The SEC recently charged the high-frequency trading firm Latour Trading LLC (“Latour”) for violating Securities Exchange Act (“Exchange Act”) rule 15c3-5 (the “Market Access Rule”) and Exchange Act rule 611(c) (the “Order Protection Rule”). In settling the matter, Latour agreed to pay approximately $8 million (comprised of a $5 million civil penalty, $2.8 million disgorgement amount, and $268,564 of pre-judgement interest). While much of the attention to this SEC order focused on issues arising from the finding that personnel of Latour’s affiliate, Tower Research (“Tower”), made code changes to Latour trading applications, we believe the specific findings related to filtering protected quotations based on in-flight and previously routed orders are perhaps the more interesting part of the SEC order. The specific findings included:
- Latour satisfied its obligation to route ISOs to certain market centers (CHX, NSX, and NYSE MKT) by sending directed orders through a conduit broker-dealer. A change to the common code base used by Latour’s trade application resulted in the loss of the market center direction instruction and prevented directed ISOs from reaching the intended market center. Additionally, because the change to the common code base was made by Tower employees rather than associated persons of Latour, Latour failed to maintain direct and exclusive control of the firm’s market-access controls.
- Latour’s trading application used logic to filter the protected size of a market center for the effect of its in-flight, canceled, or executed orders not yet manifested in market data received through proprietary data feeds. The SEC alleged that Latour’s use of the filtering logic was not a procedure reasonably designed to ensure compliance with the requirements applicable to use of ISOs under Rule 600(b)(30) because:
- Latour did not account for the possibility of an ISO executing against a better-priced, non-displayed order by implementing additional logic to cease filtering for a previously sent ISO once a fill report came back indicating that the ISO executed at a better price than reflected in the venue’s market data feed.
- Latour did not properly account for the replenishment of the reserve size of a protected quotation on three exchanges by ceasing to filter for a previously sent ISO when the exchange updated its market data feed with a quotation for the same size and price but with a new timestamp.
- Latour’s failsafe for filtering logic issues, a control that would limit the duration of the filtering logic to 1 second (and later revised to 50 milliseconds), was not implemented correctly as it only checked the age of a filtering decision after receiving a quote update rather than at the time of each ISO routing decision.
The SEC order does suggest a heightened risk of affiliated firms’ use of common infrastructure. Specifically, while firms are generally aware of the necessity to ensure exclusive control over the market access controls applied at the “gateway” level (generally credit/financial, erroneous order control, and certain regulatory risk controls), Latour highlights the risk that certain pre-trade regulatory risk controls are implemented in upstream applications that may not be as tightly controlled by the broker-dealer.
More noteworthy, however, are the allegations related to Latour’s use of filtering logic for previously sent ISOs. Filtering of protected quotations due to in-flight or canceled ISOs is a fairly common practice used to address latencies between market data feeds and a firm’s proprietary order information. The SEC is well aware of this issue and specifically endorsed the use of such filtering for no-fill and partially-filled ISOs in Reg. NMS FAQ 4.06. Firms have generally understood this practice to also be reasonable during the period in which an ISO is in-flight (i.e., after an order is sent but before an execution or cancelation report is received back from the exchange) or, in certain instances, when fully executed. Latour’s settlement highlights potential risks based on the design or methodology of filtering logic.
First, the order notes that “Latour failed to account for circumstances in which it sent an ISO to execute against a protected quotation but its order executed against a better-priced, non-displayed order (i.e., a hidden order) instead of the protected quotation. Such executions did not result in any changes to the protected quotations because the protected quotations had not been removed.” While not unexpected, the Latour settlement makes it clear that the SEC will not view a firm’s use of filtering logic as reasonable if it does not compare the price of the corresponding execution report to the pertinent protected quotation to ensure that it did not execute against better-priced, non-displayed liquidity.
Second, the order notes that “Latour failed to account for executions against protected quotations that were the initial displayed quantity of [an order associated with an additional reserve quantity]. So long as such an order has sufficient quantity in reserve, an execution will result in the protected quotation being immediately replenished at the same price and quantity. The exchange then sends data indicating that a new displayed protected quotation exists at the same price and quantity. In the quote snapshot assembled for a new ISO decision, such a replenished protected quotation will bear a new timestamp. However, for three exchanges, the servers used by Latour had not been programmed to recognize the replenishment of a reserve order.” Based on the description of Latour’s common code base in the order, the limitation of this issue to three exchanges, and the staff’s focus on the fact that “such a replenished protected quotation will bear a new timestamp,” it appears Latour may have attempted to account for this possibility but that three exchanges did not distinguish the replenishment for the original quotation in an expected way (such as using a unique quote identifier). While the precise facts of this allegation are unclear, firms should consider testing their capabilities for recognizing such quotation updates from each market center relative to their filtering logic.
Alternatively, the SEC could be implying that it does not believe filtering of any fully executed order is a reasonable policy or procedure due to the possibility of instantaneous replenishment of reserve size and the simultaneous routing requirement for additional ISOs under Rule 600(b)(30). While such a position would appear to be inconsistent with previous staff guidance, the order notes, “Latour did not fully address instances involving executions against reserve and non-displayed orders until August 2014, when the firm stopped relying in any circumstances on a fully-executed previously-sent ISO in subsequent ISO routing decisions.”
Lastly, the SEC’s assessment and calculation of a disgorgement amount for the alleged misconduct raises interesting questions for future Regulation NMS enforcement actions. The SEC appears to be attempting to use “gross trading profits” and “rebates” received in connection with the execution of non-compliant ISOs to calculate the unjust enrichment from an Order Protection Rule violation. While little detail is provided at how these figures were calculated, it appears to be the result of applying a per share profit estimate to each share executed as a result of a non-compliant ISO sweep. Failures to execute against better-priced protected liquidity result in increased trading costs to firms like Latour, and the SEC’s characterization of this activity as generating trading profits would appear controversial.