Michael Lewis’ new book Flash Boys: A Wall Street Revolt has caused a commotion on Wall Street, on Capitol Hill, and with law enforcement agencies. The SEC is the latest government agency to examine and propose new rules on alternative exchanges and high-frequency trading. The SEC’s latest proposals and enforcement actions raise questions about the agency’s plans to effectively regulate and enforce these activities and its ability to do so.
In Flash Boys, Michael Lewis—author of Liar’s Poker, Moneyball, The Blind Side, and The Big Short—follows a “small group of Wall Street investors” who he says “have figured out that the U.S. stock market has been rigged for the benefit of insiders and that, post-financial crisis, the markets have become not more free but less, and more controlled by the Big Wall Street banks.” High frequency trading is a type of trading using sophisticated technological tools and computer algorithms to rapidly trade securities in fractions of a second to profit from the slightest market blips. High frequency trading is done over traditional exchanges. In contrast, dark pools are alternative electronic trading systems conducted outside traditional exchanges that institutional investors use, sometimes to hide their trading intentions or to move the market with large orders.
SEC Reform on the Horizon?
On June 5, SEC Chair Mary Jo White addressed the current equity marketplace, including high-frequency trading and dark pools. White proposed new rules on high-frequency trading:
- An anti-disruptive trading rule to curtail the “use of aggressive, destabilizing trading strategies in vulnerable market conditions, when they could most seriously exacerbate price volatility.”
- A rule to require high-frequency traders to register with regulators as dealers.
- A recommendation to improve firms’ risk management of trading algorithms and to enhance regulatory oversight over their use.
White also addressed the lack of transparency in dark pools and alternative exchanges. She emphasized that transparency has long been a hallmark of the U.S. securities markets and fully supported FINRA in its efforts to expand its trading volume disclosure regime to off-exchange market makers and other broker-dealers. The SEC is also considering whether its regulatory structure requires more fundamental changes to align with the market realities and technological advances over the last decade.
In this regard, the SEC appears to be commencing enforcement as well as regulation efforts in these areas. On June 6, the SEC brought two administrative proceedings:
• The SEC charged Wedbush Securities and two officials for allegedly violating Securities Exchange Act Rule 15c3-5 (the “market access rule”), and other regulatory requirements as a result of trading by its market access customers. The market access rule requires investment firms to have adequate risk controls in place before providing customers with access to the market. In Wedbush, the SEC alleges that Wedbush Securities, one of the largest firms by trading volume on NASDAQ, failed to maintain direct and exclusive control over settings in trading platforms used by its customers to send orders to the markets.
• The SEC also charged Liquidnet, a New York-based dark pool operator, with allegedly violating Section 17(a)(2) of the Securities Act of 1933, which prohibits obtaining money or property by means of materially false or misleading statements in the offer or sale of securities, and two other regulatory rules aimed at ensuring that alternative exchanges establish adequate safeguards and procedures for protecting confidential trading information of its subscribers. Liquidnet’s core business is operating a block-trading dark pool for large institutional investors, and the SEC specifically attacked Liquidnet’s inability to protect its subscribers’ confidential information. Rather than protecting its subscribers’ confidential trading information, according to the SEC, Liquidnet provided its employees access to the confidential information so the employees could market the company’s services. The employees used this confidential information and trading data to advise customers when to execute transactions and advise issuers about which institutional investors they should meet during conferences. In contrast to Wedbush’s decision to litigate, Liquidnet consented to the SEC’s order, without admitting or denying the findings, and agreed to pay a $2 million penalty and cease and desist from committing these violations.
These two most recent SEC administrative proceedings demonstrate the SEC’s willingness to regulate dark pools and investment firms’ risk management, and the Enforcement Director has suggested there will be additional enforcement actions in the coming weeks and months. However, neither the Wedbush nor Liquidnet actions were brought as a scienter-based fraud action. This is particularly noteworthy with respect to Wedbush, since it was brought as a litigated action (the SEC usually brings scienter-based charges in contested actions, if it can). The SEC’s charging decisions suggest both that the Commission and its enforcement staff may recognize the difficulty in proving fraud in this rapidly expanding and complex area of trading and their willingness to settle on non-fraud terms in appropriate cases.