CURRENT ISSUES IN THE EQUITY TRADING MARKETS // February 9, 2010

Davis Polk & Wardwell LLP

CURRENT ISSUES IN THE EQUITY TRADING MARKETS

Presented by Jerry Citera

February 9, 2010

Buffalo University Law School

New York City Program

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Topics

Requirements for a National Market System

Overview of Current Market Structure

Key Regulatory Developments in the Equity Trading Markets

Evolution of the Equity Trading Market

SEC Announces Broad Review of Equity Trading Markets

SEC Concept Release on Equity Market Structure

SEC/Nasdaq Sponsored Access Rules

SEC Proposed Rule Regarding Flash Orders

SEC Proposed Rule Regarding Dark Pools

Short Sales

Use of Customer Information

Securities Lending

Glossary of Market Structure Terms

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Requirements for a National Market System

Exchange Act Requirements for National Market System

In 1975, Congress found that it is in the public interest and appropriate for the protection of investors and the maintenance of fair and orderly markets to assure five objectives:

1. Economically efficient execution of securities transactions;

2. Fair competition among brokers and dealers, among exchange markets, and between exchange markets and markets other than exchange markets;

3. The availability to brokers, dealers, and investors of information with respect to quotations and transactions in securities;

4. The practicability of brokers executing investors’ orders in the best market; and

5. An opportunity, consistent with efficiency and best execution, for investors’ orders to be executed without the participation of a dealer.

Congress also found that these five objectives would be fostered by the linking of all markets for qualified securities through communication and data processing facilities.

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Overview of Current Market Structure

Trading Centers

1. Registered Exchanges (11 Exchanges)

2. Electronic Communication Networks (“ECNs”)

3. Dark Pools

4. Broker-Dealer Internalization

Linkages

1. Consolidated Market Data

2. Trade-Through Protection

3. Broker-Dealer Routing Services

Drivers of Change

1. Technology – Manual Trading Market to Electronic Market

2. Regulatory Reform

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Key Regulatory Developments in the Equity Trading Markets

Enactment of the Securities Act Amendments of 1975 Mandating National Market System

Evolution of the Third Market and repeal of NYSE Rule 390

Limit Order Protection Rules Adopted (NASD Manning Rule and NYSE Rule 92)

Introduction of SuperSoes automated Trading Capacity

Enforcement Actions Against OTC Market Makers in 1996

Antitrust

SEC

NASD

Adoption of the Order Handling Rules (Display Rules) in 1996

Adoption of Regulation ATS in December 1998

Decimalization 2000

Adoption of Rules Requiring Disclosure of Order Execution and Routing Practices 2001

Adoption of Regulation NMS in June 2005

SEC Concept Release and Related Rule Proposals 2009-10

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In US equities, technology-based trading has completely redefined the landscape . . .

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09

NYX NDAQ TRF ex BATS & DE

BATS Direct Edge EDGX

EDGA ISE-SX Other

NYX

NDAQTRF (ex BATS, DE)

Direct Edge

BATSEDGX

Source: BATS Exchange, Inc.

Market Share, US Equities

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. . . with off-exchange venues (i.e., dark pools) steadily gaining market share in the last 2 years . . .

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09

0

10

20

30

40

50

60

70

Dark Pools as % of Consolidated Volume VIX Average Close

Source: Rosenblatt Securities

Percent of Consolidated Volume VIX Average Close

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. . . leading to the emergence of some big players in the equity execution business – that aren’t exchanges

CREDIT SUISSE CROSSFINDER

17%

GOLDMAN SACHS SIGMA X

15%

KNIGHT LINK13%

GETCO EXECUTION SERVICES

13%

LEVEL ATS7%

MORGAN STANLEY MS POOL

6%

UBS PIN5%

CITI MATCH4%

BARCLAYS LX4%

LIQUIDNET4%

ITG POSIT3%

INSTINET CBX3%

NYFIX MILLENNIUM2%

BIDS TRADING2%

PIPELINE TRADING1%

BNY CONVERGEX VORTEX

1%

Source: Rosenblatt Securities, August 2009

Breakdown of Dark Pool volume (8.6% of total volume)

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Europe has experienced similar changes

Source: Federation of European Securities Exchanges

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High Frequency Trading in the US is rumored to account for than 70% of equity volumes . . .

30%35%

47%

67%73%

0%

10%

20%

30%

40%

50%

60%

70%

80%

2005 2006 2007 2008 2009eSource: Tabb Group, August 2009

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. . . with a select few players accounting for most of the volume

Traditional99%

High Frequency

1%

Percent of US trading firms with a high frequency strategy

Traditional33%

High Frequency

67%

Percent of US equity volume driven by high frequency strategies

Source: Tabb Group, August 2009

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SEC Announces Broad Review of the Equity Trading Markets

In late 2009, the SEC announced that it is undertaking a broad review of market structure issues. Topics include:

Flash Orders – (Difference between IOI’s and orders)

Dark pools (including the use of indications of interest)

Regulation ATS thresholds (Appropriate Disclosure Levels)

Post-trade transparency of alternative trading systems

Sponsored market access – (Broker-dealers must be gatekeepers)

High frequency trading – (Volatility)

Colocation – (Fairness in access)

Short Sales

Consolidated Audit Trail

Inter-Market Surveillance System

Large Trader Reporting Requirement

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SEC Announces Broad Review of the Equity Trading Markets (cont.)

In a speech on October 27, 2009, Chairman Schapiro announced the SEC intent to conduct a broad review of the equity trading markets and identified the key market structure issues that the SEC concept release would cover.

On October 20, 2009, Senator Schumer sent a letter to the SEC calling for action on a variety of topics affecting the equity trading markets including establishment of a consolidated market surveillance authority across trading venues; various rules regarding approval and requirements for ATSs; and treating actionable IOIs as firm quotes.

On October 28, 2009, the Senate Banking Committee on Securities, Insurance and Investment held hearings on Dark Pools, Flash Orders, High Frequency Trading and Other Market Structure Issues.

On January 21, 2010, Jamie Brigagliano, Deputy Director of the Division of Trading and Markets of the SEC gave the keynote address at the SIFMA Dark Pool Symposium in which he summarized the outstanding proposals and identified two additional initiatives: SEC consideration of a larger trader reporting proposal and the implementation of a consolidated audit trail to facilitate intermarket surveillance efforts.

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Why now?

In light of the major regulatory reforms before Congress and on the plate of the SEC, why focus on these equity market structure issues at this point in time?

Regulation NMS baked in and new issues and concerns are now crystallizing

Easy Target – definable problem – shows progress and action by regulators

Political Pressure – Key Players (NYSE) fighting competitive battle supported by Senate Schumer and others

SEC fighting for life and relevance as a result of the financial crisis

Pent up initiative on SEC staff level to address these issues

Other areas of reform are still being considered by Congress and will take legislative reforms

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SEC Concept Release On Equity Market Structure

On January 14, the SEC published a broad concept release that will be the cornerstone of its review of equity market structure. SEC Release 34-61358 (Jan.14, 2010).

The 74-page concept release seeks comment on a broad range of issues, many of which have arisen since the implementation of the Commission’s Regulation NMS.

In the concept release, the SEC requests public comment on literally hundreds of questions on equity market structure performance (in particular for “long-term investors”), high frequency trading, and undisplayed liquidity. Many of the questions raise issues that could have significant potential impact for broker-dealers, proprietary trading firms, exchanges, and other market participants.

The concept release is part of an ongoing SEC review of the equity markets. As noted in the following pages, the SEC has already issued four major rule proposal addressing perceived risks in the equity trading markets.

We await proposals regarding enhanced large-trader reporting and an intermarket surveillance plan, as well as a final short-sale price restriction rule, which Chairman Schapiro has said will be brought to a Commission vote as soon as February.

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Dark Pools

The primary regulatory concerns expressed by Concept Release regarding dark pools include:

Fragmentation

The SEC is concerned that trading in dark pools is siphoning orders away from displayed markets in a way that harms public price discovery.

Dark pool trading volumes may be passing the fragmentation “tipping point.”

Are long term investors abandoning the lit markets to the machinations of the high frequency traders?

Transparency

The SEC is concerned about the reliability of public information regarding dark pool trading activity, and the lack of a uniform methodology for determining trading activity metrics.

The SEC is concerned that dark pools are using actionable indications of interest to attract order flow without the concomitant quoting obligations of a displayed market.

Fair access

The SEC is concerned that dark pools’ routing of indication of interests to selected market participants unfairly disadvantages market participants that do not have access to these indications of interest.

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Dark Pools

Proposed responses include:

Better execution quality statistics

Trade-at rule

Depth of book protection

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High Frequency Trading

Broad policy question:

Do high frequency traders add value to the market by increasing liquidity and certainty of execution at various execution prices and thereby justify the profits they take from the market (“passive liquidity providers; arbitragers”)

OR

Do high frequency traders harm markets by stepping in front of legitimate customer orders and long term investors causing rapid increases in the prices of securities, increased volatility, and making those customers pay more for the securities (“order anticipators; momentum igniters”).

Proposed responses include:

Market maker obligations

Broker-dealer registration

Regulation of manipulative strategies

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Colocation

Broad policy question:

Does co-location create two tier market giving increased access to a limited group of market participants to the disadvantage of other participants in the market

Proposed responses include:

Fair access for exchanges

Treatment of colocation facility as a facility of the exchange

Regulatory parity with respect to leased and owned data centers

Reliability and redundancy standards

Latency disclosures

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SEC Proposal On Sponsored Access

On January 19, 2010, the SEC proposed a new rule that would effectively prohibit unfiltered access to equity trading markets by requiring broker-dealers to maintain risk management controls and supervisory procedures to manage customer access to such markets. SEC Release 34-61379 (Jan. 19, 2010)

Proposed Rule 15c3-5 would apply to broker-dealers with access to trading in securities on an exchange or ATS as a result of being a member or subscriber of the exchange or ATS (“market access”), or that provide this market access to others.

These broker-dealers would be required to establish, document, and maintain a system of risk management controls and supervisory procedures reasonably designed to manage the financial, regulatory, and other risks, such as legal and operational risks, related to the market access business activity.

By requiring such controls and procedures to be under the broker-dealer’s “direct and exclusive supervision,” the proposal mandates that customer orders under these arrangements pass through systems controlled by the sponsoring broker-dealer.

The proposal would also mandate an annual review, and a CEO certification, of the effectiveness of these controls and procedures.

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NASDAQ Sponsored Access Rule

On January 19, 2010, the SEC simultaneously approved a more limited Nasdaq sponsored access rule change, which would require additional controls but not ban direct access.

Amended Nasdaq Rule 4611:

Permits members to provide access to Nasdaq by passing orders through the member’s own systems or through other means.

If the member provides market access other than through its own system, it must contractually require customers to comply with applicable laws, trade within agreed limits, and grant access to their books and records. Special requirements apply where access is provided through a third party provider.

Mandates controls reasonably designed to prevent trading in excess of credit thresholds or of restricted products, submission of erroneous/duplicative orders and regulatory violations.

Prescribes audit trail, reporting and supervisory review standards.

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Sponsored Access (cont.)

The SEC and SROs have raised the following concerns about Sponsored Access

Risk issues

Lack of risk controls over, or pre-trade monitoring of, sponsored participants

Potential for a domino effect meltdown caused by one erroneous algorithm or errant trade

Enforcement issues

Manipulative behavior by sponsored participants “Spoofing”

Marking the close

Wash sales

Frequent cancellations

SRO rule violations including market on close orders and odd lot order execution

Need for involvement of legal and compliance personnel in the algorithm creation and oversight process

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SEC Proposed Rule Regarding Flash Orders

The SEC proposed eliminating the use of flash orders. SEC Release 34-60684 (Sep. 18, 2009).

The widely anticipated proposal eliminates an exception from Rule 602 of Regulation NMS – the quote rule – for orders that are withdrawn or cancelled if not executed immediately.

Notable points in the proposal include:

The SEC continues to view immediate or cancel orders and price improvement auctions as permissible order types.

The SEC cited the Regulation ATS adopting release discussion regarding indications of interest.

Questions posed for public comment include:

Whether trading floors should be permitted to continue manual “flashing” of orders if electronic “flashing” is prohibited and what, if any, conditions should apply.

Whether there should be a distinction in approach between listed options and cash equities.

Whether requiring broader dissemination of flash orders, such as in the consolidated quote stream, or providing flash orders free of charge to anyone, would address concerns about a two-tiered market.

Comments to the proposal were due by November 23, 2009.

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SEC Proposed Rule Regarding Dark Pools

The SEC issued its formal proposal on Regulation of Non-Public Trading Interest on November 14. SEC Release 34-60997 (Nov. 14, 2009).

In essence, the proposal requires:

Post-trade reporting of ATS activity Trade reporting that identifies the dark pools, as opposed to a generic “OTC” label

Trade-by-trade disclosure versus summary statistics

Exception for large trades of $200,000 in value

Indications of Interest Actionable versus nonactionable

Expansion of Regulation ATS adopting release discussion of firm quotes

Effect on public price discovery

Regulation ATS thresholds for fair access and quoting .25%

All stocks once an ATS crosses the threshold in a percentage of its stocks

Exception for large trades of $200,000 in value

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Short Selling: New Rules

Misrepresentation of Locates:

Reg SHO requires brokers to obtain a locate prior to executing a short sale for a client.

Customers, however, may also be liable under the SEC’s anti-fraud rules if they misrepresent the availability of a locate to the broker executing a short sale.

Rule 10b-21 (eff. October 17, 2008) emphasizes/amplifies prohibitions against misrepresenting locates.

Rule 204 (eff. July 27, 2009) amended Reg SHO with the intention of “help[ing] to further [the SEC’s] goal of addressing “naked” short selling in all equity securities. Rule requires a fail to deliver position to be closed out by the beginning of regular trading hours on the next trading day following the day on which the fail first occurred.

“Today’s actions demonstrate the Commission's determination to address short selling abuses while at the same time increasing public disclosure of short selling activities that affect our markets.”

– SEC Chairman Mary Schapiro, announcing Rule 204 and other related initiatives, July 27, 2009

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Short Selling: New Rules (cont.)

Price Test Restriction Proposals

First set of proposals was released in April, followed by an additional proposal in August.

Significant issues:

Circuit breaker v. “all stocks, all the time”

Exception for market makers (including derivatives market makers)

Absolute prohibition versus policies and procedures

Short Sale Marking Issues

In August, Trading and Markets staff released new FAQs regarding short sale marking.

Marking multiple “orders in flight”

Marking “mixed” long/short orders

Treating all foreign broker-dealers (including Canadian brokers) as customers for purposes of the rule

Trading and Markets staff have said that they are listening to market participants’ reactions on the FAQs.

Big challenge by some firms that the SEC overstepped its boundaries by changing substantive trading rules without following proper administrative process

No definitive indication of an inclination to revise the FAQs

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Short Selling: New Rules (cont.)

Pre-borrow Requirement

The SEC hosted a roundtable on September 29-30, 2009 on securities lending and shorts sales that discussed the concepts of pre-borrow, arrange to borrow and hard locate requirements.

Concern about non-decrementing locates

Balance sheet implications

Disclosure issues

Daily Publication of Short Sale Volume Information:  SROs began publishing on their Web sites the aggregate short selling volume in each individual equity security for that day.

Disclosure of Short Sale Transaction Information:  SROs began publishing on their Web sites on a one-month delayed basis information regarding individual short sale transactions in all exchange-listed equity securities, excluding any identifying information.

Enhanced Disclosure of Fail to Deliver Information: The Commission enhanced the publication on its Web site of fails to deliver data so that fails to deliver information is provided twice per month and for all equity securities, regardless of the fails level.

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Use of Customer Information

Regulators are tightening standards for trading for large customer orders.

FINRA and NYSE proposed to harmonize their Rule 92 and the Manning Rules (March 2009).

The proposals would require affirmative written consent before entering into terms and conditions with institutional accounts.

FINRA proposed to broaden its front running policy (December 2008)

The proposal extends the scope beyond certain options and security futures to other types of derivatives, financial instruments and financial contracts.

The comment period closed on February 27, 2009.

OCIE “Top Five Issues” include front running of customer orders.

Regulators also are focusing on handling of small customer orders.

The FINRA and NYSE Rule 92/Manning Rule harmonization proposal applies to all customer orders.

The proposals would merge limit order and market order protections and apply them to all equity securities.

The proposals allow walling off market maker desks with information barriers bolstered by supervisory procedures.

NYSE/FINRA are conducting an ongoing sweep of algorithmic trading.

This sweep specifically is examining interaction of algo orders with proprietary trading desks.

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Securities Lending

The SEC’s recent roundtable also focused on securities lending issues.

The SEC seems to view securities lending as a part of its broader review of opaque markets (e.g., dark pools).

Chairman Schapiro has said that, “securities lending is an area that perhaps has not received the level of regulatory attention that is necessary to ensure the fair and investor-oriented operation of a multi-trillion dollar market.”

Key issues discussed at the roundtable include:

Securities lending market structure

Progress toward an automated and transparent market

Extent of public information available to beneficial owners

Whether a central counterparty is useful for the securities lending market

Short sale related issues

Does the securities lending market preclude more stringent pre-borrow/arrange to borrow/hard locate requirements?

Is a hard borrow rule necessary in light of the success of the hard delivery rule in reducing naked short selling?

Do structural issues in the current market (i.e. disconnect of actual borrow from affirmative determination particularly in the area of prime brokerage) preclude any such changes?

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Glossary Of Selected Market Structure Terms

ATS refers to an “alternative trading system” that acts as a venue for trading securities and is subject to regulation under Regulation NMS. Alternative trading systems are typically electronic trading systems involving multiple parties (although manual interdealer broker systems are also ATSs). ATSs are required to register with the SEC as broker-dealers and as an alternative trading systems, and are subject to requirements for quoting, fair access, systems reliability and information confidentiality at differing thresholds of market share. They also cannot call themselves exchanges.

Co-location refers to the practice of exchanges, ATSs or third parties providing space for the servers of market participants in the same data center housing the matching engines of the trading center. Co-location is favored by high frequency traders because it affords lower latency in the transmission of the order from the trader to the market center.

Dark Pools refers narrowly to ATSs that do not display bids and offers in the public quotation stream. More broadly, Dark Pools refers to sources of liquidity not reflected in public quotes, such as dark orders on exchanges and internalization of orders by a broker-dealer.

Decimalization refers to the transition from quoting stock prices in 1/16ths or 1/8ths of a dollar to quoting in pennies, or decimals. The transition to decimal pricing occurred in 2000.

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Glossary Of Selected Market Structure Terms

Direct Market Access refers to the practice of a broker-dealer providing its client with the ability to route orders directly to a market using the broker-dealer’s market participant identifier, or MPID. Direct Market Access sometimes refers only to orders that are routed through a broker-dealer’s systems for credit and regulatory checks before routing on the market; in this context, orders that are not routed through the broker-dealer’s systems are referred to as sponsored access or naked access.

ECN refers to an “electronic communications network,” which is an ATS used in part by market makers that displays orders within its system. ECNs do not include dark crossing systems or over-the-counter market makers’ trading as principal with customers.

Exchange refers to a national securities exchange registered with the SEC. Examples include the New York Stock Exchange and Nasdaq. Exchanges are subject to greater regulatory oversight than ATSs.

Flash Orders refers to a practice whereby a trading center will for a few milliseconds show to subscribers customer buy orders priced at the national best offer, or customer sell orders priced at the national best bid. Subscribers with fast electronic connections can then execute the orders at the flash price. If the order is not immediately executed, it is withdrawn without exposure to the entire marketplace, or is routed to other exchanges. Flash orders are only tangentially related to high frequency trading.

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Glossary Of Selected Market Structure Terms

High Frequency Trading refers to automated trading by complex algorithms that enter and often cancel orders frequently, often thousands of times a minute. Many firms that engage in high frequency trading seek to end the day with little or no exposure to the market. Various strategies are used, including statistical arbitrage, market making and event-based strategies. In general, the term is vague and probably has different meanings to different people.

Indication of Interest refers to an order that requires further agreement before it can be executed. There is significant debate as to the point at which an Indication of Interest, or IOI, should be treated as “actionable,” i.e. as a firm order, thereby requiring a facts and circumstances analysis in many cases.

Limit Order refers to an order to execute a transaction at a specified price. Marketable limit orders are buy limit orders at or above the national best offer to sell, and sell limit orders at or below the national best bid to buy. Non-marketable limit orders are buy limit orders below the national best offer, and sell limit orders above the national best bid.

Locked and Crossed Market refers to a national best bid to buy that is at the same price as the national best offer to sell (Locked Market) or at a higher price than the national best offer to sell (Crossed Market). Exchanges are required by Regulation NMS to have rules to deter and correct locked and crossed markets. Locked and crossed markets occur when a quote is temporarily inaccessible, or when the quotes have access fees that discourage hitting the quote.

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Glossary Of Selected Market Structure Terms

Naked Short Sale refers to a short sale where the seller does not borrow or otherwise have available to deliver the shares that are sold short.

Sponsored Access usually is synonymous with Naked Access.

Spread refers to the difference in price between the national best bid to buy and the national best offer to sell.

Trade-through refers to transacting an order on one market center when a more advantageous price is available at another market center, i.e. “trading-through” the order. The order protection rule of Regulation NMS requires a trading center to establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent trade-throughs, subject to numerous exceptions. Rule 611(a)(1).

Upstairs Market refers to the market for trades executed internally by a broker-dealer or over-the-counter with another broker-dealer rather than on an exchange. Dark Pools have been analogized to the “upstairs market” for block trading that was prominent in the era of stock exchange dominance.

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Gerard S. Citera

Mr. Citera is counsel in our Financial Institutions Group and a senior lawyer in the firm’s Broker-Dealer and Market Regulation practice. He has extensive experience representing broker-dealers, banks, investment banks, investment advisers and other financial institutions in a wide range of legal, compliance and regulatory matters. His advisory practice focuses on the full scope of broker-dealer regulatory issues, including compliance, supervision, trading, sales, market structure, derivatives and technology. Mr. Citera has managed implementation of major regulatory, technological and market structure changes. He also structures and implements supervisory and compliance programs and procedures, conducts internal investigations and compliance reviews, and represents clients in SEC and SRO examinations, investigations and enforcement proceedings.

OF NOTE

In 2007, Mr. Citera received the Excellence in Alumni Service Award from the University at Albany

Since 2006, he has served as a guest lecturer and project manager for the SUNY Buffalo Law School New York City Program in International Finance and Law

Since 2004, he has served as a member of the Rockefeller College Advisory Board at SUNY Albany

Mr. Citera is one of the founders of and serves on the on Executive Committee for the Advisory Council of the Center for Financial Market Regulation at SUNY Albany

Mr. Citera has published numerous articles and practice outlines on various securities law issues and is a frequent speaker at industry conferences on broker-dealer regulatory issues

PROFESSIONAL HISTORY

Counsel, Davis Polk, 2008-present

Executive Director, UBS Securities, 2000-07

Deputy General Counsel, PaineWebber Securities, 1994-99

Counsel, Broker-Dealer Regulatory Group, Wilmer, Cutler & Pickering, 1985-94

Attorney, Division of Market Regulation and Office of General Counsel, SEC, 1982-85

212 450 4881 telgerard.citera@davispolk.com

Bar Admissions

State of New York

District of Columbia

Education

B.A., Magna Cum Laude, SUNY Albany, 1977

J.D., Magna Cum Laude, SUNY Buffalo Law School, 1980