exchange to effect any transaction in a security unless the exchange is registered as a national securities exchange Section 6 provides SEC with rulemaking authority over exchanges in the public interest or for the protection of investors. Cannot unreasonably discriminate Fair representation in governance Equitable fee allocation 6

7 Exchanges, cont. Current Issues Regulation SCI Dark v. Lit Orders Consolidated Data v. Prop Feeds Maker-Taker Pricing Listing and Fees Limit Up / Limit Down Tick Pilot 7

8 Alternative Trading Systems (ATS) Alternative Trading System (ATS) Trading platforms involving multiple parties; allow for investor-to-investor trades Exempt from registering as an exchange, but must be registered with the SEC as a broker-dealer or operated by a broker-dealer, and registered as ATS with other requirements: Subject to requirements for quoting, fair access, systems reliability, and confidentiality May not refer to themselves as exchanges and no SRO powers Current Issues Exchange v. ATS -- benefits and obligations Regulation ATS proposal Enforcement cases: transparency and conflicts 8

9 Dark Trading Venues Dark venue activity estimated to make up approximately 35% of trading in U.S. listed securities, as of mid-2013 See Equity Market Structure Literature Review, Part I: Market Fragmentation, SEC Staff of the Division of Trading and Markets, fn 19 (Oct. 7, 2013) available at Dark Pool: A type of ATS that does not display bids and offers in the public quotation system Allows investor-to-investor trades Also refers more broadly to sources of liquidity not reflected in public quotes (e.g., dark orders on exchanges and internalization of orders at a b-d) Internalization: Order executed within a broker-dealer either between clients or between client and proprietary accounts without exposure to other traders What s Ahead? 9

10 Regulatory Framework 10

11 Congressional Mandate for Nat l Market System Congressional Mandates Summarized in Conference Report, Securities Acts Amendments of 1975, H.R. Rep. No , at 91 (1975): Efficient execution Fair competition among markets Price transparency Best execution of investor orders Opportunity for interaction of investor orders when consistent with efficiency and best execution Three-fold mission from the SEC: Protection of investors Maintain fair, orderly, and efficient markets Facilitation of capital formation Good Summary: Concept Release on Equity Market Structure, Exchange Act Rel. No (Jan. 14, 2010) available at 11

12 Regulation NMS Adopted in June 2005 to address changing market conditions in light of industry changes and technology advances e.g., increased fragmentation, development of automated order systems and electronic markets, movement to decimal pricing Notable rules: Order Protection Rule (Rule 611) Access Rule (Rule 610) Sub-Penny Rule (Rule 612) Market data rules (Rules 600, 601, and 603) 12

13 Order Protection Rule (Rule 611) Requires a venue to have policies and procedures reasonably designed to prevent trade-throughs Exceptions include: Orders executed when there is a failure, material delay, or malfunction of trading center equipment or systems Transactions other than regular way contracts Single-pricing, reopening, or closing transactions Transactions executed when protected quotations were crossed Intermarket sweep orders ( ISOs ) Orders executed at a benchmark price that is not based on the quoted price of an NMS stock at time of execution and where material terms are not reasonably determinable Transactions based on flickering quotations Certain underwater stopped orders 13

14 Access Rule (Rule 610) Prohibits unfairly discriminatory terms preventing efficient access to displayed quotes in an NMS stock When the venue displays quotes through an SRO display-only facility, the level and cost of access to these quotes must be comparable to those displayed by SRO trading facilities Caps fees for access to protected quotes and manual quotes Protected Quotes: Protected bid or offer Manual Quotes: Any quote other than an automated quote Requires written rules at each national exchange and association to preclude display of quotes that lock or cross any protected quote in an NMS stock Locked Market: Where the bid and offer are equal in price Crossed Market: Where a bid is entered that is higher than the offer or, one where an offer is entered that is lower than the bid 14

15 Sub-Penny Rule (Rule 612) When a bid, offer, order, or indication of interest is priced at or above $1.00 per share, the display, rank, or acceptance cannot be in an increment smaller than $0.01 Under certain circumstances, transactions resulting from midpoint or VWAP algorithms or price improvement are permitted to be done at a sub-penny level A tick pilot detour 15

16 Market Data Rules (Rules 600, 601, and 603) Govern joint industry plans for quote and transaction reporting: Market Data Revenue Market data is distributed to broker-dealers and data vendors for a fee Fee structure designed to reflect the contribution of an SRO s quotes and trades to the data stream Distributable revenue allocated among securities in the data stream and then allocated among the SROs based on usefulness of trades and quotes to investors Market Data Rules Require SRO members to transmit trade information to the SRO Also allow members to distribute the same information independently, with or without a fee Distribution of market information by an SRO or broker-dealer may not be unreasonably discriminatory On websites with trading or order-routing capability, consolidated and other market data must be given equivalent presentations 16

17 Regulation ATS Provides an exemption for a trading venue to avoid registration with the SEC as an exchange. To qualify, the venue must: Register as a broker-dealer and as an ATS Avoid the exercise of SRO powers (regulating member activity outside the trading platform) Avoid the use of words such as exchange or stock market in its name Fair access, resiliency and other requirements at certain volume thresholds Proposed Overhaul: Amend Regulation ATS by providing subscribers and market participants with the ability to assess operations and potential conflicts of interest associated with using a particular venue Detailed disclosure of the operations of NMS stock ATSs Public Availability of Form ATS-N SEC review of Form ATS-N Filings Safeguards and procedures for protecting subscriber s confidential trading information Duty of best execution requires assessment of execution quality on different venues to ensure beneficial terms for clients 17

18 Regulation ATS, cont. More information about the priority, order interaction, display, and execution procedures would help market participants make better informed decisions about where to route their orders for best execution. See Regulation of NMS Stock Alternative Trading Systems, Exchange Act Release No (Nov. 18, 2015) available at 18

19 Equity Market Structure Initiatives In June 2014, Chair White identified potential equity market structure initiatives: Preventing Market Instability Enforcement of the Market Access Rule (Rule 15c3-5) Adoption of Regulation Systems Compliance and Integrity (Reg SCI) Addressing High Frequency Trading and Promoting Fairness New Rules Regarding: anti-disruptive trading the status of unregistered active proprietary traders to subject them to rules as dealers (eliminating dealer-trader distinction) eliminating an exception from FINRA membership requirements for dealers that trade in off-exchange venues (proposed Rule 15b9-1) 19

20 Equity Market Structure Initiatives, cont. Enhancing Market Transparency and Examining Trading Venue Regulation FINRA s enhanced OTC trading volume disclosures, time stamps on data feeds and other initiatives Expanding information about ATS operations submitted to the SEC and made public (Regulation ATS Proposal) Institutional order information Comprehensive exchange regulatory reform Mitigating Broker Conflicts Potential rule to enhance order routing disclosures (but not large orders typically used by institutional investors) Exchange review of order types, how they operate, and related rule changes Building Quality Markets for Smaller Companies Pilot program to allow wider tick sizes for stocks of smaller companies 20

21 Adoption of Reg SCI Requires policies and procedures to ensure the entity s systems can maintain its operational capabilities and promote fair and orderly markets, including, for example: Business continuity and disaster recovery plans providing for next business day resumption of trading and two-hour resumption of certain critical SCI systems following a wide-scale disruption Response plan to an SCI Event Applies to national securities exchanges, higher-volume equity ATSs, FINRA, securities information processors, each registered and one exempt clearing agency, and the Municipal Securities Rulemaking Board Does not apply to ATSs trading only fixed-income securities or broker-dealers operating high-volume proprietary trading platforms Annual SCI compliance review Quarterly notices to the SEC of systems changes Testing with market participants Potential expansion to other market participants 21

22 Recent Developments 22

23 2016 Equity Market Initiatives In February 2016, Chair White reviewed on-going equity market structure initiatives and identified priorities for the SEC in the upcoming year dialing things back from prior plans Chair White listed the following as priorities for the SEC in 2016 with respect to equity market initiatives: Strengthening infrastructure of equity markets and mechanisms for ensuring market stability August 2015 issues ETFs and limit up/limit down Tick Size Pilot for smaller companies scheduled to begin in the Fall Review of equity market structure advisory committee s recommendations Maker-Taker pilot Continued review by staff of disclosure effectiveness 23

24 2016 Equity Market Initiatives, cont. Chair White highlighted two proposed rules that require new detailed disclosures and create a new process for [SEC] oversight over certain trading venues Proposed Exemption for Certain Exchange Members: Broaden oversight of active proprietary traders, including high-frequency traders Adoption of 15b9-1? Proposed Regulation on NMS Stock: Amendment to Regulation ATS (as discussed previously) Fast-track for Reg ATS reform? Beyond the Chair s speech: Institutional order routing Maker-Taker Pilot Dealer/trader guidance 24

25 The Maker-Taker Model Proponents of the maker-taker model argue that the system increases competition and attracts liquidity providers. In addition, they say that the maker-taker model lowers costs for investors, eases the trading of shares, provides better execution, and improves quoted prices.... [T]he maker-taker model may present a conflict of interest between brokers and their customers because broker-dealers are incentivized to send customer orders to the venue that pays the best maker-taker rebate, and not necessarily the venue that provides best execution. Some have argued that in order to mitigate this conflict, broker-dealers should be required to pass the maker-taker rebates they receive to their customers. Another criticism of maker-taker is that it produces quoted spreads that do not represent actual trading costs, thereby decreasing transparency, and could potentially confuse investors about the true costs of trading. Others claim that maker-taker has contributed to a market structure in which order execution is too fragmented among exchanges, dark pools, and broker-dealers that execute orders internally, and that it has incentivized some market participants, including high-frequency traders, to trade primarily, if not solely, to profit from collecting maker-taker rebates. These concerns should also be taken seriously by the mutual fund industry, since these entities are some of the largest buyers and sellers of equities. Taking an Informed Approach to Issues Facing the Mutual Fund Industry, Mutual Fund Directors Forum s 2014 Policy Conference, Remarks by Luis A. Aguilar, Former Commissioner, U.S. Securities and Exchange Commission, April 2, 2014 available at 25

26 SEC Speaks 2016: Summary of Recent Enforcement Actions Robert Cohen, Co-Chief, Market Abuse Unit, noted that recent SEC enforcement actions with respect to trading venues can be broken down into three major categories: Firms who operate dark pools in contrast to how they disclosed their operations to subscribers Firms who operate dark pools and provide preferential treatment towards certain subscribers at the expense of other subscribers Firms who operate dark pools and do not protect confidential information of subscribers in violation of Regulation ATS 26

27 SEC Enforcement Actions In Barclays Capital Inc., Exchange Act Rel. No (Jan. 31, 2016), the SEC alleged that Barclays violated certain provisions of the federal securities laws, including the Market Access Rule, by misrepresenting its efforts to police its dark pool, overriding its surveillance tools and misleading its subscribers about data feeds. In Credit Suisse Securities (USA) LLC, Exchange Act Rel. No (Jan. 31, 2016), the SEC alleged that Credit Suisse committed similar violations by mischaracterizing order flow, failing to maintain confidential order information and failing to disclose preferential treatment for two high frequency trading firms. 27

28 SEC Enforcement Actions, cont. In Latour Trading LLC, Exchange Act Rel. No (Sept. 30, 2015), the SEC alleged that Latour violated the Market Access Rule and Regulation National Market System when it sent non-compliant orders to U.S. exchanges over a four-year period. In ITG Inc., Securities Act Rel. No (Aug. 12, 2015), the SEC alleged that (i) ITG operated an undisclosed proprietary trading desk despite telling the public that it was an agency-only broker whose interests did not conflict with its customers; and (ii) ITG misused dark pool subscriber confidential trading information for its high-frequency algorithmic trading strategy. In New York Stock Exchange LLC, Exchange Act Rel. No (May 1, 2014), the SEC alleged that the NYSE exchanges repeatedly engaged in business practices that either violated exchange rules or required a rule when the exchanges had none in effect. 28

29 SEC Enforcement Actions, cont. In Edga Exchange, Inc., Exchange Act Rel. No (Jan. 12, 2015), the SEC alleged that Edga offered three variations of price sliding order types despite operating under rules that described a single price sliding process. In UBS Securities LLC, Exchange Act Rel. No (Jan. 15, 2015), the SEC alleged that UBS failed to properly disclose an order type that it pitched almost exclusively to market makers and high-frequency trading firms. The order type enabled certain subscribers to buy and sell securities by placing orders priced in increments of less than one cent; however, UBS was prohibited under Regulation NMS from accepting orders at those prices. 29

30 Questions? 30