The SEC has been quite busy of late proposing new regulations for the equity markets, prompting eloquent and passionate responses from affected firms and organizations representing the trading community.
On Nov. 13, 2009, the SEC released proposed rules to limit the activities of dark pools by, among other things, requiring the public display of "actionable" indications of interest (IOIs), which are currently not displayed by dark pools. On Jan. 19, the SEC proposed new rules that would supersede the rules of self-regulatory organizations dealing with sponsored and naked access to markets and would require broker-dealers to implement systems and procedures to control market access.
On Jan. 14, the SEC published its Concept Release on Equity Market Structure, demonstrating its interest in adopting new rules that would regulate high frequency trading, regulate exchange co-location activities, and further restrict internalization of orders by broker-dealers and dark pools. And on April 14, the SEC resurrected its long-dormant proposal to institute a large trader reporting system for NMS stocks, as we discussed in last week’s column.
In this new Age of Convergence, rule-making on the American side of the Atlantic is mirrored in Europe, and the SEC’s equity market proposals are no exception. The purpose of convergence is to eliminate the incentives for a financial services firm to engage in "regulatory arbitrage" by locating its activities where it can offer its services at the lowest regulatory cost.
Accordingly, it was not much of a surprise when, on April 1, the Committee of European Securities Regulators (CESR) released a "Call for Evidence" on "Micro-structural issues of the European equity markets," largely imitating the SEC’s recent equity market regulatory initiatives. CESR is one of two committees established by the European Commission in response to the proposals made by Baron Alexandre Lamfalussy’s "Committee of Wise Men on the Regulation of European Securities Markets" in 2001. Its job is to coordinate securities regulation among EU member states and to advise the Commission with respect to securities legislation. A Call for Evidence is more or less a concept release.
CESR’s April 1 Call for Evidence deals with high-frequency trading, sponsored access, co-location services, fee structures, tick size regimes and IOIs. The comment period closed on April 30. Thirty-nine institutions made comments, roughly reflecting the views of four industry groups: (1) banking, (2) insurance, pension and asset management, (3) investment services and (4) regulated markets, exchanges and trading systems. These categories reflect European regulatory systems. For example, banks include equity brokers.
As a general proposition, there were no serious disagreements among any of the commenters. Most thought that high-frequency traders added liquidity and contributed to the narrowing of spreads, but should be monitored by regulators. There was general agreement that firms providing market access should have controls in place to prevent improper orders, but were not in favor of banning the practice. Co-location services were acceptable, provided that they are offered on non-discriminatory terms at reasonable prices. Most commenters thought exchanges and alternative trading systems should be free to establish fee structures without restriction due to the competitive value of creative fee structures, but expressed concern about the potential for market disruption. Most argued that rates charged by exchanges and alternative trading systems should be publicly available. There was also agreement that tick sizes should be harmonized across Europe and that there was little need for smaller tick sizes.
IOIs sparked the most controversy. The nature of the comments from the various players provides another illustration of the chasm that separates European and U.S. market regulation.
European investment managers argued that IOIs were an important ingredient of customer choice. They bristled at any suggestion that there should be a single, nondiscriminatory market for all customers, however. Tossing an insult, they indicated that they had no problem with high-frequency traders, so long as they were not required to trade with them!
The proprietary traders fought back against the practice of "hidden" markets by focusing on the matter of "transparency" for market information. They argued that because IOIs impede transparency and create an "insider" price based on information that is unavailable to other market participants, IOIs should be treated as any other order and exposed to the public markets.
In Europe, the proprietary traders have had to try to make the case for a principle of fairness that is already an imbedded assumption of the U.S. regulatory apparatus. In the United States, the Exchange Act commands–and the SEC assumes as a first principle–that retail and institutional orders should interact. This principle has been difficult to achieve in practice, as every rule-making initiative intended to expose the hidden market for institutional orders has been resisted by industry-designed structures to avoid interaction. Nevertheless, dark pools and the SEC’s proposals to curb them are only the most recent chapter in a long history of battling de facto "two-tier" markets.
In that context, the SEC’s January equity market structure Concept Release is the latest and perhaps most ambitious attack on the citadel. Most past regulatory efforts to induce greater exposure for institutional orders have foundered on the fact that broker-dealers are permitted to "internalize" orders, which means they are permitted to execute client orders without first submitting them to the market.
Advocates of dark pools and other anti-interaction structures have successfully made the case in the past that it would be inconsistent and unfair to prevent the use of dark pools without also outlawing internalization by broker-dealers. Thus, though everyone must accept that, as a general principle, all order should interact, the argument has been that if broker-dealers receive an exception, then dark pools should also be allowed an exception. The SEC’s Concept Release indicates that the SEC is now seriously considering the ultimate retort to that argument: proposals that would effectively end the practice of internalization by broker-dealers, which would lead to elimination of the institutional market tier, currently the last remaining source of profitability for equity trading desks.
The European regulators, for their part, tend to believe that securities markets are best left to professionals and see no particular virtue in encouraging retail participation in the markets. As a result, there is no assumption in Europe that retail orders should interact with institutional orders, and the argument in favor of transparency doesn’t necessarily lead to elimination of two-tier market structure. It is quite conceivable that informational exposure of IOIs could be accomplished without necessarily requiring that all customers have access to those prices.
Such differences in regulatory cultures between Europe and the United States mean that while the European Commission may adopt securities regulations that, at first glance, appear to be consistent with U.S. regulations, the two sets of regulations may actually be implemented in radically different ways. Europe may institute rules in flattering imitation of U.S. regulatory initiatives, but actual convergence requires much more. Until an acceptable way is devised to bridge profound cultural differences, "regulatory arbitrage" will remain a profitable enterprise for financial services firms.
Stephen J. Nelson is a principal of The Nelson Law Firm in White Plains, N.Y. Nelson is a weekly contributor and columnist to Traders Magazine’s online edition. He can be reached at sjnelson@nelsonlf.com
The views represented in this commentary are those of its author and do not reflect the opinion of Traders Magazine or its staff. Traders Magazine welcomes reader feedback on this column and on all issues relevant to the institutional trading community. Please send your comments to Traderseditorial@sourcemedia.com
