50 Shades of Compliance

"Dick Grasso is going to be visiting the trading floor today, so you might want to be somewhere else..." When my boss said that to me with a completely straight face, I was a bit surprised. "Really?" I asked, and when he nodded, I shrugged my shoulders and said "O.K. boss..."

This conversation happened soon after I had re-started a market-making business that traded directly with Smith Barney retail orders and "printed" the trades on regional exchanges or the Nasdaq trade reporting facility, instead of on the floor of the NYSE. As a market maker, that used electronic algorithms and statistical models, we were able to provide significant price and liquidity improvement to the retail clients. We also provided superior customer service, compared to what they would have received on the NYSE. Dick Grasso, the chairman of the NYSE, at the time, was very unhappy about Smith Barney allowing this business, and wanted the opportunity to vent about it. Mr. Grasso was not very concerned about the benefits to our retail customers, but focused instead on the loss of NYSE market share. To be fair to him, he was always careful to frame his concerns around the "public good" of price discovery, rather than the profit motives of the NYSE or the specialists that had a monopoly on market making on the floor.

For those of you who know me, you might be surprised to learn that I actually left the building during this visit. After all, many of you have witnessed the joy I can get from confrontations, particularly when I strongly believe in what I am doing. In this case, we provided demonstrably better execution quality to our retail clients and had convinced both Smith Barney management, including CEO Sallie Krawcheck and Citigroup management, including CEO Chuck Prince that the improvement was worth routing away from the NYSE and their global brand.

The problem, however, was that the NYSE was not just a powerful competitor, but was also a regulator of our equity trading business. Senior compliance and legal department managers were very concerned about the potential costs we could incur if Mr. Grasso became angrier. Several of them confided to me that the NYSE might be able to wield their regulatory power as a competitive weapon and that we should try to avoid taking the risk that they would. To be clear, no allegations of this sort were ever proven and it is possible that it never took place. We continued to route away from the NYSE to provide improved execution quality to our retail clients where available. But the fact that it COULD have happened, and that execution quality for clients could potentially suffer as a result, exposed a very serious conflict of interest in the regulatory structure of that time.

As a central consideration of market structure, we at RegOne Solutions believe that there should be fewer (or only one) regulator(s) of equity trading activities, rather than having overlapping regulatory functions between the exchange SROs and the Designated Examining Authority (DEA), for individual firms (FINRA in the majority of cases). This would reduce conflicts of interest and improve the efficiency of compliance resources of market participants.

The NYSE's announcement last October stating it would take back much of their surveillance responsibilities from FINRA at the end of 2015, is a step in the wrong direction. The NYSE is investing a substantial amount of resources to build and operate a new surveillance system, presumably, to focus on monitoring activity on its own markets. They believes it is in the best position to surveil while leaving the cross-market surveillance to FINRA. But it is unclear whether NYSE's new surveillance system will be compatible with or be able to communicate with FINRA's systems. Nor how NYSE and FINRA will, if at all, cooperate and consolidate market surveillance data and analysis and get a complete picture of market activity. SEC Chair, Mary Jo White recognized the difficulty of regulatory coordination in her remarks at the SRO Outreach Conference on September 16, 2014: "Trying to build consensus on common areas of concern among this many SROs, even if you had the luxury of more time, is also daunting." Despite NYSE's apparent intent to have cross-market surveillance remain at FINRA, there are risks of regulatory overlap and differing interpretations of regulations. Each market participant will have to face a separate regime of investigation and enforcement to comply with. This will almost certainly increase compliance costs for member firms.

There are also serious issues with conflicts of interest in the current SRO model. One explanation for the NYSE move was provided by Professor James Angel of Georgetown University, who speculated that NYSE's action might not necessarily be fully motivated by perceived efficiencies from surveillance expertise. But rather was motivated by the fear of losing its "sacred cow" SRO status (and benefits such as limitation of liability). SIFMA wrote a detailed letter to Chair White on July 31, 2013, raising conflict concerns of exchanges that engage in the same businesses as and compete with those they surveil and requesting a comprehensive review. Chair White and Commissioner Daniel Gallagher recently addressed this specific issue at the 2014 SRO Outreach Conference. A December letter written to the SEC from the IEX ATS articulated this problem quite well when it said

"The self-regulatory organizations ("SROs"), which sit as the governing body of the NMS Plans managing the consolidated market data feeds provided by the SIPs, are also selling proprietary data feeds, some of which are similar in data level, such as best-price, or 'top of book' feeds, some which are more robust, such as full depth of book feeds, and some of which are explicitly sold as alternatives to compete with SIP feeds. Indeed, often the same exchange personnel, with access to participant data on the use of the SIP feeds, are engaged in marketing both consolidated and proprietary data."

We agree with IEX that even allowing the NYSE or NASDAQ to operate the SIP is a clear conflict of interest. Specifically because the larger the performance gap between the SIP and their proprietary feeds, the more those proprietary feeds are worth. Despite these serious conflict of interest concerns, as well as a significant software error with its SIP in August 2013; that halted trading for 3 hours, Nasdaq recently won the bid to continue operating its SIP (Tape C) by a unanimous vote, over a rival that designed the SEC's MIDAS surveillance system.
Sadly, these are not the only conflicts of interest in the exchange space. Today's exchanges also provide execution services away from their own exchanges that used to be the sole province of broker dealers. Not too many people in the public are aware of this, but the complexity of these exchange systems are impressive. Orders sent to markets such as NYSE ARCA, NASDAQ, or any of the BATS exchanges might well be handled by sophisticated algorithms that seek out liquidity from ATSs and other broker dealer systems. Such systems prioritize external liquidity providers based on a combination of indications of interest previously received, statistically evaluated performance characteristics, and potentially the fees paid by such providers. At the same time, exchanges also offer many variations of order routing at different levels of aggressiveness in much the same way as broker dealers.

Considering these services, does it really make sense to have those same organizations have any control over the regulation of their own best execution obligations? Of course the answer is a resounding "no", but is particularly true with the current structure of best execution regulation. Currently, firms only need to report onwhere they route orders and, even then, only if they route 5% or more of their orders to a particular destination. There is no execution quality reporting required of routed orders and no disclosure required of liquidity sources that fall under the 5% threshold. At a minimum, we strongly suggest that all routing and liquidity-sourcing algorithms be subject to external best execution surveillance. As a practical matter, it would also help to have all order routing become subject to a standard set of rules, such as SEC Rule 605, which applies mostly to retail orders.

While we understand that many of the SRO structure issues we have highlighted are complex, there are some simple steps that can be taken. All exchanges, ATSs and broker dealers have obligations to supervise their own clients trading activity, but surveillance at the meta-level should not be done by these market participants. The regulatory authority of exchanges should be limited to the regulation of their listing business, while trading supervision should reside with DEAs that do not also trade for a profit. In addition, exchanges and their affiliated routing brokers should have explicit best execution obligations with regard to their execution services that go beyond today's requirements. We should always be wary of potential conflicts of interest with regard to regulatory authority. Even the possibility that an SRO could wield such power as a competitive weapon (as many feared from Dick Grasso) can destroy confidence in the integrity of our markets.

S&P Global provides industry-leading data, software and technology platforms and managed services to tackle some of the most difficult challenges in financial markets. We help our customers better understand complicated markets, reduce risk, operate more efficiently and comply with financial regulation.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.