Experts trying to figure out how to avoid another "flash crash" are considering big changes to the U.S. stock marketplace, and one is recommending special rebates during times of stress and a crackdown on off-exchange "dark" trading.
Robert Engle, a Nobel Prize-winning finance professor at New York University, said in an interview that the regulator-appointed panel has not yet decided on its final recommendations, though he expects them to be made public at a Feb. 18 meeting.
The focus, he said, should be that buyers all but vanished during the May 6 market plunge, abandoning investors when liquidity was most needed.
This could be fixed by allowing exchanges to boost the rebates it pays for standing buy and sell orders, and by squeezing more of the trading that takes place in anonymous "dark pools" into the public markets.
"Liquidity is the key issue we should be talking about and that the recommendations need to deal with," Engle, one of eight members of an advisory committee formed by the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission, said.
During the unprecedented flash crash, the Dow Jones industrial average plunged nearly 700 points before rebounding, briefly wiping out some $1 trillion in paper capital and exposing deep flaws in the high-speed electronic market.
Engle's comments -- including concerns over little communication among panel members in the last few months -- offer the first clear insight into what the high-profile committee could recommend.
SEC Chairman Mary Schapiro, having made a handful of adjustments since May to stabilize markets and quell investor anxiety, said Friday the agency will unveil more changes this spring. The committee's recommendations could inform these.
Engle said he has pushed for rules that would come into effect when markets are under duress and in need of more liquidity, allowing exchanges to boost both the rebates they pay for orders as well as the fees they charge traders.
"You would have a peak-load pricing model, much like the way you use peak-load prices to adjust traffic across a bridge or freeway," Engle said in a telephone interview from NYU's Stern School of Business.
BANKS 'WOULD HATE IT'
In discussions with a four-member subcommittee, the professor has also recommended a move seen for years by many in the industry as far more radical: a "trade-at" rule.
Such a rule would prohibit any of the dozens of U.S. venues and wholesale market makers from executing an incoming order unless it was already publicly displaying the best bid or offer in that particular stock, or unless it improved the price by a set amount.
Trade-at would hit the business of dark pools, where investors trade larger blocks of stock without revealing their intentions to the wider marketplace. Most of the pools are run by banks such as Goldman Sachs Group Inc and Morgan Stanley.
"The big banks that are internalizing their trades obviously would hate it," Engle said. "But basically they already had this captive audience of relatively high quality trades that, it seems to me, ought to be part of the price discovery process," which primarily takes place on the public exchanges such as the Nasdaq Stock Market.
"What we might do would be to consider throwing our weight behind this sort of general proposal, but maybe not the details of what's the right threshold," Engle added.
While exchanges and others have criticized dark pools, brokers and many institutional investors have defended them as necessary to accommodate the needs of different traders.
In a June letter to the SEC, Goldman said a trade-at rule "likely would increase execution costs because of increased information leakage about trading interest, missed opportunities to access liquidity, additional latencies and increased access fees."
Some 33 percent of all U.S. stock trading takes place away from exchanges, up from 20 percent four years ago.
INTO THE MARKETPLACE WEEDS
Any further structural changes could revamp the way tens of trillions of dollars flow through the U.S. equities market, which until the flash crash was seen as a model for the world.
In a Sept. 30 report that serves to inform the committee's recommendations, the SEC and CFTC said a single $4.1-billion futures sale sparked the crash, and that it was exacerbated by computer-trading programs rapidly offsetting positions, and by the crush of sell-now orders.
While "Sunshine" laws have prevented the committee from regularly meeting, Engle said the subcommittee has discussed a bevy of sometimes esoteric market structure issues:
They include excessive quote traffic, trading curbs known as limit up / limit down, a record of all trading known as a consolidated audit trail, restrictions around unfettered "naked" access to markets, and co-locating computers next to exchanges. They also include high-frequency algorithmic trading, he said.
Still, there has been "very little" communication among the full, eight-member committee in the last few months, Engle added. "We haven't had as much communication as would be desirable."
Schapiro and CFTC Chairman Gary Gensler are co-chairs of the committee, which was struck five days after the crash, on May 11, and which also includes former CFTC head Brooksley Born and Nobel Prize-winning economist Joseph Stiglitz. The Feb. 18 meeting will be its fifth.
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