For more than a decade, regulators have been knocking down barriers to trading in the U.S. stock market. The result has been a computer-driven market in which the speed of trading is measured in millionths of a second.
That trend may be reversing. As regulators probe the causes of the May 6 “flash crash,” when stocks plunged sharply in a matter of minutes before recovering, they are weighing a number of rules that could put curbs on trading and slow things down.
“There seems to be an appetite to say we’re at the point of minimal marginal returns on speed and that the notion of speed above all, we’re past that,” said Jamie Selway, managing director of Investment Technology Group Inc. in New York.
Putting the brakes on some trading practices could limit the chance of sudden, volatile moves such as the one on May 6. But some traders say there also could be unintended consequences, such as a less liquid market. That could make it harder and more costly for investors to trade. Worst case, the stock market could suffer a downdraft if a number of high-speed firms pull out due to new rules, since these firms have in many ways become the grease that makes the wheels spin.
The practice allowed high-speed trading firms to
place orders directly on exchanges using the
computer-identification code of a broker…
Last week, the SEC banned a widespread trading practice dubbed “naked access.” The practice allowed high-speed trading firms to place orders directly on exchanges using the computer-identification code of a broker, without first putting the trade through a broker’s system.
The primary reason firms used naked access: speed. Routing orders through the computer system of the broker — giving the broker the ability to check the orders for mistakes — would result in split-second delays that could put the firm at a disadvantage to faster competitors. Greater speed provides more liquidity to the market, these firms say, resulting in better prices for all investors.
The SEC decided that the benefits of naked access don’t outweigh the risks that a trade could go awry and wreak havoc. Trading firms will have to route orders through the pipes of the sponsoring broker, resulting in a slight delay. Alternatively, the firms can apply to become a broker dealer themselves, heightening their regulatory responsibilities.
Boston research firm Aite Group has estimated that naked access trades account for 38 percent of market volume, up sharply from 9 percent in 2005, as high-speed trading has boomed. Some researchers estimate that high-frequency trading accounts for about two-thirds of all stock-market volume.
The Securities and Exchange Commission already has mandated trading curbs called circuit breakers for stocks that make big moves in a short period of time, hoping to head off another flash crash. On Monday, SEC Chairman Mary Schapiro said she is looking at “throttles” to periodically slow down computer programs that automatically send orders to exchanges.
“By throttle, I mean whether we should have mechanisms that change the way they operate given what is happening … or slows them down,” Ms. Schapiro said at a New York conference. In a report, the SEC fingered a single large algorithmic trade as a major factor behind the flash crash.
The Commodity Futures Trading Commission is also eyeing new rules to regulate potentially disruptive computer programs, according to a person familiar with the matter.
The latest moves mark a shift from regulations that encouraged faster trading. In 1997, the SEC implemented so-called order-handling rules, which helped create a new breed of trading systems called electronic communications networks, or ECNs. ECNs eased the path toward computerized trading that has dominated the market in the last decade.
In 2000, the SEC, prodded by Congress, pushed exchanges to start quoting stocks in decimals rather than fractions. That gave a boost to computer-driven trading because software programs could more quickly calculate shifts in prices, often measured by a single penny.
“When do you cross the line from a strategy to market
manipulation?”
In the summer of 2007, the SEC did away with the long-standing “uptick rule” for short sales. The rule had required firms to wait for a small move up before selling a stock short, hoping to profit from a decline in the price. Critics of the rule said it was outdated in today’s high-speed electronic trading world
Now, one focus for possible new rules to slow down trading is “cancellations” — messages sent by trading firms to cancel, buy or sell orders before they’re executed. Researchers estimate that cancellations make up 90 percent or more of all orders sent by high-frequency firms.
That’s creating a bottleneck of orders, critics say, as well confusion for institutional investors looking to buy or sell a stock. Mutual fund managers complain that when they move to make a trade at a price they like, the order sometimes disappears in a flash as a high-speed firm cancels it.
Ari Burstein, senior counsel for securities regulation at the Investment Company Institute, a fund-industry association, said at a recent conference on electronic trading at Baruch College in New York that he’s particularly concerned about whether some firms are flooding exchanges with orders and then rapidly canceling them in order to manipulate the market. “When do you cross the line from a strategy to market manipulation?” he asked.
Some have proposed a fee on cancellations to curb their use. Others have proposed a rule that would require all stock quotes to have a minimum lifespan, such as one-tenth of a second. High-speed firms say any curb on cancellations would make it riskier for them to hold on to their positions.
Meanwhile, there are signs that today’s high-speed market may have affected investor confidence. Andy Brooks, head trader at T. Rowe Price, said in a panel discussion at the Baruch conference that the flash crash has caused many mom and pop investors to pull their money out of the market. “You talk to people at the hardware store and the grocery store and you’ll see that they have been rattled,” he said.
The question for regulators, he said, is “how do we adjust our market structure to assure fairness and responsible behavior?”
