Proposed Rules regarding Ratings Agencies and Flash Orders

(Editor’s Note: This post includes the transcripts of Chairman Schapiro’s statements on nationally recognized statistical rating organizations and flash orders at the SEC’s recent Open Meeting.  The statements of each of the other Commissioners on the two subjects are available here.)

Nationally Recognized Statistical Rating Organizations

Today we are considering a series of proposal that would significantly bolster the regulatory framework around nationally recognized statistical rating organizations, or “NRSROs.”

We are also considering a recommendation to propose a ban on the practice of flashing marketable orders. Flash orders provide a momentary head-start in the trading arena that can produce inequities in the markets and create disincentives to display quotes.

We begin with the credit rating recommendations. In 2006, the Credit Rating Agency Reform Act gave the Commission the exclusive authority over rating agency registration and qualifications. In the three years since, the Commission has undertaken several rulemaking initiatives. But as I have said previously, more needs to be done.

So, today we will consider six items that are intended to create a stronger, more robust regulatory framework. In particular, these proposals would improve the quality of ratings by requiring greater disclosure, fostering competition, helping to address conflicts of interest, shedding light on rating shopping, and promoting accountability.

These proposals are needed because investors often consider ratings when evaluating whether to purchase or sell a particular security. That reliance did not serve them well over the last several years and it is incumbent upon us to do all that we can to improve the reliability and integrity of the ratings process and give investors the appropriate context for evaluating whether ratings deserve their trust.

Collectively, the changes and concepts being adopted, proposed and considered today would benefit investors in many ways:

  • They would promote greater accountability by requiring compliance officers to file annual reports with the Commission.
  • They would foster competition by enabling unsolicited ratings for structured finance products.
  • They would decrease the level of undue reliance on the nationally recognized statistical rating organizations by beginning the process of removing references to NRSRO ratings in certain existing rules. It is time that we started this process to systematically minimize the use of ratings in the SEC’s rules and, while I know, there is much to do in this regard, I am pleased that we are taking these steps today.
  • And finally, they would empower investors to make more informed decisions by helping to expose rating shopping and potential revenue-linked conflicts.

Specifically, the following six items related to NRSROs are being considered:

  • A recommendation to adopt rules to provide greater information concerning ratings histories — and to enable competing credit rating agencies to offer unsolicited ratings for structured finance products, by granting them access to the necessary underlying data for structured products.
  • A recommendation to propose amendments that would seek to strengthen compliance programs through requiring annual compliance reports and enhance disclosure of potential sources of revenue-related conflicts.
  • A recommendation to adopt amendments to the Commission’s rules and forms to remove certain references to credit ratings by nationally recognized statistical rating organizations.
  • A recommendation to reopen the comment period to allow further comment on Commission proposals to eliminate references to NRSRO credit ratings from certain other rules and forms.
  • A recommendation to require disclosure of information including what a credit rating covers and any material limitations on the scope of the rating and whether any “preliminary ratings” were obtained from other rating agencies — in other words, whether there was “ratings shopping”
  • A recommendation to seek comment on whether we should amend Commission rules to subject NRSROs to liability when a rating is used in connection with a registered offering by eliminating a current provision that exempts NRSROs from being treated as experts when their ratings are used that way.

We will consider each of these six items separately. Following that, we will take up a proposal concerning flash orders.

Flash Orders

We are considering a recommendation to propose an amendment to the Commission’s rules that would prohibit the practice of flashing marketable orders. Flash orders provide a momentary head-start in the trading arena that can produce inequities in the markets and create disincentives to display quotes.

The reason that flash orders are currently permitted stems from an exception to the Exchange Act quoting requirements. That exemption originated back when most trading took place on the floors of the exchanges.

In today’s highly automated trading environment, the exception for flash orders from quoting requirements, while potentially providing benefits to certain traders, may no longer serve the interests of long-term investors or the markets. The Commission has consistently stated that the interests of long-term investors should be upheld as against those of professional short-term traders, when those interests are in conflict.

Concerns have been raised that the use of flash orders by exchanges and other markets may detract from the fairness and efficiency of the national market system. Specifically, flash orders have the potential to discourage the public display of trading interest and harm quote competition among markets.

This occurs because a flash order allows certain participants to view an order before others that publicly display their quotes. The unfairness results because those getting that advance look do not have to publicly display a quote for everyone else to see, yet are able to rely on the information provided by the publicly displayed quotes to facilitate their transactions.

As a result, flash orders have the potential to significantly undermine the incentives to display limit orders and to quote competitively. In addition, flash orders may create a two-tiered market by allowing only selected participants to access information about the best available prices for listed securities.

Investors that have access only to information displayed as public quotes may be harmed if market participants are able to flash orders and avoid the need to make the order publicly available.

I would note that other market practices may have similar opaque features. As such, the Commission is continuing to review other forms of dark trading that lack market transparency and I expect that initiatives in this area will be considered in the near future.

Both comments and trackbacks are currently closed.

One Comment

  1. John W. Taylor
    Posted Thursday, October 1, 2009 at 10:42 am | Permalink

    In regard to credit rating agencies, you have forgotten the most important issue surrounding the ratings’ industry: who is paying for the ratings. As long as the issuer is paying for the rating there is always an inherent conflict of interest in the rating itself. The business model (payment system) for rating companies needs to be turned on its head. If investors or an independent governing body that received fees from participating members paid for the rating, it would remove the relationship between the rating agency and the company being rated. Of course, the rating agencies would also have to stop providing consulting services to companies they rate.

    I doubt the credit rating agencies will take these steps without an external nudge.