SEC warns exchanges to protect markets from glitches gone awry

April 4 (Bloomberg) -- More than five months before a software error ruined Bats Global Markets Inc.’s initial public offering, U.S. regulators put exchanges on notice that they need to do more to protect investors from technology gone awry.

The missive came in the form of a prologue to a Securities and Exchange Commission case against Direct Edge Holdings LLC in October over claims the exchange operator had weak internal controls that caused its trading system to fail.

The agency, working to avoid another event like the May 6, 2010, rout that erased $862 billion from equities in 20 minutes, decided to use the Direct Edge case to create a blueprint for actions against other exchanges, according to a person with direct knowledge of the decision. While the SEC didn’t fault exchanges in the 2010 crash, the event magnified pressure on the commission to show it can ensure the fragmented marketplace of high-speed, computer-driven trading is safe for investors.

“The consequences of a big failure are so severe that the SEC should be paying close attention to these issues,” James Angel, a finance professor at Georgetown University’s business school in Washington, said in an e-mail. “No human system is perfect and eventually something will happen, so they also want policies and procedures in place for catching problems quickly and cleaning up the mess afterwards.”

The 2010 “flash crash,” as it has come to be known, spawned about 20 separate SEC investigations encompassing a dozen areas of possible securities law violations, according to the person, who spoke on condition of anonymity because the probes aren’t public. One involves types of orders used on Bats and Direct Edge, according to another person who declined to be named because the matter isn’t public.

Focus on Disruptions

While some of the investigations involve possible illegal trading practices, those that focus on exchanges revolve around whether the venues have the right compliance structures to address trading disruptions that could spiral out of control.

Typically, the SEC’s trading and markets division and exam staff work with exchanges to ensure their internal policies and procedures are adequate. The Direct Edge case, which was a rare joint effort by those two offices and the enforcement division, showed that the agency is ready to impose sanctions on exchanges that don’t have proper systems in place.

Daniel Hawke, chief of the SEC enforcement’s market abuse unit, said “exchange conduct and compliance is an area of renewed enforcement interest.”

‘Risk of Harm’

“The risk of harm to investors and their confidence in the fairness and integrity of the markets increases when exchanges fail to follow or enforce the rules that are applicable to them or to the member firms they regulate,” Hawke said in an e-mail.

Direct Edge spokesman Jim Gorman, Bats spokesman Randy Williams, Nasdaq OMX Group Inc. spokesman Robert Madden and NYSE Euronext spokesman Richard Adamonis declined to comment.

Bats, in a statement last week, said that it responded appropriately to a computer malfunction in its IPO auction process, which triggered problems with its quotations and forced a halt in Apple Inc. Still, the public nature of the company’s March 23 debacle has cast fresh light on the complexity of modern markets and how regulators are grappling with a proliferation of electronic trading platforms.

The SEC has asked Bats for information about types of orders used by some of the fastest automated trading firms, who attempt to be first in line when supplying bids and offers, according to a person with knowledge of the matter. The agency, interested in orders with so-called price-sliding features, is also making inquiries about Direct Edge, the person said. Bats disclosed the matter in an IPO filing in February.

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