Another Flash Crash and New Rules

Home Depot became the latest security involved in an algorithm-driven "flash crash" this past Tuesday. The stock dropped more than 12% down to $86.52 nearly instantaneously as the trading day drew to a close. The NYSE immediately reviewed the trades that occurred over a one minute period (from 3:55pm to 3:56pm) and decided to cancel all trades that cleared at a price below $93.33.

We've blogged previously about the impact of algorithmic trading in markets (our White Paper on the subject is a great starting point), and this latest mishap lent a spotlight to the SEC's announcement on Wednesday of rule changes aiming to prevent these types of occurrences.  

Regulation SCI ("systems compliance and integrity") was proposed in March of last year, with a comment period until July. The new regulation would require exchanges (and other entities like clearinghouses, 'significant' alternative trading systems, and plan processors) to ensure that core technology meets certain standards. Beyond meeting those standards, entities would need to test their systems to ensure that standards are maintained and send out notifications related to any failures or disruptions. Plans for backup systems and other emergency processes would also be required for business continuity purposes.

The genesis of Regulation SCI is in the major flash crash that occurred in 2010, after which then-SEC chairwoman Mary Schapiro vowed to take steps to ensure that technology would not be the cause of any future disruptive market events. During her tenure she focused on various aspects of high frequency trading and dark pools, and that momentum has carried over to present reforms championed by current SEC chairwoman Mary Jo White.

The process of bringing Regulation SCI to completion has been arduous, with Democratic commission members Luis A. Aguilar and Kara M. Stein arguing that wholesalers like Citadel Securities should be included amongst those regulated. Republican commissioners have opposed expanding the rules reach. Brokers have been fighting to keep themselves excluded from regulation, noting that a failure on a broker's trading platforms would not necessarily have a broader market impact. Those arguing that brokers should be included point to the $440 million in losses caused by Knight Capital in 2012.

Exchanges have pushed for dark pools to be included under Regulation SCI, and the SEC plans include them if the pool trades 5% of daily volume in a single stock, 0.25% of total exchange-listed equities, or 1% of the average daily dollar volume across equities.

On Wednesday, the SEC voted to unanimously accept the proposed rule changes, with dark pools included and an expansion to cover brokers still under consideration. The rule will likely impact 44 firms, and the SEC estimates that those firms will incur one-time compliance costs of $62-176 million and $49 to $124 million in annual costs thereafter to comply with SCI.

The largest entities covered (the NASDAQ, NYSE and BATs exchanges, along with dark pools run by Credit Suisse and UBS) all indicated support for the policy goals of the SEC, but voiced concerns over the cost and complexity of complying with SCI. Some industry insiders have already speculated that the increased compliance costs will be passed along to customers, increasing trading costs for market participants.