The SEC recently proposed a new set of rules aimed at providing better monitoring of the trading activities of large hedge funds and other institutional traders. Considering the current political climate of increased financial regulation, the proposal is expected to be adopted. However, many institutional investors believe the measure is overly intrusive and unnecessary.

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A Controversial Measure
The measure is decried by institutional traders who believe the SEC has become detached from the reality of modern trading and is getting overly involved. Trading technology expert Frederic Ponzo told Risk.net, "Regulators believe hedge fund managers are trading in a very opaque manner in big chunks using high-frequency trading tools as a device to manipulate the market… It is a myth." (To learn more, see What Is High-Frequency Trading?)

Proponents of the measure believe that increased monitoring of large traders would enable greater transparency and fairness in the financial markets for all participants. To fully understand this proposal for increased monitoring of large traders in context, a bit of historical perspective is necessary.

The History of Large Trader Regulation
While proposals for tracking large traders may seem new, the need for such a system was foreseen early in the development of the modern U.S. financial markets. The SEC has had the authority to establish a large trader reporting system since the Securities Exchange Act of 1934. However, up until recently, the SEC has been able to investigate potential securities law violations using broader reporting system known as the electronic blue sheet system (EBS).

Over the last several decades, broad advances in computer technology have made it possible for large traders to trade incredibly rapidly and to route orders through many different brokers to disguise the true size and net effect of their transactions. These innovations in the financial markets create serious problems for regulators attempting to detect illegal trading or market manipulation. These trading techniques overwhelm the SEC's existing EBS reporting system which did not envision the techniques in use today.

In light of these problems, the SEC proposed the creation of a large trader reporting system in 1991 and again in 1994. However, after widespread negative reactions the SEC opted not to adopt the proposals. The SEC chose instead in 2001 to focus on enhancing its existing EBS reporting system. (To learn more, check out Policing The Securities Market: An Overview Of The SEC.)

The Details of the Proposed Regulation
Under the proposed new rules, so-called "large traders" would be required to register with the Commission and would receive a unique ID number to provide to their brokers. Brokerage houses would be required to allow regulators to access these transactions on a next-day basis.

The SEC defines large traders as market participants who trade more than two million shares (or $20 million) per calendar day or 20 million shares (or $200 million) per calendar month.

According to an SEC press release, analysts estimate that larger traders comprise more than 50% of total transaction volume on the exchanges. Thus, the SEC asserts, large institutional traders wield a large measure of market power.

The Bottom Line
Without proper regulation, it seems clear that unscrupulous large traders might be able to leverage their size and market access to manipulate markets. While this may not be the case at present, it is hard to argue against enabling greater transparency to help prevent possible future abuses. Capitalism sometimes requires a referee to make sure everyone plays by the rules. In the long run, ensuring fairness in the financial markets is beneficial to all investors, large or small. (To learn more, see our Quantitative Analysis Of Hedge Funds.)

Find out what else is making news this week in Water Cooler Finance: Everything Old Is News Again.

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