SEC Charges NYSE, NYSE Arca and NYSE MKT for Failure to Operate in Accordance with Exchange Rules (with Lofchie Comment)

The SEC announced an enforcement action against the New York Stock Exchange LLC ("NYSE"), NYSE Arca, Inc. ("NYSE Arca"), NYSE MKT LLC ("NYSE MKT") (the "exchanges") and the exchanges' affiliated routing broker, Archipelago Securities, L.L.C., for conducting business activities in violation of the exchanges' SEC-approved rules, including business activities that required a rule when none was in effect.

The SEC order covers violations from 2008 to 2012 and alleges, among other things, that (1) NYSE provided co-location services to customers on disparate contractual terms without a rule in effect, (2) Archipelago Securities failed to give the SEC timely notice that it had violated Exchange Act Rule 15c3-1 (net capital) and (3) NYSE Arca violated Rule 612(a) of Regulation NMS by accepting orders in sub-penny amounts for National Market System Stocks trading above $1.00 per share.

The charges were settled without NYSE or its affiliates admitting or denying the findings. The settlement included a $4.5 million penalty and an agreement by the exchanges to complete significant undertakings, including retaining an independent consultant to review the exchanges' policies and procedures for determining whether a business practice requires a new or modified SEC-approved rule or is conducted in accordance with an already effective exchange rule.

Lofchie Comment: The disciplinary actions result from a mixed bag of causes, with most of the violations resulting from technology that did not perform as expected. In the case of the sub-penny trading violations, NYSE Arca apparently was unaware of them for the entire period during which they were ongoing (except for the last few days after NYSE Arca was made aware of the issue) until one of the violations was observed by a customer. Another of the violations resulted from the failure of the operations staff in Chicago, which apparently was creating necessary software for implementing a required rule change fully, to properly coordinate with the legal group in New York that was writing the description of the rule change. The most serious of the technology issues, at least from a risk standpoint, was the net capital violation. That violation resulted from the exchanges' improperly taking principal positions as a result of a technological/operational screwup (an "information technology employee, in the course of conducting a system test, mistakenly connected an automated testing tool to Arca's live trading environment, rather than to a testing environment"). This violation, essentially the equivalent of a very serious "fat-finger problem", resulted in the exchanges taking over a half-billion dollars in net positions. The exchanges also were disciplined for trading out of the "error positions" resulting from the "fat-finger" problem, described above, without having an effective exchange rule in place to govern the trade out. This is an interesting violation. Since the problem itself was not anticipated, the need for the rule would not have been anticipated either. In addition, the exchanges were sanctioned because the employees who traded out of the positions were not prevented from seeing information about undisplayed customers' orders in the market, although there is no statement suggesting that the employees did see or use the information. The co-location violation is not the fact of the co-location itself, but of its being a service offered for a time without any express rule and on the basis of non-standardized fees. In the case of another of the violations, the exchanges are said to have "afforded NYSE's floor brokers an informational advantage of which other market participants and the public were not aware." However, the real problem appears to have been not the provision of the information itself, but rather the failure of the exchange to file a rule change describing the manner in which it intended to distribute the information. In summary, there appear to be two overall themes to the violations: (i) technology problems resulting from either poor internal coordination or failures to prevent "fat-finger" problems; or (ii) the failure to file rule changes in a timely manner, and to work appropriately on the implementation of those rule changes by failing to coordinate both within the exchange itself and with the SEC.

See: SEC Order; SEC Press Release.