The SEC Action Against the NYSE: The Need to Ensure Fair Markets
When corporations selectively disseminate material non-public information to one group prior to making it publically available is a violation of Regulation FD, the selective disclosure unfairly disadvantages the investing public. When a corporate executive furnishes his or her friends with the material non-public information of the firm so they can trade it is called insider trading. Again the action unfairly disadvantages the investing public.
When an exchange gives material, non-public market data to proprietary customers prior to making that information being available to the public however its called a compliance failure, a violation of Regulation NMS (National Market System) Rule 603(a). That is the charge and the basis for the proceeding captioned In the Matter of New York Stock Exchange LLC, Adm. Proc. File No. 3-15023 (Sept. 14, 2012). The proceeding is being hailed as the first of its kind. It is not the first time the NYSE has had this kind of a problem or that the investing public has been disadvantaged.
The facts on which the proceeding is based are straight forward. The NYSE receives innumerable buy and sell orders for securities each trading day. This information is fed into its Display Book or DBK for processing. For the Exchange, this is the matching engine. That engine matches orders and generates executions, redirects orders for routing to other exchanges and maintains limit orders in the NYSE’s order book for possible future execution. The matching engine also generates market data from this information. The NYSE sends quotes and trade reports regarding its listed securities to a network processor where it is combined with information from other market centers into consolidated feeds that are offered for sale to the public. The Consolidated Tape Association governs this processor.
The NYSE Display Book or matching engine feeds its information to two sources. One is a proprietary feed called Open Book Ultra. This information is then sent outside the exchange to its proprietary feed customers. The alternate path for the information from the Display Book is routed to an internal distribution system known as Info Bus. The information is then processed through alternate feeds. One is a second proprietary feed. The other is the Market Data Distribution system or MDD or its predecessor. This feed processes quotes and trade reports into the formats required by the Consolidated Tape Association. The information is then made available for sale to the public on a consolidated basis.
From June 2008 through July 2011 the internal path for the information being made available to the NYSE proprietary feed customers had less steps and thus was quicker. As a consequence of the system design, proprietary feed customers obtained information quicker. The average gap ranged from “single digit milliseconds to 100 or more milliseconds, with the worst disparities exceeding multiple seconds . . .” according to the Order.
The system here was designed by the various business groups at the NYSE. Throughout its design the compliance department was not consulted. Once it went into operation, there was no formal compliance program. Records which would have been available to analyze the operation of the system were not maintained.
Commission Rule 603(a) requires that exchanges distribute market data on terms that are “fair and reasonable” and not ‘unreasonably discriminatory,” according to the Order. The Rule also precludes releasing data regarding quotes and trades to customers through proprietary feeds before sending the information for inclusion in the consolidated feeds. Thus, under this Rule “exchanges have an obligation . . . to take reasonable steps to ensure – through system architecture, monitoring or otherwise – that they release data relating to current best-price quotations and trades through proprietary feeds no sooner than they release data to the Network Processor, including during periods of heavy trading.”
Exchange Act Section 17(a) and Rule 17a-1 require exchanges to keep and maintain at least one copy of each record made or received in the course of the business day. Under this Rule the exchange should have maintained records regarding the these transactions. Nevertheless, the NYSE failed to maintain these records.
The NYSE exchanged resolved the proceeding. The Exchange consented to the entry of a cease and desist order based on the Sections cited in the Order and to a censure. It also agreed to pay a civil penalty of $5 million.
In addition, the NYSE is required to implement a series of undertakings the Exchange included in its offer of settlement. Those include the retention of a consultant who will analyze the systems and make recommendations for improvement. They do not include any requirement for involvement of the compliance department.
The Commission has brought two prior proceeding against the NYSE regarding the use of proprietary information. In 1999 a settled action was filed which alleged that the Exchange failed to detect and halt unlawful proprietary trading by the independent floor brokers. In the Matter of New York Stock Exchange, Inc., Admin. Proc. File 3-9925 (June 29, 1999). In 2005 the Commission concluded that the Exchange failed to detect, investigate and discipline widespread unlawful proprietary trading by specialists on trading floor. In the Matter of New York Stock Exchange, Inc., Admin. Proc. File 3-11892 (April 12, 2005).
The point of the war on insider trading is to root out the misuse of proprietary information and, perhaps more importantly, to reassure the public the U.S. capital markets are fair. For a skeptical public that distrusts Wall Street and may well believe that it is all an insiders game which is rigged so they cannot win this is a critical point and a key focus of SEC Enforcement. Indeed, it is critical for the life of the capital markets.
Actions such as this more than reinforce the notion that the average investor is severely disadvantaged in these markets. For years the nation’s premier exchange has operated a system which gave distinct advantages to its proprietary customers. For years the NYSE operated a system which by design had less steps between the collection of trading information and its distribution to proprietary customers than to the public. That design should have been a red flag in and of it self – less steps clearly suggests quicker distribution. While there is discussion in the Order about the efforts to make the system comply with the Rules, the fact is the design flaws continued for six years. This can only serve to reinforce the feeling on Main Street that the game is rigged. This is particularly true in view of the Exchange’s history of compliance failures coupled with its inexplicable failure here to not even include the compliance department in the design of the system or develop a meaningful compliance system over the years. The failure to maintain the required records only serves to reinforce this and, perhaps, suggest that the errors were more than simple compliance failures.
In the end it is critical to reassure Main Street that the U.S. capital markets are fair, open and provide equal opportunity for all. This is important not just for Main Street but for Wall Street and the country. As the nation struggles to recover from the market crisis now is the time for the SEC to make this happen.