As we discussed in a recent briefing,1 on January 13th, the Securities and Exchange Commission (the “SEC” or the “Commission”) approved the issuance of a “concept release” concerning equity market structure, which was published on January 14th. The SEC seeks comment on a range of issues, including the performance of the current structure, high-frequency trading (“HFT”), and undisplayed (“dark”) liquidity,2 to determine the need for regulatory initiatives to improve market structure.


Section 11A of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), directs the SEC to facilitate creation of a national market system of electronically linked markets that provides efficient trade execution, fair competition, transparent quotation and transaction information, the ability to trade in the best market, and opportunities for trade executions without dealer participation. Congress believed that its objective would be advanced by linking markets through communication and data processing systems, thereby fostering efficiency, enhancing competition, and improving execution quality, while protecting investors and facilitating the raising of capital by issuers.

As the secondary market moved from manual to automated trading, it evolved into a complex market structure involving more than just orders being sent to an exchange floor. Today, trading is dispersed among highly automated competing trading centers. Technology generates, routes, and executes orders with ever-increasing speed, capacity, and sophistication of trading functionality. As a result, the New York Stock Exchange (“NYSE”), once the paradigm of the floor-based auction market and the dominant U.S. market center, is no longer preeminent. Instead, it competes with the Nasdaq Stock Market and other exchanges, alternative trading systems (“ATSs”), and foreign markets.

The SEC is conducting a comprehensive review of the current market structure to determine whether the rules have kept pace with technology and trading practices. The SEC seeks comments on a wide range of market structure issues, and data and analysis on the strengths and weaknesses of the current market structure. While the Release states that the SEC has not reached any final conclusions with respect to the issues presented, and will consider carefully all comments to determine whether there is a need for regulatory initiatives, there already have been rulemaking proposals focusing on issues such as eliminating flash orders and restricting certain practices relating to “dark pools.”3

The Concept Release describes the trading centers that compete for order flow in NMS stocks.4 These include exchanges; electronic communication networks (“ECNs”), a particular type of ATS that includes its best-priced orders in the consolidated quotation data and offers trading services analogousto those provided by registered exchanges; “dark pools,” ATSs that do not provide orders for inclusion in the consolidated quotation data and instead offer services to those seeking to execute trades in a manner that will minimize negative price movements and reduce costs; and broker-dealers that internally execute trades,5 acting as over-the-counter (“OTC”) market makers and block positioners. Because liquidity is dispersed among numerous trading centers, they must be linked. This includes systems to collect and distribute consolidated market information, both pre-trade (real-time best-priced quotation information, referred to as “consolidated quotation data”), and post-trade (real-time execution reports, referred to as “consolidated trade data”).  

According to the Release, broker-dealers play a significant role in linking trading centers, offering sophisticated technology to monitor liquidity and implement order routing strategies. Many provide algorithms to divide large orders into smaller ones for routing in accordance with a particular strategy, helping customers deal with dispersed liquidity and promoting efficient markets. Broker-dealers also have a duty of best execution, as well as a competitive reason to provide quality executions. Under current rules, exchanges must allow any qualified registered broker-dealer to become a member, assuring fair access to their services. An ATS must meet order display and access requirements only if it displays orders to more than one person in the ATS and it exceeds a 5 percent trading volume threshold. The SEC is considering lowering that threshold to 0.25 percent.  

Request For Comments

The SEC is seeking comments, focusing primarily on three broad categories: (1) the performance of the current market structure, (2) HFT, and (3) undisplayed liquidity. The SEC also is interested in comments on other aspects of the equity market structure, and says that the discussion in the Release “should not be construed as in any way limiting the scope of comments that will be considered.”6  

A. Market Structure Performance

The SEC requests comments on how the current market structure performs its economic functions, focusing on long-term investors who provide capital and accept the risk of owning companies for an extended period of time. Conversely, professional traders generally establish and liquidate positions in shorter time frames and have different interests. Many like short-term volatility because it offers greater trading opportunities. Nevertheless, the actions of professional traders can benefit long-term investors by narrowing spreads and improving prices. The SEC requests comment on the interests of long-term investors and short-term traders, and how market structure affects them, including:

  • When an investor should be considered a “long-term investor” and when the distinctions between long-term investors and short-term traders becomes unclear.  
  • Assuming that improved market liquidity and depth are good for long-term investors, ways in which to promote it.  
  • Whether the current market is so dispersed and complex that only large institutions can afford to use their own sophisticated trading tools, and whether the high cost of trading tools such as smart routing and algorithmic trading makes them effectively inaccessible for smaller firms.  
  • Whether it is necessary or economically feasible for longterm investors to expend resources on the fastest, most sophisticated systems and, if not, whether the fact that professional traders are always likely to trade faster makes the equity markets fundamentally unfair.  
  • Whether disparities in speed are significant to the interests of long-term investors.  
  • The appropriate standards for assessing fairness of the equity markets; whether Rules 605 and 606 under Regulation NMS, which provide statistics on order routing and execution, are useful for investors and whether they need to be updated; and whether there are useful metrics for assessing the quality of price discovery.  
  • Ways to improve transparency of order routing and execution practices.  

With respect to corporate equities, the SEC is interested in how market structure impacts issuers at different capitalization levels and whether it supports capital raising for smaller companies.  

B. High Frequency Trading  

The SEC’s second area of inquiry involves HFT, a term that, according to the Concept Release, “is relatively new and is not yet clearly defined.” As the Concept Release points out, HFT generally refers to strategies employed by professional traders such as proprietary trading firms (which may or may not be registered broker-dealers), broker-dealer proprietary trading desks, and hedge funds (referred to collectively as “proprietary firms”), which generate large numbers of proprietary trades on a daily basis. High frequency traders employ: (1) sophisticated computer programs to generate, route, and execute orders; (2) colocation services and individual data feeds from exchanges and other sources to minimize latency;7 (3) very short time-frames in which they establish and liquidate positions; and (4) numerous orders that are cancelled shortly after submission. They generally don’t carry significant unhedged positions overnight. According to the Concept Release, estimates place HFT volume in the equity markets at or above 50 percent of total volume. The Release states that the types of firms engaged in professional trading, and the strategies that they employ, vary considerably, and that the lack of a single, clear definition of HFT complicates the analysis of market structure issues.

1. Trading Strategies.

The Concept Release requests comments on HFT strategies, including:

The most frequently used strategies, key features of each, technology and other market structure components necessary to implement each strategy, and whether any such strategies are a response to particular market structure components, problems, or challenges.  

Whether implementation of a specific strategy benefits or harms market structure performance and the interests of long-term investors; whether it is possible to reliably identify harmful strategies through metrics such as adding or taking liquidity, or trading with or against prevailing price movements; and whether harmful strategies are sufficiently widespread to warrant regulatory initiatives to address them and, if so, the types of initiatives that would be most effective, but with minimal impact on beneficial strategies.  

The Concept Release notes that, in some trading centers, certain strategies have replaced specialists and market makers. However, specialists and market makers have obligations, such as displaying continuous two-sided quotations, that do not apply to firms using these strategies. The SEC requests comments on whether market quality has improved or suffered from this development, including the importance of specialist and market maker obligations to market quality, whether those obligations are more important for particular types of equities or particular periods, whether proprietary firms increase or reduce the liquidity that they provide during times of stress, and whether they should be subject to obligations that promote market quality and prevent harmful conduct. The SEC also requests comments on four specific types of trading strategies:  

a) Passive Market Making. Passive market making involves submitting non-marketable resting orders (bids and offers) at specified prices. According to the Release, although passive market makers may take liquidity from the market if necessary to liquidate a position, their primary profit sources are the “spread,” i.e., buying at the bid and selling at the offer, and monetary rebates that trading centers offer for orders that supply liquidity (“liquidity rebates”). Firms placing multiple bids and offers at different prices and sizes can generate a large volume of orders, most of which are cancelled within one second. The SEC requests comments including:

The extent to which proprietary firms engage in such strategies and whether they provide valuable liquidity for stocks of various capitalization levels.  

Whether market quality is improving or worsening as proprietary firms replace traditional liquidity providers, and the most useful data for assessing the quality of this liquidity.  

Whether the very brief duration of proprietary firm orders significantly detract from the quality of liquidity, or whether the collective liquidity provided by many proprietary firms engaging in passive market making results in a relatively stable quoted market.  

Whether liquidity rebates are unfair to long-term investors because they go primarily to proprietary firms engaged in passive market making, and whether liquidity rebates reward trading that does not benefit long-term investors or market quality.  

The effects of consolidated market data revenues on current trading center pricing, and whether there would be any benefits to revising this structure.  

b) Arbitrage. Arbitrage seeks to capture pricing inefficiencies between related products or markets (e.g., between the price of an ETF and the underlying basket of stocks) by buying one and selling the other simultaneously to capture price differences. Unlike passive market making, which generally adds liquidity to the market, arbitrage takes liquidity. The SEC seeks comments on whether arbitrage benefits or harms long-term investors and market quality in general, including:

The impact of arbitrage on volume and trading patterns, and whether that impact has been positive or negative for longterm investors and overall market quality.  

The extent to which arbitrage strategies focus on price differences among trading centers, whether such strategies depend significantly on latencies in data feeds, and the effect on long-term investors and market structure quality.  

c) Strategies Relating to Structural Issues. The Release explains that certain strategies exploit structural vulnerabilities in the market or in certain market participants. The Release asks whether proprietary firms can profitably exploit these vulnerabilities, the extent to which they engage in such strategies, and the effect on market quality.

d) Directional Strategies. Certain short-term strategies anticipate intra-day directional price movements, such as determining that a stock’s price has temporarily moved away from its “fundamental value” and establishing a position in anticipation that it will return. Such strategies may contribute to price discovery. The SEC requests comment on two types of strategies:

Order Anticipation Strategies. One strategy involves proprietary firms ascertaining the existence of large buyers or sellers and trading ahead of their orders to capture resulting price movements, indifferent to whether the other party is a buyer or seller.8 The buyer or seller can be harmed if the proprietary firm takes liquidity by trading in front of that buyer or seller. The SEC requests comments relating to such trading, including:

Whether the current market structure and sophisticated, high-speed trading tools enable proprietary firms to engage in order anticipation strategies on a greater scale than in the past, or whether the widespread use of high-speed trading tools by proprietary firms and institutions limits the ability of market participants to engage in profitable strategies.  

Whether order anticipation significantly detracts from market quality and harms institutional investors, such as by transferring wealth from investors to proprietary firms.  

Whether there are regulatory tools to address concerns about order anticipation without interfering with strategies that benefit long-term investors and market quality.  

Momentum Ignition Strategies. Another strategy involves rapid submission and cancellation of numerous orders, and execution of some trades, which can trigger other firms’ algorithms to buy or sell more aggressively and ignite a rapid price move. While manipulating the market (including placing orders solely to artificially move the price of a stock) is prohibited, the SEC is focused on whether additional regulatory tools are needed to address these strategies and any other practices associated with them. The Release thus requests comment on the extent of momentum ignition strategies, whether they present a significant problem, and whether they have become more problematic over time; whether there are objective indicia to reliably identify problematic strategies; and whether there are additional regulatory tools that could eliminate problematic strategies with minimal impact on beneficial ones.

2. Trading Tools.

The Concept Release also focuses on two important tools used by proprietary firms to implement short-term trading strategies.

a) Co-Location. Many proprietary firm strategies are highly dependent upon the speed with which they receive market data, the speed of their trading engines’ processing, the speed at which their servers can access trading center servers, and the speed of order execution and response by trading centers. Co-location is provided by trading centers that operate their own data centers, and by third parties that host the matching engines of trading centers. Market participants rent server space at trading centers, or at unregulated third-party locations, in close proximity to the trading center’s matching engine, reducing the time for data to move between the servers. The SEC is seeking comment on colocation and whether it benefits or harms long-term investors and market quality, including:

Whether co-location services give proprietary firms an unfair advantage because they have greater resources and are better able to access them; whether co-location offers benefits to long-term investors, such as enabling liquidity providers to be more efficient and improve the quality of liquidity that they provide; and whether it is fair that some market participants pay for better market access than can be obtained generally.  

Whether co-location fees are so high that they create a barrier for smaller firms, whether brokers are able to obtain co-location services on behalf of customers, whether longterm investors are harmed by being unable to use direct co-location, and whether there should be requirements that all market participants purchasing co-location services are treated in a non-discriminatory manner.

Whether co-location differs from other ways to obtain latency advantages, particularly if it is available to all on fair and reasonable terms, and whether it is possible for trading centers to guarantee equal latency for all market participants using comparable services.

Whether the SEC should prohibit or restrict trading centers from offering co-location, and whether that would lead to third parties outside the SEC’s regulatory authority obtaining space close to an exchange’s data center and renting such space to market participants.  

Whether unregulated third-party data centers at which exchanges and other trading centers place their trading engines create competitive disadvantages, whether they should be considered facilities of the exchange or trading center, and whether the exchanges and trading centers that use them should be required to obtain contractual commitments from them on terms consistent with the Exchange Act and SEC rules.  

Whether the SEC should require disclosure about speed of access to trading centers, the information that should be disclosed, and the manner of disclosure.  

Whether market participants using co-location services should be subject to any obligations with respect to their activities, similar to those applied to exchange specialists that enjoy time and place advantages by being on the floor of an exchange.  

b) Trading Center Data Feeds. Another important trading tool is the direct data feeds offered by exchanges and ECNs. While the consolidated data includes best-priced quotations of all exchanges and certain ATSs, and all reported trades, the separate data feeds of exchanges and ECNs generally include only their own quotations and trades, and may include inferior-priced orders as well. The SEC currently does not require exchanges, ATSs, and other broker-dealers to delay individual data feeds to synchronize with distribution of consolidated data; it prohibits them only from independently transmitting their own data before they transmit it to the consolidated plan processors. Thus, information in the exchange and ECN data feeds generally reaches paying market participants faster than that information reaches those relying on the consolidated data feed. The SEC requests comment on the latency between consolidated data feeds and individual trading center data feeds, including:

The degree of latency between trading center and consolidated data, and whether plan processor systems could be improved to significantly reduce such latency.  

Whether the latency or disparity in information is fair to those relying on consolidated data, whether trading center data should be delayed to assure that consolidated data reaches users first, and whether such a delay would detract from efficiency and harm long-term investors and market quality.  

Whether odd-lots should be included in consolidated trade data.

3. Systemic Risks.

In addition to the strategies and tools used by proprietary traders, the SEC questions whether HFT poses significant risks to the equity market structure, for example:

Whether the high speed and enormous message traffic of ATSs threaten operational integrity.

Whether, if a number of proprietary firms engage in similar or connected strategies that generate significant losses at the same time, it could cause those firms to become financially distressed, lead to large market price fluctuations and, to the extent that such firms are financed by other financial institutions, widespread financial distress.

Whether proprietary traders promote market integrity by providing a source of liquidity.

The Concept Release also notes that equity markets performed well during the 2008 financial crisis (although many investors lost money), and continue to operate smoothly. The SEC asks whether this shows that systemic risk has been minimized or, if not, what steps should be considered.

C. Undisplayed Liquidity

The SEC’s third area of inquiry involves undisplayed (“dark”) liquidity -- trading interest that is available for execution at a trading center but is not included in consolidated quotation data. Market participants looking to trade in large size have long faced the problem that if they prematurely reveal the full extent of their trading interest, market prices will move in a manner detrimental to their orders, but if they take no steps to indicate their interest, they may not find the other side. Finding effective ways to trade large size with lower transaction costs is a constant challenge for institutional investors, their brokers, and the trading centers that seek to execute their orders. Dark liquidity was traditionally provided on exchange floors, where floor brokers “worked” large orders by executing them in smaller transactions without revealing total order size. With the decline in NYSE market share, much of this undisplayed liquidity pool migrated to other venues, most recently to dark pools. Other sources of undisplayed liquidity are broker-dealers that internalize orders, and undisplayed order types provided by exchanges and ECNs. The SEC requests comment on all forms of undisplayed liquidity in the current market structure, particularly with respect to three issues:

1. Order Execution Quality.

According to the Release, a significant percentage of individual investor orders are executed by OTC market makers, and a significant percentage of institutional investor orders are executed in dark pools. The SEC is requesting comment on whether dark pools and market makers offer sufficient execution quality advantages to long-term investors to justify diverting orders from displayed markets. In additional the SEC seeks comment on:

  • Whether trading behavior would change if undisplayed liquidity were limited, and the types of activity that might evolve to replace such undisplayed liquidity.
  • Whether institutional investors could adjust, without incurring higher transaction costs, if undisplayed liquidity at dark pools and broker-dealers were limited.
  • The advantages and disadvantages of the different forms of dark liquidity, whether execution quality varies across different types of dark pools and, if so, whether this difference depends on the characteristics of particular securities.
  • Whether investor orders receive quality executions when routed to OTC market makers, and whether market makers charge access fees comparable to those charged by public markets.
  • Whether reference to displayed public market prices by dark pools creates opportunities for institutional investors to be treated unfairly and, if so, the extent to which this occurs.
  • Whether payment for order flow detracts from execution quality for investor orders.
  • Whether a significant number of individual investor orders are executed in dark pools and, if so, the quality of execution.

2. Public Price Discovery.

The SEC asks questions regarding whether the volume of undisplayed liquidity is great enough to detract from the quality of price discovery and executions, as well as:

  • Whether undisplayed liquidity has led to increased spreads, reduced depth, or increased short-term volatility and, if so, whether this has damaged execution quality.
  • Whether an increased number of long-term investor orders are executed in dark trading centers and, if so, whether it benefits or harms long-term investors and market quality.
  • Whether exchange and ECN undisplayed order types raise similar price discovery concerns.
  • Whether, if the quality of public price discovery has been harmed by undisplayed liquidity, there are regulatory tools that should be considere.
  • Whether there should be a “trade-at” rule prohibiting trading centers from executing trades at the national best bid or offer unless the trading center displayed that price when it received the incoming contra order, whether that would prevent order flow from moving to undisplayed trading centers and, if so, the extent to which increased order flow to displayed trading centers could provide incentives to display quotes in greater size or with better prices.
  • Whether Rule 611 of Regulation NMS, which provides “trade-through” protection to the best-priced quotations of a trading center, should protect displayed “depth-of-book” quotations.
  • Whether the larger spreads in low-price stocks leads to greater internalization by OTC market makers or more trading volume in dark pools, and whether the SEC should consider reducing the minimum pricing increment for lower priced stocks.

3. Fair Access and ATSs Regulation.

The SEC requests comment on whether appropriate regulatory requirements apply to trading centers offering dark liquidity and whether the 5 percent of trading volume threshold for fair access to ATSs should be lowered. The SEC also asks whether dark pools could comply with a fair access requirement and continue to permit large trades with minimal price impact, and whether dark pool restrictions to prevent predatory trading behavior can be drafted objectively. The SEC also asks:

  • Whether a broker-dealer’s dark pool could apply fair access standards to prevent predatory trading without using those standards to discriminate based on the broker-dealer’s self interest.
  • Whether investors have sufficient information about dark pools to make informed decisions about whether they should seek access to them.
  • Whether dark pools should be required to improve the transparency of their services and the nature of their participants and, if so, the appropriate disclosure and how to provide it.
  • Whether ATS regulation should be enhanced for dark pools and whether to modify Regulation ATS to appropriately reflect current market structure.

General Request for Comments

Finally, the SEC encourages comments on any aspect of the current equity market structure, noting that while the Release was intended to present particular issues, it was not intended to limit the scope of comments or issues that will be considered. All comments should be received on or before April 21, 2010.