On Monday, November 2, 2015, Andrew Ceresney, Director of the SEC’s Division of Enforcement, gave a speech at the SIFMA Compliance & Legal Society New York Regional Seminar in which he sought to address what he views as the future of SEC enforcement and the existing risks created by technology and innovation in equity markets.1 Mr. Ceresney highlighted that, “[w]ith the passage of Regulation NMS in 2007, the increase in the number of exchanges and other trading venues, the automation of nearly all equity trading, and the emergence of high frequency and algorithmic trading, market structure issues—especially technology-related issues— have taken on increased prominence.”2
Gone are the days when the majority of trading was done on the New York Stock Exchange trading floor, and when the handful of exchanges and markets each were self-regulatory organizations themselves or had a SRO affiliate. Today’s modern markets employ technology to effectuate trades in microseconds. The automation of trading has led to faster trades, fewer shares per trade, and increased diversity in trading venues.3 “Competition for order flow among these trading venues is intense. Venues strive to show that they offer low-costs, liquidity, price improvement, and speed of execution. Much of that order flow now comes from high frequency trading firms. Typical estimates are that high frequency trading represents 50% or more of total market volume.”4 And most self-regulation is now out-sourced to FINRA, which can leverage its multiple-market regulatory experience.
As a result, the SEC has “brought a growing number of market structure enforcement cases in recent years.”5 Expecting this pattern to continue, Mr. Ceresney’s speech focuses on four key threats to the integrity of our modern equity markets: (1) “fairness in trading venues” and adherence to SEC rules; (2) “misuse of confidential customer order information”; (3) failure to adopt policies and procedures to comply with the Market Access Rule and protect against risks of so-called out-of-control automation; and (4) “high-volume manipulative trading.”6 The SEC has been focused on market structure issues from a regulatory and enforcement perspective for a number of years, as the collection of enforcement actions highlighted in Mr. Ceresney’s speech demonstrates. Packaging these cases together to make his point also foreshadows that this area will remain in sharp focus going forward.
The History of Market Structure Enforcement
Fair Trading Venues
Prior to 2012 “the SEC had never imposed a single civil penalty on a national stock exchange,”7 yet since 2012, nine exchanges have been involved in seven different enforcement settlements leading to millions in civil penalties.8 Enforcement actions have scrutinized operational issues at exchanges9 and information-sharing inequities that affect the integrity of the market.10 Additional concerns focus on the growth of dark pools11 and other Alternative Trading Systems (“ATSs”), which are not subject to the same rules as exchanges. For example, in a recent enforcement action UBS was required to pay $14 million in disgorgement and civil penalties for offering sub-penny trades (which violate Regulation NMS) to its dark pool customers.12 Mr. Ceresney stated, “[t]he takeaway from these cases is that the Commission will enforce its rules vigorously to ensure that trading venues operate fairly and that customers receive the accurate information they need to make trading decisions.”13
Another key issue and focus of SEC enforcement is what Mr. Ceresney referred to as “out-of-control automation.” Implemented in 2011, Rule 15c3-5, commonly known as the “market access rule,” requires brokers and dealers to maintain risk management controls and procedures to manage financial risk (to prevent erroneous orders or orders exceeding capital limits) and regulatory risk (to ensure compliance with rules both pre and post-trade).18 With five enforcement cases brought in the last two years, enforcement related to automated trading issues is a “particularly active area” as the SEC seeks to ensure that proper safeguards are in place on automated trading systems.19 Mr. Ceresney discussed the most notable enforcement action of this type, involving a computer malfunction at Knight Capital, wherein the SEC found that Knight Capital’s order router traded nearly 400 million shares in 45 minutes, acquiring billions of dollars in positions by mistake.20 While systems glitches involving erroneous orders are common, Mr. Ceresney also cited enforcement actions against Morgan Stanley and Latour Trading to make the point that safeguards must be bolstered by adherence to controls and adoption of procedures to modify those controls.21 In short, according to Mr. Ceresney, firms must have “safeguards in place that anticipate mistakes and limit the harm they can cause.”22
High Volume Manipulation
Finally, Mr. Ceresney expects that high-volume manipulative trading will continue to be a focus of SEC enforcement actions. Practices such as “marking the close,” described as placing trades near the close of trading to affect the trading price, and “layering” or “spoofing,” described generally as schemes where “the trader sends nonbona fide orders that he or she intends to cancel before they are executed in order to induce others to buy or sell securities at prices that no not represent actual supply and demand,”23 have been penalized.24 Although Mr. Ceresney noted that these cases can be challenging to bring due to the large volume of order and trade data required to be analyzed, he also noted that the SEC has the “expertise and resources” to do so through use of “innovative data analytics.”25
The Future of Market Structure Enforcement and Best Practices for Market Participants
In conclusion, Mr. Ceresney promised continued focus on the threats he identified. He noted that the SEC “will remain diligent in looking at various trading venues, including dark pools. . . . [and] continue to focus on market access [rule] violations.”26 Mr. Ceresney further added that “[w]e will be particularly interested in whether brokerdealers are fulfilling their obligations both for pre-trade regulatory requirements and also post-trade surveillance.” Finally, both the SEC and market participants must develop a greater understanding of “the technology that forms the backbone of our markets” which includes an understanding of “the computer codes that direct those systems.”27
Mr. Ceresney’s speech serves as a clear roadmap of the SEC’s outlook on the future of enforcement with regard to equity markets. While technology facilitates increased sophistication and innovation in equity markets, the SEC is committed to ensuring that market integrity is maintained. Market participants, and particularly broker-dealers who Mr. Ceresney describes as the “gateways and gatekeepers”28 to the markets, can protect themselves from enforcement actions by proactively reviewing their policies and procedures governing trading controls, surveillance and market access for compliance with the current regulatory scheme, and effectiveness.