SEC Fails To Monitor More Than Half Of Stock Trading, Former Agency Lawyers Say

SEC Fails To Regulate High-Frequency Trading

The Securities and Exchange Commission does not currently have the ability to fully monitor what, by most accounts, makes up a majority of the stock trading activity in the United States, according to former SEC lawyers. What's more, recent reforms and proposals are unlikely to make much of a difference, they say.

The SEC, the primary federal agency charged with overseeing the U.S. stock market, has launched new efforts to more closely monitor high-frequency trading -- the ultrafast, computerized buying and selling of stocks, bonds and derivatives that now comprise the majority of stock trading in the country. This has increasingly come to replace the loud trading-room floor haggling that many Americans still associate with Wall Street.

But in interviews with The Huffington Post, former SEC lawyers said that those new efforts will likely be ineffective. While some argued that only a large budget increase would help the agency rein in high-frequency trading, others said that it is unlikely the agency will ever get a handle on that sophisticated market.

"It's inconceivable that they can regulate [high-frequency trading]," said Ralph Ferrara, a former SEC general counsel. "There are too many [high-frequency trading] systems; they're all idiosyncratic; they're all different. The SEC is starved for cash, starved for talent. A small-sized hedge fund can outperform the SEC," added Ferrara, who left the commission in 1982 and is now a vice chairman of Dewey & LeBoeuf who specializes in securities law.

According to SEC spokesman John Nester, two new rules have been designed to help the commission keep closer tabs on high-frequency traders. One, already adopted, requires large-scale high-frequency trading firms to provide the agency with basic information, including how many people work at the firm and the broad nature of their trading strategies. Another, proposed rule would for the first time require exchanges to keep a paper trail of trading activity across all markets. The SEC has been "working in earnest to finalize the exact contours of this complex undertaking for adoption," Nester said of that proposal.

Ferrara said that he doesn't think the new efforts are sufficient. "These rules are applying a Band-Aid when you need a tourniquet," he said. "All these rules say is when something goes wrong [in the stock markets], maybe we'll have more data on how it happened. It's a post hoc protocol, as opposed to saying, 'We want to know, on a real-time basis, whether the markets are under control and under the oversight of a human being responsible for maintaining control.' These rules can't address that."

High-frequency trading accounts for more than 50 percent of stock trading volume in the United States, according to a 2011 report by the Boston Consulting Group (that the SEC cites) and a 2012 estimate by market research and strategic advisory firm the Tabb Group.

The SEC does not publicly offer its own estimate of the percentage of the overall equity market that high-frequency trading accounts for. But in congressional testimony in 2010, SEC Chair Mary Schapiro said, "By any measure, [high-frequency trading] is a dominant component of the current market structure and is likely to affect nearly all aspects of its performance."

Asked by The Huffington Post when the agency expects to have full oversight capability over high-frequency trading across all markets, the SEC did not offer a concrete timeline. The commission is reviewing "different types of trading strategies" and "whether proprietary trading firms should be subject to any affirmative or negative obligations with respect to their trading," Nester wrote. "The staff is thoughtfully considering these [issues] and no date for any such rulemaking has been announced."

The commission is also hiring new staff to bulk up its regulatory capabilities and developing its technological capabilities, Nester said.

The commission's efforts reflect a newfound interest in high-frequency trading, articulated in recent public comments by Schapiro. In February, she told a roundtable of reporters that high-frequency trading "worried" her and suggested that one solution might be to curb the practice by charging a fee for each of the vast number of trades that firms cancel every day. Critics argue that an abundance of cancelled trades overwhelms the markets.

High-frequency trading has been linked to market instability. In May 2010, the Dow Jones industrial average mysteriously plummeted 1,000 points and then recovered its losses in a few minutes -- an event later dubbed the "flash crash." A joint report published later that year by the SEC and the Commodity Futures Trading Commission, which also has jurisdiction over some high-frequency trading, held that this practice helped fuel the crash.

Since then, certain restrictions have been implemented to try to prevent such an event from happening again, including the institution of "circuit breakers" that can shut down trading at an exchange in the event of market volatility, according to a speech Schapiro delivered in March. But those reforms do not give the SEC the ability to monitor the trading itself.

"You've got 21st-century trading strategies and software being monitored by an agency that still only has 20th-century capabilities," said former SEC enforcement attorney Philip Khinda, who left the agency in 1996.

"The commission doesn't have the ability to monitor high-frequency trading, not just in terms of sophistication; it doesn't have the cold hardware to keep up," said Khinda, now co-head of the SEC enforcement practice at Steptoe & Johnson in Washington. "It doesn't have the tools. It's only just begun to assemble them."

There's also the possibility that the Commodity Futures Trading Commission will step up its oversight of high-frequency trading -- though it has jurisdiction over only futures contracts and other derivatives but not the trade of stocks.

Last month the CFTC chair, Gary Gensler, told reporters after a speech in Washington that his agency might start considering new oversight rules before July, according to Bloomberg.

Even if the CFTC beefs up its efforts, the SEC lacks the funds to seriously enhance its own oversight, some lawyers say. "The SEC just doesn't have the resources to be everywhere -- to regulate and to be the cop on the beat," said Paul Berger, a former associate director of the SEC's enforcement division.

"For the SEC to address some of these huge issues, they need more resources; they need a bigger budget. To quote a line from 'Jaws,' 'I think we need a bigger boat," added Berger, who left the SEC in 2006 after 15 years and now focuses, in part, on securities litigation at Debevoise & Plimpton.

The SEC, through spokeswoman Florence Harmon, declined to address the specific question of whether its budget is adequate when pressed by The Huffington Post.

But in testimony before the House Committee on Financial Services in early March, Schapiro asked Congress for a 2013 budget boost of $245 million, to $1.566 billion, from this year's level. She described the need to "adequately staff mission-essential activities to protect investors, prevent regulatory bottlenecks as new oversight regimes become operational and existing ones are streamlined, strengthen oversight of market stability, and expand the agency's information technology systems to better fulfill our mission."

Other former SEC lawyers are skeptical that even a budget increase would provide the commission with the tools it needs to adequately monitor stock trading. "Equipping the SEC with six more computers will never get you there," said Ferrara, the former general counsel.

Professor Frank Partnoy, director of the Center on Corporate and Securities Law at the University of San Diego, agreed.

"The SEC is essentially trying to regulate through the rearview mirror," said Partnoy, who is penning a book about high-frequency trading due out in June. "The market is so quick that I don't think there's any hope for a regulatory approach, regardless of the resources."

The open question, as Berger put it, is whether the SEC can assemble the tools in time to prevent another market event like the crash of May 6, 2010.

"The age-old problem is, will you get there before something bad blows up?" Berger said. "I certainly hope so."

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