Today's electronic market structure has raised serious questions and concerns:  the traditional specialist and market maker roles in manual markets have largely disappeared, and been replaced by proprietary trading firms that provide liquidity through the use of highly sophisticated trading systems capable of submitting many thousands of orders in a single second. 

These high frequency trading firms can generate more than a million trades in a single day and now represent more than 50% of equity market volume.  And many firms will generate 90 or more orders for each executed trade.  "Stated another way: a firm that trades one million times per day may submit 90 million or more orders that are cancelled." 

Many see important benefits of the current market structure - competition among trading venues, liquidity providers have lowered spreads, brokerage commissions that have never been lower.  On the flip side, some investors and others ask:  (i) whether the quality of price discovery has declined;  and, (ii) whether these changes in our market structure could undermine the fair and level playing field essential to investor protection, capital formation and vibrant capital markets generally.  

    Imposing Market Obligations on Proprietary Trading Firms.   In the past, specialists and market makers had best access to the markets, and therefore the greatest capacity to affect trading for good or for ill.  Today, professional trading firms have best access.  How do they differ?

In the old manual market structure, exchange specialists and market makers were subject to significant trading obligations that were designed to promote fair and orderly markets and fair treatment of investors - e.g., affirmative obligations to provide liquidity and to promote price continuity;  negative obligations to forego trading in ways that would exacerbate price moves (such as aggressively taking out bids during a price decline and thereby driving prices even lower).

Professional or proprietary trading firms are burdened with none of those obligations.  Notwithstanding the fact that they provide benefits to the markets, they are not registered as market makers, and some aren't even registered as broker-dealers.  This means they fall entirely outside the regime for regulated entities.  Which means they have no obligations to support the stability and fairness of the markets.  This was evidenced during the Flash Crash of May 6, when stocks with broken trades highlighted the fact that the order book liquidity in those stocks completely disappeared, if only briefly, and caused trades to occur at absurd prices.  Where, the SEC asks, were the high frequency trading firms that typically dominate liquidity provision in those stocks? 

Ms. Schapiro anticipates that the May 6 report will discuss the reasons that caused these firms to pull back, which they believed to be in their interest.  The ultimate issue, however, will be whether firms that effectively act as market makers during normal times should have any obligation to support the market in reasonable ways in tough times. 

    Reducing Large Volumes of Cancelled Trades.   High frequency trading firms submit large volumes of orders into the market - most of which are cancelled - 90% or more.  The SEC and other regulators are looking carefully at certain practices in this area to assess whether they violate existing rules against fraudulent or other improper behavior.  To do this properly, the SEC and others must understand the impact this activity has on price discovery, capital formation and the capital markets more generally, and consider whether additional steps such as registration and trading requirements are needed to ensure that these and other practices are used only in ways that foster - not undermine - fair and orderly markets.  For example, one step would be to require a minimum "time-in-force" for quotations, particularly if they were submitted by market participants who otherwise were not subject to meaningful obligations governing their quoting behavior.

For further details, click onto:   [ SEC Chairman Speech, 9/7 ]