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Irregularities at Regulated Exchanges

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On Wednesday, the Securities and Exchange Commission announced a settlement with NASDAQ for the exchange's mishandling of last year's Facebook initial public offering. NASDAQ's preparations for the high-stakes Facebook offering proved inadequate. The intense volume of orders overwhelmed NASDAQ's technological capabilities, many traders were left uncertain about whether their trades had gone through, and the IPO was widely panned as a failure. Even absent the SEC action, NASDAQ would have faced market pressure to demonstrate that the troubles of the Facebook IPO would not be repeated. Now that the SEC has worked out a settlement with NASDAQ, it should look at its own role in the Facebook incident and other recent exchange issues.

The SEC wields tremendous influence over exchanges. Exchanges operate within a complex SEC regulatory framework that governs, for example, how trades are executed and market data dissemination. Exchanges also have to submit for SEC approval the rules they write to govern themselves and their members. The SEC examines exchanges for their adherence to the securities laws, SEC regulations, and the exchanges' own rules. Because of the SEC's extensive indirect and direct influence on how exchanges operate, a potential contributor to any exchange failure is the SEC itself.

Trading incidents earlier this month underscore the need for the SEC to consider how its actions affect exchanges' ability to bring buyers and sellers together in an orderly, predictable, and equitable manner. Three stocks--one on May 17 and two on May 23--experienced large, temporary drops without any clear reason. Some market observers partially blame the SEC-orchestrated phase-out of a New York Stock Exchange mechanism designed to address such market volatility. The NYSE's Liquidity Replenishment Points are being phased out, over the NYSE's objections, as part of a broader SEC plan to prevent events like the flash crash of May 6, 2010, during which many stocks dropped precipitously. The NYSE, in its April filing to eliminate the so-called LRPs, explained that "for many years, LRPs have been a key selling point of the Exchange to both investors and listed companies" and "have delivered concrete benefits to public investors in the many erroneous or aberrant trades they have eliminated." The filing went on to object to the SEC's unwillingness to allow the NYSE a pilot period in which to demonstrate that the Liquidity Replenishment Points could work effectively alongside the SEC's industry-wide mechanism for dealing with market volatility.

The SEC's decisions about how to address market volatility are one example of the many SEC decisions that profoundly shape the way markets function. Another, more far-reaching example is the major changes the SEC made to the rules that govern the equity markets in 2005 through Regulation NMS. The markets are complex, and regulating them is no easy task. Nevertheless, before setting out to craft solutions to the problems it identifies in the markets, the SEC should ask whether its own regulatory decisions have contributed to those problems.

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Rafael Mangual
Project Manager,
Legal Policy

Manhattan Institute


Published by the Manhattan Institute

The Manhattan Insitute's Center for Legal Policy.