SEC does job, ignores HFT noise

But the big market structure concern is that dark pools might be sharing order information with predatory traders who might then trade against it: If you know that Fidelity wants to buy 10 million shares of Apple, then you can go buy up small lots of Apple to sell to Fidelity at higher prices.3 But there's one trader who can't do that: Apple. An issuer can't just go around day-trading its own stock; both its purchases and sales are heavily regulated and mostly pre-announced, and it's rarely indifferent about whether to buy or sell. If Liquidnet tells an issuer that there are a lot of buyers of its stock, the only thing it can do with that information is sell them stock -- not front-run them.4

Basically, if you're worried about dark pools selling order data, this is not what you were worried about. I mean, it's a fun new thing to worry about, if you like worrying about dark pools, but it's got nothing to do with the main event of market-rigging. And the fact that the SEC caught this, and Liquidnet fixed it, will do nothing to calm the fears of those who are committed to worrying about dark pools and rigged markets.

But if you're just casually worried about dark pools because you saw Michael Lewis on TV that one time, then it's probably reassuring to see that the SEC is on the case.

The other case, against market access provider Wedbush Securities, is much messier, in part because Wedbush hasn't settled the case, and there will now be a proceeding to decide if they're guilty or not, and in part because market access is even less sexy than dark pools, which at least have a scary-sounding name.

The background is that, if you want to be a broker-dealer and trade stocks on behalf of customers, you have to register with the SEC and be a Finra member and generally be subject to a lot of red tape and supervision and risk controls. If you just want to day-trade stocks for your own account, you don't need to do any of that, or even put on pants. You just send your trading orders to your broker, and the broker executes them on the stock exchange.5

Some people want a hybrid model: They don't want to be subject to SEC oversight, because they're not brokers and are just trading for their own account, but they also don't want to do their trading through brokers. This is particularly relevant to high-frequency traders,6 who(se computers) trade for their own accounts but who don't want the delay, and the inflexibility, of submitting orders through a broker.

Market access providers like Wedbush are the solution. They have direct exchange access, and pretty much rent it to you. You can trade directly on the exchange, using their "market participant identifier." As far as the exchange knows, you're Wedbush, which is a registered broker-dealer subject to Finra and SEC oversight.

But you're not Wedbush, and you're not subject to any oversight, or to the tyranny of pants. This is ... a fairly obvious problem. Lots of proprietary traders get up to bad stuff: They manipulate markets, they do naked short sales, or they just have algorithms that run wild. In theory SEC supervision ought to catch misbehavior at regulated brokers, and in theory brokers who execute orders shouldn't execute orders that get up to bad stuff. But who will catch misbehavior at unregulated traders who access the market directly?

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,"7 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.

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