Last May, Nasdaq OMX proposed offering benchmark orders that would seek to achieve the performance of a specific yardstick such as volume weighted average price (VWAP), time weighted average price (TWAP) and percent of volume (POV). After reviewing the proposal in August and receiving comment letters protesting the benchmark order type, the SEC extended the time frame into November, and released its decision on Jan. 11.
A problem seemed to arise because Nasdaq planned to “direct the benchmark orders to a system application that is licensed from a third-party provider and dedicated to processing benchmark orders,” according to the SEC order disapproving Nasdaq’s proposal. The child orders would be generated by the third party application according to member’s instructions. The child orders would be sent to the Nasdaq matching engine or the Nasdaq router to be executed in accordance with the benchmark.
The SEC said the exchange failed to show how the “child” orders would go through pre-trade risk controls as required by the Market Access Rule (15c3-5).
From the SEC’s Order:
The Commission expressed concern as to whether Child Orders, which would be generated soley by the Application and presumably outside the control and supervision of the broker-dealer firm that entered the initial Benchmark Order, would be subject to adequate pre-trade risk chcecks, and noted that Nasdaq’s proposal did not indicate how or whether pre-trade controls would be applied to Child Orders generated by the Application.
The refusal to grant permission to Nasdaq is said to be the first time that the SEC has denied permission for an exchange to release a new order type. Some market watchers have criticized the regulator for granting carte blanche approval to exchange order types.
The move to prevent Nasdaq from introducing an algorithm also comes at a time when regulators are concerned about complex order types. Critics have charged that exchanges have created order types that to help high frequency trading shops get a better price at the expense of ordinary investors.
Nasdaq’s move would also put the global exchange operator in conflict with broker-dealers that offer similar algorithmic strategies to institutional customers. The SEC’s order states that the rules of a national securities exchange are to be designed to “remove impediments to and perfect the mechanisms of a free and open market and a national market system, to protect investors and the public interest, and not to permit unfair discrimination between customers, issuers, brokers, or dealers.”
Another bone of contention raised by the brokers’ trade association group, the Securities Industry Financial Markets Association, is that as a self- regulatory organization (SRO), Nasdaq is not subject to all of the requirements of the Market Access Rule when they offer similar algorithmic trading services.
SIFMA suggested to the SEC that the algorithmic functionality is not part of Nasdaq’s role as a market regulator, but rather is a commercial offering of the exchange. SIFMA questioned whether it’s appropriate for Nasdaq, as a national securities exchange, to offer that functionality. Furthermore, SIFMA points out that Nasdaq’s algo offering would create regulatory disparities that would give it an advantage over broker-dealers providing the same services.
The concern is that if an order would misfire and rattle the markets, causing a liability along the lines of the Facebook IPO that Nasdaq could invoke what’s known as a shield of immunity. SIFMA argued that “Nasdaq could enjoy immunity from liability that is not available to broker dealers providing identical services,” wrote the SEC in its order. The issue of whether or not exchanges should continue to be SROs has flared up in the wake of the Facebook IPO, when some brokers complained that Nasdaq was trying to use its SRO status to avoid liability. At a recent hearing in Washington, Credit Suisse’s head of US equity trading, Dan Mathisson, testified about conflicts of interest in the current SRO model and suggested that those responsibilities should be transferred to an independent entity such as FINRA or the SEC.
Meanwhile, the SEC concluded that Nasdaq did not respond to concerns raised by SIFMA “with any substantive analysis on whether regulatory immunity or exchange rules limiting liability” regarding the novel benchmark order type, traditionally offered by brokers “would impose an undue burden on competition.”
But perhaps at the heart of the SEC’s ruling is the question of what business should a national securities exchange be engaged in?
While the main role of an exchange is to operate a liquid marketplace where traders can buy and sell securities, expanding into algorithmic trading services would seem to be a new commercial offering. Even though Nasdaq said the order type was similar to other functions including order types that process member trading interest and said it would not give the exchange an inappropriate advantage over brokers, ultimately the SEC was not satisfied.