WASHINGTON (Reuters) - U.S. regulators and exchanges are getting closer to a framework for a "kill switch" that could be used to shut down trading before software glitches get out of control and wreak havoc on markets, a top exchange official said on Tuesday.
"We have all engaged in a much more detailed assessment of how a kill switch could work," Joe Mecane, an executive vice president at the New York Stock Exchange NYX.N, said in testimony before a U.S. Senate Banking panel on Tuesday.
"I think we are hopeful to have something to report in the first quarter of next year," he said.
Exchanges, brokerages and the U.S. Securities and Exchange Commission have been trying to come up with the right regulatory response after a series of high-profile glitches this year shook markets, from Nasdaq's (NDAQ.O) botched handling of the Facebook (FB.O) initial public offering to Knight Capital's KCG.N $440 million in losses due to a software error.
The kill switch idea is one of at least a dozen market structure issues being considered by the SEC.
In concept it would allow the exchange, one of its members, or both, to cancel all open orders and block new orders, either by pushing a button or through an automated function, to limit the damage in the event a trading malfunction is detected.
In early 2010, the agency launched a broad review that includes an examination of the benefits and pitfalls of high-frequency trading, and the increasing proliferation of dark pools, venues that let investors anonymously trade large blocks of stock and face less regulatory scrutiny than exchanges.
Changes in technology have forced exchanges to adapt to compete with dark pools, leading regulators to more closely scrutinize certain order types that some fear could give fast-paced traders an edge. Brokerages, meanwhile, have also cried foul, saying regulation is too skewed to favor exchanges because it gives them a "quasi-governmental status" as self-regulatory organizations (SROs).
Following the string of glitches earlier this year, Rhode Island Senate Democrat Jack Reed announced he would hold a series of market structure hearings to explore if new rules are needed to ensure market fairness and reduce systemic risks that runaway algorithms could pose.
"Part of what we want to do is make sure this issue is not ignored," Reed told reporters on Tuesday after the hearing concluded.
"We are going to keep asking questions, both of the regulators and the industry. And we're going to, if we feel legislation is in order, propose it. If not, we'll continue to keep the attention focused on this issue."
Of all the issues for the SEC to tackle, the kill switch proposal and the development of a comprehensive database containing every trade order, execution and cancellation could come first.
But some of the hardest, most controversial market structure issues have yet to be addressed.
Those include whether or not the rules for exchanges and dark pools should be harmonized.
Exchanges are required to undertake certain self-regulatory responsibilities. Current regulations, for instance, require them to notify the SEC and the public when they wish to change a rule, or launch a new order type.
Dark pools and other brokerages, by contrast, are not put under the same regulatory microscope.
At the same time, however, exchanges are granted certain legal immunities thanks to their SRO status. That status has since come into question following Nasdaq's botched handling of Facebook's IPO.
Nasdaq has proposed a $62 million settlement to those brokerages who lost money, but it is not enough to cover all of the losses and has led some brokerages to grumble about the immunity afforded to exchanges from civil liability.
"There has got to be consequence for a system-wide failure of the type that we've experienced in the Facebook circumstance," ITG (ITG.N) Chief Executive Robert Gasser told the Senate panel on Tuesday. ITG is an agency broker that offers trading services, technology, analytics and research.
"Our clients suffered, other broker dealers suffered, clearly there were some decisions that were made that were, with all due respect, the wrong ones in terms of opening that stock."
NYSE's Mecane on Tuesday said that exchanges do not have "blanket immunity," noting that such protections mostly pertain to exchanges' listing functions.
However, he agreed that the SEC should more closely look at the SRO model as part of a broader review - an issue that least one SEC commissioner has publicly called for in recent months.
"We would encourage ... a holistic review of all of the costs and benefits of being an SRO," Mecane said.
Exchange executives on Tuesday were also quick to point out that being a self-regulatory organization also comes with greater oversight, including an SEC review of all order types.
In April, Reuters reported that the SEC was broadly reviewing numerous market structure issues. Part of that review involves a closer look at order types to determine if they create an unfair advantage for certain investors, or if the exchanges are properly disclosing how their order types work.
Eric Noll, an executive vice president at Nasdaq, told lawmakers on Tuesday that the exchange's order types "do not provide advantages to certain users" and are put through a "rigorous process" to get SEC approval.
"From my own experience around the SEC review of order types and order-type introduction, we have withdrawn many more order types at the suggestion of the SEC than we have had approved," Noll said. "They do not go unreviewed."
Reporting By Sarah N. Lynch in Washington and John McCrank in New York; editing by John Wallace and Alden Bentley