Themis Trading On The SEC's Flash Crash (Non) Report

From Sal Arnuk of Themis Trading

CFTC – SEC Joint Commission Report Part Deux

Summary of the Joint CFTC/ SEC Recommendations Regarding Regulatory, Response to the Market Events of May 6th, 2010

The report is out. Click here to read the 14 page report. The Joint CFTC/SEC committee makes 14 recommendations which they intend to focus on to ensure the integrity of our connected market place. We would like to highlight the 3 recommendations that we think are “news” today, and that we have particularly expressed concern about over recent years: Recommendations 10, 11, and 12, which deal with order cancellation fees, internalization, and trade-at rules.

Missing in the report, however, is any discussion of proprietary exchange data feeds, the proliferation of exchanges, or minimum order life. Also, this report is a stark contrast to the September 30th report, which focused more extensively on an algorithm trading eMini futures from a large money manager. The HFT community, at that time, focused on that aspect of the report extensively. This report is an improvement, as it does begin to examine structural inefficiencies and risks in our current market structure.

10. The Committee recommends that the SEC and CFTC explore ways to fairly allocate the costs imposed by high levels of order cancellations, including perhaps requiring a uniform fee across all Exchange markets that is assessed based on the average of order cancellations to actual transactions effected by a market participant.

This is a win that they are recommending ANY type of cancellation fee. However we note that when you read the wording carefully, it will not be a recommendation for a fee on all cancellations; rather it will be a recommendation for a fee on cancellations that exceed a firms “normal pattern”. Lots of wiggle room here folks.

11. The Committee recommends that the SEC conduct further analysis regarding the impact of a broker-dealer maintaining privileged execution access as a result of internalizing its customer’s orders or through preferencing arrangements. The SEC’s review should, at a minimum, consider whether to (i) adopt its rule proposal requiring that internalized or preferenced orders only be executed at a price materially superior (e.g., 50 mils for most securities) to the quoted best bid or offer, and/or (ii) require firms internalizing customer order flow or executing preferenced order flow to be subject to market maker obligations that requires them to execute some material portion of their order flow during volatile market periods.

A related concern has to do with the effects.

WOW. Look into obligations for internalizers too?  While we don’t hold particularly valuable any of these affirmative obligation rules, it is nice to see that they are acknowledging how damaging the internalizer model has been.

They also feel at a minimum that internalizers should price improve by 50 mils. This is an accommodation for crossing pools that tend to trade larger blocks, and when they trade sub-penny, they trade in the middle of the spreads (half a penny). THIS IS HUGE.

12. The Committee recommends that the SEC study the costs and benefits of alternative routing requirements. In particular, we recommend that the SEC consider adopting a “trade at” routing regime. The Committee further recommends analysis of the current “top of book” protection protocol and the costs and benefits of its replacement with greater protection to limit orders placed off the current quote or increased disclosure of relative liquidity in each book.

They want to look into protecting Depth Of Book! This is big also.


Their other points, which were widely expected, follow:

1. The Committee concurs with the steps the SEC (working with the Exchanges and FINRA) has taken to

a. Create single stock pauses/circuit breakers for the Russell 1000 stocks and actively traded ETFs1

b. Enact rules that provide greater certainty as to which trades will be broken when there are multi stock aberrant price movements, and

c. Implement minimum quoting requirements by primary and supplemental market makers that effectively eliminate the ability of market makers to employ “stub quotes”

2. The Committee recommends that the Commissions require that the pause rules of the Exchanges and FINRA be expanded to cover all but the most inactively traded listed equity securities, ETFs, and options and single stock futures on those securities.

3. The Committee recommends that the SEC work with the Exchanges and FINRA to implement a “limit up/limit down” process to supplement the existing Pause rules and that the Commissions clarify whether securities options exchanges and single stock futures exchanges should continue to trade during any equity limit up/down periods.

4. The Committee recommends that the CFTC and the relevant derivative exchanges evaluate whether a second tier of pre-trade risk safeguards with longer timeframes should be instituted when the “five second limit” does not attract contra-side liquidity.

5. The Committee recommends that The Commissions evaluate the present system-wide circuit breakers and consider:

i. reducing, at least, the initial trading halt to a period of time as short as ten minutes

ii. allowing the halt to be triggered as late as 3:30 pm and

iii. using the S&P 500 Index as the triggering mechanism.

This makes immense sense. IT is not a Dow world, after all, and more importantly it is easier to coordinate the many S&P 500 related instruments.

6. The Committee supports the SEC’s “naked access” rulemaking and urges the SEC to work closely with FINRA and other Exchanges with examination responsibilities to develop effective testing of sponsoring broker-dealer risk management controls and supervisory procedures.

7. The Committee recommends that the CFTC use its rulemaking authority to impose strict supervisory requirements on DCMs or FCMs that employ or sponsor firms implementing algorithmic order routing strategies and that the CFTC and the SEC carefully review the benefits and costs of directly restricting “disruptive trading activities “with respect to extremely large orders or strategies.

Algo providers may have an obligation to develop procedures, and have responsibility for, the actions of their clients, and how those clients interact with the algo technology.

8. The Committee recommends that the SEC evaluate the potential benefits which might be gained by changes in maker/taker pricing practices, including building in incentives for the Exchanges to provide for “peak load” pricing models.

Extra Rebates! Extra Fees! They will explore “what if” rebates were greater during times of stress, and “what if” it were more expensive to hit bids.

9. The Committee recommends that the SEC evaluate whether incentives or regulations can be developed to encourage persons who engage in market making strategies to regularly provide buy and sell quotations that are “reasonably related to the market.”

Will any mandated obligation outweight potential huge losses? Reasonably related to the market? How do they deal with a quote that can be cancelled before you hit it? Will firms like Getco have a huge advantage since their technology is the fastest (and their colo the best)?

13. The Committee recommends that the Commissions consider reporting requirements for measures of liquidity and market imbalance for large market venues.

14. The Committee recommends that the SEC proceed with a sense of urgency, and a focus on meaningful cost/benefit analysis, to implement a consolidated audit trail for the US equity markets and that the CFTC similarly enhance its existing data collection regarding orders and executions.