By Jonathan Spicer and Herbert Lash
NEW YORK (Reuters) - U.S. regulators are probing certain practices around "quote stuffing," where large numbers of rapid-fire stock orders are placed and canceled almost immediately, Securities and Exchange Commission Chairman Mary Schapiro said on Tuesday.
"The SEC and other regulators are looking carefully at certain practices in this area to assess whether they violate existing rules against fraudulent or other improper behavior," Schapiro said at the Economic Club of New York.
Regulators were also looking at quote stuffing in connection with the mysterious May 6 "flash crash," when the Dow Jones industrial average dropped dramatically before quickly recovering.
Schapiro appeared to broaden the already wide array of issues the SEC is looking at in the wake of the flash crash, including the fact that some firms regularly send more than 90 buy or sell orders for every trade they ultimately make.
"Quote stuffing" is not seen as the cause of the dramatic market drop, sources have said. A report that may explain the flash crash is expected toward the end of the month, Schapiro told Reuters before delivering the speech.
Regardless, the SEC has introduced a pilot "circuit breaker" program that pauses trading in a single stock if that stock is in a free fall. Schapiro said the circuit breaker program -- which stops trading for five minutes if a stock falls more than 10 percent in five minutes -- can be improved.
"Currently, the circuit breakers can be triggered by anomalous trades that may not warrant pausing all trading in the stock for five minutes," Schapiro said.
Schapiro said the SEC's next steps are likely to include a careful review of a limit-up and limit-down procedure that would directly prevent trades outside specified parameters, while allowing trading to continue within those parameters.
A limit-up and limit-down rule, used in U.S. futures markets, is seen as a possible alternative to circuit breakers.
MARKET STRUCTURE RULES
The SEC has undertaken a review of the structure of markets, which has changed dramatically over the years. Schapiro said many investors have complained to the SEC about U.S. market structure. "We must listen closely," she said.
Quote stuffing is a term coined by Nanex LLC, a trade database developer that issued a study suggesting computer algorithms did this to gain an edge during the May 6 crash. The study argued that high-frequency traders regularly flood the marketplace with bogus orders to distract rival trading firms.
Investors could make trades under the false impression that those orders were legitimate, only to see liquidity disappear and the market move against them when the orders are canceled -- all in the blink of an eye.
The SEC is looking at the rules for high-frequency traders and anonymous trading venues known as dark pools. The flash crash threw the rapid trading industry in the spotlight, triggering some lawmakers to call on the SEC to rein in the practice.
On Tuesday, New York Senator Charles Schumer urged the SEC to consider new rules to slow the rapid trades when the market is volatile. Schumer, who sits on a committee that oversees the SEC, said the regulator should consider imposing a minimum quote duration so orders cannot be sent and canceled in a fraction of a second.
Schumer has inserted himself in other market structure issues and last year called on the SEC to ban flash orders, which give advance knowledge of stock orders to some traders.
The SEC has since proposed a ban on the flash orders. The agency has also proposed ways to shed light on dark pools.
Schapiro said the SEC continues to look at the full range of issues, including market fragmentation and market makers.
The SEC is trying to adopt the rules before they are forced to craft about 100 rules under the Dodd-Frank financial regulation bill.
Schapiro did not provide a timeline for the market structure rules.
(Reporting by Jonathan Spicer, Herbert Lash and Rachelle Younglai; Writing by Rachelle Younglai; Editing by Tim Dobbyn and Maureen Bavdek)
