NYSE was fined $14 million yesterday by the SEC for five serious violations. This note will focus on the fifth violation since we think it is the most egregious one:
NYSE and American’s Rules Failed to State That Pegging Interest Orders Created Possibility of Detection of Prices of Non-Displayed Depth Liquidity.
While we have noted many examples in the past about information leakage by the stock exchanges, this is the first time that the SEC has fined an exchange for leaking confidential client information. Here is what was going on at the NYSE between 2008 and 2015:
– Floor brokers were permitted to enter “pegging interest” orders (PI) which allowed them to peg their order to the best NYSE quote. They could specify a range of prices for this PI order to be active. If the best NYSE quote was outside the PI range, then the PI order would price at the next level closest to the quote.
– According to the SEC, “A PI’s ability to peg to the price level of a NDRO (non-displayed reserve order) created the possibility that a floor broker, or a customer who submitted a PI through a floor broker, that sent the PI, would be able to detect the presence of same side non-displayed depth liquidity if certain circumstances were present.”
***Notice that the SEC says “a floor broker or a customer who submitted the order through a floor broker”. Who do you think those customers are?
– PI orders could peg their price to a non-displayed NYSE order that was not part of their best bid or offer.
– The SEC explained how the initiator of the PI order could find out about hidden interest: “the submitter of the PI could potentially use identifying characteristics of its PI to locate it in the market data feed displayed at a price that did not previously have any displayed liquidity (because the NDRO was undisplayed), and if so located, conclude that there was same side non-displayed depth liquidity at that price level.”
And here is where the violation gets even more interesting. NYSE was notified of the information leakage issue in 2013 by a client and chose to do nothing about it. According to the SEC, “in 2013, NYSE received a complaint from a trader that the price levels of his NDROs, which were entered at prices inferior to the quote and unoccupied by any displayed liquidity, were being joined upon entry, as the trader observed in the exchange depth of book market data feed, by a displayed order.” NYSE apparently investigated the complaint and did not find any problems with the design of their order type.
NYSE submitted a rule change in March 2015 which “modified the functionality of PIs so that they only pegged to price levels occupied by displayable interest.” The SEC approved this rule change and didn’t appear to take any further action at the time.
NYSE invoked the “neither admit nor deny” defense and settled with the SEC for $14 million possibly hoping to sweep this case under the rug. While NYSE puts on a good show for the cameras on the floor of the exchange, this SEC fine proves that NYSE has been leaking information and neglecting their regulatory responsibilities.
The question now becomes: What do investors do about this? Should NYSE simply get away with neglecting their regulatory responsibilities? Should they be able to pay the $14 million and just continue doing business like nothing happened? Or, should issuers and investors shift their business to an exchange like IEX which seeks to protect them and not favor one class of client over another?
The damage to investors from these five violations is unquantifiable but we think it is certainly more than the $14 million fine that the SEC imposed. We suspect that a number of class-action lawsuits might be filed once the facts of the case are disseminated. In the past, these lawsuits had little to no chance of succeeding since exchanges enjoyed absolute immunity when acting in a regulatory capacity. But with the recent City of Providence, Rhode Island v. BATS Global Markets Second Circuit court decision, stock exchange immunity has come into question. We suspect that NYSE lawyers will be rather busy in the coming weeks and months.