SEC Caught Dark Pool and High Speed Traders Doing Bad Stuff.

http://www.bloombergview.com/articles/2014-06-06/sec-caught-dark-pool-and-high-speed-traders-doing-bad-stuff

I've said this before, but I really admire the way the Securities and Exchange Commission has responded to the recent uproar about high-frequency trading. 

The SEC talks a lot about how it's going to fix the bits of markets that don't work quite right, and it does targeted enforcement against all the buzzwordy nemeses of fair markets. And it stage manages all of it carefully: After Mary Jo White's big market structure speech yesterday, the SEC today announced two market-structure enforcement actions, one against a dark pool and the other against a company that gave high-frequency traders access to the markets. The boxes, they are checked.

The dark pool, Liquidnet, agreed to pay a $2 million dollar fine for illicitly sharing its customer order data. That's bad! One of the main market-structure conspiracy theories is that dark pools -- which are supposed to be places where institutions can go and post big orders without anyone ever seeing them -- are actually secretly selling institutional order flow to high-frequency traders. So catching a dark pool in the act is a pretty big story for the SEC.

The SEC noticed this problem and tried to fix it in 2011 with the Market Access Rule. This said, basically, that if Wedbush is giving you market access then it's responsible for supervising you. In particular, it has to "establish, document, and maintain a system of risk management controls and supervisory procedures reasonably designed to manage the financial, regulatory, and other risks of this business activity," and those controls have to "be under the direct and exclusive control" of Wedbush, not whoever it's giving market access to.

The SEC's claim here is that Wedbush basically didn't do this: It provided access to "about 50 sponsored access customers that generated average monthly trading volume of 30 billion shares,"and it basically let them manage risk however they wanted. In particular, 80 percent of those customers used non-Wedbush trading platforms, and had control over the risk settings in those platforms. Wedbush, according to the SEC, relied on perfunctory statements from the customers that they were complying with the rules, but didn't actually enforce them.

No sensible human would regulate that way, supervising high-frequency trading by telling Finra to tell exchanges to tell Wedbush to tell its customers how to behave.Of course such a crazy indirect way of overseeing high-frequency traders is going to miss some important things. Really it's weird that none of Wedbush's customers seem to have had algorithms that went haywire and like sold a billion shares of Apple for a penny, which is the biggest thing you'd worry about with unsupervised market access. But they did plenty of mischief anyway.

The SEC is embarrassed by this too. One big takeaway from Mary Jo White's speech yesterday is that the SEC wants to regulate high-frequency traders more directly, with "a rule to clarify the status of unregistered active proprietary traders to subject them to our rules as dealers." The SEC wants high-frequency traders to register with it directly, because it doesn't trust the current market gatekeepers to keep an eye on them. From this case, it's easy to see why.