SEC looks for the 'kill switches'

U.S. securities regulators have launched a sweeping review of the systems brokerages and trading firms use to place orders, intensifying their response to a spate of technological mishaps that have tested investors' confidence in the stock market.

The Securities and Exchange Commission has in recent days requested details from major broker-dealers about the internal controls of their automated trading systems, which direct the buying and selling of shares on exchanges and electronic-trading venue, according to people with knowledge of the review. The agency also wants to know about any recent malfunctions and how they were handled as well as how firms can override their computers and shut them off.

The SEC's look into trading controls and programs comes as the securities industry faces fresh scrutiny following a succession of high-profile breakdowns, most recently last month's errant trading at Knight Capital Group Inc. Knight, one of the nation's largest handlers of share orders for retail and institutional investors, had to seek emergency rescue funding after faulty computer coding in a trading program led to a $440 million loss.

That episode followed the technology missteps at Nasdaq OMX Group Inc. that marred the stock-market debut of Facebook Inc. in May, leaving many small investors frustrated with market systems. The succession of breakdowns, including a botched initial public offering in March by electronic exchange company BATS Global Markets Inc. on its own platform, has further injured investor confidence in stock-market systems after deep flaws were revealed during the 2010 "flash crash."

"In light of the recent high-profile market-structure failures and technological glitches we've had, it's natural that regulators are taking a greater interest in market-structure issues," said Justin Schack, managing director with Rosenblatt Securities Inc., which researches market issues. "It's definitely more front-of-mind."

The new inquiries go far beyond typical audits of financial firms carried out by the securities industry's self-regulator, the Financial Industry Regulatory Authority, according to people with knowledge of the regulators' practices. It is part of a broader effort by the SEC to improve its understanding and oversight of the computer-driven plumbing of the domestic capital markets, after Knight's problems fueled deeper concerns at the agency that trading technology servicing individual investors, institutions, banks and high-frequency trading specialists could run off-course before humans can intervene, triggering serious market-wide effects.

"They've gone into Knight, looked around, and said 'this is what we need to know from everyone else,'" said a securities lawyer with knowledge of the discussions. A spokeswoman for Knight, which has hired International Business Machines Corp. to review the matter, declined comment.

The push adds to a string of efforts by the SEC to gain a better grasp on heavily-automated securities markets, alongside a separate review of big high-frequency trading firms and an investigation into whether some high-speed firms enjoy special advantages when dealing with stock exchanges.

The latest sweep targets a broad spectrum of broker-dealers that handle trading by institutional and retail investors, according to people familiar with details of the review. Regulators want to know which individuals have responsibility over technology at each firm and their policies for developing and testing computer trading code. The agency also has asked to see firms' internal reviews of trading systems over the past three years, these people said.

The review seeks details on "automatic shut-offs or kill switches" that would turn off trading programs when they run afoul of preset limits on risk or other parameters, and at what point people are able to step in to switch off a system, according to people with direct knowledge of the matter. Regulators also want an accounting of any technology malfunctions related to trading since the beginning of this year.

Regulators are requesting that firms supply the information by mid-October, according to people with knowledge of the review. The information could underlie new rules around market technology, and any wrongdoing found would be turned over to the SEC's enforcement division, they said.

The review is being led by the SEC's Office of Compliance, Inspections and Examinations, according to people involved in the discussions.

Scrutiny of high-speed trading practices employed by banks, brokerages and private trading houses revived following Knight's mishap, with a Senate Banking subcommittee last week hearing calls for a tighter leash on fast dealing in stocks, alongside defenses of the market's structure.

Next week, the SEC will host a daylong "roundtable discussion" focused on ways to prevent market technology breakdowns and how to quickly deal with them before broad financial damage can be done. Exchange and brokerage operations officials are expected to lead a technical discussion of the topic, according to people briefed on the plans.

(Published by WSJ - September 26, 2012)