Outreach Blog

Tuesday, December 1, 2015

Jumping into Dark Pools and Heading off Disruptive Trading


Author: SuperUser Account SuperUser Account

Wednesday, November 18, 2015, was a busy day for the Securities and Exchange Commission.  That morning the Commission convened to propose new rules to enhance the transparency of alternative trading systems, including “dark pools.” Later that day, Chairman Mary Jo White testified before Congress about the Commission’s plans to combat disruptive trading, to require registration “of certain active proprietary traders and improvements of firms’ risk management of trading algorithms,” as well as plans for rules addressing pre-trade pricing transparency in fixed income markets.  The very next Wednesday, in what appears to be a coordinated approach to the SEC’s, the CFTC proposed its own set of rules designed to take on automated trading and disruptions that can be caused by rapid algorithmic trading.    
 
 
Dark Pools
 

The first dark pools started out in the late 1960s, portraying themselves as havens from predatory traders. And for most of their existence, they operated that way. Since the mid-2000s, however, in an effort to ensure that dark pool subscribers find counterparties for trades quickly and consistently, many dark pool operators have given high-speed traders access to their dark pools. In addition, some operators have allowed their own proprietary trading desks as well as those of their affiliates to trade within their pools. This has created an environment rife with conflicts of interest between dark pool operators and their clients.  

Some of this conflict and apparent self-dealing is an unintended consequence of the SEC’s own regulations.  The adoption of Regulation NMS in 2005, the SEC’s effort to democratize pricing data, ensure best price execution for investors, and foster competition among individual markets opened the door for those who were able to use advances in computer trading technologies to exploit arbitrage opportunities among the multitude of new exchanges.  

The SEC’s proposed new rules do not make any changes to Regulation NMS.  Rather, the new rules are focused primarily on the transparency of alternative trading systems (ATS), including “dark pools.” The proposed rules, if adopted, would require broker-dealers operators and their affiliates to publicly disclose detailed information about the operations and activities of their ATSs. The proposals would also enhance the ability of the SEC to oversee ATSs.

These proposed new rules would apply to only to ATSs that trade stocks that are listed on a national securities exchange. The rules would require that each applicable ATS file with the SEC on a new Form ATS-N, among other things, information about its broker-dealer operator and affiliates, as well as the nature of its operations.  The contents of every Form ATS-N and any amendments would be posted on the SEC’s website.  In addition, each ATS would be required to maintain a publicly available website with:

  • access to its active Form ATS-N;
  • information regarding differences in the availability of services and processes available to subscribers as opposed to the broker-dealer operator, as well as types of orders; 
  • segmentation of order flow; 
  • procedures governing trading during a suspension; and 
  • opening, reopening and closing processes. 

ATS operators would also be required to publicly disclose whether they or a subset of their subscribers enjoy any advantages over other subscribers, such as special order types and preferential access to trade information. The proposal would also require covered ATSs to disclose their policies and procedures for ensuring the confidentiality of subscribers’ information, and these ATSs would also have to identify the positions of employees and third parties that have access to this information.

The registration of ATSs would provide the SEC with some regulatory oversight of ATSs via review all Form ATS-Ns. This review would them the power to declare them effective or ineffective, thereby giving them the ability shut down noncompliant ATSs. 

Comments on the proposed rules will be due by early to mid-February, 60 days after publication of the proposal in the Federal Register.

 
Disruptive Trading
 

Later in the day on November 18, before the House Committee on Financial Services SEC Chairman Mary Jo White testified, among other things, that the SEC staff is working  on recommendations to address:

  • The registration status of certain active proprietary traders and improvements to firms’ risk management of trading algorithms;
  • Enhanced disclosure requirements concerning a broker’s order routing practices;
  • An anti-disruptive trading rule that would address the use of aggressive, destabilizing trading strategies in vulnerable market conditions; and
  • The development and implementation of a consolidated audit trail.
In addition, Chairman White testified that the Commission Staff is looking into pre-trade pricing transparency in fixed income markets, particularly with respect to ATSs and other electronic trading networks:

"With respect to our fixed income markets, I have directed SEC staff to undertake an initiative designed to enhance the public availability of pre-trade pricing information in the fixed income markets. This initiative builds on a recommendation in the Commission’s July 2012 Report on the Municipal Securities Market, and would potentially require the public dissemination of the best prices displayed by market participants on electronic systems, such as ATSs and other electronic dealer networks, in the corporate and municipal bond markets. This potentially transformative change would broaden access to pricing information that today is available only to select parties, and could facilitate enhanced execution, improve market efficiency, and promote price competition. I am mindful, however, of the need to strike the right balance of compelling the disclosure of meaningful pre-trade pricing information without discouraging market participants from producing such information. Accordingly, to help inform our initiative on pre-trade price transparency, we have been actively engaged in discussions with market participants, FINRA, and the Municipal Securities Rulemaking Board (MSRB). Before we take any actions, I also anticipate careful staff analysis of the pricing data already available to assess how best to achieve our regulatory objectives."

 

Automated Trading

 

One week later, on November 24, 2015, the CFTC proposed rules intended to be a comprehensive regulatory response to the evolution of automated trading on U.S. designated contract markets (DCMs). The proposed rules, known collectively as Regulation Automated Trading or Regulation AT, represent a series of risk controls, transparency measures, and other safeguards to enhance the U.S. regulatory regime for automated trading. According to the CFTC:

"Regulation AT takes a multilevel approach by proposing risk control and other requirements for (a) market participants using algorithmic trading systems (ATSs), who are defined as “AT Persons” in the rulemaking, (b) clearing member futures commission merchants (FCMs) with respect to their AT Person customers, and (c) DCMs executing AT Person orders. The proposed rules are intended to reduce potential risks arising from algorithmic trading activity, by requiring the implementation of risk controls such as maximum order message and maximum order size parameters, and the establishment of standards for the development, testing, and monitoring of ATSs, among other requirements. AT Persons and clearing member FCMs would also be required to submit reports on their risk controls to DCMs, and maintain books and records regarding their risk controls and other algorithmic trading procedures for review by DCMs."

Recognizing that markets and trading technologies move faster than regulation, the proposed rules would "require that all AT Persons become members of a registered futures association (RFA), and further require RFAs to consider membership rules addressing algorithmic trading for each category of member in the RFA. Taken together, these provisions would allow RFAs to supplement elements of Regulation AT in response to future industry developments."
 
The notice of proposal will be open for a 90-day public comment period following publication of the release in the Federal Register.
 
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The CSFME’s Regulatory Outreach Programs

Regulatory reform has become a collaborative process. Where once market supervisors promulgated rules without regard for input from practitioners, today’s reform process has evolved into a dialogue of mutual respect for the opinions of all stakeholders in the capital markets. The process of regulatory outreach has become embodied in virtually every developed markets in the world.

The CSFME has adopted a role of facilitating this collaborative dialogue at all stages of the professional contribution process. Starting with students’ contributions to published commentary letters, through panel presentation and webinars, right up to trade association initiatives, the CSFME provides assistance through education, data compilation, analysis and commentary for some of the most pressing issues in contemporary markets.

DLT and Preferred Securities Financing

We believe the widespread use of encrypted third-party ledgers, blockchains, and smart contracts (i.e., DLT) is inevitable in securities finance, and that those technologies will permit lending agents to offer new revenue opportunities to their clients. Among these, we believe that certain agents will use DLT to help their lenders expand their loan books by opening their lendable portfolios on a preferential basis to the hedge funds in which they've already invested, as well as to other trusted counterparties, a concept we have dubbed, “Preferred Securities Financing.”  

CSFME is openly soliciting participation in a research initiative to assess the potential benefits to securities lenders from the use of DLT and data sourced from new regulatory disclosures. Specifically, our research will focus on how DLT, blockchain, and smart contracts can facilitate Preferred Securities Financing.  Learn More about our DLT Securities Finance Initiative

Research and Analysis of the Effects of Financial Regulatory Reforms

Given the sweeping changes in financial market regulation following the financial crisis, CSFME has turned its focus to questions relating to to how these changes are affecting the risks and economics of bank activities. The purpose of the Center’s research in this area is to foster sound policymaking and effective regulation with minimal adverse and unintended consequences. CSFME studies supervision and regulation of global financial institutions, the effects of reregulation on the global financial industry, optimal roles and methods of regulation in securities markets, corporate governance at financial institutions, and the most effective metrics and methods of data collection for understanding and measuring the effects of regulations on the global financial landscape. 

Lately, in response to a call from the FDIC for research on financial sector policy and regulation, the Center submitted a paper modeling the indirect costs to markets of bank regulatory reform.  The paper critiques regulators’ models for assessing these costs, and provides empirically-based suggestions for a more complete dynamic model of the long-term effect of bank capital reform.  Mindful of the Basel Committee's ongoing reviews of modeling tools, i.e., May 2012 and March 2016, the Center's critique is intended as a constructive addition to the holistic conceptual base of the regulatory reforms.

The Center also continues to provide input on regulatory proposals.

In March of 2016, CSFME submitted a comment letter to the Bank for International Settlement's (BIS) December 2015 consultative document regarding step in risk.  While supporting generally the goals of the Basel Committee to minimize the potential systemic implications resulting from situations where banks may choose to provide financial support during periods of financial stress to entities beyond or in the absence of any contractual obligations, the Center expressed some concerns and offered some suggestions regarding the approach taken by the Consultation. Drawing on practical experience, the Center offered an example from the trade finance sector supporting its belief that the nature of step-in risk may be one example of an acceptable, non-diversifiable exposure, given the potential positives for the economy at large.

In February 2015, CSFME submitted a comment letter in response to the Financial Stability Board’s November 2014 consultative document, Standards and Processes for Global Securities Financing Data Collection and Aggregation. In its letter, the Center identified additional metrics that may be necessary to assess properly the risk of collateral fire sales associated with securities lending transactions.  In particular, CSFME asserted that FSB and sovereign regulators must expand the data initiative beyond position aggregates, to include risk mitigation resources as well as termination activity.

Students Learn to Evaluate and Contribute to the Reform Process

As the level of intensity surrounding the reform process continued to build in 2013, the CSFME began to bring a fresh perspective to the reform process. By working with finance students and the US regulatory agencies, CSFME hoped to challenge the settled views of stakeholder by introducing the views of those whose careers would be shaped by the outcome of the reforms.

In the spring of 2013, a select group of Fordham University economics students met in Washington with officials at the U.S. Treasury, Office of Management and Budget, Federal Reserve Board, and the Securities and Exchange Commission. The CSFME helped arrange the meetings and funded the logistics. By all accounts, the experience was very positive for students and regulators alike.

Buidling upon the success of the 2013 pilot program, in 2014, both Fordham and the CSFME decided to expand the outreach program and formalized the Regulatory Outreach for Student Education program as the ROSE program. Honor students in finance and economics were selected by the deans of four schools within the university: the Graduate School of Business Administration, Fordham College at Lincoln Center, the Gabelli School of Business, and Fordham College at Rose Hill. The students were organized into four teams representing their schools. The CSFME selected a contemporary issue of career significance, the Financial Stability Board’s Consultative Document on G-SIFI designation of non-bank, non-insurer financial institutions. Each team was charged with studying the issues in debate, then presenting their opinions in the manner of a formal comment letter to the FSB. Over four months, the students reviewed earlier opinion pieces, met with practitioners and regulators, and then submitted their opinions. Without influencing their opinions, the CSFME arranged access to research materials and opinion leaders, then reviewed their letters and, as appropriate, recommended submission on university letterhead. In April, 2014, the four teams’ letters were published by the FSB on its website. In recent memory, no university had ever had one letter, much less four, published on a regulatory website. To finalize the 2014 ROSE program, the CSFME arranged for all four teams to present their opinions to the key regulators at the Federal Reserve Board and the SEC in Washington, D.C. The day of meetings ended with regulators’ praise at the degree to which the students had understood the issues and presented their opinions clearly.

One student team even offered suggestions that regulators had not previously considered and praised for their creativity. “We always know what the trade groups will say, but you brought a fresh perspective.” That team, Fordham College at Lincoln Center, was awarded the 2014 ROSE Award for Analytic Excellence. In retrospect. each student completed the program with a credit that will not only endure on their resumes but also contribute to the evolution of the financial markets through the Twenty First Century.

In 2015 and 2016, Fordham formalized the ROSE Program as a for-credit course in their curriculum. The focus of the 2016 ROSE Program was the Bank for International Settlement's December 2015 consultative document proposing a preliminary framework for identifying, assessing and addressing step-in risk potentially embedded in banks' relationships with shadow banking entities.  Five teams of graduate and undergraduate students in economics, finance, accounting, management, and law researched and drafted comment letters on the consultation and submitted their letters to a panel of distinguished industry judges.  After reviewing each excellent submission, the judges then one winning letter to be presented at a visit to the Federal Reserve Bank on April 27, 2016. The winning team's letter was submitted in full to the BIS, along with a summary of the key ideas from the letters from each of the other four teams, and the submission was published on the organization's website with those of the consultation's other commenters.   All five teams of Fordham Scholars visited Washington, DC on April 27, 2016 and met with officials at the Fed, Treasury Department, and FINRA.  

Institutional Securities Lenders respond to Academic Criticisms

In 2006 the Center was created, initially for the purpose of testing academic criticisms of the securities lending markets. With funding and data support from the Risk Management Association, CSFME found “no strong evidence to conclude that securities lending programs have been used to any great extent to manipulate proxy votes or exercise undue influence on Corporate Governance issues.” Our study also found that “broker borrowbacks” had contributed to spikes in lending activity around record date – the same phenomenon that the academics had misinterpreted as evidence of hedge fund manipulation – due to the efforts of brokers to meet recall notices from securities lenders. In effect, the brokers were scrambling to acquire votes for their customers, not building positions to swing corporate elections. The academics had fatally misinterpreted their findings!

Ed Blount of CSFME testified at the SEC’s Roundtable on the results of the research in September, 2009. Then, the CSFME white paper, published in 2010, was submitted to the SEC as an attachment in response to a consultative document on the “Proxy Plumbing” process. As a result of the Center’s contribution to the collaborative process, the misguided call for reform of securities lending began to subside. Once again, securities borrowers were fairly recognized to be honest brokers in the corporate governance arena.

Securities Lenders consider new means to retain their Voting Rights

In a follow-up to the Empty Voting project (“Borrowed Proxy Abuse” as it came to be known), the CSFME responded in 2011 to requests by the participating securities lenders, by turning its attention to ways in which those lenders might be able to retain their corporate governance rights, while still benefiting from the income attributable to their securities loans. After all, as many studies have found, securities lending contributes significantly to the efficiency of market operations. Why should lenders be forced to choose between their loan fees and fiduciary duties to vote their shares, especially if they are contributing to market efficiency?? With independent funding, the CSFME retained attorneys from two prestigious Washington D.C. law firms, Stradley Ronon and Sidley Austin, to investigate the legal underpinnings to market practices which force pensions, mutual funds, insurers and other institutional securities lenders to give up their voting rights when they lend portfolio securities. In practice, margin customers of brokers also lend their securities, yet they usually retain voting rights -- and most of them aren’t even long-term beneficial owners. Both groups of beneficial owners retain dividend rights, so why, institutional investors asked, shouldn’t institutions also keep their voting rights? With the benefit of exhaustive legal research, CSFME filed a petition with the Securities & Exchange Commission to initiate a pilot program to test new market procedures by which recently-introduced efficiencies in market operations might permit lender to retain votes.  Learn more about Paradoxical Erosion of Corporate Governance

In 2013, the SEC approved that pilot program, largely in response to the encouraging recommendations of the International Corporate Governance Association, as well as the California State Teachers Retirement System and the Florida State Board of Administration.

That pilot was initiated in 2014. Simultaneously, the CSFME began to apply the results to new initiatives in Canada and Switzerland, where the pressure to meet fiduciary voting obligations was intensifying.  More about Full Entitlement Voting



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