Why The SEC Is Irreperably Conflicted On The Issue Of High Frequency Trading
Dear Senator Kaufman, we at Zero Hedge applaud your effort to bring transparency to, and evaluate the various new forces that, for better or worse, determine the modern market landscape. However, we would like to bring to your attention a fact which renders your entire approach of seeking fair and unbiased commentary from the SEC irrevocably moot. The reason is that the SEC, in alignment with many of the very industry players who may be abusing market structure for their own tiered benefit, stands to benefit significantly from an increased amount of daytrading volume across all markets, and, in fact, based on actions as recent as 4 months ago by the SEC, the regulator is well aware of the monetary benefits that ever-increasing churn creates for the commission and is fully intent on capitalizing on them. We thus suggest you bypass any protocol that has an SEC intermediation and go directly to penning a Bill which, we trust, will prove to be more fair and objective than anything the SEC would ever provide you with. The reason for the SEC's insurmountable conflict of interest is the so-called Section 31.
As Mary Schapiro has often noted, the SEC is "woefully" underfunded, regardless that for its $900 million FY 2009 budget, which comes to over $250,000 per commission worker, the agency has terminally underperformed and has been the object of repeated and justified public ridicule due to its countless lapses, backward looking methodology and overall lack of "regulating" any improprieties in the market. A fresh example of the SEC's pathological incapacity to uncover malfeasance on its own (and, what's potentially worse - pandering cronyism), is its reliance on media sources such as the recent Wall Street Journal article highlighting potential client-abusive practices at none other than Goldman Sachs.
Yet for all its complaining about being underfunded (and one can argue for hours about whether there even is a need for an agency to exist whose primary purpose these days it seems, in the words of Judge Jed Rakoff, is to "curry favor" with various prominent TARP recipients) the SEC is well aware that it needs to be self-sufficient in order to exist. Enter Section 31.
From the definition of Section 31
When you sell a stock, you may have noticed that a small transaction fee, often just a few pennies, appears on your confirmation slip. Although some broker-dealers have described this charge as an "SEC Fee," the SEC does not actually impose this fee on individual investors.
The SEC does not impose or set any of the brokerage fees that investors must pay. Instead, under Section 31 of the Securities Exchange Act of 1934, self-regulatory organizations (SROs) -- such as the Financial Industry Regulatory Authority (FINRA) and all of the national securities exchanges (including the New York Stock Exchange and the American Stock Exchange) -- must pay transaction fees to the SEC based on the volume of securities that are sold on their markets. These fees recover the costs incurred by the government, including the SEC, for supervising and regulating the securities markets and securities professionals.
The SROs have adopted rules that require their broker-dealer members to pay their fair share of these fees. Broker-dealers, in turn, pass the responsibility of paying the fees to their customers. Thus, a broker-dealer that has questions about how its fees are calculated should contact its SRO, and a customer who has questions about how his or her fees are calculated should contact the broker-dealer.
Section 31 requires the SEC to make annual and, in some cases, mid-year adjustments to the fee rate. These adjustments are necessary to make the SEC's total collection of transaction fees in a given year as close as possible to the amount stipulated for that year by Section 31. If transaction volume in a given year increases, the SEC will lower the fee rate because each transaction has to contribute less to the target collection amount. But if transaction volume falls, each transaction will have to be charged a higher fee in order for the SEC to collect the target amount required by Section 31. To find the current rate for Section 31 transaction fees, please visit the Division of Market Regulation’s Frequently Requested Documents webpage, and click on the most recent Fee Rate Advisory under “Section 31 Fees.” You’ll also find Fee Rate Advisories in the Press Releases section of our website. For official Commission Orders concerning fee rate adjustments, please visit the Other Commission Orders, Notices, and Information section of our website.
The charges on most securities transactions are known as Section 31 "fees." But the charges imposed by Section 31 on transactions in security futures are termed "assessments." As of fiscal year 2007, the assessment charged is $0.0042 for each round turn transaction (i.e., one purchase and one sale of a contract of sale for future delivery).
Now Section 31 fees are nothing new. However, a recent quiet amendment that slipped under the radar indicates just why the SEC sees HFT as the money cow it is, for a select group of investors, and for the Securities and Exchange Commission itself.
Washington, D.C., March 4, 2009 — Effective on April 1, 2009, or 30 days after the date of enactment of the Commission's regular appropriation for FY 2009, whichever is later, the Section 31 fee rate applicable to securities transactions on the exchanges and over-the-counter markets will increase to $25.70 per million dollars. Until that date, the current rate of $5.60 per million dollars will remain in effect. The Section 31 assessment on security futures transactions will remain unchanged at $0.0042 per round turn transaction.
Time for a little math.
Using the same back of the envelope analysis we did when we evaluted the cost of high frequency trading, and focusing exclusively on exchange traded stocks (and for the purpose of simplicity ignoring OTC transactions and other OTC products), we postulate 6 billion shares traded daily at a $20 average price for 250 trading days per year. Applying the old fee of $5.60 per million dollars results in an annual revenue stream of $168 million to the SEC. Applying the new fee of $25.70 per million dollars, and the SEC now would receive $750 million dollars- three quarters of a billion, and more than 80% of the SEC's annual budget. And keep in mind we did not include all other various exchange traded and OTC products that the SEC collects fees on. Did the SEC specifically request the fee increase in March as it became aware of the potential windfall that HFT driven churn, pardon, liquidity provisioning, could be for the Commission?
Now Senator Kaufman, you obviously realize, in referencing your letter to the SEC, that High Frequency Trading in its various forms now accounts for well over half of total volume in domestic and international markets. An objective analysis of HFT, as you have demanded of Ms. Schapiro, could have one of two outcomes: a favorable one, and an unfavorable one. Assuming a hypothetical outcome is indeed, unfavorable, it would have dramatic repercussions not only on the market landscape, but on overall market transaction volume, potentially impacting it to the tune of the estimated 70% of volume that HFT accounts for.
At this point it bears pointing out the flagrant conflict of interest that the SEC is faced with. An objective, unbiased and impartial analysis of HFT would leave the "cash strapped" Commission exposed to losing up to 70% of this primary revenue stream. Using the conservative estimate above, do you, Senator Kaufman, realistically believe, that Ms. Schapiro and her assistants would be able or willing to provide unbiased data on information that could impair over half a billion worth of annual revenue for the SEC.
We think not. As would no other rational human being.
Which is why, while we applaud your effort for a data mining mission with the SEC, the results ultimately presented to you by Ms. Schapiro will be highly conflicted, irrelevant and moot. We hope and are confident that you have a contingency plan for this situation, which is nothing less than one in which conflicts of interest will play the primary role in shaping the data mining and presentation.
And, as an aside, this example merely goes to show just what a cash cow HFT has become not just for governmental agencies but by implication, the key market players, as it is no secret that the government is always most willing to extract its tithe out of industries that are significant cash cows in their private sector context and would not be impaired by such comparable "fee increases." We hope you manage to read between the lines in any and all interactions you have with proponents and regulators of HFT. Yet we are confident that you do, based on your admirable dedication to your noble cause to date.