SEC does job, ignores HFT noise

I've said this before, but I really admire the way the Securities and Exchange Commission has responded to the recent uproar about high-frequency trading. A lesser regulator would have jumped on the bandwagon of HFT bashing, or even tried to get out ahead of it with its own anti-HFT branding.

The SEC, on the other hand, basically thinks high-frequency trading is fine, but it knows you don't think that, and it wants to be tactful. It could just explain that markets aren't rigged, but "markets are rigged" is sort of unfalsifiable. If the SEC says that the stock market is not a giant conspiracy to steal your money, that just means that it's in on the conspiracy.

So the SEC instead talks a lot about how it's going to fix the bits of markets that don't work quite right, and it does targeted enforcement against all the buzzwordy nemeses of fair markets. And it stage manages all of it carefully: After Mary Jo White's big market structure speech yesterday, the SEC today announced two market-structure enforcement actions, one against a dark pool and the other against a company that gave high-frequency traders access to the markets. The boxes, they are checked.

The dark pool, Liquidnet, agreed to pay a $2 million dollar fine for illicitly sharing its customer order data. That's bad! One of the main market-structure conspiracy theories is that dark pools -- which are supposed to be places where institutions can go and post big orders without anyone ever seeing them -- are actually secretly selling institutional order flow to high-frequency traders. So catching a dark pool in the act is a pretty big story for the SEC.

Except that that's not what Liquidnet did. Liquidnet did share order data, but not with high-frequency traders who then traded against it. Instead, Liquidnet shared order data with issuers. So if you were a company interested in doing a follow-on stock offering, Liquidnet would tell you, roughly speaking, how much unmet institutional demand there was for your stock. (That is, how many buy orders that it had that weren't matched by sell orders.) This could give you some idea of when to do an offering. And vice versa if you wanted to buy back stock: Liquidnet would tell you how much selling interest there was.

Liquidnet advertised, and told its customers, that it provided this "equity capital markets" function, in an aggregated way ("there is X times more selling interest than buying interest," etc.). What it didn't tell them was that its equity capital markets salespeople could see individual order data, and, being salespeople, they took advantage of it:

As part of their marketing efforts, ECM employees also frequently reached out to issuers with ad-hoc reports about recent activity in the issuers’ stocks, and some of these reports included descriptive characteristics of the members whose information was discussed. For example, on April 26, 2011, an ECM employee contacted an issuer with an update about two block executions on Liquidnet ATS in the issuer’s stock that very morning. The ECM employee included the time, quantity and price of each of the two trades; informed the issuer that both trades involved the same seller; and noted that neither the seller nor one of the two buyers involved in the trades were among the issuer’s 13F holders, but the second buyer was one of the issuer’s 13F holders. The ECM employee further informed the issuer that the “seller still has considerable quantity on the books to offload” and that “[o]ne of the buyers has some residual interest to buy today.

Now, you can see why this would be objectionable. Big shareholders of Company X might not want Company X to know that they're offloading shares, since that might cause them to lose management access. And activists accumulating a position -- or even a merger toehold -- in a company might not want the company to rush to put in a poison pill after being tipped off by some dark pool trolling for business.2

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