By Sarah N. Lynch and John McCrank
WASHINGTON, Dec 18 (Reuters) - U.S. regulators and exchanges
are getting closer to a framework for a "kill switch" that could
be used to shut down trading before software glitches get out of
control and wreak havoc on markets, a top exchange official said
"We have all engaged in a much more detailed assessment of
how a kill switch could work," Joe Mecane, an executive vice
president at the New York Stock Exchange, said in testimony
before a U.S. Senate Banking panel on Tuesday.
"I think we are hopeful to have something to report in the
first quarter of next year," he said.
Exchanges, brokerages and the U.S. Securities and Exchange
Commission have been trying to come up with the right regulatory
response after a series of high-profile glitches this year shook
markets, from Nasdaq's botched handling of the Facebook initial
public offering to Knight Capital's $440 million in losses due
to a software error.
The kill switch idea is one of at least a dozen market
structure issues being considered by the SEC.
In concept it would allow the exchange, one of its members,
or both, to cancel all open orders and block new orders, either
by pushing a button or through an automated function, to limit
the damage in the event a trading malfunction is detected.
In early 2010, the agency launched a broad review that
includes an examination of the benefits and pitfalls of
high-frequency trading, and the increasing proliferation of dark
pools, venues that let investors anonymously trade large blocks
of stock and face less regulatory scrutiny than exchanges.
Changes in technology have forced exchanges to adapt to
compete with dark pools, leading regulators to more closely
scrutinize certain order types that some fear could give
fast-paced traders an edge. Brokerages, meanwhile, have also
cried foul, saying regulation is too skewed to favor exchanges
because it gives them a "quasi-governmental status" as
self-regulatory organizations (SROs).
Following the string of glitches earlier this year, Rhode
Island Senate Democrat Jack Reed announced he would hold a
series of market structure hearings to explore if new rules are
needed to ensure market fairness and reduce systemic risks that
runaway algorithms could pose.
"Part of what we want to do is make sure this issue is not
ignored," Reed told reporters on Tuesday after the hearing
"We are going to keep asking questions, both of the
regulators and the industry. And we're going to, if we feel
legislation is in order, propose it. If not, we'll continue to
keep the attention focused on this issue."
TOUGHEST ISSUES LIE AHEAD
Of all the issues for the SEC to tackle, the kill switch
proposal and the development of a comprehensive database
containing every trade order, execution and cancellation could
But some of the hardest, most controversial market structure
issues have yet to be addressed.
Those include whether or not the rules for exchanges and
dark pools should be harmonized.
Exchanges are required to undertake certain self-regulatory
responsibilities. Current regulations, for instance, require
them to notify the SEC and the public when they wish to change a
rule, or launch a new order type.
Dark pools and other brokerages, by contrast, are not put
under the same regulatory microscope.
At the same time, however, exchanges are granted certain
legal immunities thanks to their SRO status. That status has
since come into question following Nasdaq's botched handling of
Nasdaq has proposed a $62 million settlement to those
brokerages who lost money, but it is not enough to cover all of
the losses and has led some brokerages to grumble about the
immunity afforded to exchanges from civil liability.
"There has got to be consequence for a system-wide failure
of the type that we've experienced in the Facebook
circumstance," ITG Chief Executive Robert Gasser told the Senate
panel on Tuesday. ITG is an agency broker that offers trading
services, technology, analytics and research.
"Our clients suffered, other broker dealers suffered,
clearly there were some decisions that were made that were, with
all due respect, the wrong ones in terms of opening that stock."
NYSE's Mecane on Tuesday said that exchanges do not have
"blanket immunity," noting that such protections mostly pertain
to exchanges' listing functions.
However, he agreed that the SEC should more closely look at
the SRO model as part of a broader review - an issue that least
one SEC commissioner has publicly called for in recent months.
"We would encourage ... a holistic review of all of the
costs and benefits of being an SRO," Mecane said.
Exchange executives on Tuesday were also quick to point out
that being a self-regulatory organization also comes with
greater oversight, including an SEC review of all order types.
In April, Reuters reported that the SEC was broadly
reviewing numerous market structure issues. Part of that review
involves a closer look at order types to determine if they
create an unfair advantage for certain investors, or if the
exchanges are properly disclosing how their order types work.
Eric Noll, an executive vice president at Nasdaq, told
lawmakers on Tuesday that the exchange's order types "do not
provide advantages to certain users" and are put through a
"rigorous process" to get SEC approval.
"From my own experience around the SEC review of order types
and order-type introduction, we have withdrawn many more order
types at the suggestion of the SEC than we have had approved,"
Noll said. "They do not go unreviewed."
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