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SEC Split on Including Brokerages in Trading Safeguards

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U.S. rules meant to guard against breakdowns in automated trading systems should be expanded to include brokerages that match orders away from regulated stock exchanges, two Securities and Exchange Commission members say.

Luis A. Aguilar and Kara M. Stein, both Democrats, have called on SEC Chair Mary Jo White to apply the new requirements to wholesalers such as Citadel Securities LLC and KCG Holdings Inc., which collectively execute as much as 19 percent of shares traded. Brokerages have lobbied to stay outside the reach of the Regulation SCI measures, saying failure of any one broker’s systems won’t disrupt trading beyond its own platforms.

The proposal, passed in March 2013, seeks to limit technology breakdowns at venues handling stock, option and bond trades. It would require coordinated tests to show exchanges can recover from natural disasters or terrorist acts, and regular reviews of backup systems. Trading venues would have to show their systems meet minimum capacity, security and resiliency standards issued by the U.S. Department of Commerce.

“I have not heard from the staff any persuasive arguments as to why internalizers don’t pose the same kind of risk to the market that exchanges do,” Aguilar said in an interview. “As such, the commission should give serious consideration to including internalizers in the adoption of Regulation SCI.”

Supporters of extending the requirements to brokers cite the failures of Knight Capital Group Inc., an automated trading firm that lost $450 million and almost went bankrupt after a software error in August 2012 caused it to enter millions of faulty trades in less than an hour. The errant orders caused dozens of stocks to swing as much as 151 percent.

Republican Opposition

It’s unclear whether the push by Aguilar and Stein will lead to brokerages being included. The agency’s two Republican commissioners are likely to oppose any expansion of the rules, according to a person with knowledge of their thinking, and White’s views on the changes couldn’t be learned. Gina Talamona, an SEC spokeswoman, declined to comment.

The SEC’s work on Regulation SCI began after the stock market tumult of May 6, 2010, when the Dow Jones Industrial Average suddenly dropped 9.2 percent before quickly recovering. White cited the need to finish the rules in August 2013 after a price feed operated by Nasdaq OMX Group Inc. crashed, forcing a three-hour trading halt in Nasdaq stocks.

The requirements would cover systems that control trading, market data and surveillance. The plan also calls for security requirements for secondary systems that, if breached, could allow a hacker to access an exchange’s core systems.

Regulators last year proposed applying the requirements to about 10 electronic trading venues that match stock buyers and sellers, including dark pools operated by Credit Suisse Group AG and UBS AG.

‘Serious Consequences’

The New York Stock Exchange, now owned by Intercontinental Exchange Inc., lobbied the SEC to extend the rules to so-called internalizers, brokers such as KCG and Citadel that fill orders without sending them to exchanges or dark pools. The SEC’s 2013 proposal said failures or intrusions of broker systems could create confusion in the broader market as investors struggled to grasp the extent of pricing errors.

“The real case for applying it to internalizers is they are such an important feature in the market that if they have a serious technology issue, it could have serious consequences for liquidity and stability,” said James J. Angel, a finance professor at Georgetown University’s McDonough School of Business.

Brokers have maintained that their technology failures rarely impact the broader market. They also say a rule adopted in 2010 already requires them to guard against erroneous orders.

Planned Vote

The SEC also is studying whether extending the rules to brokers would require issuing a new proposal, instead of voting on a final measure this week, as was initially planned, the people said. A reproposal could be necessary to give the brokerage industry more time to comment on the changes.

Aguilar has sought other changes, such as requiring an executive to certify compliance with Regulation SCI. He and Stein also want the rules to include a requirement to have an outside party periodically test for compliance, the people said.

Daniel M. Gallagher and Michael S. Piwowar, the two Republicans on the five-member commission, are unlikely to vote for a plan that adds requirements or covers more brokers, according to a person familiar with the matter who asked to not be named because the conversations are private. In a speech last year, Gallagher indicated that he opposes many of the provisions being pushed by Aguilar.

“There were features that some wanted to see, such as annual CEO certification and annual third-party audits of systems compliance, that would have been so incredibly burdensome, so useless for us and for the regulated community,” Gallagher said at an October 2013 forum sponsored by the Securities Industry and Financial Markets Association.

Check out SEC’s Gallagher Warns of Bond Bubble on ThinkAdvisor.


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