March 14, 2018

SEC vs NYSE

Our good friends at Themis Trading wrote last week about a $14 million settlement between the NYSE and the SEC over a series of violations.

Why care, issuers and investors? Suppose nobody told you the road you take daily to work sat atop a growing sink hole. We’re all responsible for the market that serves us and as such we have a duty to understand it. Do you know how it works?

Credit Haim Bodek for research leading to SEC action. Had not Mr. Bodek, one of the great market-structure experts of the modern era, blown the whistle, we might not know of these problems. Follow him on Twitter: @haimbodek.

Picking up from Joe and Sal at Themis (Note: With permission.  We’ve edited some for length):

The SEC Case Against NYSE

The NYSE case involves five serious violations.  We will list them all here but we want to focus on the fifth violation since we think it is the most egregious one:

1) On July 8, 2015, NYSE and American Negligently Represented That Their Quotations Were Automated When They Were Not.  NYSE and American Negligently Marked Quotations as Automated When They Had “Reason to Believe” They Were Not Capable of Displaying Automated Quotations

2) Arca Improperly Applied Price Collars to Reopening Auctions During August 24, 2015 Market Volatility.  Arca’s failure to have an effective exchange rule regarding the application of price collars to reopening auctions violated Section 19(b)(1) of the Exchange Act.

3) On March 31, 2015, Arca Erroneously Implemented a Regulatory Halt and Failed to Publish Closing Order Imbalance Information. Although Arca intended to suspend trading only on Arca, which would allow trading of Arca-listed securities to continue on other exchanges, Arca inadvertently implemented a “regulatory halt” that stopped trading in the 134 Arca-listed securities on all exchanges.

4) NYSE and American Failed to Comply with Reg SCI’s Business Continuity and Disaster Recovery Requirements. From November 3, 2015 through November 23, 2016, NYSE and American were in violation of the requirements in Rules 1001(a)(1) and 1001(a)(2)(v) of Reg SCI that each SCI entity have policies and procedures reasonably designed to ensure operational capability.

5) NYSE and American’s Rules Failed to State That Pegging Interest Orders Created Possibility of Detection of Prices of Non-Displayed Depth Liquidity.

While we have noted many examples in the past about information leakage by the stock exchanges, this is the first time that the SEC has fined an exchange for leaking confidential client information:

– Floor brokers were permitted to enter “pegging interest” orders (PI) which allowed them to peg their order to the best NYSE quote. They could specify a range of prices for this PI order to be active. If the best NYSE quote was outside the PI range, then the PI order would price at the next level closest to the quote.

– According to the SEC, “A PI’s ability to peg to the price level of a NDRO (non-displayed reserve order) created the possibility that a floor broker, or a customer who submitted a PI through a floor broker, that sent the PI, would be able to detect the presence of same side non-displayed depth liquidity if certain circumstances were present.”

***Notice that the SEC says “a floor broker or a customer who submitted the order through a floor broker”.  This is because it is widely known that some HFT firms rent out the pipes of certain floor brokers and route orders through them to gain parity which is a benefit that floor brokers enjoy.

– PI orders could peg their price to a non-displayed NYSE order that was not part of their best bid or offer.

– The SEC explained how the initiator of the PI order could find out about hidden interest: “the submitter of the PI could potentially use identifying characteristics of its PI to locate it in the market data feed displayed at a price that did not previously have any displayed liquidity (because the NDRO was undisplayed), and if so located, conclude that there was same side non-displayed depth liquidity at that price level.”

NYSE was notified of the information leakage issue in 2013 by a client and chose to do nothing about it.  According to the SEC, “in 2013, NYSE received a complaint from a trader that the price levels of his NDROs, which were entered at prices inferior to the quote and unoccupied by any displayed liquidity, were being joined upon entry, as the trader observed in the exchange depth of book market data feed, by a displayed order.”

Apparently sensing that they had a problem, NYSE submitted a rule change in March 2015 which “modified the functionality of PIs so that they only pegged to price levels occupied by displayable interest.”  The SEC approved this rule change and didn’t appear to take any further action.

What made the SEC go back and take another look at this issue?  It looks like our old friend Haim Bodek was responsible for this with another whistle blower case. According to this press release, Haim continues to protect investors and haunt the exchanges.

Themis Concludes: The question now becomes what do we, as investors and clients of NYSE, do about this?  Should NYSE simply get away with neglecting their regulatory responsibilities?  Should they be able to pay the $14 million and just continue doing business like nothing happened? Or, should issuers and long-term investors shift their business to an exchange like IEX which seeks to protect them and not favor one class of client over another?

MODERNIR EDITORIAL NOTE:  Thanks, Joe and Sal! Issuers, you should expect honest markets free of predatory practices that distort your stock price and create risk. Two of the instances producing fines occurred in the summer of 2015 when ETFs nearly imploded. The stock market is overly dependent on intermediaries that during crises may vanish.  By then it’s too late.  We need an Issuer Advisory Committee for markets.

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