[Senate Hearing 111-774]
[From the U.S. Government Publishing Office]





                                                        S. Hrg. 111-774


     EXAMINING THE CAUSES AND LESSONS OF THE MAY 6TH MARKET PLUNGE

=======================================================================

                                HEARING

                               before the

                            SUBCOMMITTEE ON
                 SECURITIES, INSURANCE, AND INVESTMENT

                                 of the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                     ONE HUNDRED ELEVENTH CONGRESS

                             SECOND SESSION

                                   ON

EXAMINING THE CAUSES AND IMPLICATIONS OF THE MAY 6, 2010, MARKET PLUNGE 
 AND IDENTIFYING WHAT POLICY CHANGES MAY BE NECESSARY TO PREVENT SUCH 
                      EVENTS FROM OCCURRING AGAIN

                               __________

                              MAY 20, 2010

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs








Available at: http://www.access.gpo.gov/congress/senate/senate05sh.html

                                  ______

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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

               CHRISTOPHER J. DODD, Connecticut, Chairman

TIM JOHNSON, South Dakota            RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island              ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York         JIM BUNNING, Kentucky
EVAN BAYH, Indiana                   MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey          BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii              JIM DeMINT, South Carolina
SHERROD BROWN, Ohio                  DAVID VITTER, Louisiana
JON TESTER, Montana                  MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin                 KAY BAILEY HUTCHISON, Texas
MARK R. WARNER, Virginia             JUDD GREGG, New Hampshire
JEFF MERKLEY, Oregon
MICHAEL F. BENNET, Colorado

                    Edward Silverman, Staff Director

        William D. Duhnke, Republican Staff Director and Counsel

                       Dawn Ratliff, Chief Clerk

                      Devin Hartley, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor

                                 ______

         Subcommittee on Securities, Insurance, and Investment

                   JACK REED, Rhode Island, Chairman

            JIM BUNNING, Kentucky, Ranking Republican Member

TIM JOHNSON, South Dakota            JUDD GREGG, New Hampshire
CHARLES E. SCHUMER, New York         ROBERT F. BENNETT, Utah
EVAN BAYH, Indiana                   MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey          BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii              DAVID VITTER, Louisiana
SHERROD BROWN, Ohio                  MIKE JOHANNS, Nebraska
MARK R. WARNER, Virginia
MICHAEL F. BENNET, Colorado
CHRISTOPHER J. DODD, Connecticut

               Kara Stein, Staff Director of Subcommittee

                     Randy Fausnacht, GAO Detailee

      William Henderson, Republican Staff Director of Subcommittee

                Nathan Steinwald, Legislative Assistant

                                  (ii)










                            C O N T E N T S

                              ----------                              

                         THURSDAY, MAY 20, 2010

                                                                   Page

Opening statement of Senator Warner..............................     1

Opening statements, comments, or prepared statement of:
    Chairman Reed................................................    47
    Senator Bunning..............................................     2

                               WITNESSES

Mary L. Schapiro, Chairman, Securities and Exchange Commission...     3
    Prepared statement...........................................    47
    Response to written question of:
         Senator Vitter..........................................   108
Gary Gensler, Chairman, Commodity Futures Trading Commission.....     5
    Prepared statement...........................................    65
Richard G. Ketchum, Chairman and Chief Executive Officer, 
  Financial Industry Regulatory Authority........................    29
    Prepared statement...........................................    82
Larry Leibowitz, Chief Operating Officer, NYSE Euronext..........    31
    Prepared statement...........................................    85
Eric Noll, Executive Vice President of Transaction Services, The 
  NASDAQ OMX, Inc................................................    34
    Prepared statement...........................................    89
Terrence A. Duffy, Executive Chairman, CME Group Inc.............    35
    Prepared statement...........................................    94

                                 (iii)

 
     EXAMINING THE CAUSES AND LESSONS OF THE MAY 6TH MARKET PLUNGE

                              ----------                              


                         THURSDAY, MAY 20, 2010

                                       U.S. Senate,
                    Subcommittee on Securities, Insurance, 
                                            and Investment,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Subcommittee met at 9:37 a.m. in room SD-538, Dirksen 
Senate Office Building, Senator Jack Reed, Chairman of the 
Subcommittee, presiding.

          OPENING STATEMENT OF SENATOR MARK R. WARNER

    Senator Warner. [Presiding.] Good morning, everyone. 
Obviously, I am not Chairman Reed. He is on his way back from 
the Pentagon and will be here momentarily, and so as the guy 
that usually sits at the other end of the dais, I get a chance 
to at least open the hearing, and I will relinquish the gavel 
once Chairman Reed gets here.
    I want to thank both Chairman Schapiro and Chairman Gensler 
and our other witnesses today for coming. I think we all saw 
recently, on May 6th, how challenging the merging of the 
advance of technology, high-frequency trading, and some of the 
results of perhaps not having totally in place all of the 
appropriate circuit breaker, stopgaps, and other tools that may 
be necessary to make sure that we do not see a repeat of $1 
trillion, 15-minute or 21-minute loss that took place on that 
day.
    Obviously, bringing both this first panel of regulators and 
then our second panel in today is very timely since at the same 
time on the floor of the Senate, we are now, I think, in week 4 
of putting in place new rules of the road for the 21st century 
for all of Wall Street and our whole financial system.
    Chairman Reed was going to talk--and I am sure he will come 
back and mention this again--about specifically what happened 
on May 6th. I definitely recall, you know, getting panicked 
calls from some of the folks who manage my investments to say, 
you know, we do not know what is happening, and to see this $1 
trillion loss. I heard the day after that a loss of actually a 
series of smaller brokers who were really questioning the whole 
integrity of the system, what happens when you have that kind 
of precipitous loss, precipitous decline in values, then 
obviously the market responded. But an awful lot of small 
investors who, I think, over the last 2 years have had a bit of 
their confidence robbed by the market falls in 2007 and 2008. 
But then to have this action, whether it was technology-driven, 
whether it was a result of the overall actions of the dramatic 
increase of high-frequency trading, is something that I hope we 
will be able to get to in this hearing today.
    There is a series of other comments that Chairman Reed was 
going to make, which I will pass on at this point since I have 
got a series of similar type questions once we get to hear from 
the witnesses. Let me introduce our first panel of witnesses, 
and then I am going to turn to Ranking Member Bunning and my 
good friend Senator Corker, although I do not know if with only 
three of us here we are going to enforce the Corker rule of 
opening statements or not. Let me go ahead and introduce our 
two witnesses; then I will turn it over to Senator Bunning.
    Our first witness will be Honorable Mary Schapiro. She is 
the Chairman of the Securities and Exchange Commission. Prior 
to becoming SEC Chair, she was CEO of FINRA, the largest 
nongovernmental regulator for all securities firms doing 
business with the U.S. public. Chairman Schapiro previously 
served as Commissioner of the SEC from December 1988 to October 
1994 and then as Chairman of the Commodity Futures Trading 
Commission from 1994 until 1996.
    Our second witness is the Honorable Gary Gensler, Chairman 
of the Commodity Futures Trading Commission. He previously 
served at the U.S. Department of Treasury as Under Secretary of 
Domestic Finance from 1999 to 2000, as an Assistant Secretary 
of Financial Markets from 1997 to 1999. Prior to joining 
Treasury, Chairman Gensler worked for 18 years at another 
firm--at Goldman Sachs--and most recently as partner and co-
head of finance.
    With those introductions, I will turn to Senator Bunning 
and then Senator Corker, if he chooses.

                STATEMENT OF SENATOR JIM BUNNING

    Senator Bunning. Thank you, Senator Warner.
    Welcome to the two witnesses we have before us. In many 
ways, this hearing is the follow-up to the hearing we held in 
this Subcommittee last October on securities and market 
structure issues. Many of the topics we discussed at that 
hearing are in the spotlight again after the May 6th stock 
market drop. I am glad to see the SEC followed through on its 
commitment to us last fall to start a broad examination of 
market structure issues.
    Technology certainly has changed the way securities and 
futures are traded, and the SEC has made significant rule 
changes over the last decade. But no one in Government has 
paused and thought about how all those changes work together.
    From what we know so far, it appears that 2 weeks ago the 
markets worked as they were supposed to, according to the rules 
and systems that were in place at the time. A broad examination 
of all the marketplace changes might have revealed the 
possibility of a sudden drop under the conditions that existed 
2 weeks ago. And, in fact, at least one commentator to the SEC 
market structure study suggested just such an outcome. Of 
course, that leads to the question of what else could happen.
    That is why I think it is critical for the Commission to 
complete the market structure study and not let other matters 
sidetrack it. I appreciate the speed and seriousness both the 
SEC and the CFTC have put into the investigation of the May 6th 
market drop. Putting in place rules, uniform rules, for pause 
trading across all exchanges seems like a good first step, and 
I am glad everyone resisted the temptation to make sweeping 
changes before first understanding everything that went on. I 
think it is also important that the trading halts will apply 
for price changes in both directions, not just in drops. But I 
also have some concerns about the reaction and what we do not 
know.
    First, since markets appear to have worked at they were 
supposed to under the rules in place, I am very concerned that 
trades were canceled on an arbitrary basis. Very concerned. 
That is unfair, undermines market discipline, and is nothing 
more than a bailout of sellers who would have faced losses from 
their own decisions to use market orders.
    Second, it is troubling that we do not yet understand the 
relationship between movers in the futures markets and the 
stock markets.
    Third, it is also troubling that some traders who claimed 
to be market makers, particularly high-frequency traders, 
pulled out of the market, thus contributing to the drop.
    Finally, I am also bothered that we do not understand why 
exchange-traded funds suffered worse losses than the securities 
they were supposed to be tracking.
    I hope our witnesses can shed some light on these concerns 
or at least explain what is being done to get to the answers. 
Thank you both for being here, and I await your testimony.
    Senator Warner. Senator Corker.
    Senator Corker. I do not have any comments. I look forward 
to the testimony, and thank you for coming.
    Senator Warner. Again, my thanks to the witnesses, and I 
think we are all very looking forward to your testimony and our 
questions afterwards.
    Chairman Schapiro.

    STATEMENT OF MARY L. SCHAPIRO, CHAIRMAN, SECURITIES AND 
                      EXCHANGE COMMISSION

    Ms. Schapiro. Thank you very much. Senator Warner, Ranking 
Member Bunning, and Senator Corker, I appreciate the 
opportunity to testify today and update you on our ongoing 
review of and response to the market disruption of May 6th.
    During a 20-minute period on that afternoon, the U.S. 
financial markets failed to execute their essential price 
discovery function, experiencing a decline and recovery that 
was unprecedented in its speed and scope. That period of 
gyrating prices both directly harmed investors who traded based 
on flawed price discovery signals, and it undermined investors' 
faith in the integrity and fairness of the markets. Today we 
continue to work to identify the events that triggered the 
unusual volatility, to better understand the various 
aggravating factors, and to adopt measures that will help 
prevent similar market disruptions.
    Over the last 2 weeks, the SEC has moved forward on two 
separate, but related, fronts. First, along with the Commodity 
Futures Trading Commission, we have been engaged in a 
comprehensive investigation into the causes of the events of 
May 6th. On Tuesday, we released a staff report detailing the 
preliminary findings of our investigation to the Joint CFTC-SEC 
Advisory Committee on Emerging Regulatory Issues, and this 
report was also made public.
    Second, we have worked with the exchanges to fashion 
measures that will help protect against a recurrence by 
imposing a limit on the extent to which certain individual 
stock prices can move before trading in that stock is paused. 
While it will take time to fully analyze the extraordinary 
amounts of data from a day in which more than 19 billion shares 
of stock were traded and to cross-test different hypotheses, 
our investigation is focusing on the following issues: the 
possible linkage between the steep decline in the prices of 
stock index products and simultaneous and subsequent waves of 
selling of individual securities; a generalized severe mismatch 
in liquidity, possibly exacerbated by the withdrawal of 
liquidity by electronic market makers; the possibility that 
this liquidity mismatch may have been aggravated by disparate 
trading conventions across the exchanges; the impact from the 
use of ``stub quotes''; the use of market orders and stop loss 
orders that might have contributed to market instability; and 
the impact on exchange-traded funds, which suffered a 
disproportionate number of broken trades.
    We have discovered no evidence that these events were 
triggered by ``fat finger'' errors, computer hacking, or 
terrorist activity, although we cannot yet completely rule out 
these possibilities.
    At this stage we continue to focus on the events that may 
have triggered the unusual volatility. But regardless of the 
cause, we believe that the initial volatility was magnified by 
a variety of factors. So as we work to determine why the first 
domino fell, we have taken an important step toward preventing 
future disruptions, working with the exchanges to develop rules 
which would impose uniform, market-wide standards for pausing 
trading of securities in the S&P 500 index if a securities 
price moves 10 percent or more in a 5-minute period.
    These proposed rules would establish a 5-minute trading 
pause designed to give the markets the opportunity to attract 
additional liquidity in the stock, to establish a reasonable 
market price, and to resume trading in a fair and orderly 
fashion. The rules have been published for comment promptly so 
that they can be evaluated as soon as practical and quickly 
adopted.
    Once adopted, the new rules would be in effect on a pilot 
basis through December 10, 2010, during which time the 
exchanges may propose appropriate adjustments to the parameters 
or operation of the circuit breaker. In addition, we understand 
that the exchanges will quickly work on expanding the program 
to include other securities, including ETFs.
    The SEC staff is also working with the exchanges and will 
coordinate with the CFTC to consider recalibrating the existing 
market-wide circuit breakers--none of which were triggered on 
May 6th.
    SEC staff is also examining ways to address the risks of 
stop loss and market orders and their potential to intensify 
sudden price declines, as well as steps to deter or prohibit 
the use of stub quotes, and we will review the impact of other 
trading protocols, including the use of trading pauses by 
individual exchanges and self-help protocols that allow the 
markets to avoid routing to exchanges that are perceived to be 
responding too slowly.
    Very importantly, and on an expedited basis, we will push 
the exchanges to propose clear, transparent, consistent, and 
fair rules for the breaking of trades that are clearly 
erroneous.
    Even before May 6th, the Commission had launched 
initiatives to strengthen the U.S. securities markets and to 
protect investors. We have proposed rules that would prohibit 
flash orders, increase the transparency of dark pools of 
liquidity, prohibit broker-dealers from providing unfiltered 
access to exchanges, and create a large trade-reporting system. 
And earlier this year, as has been mentioned, the SEC issued a 
concept release on market structure that solicited public 
comments on the impact of different trading strategies, 
including high-frequency trading, on our markets and investors. 
These issues will also be the center of a market structure 
roundtable which we will be holding early next month. And next 
week, the Commission will consider a proposal to create a 
consolidated order-tracking system to allow effective cross-
market surveillance of equities trading.
    In conclusion, we are making progress in our ongoing 
review, and we have begun putting in place safeguards that will 
help prevent this type of unusual trading activity from 
repeating. I look forward to working with Congress on these 
issues in the coming weeks, and, of course, I would be pleased 
to answer any questions.
    Thank you.

STATEMENT OF GARY GENSLER, CHAIRMAN, COMMODITY FUTURES TRADING 
                           COMMISSION

    Mr. Gensler. Good morning, Chairman Reed, Ranking Member 
Bunning, Senator Corker, Senator Warner. Thank you for inviting 
me here today. I am pleased to testify alongside Chairman 
Schapiro.
    As she mentioned, the CFTC and SEC staff released a joint 
report Tuesday that presented preliminary findings regarding 
the May 6th market events, and I just wanted to thank the 
staffs of both agencies for working tirelessly and 
cooperatively to issue this detailed report in such short 
order. I think it was a high level of cooperation and public 
service that got this to you and to the public so quickly.
    This morning I will focus my testimony on the proposal 
issues in the futures marketplace, as Chairman Schapiro has 
addressed the securities markets more broadly. But before I 
turn to those specific events of May 6th, I would like to 
discuss just the make-up of the stock index futures markets. 
These market stock index futures are derivatives contracts that 
are on central exchanges, and by far the most active--about 80 
percent of that market--is a contract called the E-Mini S&P 
500. It is based on 500 of the largest stocks. These are traded 
electronically, as you know, and we have moved toward 
electronic markets where about 88 percent of the futures 
markets today more broadly are done on electronic platforms, as 
opposed to in the old days when people were in the pits in an 
exchange.
    There is also something called algorithmic trading, which 
refers to the practice of using computer algorithms to direct 
order entry into electronic trading platforms. And in some 
cases, an investor chooses an algorithm by making only a few 
clicks, a pull-down window, just as on your home computer, 
provided by the executing firms.
    In this new environment, the futures markets do have 
automatic safety features to protect against the errors of 
order entry and extreme price swings. But I do think that we 
need to review whether further protections are needed in these 
fast-paced, computer-driven markets. And though additional 
review is necessary, preliminary staff findings suggest that a 
confluence of economic events, signals from other markets, and 
a marked increase in sell orders culminated in the significant 
decline and dislocations of liquidity in this E-Mini contract, 
this futures contract.
    May 6th began with turbulent skies in the marketplace. Many 
financial news outlets were reporting the uncertainties 
emanating out of Europe, and volatility in the middle of the 
day actually reached 61 percent higher than the prior day just 
in terms of a key market measure. Market participants also 
would have observed a number of indicators coming out of both 
the futures and securities markets. From the futures markets, 
they saw a flight to quality--to U.S. treasuries, to currency, 
to gold. And the securities markets, after 2:00 p.m., they 
started to see significant increases in what you will hear 
about later, liquidity replenishment points of the New York 
Stock Exchange where stocks went into go-slow mode, but also 
significant price drops in exchange-traded funds, as was 
mentioned by Senator Bunning.
    On May 6th, we also saw significant dislocations in 
liquidity in this E-Mini contract, and between 2:30 and 3:00 
p.m. though there was 10 times more volume--normally, higher 
volume people think of as better liquidity, there is more 
trading--actually our economists reviewing it have shown that 
there is evidence that bid-offer spreads, the difference 
between where people will buy and sell, widened out and also 
the order books started to have an overwhelming abundance of 
sell orders when you look at the details.
    By just before 2:45, a number of large traders began to 
limit their involvement in the marketplace of the E-Mini, and 
at 2:24:28 to be precise, the Chicago Mercantile Exchange, one 
of their risk management structures kicked in, a go-slow or a 
pause called a stop logic functionality, and for 5 seconds the 
market paused. And, in fact, then it started to move back up 
after that pause.
    Now, we have reviewed at the CFTC the trading activity of 
the ten most active accounts on both the long and the short 
side. We are reviewing many others as well. But of those top 
ten, the predominant ones, nine out of them actually appear to 
be both on the long and the short side. There was one using 
algorithmic execution strategies that was only on the sell side 
and represented approximately 9 percent of the activity over 21 
key minutes, from 2:32 to 2:51.
    They used a volume restriction which they put into the 
computer system of their executing broker, a volume restriction 
which in other days would have taken that volume and put it out 
in probably as much as several hours. But on this day, with 10 
times higher volume on the critical hour, the volume was placed 
over 21 minutes. And it may well be that the volume 
restrictions that on an average day would have helped to limit 
the down draft of the market may have been ineffective and 
actually limited what they had hoped to be the market impact.
    The CFTC will continue its analysis, working jointly with 
the SEC on these matters, and I look forward to taking any 
questions that you have today.
    Senator Reed. [Presiding.] Thank you.
    I would like to call on Senator Bunning.
    Senator Bunning. Thank you. This is a question for both of 
you. Thank you for your testimony. Chairman Schapiro, I will 
start with you, but I would like both of you to answer the 
question.
    As I said in my statement, I am concerned about some of the 
ways trades were canceled. Do you think that was the right 
decision? And what role did your agencies play in it?
    Ms. Schapiro. Senator, the process for breaking trades is 
one that is done under exchange rules, not by the Government. 
Exchanges work out a common standard for how far away from the 
last valid price will they break trades. In the case of May 
6th, they determined that for trades done between 2:40 and 3 
o'clock they would break trades that were done 60 percent or 
more away from the last valid price at 2:40 or before 2:40.
    That resulted in almost 21,000 trades being broken. About 
59 percent of those were on NASDAQ, about 5 percent on BATS, 
and the others were spread out more broadly. And the exchanges 
can obviously speak to the rationale behind selecting the 60 
percent number in the next panel, but, frankly, it feels quite 
arbitrary, as I am sure many people think who had trades that 
were broken that they did not want broken or those who had 
trades not broken at 50 percent or 40 percent or 30 percent.
    I think going forward we need a process that is much more 
transparent, provides certainty in advance about what trades 
will be broken and which ones will not, and creates fairness 
for investors. And so I would say that having gotten the 
circuit breaker rule proposals in, my top two priorities now as 
we continue to drive this process forward is to get the 
exchanges to propose new, clear, consistent, and fair rules for 
breaking trades within the next 2 weeks, and then to expand the 
pilot program to include stocks beyond the S&P 500.
    It is not a process that has left investors feeling at all 
good about our marketplace, and we have got to fix it as soon 
as we can.
    Mr. Gensler. Senator, in the futures marketplace, there are 
exchange rules about breaking trades. They are very clear and 
tight. They have to happen within a very short number of 
minutes where one of the parties comes in. There were no 
futures trades broken on May 6th as it was. But I do share 
Chairman Schapiro's views in the broader context that rules for 
such breaking of trades need to be clear and consistent, and 
the public needs to know in advance these rules.
    Senator Bunning. Ms. Schapiro, it is hard for me as someone 
who worked in the market for 31 years to understand how any 
trades can be broken arbitrarily by an exchange, especially 
those rules that you stated. Those are arbitrary rules. And for 
someone who is left out of those arbitrary rules--in other 
words, did not fit in the box--how do you think they feel?
    Ms. Schapiro. I think they probably feel terrible, and I 
would as well if I were in that position. And that is why the 
rules have got to have clarity, and they have got to provide 
certainty up front so people understand that if a trade is 
executed because of a ``fat finger'' problem, a technology 
problem, whatever the reason is, that is executed 30 percent or 
20 percent away from the market, that those trades will be 
broken without discretion, or they will not be broken. But 
people need to understand that up front. When people enter the 
marketplace, they need to know what the rules are that will 
apply.
    Breaking trades also discourages buyers coming in at a very 
low point and providing liquidity, for example, because their 
trades may be broken as well. So why would they go----
    Senator Bunning. In other words, those ones that were done 
at 1 cent--are those some of the trades that we are talking 
about?
    Ms. Schapiro. Absolutely. Several hundred securities that 
had trades executed against stub quotes at a penny or 5 cents 
are very likely to be 60 percent away from their last valid 
price.
    Senator Bunning. They were.
    Ms. Schapiro. And they will almost--they will certainly be 
broken.
    Senator Bunning. OK. The second question for Chairman 
Schapiro. Have you found that any market makers with 
obligations to stay in the market did not perform on their 
obligations? And do you think the rules for market makers need 
to be adjusted to reflect the greater role of new types of 
liquidity providers?
    Ms. Schapiro. We do not have evidence yet of market makers 
who had affirmative obligations withdrawing from the market. It 
is absolutely something that we are looking at, and we have 
incorporated our Enforcement Division into our ongoing 
investigation. We have close to 100 people at the SEC working 
on this inquiry.
    I do believe one of the things we absolutely have to look 
at is the fact that many affirmative obligations of market 
makers have been eliminated by the markets over the years. And 
that is how we end up with stub quotes. The obligation to 
provide a two-sided quote used to be required to be reasonably 
related to the market price, no longer is in all cases, and we 
end up with, you know, a spread of 1 cent to $100,000. And that 
is just unacceptable.
    So one of the things we will be looking at very carefully 
is the creation of affirmative obligations again.
    Senator Bunning. The only reason I bring that up is that 
market makers make their money on the spread or whatever little 
chunk they take out as being a market maker. At least that is 
the way it was for the 31 years that I dealt with market 
makers. In fact, in some of the over-the-counter stocks that I 
sat on the over-the-counter desk, we took a quarter of a point 
out of each trade, and, therefore, it was built-in profit for 
the company that I worked for.
    I do not think a market maker should be able to get out of 
the market they are making the markets in that stock under any 
circumstances, unless they are belly up.
    Ms. Schapiro. As the markets have evolved, there are other 
benefits as well of being a market maker. It might be fees and 
rebates. It might be preferential capital or margin treatment 
and so forth.
    So to the extent there is a benefit from being a market 
maker, my view is there ought to be obligations and 
responsibilities that go along with that.
    Senator Bunning. I have used up my time. Thank you.
    Senator Reed. Thank you, Senator Bunning.
    And I want to thank Senator Warner for initiating the 
hearing. I was at the Pentagon. Senator Warner.
    Senator Warner. Thank you, Mr. Chairman.
    I want to continue a little bit along the line of Senator 
Bunning. I also had some concerns about the arbitrariness of 
what the standards are of breaking trades, but you have got to 
draw a line somewhere. I think, clearly, both of you have acted 
quickly in terms of circuit breakers, pauses, other tools we 
can use.
    I have got to tell you, though, I still have some concerns, 
and I am not being critical here, I am just seeking the answer. 
We are a couple weeks after the fact. We still don't know how 
this event happened in the first place and what were the 
precipitating causes. I keep coming back to, as an advocate for 
technology, but technology--here, we may be seeing technology 
for technology's sake alone, speed for speed's sake alone, and 
at some point as we--and I have this gut sense that whether it 
is, and I appreciate what you have done, Chairman Schapiro, in 
terms of flash trading, but this whole new area of high 
frequency trading, dark pools, collocation, sponsored access, a 
lot of the firms are doing this, my sense is, to try to get a 
competitive advantage in the marketplace.
    And how do each of your institutions keep up knowledge-wise 
monitoring these activities? How do you make sure you have got 
the technology expertise? I know we have had some conversations 
where you have to rely on a series of these exchanges to 
actually get data back because you don't have real-time access 
to that kind of information in the first place. I would love to 
hear--I appreciate what you are doing circuit breaker-wise. I 
appreciate the need to get an ability to break some of the 
trades when you have got this blip or problem in the market. 
But how do we get ahead of this? Have we seen on May 6 what may 
be the first kind of warning shot of what may be the next 
potential systemic crisis because of technology run amok?
    Ms. Schapiro. Well, let me speak a little bit about how I 
have tried to approach this in the little over a year I have 
been at the Commission, because there are absolutely enormous 
challenges to regulating this highly dispersed and fragmented 
marketplace we have in the equities markets. Depending on how 
you count, there are 50, 60, 70 venues where trading is taking 
place. Some of them are dark. Some of them are less opaque. 
Orders are handled differently. The protocols and how trading 
is paused or not paused is different across all of them.
    We peeled off a few issues we thought were really critical 
during the fall. Those related to making dark pools more 
transparent so that we would not develop a two-tiered system 
where retail investors would not have access to the best 
quotes. We proposed banning flash orders. We proposed 
prohibiting unfiltered access, where large customers can go 
directly into an exchange and not pass through the risk 
management controls of a brokerage firm. We proposed 
instituting a large trader reporting system so the SEC would 
have access to the activities that are engaged in by large 
traders. Those, we felt, were really critical ``of the moment'' 
issues we needed to get started on.
    And then in January, we published this very broad concept 
release where we asked a lot of questions about what is the 
impact of high frequency trading on retail investors, on the 
health of our markets, on the ability of public companies to 
raise capital, the whole reason our markets exist at the end of 
the day, and we have received over 100 comment letters on that. 
The comment period just closed and we will proceed now to try 
to pull all of these pieces together and figure out how we go 
forward.
    At the end of the day, our goal has got to be that our 
markets operate fairly and efficiently and effectively for all 
the constituencies, and I put at the top of that list public 
investors and public companies. And then those who trade for a 
living, playing an important role. But at the end of the day, 
our markets have to be about investors and the ability to raise 
capital. So that is how we are going forward on these issues.
    Senator Warner. And before Chairman Gensler answers, and I 
know I have only got a minute left, I guess, Chairman Gensler, 
in your testimony, you described some of the tools some of 
these institutions use in terms of ``sniping'' and ``sniffing'' 
strategies, where you put out a major order and you have got an 
immediate recision component to it to kind of sniff out where 
the direction of the market is headed.
    If you are a small retail broker or a small-time trader, or 
if you are a company that is seeing your stock potentially 
manipulated, how do we get to that level of confidence when it 
seems like certain institutions are using not greater 
investigatory knowledge, but really just technology, in a 
sense, to game the market?
    Mr. Gensler. Well, I think you are absolutely right. The 
technology has advanced the markets from the humans on the 
floor of the New York Stock Exchange or the floor of the 
Chicago Mercantile Exchange to these high frequency. The trades 
are down to milliseconds and nanoseconds. There are risk 
management standards in place in the futures markets, but I do 
think that we have to review them and see whether and where we 
can do better in this regard.
    You also asked about how we stay ahead. We are fortunate in 
the futures market--and this preceded me--that we get the data 
the next day. We get all the data in and we are able to query 
it, access it, and review that data down to the, if need be, 
the order book itself. But in terms of, you mentioned sniping 
and sniffing, it is how a computer puts in a very small order, 
maybe one future contract, and sees whether it is addressed or 
hit and lifted, and then it will put in more and so forth.
    We don't know yet whether that was a piece of what was 
happening May 6. We do have enough knowledge that the automated 
execution systems--there is the platform at the futures 
exchange, but then there are platforms that are in the 
executing brokers, that there was at least in this one 
circumstance, this one sell order, that on other days may have 
taken as many as hours to execute came into the market in those 
critical minutes. We are going to continue to look at that and 
see whether there are appropriate new rules with regard to this 
very real reality. We can't stop technology, but I think that 
we have to update our regulations to stay abreast of this.
    Ms. Schapiro. Senator, could I just add that we can't 
unplug the machines, but what we can do and are doing with 
things like circuit breakers is giving the opportunity for the 
human intervention to come back into the market, to apply 
rational thinking and thought, to pause a market and reopen it 
in an orderly and effective way that serves all investors' 
interests. So we have got to get that balance right between 
when the technology, which provides benefits, is allowed to run 
and when it is not allowed to run because it has run amok and 
we can put the human factor back into it.
    Senator Warner. My time has expired, Mr. Chairman, but I 
just would love to revisit, maybe in a second round, do you 
have the technology to stay abreast of the folks on the other 
side.
    Senator Reed. Thank you, Senator Warner. We will have a 
second round.
    Senator Corker.
    Senator Corker. Thank you, Mr. Chairman, and thank you for 
your testimony.
    Why is there a circuit breaker on the way up?
    Ms. Schapiro. Interestingly, there were five securities 
whose stocks were executed at $100,000, going up very, very 
dramatically. Apple was one. So the people are disadvantaged 
when they buy a stock at a $100,000 price as much as someone 
has been disadvantaged when they sell at the penny, and so it 
is the other side of the quote. So our view is, and the 
market's view, because these are the market's rules, was that 
fairness really dictates that the circuit breaker work in both 
directions.
    Mr. Gensler. And if I might add, in the futures 
marketplace, the very small pauses, these five- or ten-second 
pauses that are across all the futures contracts, are about 
allowing liquidity to come back in. Sometimes in the 
nanoseconds, there aren't a sufficient number of buy orders or 
sell orders, so it is about liquidity pauses. In the futures 
market, it is five or 10 seconds. And so it is to make sure 
there are orderly markets. We are not a price-setting agency at 
the CFTC. It is about orderly markets.
    Ms. Schapiro. Nor, of course, is the SEC.
    Senator Corker. So after 5 minutes, you have this breaker. 
Is there any issue with how trades are--what order they are 
traded in after that? I assume there is a back-up of trades, so 
how do you decide what gets executed after that 5-minute 
circuit breaker?
    Ms. Schapiro. The primary listing market will be 
responsible for reopening the trading after the 5-minute pause, 
so during that period, they will be trying to attract liquidity 
and establish a new price for reopening a security. They will 
do it really just the way they do it now when there is a halt, 
as we have for news pending in the markets today. I am sure 
they can answer that question on the next panel in much more 
detail.
    Senator Corker. So there is no issue there?
    Ms. Schapiro. I am sure as we put these rules out for 
comment, I am sure there will be many very specific technical 
implementation issues that we will have to work through during 
that 10-day comment period and then before the markets 
implement the circuit breakers and even while they go through 
their testing of circuit breakers.
    Senator Corker. You know, the whole issue--I know there 
have been a number of questions regarding breaking trades, so 
we have this situation where we engaged in a lot of technology, 
where people, the thing they are most concerned about is how 
close they can locate to the exchanges and how quickly, and so 
that all works to the good. And then on the other hand, we 
break trades when things get out of alignment. It just feels 
incredibly arbitrary and doesn't feel like the kind of--why do 
we do that?
    Ms. Schapiro. I agree it feels----
    Senator Corker. On one hand, we create these tremendous 
advantages, and then when it doesn't work well, we figure out a 
way to make it work well.
    Ms. Schapiro. Well, in fact, that is one of the reasons for 
circuit breakers. It is our view, and I believe it is the 
market's views, that circuit breakers should dramatically 
decrease the number of trades that have to be broken because of 
a price that is clearly erroneous. Where there are better 
linkages among the exchanges with respect to things like 
circuit breakers or liquidity replenishment points or 
volatility halts and all of these things earlier on, we 
probably wouldn't have had anywhere near the number of broken 
trades.
    It is not a good position for us to be in where we are 
cleaning up afterwards, and that is what breaking trades is 
about. We need to have up-front the protection, like circuit 
breakers, that should diminish the number of trades that might 
ever have to be considered to be broken. I am sure we will 
never eliminate them entirely. There will be people who make 
mistakes when they enter orders. But they should be minimized.
    Senator Corker. So it is rare that both of you all would be 
here, and I think you both know I respect both of you and enjoy 
working with both of you. But since you are both here and it is 
just the two of you, could you explain any rational reason that 
both the CFTC and the SEC exist?
    Ms. Schapiro. I assume you meant as separate agencies----
    Senator Corker. That is correct.
    Ms. Schapiro.----as opposed to existing at all.
    [Laughter.]
    Senator Corker. No.
    Ms. Schapiro. You know, obviously, Chairman Gensler will 
want to speak to this, as well. I have chaired the CFTC and now 
the SEC. I have had tremendous experience with both agencies. 
They are both populated with incredibly talented and hard 
working and committed people. It is my view that if we were 
creating a regulatory system afresh, we would not have two 
separate agencies. The market participants largely overlap. The 
products tremendously overlap, and we know that from the debate 
in regulatory reform. The issues between our two agencies are 
coextensive.
    So I think, were it up to me, and, of course, it isn't, we 
would have one agency. We don't, and so Chairman Gensler and I 
are hugely committed to working very closely together, and I 
think the work over the last 2 weeks demonstrates that we are 
capable of doing that.
    Mr. Gensler. The first part of your question, we exist to 
protect the markets and the public----
    Senator Corker. I know----
    Mr. Gensler. And the second part of your question----
    Senator Corker.----why you all exist separately----
    Mr. Gensler. Yes. But the second part of your question 
really dates back to the 1930s, when our predecessor and the 
SEC and when President Roosevelt came to Congress and asked 
that two agencies be set up, one to oversee what was then 
called the commodities markets, and then the securities 
markets, our oversight was on derivatives contracts, call it 
futures, and it has been the will of Congress for about seven 
or eight decades now to have two agencies.
    I do think that we have worked very well together, not just 
the two of us, but, I mean, the staffs of these two agencies, 
and we are working very well with Congress now to fill the one 
big gap, the over-the-counter derivatives marketplace, to make 
sure that we cover that.
    Our focus at the CFTC has been largely on derivatives 
contracts on exchanges and the SEC, though we cover a lot of 
the same market participants, is on the issuer public and, of 
course, the asset managers under the Investment Company Act and 
the accounting regimes and so forth. So we have complementary 
regimes, and it has been the will of Congress that that is the 
way we have been for seven or eight decades.
    Senator Corker. Well, thank you both. I really do think you 
have great staffs and certainly appreciate working with you 
all. I just, as I see you sitting here, realize another issue--
we certainly have not dealt, in my opinion, with one of the 
core issues regarding this last financial crisis with this 
bill, and then, again, lack the courage as a House and Senate 
to deal with a very obvious issue, and that is that the two 
agencies are separated. But again, we deal with everything in 
the world in this bill but some of the core issues that need to 
be dealt with.
    But I thank you both for being here and I am sure you all 
will remain separated for many years.
    Senator Reed. Thank you, Senator Corker.
    Thank you for your testimony. One of the most potentially 
disturbing aspects of the testimony is that--and again, I want 
you to clarify it, will give you an opportunity to clarify it--
is that you are both not quite sure what exactly happened. It 
was a confluence of events, but as I understand the testimony, 
the precise sequence, the precise causative factor among these 
has not been identified yet. Is that a fair statement? Chairman 
Schapiro and then Chairman Gensler.
    Ms. Schapiro. It is a fair statement. You know, it has been 
2 weeks. Our staffs have been working around the clock. But 
there is an extraordinary amount of data that we have to plow 
through. And we are disadvantaged, quite honestly, on the 
equities side by the fact that we have so many different 
trading venues. We do not have a consolidated audit trail, 
which is why the Commission will be voting on that next week, 
to create one for the first time.
    But we had to get audit trail data from the options 
exchanges, from the NASDAQ and the New York Stock Exchange. 
Other markets, like BATS and ISE and NYSE Arca that don't even 
keep full audit information, they just have simple books and 
records requirements. We had 19 billion shares traded that day 
in 66 million different trades. Seventeen million of them alone 
were between 2 and 3. So the enormous amount of data coming 
from multiple sources in different formats, captured in 
different ways, is creating an enormous amount of work for us.
    Our technology, I think as you know, Senator, is not great. 
It has fallen behind over the years, and our capacity to even 
handle the terabytes of data that we are getting slows us to a 
halt sometimes while our systems kind of catch up and allow us 
to continue our work.
    So I will say that I think the staff is doing an 
extraordinary job. We need to get them the technology 
resources. We are actually looking at bringing in a third-party 
firm to help us crunch the numbers. But over the longer run, 
this agency has got to have the capability to process this kind 
of information quickly and effectively so we can reconstruct 
markets and understand exactly where our problems are.
    Senator Corker. Chairman Gensler?
    Mr. Gensler. Though there is enormous work yet to be done, 
I might lean into this a little bit more than my staff would 
want, but I think the combination of events, the economic news 
that was coming out of Europe, and by the middle of the day, 
there was definitely a lot of uncertainty in the market. There 
was additional uncertainty that was coming from market signals. 
Sometimes market signals are fundamentals, like jobs data, or 
in this case what was going on in Europe. Sometimes the trading 
data, and we saw a lot of trading data in Treasuries, in 
currency markets that were higher uncertainty, and even when 
the New York Stock Exchange started to have some of these 
securities go into slow mode or the self-help modes, all that 
market data brings you to about 2:30 on that day and the market 
is down two to 3 percent.
    At that point, our review, because we have been able to 
look in the futures markets with CFTC, and for all the reasons 
Chairman Schapiro said, we still have a lot more work to look 
into the cross-linkages of the securities to futures, but in 
the futures markets, we saw liquidity dislocations where really 
sell orders were far outstripping buy orders in the critical 
minutes into the V, the downward drift.
    In the midst of that, some liquidity providers that don't 
have an obligation to be in that marketplace did start to limit 
their participation in the critical minutes before 2:45. In 
addition, we did have one sizable sell order in the midst of 
that put in an automated execution system and through an 
automated execution system, through a little pop-down window--
we have even sent staff to look at the pop-down windows--is 
able to put in, limit my participation to about 9 percent, 
because I thought it wouldn't have a market impact. Well, on 
this day, that might have been a different feature, in some of 
those critical moments.
    So those are some of the factors that we have looked at. We 
still have to prove out some of the theories. There are a lot 
of cross-linkages that we are going to study together.
    Senator Reed. Based on that, and again, I want your 
comments, is that you cannot assure us that this problem would 
have been self-correcting given the market mechanism in place, 
is that a fair judgment?
    Ms. Schapiro. Well, I think the fact that the market 
bounced back so quickly and prices recovered so quickly 
suggests that there may well have been sufficient liquidity 
present, but the markets couldn't get to it. It wasn't detected 
or it wasn't accessible. That, to me, is a market structure 
problem, which is why we are doing circuit breakers as a way to 
sort of pause the market, try to bring that liquidity back 
where it is accessible again by the other side. It is why we 
are looking at things like the use of market orders, stub 
quotes, stop loss orders, and all of these other issues.
    But if you are asking me, can we guarantee this won't 
happen again tomorrow, I wish I could tell you that I am, but 
we can't, and it is why we are moving so quickly.
    Senator Reed. Well, another way to look at the issue is 
that this was an unusually disruptive situation in which there 
was a recovery. We don't know really what factors caused it and 
what factors we have to control, and we also really don't, I 
think, know what factors caused the recovery, the rapid 
recovery.
    So there is a distinct possibility that this situation 
might not have naturally bounced back, but it could have 
deteriorated further to a point at which the markets were 
paralyzed and the fall would have been much more severe. 
Without being hysterical about these things, does that 
possibility exist?
    Ms. Schapiro. I think because we really don't know all the 
answers yet, I think that possibility does exist.
    Mr. Gensler. We do know one thing about the recovery in the 
largest futures contract, this E-mini contract, that it took a 
5-second pause. There was in the automated system at the 
Chicago Mercantile Exchange, called Globex, it has a liquidity 
stop. It is called a stop logic functionality, words I hope to 
forget one day----
    Senator Reed. Sounds like here.
    [Laughter.]
    Mr. Gensler. Yes. But nonetheless, that 5-second pause to 
allow more orders to come into the book was coincident that the 
market in that contract moved up at the end of it. Seven 
seconds later, broad market exchange traded fund, about a $100 
billion fund called Spiders, 7 seconds later, that started up, 
and then the cash markets, anywhere from 15 seconds to 2 
minutes later started up, because that is the natural 
progression.
    Senator Reed. You know, again, we can't be alarmist, but we 
have to be very sort of tough minded about what potential 
problems exist there. One could suggest that with all these 
good things happening in Spider and the self-correcting logics, 
had suddenly the government of Greece announced that it was 
suspending all of its payments, those things would have been, I 
think, might not have been sufficient.
    So the point I think we have to look at, also, is what are 
the stand-by arrangements that if you can't get this right, 
that if the circuit breakers don't kick in correctly, what are 
those stand-by arrangements? And, I would dare say, will those 
arrangements be in place in the future? Chairman Schapiro, and 
then I will ask Chairman Gensler.
    Ms. Schapiro. Senator, we do have in existence and have 
since the 1987 crash--I guess it took about a year to put these 
circuit breakers in place, but there are existing now market-
wide circuit breakers. They have actually only been triggered, 
I think, once in the last 20-plus years that they have been in 
place. So if the market goes down 10 percent before 2, and it 
is based on the Dow, it is halted for an hour. Between 2 and 
2:30, it is halted for 30 minutes, and so forth, and there are 
different lengths of halt at a 10-percent decline in the Dow, a 
20 percent decline in the Dow, and a 30 percent decline in the 
Dow. And at a 30 percent decline in the Dow, the market shuts 
for the rest of the day.
    So there is that ultimate fall-back we have in the market-
wide circuit breakers. They have rarely ever been triggered. It 
is a pretty strong signal of big problems if they are 
triggered, and that is the reason we want to recalibrate those.
    Senator Reed. What I presume that does is give you time to 
act.
    Ms. Schapiro. Absolutely.
    Senator Reed. What actions can you take, not just the SEC, 
the CFTC, but Federal regulatory authorities?
    Ms. Schapiro. Well, I think that the market participants 
have the opportunity to try to gather liquidity into the market 
to find where there might be buyers to consolidate that 
interest in buying those securities when they reopen the stock 
in a much more orderly way. It is really about giving the 
markets a time out, human beings an opportunity to turn off the 
algorithms, change the algorithms, do whatever is necessary 
with respect to all the automated trading programs and then to 
do what market makers and specialists have traditionally done, 
which is to build interest in the market.
    Senator Reed. And are you confident that the market makers, 
given that time in circumstances like that, can get it right 
without any assistance?
    Ms. Schapiro. You know, at the end of the day, the markets 
are going to find their natural level, and if the news is dire 
enough and drastic enough, the best we can hope for, then, I 
think, is just an orderly decline coming off of the new single-
stock circuit breakers and the market-wide circuit breakers.
    Senator Reed. Chairman Gensler, and then I am going to 
recognize Senator Schumer.
    Mr. Gensler. I would associate myself with Chairman 
Schapiro. I think the market-wide circuit breakers, it is 
called inter-market circuit breakers that were set up after the 
1987 events, which have been triggered once, we are going to 
take a close look. We are going to use this advisory panel to 
look at. But as Chairman Schapiro has said, market participants 
will then have time, whether it is 30 minutes, or if it was a 
severe drop right now, the markets are closed for the rest of 
the day, it is overnight, for information to come into the 
market, for humans to be there.
    A lot of these algorithms, just because it is algorithm, 
don't think smart. A lot of the algorithms are very just rote, 
even dumb. I mean, they just do what they have been programmed 
to do repeatedly. And so giving the 30-minute pause in the 
inter-market circuit breaker or even overnight if it is a 30 
percent decline, for instance, today gives humans a chance and 
information to come in. If it is overnight, it even gives the 
whole Fourth Estate, the news media, to comment. So there is a 
lot, a flood of information. But I agree, ultimately, markets 
will find their way.
    Senator Reed. Well, unfortunately, I think when it comes to 
the media, the headlines will be, ``Markets Crash, Close, May 
Not Open,'' which might be a self-fulfilling prophecy, an 
unfortunate one.
    But anyway, Senator Schumer?
    Senator Schumer. Thank you, Mr. Chairman. Thank you for 
holding this hearing. I thank our witnesses.
    We are in a brave new world here. It reminds me a little of 
that movie ``2001,'' where they started out man and machines, 
and the machines took over and you missed something bad 
happened when machines just took over, and that is what we sort 
of have here. Everything is now so mechanized with very little 
human interaction that much of the time it works very well, and 
some of the time it doesn't work well at all, as we saw, and I 
worry about it.
    I worry that we let the technology get too far ahead of us, 
and I am hopeful that the solution you posed solves it, but I 
have a feeling we are going to have other kinds of problems 
because everything is so new and everything is so quick and 
there is, as you say, these machines are very smart and very 
dumb. OK.
    It is good to see both of you here together, the two 
agencies cooperating, but I do think there is a problem there, 
too. This started in the futures markets with one of these 
indexed, one of these indexed things, and we have the circuit 
breakers imposed in the equities markets but not in the futures 
markets. What kind of coordination is there, because I think 
most people agree that what started in futures spread to 
equities? What are you doing to deal with that kind of synapse, 
because the indexes can cause problems in individual equities 
and then we jump from the CFTC to the SEC?
    Mr. Gensler. Senator, we do have these inter-market circuit 
breakers that were set up in the 1980s. We are committed to 
take a look at those, take a look at the outside advisers, see 
whether the levels should be adjusted. So right now if it is a 
10-percent decline for a certain time, 2 and 2:30--it changes. 
But then the cross-market stops. The index futures products 
close, the equity markets close, the index options close--
everything closes for the 30 minutes or hour, depending upon 
the time of the day. We are going to take a look at that very 
closely.
    Senator Schumer. Do you think that--what happened this 
time?
    Mr. Gensler. What happened this time----
    Senator Schumer. The circuit breaker did not stop things 
from crossing from the futures----
    Mr. Gensler. It was not triggered because the market had 
not gone down 10 percent.
    Senator Schumer. I see.
    Mr. Gensler. The question is whether----
    Senator Schumer. Got it.
    Mr. Gensler. That is really what it is.
    Senator Schumer. So you have got to look at this and re-
examine it.
    Mr. Gensler. Look and re-examine whether to change those 
levels.
    Senator Schumer. Right. The next question relates--it is a 
little along the lines of my opening remarks--to dark pools. 
SEC, NASDAQ, we have registered market makers. We have a little 
bit of that human element. You go to the dark pools and you do 
not. And I am worried that this is a potential area for 
problems because by nature they are dark.
    Now, obviously, they give an advantage. Somebody wants to 
hide what they are doing--``hide'' not in a pejorative way, but 
not reveal to the market that they are making a large, large 
purchase. I understand that. But it also may create problems 
that we do not know about.
    Does what has happened in the last couple of weeks make you 
folks feels we ought to re-examine what is happening in dark 
pools as well?
    Ms. Schapiro. Absolutely, and as you know, we have proposed 
requiring that dark pools make their orders available for the 
public so that we do not end up with----
    Senator Schumer. But when?
    Ms. Schapiro. When will we----
    Senator Schumer. No, no. When do they have to make their 
orders available to the public?
    Ms. Schapiro. Oh, our proposal would have them display 
quotations broadly, not just to a select group of market 
participants as they do now when they receive the order. So the 
goal is to not allow this two-tier market to continue to 
develop where select market participants get access to quotes 
that the general public does not have access to.
    So our proposal would basically define these indications of 
interest as bids and offers and require public display, except 
for very, very large blocs where there may be some legitimate 
interest in----
    Senator Schumer. The dark pools would become a little less 
dark.
    Ms. Schapiro. Exactly right.
    Senator Schumer. Well, I think that is probably needed. Me, 
I am for openness and sunlight, first and foremost. I worry 
when we do not have it. I worry when we do not have it.
    My final question relates a little bit to what Senator 
Bunning talked about, but I would just like to follow up. Some 
markets are canceling trades that were executed after stocks 
dropped 60 percent. But there are a lot of investors who sold 
when their stocks were down 20 or 30 percent, and they lost 
thousands of dollars, even though the stocks closed right back 
where they started.
    What is the SEC doing to help these investors get their 
money back, if anything?
    Ms. Schapiro. On a going-forward basis--and I recognize we 
have to deal with the 20,000 or so broken trades that were done 
arising out of May 6th. And with respect to those, we are 
looking very carefully at whether broker-dealers who handled 
particularly a lot of retail order flow during that period gave 
best execution to their customers, if they were executed 40 or 
50 or 60 percent away from the market. And we will continue 
that investigation very quickly. There are clearly going to be 
aggrieved customers given the level at which the exchanges set 
the break threshold.
    Going forward, we have to fix this process. It is badly 
broken.
    Senator Schumer. Can I ask one final question, Mr. 
Chairman?
    Senator Reed. Yes, you may.
    Senator Schumer. Thank you.
    One final question to both of you. In general, do you think 
that in this area the rules that apply to equities and options 
should apply to futures, it should be the same kinds of uniform 
rules across the board in general? And I would like each of you 
to answer that.
    Ms. Schapiro. We need to get uniform rules--my first order 
of priority is uniform rules within the equity trading venues, 
which we do not have right now. And so we are very focused on 
that.
    We have a Joint Advisory Committee that we have convened 
and it will meet on Monday, and one of their tasks will be to 
look at where between the two marketplaces, equities and 
futures, we have disparate rules that might be contributing to 
market volatility or the transmission of volatility from one 
market to the other. And we would expect to use those market 
experts to help us figure out exactly what ought to be the 
same.
    Clearly, for things like circuit breakers, they have to 
operate across the market seamlessly. Those must be the same.
    Mr. Gensler. I would say critically market pauses, circuit 
breakers have to operate the same. There is something called a 
single stop futures market. It is not traded much but, for 
instance, that has to link into the same single stock, the 
broad market. Whether it is an S&P future, an S&P option, 
wherever, it has got to be at the same time. There are also 
risk management standards that happen in the futures markets, 
which, frankly, are a little easier to do in the futures market 
because there is not 50 or 70 venues. It is not that one is 
better or worse. It has just been easier to do.
    Senator Schumer. Thank you, Mr. Chairman.
    Senator Reed. Thank you.
    Senator Bunning.
    Senator Bunning. I brought this up earlier, but I want to 
get a little clarification of it. I am troubled by the way 
exchange-traded funds and closed-end funds move differently 
than the stocks they are actually supposed to track. As you can 
imagine, if those funds do not accurately reflect the value of 
the underlying stocks, there will be serious consequences as 
investors lose faith in them.
    What have you found out about what happened to them?
    Ms. Schapiro. It is a great question that is a huge area of 
focus for us. If you look at the canceled trades, 70 percent of 
the issuers who had canceled trades were exchange-traded funds. 
So we have much more work to do in this regard, but here is 
what we are looking at.
    For example, NYSE Arca is the primary listing exchange for 
almost all exchange-traded funds. So we want to know did the 
loss of access to Arca's liquidity pool, when two other 
exchanges routed around them to trade, disproportionately 
impact the liquidity and the trading of the exchange-traded 
funds. We want to understand why it was that the severe ETF 
price declines generally occurred after single stock price 
declines and how that linkage works.
    Did the inability of market makers, for example, to hedge 
their ETF positions during the volatility contribute to a lack 
of liquidity? Were there more stop loss orders that were 
entered in the ETF markets than with respect to individual 
stocks? Was that a contributing factor? And did institutional 
investors short the ETF to hedge their broader market exposure 
as the market was declining?
    And so those are the areas we are looking at very 
carefully. ETFs are a huge part of our marketplace now. There 
are over 800 of them. They have over $700 billion in assets. 
Real people were impacted when the ETFs were impacted, and we 
are going to continue to look at this area particularly 
closely.
    Senator Bunning. OK. I happened to be watching the market 
very closely when this was going on, and I watched a stock 
called Procter & Gamble at $61 a share and then the next trade 
was at $37 and the next trade was at $39. Now, those do not 
come within those parameters that you set out. In other words, 
the stock drop was not significant enough to be included.
    Ms. Schapiro. My understanding is that Procter & Gamble 
declined 36 percent in 3 \1/2\ minutes, so the proposed circuit 
breakers of a 10-percent drop within a 5-minute period----
    Senator Bunning. Yes, your proposed.
    Ms. Schapiro. Right.
    Senator Bunning. I am talking about current.
    Ms. Schapiro. No, that is right. Procter & Gamble also 
recovered back to that $60 in about----
    Senator Bunning. Yes, they did. I was just going to say it 
wound up at 60-something that day, and what happened to the 
poor person who sold at $37.
    Ms. Schapiro. That is right. They do not fall within the 60 
percent away from the last valid price threshold, I agree, 
which is, again, why we----
    Senator Bunning. Where is the market maker in Procter & 
Gamble? Where was the liquidity in the market maker?
    Ms. Schapiro. That would be a great question for the next 
panel of exchanges.
    Senator Bunning. Oh, OK. I will wait to ask that of the 
next panel.
    When you update the circuit breakers for stock indexes, do 
you expect to harmonize the rules between equities and futures 
in the same index?
    Ms. Schapiro. Absolutely. One of the things we are looking 
at as we think about updating the market-wide indices is 
whether we should move, for example, from the Dow to the S&P. 
Are the thresholds right? Are the trading halt periods----
    Senator Bunning. We have a day going today that you may get 
another chance at this.
    Ms. Schapiro. Great.
    Senator Bunning. I just want you to know, today.
    Ms. Schapiro. Clearly, these have to be highly coordinated 
across these two markets, and not just one.
    Senator Bunning. Well, I just am worried that by lack of 
not getting something done we could have a repeat. We are off 
almost 300 points on the Dow right now. The S&P is right at 30, 
and off. And the NASDAQ--or the other stock exchange is right 
around 60.
    Now, if we get bad news out of the IMF or Greece or 
Portugal or something that would have an adverse effect on our 
own markets, we could see the exact same reoccurrence, and we 
have not done anything.
    Ms. Schapiro. I share your sense of urgency, and we are 
moving very quickly, quicker than I have seen the SEC move in a 
very long time.
    Senator Bunning. I know that, but that is not quick enough.
    Ms. Schapiro. I understand. It is not quick enough. The 
existing circuit breakers we have will just have to be our 
fallback until we can get it done.
    Senator Bunning. I think there comes a time when you take 
emergency actions, and if we are in that situation and in a 
market situation where we need emergency powers, all you have 
to do is come here and ask, because we do not want a 
reoccurrence, and we surely do not want to arbitrarily break up 
trades that were legitimately done under a set of rules. And I 
would urge you to come and directly ask this Committee for 
emergency powers.
    Senator Reed. Senator Schumer.
    Senator Warner. I have just got one more question.
    Senator Reed. Senator Warner.
    Senator Warner. I think you are all hearing our concern. 
But my only other question is--it is not going to be very 
articulately asked, but we are trying to get in place rules for 
circuit breakers. We are trying to get in place rules if we 
have this precipitous fall on how we make good or break up 
trades that are a result of this, again, as Senator Schumer 
said, ``technology run amok.'' You know, but I think there is 
also a bigger problem about market trust here. I thought I 
spent the last year and a half on this Committee trying to get 
up to speed on how we maybe put in place rules to fix the last 
crisis. But my gut just says that we may be looking at the 
beginnings of what could be the next crisis. I mean, terms that 
I am not sure--just probably not many folks a decade ago really 
understood the first time folks talked about credit default 
swaps or naked credit default swaps; the new terms of art of 
``high-frequency trading'' or ``flash trading,'' which you have 
already taken action on; collocation, sponsored access, dark 
pools, you know, ``sniping'' and ``sniffing.''
    You have said we are 2 weeks into this and you have not 
figured out--and, again, I am not being critical here, we have 
not figured out what caused the last problem. How do we make 
sure we have not only got rules in place to prevent or 
ameliorate the next technology run amok? I just in my gut feel 
like these firms who are making hundreds of millions of dollars 
of investments to get this technology advantage are not doing 
it simply to add liquidity to the marketplace. They are not 
doing it simply as a sign of good corporate citizenship. They 
are doing it to get a competitive advantage, and who are they 
getting a competitive advantage over? They are getting a 
competitive advantage over the Jim Bunnings who used to trade 
or the Mark Warners that used to trade or, you know, the guy in 
Schenectady who is trying to see--panicking when the market is 
dropping and trying to take action because he is not competing 
on a level playing field.
    So my appeal is if you need not only action in terms of 
making sure we have got the circuit breakers in place, but how 
do we also make sure you have got the technology and the tools 
in place to make sure that we can give confidence to that 
investor in Virginia Beach who contacted me on May 7th saying, 
``What do I tell my investors who lost a lot of money on trades 
they made yesterday?'' Because it was not market reactions, but 
there was something else going on.
    Ms. Schapiro. The technology and tools are absolutely 
critical for us to be able to understand exactly what went 
wrong here. That will inform obviously the kinds of fixes and 
things we would put in place, because we do not have all those 
answers yet, though we do not want to wait to try to ameliorate 
the impact of what happened. Whatever ``it'' was--mismatch of 
liquidity, what happened in Greece, whatever the causes were--
linkages between the two markets. That is why we have moved so 
quickly on things like circuit breakers, are moving quickly on 
things we think exacerbated the volatility, the use of stop 
loss orders, the use of market orders, and all of these things.
    So we are jumping on the things we can fix immediately to 
try to fix those immediately. We are doing this longer and 
deeper dive, which I hear you all saying pick up the pace on 
and figure out what is really broken in our market structure 
and get those things fixed as quickly as you can. And that is 
really what we are trying to do.
    Senator Warner. I guess my time is up, but the question I 
am also asking is: As we sort through how we try to prevent 
this, we also have got to sort through to make sure that 
everybody is operating on a level playing field.
    Ms. Schapiro. There is no question about that, and so much 
of what we are trying--I believe the markets exist for public 
companies to raise capital, to build businesses, and create 
jobs, and they exist for investors to support that activity. 
And those are the number one and number two purposes of 
markets. And everything else from my perspective has to be put 
into the context of those two goals.
    Mr. Gensler. I would agree with what Chair Schapiro said, 
that in this new world of technology, we are not going to stop 
technology, but we have to make sure that markets are fair and 
orderly, transparent, as Senator Schumer said, they are not 
just mechanized creatures, again, as Senator Schumer said, but 
that they work for investors, they work for corporations that 
want to hedge their risk or raise capital, and that the pricing 
in those markets really reflects what buyers and sellers are 
coming together to reflect--you know, the risk and the values 
of the underlying companies.
    Senator Reed. Senator Schumer.
    Senator Schumer. Thank you, Mr. Chairman. I want to follow 
up a little bit more specifically on Senator Warner's fine 
questioning here.
    You know, we have competition among various exchanges, too, 
and some of them gain an advantage by being less regulated, if 
you will. And I am not so sure that is good or fair. So Direct 
Edge and BATS, for instance, they do not have to have 
registered market makers, nor do they have to have a 
consolidated audit trail, so it is hard to find out what 
happened even after the fact to correct them. Why should they 
be allowed--why should other exchanges like a NASDAQ or an NYSE 
have these regulations--which they should for the good of the 
markets, but we have other so-called exchanges which do not, 
even though it seems both those two having registered market 
makers, having a consolidated audit trail, why shouldn't they 
have those? And why are we letting them do this and they are 
capturing a big share of the market? I am not so sure it is 
because of technology as much as it is because they have less 
regulation.
    Ms. Schapiro. I think over the last several years, over the 
last decade, as the national market system grew and fragmented 
and splintered and there was a view that we have to encourage 
lots of innovation and lots of competition, and that would be 
good for our traditional markets, NASDAQ and the New York Stock 
Exchange in particular.
    We lost sight of the fact that we also have to ensure that 
there are obligations on these other trading venues, that there 
is transparency, that there is investor-first focus. And I am 
highly focused on that.
    We will have, I believe, a consolidated audit trail. I 
believe the Commission will approve going forward with that 
next week. And that will----
    Senator Schumer. You mean for BATS and----
    Ms. Schapiro. That will require all of the data, yes, from 
all of the trading venues.
    Senator Schumer. Right. And what about the idea of 
registered market makers? No one is saying if someone does not 
have a faster, better technology that they should not implement 
it. No one should have a monopoly. But if they are gaining 
share not because they have a better technology but because 
they have fewer obligations to protect investors, we have got 
big trouble. And I am worried that with these new--Direct Edge, 
BATS, that is just what we have.
    Ms. Schapiro. I understand that, that the self-regulatory 
obligations do not exist on all of those markets or those 
trading venues the way they exist on our exchanges, and we have 
to look at that very carefully.
    Senator Schumer. Well, are you going to put some in? Are 
you looking to equalize it?
    Ms. Schapiro. It is clearly part of what we are looking at 
in our view of market structure.
    Senator Schumer. OK. Well, I am going to be watching really 
closely and carefully about that because, again, I do not see--
let me ask you this question since I have another minute. Is 
there any justification why these two exchanges shouldn't have 
a consolidated audit trail? Is there any?
    Ms. Schapiro. I cannot speak to what has happened 
historically. My view is no. The SEC has got to have access to 
consolidated audit information and order tracking information 
across all of the trading venues.
    Senator Schumer. OK. And the second one, a little harder, 
but, still, any justification why they shouldn't have 
registered market makers?
    Ms. Schapiro. I do not know the answer to that. I guess I 
would like to come back to you on that. It depends upon the 
obligations, I think, with respect to the market makers.
    Senator Schumer. Mr. Chairman, could I ask unanimous 
consent that the SEC Chair, who I have tremendous respect for, 
have 5 days to submit an answer to that question in writing for 
the record?
    Senator Reed. Is that----
    Ms. Schapiro. Absolutely.
    Senator Schumer. Thank you.
    Thank you, Mr. Chairman. Thank you, my colleagues.
    Senator Reed. Thank you, Senator Schumer.
    This has been very useful questioning, and I want to push 
it a bit further. One of the critical events, this confluence 
of events, which we agree was somehow the course, was unusual 
trading of a futures contract regulated by the CFTC. But from 
Senator Bunning's remarks, this affected a stock like Procter & 
Gamble, which is clearly an exchange-traded, SEC-regulated 
entity. And it begs the question, I think, other than informal 
cooperation as you are exhibiting now, don't we need some more 
regular, systematic, not only review of the rules but 
consistent rules that are derived by joint rulemaking? That was 
the essence of the Dodd bill.
    Chairman Schapiro, what is your view on that?
    Ms. Schapiro. I do think we have the opportunity to bring 
much more consistency to these markets that are frequently 
economic substitutes for each other, and that is one reason we 
created a Joint Advisory Committee to help the two agencies 
understand exactly where we could benefit most from having 
similar or the same rules. And, clearly, under whatever version 
of legislation passes, we will have a fair amount of joint 
rulemaking to undertake with respect to securities-based swaps.
    Senator Reed. Well, the present legislation before us 
specifically excludes most joint rulemaking, so can I assume 
you would maybe not prefer but for the greater good would 
anticipate or support more joint rulemaking?
    Ms. Schapiro. Joint rulemaking has its own challenges, as 
we know, when we have to get ten people to vote and consider 
and get a majority to pass. So whether it is joint rulemaking 
or parallel rulemaking, we need consistency in the regulatory 
regimes that govern these economically equivalent instruments. 
So whether it is identical rules--ideally it would be one 
regulator. But whether it is identical rules or joint 
rulemaking, we cannot allow there to be differences that will 
be arbitraged and gaps where problematic conduct could be 
hiding.
    Senator Reed. Well, given the institutional arrangements 
that are likely to stay in place and given the fact that in the 
future there might not be the same kind of meeting of minds and 
cooperative spirit that you both exhibit, there has to be, I 
think, an institutional structure that guarantees that this 
will happen.
    Ms. Schapiro. I agree with that.
    Senator Reed. Chairman Gensler?
    Mr. Gensler. I think that through the financial reform 
package, it appears Congress will add some of that. I mean, 
there is joint rulemaking in the over-the-counter derivatives 
markets and products like mixed swaps and so forth where there 
are attributes of both. There is heavy consultation, I believe, 
if I remember the last drafts of this, that each agency must 
consult and so forth. We also on our own have set up 
memorandums of understanding, and I think that if the financial 
reform package went there, we should embark to update that to 
include all of the new authorities, because I agree with the 
Senator that the cooperative relationship that we have now--we 
will be out of these jobs at some point. There will be other 
people and so forth. And the nature of two agencies is not 
always to agree.
    Senator Reed. Well, I think we were all sort of--and I 
think Senator Corker was not only being his usual insightful 
and charming self, but the reality is had we started in this 
all fresh, there would be one agency dealing with these 
products that virtually can be substituted easily one for 
another. That is not going to happen.
    Senator Warner. Since we did such a good job on prudential 
consolidation.
    Senator Reed. Right. But I think this notion that we are 
going to let it the good will of the regulators does not work.
    Ms. Schapiro. No.
    Senator Reed. Unless we have an institutional structure 
that does not cause excessive delay, that there is an action-
forcing device, that it requires not just discussions but 
actually joint action, this situation will still be existing 
long after we have all left the scene.
    Ms. Schapiro. I agree with that.
    Mr. Gensler. We had even asked, jointly we asked for 
Congress to include on product review a new feature that--I 
think it is 120, but it may be 180 days--that if the two 
agencies cannot approve a product and know which way it goes, 
that we put in a judicial review feature.
    Senator Reed. I think that is very sound because I think we 
will anticipate for good reasons and sincere reasons there 
could be different perspectives, and there has to be an action-
forcing device. But if we allow this whole enterprise to be 
based upon the cooperative and collaborative model you have 
shown, things change, people change, and we would be, I think, 
very foolish.
    There is another aspect of this, too, that I think we have 
to at least recognize for the record, and you might want to 
comment about it. This was an accidental, unfortunate 
confluence of circumstances, but we all recognize that it could 
be a very deliberate attempt to disrupt trading, either through 
a physical attack on exchanges or through a cyber attack on 
exchanges.
    Are you prepared to deal with that?
    Ms. Schapiro. Our staff spends a fair amount of time 
working with the exchanges and major market participants on 
business continuity planning and back-up and contingency 
planning for those kinds of events. We have requirements for 
back-up facilities and annually review the adequacy of those 
with the markets that we regulate.
    Senator Reed. Are you and your staff concerned that this is 
a real possibility, that this is not just a theoretical----
    Ms. Schapiro. You know, in this world, I have no evidence 
or reason to believe something is imminent or could or will 
happen, but I think we absolutely have to be prepared for that 
possibility. To the extent that we suffer from this very 
dispersed and fragmented equities market structure, the one 
good thing is we have multiple trading venues where, if we had 
a physical attack on one major institution, we actually can 
pick up the slack in other places. So that is maybe the silver 
lining of our structure. But we absolutely have to be prepared 
for that possibility.
    Senator Reed. Are you comfortable that the present 
legislation pending in the Senate would prevent any assistance 
to these entities, exchanges, and clearing platforms if they 
were subject to such a physical or cyber attack?
    Ms. Schapiro. I believe so.
    Senator Reed. So you are comfortable that in a situation 
where trading has been disrupted deliberately, the market 
itself can correct without any assistance from----
    Ms. Schapiro. No. I am sorry. I misunderstood your 
question. No, I think if there were a major disruption like 
that, there clearly would be some need for--or there likely 
would be some need for the Federal Government's support in some 
way. I do not know if it is financial support or logistical 
support or other kinds of support.
    Senator Reed. And you are aware that the pending 
legislation would prohibit that support?
    Ms. Schapiro. I am.
    Senator Reed. Thank you.
    Chairman Gensler, your comments on these questions?
    Mr. Gensler. A series of comments.
    On disaster recovery and so forth, we have been working 
with the exchanges. We actually on our own are probably going 
to put out a proposed rule later in this year on strengthening 
some of the back-up recovery and disaster recovery in terms of 
cyber attacks, as you mentioned, and so forth.
    There are a series--and the futures markets maybe were 
benefited because there are fewer futures markets, but in this 
regard, that there is risk management standards, any contract, 
any transaction that comes in, has to meet the risk management 
standards of the clearinghouse, and because of that there is a 
series of filters and risk management standards before they 
come in. That does not mean that somebody could not possibly, 
as you say in a theoretical case, come in, but there is a lot 
of risk management practices. We are going to be looking to see 
if there should be more.
    I think on the third question that you ask about, Federal 
assistance, I am aware that there is sort of--if I might, there 
is a little bit of--there is in Title 8 of the pending statute 
allowing for Federal assistance and in Title 7 there is not. So 
there is an inconsistency there.
    I think that from my perspective the Federal Reserve that 
has had 13(3) authority to come in in an emergency if a 
situation should continue to be allowed, the 13(3) emergency 
authority, but not necessarily have daily access to the 
discount window. I know it might sound like it is slicing this, 
but I think the emergency authority is probably still 
important.
    Ms. Schapiro. Mr. Chairman, if I could just clarify.
    Senator Reed. Sure.
    Ms. Schapiro. Because I do not think I was very clear. I 
think that--I would agree with a policy of providing the 
Federal Reserve Board the flexibility to provide immediate 
liquidity if it is needed in a rare or an emergency 
circumstance. And we have long, I have long supported ensuring 
that the systemic risk regime would have a second set of eyes 
in addition to those of the primary functional regulators and 
comfortable with that role at the Federal Reserve as well.
    Senator Reed. This is an important point, and I think we 
should be clear about it. As Chairman Gensler points out, there 
appears to be contradictory language in the bills, which we 
will resolve, I hope. But Section 7 specifically excludes the 
ability of the Federal Reserve to use its modified emergency 
powers to assist--or change clearing platform in a general way, 
not one but in a general way. And your view would be that that 
power, the 13(3) power, should be preserved.
    Mr. Gensler. I believe it is Section 716, the vaunted 716 
that has other issues. But 716, I would retain the part of 716 
that limits the daily access of the discount window but allow 
in an emergency circumstance for the Federal Reserve to lend to 
participants in generalized liquidity programs. They would have 
to put out a rule so people would know what it is, but then the 
participants would be able to have that emergency action.
    Senator Reed. Thank you very much.
    A final question, which this, again, has been swirling 
about us, and I think you should be asked, too. There are 
several proposals that would essentially ban over-the-counter 
swaps, in some cases make them illegal. Is that from your 
standpoint, Chairman Gensler, a good policy to pursue?
    Mr. Gensler. I think that derivatives, whether they be on 
exchanges or what we call over-the-counter, are important risk 
management tools for municipalities, corporations, and 
ultimately their customers and employees. I am not familiar 
with the pending amendment, but a lot has gone on in the last 
24 hours to, quote, ban risk management tools of corporations. 
If they are customized, if they are tailored, we still think 
there should be comprehensive regulation of the dealers. I am 
pleased to see that in the Senate substitute there is truly a 
comprehensive regime. It is standard enough to be on a 
clearinghouse and clearable. And if it is then listable, then 
there is the clearing requirement and, in certain 
circumstances, a listing requirement. That, I think, is a 
strong package that you and others have put together.
    Senator Reed. Chairman Schapiro, any final comments?
    Ms. Schapiro. Just a brief thought. I assume this is 
Senator Cantwell's amendment potentially, the----
    Senator Reed. Well, there are several.
    Ms. Schapiro. There are several, OK.
    Senator Reed. There is a sizable number of colleagues who 
are thinking about this. This is a question I think should be 
addressed both you and Chairman Gensler.
    Ms. Schapiro. You know, I think the key policy question is 
whether that would provide--or create legal uncertainty for 
swaps that are accidentally not cleared or whether it creates 
the opportunity to game the system. I actually think those 
concerns can be addressed, but I would note that we already 
have under the Federal securities laws, under the Exchange Act 
Section 29(b), a similar although not identical provision, 
although it has not been applied ever in the context of 
requiring something to be cleared or not. So it might move the 
Commodity Exchange Act regime more in the direction of the 
Federal securities laws; but, on the other hand, it may have 
the potential to create legal uncertainty
    Senator Reed. Chairman Gensler, your final point.
    Mr. Gensler. Well, if it was a question about--there is one 
issue--I did not understand your earlier question to cover 
this, but if it did, if an over-the-counter derivative is 
deemed to be clearable and the regulators through a public 
comment period have determined that it must be cleared, which 
is what is in the substitute, in that circumstance there is a 
mandate that it must be cleared. If somebody knowingly does not 
follow that, what happens? And I believe the substitute right 
now gives the SEC and CFTC a lot of authority, but to be 
clarified to say that that transaction is unlawful seems 
consistent with actually what the intent is, that it is a 
mandate once you have this public comment period and it is a 
mandate, it is a real mandate.
    Senator Reed. I think part of this--and I will not get into 
the details here--is that some reading of these proposals would 
suggest that they go beyond that, saying that, in fact, you 
have--even as an exempt end user--an over-the-counter 
derivative that you present to a clearing platform and they 
will not clear it, then if you enter that contract, then that 
is illegal. But I think we have provided at least some insight 
into the proposals, and I thank you for that.
    I will invite my colleagues for further questions----
    Ms. Schapiro. Senator Reed, may I just clarify the record 
on one thing I said in response to Senator Schumer? BATS is 
actually an SRO, as is Direct Edge. He specifically mentioned 
those two marketplaces, although Direct Edge is not yet 
operating as such. And the decision about whether to have 
designated or registered market makers has been an exchange-by-
exchange decision, but it is something we will be happy to look 
at.
    Thank you.
    Senator Reed. Thank you very much, not only for your 
testimony today but for your very vigorous and thoughtful and 
demanding service to the Nation. Thank you.
    Mr. Gensler. Thank you, Mr. Chairman, Senator Bunning, 
Senator Warner.
    Senator Reed. Let me call up the second panel please.
    Thank you all, gentlemen, for being here today.
    Let me introduce our witnesses. Our first witness is Mr. 
Richard G. Ketchum. He is the Chairman and CEO of the Financial 
Industry Regulatory Authority, or FINRA, the largest non-
governmental regulator for all securities firms doing business 
with the U.S. public. Prior to becoming CEO of FINRA, Mr. 
Ketchum served as CEO of the New York Stock Exchange Regulation 
and Chief Regulatory Officer of the New York Stock Exchange and 
has also worked for Citigroup, NASD, NASDAQ, and the SEC.
    Our next witness is Mr. Larry Leibowitz, the Chief 
Operating Officer of NYSE Euronext. He joined Euronext in 2007 
after serving as the Managing Director and Chief Operating 
Officer at UBS Investment Bank and has also worked for Schwab 
Capital Markets.
    Our third witness is Mr. Eric Noll, the Executive Vice 
President of Transaction Services for the NASDAQ OMX Group. Mr. 
Noll joined NASDAQ from Susquehanna International Group and has 
also held positions at the former Philadelphia Stock Exchange 
and the Chicago Board's Options Exchange.
    Our finally witness is Mr. Terry Duffy, the Executive 
Chairman of the CME Group. Mr. Duffy has also served as 
Chairman of the Board of CME and CME Holdings and was President 
of TDA Trading from 1981 to 2002.
    All of your statements will be made part of the record. If 
you would like to summarize them, we would like it, too.
    Mr. Ketchum, please.

 STATEMENT OF RICHARD G. KETCHUM, CHAIRMAN AND CHIEF EXECUTIVE 
        OFFICER, FINANCIAL INDUSTRY REGULATORY AUTHORITY

    Mr. Ketchum. Chairman Reed, Ranking Member Bunning, and 
members of the Subcommittee, thank you again for inviting me 
today, and I commend you, Mr. Chairman, for having today's 
hearing and I thank you for the opportunity to testify.
    I would also like to commend Chairman Schapiro and Chairman 
Gensler, whom you have just spent a good deal of time talking 
with, for their leadership during the last 2 weeks and in 
coordinating the review of all relevant market data and efforts 
to identify measures that could be taken quickly to 
significantly reduce the chances of a recurrence of the 
significant market disruption that occurred on May 6.
    Immediately after the market events on May 6, FINRA, in 
coordination with the SEC and other market SROs, began the 
process of trying to identify unusual activity that could have 
contributed to the rapid market drop. Even before the market 
data had been fully collected, FINRA reviewed clearly erroneous 
trade filings and, along with NYSE Regulation, interviewed the 
approximately 20 firms with significant activity during the 
period of the decline to determine whether ``fat finger'' or 
other trading errors occurred. None of the firms identified any 
trading errors or other unusual activity, nor has any evidence 
been developed to indicate that a single large trade or basket 
of trades entered in error played a role in the market decline.
    We also contacted over 250 firms to determine the impact of 
the market disruption to the firms and their customers. Our 
inquiries covered a range of issues depending on the type of 
firm, including funding and liquidity, customer exposure, 
increased margin calls, net capital implications, and how firms 
intended to reestablish limit orders that were executed and 
canceled. While a number of operational and other issues were 
identified, none of them appeared to be systemic in nature.
    We have focused our review of the vast amounts of trading 
data on the approximately 300 stocks that experienced the most 
traumatic decline and have identified a subset of these stocks 
for further inquiry based on an analysis of the concentration 
of order and trade activity in the period immediately prior to 
and during the market drop. Focusing on the selling activity in 
these securities, we, along with our fellow regulators, have 
made inquiries of those firms that were most active. Our lines 
of inquiry include an analysis of short selling during the 
period and the role that algorithms played, including the 
specific strategies and triggers employed by each of the 
trading firms.
    While there is still much to be done before we can say that 
we have definitively pinpointed the cause or causes of the 
decline, I think we can say that certain basic truths have 
emerged and that we should not wait to adapt to them. We know 
that the process for restoring order following an event like 
last Thursday should be more transparent and predictable. Also, 
because trading in equities is dispersed among many venues, 
market quality can only be ensured through coordinated 
activities across all markets.
    In short, while our equity market structure performs well 
under normal conditions, change is urgently needed to address 
these flash market break situations. That is why the 
coordinated rule filings the SEC spearheaded are so important. 
I won't spend more time discussing the details of them since 
they were covered in detail at the last panel.
    As we look past these shorter-term steps to address what we 
saw in the market 2 weeks ago, longer-term concerns must also 
be addressed if we are able to reassure market participants 
that our equity markets are stable and fair. This is true 
irrespective of whether those issues played a major 
contributing role in the specifics of the decline on May 6.
    First, firms need to ensure that they do not continuously 
feed orders into the markets once markets have broken with 
respect to precipitous declines or employ market orders in 
these volatile periods.
    Second, firms must properly supervise customers to whom 
they have given direct access to their markets.
    Third, there should be a continued analysis of various 
market rules regarding circuit breakers and clearly erroneous 
trades with an eye toward consistency and transparency of these 
rules across markets.
    In addition, we should examine various order types, such as 
market and stop loss orders, and their impact on the events of 
May 6. We should also analyze and potentially eliminate the 
practice of stub quoting.
    Finally, the events of May 6 demonstrate the vital 
importance of the SEC's current review of market structure and 
forthcoming proposal relating to establishing a consolidated 
audit trail.
    The sometimes dizzying speed of change in the markets, 
which puts a premium on innovation and competition, has made it 
imperative that regulators act now to address the lag between 
market innovation and regulation. This is particularly 
important in the increasingly fragmented area of equity 
trading, where we have seen a rapid evolution of how and where 
trading occurs and how quickly and transparently it is 
executed. Today, orders are routed to some 50 competing 
platforms. This complex environment creates opportunities for 
traders seeking unfair advantage to manipulate markets by 
exploiting inconsistencies or gaps created when the 
responsibility of regulatory oversight is divided.
    Regulatory authorities are hampered by the lack of a 
comprehensive and sufficiently granular consolidated audit 
trail. Indeed, the frustration that many of you have expressed 
today with respect to the time it takes us to recreate what 
really occurred on May 6 is absolutely reflected by the fact 
that our audit trail today simply does not identify each of the 
entities that significantly impact pricing, but instead focuses 
on the executing broker-dealer and those who clear the trades.
    The most effective way to surveil across the wide range of 
market centers is to consolidate audit trail data in a single 
place so that violative trading practices can be more readily 
identified. While a consolidated audit trail would not 
eliminate all the challenges of analyzing the data from a 66 
million-trade day, like May 6, it would make the process 
significantly more efficient and effective. More importantly, 
it would enhance oversight of the equity markets, ensuring 
market integrity and protection of investors.
    We look forward to working with the SEC and this Committee 
on these important initiatives that lie at the heart of 
enhancing regulators' ability to best oversee today's markets, 
and I look forward to answering your questions going forward.
    Senator Reed. Thank you very much.
    Mr. Leibowitz?

  STATEMENT OF LARRY LEIBOWITZ, CHIEF OPERATING OFFICER, NYSE 
                            EURONEXT

    Mr. Leibowitz. Chairman Reed, Ranking Member Bunning, and 
members of the Subcommittee, thank you for the opportunity to 
be here today.
    We commend the Subcommittee for your proactive response to 
the events of May 6. If ever we needed one, the events of that 
day are a clarion call for the need to enhance investor and 
listed company safeguards. May 6 also confirms the wisdom of 
the SEC's ongoing efforts to improve the markets, including 
their broad market structural review and their leadership in 
bringing the markets together to develop the circuit breaker 
pilot.
    Today, I would like to discuss three things. First, the 
high-level causes of the May 6 events. Second, clarifications 
about NYSE's market model and how it worked. Third, our 
recommendations going forward.
    It is understandable that everyone is looking for a smoking 
gun behind the May 6 dip. However, the circumstances are more 
complicated than that. I will leave it to the regulators to 
link the interactions of various markets, but from our 
standpoint, we see no evidence of ``fat finger'' error or 
market manipulation due to automated trading or otherwise.
    However, we do see the following: Elevated market activity 
coming from adverse and European news, including a huge and 
broadly based wave of orders and quotes at around 2:40 p.m. A 
significant thinning in the marketplace as liquidity deserted 
the market through the day, accelerating into the downturn. 
Various microstructure issues which exacerbated the liquidity 
effect.
    One of the things that we do note is that news and fear get 
transmitted to the market faster than ever before thanks to 
technology and media advances, and we need to ensure the 
integrity of the market during these periods.
    Now, I would like to briefly turn to the NYSE market model 
and how our actions on May 6 reduced volatility to the benefit 
of investors and listed companies alike. NYSE has embraced 
electronic trading. We believe our market model provides the 
best combination of cutting-edge technology with human 
judgment. NYSE market rules expressly provide mechanisms to 
mitigate volatility and large price swings, which we have 
always believed is a critical piece of our offering to listed 
companies and their investors. In essence, at the NYSE, we have 
emphasized price over speed.
    Specifically, the NYSE incorporates a type of circuit 
breaker mechanism known as liquidity replenishment point which 
temporarily and automatically pauses trading in stocks when 
significant price movement occurs. On a typical day, LRPs are 
triggered 100 to 200 times, lasting for seconds, at most. In 
fact, these are akin to the circuit breakers that the CME 
discussed recently, which is a brief pause to allow liquidity 
to reassemble.
    Let me be clear, the LRP mechanism does not halt trading. 
When LRPs are in effect, our quote is visible to other market 
participants and new orders are continually accepted. During 
LRP mode, electronic markets may choose to ignore our quotes as 
permitted under Regulation NMS, although many participants 
choose to continue sending orders to NYSE. LRPs are analogous 
to taking the controls of a plane off autopilot during 
turbulence.
    I will highlight a few specifics. First, on May 6 during 
the 2:40 to 3 period, market share on the NYSE was 5 percentage 
points higher than usual during that time of day and the 
participation rate of our designated market makers, which were 
formally called the specialists, and supplemental liquidity 
providers was equally strong. This is evidence that our 
liquidity providers did not walk away from the market as we 
actively traded during the downturn.
    Furthermore, to demonstrate that LRPs protected orders in 
our market, stocks listed on other markets had price declines 
and erroneous executions far greater than NYSE-listed stocks.
    Last, the overall marketplace needed to cancel 
approximately 15,000 executions after Thursday's decline. On 
NYSE, even though we handled the largest share of orders in the 
marketplace, we had to cancel zero trades. In fact, 85 percent 
of the trades that ultimately were canceled were securities 
that were not even listed on the New York Stock Exchange.
    The bottom line is while there is always room to improve, 
LRPs actually worked reasonably well on May 6, and the response 
from issuers and investors has been uniformly positive. 
However, the mechanism is only truly effective if observed by 
other trading venues, and that is why we applaud Chairman 
Schapiro's leadership in helping create an industry-wide 
trading circuit breaker.
    I also want to mention an area that we believe has been the 
topic of inaccurate information. On May 6, NASDAQ declared 
self-help on NYSE Arca at 2:40 p.m. We were and are still 
unable to determine why, as all our systems and communication 
links were functioning properly. BATS also declared self-help 
at 2:47, but that was because they were sending orders outside 
of Arca's price callers, and a quick call between the venues 
resolved the matter. We welcome the SEC's review of these 
events and hope they will more generally review the use of 
self-help by venues against each other.
    Last, we need to examine the ripple effect of stock 
volatility in the ETF market and absolutely must make sure that 
these are included in circuit breaker considerations.
    In terms of recommendations, I want to quickly make a few 
points. First, we are pleased with the recently announced 
adoption of market-wide stock-level circuit breakers. LRPs will 
continue to function, as we believe they provide a significant 
advantage to companies listed on our exchange. We will review 
the need for and functioning of LRPs once the market-wide 
circuit breakers are implemented.
    Second, the current market-wide circuit breakers 
established long ago are based on market moves of 10, 20, and 
30 percent. There has not been a move greater than 10 percent 
in a single day post-2000. We understand the SEC is reviewing 
these as to whether to broaden these indexes.
    Third, we are working with the regulators and other 
exchanges to establish clearer rules for cancellation of 
trades, although circuit breakers will help mitigate this 
problem substantially. In fact, I would submit that the mere 
need to cancel trades is the sign of a market structure that 
does not function properly. Since 2008, hundreds of thousands 
of trades have been canceled from electronic exchanges with 
stocks such as Cisco Systems trading down to a penny during the 
fourth quarter of 2008. It is time we put a stop to this.
    Fourth, brokers should review their order routing practices 
to ensure they are truly getting the best prices for their 
clients and also see whether allowing market orders and stop 
loss orders really service the investing public or whether 
there are things we can jointly do to educate and protect 
retail investors from being harmed by volatile markets. 
Similarly, institutional clients should review their brokers' 
routing practices to ensure that these serve their best 
interests.
    Fifth, to facilitate a review of extraordinary trading 
events, there should be a consolidated audit trail that would 
allow regulators to review market-wide trade data. Ultimately, 
these and other important actions may be best achieved by 
consolidating market surveillance in one security self-
regulator, probably FINRA, which would require an act of 
Congress.
    In closing, we applaud the SEC and the CFTC for working 
together to develop a coordinated response to the events of May 
6. NYSE Euronext is committed to working with these agencies 
and we strongly urge all parties to play an active and 
responsible role in helping our markets function in a way that 
gives investors confidence.
    Thank you for the opportunity to appear, and I would be 
happy to answer any questions.
    Senator Reed. Thank you very much.
    Mr. Noll, please.

STATEMENT OF ERIC NOLL, EXECUTIVE VICE PRESIDENT OF TRANSACTION 
              SERVICES, THE NASDAQ OMX GROUP, INC.

    Mr. Noll. Good morning, Chairman Reed, Ranking Member 
Bunning, and Senator Warner. Before I begin my formal comments, 
I would like to convey my appreciation and respect for the 
actions of SEC Chairman Schapiro and CFTC Chairman Gensler 
during this important period of time. Their actions and those 
of their staff have been exemplary.
    We have studied the events and have worked closely with the 
SEC and the other exchanges to identify opportunities to 
improve regulation and coordination to combat market 
instability. We support the SEC's and CFTC's actions in four 
areas: One, updating existing market-wide circuit breakers; 
two, establishing new stock-by-stock circuit breakers that 
include an element of velocity of price changes; three, 
improving the handling of trade breaks to maximize consistency 
and rationalize moral hazard; and finally, four, changing the 
use of quotes and specific order types that impacted trading on 
May 6.
    The focus of these changes is consistency. While each 
individual exchange reports that its systems functioned 
according to design on May 6, the changes will improve the 
collective ability to handle unusual trading events in the 
future and help to restore investor confidence. Markets like 
consistency and predictability. They abhor uncertainty. Our 
markets are strong, despite the 17 minutes of trading that have 
garnered public attention.
    Keep in mind that on May 6, the global markets were 
nervous, becoming increasingly volatile and operating during an 
unusually long upward price trend. This volatility was 
certainly tied to the crisis in Greece and Europe. While 
developing for months, the potential harm seemed to sink into 
U.S. markets the week prior to May 6. Rating agencies lowered 
the ratings of sovereign debt of Greece, Spain, and Portugal, 
roiling debt markets. The European Union was working to fashion 
bailouts, and violence escalated in Athens. The Euro was down 
15 percent in the last 6 months, 7 percent in the prior 2 weeks 
alone.
    Against this backdrop, we arrived at the afternoon of May 
6. First, the Dow Jones Industrial Average was down 272 points 
for the day, down 500 the previous 3 days.
    Second, there was an unusually large institutional order to 
sell futures tied to the S&P 500 Index on the CME. Futures are 
a forward indicator for prices of equities. Thus, when S&P 
futures sank rapidly at 2:42, this was followed by rapid 
declines in S&P-linked equities.
    At 2:45 and 30 seconds, S&P futures became so negative the 
CME triggered a stop price logic event, a 5-second pause in 
trading to collect liquidity, effectively a market-wide halt in 
the futures market. When trading resumed, futures leveled off 
and began to climb. Shortly after, equity prices also rose. The 
CME assures that its systems functioned properly and there is 
no evidence of inappropriate activity by the CME or any of its 
members.
    Third, the NYSE Arca Exchange, the electronic market 
operated by NYSE, began experiencing communication issues, at 
least with NASDAQ, that hindered electronic linkages with other 
markets. The other exchanges were forced to route around Arca. 
Again, there is no evidence of inappropriate activity in Arca 
or any other problem, but its liquidity became less available 
to the entire market at a critical time.
    Fourth, simultaneously with Arca, the NYSE hybrid market 
began reporting multiple liquidity replenishment points in gap 
quotes that impacted trading in the NYSE-listed stocks. Under 
SEC Regulation NMS, NYSE is permitted to issue LRPs, but this 
functioned as a signal to other markets that NYSE was 
experiencing order imbalances or difficulties. This, in turn, 
allowed other markets to stop routing orders to NYSE and to 
trade elsewhere, and that is exactly what happened. NASDAQ and 
other markets routed around NYSE as Reg NMS contemplated. Even 
Arca, NYSE's own electronic market, stopped routing orders to 
NYSE. NASDAQ's ongoing analysis indicates that May 6 was 
triggered by a confluence of unusual events, including events 
outside the equity markets. We continue to investigate, but we 
have not located any single smoking gun that caused or fully 
explains these events.
    I would note also that so-called high-frequency traders 
appear to have played no distinguishing role in this event. 
They behaved in line with other liquidity providers and 
liquidity takers during that day. The SEC is engaged in an 
important review of market structure and the policies around 
high-frequency trading and we recommend that Congress allow 
that review to run its course before considering additional 
policy reactions in this area.
    From a systems standpoint, NASDAQ's markets operated 
continuously throughout the day and throughout the critical 17 
minutes. Each and every one of our systems functioned as 
designed and intended, our execution engine, market data feeds, 
and surveillance systems.
    While each exchange is reporting that its systems 
functioned as designed, no market center or regulator can be 
satisfied with the collective performance of our markets on May 
6. That is why NASDAQ supports and has filed with the 
Commission rules to implement cross-market single stock trading 
halts and supports the SEC's recommendation to update market-
wide circuit breakers. NASDAQ also supports the Commission's 
decision to review practices that cause individual markets to 
pause or go slow to determine if any other practice starves the 
market of liquidity when it is most needed, including the 
operation of certain order types or the practice of market 
maker quotes.
    Thank you again for the opportunity to share our views. I 
am happy to respond to any questions you may have.
    Senator Reed. Thank you.
    Mr. Duffy, please.

           STATEMENT OF TERRENCE A. DUFFY, EXECUTIVE 
                    CHAIRMAN, CME GROUP INC.

    Mr. Duffy. Chairman Reed, Ranking Member Bunning, thank you 
for inviting me to testify today.
    CME Group has engaged in a detailed analysis regarding 
trading activity in our markets on Thursday, May 6, 2010. Our 
review indicates that our markets functioned properly. We have 
identified no trading activity that appeared to be erroneous or 
contributed to the break in the cash equity market during this 
period. Indeed, our markets led the recovery. Moreover, no 
market participant in our markets reported that trades were 
executed in error, nor did CME Group exchanges cancel, bust, or 
reprice any transactions as a result of the activity on May 6.
    Futures contracts by design provide an indication of the 
market's view of the value of the underlying stock index. That 
is why CME Group's E-mini S&P 500 is a leading indicator, not a 
cause, of a decline in the underlying primary market.
    To illustrate this point, I would like to draw your 
attention to these two charts. Chart 1 shows that the E-mini 
S&P, which is the blue line, move virtually in tandem with the 
S&P 500 Index, which is the red line. You can see that at 
13:46, the market had had time to attract liquidity and 
rebalance and the E-mini led the recovery, ultimately rallying 
40 S&P points, or the equivalent of approximately 400 points of 
the Dow.
    Chart 2 shows price movement in the E-mini S&P futures as 
well as 3M stock. As you can see, the price of 3M stock 
declined much more rapidly starting at 13:45, with the E-mini 
S&P 500 hitting the low at 13:45:50, at which time you see the 
market and the E-mini S&P reverse while the 3M stock continues 
to decline.
    Market integrity is of the utmost importance at CME Group. 
We have developed systems that maintain integrity in all our 
markets, including a number of control to protect market users, 
such as stop price logic functionality, price banding, and 
circuit breakers. Stop price logic functionality serves to 
mitigate artificial market spikes that can occur because of the 
continuous triggering, election, and trading of stop orders due 
to insufficient liquidity.
    On May 6, the stop price logic trigger, a 5-second pause in 
the E-mini S&P Equity Index, allowing the market to locate 
liquidity and to stabilize. We have seen no evidence that high 
frequency or other specific trading practices in any way 
magnified the decline on May 6. In fact, our market indicates 
that the high-frequency traders in our market provided 
liquidity on both sides of the market on this extraordinary 
day.
    The CFTC and SEC issued a joint report Tuesday that 
reflects preliminary staff findings resulting from their 
ongoing reviews of the events of May 6. We commend both the 
Commissions on their swift response and look forward to working 
with them to identify constructive solutions.
    In particular, we are pleased and concur with those 
recommendations seeking harmonization across the national 
market system. As the report suggests, circuit breakers, 
including circuit breakers for individual stocks, such as those 
implemented by the NYSE, must be harmonized across markets. 
Stop logic functionality should be adopted across markets to 
prevent cascading downward market movements as the report 
confirms it did on May 6 in the E-mini. Last, the current 
circuit breaker levels and the duration of the halt should be 
reevaluated and updated to current market conditions.
    I thank the Committee for this opportunity and I look 
forward to answering any questions.
    Senator Reed. Well, thank you very much, gentlemen.
    Listening today to the testimony, I think we all would be 
more relieved if it was the fault of ``fat finger,'' who sounds 
suspiciously like a character in a Mike Myers James Bond spoof, 
but that is not the case.
    We are still left, I think, based on your testimony, with 
the conclusion that we are not quite sure what was the decisive 
precipitating course. There were several factors, and I will 
give you the chance to comment about that. But it strikes me, 
too, that one thing is clear. We have highly interrelated 
markets and we have different rules in those markets. Some of 
these rules, I presume, were crafted with the awareness of 
other rules, but perhaps not consciously and deliberately 
complemented or syncopated or whatever the word is, and that 
part of the effort here is to begin to harmonize rules and ask 
tough questions about whether that harmonization means to make 
them all the same, which could exacerbate a crisis or at least 
make them responsive to and reflective of the other rules.
    So with that long, long sort of introduction, the basic 
first question is can you comment about sort of the status of 
what do we know and what don't we know about May 6 and also 
about the need for a much more coordinated structure of rules. 
Mr. Ketchum first, and we will go right down the line.
    Mr. Ketchum. Thank you, Chairman Reed, and I think your 
points are well made.
    I would agree with a great deal of what Chairman Gensler 
said earlier. We do know a great deal about what happened on 
that day at this point. While we are cautious not to 
characterize everything without fully understanding all of the 
underlying activity of customers behind it, a few things seem 
pretty clear, and you categorized it fairly well.
    This was not the result of one single program. It was the 
result of large numbers of programs that operate very similarly 
together. It was the result of real selling activity with 
respect to real things happening in the marketplace, but the 
response of the concentrated selling activity and the speed in 
which liquidity can disappear from the market is close to 
absolute. And that is combined with an environment now, as you 
discussed in earlier panels and discussed in the opening 
statements, where there aren't consistent market maker 
obligations across markets at this point, and without that, 
where there isn't an ability for participants to be able to 
pause and reinsert buying activity. That is simply 
unacceptable.
    The first step, the pauses are important and they need to 
move beyond the S&P 500 once they are appropriately crafted to 
ETFs and other securities. That will allow for the ability for 
algorithms and people to understand and be able to reinsert 
buying activity. It is not that it will miraculously appear, 
but computers are designed when they don't understand something 
to withdraw. You need enough time to determine that the world 
actually hasn't ended and that there are reasons to continue to 
buy stocks.
    That needs to be combined with consistency across each 
market and stocks and futures. You are right. These are not 
always identical things, but with respect to areas like pauses 
and circuit breakers, they should be absolutely consistent.
    Senator Reed. Mr. Leibowitz, any comments in this whole----
    Mr. Leibowitz. Sure. While I think it is very comforting, 
it would be comforting to know what the triggering cause of 
this was, I think it is largely irrelevant. It is like airport 
security. We all take our shoes off because someone happened to 
put a bomb in his shoes, and we all wondered what would happen 
if somebody put it in their pants, and they did.
    I think what we need to do is take the step back and say, 
what are the factors in our market in terms of the order types 
that retail traders use, stop losses, things like that? What do 
we do about liquidity obligations, how fast the markets react 
to news now, and can liquidity get there in time, because we 
have talked about liquidity thinning. It actually thinned on 
the sell side, as well. It didn't just disappear from the buy 
side.
    And so I think we have to look at the factors that make up 
our market structure, which actually functions very well on a 
normal day, but during times of stress actually sometimes 
doesn't, because I think what we have is a loosely coupled, 
fragmented market that is very deep at the top of the book, but 
when the market moves through that top of the book very 
quickly, then it is not nearly as efficient as it was in the 
past.
    Senator Reed. Thank you.
    Mr. Noll?
    Mr. Noll. Thank you, Chairman Reed. Like Mr. Leibowitz and 
Mr. Ketchum, I don't think we are ever going to identify the 
precise, exact cause of May 6. However, we believe that if we 
can solve what we think are some of the negative outcomes of 
May 6, that we will avoid the issues of what the precise cause 
was and be able to move forward with a very robust market. So 
those are obviously coordinated responses across circuit 
breakers across all markets. We don't believe markets should 
compete on circuit breakers. We don't believe that markets 
should compete on volatility halts. We think that those things 
need to be consistent.
    I think it is probably fair to say that we should have been 
able to identify that before this had occurred, but the market 
had never experienced this kind of liquidity dearth and this 
kind of an event before. So we now recognize that as a flaw and 
we are moving very quickly, working with one another, to fill 
that hole.
    I do think that there are lots of positives to innovation 
in our different market models. NASDAQ is very proud of its 
market model. I know NYSE is very proud of its market model, 
and there is still going to be room for us to be competitive 
and compete on innovation and drive down costs and provide 
better service to investors. But in areas like this, I think it 
is incumbent on us to cooperate with one another and we are 
doing so.
    Senator Reed. Thank you.
    Mr. Duffy, please.
    Mr. Duffy. Senator, I think that the harmonization of rules 
is absolutely essential, but when you are talking about 50, 60, 
or even more pools of liquidity, some with certain protocols, 
some with no protocols, it is going to be very confusing for a 
marketplace. So when an order gets entered into one marketplace 
where there is NYSE, NASDAQ, or BATS and they don't find the 
liquidity because of the protocols being in place, these things 
are trading in microseconds. They are seeking liquidity. There 
are going to so many other pools trying to find liquidity. Then 
you can find out why the prices did what they did. I don't 
think it is a big secret.
    I think the 10, 20, and 30 percent circuit breakers need to 
be revisited. They may be a bit wide. We have not hit the 10 
percent, as everybody has said here, so that needs to be done.
    I think the stop logic functionality that the CME Group has 
put in place, this is patented technology. It clearly worked. 
The charts don't lie. The numbers don't lie. The markets 
stopped and we had an opportunity to replenish our liquidity. 
That stop market functionality kicked in in the six-handle 
range, which is the equivalent of a half of 1 percent of the 
value of the S&P contract. To us, that makes sense.
    We have offered this up publicly to give it to the 
marketplace, even though it is under a patent by the CME Group. 
We think it makes sense. So we think that there are a lot of 
good things that we could be a part of the solution to.
    Senator Reed. Let me--I think it is important to try to 
continue to find what the course might be, because it will make 
the response, I think, much more attuned and much more fine. 
But I think the point that Mr. Leibowitz makes is we already 
know there are problems there and that we just can't sort of 
say that this is a one-off experience and it will never happen 
again. As fact, as I suggested in my questions to the two 
Chairmen, this was an accidental confluence of bad news from 
Europe, some trading irregularities, et cetera, but we all have 
to plan for a very deliberate attempt to undermine the market, 
either through some physical or some technological attack.
    So in this context, do you think that you are prepared for 
it, one, and two, if you are not prepared for it, are you 
planning, at least implicitly, that in a serious enough 
situation that there will be support from the government to get 
you through a difficult moment? Mr. Duffy?
    Mr. Duffy. On an operational standpoint, there is no 
question that we are prepared for it. We prepared for it pre-
September 11 of 2001. So we have been building remote 
facilities going back to 1999 and 2000. We have redundancy in 
multiple different locations in the Chicago metropolitan area. 
We don't even actually run all of our facilities out of the CME 
Group any longer. So we have the same set-up in New York 
because of our New York operations. So we are, without 
question, prepared for whatever needs to go forward.
    As far as the legislation, we do believe that there are 
certain situations where everybody should have access to the 
discount window. I disagree with Chairman Gensler and Chairman 
Schapiro. I think that the CME Group or any other clearing 
entity, now that we are going to be potentially forced into 
taking clearing of some of these OTC products, we may not have 
an opportunity to get to our bank lines in a reasonable time. 
We settle our markets twice daily, and that is the reason why 
we haven't had the flaws in the 150 years in our system.
    So I think it is important, even though we have never gone 
to the discount window to borrow, that we still have that 
ability, and not just under emergency procedures.
    Senator Reed. Let me just raise a point that I would like 
to make, or at least to put on the table, is that there was a 
presumption a decade ago that securitization of mortgages are 
not particularly dangerous because, after all, who defaults on 
your mortgage. It is 20 percent down and if the FICO is 680. 
But the mortgage of 1999 was not the mortgage of 2005, where it 
is nothing down, no income statement, no FICO, and yet we were 
still treating those and securitizing those.
    Now, this is not the exact analogy, but essentially, we are 
going to ask under this legislation the clearing platforms to 
take much different types of products that they are clearing 
today, probably more risky because they are not being cleared 
today--if they weren't risky, they would probably be able to 
make some money and do it yourself. And that, I think, goes to 
the point that you are making, Mr. Duffy, about that in rare 
circumstances, we hope, there might be need for support. So I 
just----
    Mr. Duffy. There is no question, sir. In the legislation, 
it also calls for the clearinghouse to have the right to refuse 
an over-the-counter transaction, which we think is critically 
important, because if you can't risk manage these things, the 
only thing they did was transfer the risk from you to me and 
then said you are going to blow me up. So we don't think that 
is a good solution. So we need to have the risk management 
tools in place, which we do, and we do think one of them is 
also to have access to the Fed window if we need it.
    Senator Reed. Mr. Noll, your comments, and we will go right 
down the line, and then I will recognize Senator Bunning.
    Mr. Noll. So from a physical security point of view, we, 
too, are well prepared for any break in our technology or any 
attack or any other break in the way our technology operates. 
So we have multiple facilities that back one another up and 
they are hot sites. They are connected to one another and the 
rest of the marketplace. And they are multi-State, as well, so 
they aren't all in the same general area. They are spread out 
quite a bit. So from a physical security point of view and a 
technology point of view, we feel quite confident that we are 
prepared for any sort of event like that.
    In terms of clearing and access to the Fed window, while 
NASDAQ OMX does not operate a U.S.-based equity clearinghouse, 
we are a significant investor in a clearinghouse called 
International Derivatives Clearing Group, which is designed to 
clear interest rate swaps. So like most of the other 
participants at this table, we would think that, at the end of 
the day, we think clearing is a better solution than not 
clearing these products, but in the eventuality of ultimate 
risk, we do think that at some point we may need access to the 
Federal Government's support in the event of a major crisis.
    Senator Reed. Mr. Leibowitz?
    Mr. Leibowitz. Yes, thanks. To echo what the two previous 
speakers have said, I think we have hot back-up and, in fact, 
we are examined in rigor by our regulator to make sure that we 
are living up to certain standards of disaster recovery, 
business continuity planning of all sorts. We also have people 
who have security clearance for such things as with Homeland 
Security and other agencies, and we work very tightly with 
those agencies in terms of things that could come over the 
Internet, you know, denial-of-service attacks, other hacking 
events.
    I agree also that the clearinghouse is going to be an issue 
in terms of knowing risk exposure across instruments. The world 
has gotten a lot more complex. We started to analogize with the 
financial meltdown, and I actually think you are dead on, which 
is, during the financial meltdown, we had a bunch of 
quantitative models that all said nothing could really be that 
bad. Each individual player thought that they were protected, 
and they just had not really taken account of the fact of what 
if it all goes bad at once and what if we all have to go 
through the same exit door at once and what if these things are 
worse than we thought. And I think we need to approach how we 
structured the market, how we structures our back-up, how we 
structure clearing facilities with all of those things in mind, 
or we are actually not doing a good job.
    Senator Reed. Final word, Mr. Ketchum.
    Mr. Ketchum. Again, while FINRA as a regulator is in a very 
different business than these two gentlemen for delivering 
real-time market executions and being involved in the clearing 
side, we also feel very good about our ability from a physical 
security standpoint, disaster back-up standpoint. We also focus 
intensely on potential intrusions, denial-of-service efforts, 
and we feel good about our protections from that side.
    I will not repeat what Mr. Leibowitz said, but I think he 
said it extremely well.
    Every conception should be challenged, and challenged 
regularly with markets that are changing as quickly as these 
are. That certainly demands some flexibility from the 
standpoint of the clearing changes that are going to occur and 
some capabilities to ensure that there remains liquidity and 
they remain sound.
    So, FINRA feels in very good shape from the standpoint of 
being able to respond to attacks of any sort, but this is an 
appropriate issue for Congress to continue to focus on.
    Senator Reed. Thank you very much.
    Senator Bunning, and take as much time as you want, Jim. I 
apologize for the lengthy time of my questioning.
    Senator Bunning. That is all right. Thank you.
    Mr. Noll, I am going to start this question with you since 
you talked about it more in your written statement than anyone 
else, but I would like the others to respond as well.
    As I said in my statement, I am concerned about the way 
some trades were canceled. Given that everyone seems to agree 
the system worked the way it was set up to do, how do you 
justify canceling trades and protecting sellers from their bad 
decisions?
    Mr. Noll. I share much of your concern, Senator Bunning, 
and it was a very difficult day to make that decision. It was 
done in coordination with all of the other markets on an 
ongoing discussion that, quite frankly, lasted many hours 
trying to decide what the appropriate decision was there. So we 
were trying to balance the needs and requirements of what we 
would call moral hazard issues, which is making people aware 
and bear the consequences of their activities in the 
marketplace, for good or for ill, with what was clearly a 
dysfunctional marketplace that was not functioning as it should 
function.
    So in the absence of any clearly erroneous trade, we looked 
at the decay of what we would call price discovery and the 
provision of liquidity, and we tried to draw that line, 
admittedly somewhat more arbitrarily than I think any of us are 
comfortable with, draw that line in an appropriate area where 
we did not reward anyone for bad behavior but we did solve the 
problem of what we considered to be a dearth of liquidity.
    That being said, I think we are very confident that the 
stock-by-stock circuit breakers that we are putting into place 
will prevent a reoccurrence of this kind of situation.
    Senator Bunning. Looking back, we all have 20/20.
    Mr. Noll. I think that is true. So we believe that we would 
like to put the stock-by-stock circuit breakers in place. We 
think that will prevent this going forward, these kind of 
events going forward, but more importantly, we endorse Chairman 
Schapiro's desire that we have transparent, understandable, 
agreed upon across all markets, trade-break, clearly erroneous 
rules that remove the discretion from any one market actor or 
any group of market actors so that everyone knows visibly and 
clearly what those events are and how they will be triggered.
    Senator Bunning. Anybody else like to jump in. Go ahead.
    Mr. Leibowitz. Sure. So I had the fortune of sitting on the 
NASDAQ Quality of Markets Committee at the time that the first 
erroneous trade policy went in, and I think, Rick, you were 
actually----
    Mr. Ketchum. I was there.
    Mr. Leibowitz.----the CEO at the time or COO at the time. 
And it troubled me then and it troubles me now. Markets that 
have to resort to breaking trades as a response to conditions 
are just not orderly markets in my mind. That is not the way we 
should do our business.
    I think in this case, the big challenge was not--we had 
institutional investors who made a mistake. You know what? You 
are right. They should pay the price. The challenge here was 
that we had retail investors who had submitted market orders 
that essentially went into a black hole. They had stop loss 
orders in high-cap stock----
    Senator Bunning. But I am sorry, sir. Sophisticated--even 
if they are not sophisticated, anybody that puts a market order 
in knows exactly what is going to happen to a market order.
    Mr. Leibowitz. So I would agree with you that their broker 
probably does, and maybe the answer is the broker should have 
stood up for that trade. I would submit to you that a lot of 
the public does not. And I will tell you----
    Senator Bunning. A lot of the public does not know that if 
you put a market order in, it is executed?
    Mr. Leibowitz. They think maybe it will go, you know, be a 
dollar----
    Senator Bunning. Rather than a limit order?
    Mr. Leibowitz. Well, they do not realize that when I trade 
Accenture, it is going to be down 99 percent. What are they 
getting now?
    Senator Bunning. I agree with that.
    Mr. Leibowitz. And that is----
    Senator Bunning. But if you put a market order in, that is 
your execution.
    Mr. Leibowitz. You are absolutely right in that regard, and 
I think we have to make sure that it just cannot happen in the 
market. We also need to talk about whether market orders should 
be allowed at all and how we educate people so these things do 
not happen.
    But I agree, there should not be the moral hazard of 
breaking trades. It is not the right way to make a market 
function properly.
    Senator Bunning. Anyone else? Go.
    Mr. Duffy. I do believe that you need to have clarity on 
rules, and we have bust rule clearly put on our website so 
anybody that is going to participate in the CME Group markets, 
they know the rules prior to making a trade on our exchange.
    As far as busting trades, you know, every order in our 
place has to have a limit on it. You cannot just order--send in 
a market order. So what Mr. Leibowitz is referring to is you 
can order--you have to have a limit on every order----
    Senator Bunning. I understand limit orders.
    Mr. Duffy. So we do not accept market orders is my point, 
and that is the reason why our system works. And I think that 
is a very important point----
    Senator Bunning. In other words, you did not have any big 
losses on your market.
    Mr. Duffy. There were losses. I am not saying there were 
not losses, sir, because the market had a lot of up and down in 
it. But it was important to note that the orders were not these 
heat-seeking missiles that could go to infinity or to zero like 
it did on the future.
    Senator Bunning. The one.
    Mr. Duffy. Correct, sir. Also, we think that is important.
    Another reason with busting trades is if someone buys a 
trade and gets busted out of that trade, he might have elected 
to liquidate that trade prior to the bust rule coming into 
place. He goes home to go to sleep, and now he is short the 
market and had no idea he was short the market. There are some 
serious unintended consequences when the rules are not clear.
    Senator Bunning. Absolutely. That is what I am getting at.
    What should be done so that it will be predictable when 
trades will be broken in the future, other than what has been 
suggested?
    Mr. Noll. Senator Bunning, I think what we are planning to 
do--as a matter of fact, Mr. Ketchum just called a meeting for 
all of the exchanges and the SEC early next week--I think it is 
on Tuesday--to come up with a set of standards about clearly 
erroneous and how we are going to move forward in addition to 
the circuit breakers that we are putting into place. So how are 
we going to move so that we have a very clearly defined 
standard of when trades are going to stand and when they will 
not so that we do not ever face this issue again.
    Senator Bunning. If I am in Schenectady, New York, and I am 
dealing with a broker-dealer in Schenectady, any broker--I am 
not going to give anybody a plug here--how do I compete with 
the electronic traders that have nanosecond access?
    Mr. Duffy. I will make a comment on that, and this is more 
in your line, but in capital formation markets, sir, most 
participants coming in for the public are not trying to compete 
on the bid-offer in a nanosecond market. They are buying or 
selling stocks for probably a period of time----
    Senator Bunning. Hold. They are going to hold the stock.
    Mr. Duffy. They are more of a holder participant. Whereas 
these people that are trading in what we refer to as 
microseconds, we think of them as liquidity providers. They 
have actually tightened up the markets, but they are actually 
not in for that. So they are actually competing against each 
other----
    Senator Bunning. They may be day traders. They may be 
someone who is in it just for a very short period.
    Mr. Duffy. Yes, sir.
    Senator Bunning. Mr. Leibowitz, since most exchange-traded 
funds are listed on one of your exchanges, I am going to start 
this question with you, and anyone else who wants to add 
something can. Why do you think we saw a more severe move in 
exchange-traded funds than in the underlying stocks? Should 
investors be worried that these products are not as reliable as 
everyone thinks they are?
    Mr. Leibowitz. So I think the important think to first say 
is the fact that ETFs got hit as hard as they did was an 
effect, not a cause. They did not cause the market meltdown. 
They had no role in it. They were essentially the victim of the 
market as it went down.
    Normally, there is a pretty tight arbitrage mechanism 
between the ETFs and the underlying instruments that make up 
that. During this period, that mechanism broke down because the 
traders who were bidding on the stocks could not tell where the 
actual stocks underlying the ETF were trading.
    So, for example, if Accenture or some other stock, PG, was 
in that index, was PG at 39 or 56, or even at 39, it would lead 
you to bid in a very crazy place.
    The other thing that is unique about ETFs is they do not 
tend to have deep liquidity books on the book. There is not a 
lot of retail orders. A lot of executions occur in wholesalers 
above the market. So what happens is wholesalers are committing 
capital to keep that market really tight.
    There is an article in the Wall Street Journal today that 
suggests that two of the major wholesalers actually had system 
problems during this meltdown, and what that probably did is 
suck capital out of the market to commit to the ETF product and 
other products that allowed it to tighten up. If you couple 
that with stop losses, which triggered into the market--you 
know, and no pause in that market. The difference between what 
happened on NYSE and what happened in Arca is this: Both 
markets have market makers with obligations. But in the ETF 
market, both on NASDAQ's listing and Arca's, there are these 
things called LMMs. They have obligations. The problem was 
trading did not pause long enough for the books to refill and 
for them to commit capital. They were basically looking into a 
black hole, and so the function did not work properly.
    So we are looking at this with the issuers and with the 
market in terms of how do we fix the market structure so that 
it works better during these periods. I think it is imperative 
that ETFs be included in the circuit breaker pilot.
    Mr. Ketchum. Senator, if I can, let me just add on to that 
point. I would first underline that it is imperative for ETFs 
be included in the pilot as quickly as possible for two 
reasons. First, ETFs, like futures, are aggregated vehicles 
that are the most convenient, efficient, and effective way to 
react when you see market risk, as you know, being involved in 
the industry. Therefore, they will almost always be hit very 
quickly with respect to any market reaction from the standpoint 
of selling activity or buying activity.
    Second, unlike futures, as Larry indicated, they often are 
not that liquid, at least given the wide range of those 
products that have been developed over time. So this is an area 
where we absolutely have to move quickly to include beyond the 
S&P 500.
    I also have to just note, Senator, as someone who was born 
and raised in Schenectady, I want to thank both you and Senator 
Warner for particularly singling out your concerns in 
Schenectady. I will speak for the city, and we appreciate it.
    Senator Bunning. Schenectady, it is an old town I played 
ball in, so I remember it very well.
    Mr. Ketchum. I actually watched you when you played for the 
Blue Jays.
    Senator Bunning. You are not that old.
    [Laughter.]
    Mr. Ketchum. I am pretty close.
    Senator Bunning. Mr. Ketchum, I am going to start you with 
this question since you mentioned it in your written statement, 
but I would like to hear from anyone else, also.
    In your statement, you said that changes in the marketplace 
have eliminated meaningful market makers' obligations. What 
changes should be considered to market makers' rules to reflect 
the current marketplace and the rules of new type of liquidity 
providers?
    Mr. Ketchum. Well, Senator, I think that is a very good 
question, without a simple answer. I start by believing in 
competition, and much of the reason for changes in market maker 
obligations have been by the SEC's effort to encourage 
competition across markets. But it is a reality that today in a 
number of marketplaces there are not obligations ``reasonably 
related to the market.''
    I would say two things need to happen quickly. The first 
thing is where there is not an obligation to quote reasonably 
related to the market, there should not be two-sided quote 
obligations, and perhaps they should not benefit from a margin 
and capital standpoint. But you have to eliminate stub quotes 
to avoid these ridiculous trades down at a penny, 5 cents, et 
cetera.
    Second, I think there needs to be an evaluation--and 
Chairman Schapiro committed to it afterwards--to look hard at 
whether the requirements that used to exist--that required 
regular quoting and participation in the market if you were to 
benefit from market making status--should be reconsidered. You 
raised that question earlier because I know you have been 
involved in the industry, and personally I believe that ought 
to be reviewed and reconsidered.
    Senator Bunning. Anybody else?
    Mr. Leibowitz. Sure. I think this is a really serious 
question, which is: Where is all the liquidity in the market? 
And who has got an obligation to the market?
    For one thing dark pool liquidity may have been sitting off 
on the side, and when the market went down, it was not included 
at all. It did not help essentially provide a backstop to the 
market.
    Over time, a lot of the markets have evolved to speed over 
obligation, and so what happens is, for example, we have DMMs 
on NYSE. LMMs exist on both Arca and NASDAQ for ETFs. Looking 
at the stub quotes, that is a sign of a problem, not a problem 
itself. What really happened--I am dating myself again--is the 
NASDAQ market makers used to have a requirement for quoting 
close to the market, but they also had a requirement of how 
deep they made the market and what size they had to buy at 
every price. As the market evolved to a faster, more electronic 
marketplace, those market makers were not able to keep up, and 
as a result, their requirements kept getting thinned out to the 
point where really the only requirement is that they have 
equity in the market, it does not matter where. Hence, the 
penny at a thousand. What that does is it gives them other 
rights in the marketplace, like internalizing orders.
    The real question is: What do you owe to the market in 
exchange for that right that you have got? And that is the sort 
of thing that we all need to look at, you know, in our 
individual----
    Senator Bunning. Or the market maker.
    Mr. Leibowitz. And collectively.
    Senator Bunning. OK. Thank you.
    Senator Reed. Well, thank you, Senator Bunning. Your 
experience is obvious in terms of the thoughtful questions that 
you have not only posed today but consistently.
    I think the hearing has indicated that you gentlemen and 
the regulators have a lot of work to do, and we have got a lot 
of work to do. This is an evolving issue, and we fortunately 
missed the worst outcome in this situation. But I cannot feel 
after today we can assure ourselves that we will not have other 
challenges ahead. In fact, I think we all understand we have to 
do a lot more to understand this problem, series of problems, 
and to take effective action.
    I thank you. This has been a very helpful beginning, as I 
suggest, of a series of hearings that we shall hold about the 
status of the markets, high-frequency trading, market makers' 
responsibilities, and the interconnection of all of these 
aspects.
    If my colleagues have any written statements or additional 
questions, I would ask them to submit them no later than next 
Thursday, May 27th. I would also ask the witnesses to submit 
responses to questions within 2 weeks. And, obviously, all of 
the written testimony that you submitted will be made part of 
the record, and any other items that you would like to submit 
to the record will be made part of the record.
    Without additional information, the hearing is adjourned.
    [Whereupon, at 12:01 p.m., the hearing was adjourned.]
    [Prepared statements and responses to written questions 
supplied for the record follow:]
                PREPARED STATEMENT OF CHAIRMAN JACK REED
    I want to welcome Chairman Schapiro, Chairman Gensler, and our 
other witnesses to today's hearing, and thank them for making time in 
their very busy schedules to testify on this important topic.
    I also appreciate their efforts following the events of May 6th to 
coordinate the investigations, report their findings, and quickly 
propose circuit breaker and other changes in response.
    This week the Senate is on the verge of making fundamental and 
urgently needed changes to reform Wall Street and protect consumers and 
investors. In the midst of this important debate, Senator Bunning and I 
felt it was important to hear your thoughts on the causes of the events 
of May 6th, and to discuss any changes that may be needed to ensure 
that our markets function in a fair and orderly way going forward.
    As we know, on May 6, 2010, starting around 2:40 p.m., the stock 
market plummeted, but then quickly recovered. At its lowest point 
during this 20-minute incident, the Dow Jones Industrial Average had 
fallen 9.2 percent, erasing more than $1 trillion in market 
capitalization within a matter of minutes.
    Although the Dow average rebounded to end the day down only 3.2 
percent, the May 6 intraday trading loss on the Dow index not only 
exceeded the extreme market volatility that occurred during the height 
of the financial crisis in the fall of 2008, but it also represented 
the index's largest intraday percentage drop since the October 1987 
crash.
    This Committee has regularly held hearings examining the equity 
markets, most recently in October to discuss dark pools, flash orders, 
and high-frequency trading. Today's hearing is another check-up on our 
equity markets, particularly amidst concerns that technological 
developments in recent years may be posing new risks to investors and/
or the markets more broadly.
    Electronic trading has evolved dramatically over the last decade, 
and it is important that regulators keep evolving with these 
developments. Trading technology today is measured not in seconds or 
even milliseconds, but in microseconds, or one millionth of a second.
    Today's hearing will help to answer some important questions about 
the causes of the May 6 market volatility. In addition to speaking 
about the causes of the plunge, I've asked today's witnesses to discuss 
what role automated trading, high-frequency trading, and other 
technological advances may have played in the market disturbance.
    I've also asked them to discuss the extent to which disparate 
trading conventions and rules across various markets contributed to the 
down and up spike. And I've asked them to discuss any changes to 
Regulation NMS or other laws or regulations may be necessary to 
mitigate such market fluctuations in the future.
    Finally, I'd like to discuss whether the regulators have all the 
tools and authorities they need to investigate market disturbances or 
whether legislative or other changes may be needed to help them more 
quickly identify the causes of extreme market disturbances.
                                 ______
                                 
                 PREPARED STATEMENT OF MARY L. SCHAPIRO
              Chairman, Securities and Exchange Commission
                              May 20, 2010
I. Introduction
    Chairman Reed, Ranking Member Bunning, and Members of the 
Subcommittee:

    I appreciate the opportunity to testify concerning the market 
disruption that occurred on May 6, 2010.\1\ The sudden decline and 
recovery of the U.S. financial markets on that day was unprecedented in 
its speed and scope. It is vital that investors and listed companies 
feel confident in the integrity of the prices generated by our equities 
markets.
---------------------------------------------------------------------------
    \1\ My testimony is on my own behalf, as Chairman of the SEC. The 
Commission has not voted on this testimony.
---------------------------------------------------------------------------
    During a 20-minute period during the afternoon of May 6, the U.S. 
financial markets failed to live up to their essential price discovery 
function. That period of gyrating prices directly harmed those 
investors who traded based on flawed price discovery signals, and it 
undermined the confidence of investors in the integrity of the markets. 
We are committed to taking all necessary steps to identify causes and 
contributing factors and are already working to reduce the likelihood 
of a recurrence of that day.
    Over the last 14 days, the SEC has focused intensely on moving 
forward on two separate, but related, fronts. First, we, along with the 
Commodity Futures Trading Commission (CFTC), have been engaged in a 
comprehensive investigation into the events of May 6 to gain a full 
understanding of what caused the volatility. Second, even as we work to 
understand the causes of the volatility, we have worked with the 
exchanges to fashion effective measures that will operate to help 
protect against a recurrence by imposing a limit on the extent to which 
prices can move in individual stocks before there is a pause in 
trading. We are also addressing a number of additional areas that may 
have contributed to the volatility. These are discussed below.
     With respect to our investigation, this past Tuesday, SEC and CFTC 
staff issued a joint report of their preliminary findings regarding the 
market events of May 6 to the Joint CFTC-SEC Advisory Committee on 
Emerging Regulatory Issues (Staff Report).\2\ The establishment of the 
Committee was one of the recommendations included in the agencies' 
joint harmonization report issued last year.\3\ The Staff Report sets 
forth the preliminary findings of the ongoing review of the events of 
May 6. It briefs the Advisory Committee regarding the events and 
provides context regarding the current structure of the equity and 
futures markets, and the regulatory framework for those markets. The 
Staff Report is intended to assist the Advisory Committee as it works 
with us to review the events of May 6. I expect that the Committee will 
advise the Commission with respect to market structure problems that 
may have led to the volatility experienced on that day and suggest 
potential approaches.
---------------------------------------------------------------------------
    \2\ Report of the Staffs of the CFTC and SEC to the Joint Advisory 
Committee on Emerging Regulatory Issues, May 18, 2010. http://
www.sec.gov/sec-cftc-prelimreport.pdf.
    \3\ Joint Report of the SEC and the CFTC on Harmonization of 
Regulation, October 16, 2009.
---------------------------------------------------------------------------
    In addition, earlier this week, the stock exchanges and the 
Financial Regulatory Industry Authority (FINRA) filed proposals that 
would aid in preventing the type of severe price swings that some 
individual stocks in the S&P 500 experienced on May 6. These rules 
would establish a market-wide 5-minute trading pause in the event that 
the price of a stock in the S&P 500 moves more than 10 percent during 
the preceding 5 minutes. The pause would give the markets the 
opportunity to attract additional liquidity in the stock, establish a 
reasonable market price, and resume trading in a fair and orderly 
fashion.
    My testimony today first will summarize the events on May 6, using 
the best information that is available at this point. Next, it will 
give a brief summary of initial steps taken to identify the causes and 
contributing factors of the unusual market activity on May 6, as well 
as initial steps to help protect against such activity from occurring 
in the future. Finally, I will discuss various potential regulatory 
responses that need to be considered in determining how best to 
maintain fair and orderly financial markets and to prevent subsequent 
severe market disruptions.
II. Summary of Events on May 6, 2010
A. Chronology of Trading
    On Thursday May 6, the stock markets had spent much of the morning 
and early afternoon in moderately negative territory, with the Dow 
Jones Industrial Average (``DJIA'') declining 161 points, or 
approximately 1.5 percent, by 2:00 p.m. (ET). Concerns over the 
financial situation in Greece, uncertainty concerning elections in the 
United Kingdom, and an upcoming jobs report, among other things, hung 
over the market. Shortly after 2:30 p.m., however, the market decline 
began to steepen and, by 2:42 p.m., the DJIA was at 10,445.84, 
representing a decline of approximately 3.9 percent. The DJIA then 
suddenly dropped an additional 573.27 points, representing an 
additional 5.49 percent decline, in just the next 5 minutes of trading, 
hitting 9,872.57 at 2:47 p.m., for a total drop of 9.16 percent from 
the previous day's close (which, as discussed below, was not sufficient 
to trigger the existing circuit breaker trading halt).
    Our preliminary analysis shows that this precipitous decline in 
stocks (and the subsequent recovery) followed very closely the drop 
(and recovery) in the value of the E-mini S&P 500 future (which tracks 
the normal relationship between futures and stock prices for the 
broader market). Similar declines were seen in stock market indexes 
other than the DJIA, such as the S&P 500 Index. In addition, the CBOE 
Volatility Index (``VIX''), a widely followed measure of market 
volatility sometimes known as the ``fear index,'' climbed above 40, a 
level not reached in over a year.\4\
---------------------------------------------------------------------------
    \4\ See Appendix A, Figures 2 and 3.
---------------------------------------------------------------------------
    As quickly as the market dropped, it suddenly and dramatically 
reversed itself, recovering 543 points in approximately a minute and a 
half, to 10,415.65. By 3 p.m., the total daily decline in the DJIA had 
been reduced to 463.05 points (4.26 percent). The DJIA ended the day at 
10,520.32, down a total of 347.80, or 3.20 percent, from the prior 
day's close. This represented a significant down day for the markets, 
but the closing numbers belied the market's dramatic moves down and 
then up during approximately 20 minutes of trading in the mid-
afternoon. In addition, as has been widely reported in the press, many 
individual securities experienced much larger swings in their trading 
activity. For example, two DJIA components--Procter & Gamble and 3M--
experienced declines of approximately 36 percent and 18 percent, 
respectively. In addition, trades in certain stocks were executed at 
absurdly low prices, such as one stock which opened above $40, was 
traded at one point at a penny, and then closed the day above $40. 
Figure 1 in Appendix A illustrates the volatility of this activity. 
This extreme volatility in the markets suggests the occurrence of a 
very severe temporary liquidity failure, rather than the effect of any 
economic factor that might explain price discovery indicating that the 
equity value of U.S. listed companies truly could drop and recover such 
a large amount in just a few minutes.
    In addition, a large number of registered investment companies 
known as Exchange Traded Funds (``ETFs'') traded for short periods of 
time with massive intraday price swings. The shares of more than 25 
percent of all ETFs experienced temporary price declines of more than 
50 percent from their 2:00 p.m. market prices. One large ETF sponsor 
reported to us that 14 of its domestic stock ETFs experienced 
executions of $.15 or less per share (including five ETFs that had 
executions of one cent or less) while also observing that its domestic 
bond ETFs appeared to execute at reasonable prices. We also will 
explore whether the practice of shorting ETFs by institutional 
investors to effectively eliminate broad market exposures might have 
contributed to the intraday price swings experienced by certain ETFs.
B. Breaking of Clearly Erroneous Trades
    As the markets closed on May 6, officials from each of the equity 
markets, pursuant to exchange rules, worked out a common standard to 
cancel trades that were effected at prices that were sharply divergent 
from prevailing market prices (so-called ``clearly erroneous'' trades). 
The exchanges determined to cancel any trades effected from 2:40 p.m. 
to 3 p.m. at prices 60 percent away from the last trade at or before 
2:40 p.m. Transactions in 326 individual securities were canceled in 
this manner. In addition, on Friday May 7, several options exchanges 
similarly decided to cancel certain options trades from the afternoon 
of May 6.
    A significant number of broken trades were in the shares of ETFs. 
These funds are hybrids--they are mutual funds that have shares that 
trade throughout the day like ordinary stocks. ETF sponsors reported to 
us that, internally, they experienced no significant problems in 
managing the funds on May 6. Stability had returned to the market by 
the 4:00 p.m. market close and, as a result, these funds were able to 
calculate their net asset values based on the market prices of the 
securities in their portfolios as required by our rules. From the 
viewpoint of the ETFs, they saw nothing out of the ordinary or unusual 
compared to any other day in computing their end-of-day net asset 
values.
    Information on broken trades clearly suggests that ETFs as a class 
were affected more than any other category of securities. We continue 
to investigate precisely why they were affected so dramatically.
C. Evaluation of Trading
    The Commission is committed to understanding fully and exactly what 
occurred on the afternoon of May 6, and has been aggressively 
investigating and analyzing the events of that day. We believe it is 
critical to understand the causes and effects of this event so that we 
can work to ensure that it does not occur again. Throughout this time, 
the Commission and its staff have been in close and continuous contact 
with the CFTC and other Federal agencies, as well as the larger 
national securities exchanges, FINRA, and clearing organizations. In 
addition, we have been in contact with a wide variety of market 
participants, including broker-dealers, proprietary trading firms, and 
asset managers. We have obtained extensive data from the exchanges and 
other market participants and are in the process of analyzing that data 
to ascertain the triggers and impacts of trading that day.
    The Commission also has been in close contact with our foreign 
counterparts. Some of our counterparts have circuit breaker-like market 
intervention mechanisms linked to our own and others have market 
intervention mechanisms that halt trading on specific securities 
affected by unexpected market volatility. This coordination will 
continue as we seek information on specific trades or events that may 
have precipitated any problems.
    The various regulatory authorities are making substantial progress 
in analyzing the trading on May 6 and sifting through the voluminous 
trading records involved (including more than 17 million trades in 
listed equities between 2:00 p.m. and 3:00 p.m. alone). We will 
continue to provide investors and the public with information on the 
events that may have contributed to this volatility as it becomes 
available, as we have done with our preliminary staff report issued 
this week, but we should recognize that it will take time to fully 
analyze the data and cross test our different hypotheses.\5\ Although 
developments in the markets and in technology may help speed access to 
market data, they also greatly complicate our efforts to analyze the 
complex web of trading arrangements and market dynamics that have 
developed since 1987. For example, the key day in the 1987 Market Break 
Study involved a trading session processing a little over 600 million 
shares in NYSE stocks. On May 6, the markets processed 10.3 billion 
shares in NYSE stocks alone.
---------------------------------------------------------------------------
    \5\ The report setting forth the events of the October 1987 Market 
Break was released months later, in January 1988.
---------------------------------------------------------------------------
    In addition, the interconnections among markets and among equity 
securities and derivatives have grown immensely more complex over the 
past few years. Orders in one stock directed to one market can now 
ricochet to other markets and trigger algorithmic executions in other 
stocks and derivatives in milliseconds. By contrast, in 1987, 
investigators could focus their attention on discrete transactions 
largely effected on only one or two markets.
    To conduct our analysis, we are obtaining and reviewing data 
regarding order books and order audit trails from various sources to 
understand the behavior of providers and consumers of liquidity. This 
involves billions of data elements regarding millions of trades in 
thousands of securities executed in milliseconds. This data will be the 
subject of targeted analysis by SEC staff.
    We plan to examine in more detail data on options transactions and 
quotes to better understand the role that participants in this market 
may have played.\6\ We also expect to examine existing data on 
institutional mutual fund and ETF holdings, as well as data from 
broker-dealers that will help attribute trades to specific brokerage 
accounts. In addition, we will examine trade and order characteristics 
to determine whether specific order types played a role in the 
breakdown of the price discovery mechanism.
---------------------------------------------------------------------------
    \6\ Our initial options analysis suggests that there were not 
triggers originating from the options markets.
---------------------------------------------------------------------------
    Another key component of our analysis is examining the behavior of 
groups of market participants. For example, we will continue to examine 
the role of providers of liquidity, including market participants who 
have formal obligations under the Federal securities laws or SRO rules. 
To the extent that data is available, we will seek to understand the 
impact of traders following high-frequency or algorithmic trading 
strategies. Many proprietary trading firms engage in automated 
strategies that continually monitor the various markets and products 
for disparities in prices. When the trading systems for these firms 
spot such disparities, they can generate in microseconds an enormous 
volume of orders that are intended to capitalize on these disparities. 
We also will examine the activities of ETF Authorized Participants in 
order to understand what, if any role, they played, in the markets of 
May 6.
    Even as our investigation into this matter continues, a preliminary 
picture is beginning to emerge. At this point, we are focusing on the 
following working hypotheses and findings--

  (1)  possible linkage between the precipitous decline in the prices 
        of stock index products such as index ETFs and the E-mini S&P 
        500 futures, on the one hand, and simultaneous and subsequent 
        waves of selling in individual securities, on the other, and 
        the extent to which activity in one market may have led the 
        others;

  (2)  a generalized severe mismatch in liquidity, as evinced by 
        sharply lower trading prices and possibly exacerbated by the 
        withdrawal of liquidity by electronic market makers and the use 
        of market orders, including automated stop loss market orders 
        designed to protect gains in recent market advances;

  (3)  the liquidity mismatch that may have been exacerbated by 
        disparate trading conventions among various exchanges, whereby 
        trading was slowed in one venue, while continuing as normal in 
        another; (4) the use of ``stub quotes'', which are designed to 
        technically meet a requirement to provide a ``two sided quote'' 
        but are at such low or high prices that they are not intended 
        to be executed;

  (4)  the use of market orders, stop loss market orders and stop loss 
        limit orders that, when coupled with sharp declines in prices, 
        for both equity and futures markets, might have contributed to 
        market instability and a temporary breakdown in orderly 
        trading; and

  (5)  the impact on ETFs, which suffered a disproportionate number of 
        broken trades relative to other securities.

    We have found no evidence that these events were triggered by ``fat 
finger'' errors, computer hacking, or terrorist activity, although we 
cannot yet completely rule out these possibilities.
    As we move forward in our inquiry into the events of May 6, we are 
focusing on several important issues.
1. Linkages between Futures and Securities Markets
    One focus has been the role of the E-mini S&P 500 future in leading 
the market decline and recovery. To a great extent, this concern 
reflects a basic fact of market dynamics--much of the price discovery 
for the broader stock market occurs in the futures markets. Those who 
believe that the broader market is overpriced (or underpriced) often 
will first sell (buy) futures for a broad market index rather than sell 
(buy) the individual stocks that make up that index. Moreover, many 
professional traders study the relationship between futures prices and 
stock prices. If they see a decline (rise) in the price of the futures 
compared to the price of the stocks, they will sell (buy) the 
underlying stocks in expectation that the stock prices quickly will 
follow the futures price. Indeed, this type of activity helps assure 
that stock prices will closely follow futures prices up or down.
    Accordingly, given that the E-mini S&P 500 futures price fell by 
more than 5 percent in a few minutes and then quickly recovered all of 
the 5 percent decline, it should be no surprise that the broader stock 
market indexes showed similarly fast and similarly large declines and 
recoveries. It must be recognized, however, that the fact that stocks 
prices follow futures prices chronologically does not demonstrate what 
may have triggered the price movements. The triggering factor may have 
been an event in the futures market (such as an exceptionally large 
order), but it could have been other factors as well. In the coming 
days, we intend to pursue this critically important linkage between the 
derivatives and equities markets that so significantly affects the 
price discovery that indicates the value of individual listed companies 
and of investor portfolios.
2. Absence of Professional Liquidity Providers
    According to anecdotal evidence, as well the large number of trades 
that executed against stub quotes, as discussed below, it appears that 
some professional liquidity providers \7\ temporarily did not 
participate in the market on the buy side in many stocks that suffered 
particularly egregious price declines, whether because of an 
intentional decision to withdraw or because of specific market 
practices. Some types of professional liquidity providers have 
``affirmative'' obligations to provide liquidity whether the market is 
up or down, as well as ``negative'' obligations not to take liquidity 
in ways that would destabilize the markets. Other professional 
liquidity providers do not have such responsibilities, including some 
of the high frequency proprietary trading firms that also are discussed 
below.
---------------------------------------------------------------------------
    \7\ Professional liquidity providers are proprietary traders in the 
business of providing liquidity to the market, often through the 
submission of limit orders that rest on the electronic order books of 
exchanges and other trading venues. They include registered entities, 
such as exchange specialists and market makers, as well as unregistered 
proprietary trading firms that engage in passive market making and 
other types of trading strategies.
---------------------------------------------------------------------------
    There is evidence that some firms that had previously been active 
participants in the markets withdrew their liquidity after prices 
declined rapidly. These firms may have acted appropriately under 
current rules, as a firm's risk models may have concluded that the 
action in the market presented too substantial a risk. As discussed 
below, however, we are looking at the data and considering the types of 
obligations that should apply to certain liquidity providers.
3. Disparate Exchange Practices
    The decline in the market on May 6 also focused attention on 
disparate exchange practices for dealing with major price movements and 
other unusual trading conditions. One of these is the NYSE's mechanism 
for ``liquidity replenishment points'' (``LRPs''). The NYSE utilizes a 
hybrid floor/electronic trading model, unlike most other markets today 
which are fully electronic. There are disagreements regarding whether 
the one model performed better than another in these circumstances.
    Although the ultimate answer to that question requires additional 
study and analysis, it is useful to describe the effect a certain 
feature of the NYSE had on market movements that day. In attempting to 
meld the traditional open-outcry floor-based auction model with today's 
technology, the NYSE's trading system utilizes what are known as 
``liquidity replenishment points,'' or LRPs. LRPs are best thought of 
as a ``speed bump'' and are intended to dampen volatility in a given 
stock by temporarily converting from an automated market to a manual 
auction market when a price movement of sufficient size is reached. In 
such a case, trading on the NYSE in that stock will ``go slow'' and 
pause for a time period to allow the Designated Market Maker to solicit 
additional liquidity before returning to an automated market. This 
``speed bump'' occurs even when there may be additional interest beyond 
the LRP price point.
    On days of major market volatility, stocks with significant and 
continual declines may cause NYSE trading to remain in the ``go slow'' 
mode for extended periods or to intermittently return to automated 
execution status before quickly again hitting another LRP and thereby 
``going slow'' again. Some have suggested that this practice caused a 
net loss of liquidity as orders were routed to other markets still 
offering automated executions. Others believe that the LRP mechanism 
served to attract additional liquidity that helped soak up some of the 
excess selling interest. We will examine the role and operation of LRPs 
to assess their effect on overall market quality and intend to promptly 
finalize this analysis. If any adverse effects on overall market 
quality are identified, we will take immediate steps to rectify that 
impact. We are focusing on whether the disparity in exchange practices 
can be addressed to promote more consistency in how orders are handled 
in the context of rapidly changing prices without undermining the 
benefits of individual market practices.
    An exchange typically will route an order to another exchange when 
the other exchange is displaying a better price. The routing exchange 
does this to avoid ``trading through'' the other exchange, that is, 
executing the order at a price worse than is available at the other 
exchange. When one exchange believes that another exchange is 
experiencing systems problems, the exchange may declare what is called 
``self-help'' against the other exchange. After declaring ``self-
help,'' the declaring exchange may trade through the quotations of the 
other exchange. The result of a self-help declaration is that the 
declaring exchange will exclude the quotations of the other exchange 
from its determination of whether the other exchange has a better 
``protected'' price to which it must route orders for execution. 
Appendix B provides additional detail on Regulation NMS.
    On the afternoon of May 6, just prior to the steep market decline, 
NASDAQ and NASDAQ OMX BX declared self-help against NYSE Arca, thereby 
excluding NYSE Arca's quotations (and liquidity) from their routing 
tables. The NYSE Arca has asserted that it did not experience systems 
problems that would warrant the declaration of self-help. We are 
investigating these issues and whether there needs to be greater 
consistency in exchange practices with respect to the self-help 
mechanism.
4. Exchange-Traded Funds
    Of the U.S.-listed securities with declines of 60 percent or more 
away from the 2:40 p.m. transaction prices, which resulted in their 
trades being canceled by the exchanges, approximately 70 percent were 
ETFs. This suggests that ETFs as a class were affected more than any 
other category of securities.
    Based on our analysis to date, we are focused on a number of issues 
that may have contributed to the ETFs' experience, including:

    Because ETFs generally track securities market indices, the 
        extraordinary price declines in certain individual securities 
        likely contributed to the ETF price declines. For the most 
        part, the severe ETF price declines followed, in time, the 
        sharp decline in the broad markets. ETFs that track bond 
        indices generally did not experience severe price declines. We 
        therefore are reviewing the linkages between ETF price declines 
        and the declines in the equity market.

    The role of market makers and authorized participants in 
        ETFs, and whether an inability to hedge their ETF positions 
        during periods of severe volatility may have contributed to a 
        lack of liquidity in ETF shares.

    The use of ETFs by institutional investors as a way to 
        quickly acquire (or eliminate) broad market exposures and 
        whether this investment strategy led to substantial selling 
        pressure on ETFs as the market began to decline significantly. 
        We also will explore whether the practice of shorting ETFs by 
        institutional investors to effectively eliminate broad market 
        exposures might have contributed to the intraday price swings 
        experienced by certain ETFs.

    The impact of ETF stop loss market orders, particularly 
        from retail investors, on the overall ETF market price 
        declines.

    Given that NYSE Arca is the primary listing exchange for 
        almost all ETFs, whether the impact that the declaration of 
        ``self-help'' against NYSE Arca by other exchanges may have 
        impacted NYSE Arca-listed stocks generally and ETFs in 
        particular. The loss of access to NYSE Arca's liquidity pool 
        may have had a greater impact on market liquidity and trading 
        for ETFs.
5. Other Factors
    A variety of other factors likely contributed to or potentially 
exacerbated the events of May 6. For example, many of the securities 
that were subject to trade cancellations were thinly traded, including 
certain exchange-traded funds and preferred stocks. For such illiquid 
securities, a large order or influx of orders easily can soak up 
available liquidity across the market, resulting in an order, 
particularly if it is a market order, breaking through many price 
levels in an effort to obtain an execution at any price. A market order 
is an order to buy or sell a stock at the best available current price. 
Market orders do not require an execution at a specific price or price 
range. With market orders, the order submitted generally is assured an 
execution; however, there is no limit on what the execution price can 
be. This contrasts with limit orders, which are submitted with a 
specified limit price. Limit orders guard against executions at prices 
at which the order submitter is not willing to trade, though the 
tradeoff is that the order may not be executed if the market suddenly 
moves away from the suggested limit price.
    In addition, the effect of market orders on prices may have been 
further exacerbated on May 6 by the use of stop loss market orders. 
These orders turn into market orders when the stop price of the order 
is reached. When an investor places a stop loss market order, the 
investor is instructing the broker to sell a stock at the market if it 
falls to a certain price. In a normal market, where liquidity exists as 
the stock price goes up or down, this strategy can protect an investor 
from taking a major loss if the stock drops significantly by selling at 
a predetermined price to minimize the loss. However, on May 6, the use 
of market orders when stop loss orders were triggered may have led to 
automated selling that resulted in executions at aberrant prices.
    Furthermore, the absurd result of valuable stocks being executed 
for a penny likely was attributable to the use of a practice called 
``stub quoting.'' When a market order is submitted for a stock, if 
available liquidity has already been taken out, the market order will 
seek the next available liquidity, regardless of price. When a market 
maker's liquidity has been exhausted, or if it is unwilling to provide 
liquidity, it may at that time submit what is called a stub quote--for 
example, an offer to buy a given stock at a penny. A stub quote is 
essentially a place holder quote because that quote would never--it is 
thought--be reached. When a market order is seeking liquidity and the 
only liquidity available is a penny-priced stub quote, the market 
order, by its terms, will execute against the stub quote. In this 
respect, automated trading systems will follow their coded logic 
regardless of outcome, while human involvement likely would have 
prevented these orders from executing at absurd prices. As noted below, 
we are reviewing the practice of displaying stub quotes that are never 
intended to be executed.
    Finally, we are examining the effect of short selling during the 
decline in prices. While short selling did not account for a 
disproportionate percentage of trading volume over the course of the 
day, our analysis thus far of broken trades has found that short sales 
accounted for a very high percentage (70-90 percent) of executions 
against stub quotes between 2:45 p.m. and 2:55 p.m. Notably, short sale 
executions against stub quotes would be subject to the alternative 
uptick rule (Rule 201) adopted by the SEC in February 2010, with a 
compliance date in November 2010.
6. Initial Steps
    On the Monday following the events of May 6, I met here in 
Washington with the leaders of six markets--New York Stock Exchange, 
NASDAQ Stock Market, BATS Exchange, Direct Edge ECN, International 
Securities Exchange, and Chicago Board Options Exchange--and FINRA, to 
discuss the causes of market events of May 6, the potential 
contributing factors, and possible market reforms. The meeting was 
productive and collaborative, and there was a strong consensus that the 
type of aberrational volatility experienced on May 6 is wholly 
unacceptable in our markets.
    Earlier this week, the national securities exchanges and FINRA 
filed proposed rules for uniform market-wide circuit breakers for 
individual securities in the S&P 500 Index that experience a rapid 
price movement.
    Under the proposed rules, which are subject to Commission approval 
following the completion of a comment period, trading in a stock would 
pause across U.S. equity markets for a 5-minute period in the event 
that the stock experiences a 10 percent change in price over the 
preceding 5 minutes. The pause would give the markets the opportunity 
to attract additional liquidity in an affected stock, establish a 
reasonable market price, and resume trading in a fair and orderly 
fashion. Initially, if approved, these new rules would be in effect on 
a pilot basis through Dec. 10, 2010. The markets can use the pilot 
period to make appropriate adjustments to the parameters or operation 
of the circuit breaker as warranted based on their experience, and to 
expand the scope to securities beyond the S&P 500 (including ETFs) as 
soon as practicable.
    The proposed rules are available on the SEC's website as well as 
the websites of each of the exchanges and FINRA. The Commission is 
publishing the proposed rules for a 10-day public comment period, and 
will determine whether to approve them shortly thereafter. Circuit 
breakers for individual securities across the exchanges should help to 
limit significant volatility, promote orderly markets, and bolster 
investor confidence.
    In addition, during the pilot period, I have asked the SEC staff to 
consider ways to address the risks of market orders and their potential 
to exacerbate sudden price moves, as well as to consider steps to deter 
or prohibit the use by market makers of ``stub'' quotes, which are not 
intended to indicate actual trading interest. The staff also will study 
the impact of other trading protocols at the exchanges, including the 
use of trading pauses by individual exchanges that supplement the 
market-wide circuit breakers, and ``self-help'' protocols that allow 
the markets to avoid routing to exchanges that are perceived to be 
responding too slowly. The SEC staff also will continue to work with 
the exchanges and FINRA to improve the process for breaking erroneous 
trades, by assuring speed and consistency across markets. Another area 
of review is the need to consider recalibrating market-wide circuit 
breakers currently on the books--none of which were triggered on May 6.
    As noted above, SEC and CFTC staff recently issued a joint report 
of preliminary findings regarding the market events of May 6 to the 
Joint Advisory Committee on Emerging Regulatory Issues. The Committee 
will hold its first meeting Monday. The Commission looks forward to 
working with the Committee, whose first charge is to review the market 
break and make recommendations related to market structure issues that 
may have contributed to the volatility experienced on that day, as well 
as disparate trading conventions and rules across various markets.
    The following week, on June 2, the Commission will hold a 
roundtable with various market participants to discuss the structure of 
the securities markets. In publishing notice of the roundtable in the 
Federal Register, the Commission has solicited public comment on the 
current market structure including how well it is serving various 
market participants. The roundtable will provide an open forum for 
market professionals, investors, and academics to express their views 
on the current market structure, possible causes of the unusual trading 
activity on May 6, and ways to improve the markets to ensure that, 
first and foremost, our markets are fair and orderly.
    Finally, our inspections and enforcement staff also have been fully 
integrated into our review of the events of May 6. I am deeply 
concerned about the effects that this volatile market had on investors, 
especially retail investors whose trading orders may not have behaved 
as they were intended or who otherwise may have been unfairly harmed. 
The SEC has received numerous complaints from investors, for example, 
who used stop loss orders to protect them from rapidly declining 
markets. It appears that some investors' accounts were liquidated as 
share prices plummeted only to have stock prices close significantly 
above their sale prices. We are looking at a wide variety of actions on 
May 6 involving the full range of market participants. We will examine 
such things as whether market professionals fully met their 
obligations, including, where applicable, their best execution 
obligations, and whether the decision to bust trades was made and 
applied fairly and consistently among investors. If we identify any 
activity that violates the securities laws, we will take appropriate 
action.
III. Potential Regulatory Responses
    To the extent there was anything positive in the events of May 6, 
it was that the markets proved to be resilient and recovered quickly. 
Nevertheless, such a severe market disruption harms investors and the 
markets generally. First, it harms those investors who may have traded 
at erroneous prices. For example, many investors use stop loss orders 
that are triggered by significant price moves and can liquidate 
positions at very unfavorable prices. Other investors may see a 
precipitous price decline and initiate new orders to sell to minimize 
losses. These new orders likewise may liquidate positions at very 
unfavorable prices for the investor.
    Some of these trades may be canceled and some may not. But even for 
trades that are canceled, they may cause losses for those investors and 
traders who stepped in and bought during the midst of a severe price 
decline. These investors and traders accepted the risk of a market 
meltdown and significant losses, but, if their trades are canceled, 
were not rewarded for their willingness to buy when everyone else was 
selling. Finally and more generally, such disruptive price movements 
undermine the confidence of investors in the integrity and fairness of 
our markets, undermining the essential function of supporting capital 
formation.
    In response to the global economic crisis and evolving market 
practices, the Commission had already undertaken a number of 
initiatives to strengthen the integrity our markets, even before the 
events of May 6. In February, for example, the Commission adopted a 
short sale circuit breaker. That rule is designed to limit short 
selling where an individual stock is under stress and has experienced a 
decline of 10 percent from the previous day's close. At that point, the 
restrictions of the rule provide assurances to investors that short 
sellers are not taking the stock down, while retaining the value of 
short selling in the price discovery process. In so doing, we believe 
that the rule will promote investor confidence.
    The market events of May 6 add greater urgency for the Commission 
to vigorously pursue a number of meaningful initiatives to promote 
investor confidence in the integrity and fairness of the securities 
markets, including a number of proposals already underway. I first will 
address additional initiatives relating to time out mechanisms, 
destabilizing short-term trading strategies, and correction of 
erroneous trades. I will conclude by noting various initiatives already 
proposed or soon to be considered that may help address disruptive 
market conditions.
A. New Initiatives
    In January, the Commission published a concept release on equity 
market structure (``Market Structure Concept Release'') that 
highlighted many aspects of today's highly automated markets and 
requested public comment on a wide variety of issues. The Market 
Structure Concept Release was designed to further the Commission's 
broad review of market structure to assess whether its rules have kept 
pace with, among other things, changes in trading technology and 
practices.
    The events of May 6 implicate a number of issues raised in the 
Market Structure Concept Release. For example, it asked whether the 
current market structure appropriately minimizes the short-term 
volatility that can be harmful to long-term investors. It asked whether 
the relatively good performance of the market structure in 2008 
indicated that systemic risk was appropriately minimized in the current 
market structure and, if not, what further steps the Commission should 
take to address systemic risk. Finally, it noted the dominant role of 
HFT firms in today's market structure and observed that they had 
largely replaced the role of specialists and market makers with 
affirmative and negative obligations for market quality. More 
specifically, the Market Structure Concept Release asked whether there 
is any evidence that proprietary firms increase or reduce the amount of 
liquidity provided to the market during times of stress. It also 
discussed various types of short-term trading strategies, including 
``directional'' strategies, such as ``momentum ignition,'' that could 
present serious problems in today's market structure by exacerbating 
short-term volatility.
    The public comment period on the Market Structure Concept Release 
ended on April 21. The Commission has received more than 100 comment 
letters reflecting a broad range of perspectives. Many of the letters 
set forth detailed views on very complex issues, and the Commission 
continues to review them carefully.
    In addition, the Commission has published a series of concrete 
market structure proposals that are designed to strengthen the U.S. 
securities markets and to protect investors. These include the proposal 
to prohibit flash orders and the proposal to increase the transparency 
of ``dark'' pools of liquidity, as well as the market access proposal 
(discussed below) to strengthen broker-dealer risk management controls 
and the large trader reporting proposal (also discussed below) to 
enhance the Commission's surveillance and enforcement capabilities.
    The events of May 6 demonstrate the urgency and importance of these 
efforts and provide a valuable concrete example of how the market 
structure performed under particularly stressful conditions. As such, 
they highlight particular regulatory steps that warrant close attention 
in the near future.
1. Destabilizing Short-Term Trading Strategies
    In addition to focusing on liquidity, we must also consider the 
sources of the selling pressure that can suddenly generate such 
enormous demand for liquidity to buy. What triggered the selling 
pressure? What types of market participants were selling and what types 
of trading strategies were they pursuing?
    For example, to what extent, if at all, did the wave of selling on 
May 6 come from proprietary firms employing ``directional'' strategies 
triggered by signals that attempt to exploit short-term price 
movements? These directional strategies were discussed in the Market 
Structure Concept Release and include ``momentum ignition'' strategies 
that are designed to start and exacerbate price movements. It is too 
early to know whether short-term professional trading strategies played 
any role in the events of May 6. If they contributed significantly to 
the precipitous decline, however, we must consider whether additional 
regulatory requirements are necessary.
    For example, in the past, professional liquidity providers with the 
best and fastest access to the markets were charged with affirmative 
and negative obligations to promote market quality. One of the most 
significant negative obligations was a restriction on ``reaching across 
the market'' to take out quotations and thereby drive prices up or 
down. Many of the most active and sophisticated traders in today's 
market structure are not subject to any obligations with respect to the 
nature of their trading. If active trading firms exploited their 
superior trading resources and significantly contributed to the severe 
price swings on May 6, we must consider whether regulatory action is 
needed to address the problem.
2. Fair and Consistent Process and Policies for Correcting Erroneous 
        Trades
    We also must work with the various exchanges and other trading 
venues to assure that the process and policies for dealing with the 
correction of erroneous trades are fair for investors and consistently 
applied--both in the context of a single event and across different 
events. Currently, the threshold level for correcting trades is set by 
the exchanges on a case-by-case basis. The particular level that is 
chosen may affect investors and other market participants in profound 
and varying ways. Obviously, the primary objective should be a market 
structure that minimizes to the greatest extent possible any need to 
correct erroneous trades. When necessary, however, the process and 
policies should be applied in a consistent manner under established 
rules that are fair to investors.
B. Ongoing Initiatives
1. Market Access Proposal
    In January, the Commission proposed a rule that would require 
effective risk management controls for broker-dealers with market 
access, including those providing customers sponsored access to the 
markets. Our proposal would effectively prohibit the growing practice 
by some broker-dealers of providing ``unfiltered'' sponsored access, 
where a customer is permitted to directly access the markets using the 
broker-dealer's market participant identifier but without the 
imposition of effective pre-trade risk management controls. All broker-
dealers accessing the markets should implement controls to effectively 
manage the risks associated with this activity, and our proposal would 
unequivocally require them to do so. These risks include the potential 
breach of a credit or capital limit, the submission of erroneous orders 
as a result of computer malfunction or human error, and the failure to 
comply with regulatory requirements. Effective risk management controls 
for market access are necessary to protect the broker-dealer, the 
markets, the financial system, and ultimately investors. Such controls 
would help prevent trading activity that could trigger a market 
disruption. We have received numerous comment letters on our sponsored 
access proposal and the staff is considering those comments and will 
soon make a recommendation to the Commission. I expect the Commission 
to act on this important proposal by this summer.
2. Large Trader Reporting Proposal
    Last month, the Commission proposed to create a large trader 
reporting system that would enhance our ability to identify large 
market participants, collect information on their trades, and analyze 
their trading activity. To keep pace with rapid technological advances 
that have impacted trading strategies and the ways in which some market 
participants trade, the Commission must be able to readily identify 
large traders operating in the U.S. securities markets, and obtain 
basic identifying information on each large trader, its accounts, and 
its affiliates. In addition, to support its regulatory and enforcement 
activities, the Commission must have a mechanism to track efficiently 
and obtain promptly trading records on large trader activity.
    The current system for collecting transaction data from registered 
broker-dealers is generally utilized in more narrowly focused 
investigations involving trading in particular securities, and is not 
generally conducive to larger-scale market reconstructions and analyses 
involving numerous stocks during periods of peak trading volume. In 
addition, existing tools often require weeks or longer to compile 
trading data to identify potentially large traders. The Commission's 
need to develop the tools necessary to readily identify large traders 
and be able to evaluate their trading activity is heightened by the 
fact that large traders, including certain high-frequency traders, are 
playing an increasingly prominent role in the securities markets.
    The proposed rule would enhance the Commission's ability to 
identify those ``large trader'' market participants that conduct a 
substantial amount of trading activity in U.S. securities, as measured 
by volume or market value. In addition, the proposal would facilitate 
the Commission's ability to obtain from broker-dealers records of large 
trader activity. By providing the Commission with prompt access to 
information about large traders and their trading activity, the 
proposed rule is intended to facilitate the Commission's efforts in 
reconstructing market activity and performing analyses of trading data, 
as well as assist in investigations of manipulative, abusive, and other 
illegal trading activity.
3. Consideration of Consolidated Audit Trail Proposal
    One of the challenges we face in recreating the events of May 6 is 
the reality that the technologies used for market oversight and 
surveillance have not kept pace with the technology and trading 
patterns of the rapidly evolving and expanding securities markets. 
There are mechanisms already in place to coordinate surveillance among 
markets. For example, the Intermarket Surveillance Group provides a 
framework for the sharing of information and the coordination of 
regulatory efforts among exchanges trading securities and related 
products to address potential intermarket manipulations and trading 
abuses. However, audit trail requirements vary between markets, 
resulting in a lack of current, readily accessible securities order and 
execution data. Today's fast, electronic, and interconnected markets 
demand a robust consolidated audit trail and execution tracking system.
    Since last summer, SEC staff have been working, in consultation 
with SROs and others, on a rule proposal that would require the SROs to 
jointly develop, implement and maintain a consolidated order tracking 
system, or consolidated audit trail. Next week, the Commission will 
consider this rule proposal, which should result in a continuous 
reporting mechanism for market participants that would capture the data 
needed for effective cross-market surveillance. The proposed changes 
will significantly improve the ability to conduct timely and accurate 
trading analyses for market reconstructions and complex investigations, 
as well as inspections and examinations. Indeed, I expect that the 
proposed consolidated audit trail would result in our ability to access 
in real time the majority of the data needed to reconstruct the type of 
market disruption that occurred last week, with remaining information 
available within a matter of days rather than weeks. A consolidated 
audit trail would be invaluable to enhance the ability to detect and 
monitor aberrant and illegal activity across multiple markets, and 
would greatly benefit investors and help to restore trust in the 
securities markets.
IV. Conclusion
    In conclusion, the events of last week are unacceptable. The SEC is 
engaging in a comprehensive review and is taking the necessary steps to 
implement additional safeguards to prevent the type of unusual trading 
activity that occurred briefly last week. The Commission is considering 
a number of proposals that will address key issues raised on May 6 and 
we will move expeditiously to address all issues we determine caused or 
contributed to those events.



                                 ______
                                 
                PREPARED STATEMENT OF RICHARD G. KETCHUM
       Chairman and CEO, Financial Industry Regulatory Authority
                              May 20, 2010
    Chairman Reed, Ranking Member Bunning and Members of the 
Subcommittee:

    I am Richard Ketchum, Chairman and CEO of the Financial Industry 
Regulatory Authority, or FINRA. On behalf of FINRA, I would like to 
thank you for the opportunity to testify today.
    I would also like to commend SEC Chairman Mary Schapiro and CFTC 
Chairman Gary Gensler for their leadership during the last 2 weeks. 
They swiftly engaged with exchange leaders and regulators and 
established a collaborative process to coordinate review of all 
relevant market data, as well as to identify measures that could be 
taken quickly to significantly reduce the chances of a recurrence of 
the severe market disruption that occurred on May 6.
    There remains much more work to do, both in terms of diagnosing 
what led to the market drop May 6 and identifying additional proactive 
steps we may want to take to ensure that our markets are able to 
function more efficiently under highly volatile conditions. Ultimately, 
we all realize that the extreme market volatility 2 weeks ago 
underscored the need for regulators, and others operating in and around 
financial markets, to step back and recognize that with the immense 
changes in the market, there is a serious need to look at market 
structure, and identify a variety of measures that can enhance the 
information regulators receive to ensure market integrity and the 
protection of investors.
Efforts Undertaken Since May 6
    Immediately after the market events on May 6, FINRA, in 
coordination with the SEC and other self-regulatory organizations 
(SROs), began the process of trying to identify unusual activity that 
could have contributed to the rapid market drop. Even before the market 
data had been fully collected, FINRA staff reviewed clearly erroneous 
trade filings and, along with NYSE Regulation, interviewed the 
approximately 20 firms with significant activity during the period of 
the decline. Along with NYSE Regulation, we contacted the firms to 
determine whether ``fat finger'' or other trading errors occurred, 
either as a result of proprietary or customer activity. None of the 
firms contacted identified any trading errors or other unusual activity 
on their part, nor has any firm come forward since, nor has any 
evidence been developed to indicate that a single large trade or basket 
of trades entered in error played a role in the market decline.
    On May 7, we contacted over 250 firms to determine the impact of 
the market disruption to the firms and their customers. Our inquiries 
covered a range of issues depending on the type of firm, including 
funding and liquidity, customer exposure, increased margin calls, net 
capital implications and how firms intended to reestablish limit orders 
that were executed and then canceled. We followed up with particular 
firms last week to ensure that appropriate steps had been taken to 
address any issues identified in our initial discussions. While firms 
cited a number of operational and other issues, none appeared to be 
systemic in nature. In addition, we are examining the flow of customer 
complaints to both us and the firms concerning order handling and 
execution practices during the market decline.
    We have focused our review of the vast amounts of trading data on 
the approximately 300 stocks that experienced the most dramatic decline 
during the 30-minute period in question. That list, unsurprisingly, 
coincides with the list of securities that were the subject of 
cancellations and reversals by the markets on the evening of May 6. We 
continue to review order entry and trade reporting data for the 300-
plus stocks, and have identified a subset of these stocks for further 
inquiry, based on an analysis of a concentration of order and trade 
activity in the period immediately prior to and during the market drop. 
Focusing on the selling activity in these securities (some of which, 
incidentally, are exchange-traded funds), we, again working closely 
with both SEC staff and staff from the other markets, contacted those 
firms that were most active. Our lines of inquiry, while quite broad, 
include an analysis of short selling during the period and the role 
that algorithms played, including the specific strategies and triggers 
employed by the trading firms. Finally, we are talking to the largest 
broker-dealer alternative trading systems to determine whether they had 
system issues that may have contributed to the market drop.
    While there is still much to be done before we can say that we have 
definitively pinpointed the cause or causes of the decline, I think we 
can say that certain basic truths have emerged, and that we should not 
wait to adapt to them. First, we know that the process for restoring 
order following an event like last Thursday should be more transparent 
and predictable.
    Second, this event demonstrated that the conventional wisdom that 
the futures markets tend to move first continues to hold, as does the 
notion that the market is highly efficient in shifting that momentum 
from the derivatives side to the cash side, creating fast and focused 
selling pressure across wide numbers of stocks and ETFs. That point, 
that the equities markets can find themselves dramatically influenced 
by external market movements, now has a clear corollary completely 
self-contained in the equities space.
    Specifically, as we've seen exchange barriers to entry drop, 
competition rise and market structure policy compel connectivity among 
exchanges and between exchanges and other execution venues, we see that 
market quality can no longer be ensured by a single exchange acting in 
a siloed fashion. Moreover, while the market fragmentation that has 
occurred has lowered barriers to entry and created fierce competition 
resulting in narrow quotation spreads and a high level of liquidity in 
good times, it also results in the fact electronic removal of liquidity 
when markets are stressed. It also generally resulted in the 
elimination, in many cases, of meaningful market maker obligations 
while retaining residual regulatory requirements for two-sided quotes 
that has led to the ``stub quoting'' phenomenon that contributed to the 
extreme price volatility. In short, while our equity market structure 
performs well under normal conditions, change is urgently needed to 
better address these flash market break situations.
    Taking note of that last point, FINRA was pleased to have 
participated in a series of discussions with the U.S. equities and 
options exchanges, at the direction of the SEC, to establish a 
framework for market-wide, stock-by-stock circuit-breaker rules and 
protocols. The result of this coordinated effort are the rule changes 
filed on Tuesday by each of the exchanges and FINRA to implement the 
following stock-by-stock circuit-breaker protocols on a pilot basis for 
all securities included in the S&P 500:

    If the price of a security changes by 10 percent within a 
        rolling 5-minute period, trading in that security will be 
        halted for 5 minutes.

    A message will be sent simultaneously to all the markets 
        and FINRA.

    The primary market for the security will employ its 
        standard auction process to determine the opening print after 
        the 5-minute halt period.

    The authority will apply from 9:45 a.m. to 3:35 p.m., 
        Eastern Time.

    This solution will allow a pause in trading that will allow market 
participants to better evaluate the trading that has occurred to 
correct any erroneous ``fat finger'' orders and to allow a more 
transparent, organized opportunity to offset the order imbalances that 
have caused the volatility. In this way, this regulatory response 
should reduce the negative impacts of sudden, unanticipated and 
otherwise unexplained dramatic price movements in individual 
securities. This is far preferable to the markets having to be in the 
position of going back after the fact to determine what trades should 
be broken when markets go close to zero.
    Additional implementation and technological issues will be 
discussed and resolved by the relevant markets in the coming weeks, 
with the goal of implementing the new circuit-breaker authority within 
30 days after Commission approval. Once implemented, the markets and 
FINRA will be monitoring continuously the application and effectiveness 
of the rule's framework and protocols to determine the most efficient 
and effective permanent approach, in anticipation of such authority 
being expanded to a broader range of securities.
Next Steps
    As we look past these shorter term steps to address what we saw in 
the market 2 weeks ago, longer term concerns must also be addressed if 
we are to reassure market participants, including retail investors, 
that our equities markets are stable and fair. And this is true 
irrespective of whether these issues played a major contributing role 
in the specifics of the decline on May 6.
    First, firms need to ensure that they do not continuously feed in 
orders once markets have broken with respect to precipitous declines.
    Second, firms must properly supervise customers to whom they have 
given ``direct access'' to the markets, thereby allowing a customer to 
trade on an exchange using the firm's market participant identification 
code. Any firm that provides its name to and/or sponsors a transaction 
has a responsibility to ensure the proper reviews for those 
transactions are in place.
    Third, there should be a continued analysis of various markets' 
rules regarding circuit breakers and clearly erroneous trades, with an 
eye toward consistency and transparency of these rules across markets. 
As Chairman Schapiro has said, ``the primary objective should be a 
market structure that minimizes to the greatest extent possible any 
need to correct erroneous trades. When necessary, however, the process 
should be applied in a consistent manner under established rules that 
are fair to investors.'' I also agree with Chairman Schapiro that the 
practice of displaying stub quotes should be analyzed and potentially 
eliminated.
    Finally, and most broadly, the events of May 6 demonstrate the 
vital importance of the SEC's current review of market structure, rule 
proposals on direct market access and large trader reporting, and the 
forthcoming proposal related to establishing a consolidated audit 
trail.
Market Structure Review and the Need for a Consolidated Audit Trail
    The sometimes dizzying speed of change in the markets, which puts a 
premium on innovation and competition, has made it imperative that 
regulators act now to close regulatory gaps that ineffectively 
discourage illicit activity in the shadows. The lag between market 
innovation and regulation is particularly pronounced in the 
increasingly fragmented area of equity trading. There, we have seen a 
rapid evolution of how and where trading occurs, and how quickly--and 
transparently--it is executed. High-frequency trading, dark pools and 
direct access are now commonplace, compelling regulators to adapt to 
ensure that market participants play by the rules.
    A generation ago, the vast majority of activity occurred on the 
equity market that listed the security. Today, orders are routed to 
some 50 competing platforms. This complex environment creates 
opportunities for traders seeking unfair advantage to manipulate 
markets. How? By exploiting inconsistencies or gaps created when the 
responsibility of regulatory oversight is divided. Regulatory gaps and 
splintered oversight make it possible for trading abuses--such as 
market manipulation, marking the close and front-running customer 
orders--to be carried out furtively across multiple markets, with a 
reduced chance of detection.
    By spreading trading activity across different market centers, 
firms can attempt to disguise abusive trading activity by exploiting 
the existing gaps in audit trail data. Although regulatory authorities 
currently examine for, investigate and prosecute abusive trading 
activity when it violates existing regulatory obligations, we are 
hampered by the lack of a comprehensive, sufficiently granular and 
robust consolidated audit trail across the equity markets. The most 
effective way to surveil for these trading practices across the wide 
range of market centers is to consolidate audit trail data in a single 
place so that violative trading practices can be more readily 
identified.
    Each market is required to have in place rules that, among other 
things, seek to prevent fraudulent and manipulative acts and practices, 
and protect investors and the public interest. Although each market is 
responsible for regulating and surveilling the trading conducted on its 
market, as markets become increasingly fragmented and securities trade 
on multiple venues, regulation of activity that crosses markets becomes 
a vital component of ensuring overall market integrity and maintaining 
investor confidence. This is particularly so because trading abuses 
such as insider trading, market manipulation, marking the close and 
trading ahead of customer orders so easily can be conducted across 
multiple markets. FINRA believes that a consolidated audit trail across 
markets, and eventually across investment products, is essential to 
ensure comprehensive surveillance of the equity markets and related 
markets so that abusive trading activity can be detected in a more 
timely, efficient and comprehensive manner.
    Today, regulation of the equity markets is split among FINRA and 
other SROs, and no single regulator has a full picture of all trading 
activity in the U.S. equity markets, either on a product-specific, 
firm-specific or, under certain circumstances, even an order-specific 
basis.
    The announcement on May 4 that FINRA will assume market regulation 
for NYSE Euronext's U.S. platforms is a major step toward establishing 
such a unified approach to market oversight. Under the plan, FINRA--
which already conducts market surveillance for the NASDAQ Stock Market 
and trading occurring off-exchange--will be responsible for aggregating 
and regulating approximately 80 percent of trades in equities made at 
U.S. market centers. The benefits for market integrity and investor 
protection are profound. But perhaps more importantly, empowering a 
single set of eyes to oversee the majority of transactions will 
facilitate the necessary progress toward a truly holistic approach to 
regulation that addresses the realities of today's marketplace.
    Quite simply, technological advances in trading systems, coupled 
with market fragmentation, have led to a situation where comprehensive 
intermarket surveillance is essential to ensuring the overall integrity 
of the equity markets. Moreover, the major hurdles of just a few years 
ago to consolidated market surveillance have been significantly reduced 
due to the progression of market structure and the convergence of many 
aspects of exchanges' business models. With the changes to market 
structure resulting from Regulation NMS and virtually all aspects of 
trading becoming electronic, the previous distinctions between market 
types are quickly fading away, minimizing many of the prior obstacles 
to consolidated audit trail data and oversight.
    Since the adoption of Regulation NMS in 2005, there has been a 
significant increase in market linkages, the result of which is that 
trading activity that originates on one market often has a profound 
effect on other markets. This, of course, creates a much greater 
possibility of cross-exchange market manipulation where, for example, 
trading on one market is used to artificially affect a security's price 
and trading on another market is used to take advantage of that price 
change. A similar problem exists when surveilling for compliance with 
rules that prohibit firms from trading ahead of a customer order, such 
as limit order protection rules and front running rules. In these 
cases, the proprietary trading may be executed on one market while the 
customer trade is executed on another. These problems are exacerbated 
by the fact that some firms trade using multiple market participant 
identifiers (MPIDs) or trade pursuant to market access arrangements 
whereby the firm's trading is identified with an MPID assigned to a 
different firm.
    FINRA believes there should be consistent and uniform gathering of 
order, trade and quote information across all equity and options 
markets, and that the audit trail must be sufficiently granular to 
enable regulators to readily identify trading activity by market 
participants across markets. A consolidated audit trail would not 
eliminate all the challenges of analyzing the data from a 66 million 
trade day like May 6, but it would make the process significantly more 
efficient and effective.
    We look forward to working with the SEC, and with this Committee, 
as we continue our work on these important initiatives that lie at the 
heart of enhancing regulators' ability to best oversee today's markets.
Conclusion
    We will continue to work with our fellow regulators to diagnose and 
identify corrective measures to address the significant market 
disruption 2 weeks ago. The SEC and CFTC spearheaded a process that has 
resulted in a coordinated, market-wide proposal that will quickly and 
dramatically lessen the chances for an event like that we saw May 6. 
But the effort is far from over.
    Further analysis of rule changes, highlighted by both the market 
drop and the SEC's current market structure review, can and will 
strengthen our system to further ensure that rules and regulators are 
best positioned to ensure the continued integrity of U.S. markets and 
to protect all investors who participate in those markets.
    Again, I appreciate the opportunity to share our views. I would be 
happy to answer any questions you may have.
                                 ______
                                 
                 PREPARED STATEMENT OF LARRY LEIBOWITZ
                 Chief Operating Officer, NYSE Euronext
                              May 20, 2010
Introduction
    Chairman Reed, Ranking Member Bunning and Members of the 
Subcommittee, my name is Larry Leibowitz and I am Chief Operating 
Officer for NYSE Euronext.\1\ I appreciate the opportunity to share 
with the Subcommittee our written testimony on the subject of today's 
hearing.
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    \1\ NYSE Euronext is a leading global operator of financial markets 
and provider of innovative trading technologies. The company operates 
cash equities exchanges in five countries and derivatives exchanges in 
Europe and the United States, on which investors trade equities, 
futures, options, fixed-income and exchange-traded products. With more 
than 8,000 listed issues, NYSE Euronext's equities markets--the New 
York Stock Exchange, NYSE Euronext, NYSE Amex, and NYSE Arca--represent 
nearly 40 percent of the world's equities trading, the most liquidity 
of any global exchange group. NYSE Euronext also operates NYSE Liffe, 
the leading European derivatives business, and NYSE Liffe U.S., a new 
U.S. futures exchange. We provide technology to more than a dozen cash 
and derivatives exchanges throughout the world. The company also offers 
comprehensive commercial technology, connectivity and market data 
products and services through NYSE Technologies.
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    We commend the Subcommittee for its proactive response to the 
trading events of May 6, 2010. We agree with the Subcommittee that an 
orderly trading environment is fundamental to ensuring the reliability 
and integrity of our financial markets, fostering investor confidence 
in the markets, and safeguarding the U.S. financial system and economy. 
NYSE Euronext has always worked and will continue to strive to be the 
standard for accountability and transparency in the regulated 
marketplace. Thus, we believe it is essential to carefully examine the 
market events that occurred on May 6, 2010 and to consider potential 
market design and regulatory actions that could mitigate any similar 
occurrences in the future. NYSE Euronext is firmly committed to working 
with regulators and market participants toward achieving this critical 
objective, and we strongly urge all parties to play an active and 
responsible role in helping our market function in a way that gives 
investors confidence. The trading events of May 6 are indicative of 
broader changes to markets and trading practices for which recent 
advances in technology have been a catalyst, and which the SEC wisely 
has opened for review. We particularly applaud the extraordinary effort 
and professional dedication of the SEC and CFTC in producing a 
thoughtful preliminary report on the events of May 6th in such a short 
timeframe.

    Today I would like to discuss:

    the trading events of May 6, 2010;

    the role automated trading and high frequency trading 
        played in the market disturbance;

    the actions, and rationale behind those actions, that the 
        New York Stock Exchange took during those events; and

    our recommendations for market design and regulatory 
        changes to avoid similar events and enhance investor safeguards 
        in the future.
The May 6, 2010 Market Drop
    On May 6, 2010, from 2:40 p.m. to 3 p.m. Eastern time, the U.S. 
equity trading markets experienced a precipitous decline. At its lowest 
point, the Dow Jones Industrial Average suffered an intraday decline of 
998.5 points, representing approximately $1 trillion in market value, 
with the most severe trading pressure occurring between 2:40 p.m. and 3 
p.m. Some individual stocks lost nearly 100 percent of their market 
value. Although some of the underlying economic and global financial 
conditions that influenced this selling activity are known, the exact 
succession of events and what precipitated them remain unclear. The 
Securities and Exchange Commission (the ``SEC'') and the Commodity 
Future Trading Commission (the ``CFTC'') are aggregating and analyzing 
trading data from all of the equity and derivatives markets and, in 
addition to their preliminary findings issued on May 18, 2010, will 
form a complete picture of the situation. We and other markets are 
working with the SEC and CFTC to supply and interpret this data, but we 
cannot do so on our own, as any single exchange has access only to the 
data from trades sent to or executed on that exchange.
    From our standpoint, we see no evidence of fat finger error or 
market manipulation, due to automated trading or otherwise. However, we 
do see the following:

    Elevated market activity coming from adverse European news, 
        including a very large and a broadly based wave of orders and 
        quotes at around 2:30 p.m.;

    A significant reduction in marketplace liquidity as 
        measured by the size of order books through the day, which 
        accelerated dramatically through the downturn;

    Increased downward pressure exacerbated by the triggering 
        of retail Stop Loss orders, which sent market sell orders into 
        an already weak market; and

    Various microstructure issues that resulted in certain 
        marketplaces not interacting with one another, which 
        exacerbated the liquidity effect.

    Trading activity like we experienced on May 6 underscores the 
importance of the broad market structure review that the SEC is 
undertaking at present. As you know, in 2005 the SEC adopted Regulation 
NMS, which is the main set of regulations that govern the interaction 
of the competing markets in equity securities. Regulation NMS has 
resulted in a number of benefits to the equity markets, including 
narrower spreads and a greater use of technology, positioning the 
equity markets to handle the extreme market stresses that began in the 
fall of 2008. Additionally, Regulation NMS resulted in vibrant 
competition in the markets. We strongly support competition in the 
equity markets, but competition among trading centers and models has 
also resulted in significant market fragmentation. There are currently 
upwards of 40 market centers in the equities markets, including 
registered exchanges and alternative trading systems.
    Moreover, the broader market structure has evolved to one that 
values speed over most other factors, while on the New York Stock 
Exchange we have put a special emphasis on arriving at the right price. 
When a trading problem occurs, such as the May 6 experience, there is 
no central mechanism to coordinate a market-wide response, or better 
yet to briefly pause, reassess what is happening in the marketplace and 
re-aggregate liquidity for the express purpose of conducting price 
discovery. Exchanges have rules for trading halts regarding pending 
news and trading problems and also have had to implement rules to 
address erroneous trades, most of which would not occur in a well 
functioning market structure. And while the securities and futures 
exchanges, along with the Financial Industry Regulatory Authority 
(FINRA), have adopted the market-wide circuit breakers developed after 
the 1987 market crash, there were no pre-established mechanisms in 
place on May 6 to address precipitous declines on a stock-by-stock 
basis, or trading problems that result in market-wide drops of less 
than 10 percent.
    We are confident that the May 6 market drop will inform the SEC's 
current examination of the changes in the markets, and in particular 
how certain recent advances in technology may have fostered trading 
practices that negatively impact the entire market, and how practices 
that in the past were considered standard do not function well in 
today's market. We are committed to working with the SEC and the CFTC 
as they consider these important issues.
    It is worth noting that a theme in some responses to the 
outstanding SEC market structure review is that policymakers should 
refrain from tinkering with the equity capital markets because they 
operate smoothly and efficiently, with deep liquidity and narrow 
spreads. While we do not disagree with many of these observations on 
the whole, we believe May 6th highlights why we do in fact need to 
focus on new rules and frameworks to avoid potential issues that arise 
in our fragmented marketplace, in a manner that is sensitive to 
maintaining an innovative environment. At the same time, we do not 
think it is right to point blame at professional traders or one 
category of liquidity providers, but rather believe that events of May 
6 further highlight some of the issues raised in the SEC's Concept 
Release regarding market maker commitments to the marketplace, dark 
liquidity and overall transparency.
    In this regard, I want to say a few words about high frequency 
trading. One of the challenges in addressing the topic is that there is 
no accepted definition of high frequency trading, but for present 
purposes I use the term to refer to a variety of high-speed techniques 
that have effectively filled the void left by human market makers who 
could no longer compete when decimalization greatly shrunk spreads.
    The New York Stock Exchange Euronext believes that high frequency 
trading adds liquidity to the markets, to the benefit of investors. It 
is most common in high-volume stocks and research demonstrates that 
since 2002, quoted spreads between bid and offer on stocks have 
tightened the most in high volume stocks compared to lower volume ones, 
presumably showing the benefits of high frequency trading. Moreover, 
the New York Stock Exchange Supplemental Liquidity Provider (SLP) 
program gives high frequency traders an economic incentive to quote at 
the best price a certain percentage of the time, thus rewarding the 
provision of liquidity.
    I want to be clear that the New York Stock Exchange Euronext does 
not favor high frequency trading or any other type of strategy over 
others. Rather, our role is to provide liquid, transparent and well-
regulated exchanges, and let customers choose how they wish to access 
our markets.
    Before describing our actions on May 6, I believe it would be 
useful to explain the rules of the New York Stock Exchange that are 
designed to mitigate volatility which arises out of brief bursts of 
liquidity demand.
The New York Stock Exchange's Market Model
    The New York Stock Exchange has embraced electronic trading, and we 
believe our market model provides the best combination of cutting-edge 
technology and human judgment. The New York Stock Exchange market rules 
expressly provide mechanisms to mitigate volatility and large price 
swings--which we have always believed is a critical piece of our 
offering to listed companies and their investors.
    Specifically, the hybrid design of the New York Stock Exchange 
incorporates in its trading structure a type of circuit breaker 
mechanism, known as Liquidity Replenishment Points (``LRPs''), which 
temporarily and automatically pause trading in stocks when significant 
price moves occur. The LRPs are triggered by specific criteria based on 
the prices of particular stocks, which criteria are included in our 
rule book and were approved by the SEC. On a typical day, LRPs are 
triggered a few hundred times, lasting for seconds at most, and served 
the market well during the recent financial crisis.
    LRPs are designed to allow pauses and judgment to supplement 
artificial intelligence when trading appears irrational. The New York 
Stock Exchange's human liquidity providers absorb the news and trading 
patterns with respect to individual stocks and can conduct auctions of 
order imbalances. To be clear, the LRP mechanism does not halt trading 
and does not allow liquidity providers to Written Statement of Larry 
Leibowitz, step away from the market. Instead, for a short time, 
trading is automatically paused to facilitate more accurate price 
discovery, mitigate confusion and reduce panic, and prevent the market 
from experiencing a sudden and significant move. During this pause our 
quote is visible to other market participants and new orders are 
accepted. Our LRPs are analogous to taking the controls of a plane off 
autopilot during turbulence.
    Necessarily, and beneficially, this process is more deliberate and 
time consuming than fully electronic trading. Although Regulation NMS 
permits electronic trading to ignore the New York Stock Exchange when 
we are in our circuit-breaker mode, many market participants 
specifically chose our mode of trading in this time of stress: during 
the 20-minute period of focus on May 6, including the periods when the 
New York Stock Exchange was in LRP mode, market share on the New York 
Stock Exchange was 5 percentages points higher than usual during that 
time of day, and the participation rate of our Designated Market Makers 
(formerly known as Specialists) and Supplemental Liquidity Providers 
was actually higher than usual. This is evidence that our liquidity 
providers did not walk away from the market as we actively traded 
during the downturn.
    Once the New York Stock Exchange's circuit breakers were triggered, 
prices on the New York Stock Exchange were dramatically different from 
prices on electronic exchanges that did not have in place a similar 
circuit breaker mechanism. Because the New York Stock Exchange had 
switched to LRPs, and because Regulation NMS allows traders to bypass 
us, orders were routed to electronic markets that had not mitigated the 
volatile price declines and which had limited amounts of liquidity on 
their books.
    To demonstrate that LRPs protected orders in our market, stocks 
listed on other markets had price declines and erroneous executions far 
greater than stocks listed on the New York Stock Exchange. For 
instance, while Proctor and Gamble traded no lower than $56.00 on the 
New York Stock Exchange during the 20-minute period of focus, it traded 
as low as $39.37 on electronic exchanges. In terms of erroneous 
executions, the overall marketplace needed to cancel approximately 
15,000 executions after Thursday's decline. On the New York Stock 
Exchange--even though we handled the largest share of orders in the 
marketplace--we had to cancel ZERO trades because of the protective 
measures in our market--while still trading more shares than any other 
venue. In fact, 85 percent of the trades that ultimately were canceled 
were securities that were not listed on the New York Stock Exchange.
    I emphasize these points to dispute the notion that the New York 
Stock Exchange stepped away from the marketplace during this crisis.
    We should note that LRPs are not intended to prevent the market 
from falling; indeed that is not the role of an exchange, and could not 
be achieved by any one market. Rather, our LRPs are designed to protect 
the integrity of our market by preventing a panic-led downdraft and 
mitigating systemic risk. Yet, when we are in this ``slow'' mode, other 
electronic markets may choose to ignore our quotes, as permitted under 
Regulation NMS. Thus, a circuit breaker on a single trading market, 
such as the New York Stock Exchange, is not able to staunch volatile 
and panicked trading on other markets especially if those markets 
choose not to participate in our circuit-breaker mechanisms.
    The bottom line is that while there is always room to improve LRPs 
and other such mechanisms, these actually worked well on May 6th. 
However, the mechanism is only truly effective if observed by other 
trading venues, and that's why Chairman Schapiro's plan for an 
industry-wide trading circuit breaker is needed.
Recommendations
    One clear lesson of May 6 is that our markets need a predictable, 
preestablished, coordinated way to respond to extreme and rapid market 
volatility. The LRP system has worked, but market-wide circuit breakers 
are necessary and will be even more effective. The listing and trading 
venues, under the SEC's guidance, have filed proposals to adopt stock-
level circuit breakers to pause trading when the price of a security 
has changed by 10 percent in a 5-minute period. Once circuit breakers 
have been triggered in a security, they will apply to all trading in 
the security, wherever it takes place, with the decision to invoke and 
reopen governed by the primary listing market. In this regard, we would 
also highlight the order protection rules under Regulation NMS. The 
original intent of the rule may have been to give automated markets the 
option of bypassing a market that was temporarily operating in a manual 
mode. In practice, however, the ability of markets to bypass a manual 
market by default resulted in a situation where markets effectively 
chose to ignore and trade around our quotes once our Written Statement 
of Larry circuit breakers were triggered. While we feel the LRPs helped 
the market overall on May 6th and certainly did not exacerbate the 
problems, most of the benefit accrued to orders on the NYSE 
marketplace, and the events of May 6 have demonstrated that it may be 
time to reconsider routing practices that trade through functioning 
quotes as a default matter.
    Second, the current market-wide circuit breakers were established 
long ago and are based on market moves of 10 percent, twenty percent 
and thirty percent. There has not been a move greater than 10 percent 
in a single day post-2000. These levels should be tightened, and the 
circuit breaker should be based on a broader index rather than a narrow 
Dow Jones index.
    Third, the rules on cancellation of trades should be further 
defined. On May 6, it was announced after markets closed that any 
trades executed at 60 percent above or below the last price at 2:40 
p.m. would be canceled. This action was not predictable and caused 
confusion in the markets. We are working with regulators and other 
exchanges to establish clear cancellation rules for the future, which 
set thresholds and circumstances under which trades will be canceled or 
adjusted, to correct errors rather than market-wide movements.
    Fourth, brokers should review their order routing practices to 
ensure they are truly getting the best prices for their clients, and 
also see whether allowing market orders and Stop Loss orders really 
service the investing public, or whether there are things we can 
jointly do to educate and protect retail investors from being the 
victims of volatile markets.
     Fifth, to facilitate a review of extraordinary trading events, 
there should be a consolidated audit trail that would allow regulators 
to easily review market-wide trade data. Having such a mechanism in 
place very likely would have aided the review of the May 6 events. We 
understand the SEC is developing such a proposal, and we are committed 
to assisting in that effort.
    We also note that the SEC has recently proposed regulations that 
would govern the risk controls applicable to providers of market 
access, to provide more transparency to the equities markets more 
broadly, and more generally review the functioning of the equities 
markets, and we have expressed our support for many of these proposals. 
In order to both avoid similar trading events and to facilitate 
surveillance, there should be uniform standards across markets that 
govern the risk controls and procedures that market access providers 
are required to implement. In addition, the SEC has proposed rules to 
gather information from large traders. These proposals may address some 
of the problems associated with aggregating and reviewing trading 
activity.
    Ultimately, these and other important actions may best be achieved 
by consolidating market surveillance in one securities self-regulator--
probably FINRA, which would require an act of Congress. We also need to 
ensure both the SEC and FINRA have the funding required to perform 
these duties.
    Finally, the SEC should continue its broad-based market review to 
help find ways to improve our current market structure.
Conclusion
    The events of May 6, 2010 demonstrate that the markets would 
benefit from a comprehensive structural review of the rapid advances in 
technology and their effect on trading practices and market integrity. 
As you know, the SEC has already commenced such a review, issued 
several rule proposals and has indicated that other proposals are 
forthcoming. We are committed to working with the SEC in these 
initiatives, and we strongly urge all parties to play an active and 
responsible role in helping our market function in a way that gives 
investors confidence. In addition, we applaud the SEC and the CFTC for 
working together to review the events that transpired on May 6, their 
extraordinary effort in producing their May 18, 2010 preliminary 
findings, and their continued work to develop a coordinated solution to 
prevent a recurrence of those events.
    Once again, thank you for the opportunity to appear before the 
Subcommittee. I would be happy to answer any questions you have.
                                 ______
                                 
                    PREPARED STATEMENT OF ERIC NOLL
          Executive Vice President, The NASDAQ OMX Group, Inc.
                              May 20, 2010
    Good afternoon Chairman Reed, Ranking Member Bunning and 
Subcommittee members. Thank you for offering the NASDAQ OMX Group, Inc. 
the opportunity to share our perspective on the events of May 6th. As 
Executive Vice President of NASDAQ U.S. Transaction Services, I have 
responsibility for trading of equities and options on the NASDAQ Stock 
Market, as well as trading on NASDAQ's markets in Philadelphia and 
Boston, NASDAQ OMX PHLX and NASDAQ OMX BX.
    NASDAQ understands the critical role of capital markets in the U.S. 
economy and the obligations of all national markets to protect U.S. 
investors. We have studied the events of May 6th and what they suggest 
about the current operation of the U.S. equities markets. It is 
important to learn the lessons that are available from May 6th and to 
prevent a repeat of those events.
    To accomplish that, we have worked closely with the Securities and 
Exchange Commission, the CFTC, the New York Stock Exchange, and other 
national securities exchanges to protect investors. We have met with 
senior officials and staff at the SEC to identify opportunities to 
improve regulation and to develop a coordinated strategy to combat 
market instability. We support the Commission's and the CFTC's actions 
in four areas:

  (1)  Updating existing market-wide circuit breakers to include 
        tighter parameters and a broader index reference point;

  (2)  Establishing new stock-by-stock circuit breakers that include an 
        element of ``velocity'' or rapidity of price changes,

  (3)  Improving the handling of trade breaks during unusual market 
        events to maximize consistency and rationalize moral hazard; 
        and

  (4)  Changing the use of quotes and specific order types that 
        impacted trading on May 6th.

The focus of these changes is consistency. While each individual 
exchange reports that its systems functioned according to design on May 
6th, the changes currently being considered will improve the markets' 
collective ability to handle unusual trading events in the future and 
help to restore investor confidence in the safety of U.S. markets. 
Markets like consistency and predictability; they abhor uncertainty.

    We believe NASDAQ is qualified to assist the Commission at times of 
market stress. We are the world's largest exchange company. We list 
over 3,700 public companies, operate 22 markets and 10 clearinghouses 
worldwide, provide technology to over 70 exchanges, clearing 
organizations and central securities depositories in over 50 countries, 
and regulate the trading and clearing of equities, options, 
commodities, and derivatives across the globe. We understand the role 
we play in serving and protecting millions of investors in the United 
States and around the world that rely on the safety and predictability 
of our markets to grow their savings and safeguard their futures.
    U.S. capital markets are the deepest, fairest, most effective 
markets in the world. Our cash equities markets have been and remain 
the engine of sustainable economic growth, allowing U.S. companies to 
raise trillions of dollars in capital, create millions of jobs, and 
spur new industries around the globe. Cash equities markets functioned 
without interruption during the financial meltdown of 2008 and 2009, 
unlike the credit and derivatives markets. Our markets are strong, 
despite the seventeen minutes of unusual trading that occurred between 
2:39 and 2:56 p.m. on May 6th. In fact, the markets' rapid recovery 
that day confirms that our markets are resilient and strong even under 
extraordinary strain.
    We have been studying and will continue to study the data and 
behaviors recorded on May 6th. To understand fully the events of May 
6th, it is important to understand the information the markets were 
trying to process. Markets were nervous. Equity markets had experienced 
an unusually long and large upward price movement, with the NASDAQ 
Composite Index nearly doubling between March 9, 2009 and April 26, 
2010. Market analysts will tell you that following such gains, it is 
not unusual for markets to experience a price correction.
    Markets were becoming increasingly volatile. NASDAQ monitors the 
CBOE Volatility Index or VIX, which measures the implied volatility of 
the S&P 500 expected over the next 30 days. The VIX generally measures 
below 20. It rose during the financial crisis, reached a high of 89 on 
October 24, 2008, and then gradually declined throughout 2009 and early 
2010. From February 26, 2010 through April 26, 2010, the VIX 
continuously stayed below 20, dropping below 16 on April 12th and April 
20th. Volatility returned on April 27th, when the VIX once again broke 
above 20 and began rising steadily. By May 5th the VIX reached the 
upper 20s, and on May 6th and 7th it closed above 30.
    This increased volatility was tied to the escalating financial 
crisis in Greece and the Eurozone. Although the issues in Greece had 
been developing for several months, the potential harm seemed to sink 
in to U.S. markets only within the week prior to May 6th. Credit 
ratings agencies had just lowered their rating of the sovereign debt of 
Greece, Spain and Portugal, roiling sovereign debt markets; the 
European Union and International Monetary Fund were working to fashion 
workable bailouts; and social tensions and violence escalated in 
Athens. The Euro had lost 15 percent of its value in the last 6 months, 
including 7 percent in the prior 2 weeks alone.
    Against this backdrop, we experienced a unique confluence of events 
beginning at 2:35 p.m. on the afternoon of May 6th. First, the Dow 
Jones Industrial Average was already trading off 272 points for the day 
and 500 points in the previous 3 days. Market conditions were already 
volatile.
    Second, the Chicago Mercantile Exchange received an unusually large 
institutional order to sell futures tied to the S&P 500 Index. Futures 
are a forward indicator for prices of equities and options that are 
also tied to the S&P 500 Index. Thus, when S&P futures prices begin 
sinking rapidly at 2:42, this was followed closely by rapid price 
declines in S&P-linked equities. At 2:45:30, S&P futures trading became 
so negative that the Chicago Mercantile Exchange triggered a ``Stop 
Price Logic Event'' that caused an automatic 5-second pause in S&P 
futures trading to collect liquidity. Given CME's near-100 percent 
market share in S&P futures, the Stop Price Logic Event was, 
effectively, a market-wide halt. When trading resumed, futures prices 
immediately leveled off and began to climb rapidly. Shortly after, 
equities prices also rose rapidly. After a thorough review, the CME has 
announced that its systems functioned properly that day and that there 
was no evidence of wrongdoing or clear errors by CME or CME members.
    Third, the NYSE Arca Exchange, the all-electronic market operated 
by NYSE, began experiencing data communication issues that hindered the 
electronic linkages between it and NASDAQ, the BATS Exchange, and the 
Chicago Board Options Exchange. When Arca became unable to communicate 
properly, this signaled other markets to stop sending orders to it. 
This is exactly what happened; NASDAQ, BATS and CBOE each stopped 
sending orders to Arca at a critical point in time. Again there is no 
evidence of inappropriate activity at Arca. Nevertheless, its liquidity 
became less unavailable at a critical time.
    Fourth, simultaneous with events at NYSE's electronic Arca 
exchange, the NYSE hybrid market began reporting multiple ``Liquidity 
Replenishing Points'' and ``gap quotes'' that impacted the trading of 
individual S&P stocks in the NYSE market. Under SEC Regulation NMS, the 
NYSE is permitted to issue LRPs and gap quotes. What this did, in our 
view, was to signal other markets that NYSE was experiencing order 
imbalances or other difficulties. This, in turn, signaled that other 
markets may stop routing orders to NYSE and trade at other markets 
instead. This is exactly what happened; NASDAQ and other markets 
stopped routing orders to NYSE. Even Arca, NYSE's own all-electronic 
market, stopped routing orders to NYSE. NYSE was the only market to 
issue LRPs or gap quotes on May 6th.
    This confluence of events caused a rapid drop in the markets. From 
2:39 to 2:47 p.m. the Dow dropped 723 points to 9869, its low for the 
day and down 995 points total from the prior close. From 2:47 to 2:56 
the Dow recovered just as rapidly, risings 612 points from 9862 to 
9974, down 387 points for the day. From 2:56 p.m. to the close the Dow 
rose another 45 points, ending the day down 342 points.
    How should we respond to these events? As you know, the markets and 
market participants are subject to multiple layers of regulation; the 
Securities and Exchange Commission oversees trading and markets, 
including regular and special examinations of markets and market 
participants. There was in place a market-wide circuit breaker that 
limits aggregate movement of market indices, but it was not triggered. 
NASDAQ and other markets have ``collars'' that limit the impact of 
individual market orders, but there were limited numbers of market 
orders entered that day. Members have obligations to have procedures, 
controls, and systems in place to limit aberrant trading and control 
risk. The Financial Industry Regulatory Authority, acting as NASDAQ's 
agent, examines firms to ensure that those procedures, controls, and 
systems are in place and effective. Should these safeguards have 
prevented the rapid decline and recovery in the markets on May 6th? We 
have already begun to re-examine each of these safeguards in light of 
those events.
    From a systems standpoint, NASDAQ's market operated continuously 
throughout the day and throughout the critical seventeen minutes. Each 
and every one of NASDAQ's electronic systems functioned as designed and 
as intended. Its execution engine, market data feeds, and surveillance 
systems all functioned as designed. Each exchange is reporting that its 
individual systems functioned as designed. That said, no market center 
or regulator can be satisfied with the collective performance of the 
markets on May 6th. As discussed earlier, the Commission and the 
exchanges are developing coordinated strategies to improve the 
exchanges' collective ability to respond to unusual trading events.
    What did NASDAQ See and Do? NASDAQ operates one of the most heavily 
monitored exchanges in the world. NASDAQ's MarketWatch and Trading 
Operations departments monitor our equities markets from 6:30 a.m. to 8 
p.m. using sophisticated technology that looks for trading anomalies, 
market rumors and manipulations. These departments process 17,000 phone 
calls in the average month and MarketWatch reviews more than 50,000 
issuer press releases in the average year.
    At 2:23pm NASDAQ's automated surveillance systems began issuing 
alerts in multiple securities exhibiting unusual price movements. In 
response to the alerts, NASDAQ's regulatory staff in the MarketWatch 
and Trading Operations departments began reviewing trading activity. 
NASDAQ's MarketWatch group uses high speed technology to oversee 
trading in the NASDAQ equity venues. On average the MarketWatch's 
surveillance system processes 1.9 billion equity related messages a 
day. On May 6 there was a large spike in surveillance alerts generated 
that coincided with the largest drops in the Dow Jones Industrial 
Average.
    At 2:30 p.m. the Chicago Board Options Exchange issued a 
communication stating ``The CBOE has declared Self Help against NYSE/
ARCA as of 1:30 CT. The NYSE/ARCA is out of NBBO and unavailable for 
linkage. All CBOE systems are running normally.'' Under SEC Rule 611 
under Regulation NMS, CBOE's announcement signaled that CBOE had 
stopped attempting to trade with NYSE's all-electronic Arca exchange 
pending renewed communication from that exchange
    At 2:36:59 NASDAQ systems also detected a data disruption at NYSE 
Arca and NASDAQ also declared ``Self Help'' against that exchange. At 
2:42 p.m., NASDAQ published a ``System Status'' update on its member 
website stating ``NASDAQ has declared Self Help against NYSE ARCA 
(ARCA) as/of 14:36:59 E.T. All NASDAQ systems are operating normally.''
    At 2:43 p.m. NASDAQ issued another System Status update stating 
that NASDAQ OMX BX had also declared Self Help against NYSE Arca as of 
14:38:40. All NASDAQ systems were operating normally.
    At 2:45:30, trading in E-Mini futures became so volatile and 
negative that the Chicago Mercantile Exchange triggered an automatic 5-
second pause in E-Mini futures trades.
    At 2:48 p.m., NASDAQ MarketWatch communicated with NYSE Arca's 
regulatory staff about regulatory alerts being generated by NASDAQ's 
market surveillance systems. NYSE Arca staff confirmed that they also 
had detected unusual trading activity. Neither market had received any 
communication from members regarding system malfunctions or errant 
orders that might have contributed to price movements.
    At 2:49 p.m. the BATS Exchange declared Self-Help against the NYSE 
Arca Exchange. As of 2:49 p.m. four markets had declared Self-Help 
against NYSE's all-electronic Arca exchange.
    At 3:00 p.m., NASDAQ staff opened an internal call including key 
NASDAQ personnel from multiple departments. NASDAQ uses this procedure 
where necessary to gather knowledge quickly and to respond effectively 
to unusual trading activity. The call lasted until nearly 1:00 a.m. the 
following morning.
    At 3:16 p.m. NASDAQ took the lead and initiated a market-wide call 
for the entire national market system. The triggering of a market-wide 
call is designed to establish communication and ensure coordination 
among exchanges that trade the same securities. It has become a 
critical procedure for exchanges to manage events such as this that 
involve cross-market trading activity. At 3:56 p.m. observers from the 
SEC's MarketWatch and Trading and Markets staff joined the market-wide 
call initiated by NASDAQ.
    At this point, NASDAQ began focusing communication on the 
identification and treatment of ``clearly erroneous trades'', those 
trades that might be broken or unwound as a result of the market 
events. NASDAQ issued the following System Status update on its website 
at 3:37 p.m. ``NASDAQ is currently working with other markets to review 
the broad market activity that occurred between 2:00 and 3:00 p.m. 
today. NASDAQ will advise when more information is known.''
    At approximately 4:00 p.m. the markets jointly determined to review 
and potentially break trades that occurred between 2:40 and 3:00 p.m. 
The markets briefly considered breaking trades executed between 2:30 
p.m. and 3:00 p.m. but they then decided collectively upon the 2:40 
p.m. start time instead. Trades outside this period were still eligible 
for review by individual exchanges under their own authority. At 4:24 
p.m. NASDAQ issued another System Status update announcing the decision 
to review trades that occurred between 2:40 and 3:00 p.m.
    After jointly determining which trades to review, the markets 
jointly continued to discuss which trades to break. There was debate 
among the exchanges regarding the proper break point for trades 
executed between 2:40 and 3:00 p.m. After extended discussion, the 
exchanges each agreed on a joint market ruling to cancel trades during 
the review period that deviated by greater than 60 percent from the 
consolidated last sale price in that security at 14:40 or immediately 
prior. Each exchange communicated this information to its members; 
NASDAQ announced the decision to its members via a System Status update 
published at 6:03 p.m.
    NASDAQ staff continued reviewing trades until after midnight on May 
7th. NASDAQ regularly communicated rulings to its members by issuing 
System Status updates at 8:24 p.m., and 12:25 a.m. Additionally, at 
8:28 p.m. NASDAQ issued a press release describing the market events 
and the decision of all markets jointly to break trades. It is 
important that trades be broken quickly, if at all, to avoid negative 
impact on clearing and settlement.
    Multiple equities and options exchanges broke trades executed 
between 2:40 and 3:00 p.m. on May 6th. In addition to over-the-counter 
trades broken by FINRA, and trades broken by the BATS Exchange, NYSE's 
electronic Arca exchange broke over 4,000 trades, and NASDAQ broke over 
10,400 trades representing 1,410,692 shares in 236 unique securities. 
To put this into perspective, from 2:40 to 3:00 p.m., NASDAQ executed 
over 2.4 million trades representing over 500 million shares traded. In 
other words, NASDAQ broke less than one half of 1 percent of trades and 
roughly one-quarter of 1 percent of shares executed during the 20-
minute period from 2:40 to 3:00 p.m. on May 6th.
    NYSE called LRPs or slow quotes in all 42 stocks listed on its main 
market in which NASDAQ broke trades. Over 90 percent of the 236 
securities in which NASDAQ broke trades were listed on NYSE, NYSE Arca 
or NYSE Amex. Over 87 percent of the trades and 89 percent of the 
executed shares broken by NASDAQ were in NYSE-listed securities. NASDAQ 
declared no slow quotes in the 20 stocks listed on its market in which 
trades were broken.
    Why Do The Markets Break Trades? Markets break executed trades when 
the price discovery process ceases to function properly and trade 
prices cease to reflect a true market. For such circumstances, the SEC 
has approved uniform clearly erroneous rules across all U.S. cash 
equities markets giving the exchanges the self-regulatory authority to 
cancel clearly erroneous trades executed by their systems. We followed 
those rules.
    The exchanges can review trades and exercise this authority on 
their own initiative in response to extraordinary market conditions, 
or, upon the timely request of a party to a particular trade(s). Trade-
break authority exists to nullify trades that take place in market 
conditions where errors, be they human or technological, or other 
unanticipated events, preclude fair and proper price-discovery. The 
primary topic of the market-wide call was to determine whether the 
exchanges would coordinate their regulatory efforts to break trades 
that were considered ``clearly erroneous.''
    NASDAQ's clearly erroneous trade policies strive to maximize 
consistency, transparency and finality regarding trade-break decisions. 
NASDAQ pioneered the use of standardized numerical parameters that seek 
to define how far a trade must deviate from previous transactions in 
order to be considered erroneous. By focusing on objective numerical 
criteria rather than subjective criteria, NASDAQ avoids even the 
appearance of bias in the trade break process. These standardized 
criteria have now been adopted by all U.S. exchanges. It is important 
to remember that every trade has two parties--generally one will be 
happy to break the trade and avoid a loss while the other will want to 
keep the trade and any gain he or she has made. Therefore, it is 
important that NASDAQ use its authority only where necessary.
    One key component to NASDAQ's approach to clearly erroneous trade 
processing is the belief that it is important, where possible, to allow 
transactions priced close to the inside market or other reference price 
to stand, even if the transactions directly resulted from a mistake or 
system error. This ensures that market participants have economic 
incentives to develop and maintain internal controls with a goal of 
preventing erroneous trading activity. NASDAQ refers market 
participants for investigation by the Financial Industry Regulatory 
Authority (``FINRA'') in its capacity as NASDAQ's regulatory services 
provider in all circumstances where a firm's erroneous trades raise 
questions as to the adequacy of the firm's computer systems and 
internal controls.
What Lessons Can We Learn From Trading On May 6th?
    NASDAQ's preliminary analysis indicates that unusual trading 
activity on May 6th was triggered by a confluence of unusual events, 
including events outside the cash equities markets. Aggressive, nervous 
selling of S&P 500 options and futures migrated to trading of closely 
correlated cash equities. Cash equity markets then experienced several 
challenging conditions as described above. NASDAQ experienced no system 
malfunctions or aberrations. No NASDAQ member has identified to NASDAQ 
a system error or aberration within their own systems. We have at this 
point in time detected no system malfunction or errant trade by a 
NASDAQ member interacting with the NASDAQ Stock Market. NASDAQ 
continues to investigate the events of May 6th, but has at present 
located no ``smoking gun'' that single-handedly caused or explains 
those events.
    We note that although index products such as ETFs linked to the S&P 
500 Index were involved in the trading events on May 6th, there is no 
evidence that ETFs caused those events. To the contrary, the unusual 
trading and subsequent trade breaks in ETFs can be explained by 
existing market structure and characteristics of ETF trading. ETFs are 
widely used as a tool for gaining exposure to the broad market, 
particularly during periods of high volatility. Therefore, demand for 
ETF liquidity was likely rising during the May 6th trading event. While 
ETF demand was increasing, ETF liquidity was decreasing. NYSE Arca, 
which lists ETFs and is a source of ETF liquidity (particularly for 
thinly traded ETFs) was experiencing communications and linkage issues. 
Three markets had stopped routing orders to it, effectively removing 
Arca's liquidity from the marketplace. The resulting liquidity 
imbalance in ETFs exacerbated the rapid price changes that many stocks 
were experiencing at that time. In other words, the events of May 6th 
affected ETFs more than many other securities but not differently.
    NASDAQ supports the rapid and holistic response by the Securities 
and Exchange Commission. We support the Commission's recommendation to 
update market-wide circuit breakers that limit large price changes. The 
proposed circuit breaker would automatically halt trading in all stocks 
and in all markets in measured stages. As currently contemplated, 
trading will be halted for fifteen minutes when the S&P 500 Index 
declines by 5 percent; for 1 hour when the Index declines by 10 
percent; and for the remainder of the trading day when the Index 
declines by 20 percent.
    NASDAQ also supports the Commission's decision to implement cross-
market single-stock trading halts. The important characteristics of 
these halt are initiation and resumption by the primary market, as well 
as consistency across all markets. The markets have taken a flexible 
approach that recognizes that stocks trade in different ways, rather 
than a one-size-fits-all approach that treats all stocks identically. 
These single stock circuit breakers will greatly reduce the occurrence 
of clearly erroneous broken trades by preventing them from executing in 
the first instance.
    In addition to endorsing and assisting Chairman Schapiro in 
achieving the goal of consistency and cooperation across all markets, 
NASDAQ also supports regulators' decision to review practices that 
cause individual markets to pause or go slow. As stated in the joint 
SEC and CFTC report issued on May 18, 2010, ``Preliminary Findings 
Regarding the Market Events of May 6th'', while such practices are 
designed to dampen volatility, a determination must be made whether 
they also ``inappropriately impede liquidity.''
    Finally, NASDAQ is exploring other ideas which may encourage high-
quality and continuous quoting on all markets. Other options to 
consider that may reduce the number of disruptive trading events are: 
(1) requiring priced orders rather than market orders; (2) eliminating 
or limiting the practice of ``stub quoting;'' and (3) creating better 
incentives to provide liquidity during periods of market stress. NASDAQ 
has already been a leader in promoting more aggressive risk management 
controls for al orders entered into all market centers. NASDAQ has 
actively supported the Commission's proposal to improve regulation of 
all forms of market access that create systemic risk in our markets.
    Thank you again for the opportunity to share our views. I am happy 
to respond to any questions you may have.
                                 ______
                                 
                PREPARED STATEMENT OF TERRENCE A. DUFFY
                   Executive Chairman, CME Group Inc.
                              May 20, 2010
    I am Terrence A. Duffy, executive chairman of CME Group Inc. Thank 
you Chairman Reed and Ranking Member Bunning for inviting us to testify 
today. You asked us to discuss issues surrounding the activity in the 
equity markets on Thursday, May 6, 2010, particularly to review the 
causes and implications of the market activity as well as to identify 
what policy changes may be necessary to avoid a recurrence of such 
activity.
    CME Group is the world's largest and most diverse derivatives 
marketplace. We are the parent of four separate regulated exchanges, 
including Chicago Mercantile Exchange Inc. (``CME''), the Board of 
Trade of the city of Chicago, Inc. (``CBOT''), the New York Mercantile 
Exchange, Inc. (``NYMEX'') and the Commodity Exchange, Inc. 
(``COMEX''). The CME Group Exchanges offer the widest range of 
benchmark products available across all major asset classes, including 
futures and options on futures based on interest rates, equity indexes, 
foreign exchange, energy, metals, agricultural commodities, and 
alternative investment products. The CME Group Exchanges serve the 
hedging, risk management and trading needs of our global customer base 
by facilitating transactions through the CME Globex' 
electronic trading platform, our open outcry trading facilities in New 
York and Chicago, as well as through privately negotiated CME ClearPort 
transactions.
I. Introduction
    Since May 6, 2010, CME Group has engaged in a detailed analysis 
regarding trading activity in its markets on that day. Our preliminary 
review indicates that our markets functioned properly. We have 
identified no trading activity that appeared to be erroneous or that 
caused the break in the cash equity markets during this period. 
Moreover, no market participant in our markets reported that trades 
were executed in error nor did the CME Exchanges cancel (``bust'') or 
re-price any transactions as a result of the activity on May 6th. 
Moreover, the CME markets provided an important price discovery and 
risk transfer function on that day and served as a moderating influence 
on the markets.
    In the following sections, we discuss: (1) the functioning of and 
the role played by our markets on May 6, 2010, (2) the existing circuit 
breaker rules and the need for consistent and transparent rules across 
markets and (3) CME electronic functionality, particularly CME Stop 
Price Logic functionality and price banding, among others, which serve 
to protect our markets. Finally, we have also included certain 
recommendations as to changes that could avoid a recurrence of this 
type of event in the future.
II. The CME Markets Functioned Properly on May 6, 2010
a. CME Has Conducted an Initial Review of Detailed Trading Records
    CME Group analyzed trading volume and activity throughout May 6 and 
focused particularly on the activity taking place during the period of 
1pm to 2pm Central Time. Total volume in the June E-mini S&P futures on 
May 6th was 5.7 million contracts, with approximately 1.6 million or 28 
percent transacted during the period from 1pm to 2pm Central Time. 
During that hour, the market traded in a range of 1143.75 to 1056, or 
87.75 points--beginning the hour at approximately 1142 and ending the 
hour at approximately 1113. More than 250 CME Globex execution firms 
and 9,000 User IDs were active in the market during this period of 
time.
    During most of that hour, the bid/ask spread was a tick wide (.25 
points) and the market traded in a largely orderly manner despite the 
significant sell off and subsequent rally. At approximately 1:45:28, 
following a sharp 12.75 point decline over a period of approximately 
500 milliseconds on the sale of 1100 contracts by multiple market 
participants, the bid/ask spread widened to 6.5 points or 26 ticks for 
less than one millisecond.
    At that point, one of CME Globex's risk management functionalities, 
a CME Globex Stop Price Logic event, which is discussed in more detail 
below, was triggered. As a result, the market was automatically paused 
for 5 seconds to allow liquidity to come into the market. The market 
subsequently reopened at 1056.75, and thereafter rallied more than 40 
points to 1097 in the following 3 minutes.
    The Market Regulation Department reviewed a significant amount of 
activity during this period, a period that included more than 3 million 
system messages, and, in particular, examined the activity of 
participants whose trading activity during the 1-hour period was 
significant or otherwise warranted further review. The review conducted 
by Market Regulation staff has not identified any evidence of improper 
or illegal activity by market participants.
b. CME Markets Provided an Important Price Discovery and Risk Transfer 
        Function on May 6
    From a broader perspective, the cumulative record of May 6 trading 
activity underscores the fact that CME's futures markets, due to their 
high level of liquidity, provided an important price discovery and risk 
transfer mechanism for all market participants on that day.
    The equity index futures contracts traded on CME Group designated 
contract markets provide an essential risk management function, 
allowing investors to hedge their exposure against a portfolio of 
shares or equity options. The most significant equity index futures 
contract traded on the CME Group Exchanges is the E-mini S&P 500 
futures contract. In 2009, the E-mini contract traded over 556 million 
contracts, which represents an average daily volume in excess of 2.2 
million contracts, making the E-mini S&P futures contract the most 
liquid equity index futures contract worldwide. Throughout the 
challenging market conditions on May 6, market participants utilized 
the liquidity and efficiency of the E-mini S&P 500 futures contracts to 
meet their risk management needs; the contract effectively facilitated 
customer demand to hedge exposure to a declining broader market and, as 
will be shown below, represented a moderating factor during the 
session.
    The primary purposes of futures markets are to provide an efficient 
price discovery and risk management mechanism. In particular, the 
academic literature underscores the efficacy of futures markets as a 
tool of price discovery. According to one study, ``[e]mpirical results 
confirm that futures market plays a price discovery role, implying that 
futures prices contain useful information about spot prices.''\1\ As 
such, stock index futures frequently represent the venue in which price 
information is revealed first, generally followed closely by spot 
markets. In fact, most researchers find that ``futures lead the cash 
index returns, by responding more rapidly to economic events than stock 
prices.''\2\
---------------------------------------------------------------------------
    \1\ See Floros, C. and Vougas, D. V. (2007) Lead-Lag Relationship 
between Futures and Spot Markets in Greece: 1999-2001, International 
Research Journal of Finance and Economics, 7, 168-174.
    \2\ Kavussanos, Manolis G., Visvikis, Ilias and Alexakis, 
Panayotis, The Lead-Lag Relationship between Cash and Stock Index 
Futures in a New Market. European Financial Management, Vol. 14, Issue 
5, pp. 1007-1025, November 2008.
---------------------------------------------------------------------------
    Futures contracts, by design, provide an indication of the market's 
view of the value of the underlying stock index. Casual observation may 
lead to the conclusion that the E-mini S&P futures prices appeared to 
lead the decline in the cash market. However, the decline was 
consistent with declines in the most complementary equity derivative 
products, ETFs based on the same index, trading in the cash market. 
Unlike the cash market, the decline in the futures market was then 
mitigated by the operation of our risk management technology which 
halted the market for a short period to enable additional liquidity to 
enter into the futures market. Attached as Exhibit 1 is a chart which 
illustrates the comparative value of the E-mini, traded on the futures 
market, as compared to the equities markets. The ETF most comparable to 
the E-mini S&P 500 futures is the SPDR S&P 500 ETF Trust (SPY). The 
chart demonstrates that the E-mini S&P moved virtually in tandem with 
the comparable cash instrument until the moment when our Stop Price 
Logic was triggered which caused our matching engine to pause for 5 
seconds while continuing to allow new orders to be entered. At the time 
the Stop Price Logic was triggered, the E-mini S&P ceased its drop, 
while certain individual stocks in the cash market continued their 
steep decline. Following the halt, the E-mini S&P then rallied sharply. 
We believe this recovery was positively influenced by our Stop Price 
Logic functionality which stabilized market activity. This type of 
functionality is not available in the securities market. Consequently, 
even while the broad based index markets--SPYs and CME E-mini S&P--were 
substantially recovering, there were continued price declines in 
individual stocks which persisted for minutes (not seconds).
    More specifically, to illustrate this point, we reviewed the period 
from 13:30 to 14:00 (CT) during which the market activity occurred as 
depicted in Exhibit 2. E-mini S&P 500 futures were declining after 
13:30 (CT) followed by spot equity markets including Proctor & Gamble 
(PG), 3M (MMM) and Accenture (ACN). The June 2010 E-mini S&P 500 
futures traded at its low of 1,056.00 at 13:45:28 (CT), at which point 
the Stop Price Logic functionality was triggered halting the decline, 
and the market rallied following the 5-second halt. PG, MMM and ACN 
continued to slide even after futures hit their low and began to 
recover. Those stocks were put into a reserve mode by the New York 
Stock Exchange (NYSE) per its Rule 1000(a), Liquidity Replenishment 
Points, at 13:45:52, 13:50:36, 13:46:10 (CT), respectively; however, 
these stocks continued to decline. We believe that this decline 
continued because orders were re-routed to possibly less liquid 
security trading venues which were not coordinated with NYSE Rule 
1000(a). PG printed a low of $39.37 at 13:47:15 (CT); MMM printed a low 
of $67.98 at 13:45:47 while ACN printed a low of $0.01 at 13:47:54 
(CT). Thus, the E-mini S&P 500 futures were rallying while PG, MMM and 
ACN continued to decline.
    As stated above, we believe that this temporary de-linkage between 
the futures and stock markets may be attributed to inconsistent rules 
across the equity markets which enabled the stocks to decline even 
further.
    The trading activity during this time period also evidences that 
the futures markets provided an important source of liquidity which 
served as a moderating influence in the markets. There is strong 
evidence that the E-mini S&P futures contract was much more liquid than 
the fragmented underlying stock market on May 6. During the period 
between 1:40 and 2 CST, the volume of E-mini S&P futures (notionally 
adjusted) was 3 to 4 times greater than the SPY volume and, at the peak 
of the market's volatility, was to 8 to 10 times greater. As noted 
above, E-mini S&P 500 futures slightly lead SPYs during the downturn. 
Both E-mini S&P 500 futures and SPDRs turned around near 13:45:28. But, 
as shown in Exhibit 1, the rally in futures was relatively consistent 
and orderly in contrast to the rally in SPYs which was very uneven and 
was highlighted by a significant increase in cash equity market 
spreads.
    The second-by-second trading range, which is an indicator of the 
liquidity in the market, was much tighter in E-mini S&P 500 futures 
than in the comparable equity product, the SPYs. In examining the ratio 
of the futures trading range relative to the SPYs (SPDR) trading range 
in 1-minute intervals between 13:30 and 14:00 (CT), the respective 
trading ranges were very similar at the beginning of the period. By the 
height of the incident near 13:45-13:50, however, the ratio had fallen 
to as low as 20 percent that of the SPDR range. While all the markets 
were less liquid than in normal times, the liquidity in the futures 
market degraded much less than in the SPY market (which, in turn, 
degraded much less than the individual stocks, especially those stocks 
that are thinly traded.) This suggests that the futures order book was 
much deeper and more resilient than the SPDRs order book. In other 
words, the E-mini S&P 500 futures market continued to absorb trading 
volume and trade in an orderly fashion even in the face of apparent 
crisis in spot equity markets when liquidity was most sorely needed. As 
such, futures represented a moderating factor throughout the incident.
    If the futures market had not been available as an alternative, the 
selling would have manifested itself through another venue, potentially 
in a less liquid market, such as the underlying stock market or the OTC 
derivatives market. The relative tightness of the spread in the futures 
market underscores the fact that a concentration of liquidity supported 
the important price discovery and risk transfer role of the futures 
market.
III. Circuit Breaker Levels Should be Reviewed In View of May 6 and 
        Rules Should be Consistent Across Markets.
    One of the mechanisms that exchanges have implemented to curb 
market volatility are ``circuit breaker'' rules. Circuit breaker rules 
require an automatic halt in trading when pre-determined price 
thresholds are reached. CME Group Exchanges currently have circuit 
breaker rules in effect for equity index products which are consistent 
with the circuit breaker rules in the underlying equity markets.
    Circuit breaker rules were originally introduced following the 
September 1987 market crash. The circuit breakers were implemented 
uniformly across all equities and options exchanges and were set at a 
fixed price level tied to the DJIA. This rule was embodied in NYSE Rule 
80B. On October 27, 1997, the circuit breakers were triggered for the 
first time and the circuit breaker rules were subsequently modified to 
employ percentage declines of 10, 20 and 30 percent in the DJIA 
established at the start of each calendar quarter in lieu of the fixed 
point triggers previously used. That rule remains in effect.
    In addition to the coordinated circuit breakers, CME adopted price 
limit rules for its equity index contracts. The price limit structure 
and levels changed several times as the Exchange acquired more 
experience and as the trading halt rules in the equity market were 
modified.In January 2008, however, CME harmonized its price limit 
percentage thresholds to be fully consistent with the percentage 
thresholds reflected in NYSE Rule 80B (and also consistent with the 
methodology employed by the CBOT with respect to the DJIA futures). CME 
did, however, retain the references to the specific stock index that is 
the subject of the futures contract rather than tying these limits to 
movements in the DJIA, meaning, for example, that the E-mini S&P 500 
price limits are tied to price movements in the related index.
    CME implements an unconditional futures trading halt in the equity 
index futures when the primary stock market is halted, regardless of 
whether a particular index product has hit a limit or not. CME also 
enforces a 5 percent limit bid or offer policy during overnight 
electronic trading hours; if equity index futures are locked limited at 
8:15 a.m. Central Time (``CT'') and remain so at 8:25 a.m. CT in the 
lead month futures contract, there will be a trading halt in effect 
until the commencement of regular trading hours (floor and electronic 
trading). During the trading halt, the Exchange will provide an 
Indicative Opening Price of the re-opening of trading on CME Globex, if 
applicable. If the lead month futures contract is no longer locked 
limit at 8:25 a.m. CT, trading will continue with the 5 percent limit 
in effect. At 8:30 a.m. CT, the 5 percent overnight electronic trading 
hours limit no longer will be applicable.
    On May 6, the declines in the DJIA were just short of 10 percent at 
a time of day when the 20 percent trigger was in effect. As a result, 
the circuit breakers in the primary and the futures markets were not 
triggered. Accordingly, we believe that the current circuit breaker 
levels of 10, 20 and 30 percent, the duration of the halt and the time 
of day at which such triggers are applicable, should be reevaluated in 
light of current market conditions to determine whether any changes are 
warranted
    After May 6, CME staff reviewed the relevant processes and rules 
across the CME and equities exchanges to determine what protections 
existed in the operating rules of the numerous equities platforms in 
the event of a market disruption. Due to the fragmented nature of the 
equity markets, it appears to us that there is a lack of consistency 
across this market which could exacerbate issues in time of market 
stress.
    For instance, as noted above, we believe that the lack of 
consistency and coordination among equity platforms in the 
establishment of circuit breakers for individual stocks led to extreme 
market disruptions; when the NYSE rule circuit breaker rule was invoked 
with respect to trading in individual stocks, order flow circumvented 
the NYSE market and trading continued on other platforms which did not 
have comparable protections. Consequently, as a result of the lack of 
liquidity on these other platforms, trading in those individual stocks 
suffered significantly.
    We also note that in the aftermath of the May 6 incident, there was 
significant confusion in the equity markets over the cancellation or 
``busting'' of trades. The standards for cancellation of trades are not 
consistent or transparent across the equity markets as a whole. At the 
CME, we have clear standards for the implementation of ``no bust'' 
ranges (i.e., ranges within which trades may not be canceled) and error 
trades. These policies are clearly set forth in our rulebook and are 
posted on our website.
    We believe that, to ensure the integrity of the market and to 
promote market confidence among users, there must exist a clearly 
defined rule set which is transparent to market users, understood by 
market users and which is consistent across all markets.
IV. CME Has Risk Management Controls to Mitigate the Potential for 
        Disruption of its Markets
    In addition to the circuit breaker and price limit rules described 
above, CME has in place numerous risk management processes, procedures 
and systems to preserve the integrity of its market in light of the 
many risks associated with maintaining a primarily electronic market. 
For example, CME is the only exchange in the world that requires pre-
execution credit controls which become mandatory in June 2010. Appended 
as Exhibit 3 is a detailed list and description of the multitude of 
controls that the CME employs on its CME Globex system, including 
credit controls, messaging volume controls and risk protection policies 
and procedures.
    There are certain risk protection tools employed by the CME which 
are important to note individually and which are relevant to today's 
discussion. One of these tools, CME Globex Stop Price Logic 
functionality, was employed on May 6--its operation and effect are also 
described below. In addition, CME Exchanges have a number of other 
policies and procedures, such as our messaging policy and practice of 
registering Automated Trading Systems (``ATS'') that provide us with 
the tools to monitor and maintain orderly administration of the 
electronic markets and provide real time surveillance and oversight of 
trading activity.
a. Stop Price Logic Functionality
    The CME Globex system has a Stop Price Logic functionality which 
serves to mitigate artificial market spikes that can occur because of 
the continuous triggering, election and trading of stop orders due to 
insufficient liquidity. If elected stop orders would result in 
execution prices that exceed pre-defined thresholds, the market 
automatically enters a brief reserved state for a predetermined time 
period, ranging from 5--10 seconds. During this period, no orders are 
matched but new orders other than market orders may be entered and 
orders may be modified and canceled. The momentary pause that occurs 
when Stop Price Logic is triggered allows market participants the 
opportunity to provide liquidity and allows the market to regain 
equilibrium, thereby mitigating the potential for disruptive market 
moves.
    The stop spike price and time parameters in the E-mini S&P futures 
are 6 index points (approximately \1/2\ of 1 percent of the S&P 500 
index value) and 5 seconds, respectively.
    The Stop Price Logic was triggered on May 6th in the E-mini S&P 500 
equity index. At 1:45:27, 1 second prior to going into reserve state, 
the front month E-mini S&P 500 equity index futures contract was 
trading just under the 1070.00 level. Multiple parties entered the 
market selling and taking the market down to 1062.00. There was a stop 
order to sell 150 contracts at 1062.00 which moved the markets to 
1060.25, and elected additional stops that were filled down to 1059. 
The trades at 1059 triggered another 150 lot stop at 1059.00 which was 
executed down to a level of 1056.00, which would have elected 
additional stops.
    However, at this point, following the 6 point move from 1062 to 
1056, the front month E-mini S&P 500 equity index futures market went 
into reserve state as a result of Stop Price Logic functionality being 
triggered at 13:45:28. The market came out of this reserve state 5 
seconds later. As a result of this brief suspension of trading, the 
decline in the E-minis was halted and the market came out of the 
reserve state with an initial price of 1056.75, after which it rallied 
sharply. Consequently, we believe that the triggering of this 
functionality served its intended purpose of allowing market 
participants the opportunity to provide liquidity and permitting the 
market to regain its equilibrium.
b. Price Banding Functionality
    To ensure fair, stable and orderly markets, CME Globex subjects all 
orders to price verification using a process called price banding. The 
platform utilizes separate mechanisms for futures price banding and 
options price banding. Price banding prevents the entry of erroneous 
orders such as a bid at a price well above the market or an offer at 
prices well below the market which could trigger a sequence of market-
moving trades that require subsequent cancellations. In order to 
determine the level of price banding, CME Exchanges use the most 
current and relevant market information, including, for futures, 
trades, best bid and offer and implied bid and offer or indicative 
opening price, and for options, last price of an option or spread and a 
theoretical options price based on options pricing algorithms.
c. Protection Points for Market and Stop orders
    This CME Globex functionality automatically assigns a limit price 
(Protection Point) to futures market orders and stop orders to preclude 
the execution of these types of orders at extreme prices in situations 
where there is insufficient liquidity to support the execution of the 
order within an exchange-specified parameter of the current market.
    The Protection Point values vary by product, and in the E-mini S&P 
futures the Protection Point is established at 3 index points. The CME 
Globex system calculates the limit price for a Market Protected Order 
by applying the Protection Point value to the best bid or offer price 
(depending on the order's side of market) and by applying the 
Protection Point value to the trigger price for a Stop Protected Order. 
Any unmatched quantity remaining for a Market Protected or Stop 
Protected Order after it is executed to the Protection Point limit 
becomes a Limit Order at the Protection Point limit price.
d. Maximum Order Size Protection
    Maximum order size functionality on CME Globex prohibits entry of 
an order into the trading engine which exceeds a pre-determined 
quantity. For E-mini S&P 500 futures, the order size is 2,000 
contracts. This functionality provides protection against the so-called 
``fat finger'' trades.
    In addition, we would like to point out certain risk management 
practices and measures we take which, in addition to the risk 
management tools noted above, serve to mitigate potential problems that 
could result from electronic trading, particularly with high frequency 
trading.
e. Messaging Policies
    CME has in place certain controls and policies which are designed 
to avoid problems associated with excessive messaging by market 
participants. CME has instituted a CME Group Messaging Policy that 
encourages market participants to trade and quote appropriately without 
harming market liquidity or performance. Inefficient messaging slows 
system performance, negatively impacts other market participants and 
increases system capacity requirements and costs. To mitigate this, CME 
has implemented automated controls which monitor for excessive new 
order, order cancel and order cancel/replace messaging. If a session 
exceeds a designated message per second threshold over a 3-second 
window, subsequent messaging will be rejected until the average 
message-per-session rate falls below this threshold.
    CME has also instituted a policy of fining for excessively high 
messaging rates. This policy benefits all customers trading on CME 
Globex by discouraging excessive messaging abuses, which in turn helps 
to ensure that CME Globex maintains the responsiveness and reliability 
of the system. Under the CME Globex Messaging Policy, each clearing 
member firm must not exceed product-specific benchmarks, individually 
tailored to the valid trading strategies of each market. CME Group 
calculates benchmarks based on a per-product volume ratio, defined as 
the number of messages submitted for each executed contract in a given 
product.
f. Registration of ATS
    All Automated Trading Systems (``ATS'') using CME Globex are 
required to identify themselves as an ``ATS'' and register with the CME 
Group Exchanges. Subsequent to their registration, the CME Group 
Exchanges are able to monitor the trading activity of ATSs on both a 
real time and post-trade basis. CME has required ATS registration for 
its equity index products since 2006. This policy has now been expanded 
to ATS' for all products and we currently have over 10,000 ATS 
registered.ATSs are treated like any other market participant and are 
subject to the messaging policy. This, in turn, enables CME to prevent 
a malfunctioning trading system from impacting our markets.
V. High Frequency Trading Enhances Liquidity
    An important issue raised in this discussion is the contribution of 
high frequency traders (``HFTs'') to the current situation and their 
future role in the markets. As recently described in the SEC's Concept 
release on market structure, high frequency trading was identified as 
one of the most significant market structure developments in recent 
years. Although HFT is not clearly defined, ``it typically is used to 
refer to professional traders acting in a proprietary capacity that 
engage in strategies that generate a large number of trades on a daily 
basis.''
    CME believes that HFTs play an important role in the markets, 
particularly when such activities are engaged in the types of risk 
management procedures detailed in the previous section. HFTs are an 
important part of daily trading activity in the marketplace and have 
evolved in response to advancements in technology. This represents the 
natural evolution of technological advancements and improvements in the 
marketplace and the percentage of trading volume attributable to HFTs 
will likely continue to increase in the future. There is evidence that 
HFTs increase liquidity and transparency in the marketplace and narrow 
spreads which allows investors to buy and sell securities at better 
prices and at lower costs.
    It is also important to note that not all HFTs are alike. A 
significant proportion of HFTs on the CME promote liquidity by 
providing continuous markets in our products. As illustrated by the 
events of May 6, in analyzing the role of several HFTs, a majority of 
those entities' trading executed during the relevant 1-hour period was 
related to the firm's market making activities. Thus, before 
considering restrictions on HFT activity, consideration should be given 
to the beneficial role played by HFTs in providing liquidity during 
normal market activity as well as during times of increased market 
stress.
    The use of high frequency trading by proprietary trading firms, 
investment banks, hedge funds and index traders, among others, has made 
the marketplace more efficient and competitive for all market 
participants. Careful consideration should be given to any decision to 
place significant restrictions or limitations on HFTs that would be 
harmful to the marketplace and result in less efficient and less liquid 
markets. It is also important to note that automated trading or 
algorithmic trading has its origins in Europe. Accordingly, efforts to 
place limits or impose regulatory burdens on HFTs in the United States 
may encourage HFTs to shift the trading they currently conduct in the 
United States to Europe and other foreign jurisdictions that are 
already well-equipped to handle additional growth in both equities and 
futures.
    As noted above, CME Globex employs many risk management policies 
and procedures which assist in the mitigation of risk associated with 
any type of electronic trading, including that of HFTs. In addition, 
the CME Group Exchanges are proactive in monitoring the trading 
activity of HFT entities. In sum, CME believes that HFTs play an 
important role in the markets, particularly when such activities are 
engaged in with the types of risk management procedures detailed in the 
previous section.
VI. Recommendations
    As noted previously, CME has endeavored to extensively examine the 
activity in our markets on May 6, 2010. Upon review of the activity, to 
this point, we believe that there are potential changes which would 
improve the functioning of the markets during times of severe stress.
    Throughout this process we have worked closely with our regulator, 
the CFTC, as well as with other regulators not only to identify the 
causes of significant volatility on May 6, but also to assist in 
providing thoughts and recommendations for market improvement. Of 
course, as we continue to study the events further, we would be happy 
to contribute our further thoughts and recommendations.

    Circuit breakers, including circuit breakers for individual 
        stocks such as that implemented by the NYSE, must be harmonized 
        across markets. As we stated above, we believe that consistency 
        and transparency across markets benefits the market by 
        providing clarity in times of market stress. In reviewing the 
        trading activity of May 6, we believe that the lack of 
        consistency and coordination across markets exacerbated the 
        decline in price of certain individual stocks. The NYSE 
        exercised its Liquidity Replenishment Rule (i.e., its 
        individual stock ``circuit breaker'' rule) to slow down its 
        markets; Orders were then directed to other less liquid 
        electronic trading venues which had no such rule.

    Stop Price Logic functionality should be adopted across 
        markets, on a product by product basis, to prevent cascading 
        downward market movements. As evidenced by the trading activity 
        on May 6, we believe that our Stop Price Logic functionality 
        provided the opportunity to source needed liquidity at a 
        crucial time and contributed to allowing the market to gain its 
        equilibrium.

    The current circuit breaker levels of 10, 20 and 30 
        percent, the duration of the halt and the time of day at which 
        such triggers are applicable, should be reevaluated in light of 
        current market conditions to determine whether any changes are 
        warranted. A comprehensive, coordinated and quantitative review 
        of the market wide circuit breaker levels and duration of pause 
        should be undertaken across all market centers and trading 
        venues supporting equity based products, including cash 
        equities, single name and index options, single stock futures, 
        index futures and options on index futures and total return 
        swaps and structured products. Any effort should be examined 
        and coordinated across markets and the input of all market 
        operators should be sought.
        
        
        
                                 ______
                                 

  RESPONSE TO WRITTEN QUESTION OF SENATOR VITTER FROM MARY L. 
                            SCHAPIRO

Q.1. In your testimony, Chairman Schapiro, you described the 
events of May 6 as ``a 20-minute period during the afternoon of 
May 6'' in which ``the U.S. financial markets failed to live up 
to their essential price discovery function.'' As a result, you 
have announced that the SEC is focused on taking steps ``to 
reduce the likelihood of a recurrence of that day.''
    If it is the case that the ``flash crash'' was the result 
of high volume players pulling out of the market, removing a 
dramatic amount of liquidity, how will the changes the SEC 
intends to implement protect against that?

A.1. On September 30, 2010, the staffs of the SEC and CFTC 
released a report on the findings regarding the market events 
of May 6. As highlighted in that report, one of the key lessons 
learned from the events of May 6 is that many market 
participants employ their own versions of a trading pause--
either generally or in particular products--based on different 
combinations of market signals. While the withdrawal of a 
single participant may not significantly impact the entire 
market, a liquidity crisis can develop if many market 
participants withdraw at the same time. This, in turn, can lead 
to the breakdown of a fair and orderly price-discovery process, 
and in the extreme case trades can be executed at stub-quotes 
used by market makers to fulfill their continuous two-sided 
quoting obligations.
    In response to this phenomenon, and to curtail the 
possibility that a similar liquidity crisis can result in 
circumstances of such extreme price volatility, the SEC staff 
worked with the exchanges and FINRA to promptly implement a 
circuit breaker pilot program for trading in individual 
securities. The circuit breakers pause trading across the U.S. 
markets in a security for 5 minutes if that security has 
experienced a 10 percent price change over the preceding 5 
minutes. On June 10, the SEC approved the application of the 
circuit breakers to securities included in the S&P 500 Index, 
and on September 10, the SEC approved an expansion of the 
program to securities included in the Russell 1000 Index and 
certain ETFs. The circuit breaker program is in effect on a 
pilot basis through December 10, 2010.
    A further observation from May 6 is that market 
participants' uncertainty about when trades will be broken can 
affect their trading strategies and willingness to provide 
liquidity. In fact, in the staff interviews many participants 
expressed concern that, on May 6, the exchanges and FINRA only 
broke trades that were more than 60 percent away from the 
applicable reference price, and did so using a process that was 
not transparent.
    To provide market participants more certainty as to which 
trades will be broken and allow them to better manage their 
risks, the SEC staff worked with the exchanges and FINRA to 
clarify the process for breaking erroneous trades using more 
objective standards. On September 10, the SEC approved the new 
trade break procedures, which like the circuit breaker program, 
is in effect on a pilot basis through December 10, 2010.
    Going forward, SEC staff will evaluate the operation of the 
circuit breaker program and the new procedures for breaking 
erroneous trades during the pilot period. As part of its 
review, SEC staff intends to assess whether the current circuit 
breaker approach could be improved by adopting or incorporating 
other mechanisms, such as a limit up/limit down procedure that 
would directly prevent trades outside of specified parameters, 
while allowing trading to continue within those parameters. 
Such a procedure could prevent many anomalous trades from ever 
occurring, as well as limit the disruptive effect of those that 
do occur, and may work well in tandem with a trading pause 
mechanism that would accommodate more fundamental price moves.
