SEC Making a Statement with NYSE Fine

Penalty for oversight violations is agency's first shot fired since publication of the book 'Flash Boys.'

The New York Stock Exchange’s (NYSE's) $4.5 million penalty for oversight violations represents the Securities and Exchange Commission’s (SEC's) first salvo since Michael Lewis reignited scrutiny of market structure.

NYSE, which was bought by IntercontinentalExchange Group Inc. (ICE) last year, agreed to settle allegations that it failed to formulate or ignored rules governing everything from how traders connect computers to when prices are disseminated to floor brokers. It’s only the fifth time the SEC has imposed a monetary punishment on a U.S. exchange.

The action had something for everybody in the market structure debate, with regulators making NYSE pay for lax compliance while citing years-old offenses that were mostly procedural. In September 2012, the company paid $5 million over rule violations for giving certain customers trading data before the public.

“When you compare it to the $5 million NYSE paid in the data feeds settlement, the amount of this fine is a big deal,” Dave Lauer, president of consulting firm Kor Group LLC said in a phone interview yesterday. “At the end of the day, the SEC is making a statement. This is the way they operate now.”

The sweeping complaint is the SEC’s first regulatory broadside against a major U.S. exchange since the publication of Lewis’s “Flash Boys” a month ago. The book sparked a debate about how fairly the American equity markets are structured. While the payment is small compared with NYSE’s earnings, until recently fines were never levied against U.S. equity exchanges, which are shielded from legal scrutiny.

“It seems the case now that the SEC is treating exchanges just like any other regulated entity,” Lee Schneider, New York-based counsel at law firm Debevoise & Plimpton LLP, said by phone. “The level of detail they go into also indicates to me they’re looking into all activities at an exchange, rather than at a higher, level.”

Eric Ryan, a spokesman for Atlanta-based ICE, declined to comment. Shares of IntercontinentalExchange were little changed today, trading at $205.77 at 9:35 a.m. New York time.

“The order highlights instances where the exchanges conducted business without a rule in place due to weak or inadequate policies and procedures,” the SEC said in a statement. “In other instances, the exchanges did not operate in compliance with their effective rules. Both failures reflect a troubling lack of compliance with the requirements and obligations imposed on securities exchanges.”


Self Regulation

Like other stock venues, the NYSE is a self-regulatory organization (SRO), meaning it writes its own rules and submits them to the SEC before they are enacted. In yesterday’s complaint, the SEC alleged that the NYSE failed to develop strong enough procedures in some cases, and broke existing ones in others, and at times did not act when told by the agency’s staff that it was in violation of regulations.

“The SEC probably sees a problem in the SRO model when they can’t get an SRO to do what they want,” Lauer said.

Listed in the SEC release were violations related to day-to-day operations at NYSE, among them the practice of colocation, which allows brokers to place computers close to exchange machines in order to reduce the time it takes to transmit orders. The citations were procedural, alleging NYSE rules lacked specificity or were ignored, and the SEC stopped short of indicating the practices themselves are illegal.

For instance, when NYSE provided colocation services to customers, it did so “without an exchange rule in effect that permitted and governed the provision of such services on a fair and equitable basis,” according to the SEC. A feed that published data on trading imbalances to floor brokers was distributed at 2 p.m. from December 2008 through May 17, 2010, even though that did not comply with a NYSE rule stating the feed would first be sent to floor brokers at 3:40 p.m.

In another example cited by the SEC, the NYSE exchanges used an error account maintained at Archipelago Securities LLC to trade out of securities without having appropriate rules. Archipelago maintains the error account to trade securities that it acquires when computer malfunctions require it to buy or sell stock to maintain an orderly market.

In one instance, on Jan. 11, 2010, a testing error led ArcaSec to acquire erroneous positions with a total value of more than $4 billion, ultimately suffering a net loss of $1.2 million.

The exchanges, without admitting or denying the findings, agreed to settle the claims by retaining an independent consultant and paying the penalty along with ArcaSec, the SEC said.

Yesterday’s settlement was the second time in less than two years that the NYSE has been assessed a cash penalty by the SEC, and the fifth civil monetary penalty between the regulator and an equities exchange.

In August, Chicago Stock Exchange Inc. agreed to pay $300,000 to settle regulatory claims that it failed to comply with rules designed to ensure all investors get the best prices. The SEC exacted a $6 million settlement from CBOE Holdings Inc. in June after it was found to have interfered with a three-year SEC investigation of short selling at a member firm. In May 2013, Nasdaq OMX Group Inc. agreed to pay the regulator $10 million to settle charges that it violated securities laws during Facebook Inc.’s initial public offering in 2012.

SEC Chairman Mary Jo White faced questions from lawmakers at a congressional hearing April 29 about criticism of the SEC’s oversight of stock markets and automated trading strategies. While Republicans praised White for conducting a comprehensive review of market rules and activity, they questioned her proposal for a larger budget.

“We could not be doing a more intensive review of all of the issues,” White said, adding that she couldn’t disclose when the SEC would issue recommendations for new rules.


‘Token’ Fine

In March, the New York attorney general began a broad investigation into the U.S. stock market, while the Federal Bureau of Investigation is examining some strategies.

Not everyone believes yesterday’s settlement was a strong signal to the industry.

“Most likely it was a token, kind of, ’We want you to pay more attention to this, but we’ll let it slide this time; just do better next time,’ whatever 'better' means,” Javier Paz, a senior analyst at Boston-based Aite Group LLC said by phone.

That the settlement was reached now suggests the process began two or three years ago, Paz said, implying that it wasn’t the SEC simply responding to recent controversies.

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