The May 2010 flash crash was bad for almost everyone involved in the stock market, but for the Securities and Exchange Commission, it was a disaster.

With $1 trillion in shareholder equity wiped out in a matter of minutes - however temporarily - alarmed investors demanded answers.

Embarrassingly, the heads of the New York Stock Exchange and Nasdaq Stock Market got into a spat on television, blaming each other for the mess, and the SEC realized that it didn't have the information to explain what caused the scariest few minutes in recent Wall Street history.

The regulators had to seek the data from the exchanges, delaying a much-anticipated report on the crash by nearly five months. The unwelcome lapse in oversight laid bare the SEC's limited ability to track the inner workings of the marketplace when it matters most.

The idea that the regulator of the largest capital markets in the world cannot easily reconstruct trading when there has been a problem, or when there is a suspicion of manipulation or misconduct, is not acceptable to me, said SEC Chairman Mary Schapiro in an interview.

We have to have this capacity.

In response to the crash, Schapiro has ordered an SEC crackdown on the exchanges - the front-line for fighting structural flaws and abusive trading in equity markets - in order to oversee more actively a marketplace whose complexity masks serious risks for investors.

The crackdown has come in the form of enforcement actions and gag orders against exchanges. Regulators are moving ahead with a plan to put together a record of all market activity to better oversee trading, a massive undertaking given the volume and rapid-fire pace.

Some say the SEC is pushing hard for high-profile actions to burnish its image after the flash crash and its failure to spot Bernard Madoff's Ponzi scheme.

It all points to a bigger government role. Regulators are now seeking a better grasp of high-tech markets that were allowed to fragment and proliferate over the last decade in the name of competition and lower costs. The SEC's actions suggest, at a minimum, that regulators believe the exchanges have not always honored their commitment to maintain stable markets.

Schapiro said the SEC's move to police the market more effectively was driven by the rise in computer-driven algorithmic trading as the dominant force in trading and the need to fully enlist the exchanges, which are self-regulatory organizations (SROs).

We need to have very careful, thorough and rigorous oversight of SROs if we are going to rely on them to do front-line surveillance, Schapiro told Reuters. Given the lack of resources at the SEC and the explosion in trading, the SROs need to be truly vigilant, she said.

The market absorbs hundreds of thousands of quotes every second in a frenzy that can befuddle investors and traders alike. While perhaps good for exchanges and high-frequency traders, the value of this explosive growth has been questioned.

Shortly after the flash crash, regulators pushed NYSE Euronext , Nasdaq OMX Group and other market operators to craft new trading rules to avoid future breakdowns.

Reuters has learned the SEC took the unprecedented step of serving those exchanges with non-disclosure agreements, effectively muzzling them to prevent further public bickering and to get the fierce competitors to work together.

The move puzzled some participants in those post-crash talks. Yet it heralded a new era in which the SEC is exerting its authority.

In October, the regulator moved against exchange operator Direct Edge, sanctioning it for weak internal controls that led to millions of dollars in trading losses and a systems outage. Later that month, the SEC brought $1.2 million in fines against a dark pool called Pipeline and two of its executives for misleading investors on how it executed trades. Trading is anonymous in a dark pool - a platform that allows blocks of shares to be bought and sold without prices being revealed until after trades are completed. For details, see

More cases involving stock exchanges are pending, according to a person familiar with the matter, suggesting the SEC's leash will grow tighter this year.

It's appropriate that the commission aggressively and robustly oversee the SROs, said SEC Commissioner Luis Aguilar.

For the most part, the exchanges have publicly backed the SEC's proposed structural changes. NYSE Euronext, Nasdaq OMX, Direct Edge and BATS Global Markets, the top four U.S. exchange operators, declined to comment for this article.


The exchanges of today are a far cry from their more utilitarian days. As publicly traded companies whose shareholders demand profits, they are viewed more skeptically by regulators.

Schapiro oversees a marketplace with about 50 competing venues ranging from the Big Board to dark pools Liquidnet and Goldman Sachs Group Inc's Sigma X. Execution is mostly automated and blazing fast, making it hard to detect manipulation. The number of quotes that bombard the marketplace every second has spiked 125-fold in the past five years, according to the Financial Information Forum, a group of more than 75 firms that addresses industry-wide issues.


Graphic on spike in quotes:


When the flash crash occurred on May 6, 2010, it left the SEC shocked at how hard it was to understand what happened. To overcome this breach, the agency proposed building a consolidated audit trail that would, for the first time, track all orders, messages and trades in real time.

There are questions over who will pay the SEC's estimated $4 billion price tag for the audit trail and whether to build it from scratch. Yet it is possible that an SEC-controlled system could sideline the exchanges from investigations into future malfunctions, and strip them of some oversight responsibility.

It is clear that they want to have a more active ability to manipulate the surveillance data for their own regulatory purposes, said Richard Ketchum, chairman and chief executive of brokerage watchdog Financial Industry Regulatory Authority (Finra), which is also an SRO.

But Ketchum, formerly in charge of NYSE Regulation and a past president of the Nasdaq Stock Market, said the SEC wants to work within the established framework of the SROs.

There's nothing I've seen that suggests that the SEC wants to change or replace the role that Finra or the exchanges provide respective to monitoring the markets, he said.

A consolidated audit trail would enhance regulators' ability to determine how an order or group of orders might disrupt the marketplace, and provide quicker answers to investors and regulators when the need arises. Schapiro said the audit trail was critical to the SEC's ability to oversee markets.

Yet a comprehensive system could take years to set up given its complexity.

To provide the same access to information across the gamut of investment classes is daunting to almost insurmountable, said Joseph Cangemi, head of equity trading and sales at ConvergEx Group in New York, and a former chairman of the Security Traders Association.


The flash crash - when the Dow plunged 700 points in mere minutes before it sharply recouped most losses - shook the faith of Americans in one of the country's greatest institutions.

A day later, senators Ted Kaufman and Mark Warner requested an amendment to the landmark Dodd-Frank act, which overhauled the way financial markets are governed. The senators wanted regulators to report to Congress on the need for an audit trail, order screening and the risks of high-frequency trading.

One change they proposed - circuit breakers to halt volatile trading in stocks - was already at the top of the SEC's agenda. That discussion soon turned to a limit up-limit down plan to set ceilings and floors for movements of share prices, and the SEC then asked the exchanges to sign the non-disclosure agreements, sources said.

People who knew of the agreements, and spoke on condition of anonymity, said they were intended to compel exchanges to leave their differences aside for the good of the public markets. Some said they were also meant to stop leaks to the media about the preliminary, and sometimes patchy, plans for new rules.

The SEC didn't want people taking shots at each other in the press, an official at one exchange said. It's an odd way of doing things, but not a bad way of doing things.

Addressing the televised discord between NYSE's Duncan Niederauer and Robert Greifeld of Nasdaq, Schapiro said differences between the exchanges were beside the point.

This is about confidence in the broader marketplace, Schapiro said, recalling what she later told both men. We all have to be working on the same team and working in the interest of investors, not one competitive model over another.

The circuit breakers were adopted in June 2010 and have since been expanded twice to cover more stocks. However, 20 months after the crash, limit up-limit down rules - which would slow but not stop trading - have yet to be adopted.

The SEC in the fall completed exams of all U.S. equity and options markets, reviewing internal data on governance, operations, funding and risk management, Schapiro said.

The pending matters with exchanges involve the SEC's enforcement division, a source familiar with the matter said. One SEC official added: The markets have shown they can break down, badly.

Given the number of detailed information requests, some industry officials say they expect the SEC to bring more cases on the heels of Direct Edge and Pipeline. The government regulator even publicly scolded Finra, where Schapiro was previously CEO, for allegedly doctoring documents that were to be examined by the SEC.

This of course is not the first time the SEC's examiners and enforcement units have zeroed in on exchanges. But cases brought in 2006 and 2007 against the American Stock Exchange, the Philadelphia Stock Exchange and the former head of the Boston Stock Exchange focused on failures to enforce rules or on deficiencies in surveillance.

This time around, sources said, the SEC's focus has shifted to issues such as data feeds and whether certain market players may get an information advantage, as well as adequate investments by exchanges into technology and infrastructure.

For some in the market, the SEC's actions are a relief.

Virtually every SRO has had some form of a lashing from the SEC, said Christopher Nagy, managing director of order strategy at TD Ameritrade Holding Corp , the largest U.S. online brokerage. I think it's fantastic, long overdue.

(Reporting By Jonathan Spicer, Herbert Lash and Sarah N. Lynch; Editing by Andrew Hay)