SEC rule could push trading costs higher

The Securities and Exchange Commission's latest salvo in the war against market instability could mean higher trading fees for money managers and some smaller equity trading venues curtailing operations or shutting down completely.

The SEC's Regulation Systems Compliance and Integrity, or Reg SCI, would require all trading venues — exchanges, automated trading systems and dark pools — to submit alternative plans for operations in the event of a system breakdown. It also would require regular testing by the venues to ensure those alternative plans would work.

Now, those emergency systems are not required by the SEC.

The agency is expected to release a final proposal for the regulation this month with a final vote by commissioners in October.

“The exchanges will have to pay for the testing, and that will be passed on to the execution firms, the brokers,” said Christopher Nagy, founder and CEO of market structure research firm KOR Group LLC, Omaha, Neb. “And there will be significant costs. It'll raise the bar for cost to entry, and certainly could and likely will reduce the number of (automated trading systems) and smaller brokerage firms. More ATS independents will have much more trouble from a cost perspective.”

“This is another level of insurance, and someone will have to pay for it,” said Henry Yegerman, director of trading analytics and research at financial data provider Markit Group Ltd., New York. “Initially the sell side (venue operators, for example) will pay, but the question is, will this be extended eventually to the buy side and the original asset owner. The sell side is already financially stressed by regulations.

“Trading is the cash register by which the buy side pays for research,” Mr. Yegerman added. “This new added cost will go to the traders, who'll pass it on to the buy side.”

The SEC in its proposal said the estimated initial cost for organizations subject to the Reg SCI would be up to a collective $242 million, with another $191 million in annual costs.

Kevin McPartland, head of market structure, Greenwich Associates, Darien, Conn., said he doesn't think the cost of Reg SCI compliance will be onerous. “I don't think it'll be cost-prohibitive,” he said.

But Sudhanshu Arya, managing director, global development head of electronic brokerage at dark pool operator Investment Technology Group, New York, said the cost to his firm would be higher than what the SEC estimates because of ongoing changes to system backups. He said ITG officials made their feelings known to the SEC during the comment period that ended in July 2013.

“The cost is not just monetary,” said Mr. Arya. “It's other costs of development and compliance. Under the regulations as written, any system change would need the SEC's OK. We told the SEC that if every SCI entity submitted their plans for upgrades and changes with the SEC, it would put them in a very odd spot with a lot of proposals to approve.”

He added: “Also, as written, the regulation would require us to notify the SEC every time a semblance of an outage was noted, which could mean SCI-regulated systems would be bombarding the SEC with false alarms. We agree notification is needed, but there should be some threshold set by the industry.”

A preliminary SEC requirement would be that exchanges submit outage details when they happen, compile the data for six months, and enable the SEC to base new SCI regulations on that information based on actual market occurrences.

“We think that's too overarchingly wide,” Mr. Arya said. “The regulation should really pertain to things core to the trading operation, like the routing systems.”

If the cost of complying with Reg SCI is passed on eventually to money managers, smaller firms will feel the pinch more, said Michael T. Lee, CEO, president and chief investment officer at RBC Global Asset Management (U.S.) Inc., Minneapolis.

“I couldn't see us passing on the cost of this to our customers. If I were a smaller player, I could see it having a greater impact and they might have to pass that cost on to their clients.” The firm had $45.2 billion in assets under management as of June 30.

Despite the cost issues, “disclosure in general is a very positive thing,” Mr. Lee said. “We talk to our clients about due diligence all the time. In most cases, trading has become a major point of interest to them.”

KOR Group's Mr. Nagy called Reg SCI “a Sisyphean task. It's a good goal, but it won't keep system failures from happening. It looks to address rules and testing procedures, protocols and oversight, but these things will have to be undertaken by the exchanges themselves.”

SCI also highlights the SEC's approach to dealing with issues, Mr. Nagy added.

“The U.S. is very unique in how rules are set for market structure,” he said. “Those rules go back to 1933-'34, and most of those rules are still in force and expanded. That gets to the whole complexity issue. What they're doing is creating further complexity by adding regulations to an already complex system. This just makes the buy-side traders' job that much more difficult. ... The SEC needs to make things more simplified, rather than add to the complexity.”