SEC begins overhaul of US equity markets with ban on direct market access

SEC begins overhaul of US equity markets with ban on direct market access

The US Securities and Exchange Commission has proposed new rules prohibiting broker-dealers from providing customers with unfiltered or naked access to an exchange or ATS. The watchdog has also called for comment on issues relating to high-frequency trading, co-locating trading terminals and dark pool trading as it seeks to re-write the rule-book for a new era of computer-driven trading.

Approximately 38% of the daily volume in US equity markets is traded by firms accessing trading venues via sponsored or direct market access arrangements through their broker-dealers.

The SEC's proposed rule would require brokers to put in place risk management controls that would help prevent erroneous orders, ensure compliance with regulatory requirements, and enforce pre-set credit or capital thresholds.

"Unfiltered access is similar to giving your car keys to a friend who doesn't have a license and letting him drive unaccompanied," says SEC chairman Mary Schapiro. "Today's proposal would require that if a broker-dealer is going to loan his keys, he must not only remain in the car, but he must also see to it that the person driving observes the rules before the car is ever put into drive."

The rule change comes amid a broad review of rapidly-changing US equity market structures by the SEC which is under pressure from Washington to protect the interests of long-term investors and preserve the market's primary function as a mechanism for capital formation.

With this in mind, the watchdog has issued a "concept release" seeking public comment on issues relating to high frequency trading, co-location, and dark pool trading.

The release asks a series of specific questions about the current market structure, including:

Market quality metrics
  • What are the best metrics for assessing market quality for long-term investors and have these metrics improved or worsened in recent years?


Fairness of market structure
  • Is the current highly automated, high-speed market structure fundamentally fair for investors?


High frequency trading
  • What types of strategies are used by the proprietary trading firms loosely referred to as high frequency traders, and are these strategies beneficial or harmful for other investors?
  • Is the overall use of any harmful strategies by proprietary firms sufficiently widespread that the Commission should consider a regulatory initiative in this area?


Co-location
  • Do co-location services (which enable exchange customers to potentially route trades faster by placing their computer servers in close proximity to an exchange's computer system) give proprietary trading firms an unfair advantage?
  • If so, should the proprietary firms that use these services be subject to any specific trading obligations?


Dark liquidity
  • Has the trading volume of undisplayed trading centers (such as dark pools) reached a sufficiently significant level that it has detracted from the quality of public price discovery?
  • If more individual investor orders were routed to public markets, would it promote quote competition in the public markets, lead to narrower spreads, and ultimately improve order execution quality for individual investors beyond current levels?
  • Are a significant number of individual investor orders executed in dark pools and, if so, what is the execution quality for these orders?

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