Trading problems sparking calls for closer oversight of exchanges

A spate of recent glitches in trading markets is putting pressure on federal regulators to step in, and on institutional money managers to pay more attention to market infrastructure.

After the latest incident Aug. 22, when Nasdaq suffered a three-hour trading halt, Securities and Exchange Commission Chairwoman Mary Jo White wasted no time in calling for a Sept. 12 meeting of exchange officials and major market participants such as self-regulatory organizations and alternate trading firms to consider next steps.

The Nasdaq incident, while resolved within the day, “should reinforce our collective commitment to addressing technology vulnerabilities of exchanges. The commission is determined to enhance the safeguards,” Ms. White said in an Aug. 22 statement. She also vowed to speed up proposed rules to address the markets' operational risks, including technological failures, natural disasters and cyberattacks.

The agency is also in the midst of a review to see if its rules have kept pace with trading technology and practices such as high-frequency trading and dark pools.

Some pension fund officials and their managers hope to be included in the overall review. “We feel that (the SEC) should include public and corporate pension funds in the discussion since they are the largest group of asset owners, and larger plans manage equities internally,” said Schorr Johnson, spokesman for the $80 billion North Carolina Retirement Systems, Raleigh.

”Institutional investors should be part of the conversation,” said Verne Sedlacek, president and CEO of Commonfund, Wilton, Conn., and a member of NYSE Euronext's Pension Managers Advisory Committee.

“We've gotten what we wanted — faster execution and less cost — but now we don't like it. The institutional market did not recognize the hidden costs. There is no way we can undo it, so how do you deal with it in the new environment?

“I tell our clients to be prepared for volatility. Volatility for institutional investors isn't necessarily bad” unless it scares retail investors enough to affect the market, said Mr. Sedlacek.

Jason Lenzo, director of global equity and fixed income trading at Russell Investments, Seattle, said he gets asked about market structures “quite frequently” by pension fund clients, and stressed the need to “ensure that there is a good risk management process in place.”

The chief investment officer of an $11.5 billion pension fund who declined to be identified does reach out to his equity managers' traders to try to understand how the exchanges are evolving. While price discovery has gotten better, the Nasdaq incident “reminds me that the increasing complexity and speed of the markets make it more brittle. It is not unambiguously beneficial to the big institutional investors that are going to be in it over the long haul. High-speed traders are eating somebody's lunch. For someone with $6 billion in equities, it's a concern,” said the CIO.

While no one is talking about avoiding exchanges, money managers are hopeful the SEC can make them safer before they become a bigger problem.

“The migration of trading to an instantaneous, fully automated process, while necessary and important, may reveal weaknesses in functionality,” said Tim Barron, CIO of investment consultant Segal Rogerscasey, Darien, Conn. But for now, he gives credit to the exchanges. “(They) are expected to operate on a fully seamless, zero-error standard and for the most part they have accomplished that,” he said.

Andrew Hogg, vice president for investment solutions at Segal Rogerscasey, credits U.S. exchanges for doing a good job with straight-through processing and helping money managers calculate if they've gotten best execution. “It's gotten better in terms of monitoring,” said Mr. Hogg, who also credits exchanges for instituting curbs on securities lending and short trading by hedge funds and others.

But Mr. Hogg and others worry about what might happen as exchanges are pressured to shorten settlement periods, which would increase the volume of trades. “You create quicker liquidity (but) the big issue that I have there is, what would be the downside to that? Could you see a lot more fail?” asked Mr. Hogg.

Mr. Sedlacek of Commonfund thinks that an important first step is looking at how much of that liquidity is real, vs. “fake” seconds-long activity by high-frequency traders who “have no responsibilities to create orderly markets.”

“We can't go back, but what we can do is try to put in the trading slowdowns” and possibly a tax on trades under 60 seconds. “There probably has to be a higher cost to execution,” said Mr. Sedlacek. “If you penalize those transactions that are not (real) it may help to stabilize the market.“

Michael O'Brien, vice president and director of global trading for Eaton Vance Management in Boston, pointed to other glitches in August, including outages at BATS Global Markets and the Deutsche Bourse's Eurex trading platform, plus a flood of erroneous options orders from Goldman Sachs Group Inc. “How fast these are all happening is a concern to me. I'm a lot more worried than I was a week ago.”

While a lot of their attention is on technological changes in the markets, SEC officials are still focusing on the human element in market failures. In May, when the SEC announced that Nasdaq would pay $10 million to settle charges over delayed handling of Facebook Inc.'s 2012 initial public offering, Daniel Hawke, chief of the SEC enforcement division's market abuse unit, took aim at both system weaknesses and Nasdaq's approach to them.

“Too often in today's markets, systems disruptions are written off as mere technical "glitches' when it's the design of the systems and the response of exchange officials that cause us the most concern,” he said.

One major shortcoming, said Mr. Lenzo of Russell, “is that the technology has not been invested (in) to the extent that it needs to be.”

He sees some pressure to improve market structure issues coming from his peers and from clients but thinks the issue also calls for regulatory solutions.

Mr. Lenzo acknowledged “it's challenging to think that you're going to cover everything,” but believes all market participants should be scrutinized. “It's highly unlikely that it is a single segment (causing the problems). The burden of proof needs to be on those participants to prove how they are interacting in the market.”