U.S. regulators are probing certain practices around "quote stuffing," where large numbers of rapid-fire stock orders are placed and canceled almost immediately, Securities and Exchange Commission Chairman Mary Schapiro said on Tuesday.
"The SEC and other regulators are looking carefully at certain practices in this area to assess whether they violate existing rules against fraudulent or other improper behavior," Schapiro said in remarks to be delivered at the Economic Club of New York.
Regulators were also looking at quote stuffing in connection with the mysterious May 6 flash crash, when the Dow Jones Industrial Average dropped dramatically before quickly recovering.
However, it is not seen as the cause of the dramatic market drop, sources have said. A report that may explain the flash crash is expected toward the end of the month, Schapiro told Reuters before delivering the speech.
Regardless, the SEC has introduced a pilot "circuit breaker" program that pauses trading in a single stock if that stock is in free fall. Schapiro said the circuit breaker program — which stops trading for 5 minutes if a stock falls more than 10 percent in 5 minutes — can be improved.
"Currently, the circuit breakers can be triggered by anomalous trades that may not warrant pausing all trading in the stock for 5 minutes," Schapiro said in her prepared remarks.
Schapiro said the SEC's next steps are likely to include a careful review of a limit-up and limit-down procedure that would directly prevent trades outside specified parameters, while allowing trading to continue within those parameters.
A limit-up and limit-down rule, used in U.S. futures markets, is seen as a possible alternative to circuit breakers.
The SEC has undertaken a review of the structure of the equity markets, which has changed dramatically in the past few decades.
Quote stuffing is a term coined by Nanex LLC, a trade database developer that issued a study suggesting computer algorithms did this to gain an edge during the May 6 crash. The study argued that high-frequency traders regularly flood the marketplace with bogus orders in order to distract rival trading firms.
Investors could make trades under the false impression that those orders were legitimate, only to see liquidity disappear and the market move against them when the orders are canceled — all in the blink of an eye.
The SEC is looking at the rules for high-frequency traders and anonymous trading venues known as dark pools. The flash crash threw the rapid trading industry in the spotlight, triggering some lawmakers to call on the SEC to rein in the practice.
So far, the SEC has proposed to ban so-called flash orders, which give advance knowledge of stock orders to some traders.
The agency has also proposed ways to shed light on dark pools. The SEC is trying to adopt the rules before they are forced to craft nearly 100 rules under the Dodd-Frank financial regulation bill.
Schapiro did not provide a timeline for the market structure rules.
The Dodd-Frank legislation gives the SEC new authority to regulate the trillion dollar over-the-counter derivatives market and new powers to oversee hedge fund advisers.
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