A new bill was just introduced by Representative Loudermilk (R-GA), which would amend the Securities and Exchange Act of 1934 to basically reduce or eliminate regulation overreach into business models of exchanges that do not involve either reporting or effecting a transaction on the exchange. As Representative Loudermilk put it in the following statement when introducing the bill, “Regulatory agencies have a tendency to expand their reach into areas they should not be regulating and engage in mission creep, which can stifle innovation”.
If innovation is referring to the exchanges seizing opportunities to create new revenue streams by selling speed, rather than effecting and recording transactions, then perhaps we need regulation overreach.
The unprecedented structure of exchanges and dark pools today is dramatically different than even a decade ago. It appears that HR3555 would put safeguards in place to prevent agency over-regulation, or in other terms would allow regulating agencies to turn a blind eye to the new market structure by not addressing these issues.
HR3555, The Exchange Regulatory Improvement Act as it is titled, aims to further define the term “facility” regarding regulatory purposes of an exchange, adding that the term does not refer to business activities with a purpose that is not intended to either report or effect a transaction on the exchange.
What does this mean? In simple terms, it means that this bill attempts to provide an exempt status, or immunity altogether, for an exchange’s business activities outside the core functions of effecting and reporting trades.
Exchange Activities Receiving Immunity
To understand the effect that passing HR3555 would have, we need to understand the activities in question. Exchanges today earn revenue in ways other than facilitating trades. The most recognized activities include enhanced proprietary data feeds, colocation of servers, and complex order types all designed to give an unfair advantage to high frequency traders which currently make up at least 50% of all trading activity in US Markets. For more information on how stock exchanges make money with business activities other than recording or effecting trades, check out this post on How Rising Costs of Stock Exchange Data Fees Affect Online Equity Trading.
Proprietary data feeds allow high frequency trading firms to purchase premium data for a hefty price as an optional service, although it is impossible for firms to compete without it, making it necessary rather than optional. Colocation of servers provides the advantage, or unfair advantage, of increased speed which is the deciding factor on how black your bottom line will be when the bell rings at the end of a day on Wall Street.
Creating complex order types is another tactic many exchanges and dark pools use to seize profits in this opportunistic environment. Preprogrammed order types with identifiers aimed to provide service and convenience to investors are really a way to leak information to HFT firms, especially the firms that purchase the proprietary data feeds, which is all of them. Check out the Day Trading Guide to Stock Order Types for more information on specific orders such as Nasdaq’s ELO Order, and the Discretionary Peg (D-Peg®) Order by IEX.
All these additional revenue streams earn billions of dollars for the exchanges and dark pools providing them, in addition to padding the pockets of the HFT firms paying for the service. These monetary incentives must come from somewhere. According to Michael Lewis in the highly publicized bestseller “Flash Boys”, these big profits come at the expense of long-term investors in earnings skimmed off of retirement funds and pensions.
Why Introduce HR3555, The Exchange Regulatory Improvement Act?
Since the publication of Flash Boys in 2014, there have been a flurry of lawsuits against exchanges and dark pools, amid accusations of market rigging and aiding HFT activity, in essence aiding and enabling unfair trading. One such lawsuit alleged that dark pool Barclays in addition to seven US stock exchanges, including Nasdaq and the NYSE, manipulated pools to give HFTs market advantages. Day Traders everywhere were watching the outcome as this has been a frustrating development in the market for quite some time.
This groundbreaking lawsuit brought under U.S. District Judge Jesse Furman was a consolidation of four suits from the District of New York, with one suit from the State of California, and was eventually thrown out in August of 2015. Counsel for the defendants stated that the Plaintiffs rushed into a lawsuit without taking the time to properly plead their case, partially brought on by the allegations in the book Flash Boys.
The Judge threw out the lawsuit stating that stock exchanges had immunity as their actions fell within “quasi government” powers.
While the exchanges and dark pools may have won the battle, the war is not yet over.
Status of HR3555 – To Grant or Not to Grant Immunity
Since the filing of the combined lawsuits, the Securities and Exchange Committee (SEC) contributed by saying that they had no authority to adjudicate the lawsuit, and that “immunity only applied when stock exchanges acted as a regulator, and not as an operator of a market”. In other words, this means that the SEC is claiming that exchanges are NOT entitled to absolute immunity arising from commercial activities such as enriched data feeds or selling collocation.
This might be weighing on the minds of the executives of the exchanges, prompting the introduction of HR3555. The bill must pass the House and Senate before becoming law and will most likely be reviewed by committee before it’s sent to the House.
If passed, Loudermilk’s bill seems to give protection from investor lawsuits stemming from unfair advantages granted to HFT firms. The implied intent is to skirt the SEC’s role of protecting investors by finding a way around them in Congress. Just by adding one paragraph to the original Securities Exchange Act of 1934, the SEC could be prevented from acting as a regulator of stock exchanges for any issue surrounding the selling of speed.
If HR3555 carves out the non-execution portions of their business from regulation, wouldn’t that also carve those out of their immunity? That would take it out from under the SEC, but it seems like it would also take it out from under the immunity umbrella afforded to “quasi-government” stock exchange activities.
If they carve out those activities from what is regulated under the SEC Act of 1934, how could they then claim immunity for those activities? They would have it both ways – not included under the Exchange umbrella for regulatory purposes, but included when courts look at Exchange immunity.
We’ll have to watch the outcome of this one, and see what the Committees have to say.
Is it coincidence that the sponsor and four additional co-sponsors of HR3555 are from the following states: GA (home of Jeff Sprecher’s Intercontinental Exchange, ICE), NY, and IL (Chicago Stock Exchange was a defendant in the dismissed lawsuit)?
We’ll let you decide, and we will be watching the progress on HR3555 as it moves through the legislative process.
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