* 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
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
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
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
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.