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Exchanges Issue Response to SEC's Demands to Strengthen Critical Market Infrastructure

Yesterday, US stock and options exchanges said they have reached agreement on several proposals to prevent breakdowns in SIPs, critical infrastructure, halts, trade breaks and kill switches.

The main US stock and options exchange operators disclosed collective plans to strengthen the market systems and key data feeds after a series of technology breakdowns that have brought scrutiny from regulators.

US equity and options exchanges, including NYSE Euronext, Nasdaq OMX, BATS Global Markets and Direct Edge, made the announcement on Tuesday in response to a Sept. 12 meeting they had with SEC Chair Mary Jo White who gave them 60 days to come up with action plans for improving market resiliency, disaster recovery and governance of critical infrastructure, including the key consolidated data feeds known as securities information processors.

After the failure of Nasdaq’s securities information processor (SIP) on Aug. 22 led to a three-hour trading halt, there are concerns about the frequency of systems breakdowns as well as the stability of the consolidated data feeds for equities and options.

Even since the meeting there have been several technological malfunctions at options exchanges including one involving the OPRA options feed.

“We’re working closely together to kind of coordinate the rulemaking and how each exchange will respond to industry-wide events,” said Lisa Fall, president of BOX Options Exchange in Boston. Fall said the equity exchanges had made concerted efforts and some of the coordination has already taken place.

The exchanges' proposals address the need to improve the operational resiliency of the SIPs, develop contingencies for critical infrastructure such as limit-up limit down (LULD) and halts, along with open/close of the markets, IPOs, DTCC/OCC outages, industry testing and connectivity to exchange disaster recovery sites. They are also cooperating to reconcile trade breaks among the exchanges, and working on building consensus for kill switches.

One of the sore spots has been the lack of consistency in handling erroneous trades when a market disruption occurs. Two days before the Nasdaq data feed problem, Goldman Sachs had a software issue that caused it to route erroneous options orders. But due to differences in rules among the 12 options exchanges, Goldman was allowed to escape steep losses “after it mistakenly issued waves of orders to trade stock-options contracts for prices well off the prevailing market rate,” noted The Wall Street Journal.

“The options markets are working to make sure we have some coordinated rules so the industry has some transparency so they can predict what the outcome will be,” said Fall.

Right now each option exchange follows its own rules, says Fall. “If you have a market wide event you can get disparate treatment from the two exchanges. You don’t get busted on one exchange, but on another, it could be upheld,” explained Fall. “It’s not Willy-nilly. Each exchange has their own rules which they follow.

Now the group of exchanges is cooperating with each other to find common ground. “We want consistent treatment, we don’t think regulation should be an era of competition,” says Fall. “It should be across the board and whittled down,” adds Fall, referring to how exchanges handle market events like infrastructure changes, trading halts and trade breaks.

Rules that exchanges are working on should lay out specific parameters for when a halt is declared, and when it’s cleared, and what steps should be taken for a market reopen. The SEC asked the exchanges to develop best practices and coordinated procedures so it doesn’t look like they are figuring the situation out as it happens. “We’ve heard from our customers that they want consistency. They just don’t want to wait around and be surprised by the incident,” says Fall.

While exchanges will coordinate certain responses, such as to trading halts and trade breaks, Fall expects to see some individual rule filings related to kill switches, price filters and certain types of protections.

Exchanges will need to file their rules with the SEC and in most cases the SEC will publish them for public c comment. Kill switches are an area where the public will see filings from each exchange describing their switch and on whether or not they will have a kill switch.

“I think kill switches are a broad term,” said Fall, who suggests that software is not the only way to go. “Maybe you could call up the exchange or desk and tell someone to remove all of your orders,” she said. It’s possible there would be a separate API (application programming interface) that people would go to. “I think the understanding is each exchange will discuss the availability of kill switches and to what extent they will have it, and that will be up to each exchange and the SEC, said Fall.

Defining the kill switch in terms of what each exchange is comfortable with could be more complicated. According to yesterday’s joint announcement, work continues in the equities markets on a year-long effort to reach a consensus on a proposed common “kill switch” functionality to prevent risk and disruption to the markets.

A malfunction in technology such as the Knight Capital software-induced trading loss could cause exchanges to question whether they want the kill switch to be software, said Fall. “There’s a lot that goes into it. I don’t think any of this is a simple solution,” said BOX’s president.

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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