* Stepped-up inquiry sparked by 2010 "flash crash"
* SEC probing 20 issues related to electronic exchanges
* Eye on whether exchanges disclose material changes
* Lack of disclosure part of SEC's probe into BATS
By Sarah N. Lynch and Herbert Lash
WASHINGTON/NEW YORK, April 4 U.S. regulators are closely scrutinizing stock exchanges for failure to disclose material changes to their businesses, part of some 20 different areas of inquiry by the U.S. Securities and Exchange Commission into how the electronic marketplace works.
The SEC is interested in everything from the type of orders that the exchanges have devised to allow their clients to execute trades, to whether they are properly self-policing their markets, according to people familiar with the matter.
The stepped-up inquiries, which center on a marketplace where trades are now executed at speeds far faster than a blink of the eye, were sparked by the "flash crash" in May 2010, which one official called a "game changer."
The agency is concerned the electronic exchanges may be conducting their business in a way that could provide certain clients preferential treatment.
The inquiries also coincide with an embarrassing technical glitch in March that derailed the much-anticipated initial public offering of one of the fastest-growing electronic exchanges, BATS Global Markets Inc.
Failure to disclose could lead to enforcement actions by the SEC, although fraud or illicit conduct have not been a major focus, these people told Reuters. Exchanges need to disclose rule changes and get the SEC's approval.
Disclosure issues tripped up exchange operator Direct Edge, which the SEC sanctioned in October after an affiliated routing broker engaged in proprietary trading, even though the exchange's rules forbade such transactions.
It is also one element of the SEC's probe into BATS, which said in February that regulators sought information about certain order types and its communications with market participants.
One person familiar with the matter said that the SEC is looking at whether BATS should have filed certain rules disclosing how its order types work, and also whether those order types may give some market participants an advantage over others.
BATS declined to comment.
Exchanges act as self-regulatory organizations, which means they must police their own markets for abuse. The exchanges are called SROs because of that distinction.
Exchanges must file SRO rules with the SEC any time a material change is made. Those rules are vetted through a public comment process, and the SEC can also intervene if it feels the proposed rule violates certain legal provisions, such as an anti-discrimination clause that prevents exchanges from favoring one group of clients over another.
But over the years, as more exchanges have gone from member-owned organizations to profit-driven public companies, regulators say that the quest for profit has at times trumped self-regulatory responsibilities.
Moreover, in today's world of multiple trading venues and trades measured in microseconds, the way things actually work on an exchange is not always properly communicated in an SRO's own rules.
Historically, there have always been problems with exchanges at times failing to make the proper rule filings.
However, after the flash crash the SEC stepped up its scrutiny of exchange oversight and started to discover repeated failures in this area. Now, the SEC has also become much more willing to recommend enforcement action for technical violations that in the past might have flown under the radar.