SEC on Market Structure: The Chair Speaks and Enforcement Acts

1. SEC on Market Structure: The Chair Speaks and Enforcement Acts Morris Simkin, Esq. Simkin Law Office 212 455 0476 msimkin@securitiesregslawyer.com June 18, 2014

2. Equity Market Structure: the Chair Speaks and Enforcement Acts • June 5, 2014 speech by SEC Chair Mary Jo White • Settled Administrative Proceeding of June 6, 2014 against Liquidnet • Order Instituting Proceedings against Wedbush Securities Inc. on June 6, 2014

3. Mary Jo White Speech • June 5, 2014 Speech by Mary Jo White, SEC Chair, at the Sandler O’Neill & Partners, L. P. Global Exchange and Brokerage Conference

4. Mary Jo White Speech • Current Market State—It isn’t broke but may need some fixing: • Institutional investor costs to execute large orders is more than 10% less in 2013 than in 2006; • Intraday volatility of S&P 500 nearly the same in 2013 as it was in 2006 • Spreads between bid and ask prices as narrow as they have ever been

5. Mary Jo White Speech • But there are some issues: • Improved technology has lead to excessive intermediation; • Institutional investor costs to trade small-cap stocks relatively high in contrast to large declines in costs for the broader market; • Market structure rules and industry practices were developed with manual markets in mind.

6. Mary Jo White Speech: Recommendations • High Frequency Trading • Develop a recommendation to the SEC for anti-disruptive trading rule– apply to active proprietary traders when liquidity is most vulnerable and risk of price disruption • Clarify status of proprietary traders to subject them to dealer rules • Eliminate exception from FINRA membership for BDs that trade only with other BDs

7. Mary Jo White Speech • Recommend to SEC to improve BDs risk management of trading algorithms and enhance regulatory oversight over their use; • Asks SROs to include a time stamp on data feeds to SIP; • Ask SROs for recommendations to deal with increasingly expensive search for speed--e.g. rules like 11(a)(1)-1(T).

8. Mary Jo White Speech • Market Fragmentation– 11 exchanges, more than 40 Alternative Trading Systems and more than 250 broker-dealers, proliferation of dark trading venues: • Is dark trading volume at levels that risks undermining quality of price discovery; • Has Regulation NMS trade through rule contributed to fragmentation?

9. Mary Jo White Speech • Broker-dealer conflicts: • Maker-taker fees and payment for order flow do not flow through to the customer • Staff to recommend rule to amend NMS Rule 606 to enhance order routing disclosure- e.g. cover large orders, and disclose customer specific information to institutional investors on request; • Large number of complex order types- usually due to maker taker fees- Asks exchanges to consider rule changes to clarify these rules and how they affect fair, orderly and efficient markets.

10. Mary Jo White Speech • Tick Size • Asked staff to recommend a pilot program for wider tick sizes for smaller companies’ stock

11. Mary Jo White Speech • Ask to establish an SEC Market Structure Advisory Committee – comprised of experts with different backgrounds and viewpoints, review specific initiatives and rule proposals

12. Secondary Market– Enforcement Cases • Two administrative proceedings on June 6, 2014: • Liquidnet, Inc. Release No. 34-72339 • Wedbush Securities Inc. and 2 individuals Release No. 34-72340

13. Liquidnet, Inc. • It is a registered broker-dealer and an Alternative Trading System (ATS) • Regulation ATS, Rule 300(a) defines an ATS as one that provides a market place to bring together buyers and sellers of securities, and does not have conduct rules or discipline subscribers. • Regulation ATS Rule 301 imposes obligations upon an ATS. These include: • File Form ATS with the SEC, and periodically update it; • If within 4 of the last 6 months it had average daily trading volume of 5% or more of an NMS stock, make its best bids and offers available to the exchanges and other broker-dealers (go light); • Have adequate safeguards and procedures to protect subscribers’ confidential trading information.

14. Liquidnet, Inc. • Subscribers gave Liquidnet electronic access to their Order Management Systems. The OMS showed what securities they were planning to buy or sell, quantities and prices. Where Liquidnet detected a potential match, it notified the two subscribers and, on an anonymous basis, they could negotiate a trade through Liquidnet. When they reached agreement the buyer and seller were identified to each other.

15. Liquidnet, Inc. • Liquidnet wanted to expand its subscriber base to issuers, control persons and venture capital and venture equity firms. • It formed a new unit called Equity Capital Markets (ECM). • It launched an application for issuers called InfraRed. InfraRed was given to corporate executives, and showed the ratio of buys to sells of that issuer’s stock in the Liquidnet system. • InfraRed also identified to ECM personnel what subscribers were interested in buying and selling, and the number of shares. • In presentations to corporate issuers ECM staff described subscribers with buying and selling interests. • ECM staff reached out to issuers with reports of recent activity in their stock on Liquidnet, often including detailed trading data- buys, sells, quantity and price. They also reported to 13F reporting companies on average daily trading volume in those securities, and information as to liquidity depth. • They gave corporations information as to interests in their stock by firms the corporation was planning to meet with. • ECM staff gave corporations advice as to when to buy or sell, and if subscribers had particular interests in their stock.

16. Liquidnet, Inc. • Liquidnet developed “Ships Passing” alerts. These alerts notified its Relationship Managers (RMs) about missed execution opportunities between subscribers’ algorithmic orders and subscribers’ indications of interest. • It also developed “Aqualytics.” This identified stocks where Liquidnet’s recent trading made it a dominant force in the market for the security. This report was used to by RMs to contact subscribers to alert them to this fact.

17. Liquidnet, Inc. • These actions were found to be violations of Regulation ATS’s obligations to establish adequate safeguards and procedures to protect subscribers’ confidential trading information and to amend its Form ATS prior to implementing a material change to its operations. • Liquidnet was censured, ordered to cease and desist, and fined $2,000,000. (The gross revenue from the expanded issuer and VC/PE marketing was $1.66 million.)

18. Wedbush Order Instituting Proceedings • This is the second case brought under Rule 15c3-5. The first was against Knight Capital because on August 1, 2012 its order entry system generated multiple orders that were not authorized due to failures in its operating systems.

19. Wedbush • Rule 15c3-5 was adopted in 2010 and became effective July 14, 2011. It applies to brokerage firms that allow others to use its access to trading markets of which it is a member (stock exchanges) or subscriber (ATSs) to place trades using the broker’s member proprietary identification. • Rule 15c3-5(b) requires the firm providing market access to have a system of risk management controls to mange the financial, regulatory, and other risks of this business activity. • Rule 15c3-5(c)(1) requires the broker to have risk management controls and supervisory procedures to limit the financial exposure of the broker that could result from market access– e.g. orders exceeding pre-set credit or capital threshold, or the entry of erroneous orders. • Rule 15c3-5(c)(2)requires the broker to have supervisory controls designed to assure compliance with all regulatory requirements. This includes the pre-order entry rules (Regulation SHO), and to restrict access to only personnel pre-approved by the broker. • Rule 15c3-5(d) requires that this system of management controls must be under the direct and exclusive control of the broker.

20. Wedbush • The SEC charged the firm and two senior personnel in its Correspondent Services Division with violating Rule 15c3-5.

21. Wedbush • Wedbush provided sponsored market access to some 50 customers through its correspondent services business. These customers generated monthly average trading volume of 30 billion shares. Several had more than 1,000 traders, and one had more that 10,000 traders. These customers could direct their trades directly to an exchange or ATS under Wedbush’s identity. • The correspondent services business was Wedbush’s most profitable operation.

22. Wedbush • Wedbush was familiar with Rule 15c3-5. • A Latvian sponsored access customer used the service as part of scheme to intrude third party accounts and engage in market manipulation. • Another customer used the service as part of its activities as an unregistered broker-dealer. • The SEC Office of Compliance Inspections and Examinations sent Wedbush an Examination Deficiency Letter on May 17, 2011. Among other things the letter cited repeated violations of Reg SHO because of dependence on an access customer’s claimed ability to locate shares being sold short. • Wedbush representatives met with the SEC on July 5, 2011 to discuss the impending effectiveness of Rule 15c3-5.

23. Wedbush • Alleged violations: Control • Most of Wedbush’s customers used third party trading platforms that Wedbush could not control. Even if Wedbush set controls and limits on these customers through their platforms, the customer could override or revise whatever controls or limits Wedbush had set. • Wedbush did not receive any demonstrations of the actual risk controls that were in effect for a customer, had no physical ability to prevent the customer changing the settings on the platform. Wedbush had no contractual relationship with the operators of these platforms that would give it access to a customer’s platform.

24. Wedbush • Short Sales (pre-order entry rules) • Reg SHO Rule 203(b)(1) requires a firm entering a short sale to either have borrowed the security, entered into an arrangement to borrow the security or have reasonable grounds to believe that the security can be timely borrowed (easy borrow list). • Wedbush relied on its customers or the trading platforms that they used to comply with this rule.

25. Wedbush • AML and Suspicious Activity Reports • Broker-dealers are required to file Suspicious Activity Reports if they know or reasonably believe that there have been violations of law by themselves or others. • Wedbush learned from stock exchanges of suspicious wash sale and/or pre-arranged trading by some of its correspondents. • Correspondents allowed their traders to use more than one identification. Several of these same user identifications traded with another identification of the same trader- wash sales. • Layering is the entry of large number of non-bona fide orders on one side of the market, and promptly cancelling them in order to obtain a favorable execution of an order on the other side of the market. Wedbush learned from exchanges that traders in the same customer account were engaging in layering.

26. Wedbush • Unauthorized traders. Rule 15c3-5(c)(2)(iii) requires that Wedbush limit access to its system to persons and accounts pre-approved by it. • The firm’s practice was to review and approve the principals of a correspondent for use of its services. In cases where it did get the names of the traders, it ran their names against OFAC’s list of SDNs. It did not pre-approve all of the traders that these customers had. In many cases it did not know who were these traders.