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The Blurring Lines Between Stock Exchanges and Brokers

15

October, 2012

Trouble in paradise?  The interconnected world of broker algos and exchanges has been facing some stress lately.  After the Facebook IPO, brokers led by the outspoken CEO of Knight Capital, were screaming that NASDAQ’s failure to open the IPO promptly cost them millions of dollars.  Then of course, there was the Knight algo disaster which was allowed to go on for 45 minutes.  This has stirred the debate of kill switches at the exchange level.

The latest battle amongst the brokers and exchanges is being fought about a proposal by NASDAQ to establish “Benchmark Orders”.  Back in May of this year, NASDAQ proposed  to offer a suite of execution algorithms to their members.  ”The Benchmark Order would allow NASDAQ members to enter a single order in a single security that seeks to match the performance of one of three selected benchmarks – VWAP, TWAP or POV – over a pre-determined period of time.”

On August 14, 2012, due to numerous concerns, the SEC began the process of not approving this new NASDAQ proposal:

Pursuant to Section 19(b)(2)(B), the Commission is providing notice of the grounds for disapproval under consideration. The sections of the Act applicable to the proposed rule change that provide the grounds for approval or disapproval under consideration are Section 6(b)(5) 15 and Section 6(b)(8).

The SEC asked again for public comment on the NASDAQ proposal.  SIFMA responded and on October 5th wrote a letter  blasting NASDAQ on its proposal.  Apparently SIFMA sees this NASDAQ proposal as an intrusion by a stock exchange into the broker/dealer space and they state some pretty good reasons why the SEC should disapprove the NASDAQ benchmark order proposal:

1) Is it appropriate for an exchange to compete with its broker/dealer members?  SIFMA states: “Nasdaq’s proposal could create regulatory disparities that would give Nasdaq an inappropriate advantage over broker-dealers providing the same services, both in terms the Commission’s Market Access Rule,5 and other regulatory requirements that apply to broker-dealers.”

2) Does adding algos at the exchange level conflict with the exchange goal of making markets more efficient and transparent?  SIFMA stated “SIFMA believes that an algorithmic trading function clearly is not “incidental” to an exchange’s core functions.”

3) Should NASDAQ enjoy the benefits of its regulatory function while undertaking a commercial offering? “SIFMA believes that Nasdaq plans to characterize the Benchmark Order functionality as a regulatory function rather than a commercial offering…Nasdaq’s characterization of the proposal leads to concern that it would use the doctrine of regulatory immunity to protect itself from any liability that arises out of the Benchmark Order functionality, through systems issues or otherwise.  In light of recent events in the markets, it would be an incongruous result if Nasdaq were permitted to use the doctrine of regulatory immunity as a shield against liability, while competing algorithm providers offering the same services may assume unlimited liability for systems issues unless the provider and its customer agree otherwise by arms-length agreement.”

4) How is offering benchmark algos considered a regulatory function? “SIFMA questions how a proposal that is not only designed to mimic the existing functionality of its members, but also has been expressly created to attract order flow and execute transactions on the Exchange could be characterized as a regulatory function…the commercial offerings of a national securities exchange should not enjoy an immunity from liability that is not available to broker-dealers providing identical services.”

5) Would the NASDAQ algo be required to adhere the risk controls of the Market Access Rule?  SIFMA doesn’t think so and says: “We object to the proposal because it would allow Nasdaq to offer a functionality associated with broker-dealers without the same regulatory obligations and controls that apply to broker-dealers…Nasdaq is not subject to the Market Access Rule, and its affiliated routing broker-dealer benefits from significant exceptions to the Market Access Rule.”

Based on the above facts, it is clear to us that the SEC should finalize its disapproval of the NASDAQ proposal.  The “benchmark order” proposal is further evidence of the blurred lines that now exist between for-profit exchanges and broker/dealers.  Somewhere along the way, after Reg NMS, exchanges got the idea that they were just another for profit organization which were competing for client business.  However, as SIFMA has pointed out in their letter, one of the main responsibilities of an exchange is to make markets more transparent and efficient. Adding a suite of algos doesn’t seem to us to be a function of a stock exchange. Enhanced proprietary data feeds, payment for order flow and special order types also don’t seem to be fair and transparent stock exchange functions.

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