[Senate Hearing 111-922]
[From the U.S. Government Publishing Office]
S. Hrg. 111-922
EXAMINING THE EFFICIENCY, STABILITY, AND INTEGRITY OF THE U.S. CAPITAL
MARKETS
=======================================================================
JOINT HEARING
before the
SUBCOMMITTEE ON
SECURITIES, INSURANCE, AND INVESTMENT
of the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
and the
PERMANENT SUBCOMMITTEE ON INVESTIGATIONS
of the
COMMITTEE ON
HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS
UNITED STATES SENATE
ONE HUNDRED ELEVENTH CONGRESS
SECOND SESSION
ON
EXAMINING THE EFFICIENCY, STABILITY, AND INTEGRITY OF THE U.S. CAPITAL
MARKETS
__________
DECEMBER 8, 2010
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
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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
Dawn Ratliff, Chief Clerk
William Fields, 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 M. Stein, Subcommittee Staff Director
William Henderson, Republican Subcommittee Staff Director
Paul Saulski, SEC Detailee
Dean Shahinian, Senior Counsel
Levon Bagramian, Legislative Assistant
(ii)
?
COMMITTEE ON HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS
JOSEPH I. LIEBERMAN, Connecticut, Chairman
CARL LEVIN, Michigan SUSAN M. COLLINS, Maine
DANIEL K. AKAKA, Hawaii TOM COBURN, Oklahoma
THOMAS R. CARPER, Delaware SCOTT P. BROWN, Massachusetts
MARK L. PRYOR, Arkansas JOHN McCAIN, Arizona
MARY L. LANDRIEU, Louisiana GEORGE V. VOINOVICH, Ohio
CLAIRE McCASKILL, Missouri JOHN ENSIGN, Nevada
JON TESTER, Montana LINDSEY GRAHAM, South Carolina
CHRISTOPHER A. COONS, Delaware MARK KIRK, Illinois
Michael L. Alexander, Staff Director
Brandon L. Milhorn, Minority Staff Director and Chief Counsel
Trina Driessnack Tyrer, Chief Clerk
Patricia R. Hogan, Publications Clerk and GPO Detailee
______
PERMANENT SUBCOMMITTEE ON INVESTIGATIONS
CARL LEVIN, Michigan, Chairman
THOMAS R. CARPER, Delaware TOM COBURN, Oklahoma
MARK L. PRYOR, Arkansas SUSAN M. COLLINS, Maine
CLAIRE McCASKILL, Missouri JOHN McCAIN, Arizona
JON TESTER, Montana JOHN ENSIGN, Nevada
CHRISTOPHER A. COONS, Delaware
Elise J. Bean, Staff Director and Chief Counsel
Christopher J. Barkley, Minority Staff Director
David H. Katz, Counsel
Ty Gellasch, Office of Senator Carl Levin
Mary D. Robertson, Chief Clerk
Anthony Cotto, Counsel to the Minority
(iii)
?
C O N T E N T S
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WEDNESDAY, DECEMBER 8, 2010
Page
Opening statement of Chairman Reed............................... 1
Opening statement of Chairman Levin.............................. 3
Prepared statement........................................... 52
WITNESSES
Mary L. Schapiro, Chairman, Securities and Exchange Commission... 8
Prepared statement........................................... 78
Responses to written questions of:
Chairman Reed............................................ 169
Chairman Levin........................................... 171
Senator Coburn........................................... 176
Gary Gensler, Chairman, Commodity Futures Trading Commission..... 10
Prepared statement........................................... 84
James J. Angel, Associate Professor of Finance, McDonough School
of Business, Georgetown University............................. 24
Prepared statement........................................... 87
Responses to written questions of:
Chairman Reed............................................ 179
Thomas Peterffy, Chairman and Chief Executive Officer,
Interactive Brokers Group...................................... 26
Prepared statement........................................... 156
Responses to written questions of:
Chairman Reed............................................ 187
Manoj Narang, Chief Executive Officer, Tradeworx, Inc............ 27
Prepared statement........................................... 159
Kevin Cronin, Global Head of Equity Trading, Invesco Limited..... 29
Prepared statement........................................... 161
Steve Luparello, Vice Chairman, Financial Industry Regulatory
Authority...................................................... 31
Prepared statement........................................... 164
Additional Material Supplied for the Record
Letter Submitted by Timothy B. Henseler, Deputy Director,
Securities and Exchange Commission............................. 189
(iv)
EXAMINING THE EFFICIENCY, STABILITY, AND INTEGRITY OF THE U.S. CAPITAL
MARKETS
----------
WEDNESDAY, DECEMBER 8, 2010
U.S. Senate,
Subcommittee on Securities, Insurance, and Investment,
Committee on Banking, Housing, and Urban Affairs,
Permanent Subcommittee on Investigations,
of the Committee on Homeland Security and Governmental
Affairs,
Washington, DC.
The Subcommittees met at 3:30 p.m., in room SD-538, Dirksen
Senate Office Building, Hon. Jack Reed, Chairman of the
Subcommittee, presiding.
OPENING STATEMENT OF CHAIRMAN JACK REED
Chairman Reed. Let me call the hearing to order, and I want
to thank the Members of the Permanent Subcommittee on
Investigations, chaired by Senator Levin, for joining us in the
joint hearing this afternoon. Both of our Subcommittees are
extremely interested in understanding both the causes and
implications of the May 6th Flash Crash, and in particular, we
want to focus on how we can avoid and mitigate the effects of
such events in the future.
I am going to make an opening statement. I have been
informed that Senator Bunning may be delayed and asked us to go
ahead. Then I will turn it over to Chairman Levin who will
recognize Senator Coburn when he arrives.
Also, under the rules of the Committee on Investigations,
witnesses are sworn, and I will ask Chairman Levin to do the--
after my opening statement, when the witnesses are introduced,
to do the official swearing-in according to the rules of his
Subcommittee.
I certainly want to thank Chairman Schapiro and Chairman
Gensler for being here, and all our other witnesses, and I want
to commend both Chairman Schapiro and Chairman Gensler for the
effort, the collaboration, the hard work they have done already
to implement the Dodd-Frank bill. It was a spirit that has been
noticed of cooperation and collaboration, which is a model for
all of us. Thank you so much.
I want to also apologize ahead of time for the schedule of
the Senate. First we had to delay the hearing, and I thank the
witnesses for understanding that. We also understand that a
series of four votes will begin some time after 4 p.m. this
afternoon. It is our hope that we can proceed, get the opening
statements of at least our first panel, questions. Senator
Levin and I have agreed to shuttle back and forth so that we do
not necessarily have to recess the hearing. So we will do our
best to maintain the continuity of the hearing throughout the
afternoon, but I apologize again for these four votes that are
pending.
Let me now focus on the substance of our hearing. Although
the recently released report on the events of May 6th was quite
thorough and thoughtful, the length of time it took to complete
is an issue. What tools do our regulators need so that they can
understand what is happening in our capital markets when it is
happening, or at least very shortly thereafter? That is, I
think, one of the first issues. What resources do you need to
effectively surveil and oversee capital markets, particularly
markets that are evolving at such a tremendous rate given
technology?
In the report, the SEC and the CFTC reconstruct the events
that took place across a myriad of securities and futures
markets on May 6th, and I think that is a very important point.
The interrelated aspect of securities markets and of CFTC
product markets is such now that something happening in one
market cannot be easily isolated. According to the report, a
single trade by a mutual fund was the primary cause of the
chain of events that led to the volatile swings in the capital
markets on May 6th. In effect, a CFTC-regulated product
produced significant impacts within SEC-regulated equity
markets, and I am sure the opposite could occur, unfortunately,
under the right circumstances.
Even before the plunge, the markets were already stressed
and showing high volatility due to the mounting concerns of the
debt crisis in Europe on that particular day. According to the
report, it was against this backdrop and a Dow Jones average
that was already down about 2.5 percent that the mutual fund
initiated an automated algorithmic trading program to sell $4.1
billion worth of E-Mini futures contracts which track the
Standard & Poor's 500 stock index. In essence, the interaction
of this one mutual fund's trading algorithm with the trading
algorithms of other market participants, particularly high-
frequency traders, seemed to have created a vicious feedback
loop that increasingly accelerated the rate at which the orders
were executed. In the end, this one trade sold in a span of 20
minutes. It was the largest single trade in E-Mini futures
since the start of the year. The net effect of this order was
to send panic into the marketplace.
How could one order by one trader do this? That is
certainly an issue. How do we stop this from happening again?
The events of May 6th bring into sharp focus concerns about the
efficiency, stability, and integrity of our capital markets and
the current structure of these markets. The existing structure
of the U.S. equity markets is governed by a series of rules and
regulations collectively known as Regulation National Market
System, or RegNMS. One of the questions before us today is how
does RegNMS need to be updated to modernize and strengthen the
national market system for equity securities for the 21st
century?
In addition to the January 2010 Concept Release by the
SEC--and, again, let me commend you, Chairman Schapiro and
Chairman Gensler, for working on these issues proactively--on
possible revisions to the RegNMS, the SEC has responded with
specific regulatory actions related to market structure and
trading since May 6th, such as the institution of a stock-by-
stock circuit breaker pilot program.
We hope that today's hearing will help us understand some
of the regulators' recent proposals and answer some of the
other important questions as well. These questions are long,
but let me suggest a few.
What does the May 6th Flash Crash tell us about the
stability and vulnerability of the U.S. capital markets? And to
what extent, if any, can the May 6th problems be attributed to
the current fragmentation market structure and
interconnectedness between the futures, options, bond, and
equities markets?
What effect do technology-driven trading practices have on
the stability and integrity of U.S. capital markets? What type
of information tools and authorities will regulators need for
the effective supervision of the capital markets? How can they
more actively police across both products and trading venues?
What are effective strategies for minimizing future market
dysfunctions like the May 6th event and for minimizing market
abuses caused by technology-driven trading practices? What are
the effects of the current market structure in trading
practices on long-term capital formation in U.S. markets and,
as a consequence, the health and vitality of the U.S. economy
more generally?
We look forward to hearing your testimony on all these
topics, and I think I have just probably listed just a few of
the questions that you have been dealing with quite diligently
over the several months. Clearly, the cops on the beat--the SEC
and the CFTC--need to have the same tools and resources as the
traders so that they can police capital markets effectively.
I will close with an old saying by the great New England
poet Robert Frost: ``Good walls make good neighbors.'' You are
the folks that build the walls and make sure the neighbors
behave, and so we hope you can keep doing that.
Now I would like to recognize Chairman Levin.
OPENING STATEMENT OF CHAIRMAN CARL LEVIN
Chairman Levin. Today, U.S. capital markets, which
traditionally have been the envy of the world, are fractured.
They are vulnerable to system failures and trading abuses, and
they are operating with oversight blind spots. The very markets
that we rely on to jump start our economy and invest in
America's future are susceptible to market dysfunctions that
jeopardize investor confidence.
I want to begin by thanking Chairman Jack Reed, his Ranking
Member Senator Bunning, and all of our colleagues on the
Securities, Insurance, and Investment Subcommittee, who have
already held hearings on these issues. We thank him for
welcoming our Subcommittee, including our newest Member,
Senator Coons, to join with them today to shine a light on
problems that threaten U.S. market stability and integrity.
The first fact that we need to grapple with is that our
markets have changed enormously in the last 5 years. In the
past, most U.S.-listed stocks were traded on the New York Stock
Exchange or the NASDAQ. Seven years ago, the New York Stock
Exchange alone accounted for about 80 percent of the trades in
its listed stocks. But today, less than 25 percent of the New
York Stock Exchange-listed stocks are traded there.
What happened?
There is a chart, which we will put up here. Exhibit 1
shows how the U.S. stock market has fractured. Stock trading
now takes place, not on one or two, but on 13 stock exchanges,
as well as multiple off-exchange trading venues, including
three electronic communication networks, 36 so-called dark
pools, and over 200 registered broker-dealer internalizers.
Now, those off-exchange trading venues may need some more
explanation. Electronic communication networks, or ECNs, are
computerized networks that enable their participants to post
public quotes to buy or sell stock without going through a
formal exchange. Dark pools, by contrast, are electronic
networks that are closed to the public and allow pool members
to buy and sell stock without fully disclosing to each other
either their identities or the details of their prospective
trades. A broker-dealer internalizer is a system set up by a
regulated broker-dealer to execute trades with or among its own
clients without sending those trades outside of the firm. These
off-exchange venues are increasing their trading volumes, most
use high-speed electronic trading, and they escape much of the
regulation that applies to formal exchanges.
These new trading venues did not appear out of thin air.
They are largely the result of Regulation NMS which the SEC
issued in 2005. Some call the resulting new world of both on-
exchange and off-exchange trading a model of competition.
Others call it a free-for-all that defies oversight and is ripe
for system failures and trading abuses. In reality, both
descriptions have some truth. Trading competition has led to
lower trading costs and faster trading, but it has also opened
the door to new problems.
One of those problems involves system failures, of which
the May 6, 2010, Flash Crash is the most famous recent example.
On that day, out of the blue, the futures market suddenly
collapsed and dragged the Dow Jones Industrial Average down
nearly 700 points, wiping out billions of dollars of value in a
few minutes for no apparent reason. Both the futures and stock
markets recovered in less than 20 minutes, but left investors
and traders in shock. After 5 months of study, a joint CFTC-SEC
report has concluded that the crash was essentially triggered
by one large sell order placed in a volatile futures market
using an algorithm that set off a cascade of out-of-control
computerized trading in futures, equities, and options. That
one futures order, placed at the wrong time, in the wrong way,
set off a chain reaction that damaged confidence in U.S.
financial markets.
In some ways, the May 6th crash was a high-speed version of
the 1987 market crash, where a sudden decline in the futures
market led to a corresponding collapse in the broad stock
market, which led, in turn, to crashes in individual stocks.
And it is not the only type of system failure affecting our
financial markets. So-called mini flash crashes in which one
stock suddenly plummets in value for no apparent reason have
become commonplace.
On June 2, 2010, for example, shares in Diebold Inc., a
large Ohio corporation, suddenly dropped from about $28 to $18
per share. The stock recovered, but the company was left trying
to understand and explain what happened. Even after the SEC
initiated a pilot circuit breaker program after the May 6th
crash, at least 15 other companies have had similar
experiences, including Newcor, Intel, and Cisco. A former
senior NASDAQ executive told the Subcommittee that the NASDAQ
exchange has experienced single-stock flash crashes five times
per week. The New York Stock Exchange and FINRA told us these
crashes are commonplace and attribute them to various glitches
in computerized trading programs.
Single-stock crashes might seem to be a minor problem, but
what happens if the security that crashes is a basket of stocks
or commodities? On November 29, 2010, three of the top five
equities traded by volume were actually baskets of stocks. If a
basket of stocks or commodities crashes in value, what happens
to the underlying financial instruments? Uncontrolled
electronic trading and cascading price declines in multiple
trading venues, including in futures, options, and equities
markets, could be the result--in other words, another May 6th.
Many investors, by the way, are not waiting around to find
out if our regulators have fixed the problem. According to the
Investment Company Institute, each month since May, more
investors have fled our markets, pulling billions of dollars of
U.S. investments.
System failures are not the only problem raised by our
fractured markets. Another problem is their increased
vulnerability to trading abuses. Traders today buy and sell
stock on-exchange and off-exchange, simultaneously trading in
multiple venues. Traders have told my Subcommittee that orders
in some stock venues are being used to affect prices in other
stock venues; and that futures trades in the CFTC-regulated
markets are being used to affect prices on SEC-regulated
options and stock markets. Some traders are also using high-
speed trading programs to execute their strategies, sometimes
submitting and then canceling thousands of phony orders to
affect prices.
To get a sense of the trading activity that goes on today,
take a look at this stack of paper. This stack, nearly 5 inches
high, contains the actual message traffic generated in the
futures, options, and equities markets with respect to one
major U.S. stock over the course of 1 second. One stock, in 1
second, produced over 29,000 orders, order modifications, order
executions, and cancellations. This stack shows in black and
white how traders are now analyzing orders in all three markets
at once, evidencing how the futures, options, and equities
markets are interconnected. Imagine the same stack multiplied
countless times, filling this entire hearing room and the
interconnectedness of the markets as well as the potential for
system failures and trading abuses becoming alarmingly clear.
One well-known trader, Karl Denninger, recently made this
public comment about U.S. trading activity: ``Folks, this crap
is totally out of hand,'' he said, ``and it is now a daily game
that is being played by the machines, which are the only things
that can react with this sort of speed, and they are guaranteed
to screw you, the average investor or trader. Go ahead,'' he
said, ``keep thinking you can invest.''
While fractured markets and high-speed trading are causing
new problems and forms of manipulation, they are also leaving
our regulators far behind. Traders are equipped today with the
latest, fastest technology. Our regulators are riding the
equivalent of mopeds going 20 miles per hour chasing traders
whose cars are going 100 miles per hour.
Our regulators are confronting at least four challenges,
and before I go through those challenges, I want to join
Chairman Reed in congratulating and thanking our witnesses here
today. You have led your agencies in important new directions
and reforms, and you are doing it with, I think, great
professionalism and talent;, and we commend the efforts that
you are making. Here are some of the challenges that our
regulators are facing.
The first is the fact that each trading venue today has its
own infrastructure rules and surveillance practices. Besides
the expense and inefficiency involved, no regulatory agency has
a complete collection of trade data from all the venues, much
less a single integrated data flow allowing regulators to see
how orders and trades in one venue may affect prices in
another.
Second, even if regulators had an integrated data flow, the
current data systems fail to identify key information,
including the names of the executing broker and customer making
the trades. That means that regulators cannot use the
electronic records to, for instance, trace trading by one
person or set up alerts to flag trades. Instead, before any
trading analysis can start, regulators have to figure out the
broker and customer behind each trade. Patterns of manipulation
are hidden.
The third problem is that the SEC has no minimum standards
for automated market surveillance by self-regulatory
organizations, so-called SROs, and the quality of those efforts
is apparently all over the map. Recent SEC examinations of
certain exchanges have found, for example, that some
ineffective surveillance systems were unable to detect basic
manipulations or used such restrictive criteria that they
failed to flag suspect activity, some exchanges failed to
review some surveillance alerts, and some exchanges had only
rudimentary or underbudgeted investigative examination and
enforcement programs.
The fourth problem is that the SEC and CFTC have not set up
procedures to coordinate their screening of market data to see
if trades in one agency's markets are affecting prices in the
other's markets. Given the strong relationships between the
futures, options, and equities markets, joint measures to
detect intermarket trading abuses are essential.
The impact of the regulatory and technology barriers is
demonstrated by the fact that it took the CFTC and the SEC 5
months of intense work to figure out what happened over a few
minutes on May 6th, and I believe that Chairman Reed made this
same reference. In addition, over the past 5 years, there have
been few meaningful single-day price manipulation cases. One
recent case involves a small trading firm, Trillium Trading
LLC, which apparently used phony trading orders to influence
the price of several stocks. In that case, FINRA found that
over a 3-month period in 2006 and 2007, Trillium submitted
phony orders in over 46,000 manipulations, netting gains of
about $575,000. Apparently, the victims of the price
manipulations got annoyed enough to research the manipulative
trading and hand over the data to FINRA. Even then, it took
FINRA 4 years to reconstruct the order books, prove who was
behind the trades, and resolve the matter. Trillium and its
executives recently settled the case by agreeing to pay over
$2.2 million in fines and disgorgements.
Traders and regulators have told us that Trillium is not
the only company that has engaged in or is engaging in price
manipulation in U.S. financial markets. In fact, one of the
more chilling examples involves suspect trading involving
traders located in China. Are overseas traders trying to
manipulate U.S. stock prices? Our regulators are currently ill-
equipped to find out.
The May 6th Flash Crash and the Trillium case provide
powerful warnings that we need to strengthen U.S. oversight of
our financial markets to restore investor confidence. Much
needs to be done. Recent actions by the SEC to prohibit phony
quotes, impose single-issue circuit breakers, and set up a
consolidated audit trail are important advances. But there is a
long, long way to go, particularly with respect to coordinating
market protections and surveillance across market venues, and
across the futures, options, and equities markets.
There also needs to be a greater sense of urgency. The
SEC's proposed consolidated audit trail is expected to take
years to put into place and will not cover all of the relevant
products and markets. Requiring executing broker and customer
information, an essential component to effective oversight, is
in limbo, pending completion of the consolidated audit trail,
as is integrating the trade data for multiple trading venues.
Integrating trading data and market surveillance of futures,
options, and equities markets by the CFTC and SEC is not even
on the drawing board.
I hope this hearing will help inject greater urgency into
strengthening U.S. oversight of our fractured, high-speed
markets to restore investor confidence.
Again, I want to thank you, Chairman Reed, for holding
these hearings and for the kind of leadership that you have
shown in digging into these kind of issues over the years.
Thank you.
Chairman Reed. Thank you very much, Mr. Chairman.
Let me introduce our witnesses. Our first witness is the
Honorable Mary Schapiro, Chairman of the Securities and
Exchange Commission. Prior to becoming the SEC Chairman, she
was the CEO of the Financial Industry Regulatory Authority,
FINRA, the largest nongovernmental regulator for all securities
firms doing business with the United States public. Chairman
Schapiro previously served as a 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, the
Chairman of the Commodity Futures Trading Commission. He
previously served at the U.S. Department of Treasury as the
Under Secretary of Domestic Finance from 1999 to 2000 and as
Assistant Secretary of Financial Markets from 1997 to 1999.
Prior to joining the Department of Treasury, Chairman Gensler
worked for 18 years at Goldman Sachs, most recently as a
partner and cohead of finance.
Before you begin your testimony, I will turn it over to
Chairman Levin to administer the oath pursuant to Rule VI of
the Rules of Procedure of the Senate Permanent Subcommittee on
Investigations. Would you please stand?
Chairman Levin. Thank you very much, Chairman Reed.
As he said, pursuant to the rules of our Subcommittee, all
witnesses need to be sworn. If you would raise your hands.
Do you solemnly swear----that the testimony that you will
give before these Subcommittees will be the truth, the whole
truth, and nothing but the truth, so help you God?
Ms. Schapiro. I do.
Mr. Gensler. I do.
Chairman Reed. Chairman Schapiro, you may begin.
STATEMENT OF MARY L. SCHAPIRO, CHAIRMAN, SECURITIES AND
EXCHANGE COMMISSION
Ms. Schapiro. Thank you very much, Chairman Reed and
Chairman Levin. Thank you for the opportunity to testify on
behalf of the Securities and Exchange Commission concerning the
U.S. equity market structure.
When we discuss market structure, we are talking about
everything from the organization of a market to the number and
types of venues that trade a financial product, and we are
talking about the rules by which those markets operate.
Although these issues can be complex and the rules arcane, a
stable, fair, and efficient structure is the backbone of the
equity markets and an important engine of our economy. Keeping
that backbone strong means responding to the ongoing dramatic
changes that are reshaping our financial markets.
A decade ago, most of the volume in stocks was executed
manually. Now nearly all orders are executed by fully automated
systems, often in less than a thousandth of a second. And as
you have mentioned, just 5 years ago, the New York Stock
Exchange executed about 80 percent of the volume in the U.S.
equities it listed. Today it executes about a quarter of that
volume. The remainder is split among 13 public exchanges, more
than 30 dark pools, 3 ECNs, and more than 200 internalizing
broker-dealers; and about 30 percent is executed in venues that
do not display their liquidity or make it generally available
to the public.
At the SEC, we know that we must keep pace with the
changing landscape of our securities markets. That is why more
than a year ago we initiated a thorough review of equity market
structure. As part of that review, we have received hundreds of
public comments, some emphasizing the benefit of today's
structure and others raising concerns.
We have heard how our current market structure fosters
competition among trading venues and liquidity providers,
lowering spreads and brokers' commissions. We have heard about
the benefits of highly interconnected markets and have been
cautioned about regulatory changes that might have unintended
consequences. But on the other hand, we have also heard deep
concerns about the quality of price discovery and whether the
current market structure offers a level playing field on which
all investors can participate meaningfully and fairly.
As we consider regulatory responses, the Commission will
evaluate these issues with a particular focus on obtaining the
appropriate data and analysis to support our next steps. We
will ask whether the changes we consider will aid capital
formation and investor protection, enhance competition and
price discovery, and improve inspection, surveillance, and
enforcement.
In this context, the prism through which I will view the
role of market professionals, whether they are exchanges or
ATSs, broker-dealers or high-frequency traders, is whether they
compete in ways that ultimately benefit investors and are
companies seeking to raise capital.
As you know, our market structure review is not a
theoretical exercise. Indeed, the events of May 6th, which
profoundly impacted investors and listed companies,
crystallized the importance of this effort. May 6th highlighted
the need for regulators to be able to reconstruct the events of
a given day across millions of trades, billions of shares, and
multiple markets.
Today each exchange has its own unique and often incomplete
data collection system, complicating efforts to reconstruct
trading activity that can involve millions of records across
dozens of exchanges.
In response, the Commission has proposed large-trade
reporting requirements and a consolidated audit trail. This
would for the first time allow regulators to track trade data
across multiple markets, products, and participants
simultaneously. We would also be able to rapidly reconstruct
trading and quickly analyze unusual market events.
Since May 6th, we have taken a series of measures to reduce
the chances of such an event recurring. For instance, we
approved a circuit breaker program that limits excessive price
volatility in individual stocks. We approved rules designed to
bring order and transparency to the process of breaking clearly
erroneous trades. We adopted a new rule to require brokers and
dealers to have risk controls in place before providing their
customers with access to the market--a rule that effectively
bans naked access. And we approved rules to enhance the
quotation standards for market makers, including eliminating
stub quotes, which represented a significant proportion of the
trades that were broken after May 6th.
In addition to regulatory responses, we are aligning our
examination and enforcement efforts with the current realities
of market fragmentation and high-frequency trading. We are
making fundamental structural changes in the way we approach
and conduct examinations of self-regulatory organizations,
including focusing on how SROs surveil for potentially abusive
high-frequency, high-quote, or other algorithmic trading
strategies.
At the same time, our Enforcement Division is investigating
whether various market participants have sought to unlawfully
exploit the fragmentation of the markets, manipulate the price
and volume of securities, or contribute to the market's
volatility at the expense of investors. Additionally, we
created a specialized market abuse unit to conduct
investigations and develop expertise in particular high-risk
program areas.
We cannot turn the clock back to the days of trading crowds
on exchange floors, but we must continue to carefully analyze
market structure issues to ensure our rules keep pace with the
new trading realities and to identify ways to improve our
markets, provide additional transparency, and increase investor
protection. As we move ahead, we look forward to working
closely with the Congress, and I look forward to answering your
questions. Thank you.
Chairman Reed. Thank you very much.
Chairman Gensler.
STATEMENT OF GARY GENSLER, CHAIRMAN, COMMODITY FUTURES TRADING
COMMISSION
Mr. Gensler. Good afternoon, Chairman Reed, Chairman Levin,
Members of the two Subcommittees. I thank you for inviting me
here today. I am also pleased to be testifying along with
Chairman Schapiro. I think this is our seventh time testifying
together, and at least our third time since on May 6.
The CFTC-regulated markets have rapidly transitioned from
face-to-face. Electronic trading now represents 88 percent of
our markets. As a father of three daughters, I have learned
much about the new world of Twitter, social networking, and
certainly texting. Well, just as we cannot turn back that
clock--as a father, sometimes I might wish to--we cannot turn
back the clock which now we have of automated execution,
algorithmic market making, and high-frequency trading.
The May 6 events highlighted the cross-market linkages that
you spoke about between prices and volatility in the securities
markets, the futures markets, and other derivatives markets,
and it is all enabled by technology. Price discovery, which may
first occur in any one of these markets, futures or securities,
can then move rapidly over into correlated products in other
markets. Where small disparities in prices arise, even just for
milliseconds, market participants try to profit in what
economists call arbitrage between these markets.
The CFTC's surveillance program works to promote market
integrity and protect against fraud, manipulation, and other
abuses. The CFTC is coordinating closely with the SEC on policy
levels, specifically trying to coordinate with rulemaking
implementation of Dodd-Frank, but importantly, we also work
very closely on surveillance and data sharing.
After May 6, as one example, our staffs promptly shared
with the SEC position data and transaction data with regard to
that day's events, and the exchanges and the self-regulatory
organizations, importantly, conduct front-line market
surveillance and also coordinate very closely, not just on May
6, but on many other days, as well, and have regular
interactions.
In terms of data, the CFTC does currently receive futures
data on a daily basis. This is most important for us. We get it
the very next morning, the open interest and the transaction
data. We do not regularly get the order book because we do not
have the resources, really, to get that. May 6, we asked for
it. It was 14 million orders. I have just calculated. It would
476 times more than that stack right there for that 1 day in
one contract in 1 month, and that was part of why it took a
while to analyze that data, but we did get it and shared it
with the SEC where they wanted it.
We do in our marketplaces, in the futures marketplaces,
have what we would call pretrade risk management functionality.
Let us call them safeguards. These safeguards protect against
extreme movements. They could be price bands, maximum order
side, protection against market stop loss orders, and
importantly, market pauses, sort of time-outs, back to the
children's theme, but a little time-out in the market.
Exchanges are required to have these, and executing brokers
also have to have some pretrade risk parameters for uses of the
clearinghouses for the transactions. Last week, the Commission
actually put out a proposal that mandates that markets have
pretrade risk safeguards such as these but asked the public for
their views.
The events of May 6 and the Dodd-Frank Act present new
challenges, however, and those new challenges, I just want to
highlight a couple very quickly. Our new authorities also give
us from Congress authorities to work with regard to disruptive
trading practices. The Act prohibits three specific things, but
we are also asking the public and working on other acts, and we
put out an Advance Notice of Proposed Rulemaking.
The second thing I would mention is resources, if I might.
The CFTC's current funding is less than what we would need to
really do the surveillance, not only for the events of May 6,
but, of course, the new Dodd-Frank Act. We currently have about
680 full-time staff. We estimate that we will probably need
about 400 more staff. To put these in dollar terms, our current
funding from last year was $169 million. The President's
request for 2011 is $261 million. We anticipate we will have
300 to 400 new applicants that will arrive on our doorstep next
summer. These are swap dealers and swap execution facilities
and so forth. We have no intention of robo-signing these
applications. I mean, we are going to thoughtfully look at them
as we are supposed to. We will need the resources to do that.
Thank you.
Chairman Reed. Well, thank you both very much.
Chairman Gensler, let me thank you, but also, I think you
have raised a troubling concern, which Chairman Schapiro has
also suggested in her testimony. Chairman Schapiro, in your
testimony, you state, budget permitting--your words--the SEC
hopes our enforcement staff with expertise in algorithmic
trading strategy, market abuse, quantitative analysis, and many
other skills you need.
According to the numbers in the SEC's fiscal year 2011
budget request, between fiscal years 2005 and 2007, the SEC
experienced 3 years of flat or declining budgets, which in
effect with even small inflation means declines. The net result
was that the SEC lost 10 percent of its workforce and was
severely hampered in key areas, such as enforcement and
examination. By 2008, I think this became readily apparent to
every American with the dysfunction in our marketplace.
Even in the fiscal year 2010 budget levels, if you stay at
that, your workforce is still below the 2005 level, as I
understand it. And at the same time, as Chairman Gensler and
you both point out, with the Dodd-Frank legislation, there is
significantly expanded responsibilities which we expect you to
carry out.
So, really, for both of you, to what extent are staff
levels hampering your ability to improve and strengthen
oversight of current high-tech trading, implement the new
provisions of the Dodd-Frank Act, and then do what you both
alluded to, try to keep up with the most dynamically and
rapidly changing marketplace that we have ever had, from 80
percent of trades on the exchanges to a fraction of that today?
So let me ask both of you to comment, and you can begin,
Chairman Schapiro.
Ms. Schapiro. Thank you very much, Chairman Reed. Well,
obviously, resources are a significant concern for the agency.
As you rightly point out, we have had a very volatile history
of funding at the Securities and Exchange Commission, and while
Congress has been very generous in the last couple of years and
we have been able to begin to staff up, we are really just now
reaching our 2005 levels of staffing and technology spending.
We have been enormously fortunate in the last year to be
able to attract tremendous help to the agency to supplement our
already very talented staff, but we are trying to bring in new
skill sets, people with expertise in algorithmic trading,
people from credit rating agencies and trading desks and hedge
funds, to try to help us have the capability to do the job we
have always been charged with doing, but also to take on the
new responsibilities, as you point out, that we have been given
under Dodd-Frank. It is absolutely essential that we be able to
continue to bring that kind of skill set into the agency.
One of the most important initiatives for us going forward
really is the consolidated audit trail, and I would love to
respond at the appropriate time to Chairman Levin's comments
about how long it is going to take because we think there is
good news on that front. But in order to make use of the data
that we would receive from a consolidated audit trail, even
understanding that the exchanges will be the primary users of
that data, we need people with capacity in data management,
quantitative analysis, and the servers and system capability to
receive something on the order of 20 terabytes of data in a
month.
So our needs for both Dodd-Frank and for stepping up and
doing what I think the American public has a right to believe
we are doing with respect to the oversight of our highly
fragmented marketplace, we need significant resources.
Chairman Reed. Chairman Gensler, go ahead, please.
Mr. Gensler. I thank you for that. I do think that our
agency, on a little bit smaller base, we are going to be asked
to take on the swaps market, which is approximately $280
trillion, notional amount, nearly 20 times the size of our
economy, just arithmetically. We currently oversee a market
that is about $40 trillion in notional, the futures
marketplace. So it is about seven times the size. We think we
need about 70 percent more people, so we are trying to be
efficient.
Part of the efficiency comes from technology. We have asked
for $18 million more in this coming year, and that is part of
the President's request for $261 million. That is to deal with
data. A lot of data will be in data repositories, but we will
need to be able to, in essence, put a pipeline into that data
and to search it, to analyze it, and to have automated
surveillance. In later testimony, I noted that FINRA currently
has surveillance tools and alerts on 300 different algorithms.
I can assure you, we at the CFTC have a fraction of that right
now. We only started the program of building our own algorithms
in the last 2 years in a serious way.
Chairman Reed. Let me ask you both, and perhaps this might
be a point if you wanted to comment on the consolidated audit
trail, but essentially, we are asking two agencies who--and I
again commend you for your collaboration, both informally and
formally--to surveil these markets, to have sort of ongoing
insights into what is going on. How are you doing that in
informal and formal ways? How are you coordinating? I presume,
Chairman Gensler, you have something comparable to the
consolidated audit trail that you are trying to roll out. So
let me begin with Chairman Schapiro, and talk about some of the
collaboration as you go forward. You might even want to talk
about the time tables that you have.
Ms. Schapiro. Sure. The collaboration really has been
superb between the two agencies, and I think May 6 is a great
demonstration of how the two staffs work together, understand
each other's data, and the interconnections between the
marketplace.
The consolidated audit trail would be designed in the first
instance to give us a single consolidated set of data with
really all the information one could want with respect to the
equities markets and the options markets, but it would be our
view that, over time, it should absolutely include all related
financial products so that we should include municipal
securities, Government securities, and futures that are on
equities or equity products so that we have a truly
comprehensive view of the trading of instruments in our
economic substitutes for each other. Otherwise, it will not be
a very effective system.
The initial estimates of the SEC staff when we proposed the
consolidated audit trail were quite extraordinary in terms of
the dollar cost and the timeframe, about $4 billion all in and
as long as three to 4 years to implement. We would ask that the
SROs actually develop the plan for the consolidated audit
trail. The SEC would set out the criteria, what has to be real-
time reporting and what all the data elements are, and are many
in order to have the information that we need.
But as a result of the comment process and our meeting with
a number of technology firms, we believe that we can
dramatically reduce the cost and the timetables of
implementation because a large portion of those costs, well
over half, were thought to be necessary to allow broker-dealers
to build the reporting systems to get the information into the
repository. We do not think that that is likely to be necessary
and that there are, in fact, technologies that already exist
that can be utilized in this space. So we are hopeful that when
we come to approving a final rule, the costs and the
implementation period will be down significantly, which to my
mind would mean we could more quickly bring in all the related
products that we think are necessary for this to truly be a
consolidated audit trail.
Chairman Reed. And in that regard, Chairman Gensler, you
both essentially regulate economic equivalence of each other in
some cases, and you, I presume, have a complementary sort of
vision about how you can build something like the consolidated
audit trail. Could you comment on that?
Mr. Gensler. We are fortunate. We have a less fragmented
market now. I think in the swaps world, it would become
fragmented with these execution facilities. By the morning of
May 7, but every morning, we have the full transaction file
from the day before in the futures world already in our system
and our analysts are able to analyze it. Actually, on the
evening of May 6, we already knew of the single large trader,
the 75,000 contract, and we told the SEC that evening and some
of the other regulators that evening and interviewed the
executing broker the morning of the 7th. So we ere fortunate in
that way.
Our challenges are we do not currently have what is called
account ownership and control information. We put out a rule
this summer and we very much need to do that. We have the data,
but we do not always have the ownership.
The second challenge is we do not have the resources to
analyze the order book every day. We only did that for May 6.
But it is 14 million orders on one contract. Imagine on the
whole market. It is probably measured in the billions of
orders.
And the third challenge is with the swaps market coming in,
how we aggregate the data across the swaps and futures market,
and, of course, aggregate.
I do believe that we have work to do to institutionalize
our cooperative nature. It has been a great working
relationship, but we will not be there forever and our staffs
will change and so I think we do have work to do to
institutionalize some of this.
Chairman Reed. My last comment. You are collectively
working on an institutionalization both in terms of technology
systems and communication systems as well as people. That is
going to go on.
Mr. Gensler. Yes, in the midst of a lot of rulemaking.
Chairman Reed. Right. Right. Let me recognize the Chairman.
Chairman Levin. Chairman Schapiro, since we are talking
about your consolidated audit trail and the good news you
brought us, give us an estimate. Will it be less than half the
cost and half the time? Is that fair, or is that too
optimistic?
Ms. Schapiro. Almost certainly, any estimate I give you
will be wrong, but I will tell you that we think that between
50 and 80 percent of the current cost estimate is associated
with the requirement for the broker-dealers to build the
reporting systems, and to the extent there are existing
technologies that would facilitate that, it should make a very
significant change in the cost level and----
Chairman Levin. Would that be up to half, do you estimate?
Could it be as much as half?
Ms. Schapiro. I would hope so. I honestly do not know. I
also think it is important to point out that while it is a very
large number, $4 billion, these are markets that trade $220
billion worth of securities every day. So it is a big number,
but there is a lot at stake in getting this market structure
right.
Chairman Levin. Absolutely. That is why we are pressing it.
Do you think it could be done in perhaps less than half the
previously estimated time?
Ms. Schapiro. Again, I do not know and I do not want to be
misleading in any way because I truly do not know, but it would
very much be my hope. I think this is perhaps for me one of the
most important things I can try to get accomplished at the SEC.
Chairman Levin. OK. Thank you. In your opening statements,
you both acknowledged that the market prices in each venue are
nearly simultaneously affecting each other and that the futures
and stock prices in America--regulated by each of your
Commissions--also affect each other. In my judgment, since
these markets are so connected, it would seem to me that there
is nothing preventing somebody from using one market to
manipulate another market.
So let us take a look at Exhibit 2, a chart. I do not know
if you can see that or not. Turn that around, if you would, so
they can see it, unless it is in front of them. Let us assume
that Joe Trader was entering orders that he never intended to
have executed in one market so that it would move prices to his
benefit in another related market. After moving the market
price and taking advantage of the price movement that he
caused, he then cancels his original orders, allowing the
markets to return to normal. Now, that seems to me to be a
variation of what Trillium traders did, but this time using two
markets.
My question to you is, might that type of trading strategy
be a manipulation? I am not asking you whether it is. You
obviously cannot know. But might that kind of strategy I just
outlined be manipulative?
Ms. Schapiro. I think it is entirely possible that it could
be.
Chairman Levin. OK.
Mr. Gensler. Because our statutory framework relates to
intent, it would depend on the party's intent. But it could be
if the intent was there to manipulate a market.
Chairman Levin. Now, I think you have testified already
that since people trade in multiple markets, that our
regulators need to be able to compare the trading data from
more than one market to see if trading in multiple markets is
being improperly used. Can your agencies coordinate your
automated surveillance efforts to spot this type of cross-
market price manipulation or anything else that might be
appropriate? Is that a possibility?
Ms. Schapiro. I think it is a possibility. With the
consolidated audit trail--and now again, we have two different
agencies with different jurisdictions. We would have to
ultimately agree to require that the exchanges and the market
participants under two separate agencies' jurisdictions agreed
to contribute data to the same consolidator and to the same
audit trail. But I do not know of any reason why, if there is a
will to do it and there is the technical capacity to do it, why
we would not do it, frankly.
Chairman Levin. All right. Mr. Gensler.
Mr. Gensler. We already do it. I would say it is more on an
ad hoc basis or an event-driven basis and an enforcement case-
driven basis, and we have had some very good collaboration. I
think to do it and institutionalize it might take some rule
changes on both sides to have exchanges and self-regulatory
organizations on a regular basis from the two jurisdictions
sharing information and that would be worthwhile to consider.
Chairman Levin. OK. If you would consider that, it would be
helpful.
Chairman Schapiro, do you currently have an automated
surveillance to detect cross-market manipulations? Do you have
that in place now?
Ms. Schapiro. No. We have some tools in place that allow us
to, upon request from the--we request the exchanges to provide
us with information and so we can see activity in options
markets and equity markets, but we do not have routine
capability to see across to other derivative markets, over-the-
counter markets, and we do not really have the tools to
efficiently utilize the data that we do get.
Chairman Levin. Now, is that what you hope the consolidated
audit trail will help obtain?
Ms. Schapiro. That, as well as the large trader reporting
system, which we believe could be in place even much sooner,
that will at least give us the capacity to see what larger
traders are doing in our market.
Chairman Levin. OK. And when do you think that is possible,
that large trader reporting system?
Ms. Schapiro. It was proposed earlier this year and it
would be my hope that we would be able to finalize the rules
for both that and the consolidated audit trail early in the new
year, and then I do not know off the top of my head what the
implementation timeframes are for large trader. They are
measured in months, not in years.
Chairman Levin. Now, FINRA has an Order Audit Trail System,
as I understand it O-A-T-S. Are you familiar with it?
Ms. Schapiro. That is right, yes. Yes.
Chairman Levin. Is that something which you could use as an
interim step?
Ms. Schapiro. I think it is a great question and there
are--FINRA has the OATS system. The New York Stock Exchange has
the Order Tracking System. And the options exchanges have an
audit trail that they use, as well. And I think it is kind of a
philosophical question almost. The OATS system gathers data and
it covers a significant portion of the marketplace. So we could
look at whether to spend resources and time trying to make it a
little bit better and a little more robust and broader or we
could take those resources and time and create a genuinely
consolidated audit trail system that is very scalable and very
capable of capturing all the economic substitutes for equities.
And so I think what we have said in the consolidated audit
trail proposal is we expect exchanges and FINRA to come to us
with a plan for how they are going to implement a consolidated
audit trail that gives us all of the data that we need as
regulators and that we expect them to use as market surveilors
and leave the choice of the technology to them.
Chairman Levin. And to kind of summarize your previous
point: at the moment, at least, you are relying on someone to
identify a problem for you first and then you can look across
markets----
Ms. Schapiro. I think that----
Chairman Levin. At the moment. At the moment.
Ms. Schapiro. I think that is generally true, either
someone identifying a problem or our own staff obviously sees
market activity and may be concerned about a big spike in
volume, for example, ahead of a corporate announcement, and
then we would utilize a tool called the Electronic Blue Sheets
to investigate whether the people who traded ahead of that
corporate announcement might have had access to material
nonpublic information and violated the Federal securities laws.
So it is a combination.
Chairman Levin. Let me just raise a question before I have
to run off. We are talking about trading abuses here and I want
to talk about a trading abuse that involves credit default
swaps. Now, they were not subject, those swaps, to regulation
before Dodd-Frank came along and that includes credit default
swaps that bet against mortgage-backed securities, which are
the bets that made a major contribution to the financial
crisis.
Now we have got Dodd-Frank, which requires your agency to
monitor those types of swaps for a variety of uses, and I want
to give you a description of something that my Subcommittee
uncovered during our investigation of the financial crisis. I
think you or your staff has seen some of these documents, which
we were able to get to you yesterday, which we uncovered during
our investigation of the financial crisis. I want to get your
thoughts as to how either of your agencies could monitor swaps
electronically to detect a type of market squeeze.
From late 2006 to early spring of 2007, major financial
investors had begun betting against subprime-related CDOs by
purchasing credit default swaps, or CDSs. Soon, the price rose
and no one in the market was willing to offer any more CDS
protection against a fall in the value of subprime-related
CDOs. Goldman Sachs wanted to continue to buy CDSs, but none
were available at a reasonable price, so it changed the
situation. Goldman's asset-backed securities desk, their ABS
desk, decided it would offer CDS protection at a lower and
lower price in order to drive down the market price and induce
current CDS holders to sell off their holdings. And when the
sell-off was large enough and the price got low enough, Goldman
planned to move in and purchase the CDSs for itself at
artificially low prices.
Now, that short-squeeze strategy was described in a number
of exhibits, including Exhibit 3A, which I will start with. It
is a self-evaluation which was done by one of the Goldman
traders on the ABS desk who participated in that activity, and
we will include that in the hearing record at this time, a
self-evaluation report by a Mr. Salem, S-a-l-e-m.
On page 15 of that Exhibit 3A, at the bottom of the first
paragraph, this is what he wrote. ``In May, while we remained
as negative as ever on the fundamentals and subprime, the
market was trading very short,'' in caps, ``and susceptible to
a squeeze. We began to encourage this squeeze with plans of
getting very short again and after the short squeeze caused
capitulation of these shorts. This strategy seemed doable and
brilliant, but once the negative fundamental news kept coming
in at a tremendous rate, we stopped waiting for the shorts to
capitulate and instead just reinitiated shorts ourselves
immediately.''
Now, in an interview with us, the trader who wrote this
self-evaluation denied that the ABS desk ever intended to
squeeze the market. He claimed that he had wrongly worded his
own evaluation report, and that his account is consistent with
other Goldman documents.
In May 2007, for example, Michael Swenson, the manager of
the ABS desk who oversaw the traders' efforts, wrote e-mails in
which he encouraged the attempt to squeeze the market, and we
will include these e-mails, Exhibits 3B and 3C, in the record
at this time.
In the first e-mail, dated May 25, Mr. Swenson wrote, ``We
should be offering a single-name protection down on the offer
side to the street on tier one stuff to cause maximum pain.''
And then on May 29, he followed up with another e-mail. ``We
should start killing the single-name shorts in the street.
Let's pick some high-quality stuff that guys are hoping is
wider today and offer protection tight. This will have people
totally demoralized.''
Now, when interviewed, Mr. Swenson also denied there was an
effort by Goldman to squeeze the shorts. He said the purpose
behind Goldman's effort was to restore balance to a market that
had gone too far to one side, leading to an artificially high
cost for CDS protection, but he could not explain why he used
the terms he did, ``cause maximum pain'' and ``this will have
people totally demoralized'' to describe an effort to restore
balance to the market.
Other e-mails suggest that the attempted short squeeze by
Goldman negatively impacted its own clients. For several weeks,
as Goldman tried to drive down the price of CDS protection, it
required some of its clients to make collateral payments to
Goldman on CDS protection that they had bought at a higher
price. In some e-mails, clients asked Goldman how they could
owe more collateral to Goldman when the clients had shorted the
mortgage market, which was declining in value.
In the end, short sellers did not offer to sell their
shorts at the lower price. Instead, most went even shorter and
Goldman abandoned its efforts to squeeze the market. Even after
Goldman abandoned the effort, some investors were harmed by the
lower prices.
Now, this is my question. Chairman Gensler first. You are
familiar with short squeezes in the commodities markets. Would
this type of attempted short squeeze in the mortgage-backed
securities market trouble you, number one, either as a conflict
of interest or as manipulation on the part of Goldman. Mr.
Gensler.
Mr. Gensler. Are you sure you did not want Chairman
Schapiro to go first?
[Laughter.]
Mr. Gensler. No, in more seriousness, I am not familiar
enough with the facts, and the first time I have seen the
document is, of course, now. But in our markets, in the futures
markets, manipulation relates to intent and to distort a price.
There is a four-factor test about price manipulation. The Dodd-
Frank bill actually, fortunately, I think, broadens that, and
we have a proposed rule out on fraud-based manipulation, and
also Congress has given us additional authorities on disruptive
trading practices, all that we will be publishing rules on and
get public comment on that are very helpful.
In the current statutory framework on what is called price
manipulation, you need to have an intent to, in essence,
distort a price, and the price has to have been distorted, and
those would be sort of the factors that would have to be
applied to this situation or other situations.
Chairman Levin. Alright, Chairman Schapiro, let me ask you
a question. Does the SEC have the capacity to monitor MBS
markets for this type of activity? Is the capacity there to
monitor?
Ms. Schapiro. It is not there now.
Chairman Levin. Would it be helpful for you to have it?
Ms. Schapiro. I think so, and I do think that we will have
better capacity generally with respect to the asset-backed
securities markets going forward based on rule proposals we did
last spring, but also authorities under Dodd-Frank. But it
would be, obviously, helpful. That is troubling language that
you read to us.
Chairman Levin. Thank you both very, very much, and I am
going to run and vote.
Chairman Reed. Well, we again apologize for the tag-team
actions caused by the votes, but one point I want to raise, and
it goes to sort of the conceptual issue. The presumption, I
think, from most people--not perhaps the most sophisticated
traders in the world, but people who own a few stocks--is that
the value of stocks, the liquidity associated with the stocks
is directly a function of their economic value. The same thing
with debt instruments, the same thing with derivatives, that
there is a real economic value here. And one of the issues that
we have to deal with is with the proliferation of these
algorithmic high-frequency trades. Some of these algorithms do
not take into account the fundamentals of the instrument, the
economic value, the dividends, or the status of the
municipality issuing them. They are simply saying if enough of
these are sold, then we start selling. And then if we start
selling, another algorithm kicks in.
To the extent we get further away from the economic values
here, does that not only cause concern but is that--you know,
is that something that is good for the economy? It may be a
naive question, but I will pose it.
Ms. Schapiro. I do not think it is a naive question at all.
I actually think it is sort of the fundamental question that we
are really grappling with: What is the role of traders versus
investors? And what kind of trading really provides liquidity
to the marketplace that enables investors to get in and out of
positions successfully?
When we meet with public companies--and I always ask this
question of them, and I always ask this question of retail
broker-dealers: How are the markets working for you, for what
you need to do, as a public company, in raising capital; what
your customers, as a retail broker-dealer, are looking for in
the marketplace? And there is a lot of concern about whether
the price discovery mechanism is efficient or whether we have
the development of two-tiered markets that is hindering
effective price discovery, whether the playing field is level
so that long-term investors are going to be buyers and holders
of securities, have an equal opportunity to get the best price
in the marketplace, as traders do, whether issues like speed
and colocation and access to proprietary data feeds, skews the
ability of others to effectively participate in the
marketplace. And I do not know the answers to all those
questions, but they are very much questions that are on the
minds of the retail public and on the minds of public
companies--for whom these capital markets are their lifeblood.
Their capacity and their capability is in these markets to
expand and grow and create jobs.
So I think these are exactly the kinds of questions that we
are trying to explore through our Concept Release. When we ask
about what is the quality of the marketplace and what is the
quality of our market structure and what are the best metrics
to measure that in addition to looking at detailed questions
about the role of algorithms and high-frequency traders and as
well as dark pools of liquidity.
Chairman Reed. Before I turn to Chairman Gensler, one of
our roles is to amplify these questions in the broader context
and in the public debate and also to see if we can drive
effective answers, and they might change over time. So I
appreciate what you are doing, I know what you are doing, but
your efforts--and please, ask us how we can be helpful--to find
real answers to this that are questions that are to be posed,
as you point out very adroitly, not only by the investor on the
street but large institutional investors, large corporations,
et cetera, go really to the nature of a functioning market
versus a highly lucrative trading venue. And they can be two
different things.
Ms. Schapiro. I think you made an excellent point. In the
comment process that followed the Concept Release and a
roundtable that we also held back in June to look at market
structure issues, one commenter supplied a survey that they had
done of a number of investors across a range, and not just
investors but also trading firms and others, and even large
institutional investors in that survey, only about half of them
said they felt like the market structure was fundamentally
working for institutional investors' interests at this point.
Chairman Reed. Thank you.
Chairman Gensler, your comments from your perspective?
Mr. Gensler. I think that markets have to have the
confidence of the public, not just the investing public but as
Chair Schapiro said, the capital formation and the markets, we
oversee those that hedge, whether it is a farmer or a rancher
in our core groups or a modern financial company hedging a
risk.
I think that markets for decades have included hedgers,
investors, and speculators, and have even included the
interdealer trader. In the old days, it was somebody in the
pits of a Chicago futures exchange or on the floor of the New
York Stock Exchange. Today in the modern Twitter and high-
frequency world, it is somebody with a computer who is maybe
collocated and so forth.
I think the core that we have to make sure is that these
markets--that everybody has sort of an equal access to these
markets, that they are very transparent. That is at the core of
the new Dodd-Frank bill for the swaps market, but that they are
transparent and somebody does not have some information
advantages, and that we do effectively police them against
fraud manipulation. Whether what Chairman Levin laid out is
manipulation I could not speak to, but we have to police
against those manipulations and have the tools to do that.
Chairman Reed. I think I have asked this question in
different words, but succinctly, so much of this is cross-
market activity, and you alluded to it, Chairman Gensler, and
you, Chairman Schapiro, in your comments. The obvious thing is
that arbitrage is something that is attractive because if you
can catch two markets in a quick match, that is usually a
profitable exchange.
Again, anything that you want to add with respect to the
steps you are taking to ensure that cross-market activities,
someone who is trading a future to affect the price of an
equity so that they can either short or go long on the equity,
what are you doing? And then, Chairman Schapiro, what are you
doing, or what do you both think you are doing?
Mr. Gensler. Well, candidly, most of what we are doing is
within the jurisdiction that we are in, and so there is cross-
market arbitrages within the futures market, the options on
futures, and then most recently the swaps markets. So we are
going to try to work to make sure that we really do have the
data set within these markets and can aggregate and do
surveillance across those markets, because they can even be in
one futures contract between the months--that is called a basis
trade or a spread trade. I do think we need to do more to
institutionalize across the markets as well. But it is within
our jurisdiction and then across our jurisdiction.
Chairman Reed. Chairman Schapiro.
Ms. Schapiro. Yes, I would really agree with that. I think
our problem is we have so many markets and we have so many
venues where trades are executed that just getting it to a
point where we have consolidated data about the equity markets
would be an enormous step forward. But it would be my hope that
we would ultimately have a consolidated audit trail and the
capability to surveil across related instruments.
Chairman Reed. In your Concept Release in January of 2010,
Chairman Schapiro, you said, ``Regulation has not kept pace
with the rapid evolution of the securities markets.'' I would
assume you would both agree with that. I certainly agree with
it.
But there is another, I think, again, perhaps naive but I
think a profound question. There is a window to catch up, and
if you cannot catch up, are we always going to--is this
something that will get beyond our capacity to regulate,
frankly? And I think it goes back to the issues we have talked
about in terms of resources, in terms of personnel, in terms of
technology systems, et cetera. But, you know, this is not your
father's market or your grandfather's market where it moves at
something close to the pace--I hesitate to use the Congress as
a model, but at a pace much slower than what is happening now.
And I must say that one of my fears is that this is a critical
moment to not only get up to speed and so that we are
regulating on a near real-time basis or an effective basis, but
if we miss this moment, the gap will widen so significantly
that regulation will be simply--it will not be effective. It
will be there, but it will not be effective. And the second
part of this is just this proliferation of markets where you do
not even have a perspective into it. Comment on those two major
points, and then I will conclude.
Ms. Schapiro. Sure. There are two things that I think are
critical. One is the need for regulators to be, as you said, up
to speed for the purposes of policing the market, to understand
the activity that is happening, where there are abusive
practices going on. Our enforcement program is looking into
about 12 different kinds of trading strategies that we think
have the potential to be problematic. So we have to have the
capacity to do all that with the audit trail and with the human
and technical resources at the SROs as well as at the SEC.
But I think we also have to look at whether there are
regulatory changes that are necessary in our marketplace in
order to create a stronger infrastructure. We have talked about
the things that we have done already with respect to--
relatively simple things like single-stock circuit breakers,
eliminating stub quotes, prohibiting naked access to the
markets. But we also have a menu of ideas--and at this point
they are really just ideas--for other steps that we might be
able to take at the SEC that would strengthen that backbone of
the market structure, including requiring broker-dealers to
have procedures that prevent algorithms from behaving
destructively in the marketplace, something we saw, obviously,
on May 6th. Whether there should be obligations on market
makers to either support the markets or at least not to trade
in ways that detracts from the quality of the marketplace,
looking again at the quality of exchange data feeds and whether
the public data feed is sufficiently robust in comparison to
the one they sell for a lot more money in their proprietary
context, we need to assess the fee structures within the
exchanges, the maker-taker fee and so forth. And we are talking
now very actively about migrating the single-stock circuit
breaker to a limit up/limit down model which would much more
closely actually mimic the futures model.
So I think there are lots of things for us to do that will
be incrementally important but important to try to solidify
this market structure in addition to trying to do a better job
with surveillance and viewing across all markets the activity
that we see.
Chairman Reed. Chairman Gensler.
Mr. Gensler. I was going to say that maybe--the glass is
half-full. I am an optimist, and we have certain tools. We
leverage off of the exchanges. We leverage off of the self-
regulatory organizations and also the big market participants,
the dealers mostly, what we call futures commission merchants
in our world. And we leverage by certain tools. We publish
rules. We hopefully update them. They are never quite up-to-
date, but, you know, we update them on a regular basis. We use
enforcement actions as well. Sometimes there is signaling to
the markets when there is a particularly bad actor or
manipulation and so forth. I think these pretrade risk
safeguards are absolutely critical. That is why we last week
published a rule that included that the exchanges themselves--
they have had them in a voluntary way, and the futures market
has been very fortunate to have very robust pretrade risk
management, but now we require some of this pretrade risk
management. So I think we have to always leverage off the
market participants and the self-regulatory organizations, use
rules, enforcement mechanisms, and as I say, risk safeguards.
The last thing we use is transparency. I am a big believer
that transparency helps economic activity, but it also helps in
a sense the regulators, because, frankly, you get more people
bringing information to you, too.
Chairman Reed. Well, thank you very much for your testimony
and for your great effort at both the Securities and Exchange
Commission and the CFTC. Thank you very much, and I am sure we
will meet again. Thank you.
Mr. Gensler. Thank you.
Chairman Reed. The second panel can come forward.
Let me introduce now the second panel, and then I am
awaiting Senator Levin's return. The second vote has been
called. He will vote, return, then I will depart. But in the
meantime, I can introduce the panel. He is not here. I will
also swear the panel in, and then we can begin the testimony.
Our first witness is Dr. James Angel, Associate Professor
of Finance at Georgetown University's McDonough School of
Business. Professor Angel specializes in the structure and
regulation of financial markets around the world. His current
research focuses on short selling and regulation. Dr. Angel
currently serves on the Board of Directors of the Direct Edge
Stock Exchange.
Our next witness is Thomas Peterffy. Mr. Peterffy is
Chairman and CEO of the Interactive Brokers Group, a global
market-making and brokerage firm with nearly $5 billion in
equity capital. Its trading subsidiary is a registered broker-
dealer and futures commission merchant that provides high-
speed, technology-driven trade to individual clients, hedge
funds, institutional investors, and others. Another subsidiary
was one of the world's first electronic market-making firms and
is a registered market maker and liquidity provider in all
major U.S. futures and securities markets.
Our third witness is Manoj Narang, the CEO of Tradeworx.
During the 1990s, he held a variety of technology research and
trading positions at several major Wall Street firms, gaining
experience in a multitude of markets, including equities,
foreign exchange futures, and fixed income. In 1999, he left
Wall Street to found Tradeworx Inc. with the mission of
democratizing the role of advanced technology in the financial
markets.
Our fourth witness is Mr. Kevin Cronin, global head of
equity trading at Invesco Ltd. He is responsible for Invesco's
trading desk in Atlanta, Hong Kong, Houston, London, Melbourne,
Taipei, Tokyo, and Toronto. Mr. Cronin joined Invesco in 1997
as the head of listed equity trading for Invesco AIM and later
became director of equity trading. Mr. Cronin is currently the
chairman of the Investment Company Institute's Equity Markets
Advisory Committee, a recently appointed member of the NASDAQ
Quality of Markets Committee, and a member of the National
Association of Investment Professionals and the Securities
Traders Association. Thank you, Mr. Cronin.
Our final witness is Steve Luparello, vice chairman of the
Financial Industry Regulatory Authority, or FINRA, the largest
nongovernmental regulator for all securities firms doing
business with the United States public. In this capacity, Mr.
Luparello oversees FINRA's regulatory operations, including
enforcement, market regulation, member regulation, and business
solutions.
And now pursuant to Rule VI of the Rules of Procedure of
the Senate Permanent Subcommittee on Investigations, would you
gentlemen please stand and raise your right hands? Do you swear
that the testimony you will give before this Subcommittee will
be the truth, the whole truth, and nothing but the truth, so
help you God?
Mr. Angel. I do.
Mr. Peterffy. I do.
Mr. Narang. I do.
Mr. Cronin. I do.
Mr. Luparello. I do.
Chairman Reed. Thank you very much, gentlemen.
Dr. Angel, your testimony, please.
STATEMENT OF JAMES J. ANGEL, ASSOCIATE PROFESSOR OF FINANCE,
MCDONOUGH SCHOOL OF BUSINESS, GEORGETOWN UNIVERSITY
Mr. Angel. Thank you. It is an honor to be here. I would
like to thank you for the invitation. As you mentioned in the
introduction, I study the nuts-and-bolts details of how
financial markets operate around the world. And I am also the
guy who warned the SEC in writing five times in the year before
the Flash Crash that our markets are vulnerable to these kind
of events, and I would like to say that the Flash Crash can
happen again, and here is why.
First, our market is a very complex network. It consists
not only of equity exchanges and futures exchanges and options
exchanges, but of all the broker-dealers, fixed commission
merchants, IT vendors, analytics providers, media entities, and
investors. It is a very rich and complex ecosystem, and a
disruption anywhere in that network can feed throughout the
network.
Now, most of the time, this market network works pretty
well--except when it does not--but, by most measurable
dimensions in market quality, our market works far better,
faster, and cheaper than it did 5, 10, 20 years ago. However,
like any finite system, like any human system, our market has
finite capacity. It can only handle so much trading activity
before it chokes. And from time to time, our market is
overwhelmed by massive quantities of trading activity that
cause the market to choke.
Now, this is not a new phenomenon. If you look in the
history of financial markets, you will see that going back in
time this has happened over and over again. In 1906, the New
York Times had a headline that blared--let me get the words
right here--``Stocks Break and then Recover.'' We saw it in
1929, we saw it in 1962, we saw it in 1987. We see these waves
of activity that overwhelm the market mechanism. So what we
need are safeguards for this market network that are integrated
across the entire market network. And what we need is we need
somebody to be able to call a timeout when the market network
is going crazy, and we do not really have that right now.
Now, some people grumble about market fragmentation. I
think we need to worry less about the fragmentation of the
market than we do about the fragmentation of regulation. We
have literally hundreds of different financial regulators at
the Federal and State levels, and, you know, they do not always
play nicely with each other. A lot of stuff has fallen through
the cracks, as we saw in the meltdown of 2008, and there is
also a lot of duplication. And most of these regulators have a
pretty narrow mandate. And, here in Washington, we have the SEC
in one granite fortress on F Street, the CFTC in another
granite fortress a couple miles away in Lafayette Center. Both
of them are hundreds of miles away from the financial markets
they try to regulate. That lack of physical proximity makes it
really hard to actually regulate the markets because it makes
it much harder to figure out what is going on.
How long it took the regulators to figure out what was
going on in the Flash Crash is a direct result of the
fragmentation of regulation and having regulators hundreds of
miles away from the markets they are trying to regulate. So our
regulators need better market intelligence, and they need
better funding as well.
We have spent approximately $18 billion on the SEC since
its founding in 1934. That is less than half of what investors
lost from Bernie Madoff alone. So I think we have been really
penny-wise and pound-foolish in the way we have funded our
regulators.
Now, what can we do about this? First of all, I understand
that there are political forces that make it really hard to
consolidate agencies. But one thing we can do is we can deal
with this fragmentation of regulation by putting all the
financial regulatory agencies in one building. Instead of
having them miles apart, which makes any kind of interaction
difficult, stick them in the same building.
Second of all, let us stick this building in the heart of
our financial district in New York. That will make it much
easier for our regulators to find out what is going on, and it
will make it easier for them to attract the kind of people with
market experience they need to understand what is going on in
the markets.
Finally, as we pay attention to market structure, we need
to think about how the markets are working for all companies,
large as well as small. And I think we need to pay attention to
the fact that the number of public U.S. companies has fallen by
almost 50 percent in the last 15 years. The number of public
companies is shrinking steadily, and if we run out of public
companies, we run out of jobs. In 1997, before the dot-com
bubble got out of hand, there were 8,200 U.S. public companies
listed on our exchanges; at the end of 2009, approximately
4,400.
Now, if you figure half of the missing 4,000 companies were
dot-coms that should not be there or companies that were
merged, well, that leaves 2,000 missing public companies. If
each of them were responsible for 1,000 jobs, that is 2 million
jobs lost to our public markets. That would make a big dent in
our unemployment rate of 15 million.
There are a lot of reasons for that, and I just want to say
I think you should hold further hearings on the reasons why we
are losing our public capital markets.
Thank you.
Chairman Reed. Thank you very much, Dr. Angel.
Just for everyone's understanding, your statements will be
made part of the record, so if you want to summarize, feel free
to do that. Thank you, Professor.
Now Mr. Peterffy, please.
STATEMENT OF THOMAS PETERFFY, CHAIRMAN AND CHIEF EXECUTIVE
OFFICER, INTERACTIVE BROKERS GROUP
Mr. Peterffy. Thank you for inviting me. I am Chairman of
Interactive Brokers Group, a brokerage and market-making firm
that is headquartered in Connecticut. Our customers have about
$21 billion of assets with us, so we are very focused on the
health of the U.S. markets.
Here is my worst nightmare. Imagine a high-frequency
trading firm, or HFT, with a few computers, some programmers,
and $30 to $50 million in capital. These operations exist all
over the world trading with sponsored access, where an often
undercapitalized U.S. broker allows the HFT to send orders
directly to the exchange using the broker's membership ID.
These orders are never seen by the broker before they are
executed.
One day, at 3:45 p.m., the HFT starts sending waves of
orders to sell large cap stocks and ETFs. As the close nears,
more sellers jump in and stop orders are triggered. The market
closes down 30 percent. The next morning, terrified investors
and brokers holding undermargined accounts run for the exits
and sell into cascading circuit breakers. Brokers fall like
dominoes, but the HFT that started it all makes a huge profit,
covering its short at fire-sale prices and moving its gains
offshore before the regulators know who did it.
In the alternate scenario, the market realizes that it was
duped. No news is seen causing the prior day's drop, and the
market moves up 40 percent the next morning. The HFT's short
sales are big losers, and the sponsoring broker and clearing
broker go bust, possibly starting a chain reaction. Under
either scenario, innocent investors will be caught by the huge
down move or up move, and confidence in our markets will suffer
further.
This is not far-fetched. We have nothing in place to
prevent this from happening. It could happen on any day. It
could be a manipulator seeking profits or a disgruntled
employee at the hedge fund or HFT or a brokerage firm. It could
be a terrorist act or a simple computer bug.
What can be done? I have four recommendations to review
briefly that are explained in detail in my written testimony.
These recommendations apply to the securities and futures
markets because these markets are inextricably linked, and it
is critical for the rules and surveillance tools of the two
markets to be coordinated with close coordination between
regulators.
First, sponsored access. Rather than in July of next year,
the SEC's new rules banning sponsored access should apply right
away by emergency order of the Commission. Seven months is much
too long to continue at risk. We screen or pat down over a
million people every day to prevent a plane crash, yet we do
not screen electronic orders to prevent the market crash. The
ability to send orders to the exchanges should be restricted to
brokers that are members of the clearinghouse. Brokers with no
financial stake in the clearinghouse should not be sending
unfiltered orders directly to exchanges any more than the HFT
should.
Second, surveillance tools. Regulators need real-time
surveillance, especially the identity of the person behind each
trade. The SEC should approve its proposed audit trail rules,
but shorten the 2-year implementation deadline. And until then,
the Commission should order that clearing brokers record the
identity of the person associated with each trade, starting
now. The CFTC should approve similar rules at the two agencies
as they must work together.
Third, improving liquidity of the exchanges. We must
improve liquidity by banning or restricting off-exchange
trading of exchange-listed securities. It is bizarre that under
Dodd-Frank over-the-counter equity derivatives must trade on
exchanges, yet exchange-listed securities can still trade over
the counter. When exchange-listed products are traded on OTC,
market makers leave and liquidity on the exchanges dries up,
allowing crashes like May 6th to happen. We must address this
by bringing trading in listed securities back to the exchanges.
Fourth, and last, circuit breakers. The current circuit
breakers are in effect only from 9:45 a.m. to 3:35 p.m., but
they should be in effect at all times when the market is open.
Also, the circuit breakers should kick in fixed price intervals
instead of being moving targets so that everyone can
precalculate what prices are allowed and not allowed. This
would eliminate the single-stock mini crashes that seem to
occur almost every week and that you were referring to some
time ago.
There should also be a marketwide circuit breaker that
would not allow transactions to take place outside a certain
limit for the day, but would allow continued trading inside
those limits.
Finally, the circuit breaker level must be coordinated
among the stock and related derivative markets so as not to
cause price misalignments that could result in temporary
insolvencies.
Thank you.
Chairman Levin. Thank you very much.
Mr. Narang, is that how you say your name?
Mr. Narang. That works.
Chairman Levin. Thank you very much.
Mr. Narang.
STATEMENT OF MANOJ NARANG, CHIEF EXECUTIVE OFFICER, TRADEWORX,
INC.
Mr. Narang. My name is Manoj Narang and I am the CEO of
Tradeworx, Inc. We are a financial technology firm that
provides high-performance trading infrastructure to investors
and trading firms. In addition to supporting outside clients
with our technology, we operate a proprietary trading practice
which utilizes the same technology to engage in high-frequency
trading strategies. Our proprietary trading business consists
of highly complex and data-intensive algorithms based on
correlations between securities that span multiple markets,
including stocks, options, and futures.
Before I begin, I would like to express my gratitude for
the opportunity to share my perspectives and insights in
today's hearing and to recognize that smaller firms such as
Tradeworx are not often afforded such a privilege.
My prepared remarks are on the topic of restoring investor
confidence to our markets. It is self-evidence that markets
depend on confidence in order to function smoothly, and there
is no denying that the confidence of investors was severely
shaken on May 6. It is this loss of confidence that transformed
the Flash Crash from just the most recent chapter of the
ongoing credit crisis into the referendum on market structure
that it has become.
Ever since May 6, investors have been plagued by the
nagging suspicion that the regulatory agencies are powerless to
understand the inner workings of the market or to meaningfully
assess the practices of its most active participants. For the
past 2 years, the public has been treated to endless debate
about market structure issues. Are the prices posted by market
makers fair or are they subject to widespread manipulation?
What impact do rebates or elevated cancellation rates have on
liquidity? Why is speed important to strategies which provide
liquidity? How do the equities, options, and futures markets
influence and interact with each other?
The public should not be forced to accept anecdotal or
speculative answers to such questions when definitive answers
can be found by analyzing data. Firms like Tradeworx have the
infrastructure to easily calculate objective answers to these
kinds of questions, and while we happily share our insights
with the SEC, what is needed to boost markets' confidence is
for the markets' chief regulator to have these capabilities on
its own.
Another key issue related to investor confidence is that
the market has become too complicated for ordinary investors to
understand. That is one of the things that leads to speculation
and unsubstantiated hypotheses. Our stock market sports the
most complex and fragmented structure known to mankind. The
cornerstone of this system, Regulation NMS, was 10 years in the
making and it spans over 520 pages. For perspective, consider
that in competitive games like chess, extraordinary complexity
arises from just a handful of rules. It should surprise nobody
that an undertaking of this magnitude might backfire, nor
should it surprise anyone that such unnecessary complexity
might fuel the perception among investors that the system is
somehow rigged against them.
Regulation NMS does many things, but at its core, its
objective is to keep prices at the different exchanges
synchronized. In most markets, this is accomplished via
arbitrage, which tends to be incredibly efficient in this role.
For example, consider the relationship between the stock SPY
and the IVV S&P futures contract, both of which track the S&P
500 index. Because they are completely different securities
that trade on different markets, their prices are not protected
by Regulation NMS. But if you sample their prices at subsecond
intervals, you will find that they have a 99.9 percent
correlation to each other. I have diagramed that correlation in
the exhibit. You can see on the exhibit just how stable this
relationship is, despite the existence of any regulation to
cause that correlation to be that high.
But apparently a 99 percent correlation was not good enough
to dissuade policy makers from the incredibly daunting task of
crafting rules to keep prices in sync. Unfortunately, the price
for complex rules that solve imaginary problems is rather high.
Rather than minimizing fragmentation, which was the stated
goal, Regulation NMS has directly exacerbated it by
guaranteeing that new exchanges will have orders routed to
them. Rather than limiting the role of arbitrage, the
regulation has diverted its focus from productive uses to the
exploitation of the regulation itself. And to top it off, the
rule has managed to ignite a massive technology arms race by
making the speed of information transmission a more critical
issue than it ever was before.
Now that a heightened appetite for more rulemaking clearly
exists, I feel that we are doomed to repeat our past mistakes.
Once again, proposals abound to solve nonexistent problems. It
is easy to conjure up gimmicks such as speed limits on order
cancellations, but it is also trivially easy to demonstrate how
they would backfire and harm long-term investors. When lawyers
with minimal trading expertise devise such rules, they should
recognize that world-class engineers with profit motive will be
there to exploit them. History makes abundantly clear who tends
to win this battle of wits.
Many market professionals have strong opinions on how to
fix market structure, but to win back the confidence of
investors, the SEC should engage in rulemaking that is
supported by empirical evidence and analysis rather than by
opinions and speculation. Furthermore, adding ambitious or
superfluous regulations to a system which is already hopelessly
complex is guaranteed to backfire by inviting unintended
consequences. Such rulemaking will not restore investor
confidence in our markets. Fixing the very real flaws in our
existing regulations will.
I hope to have the opportunity to elaborate on these topics
at today's hearing and I ask that the entirety of my written
remarks be included in the record.
Chairman Levin. They will be. Thank you very much, Mr.
Narang.
Mr. Cronin.
STATEMENT OF KEVIN CRONIN, GLOBAL HEAD OF EQUITY TRADING,
INVESCO LIMITED
Mr. Cronin. Thank you, Chairmen Reed and Levin, Ranking
Members Bunning and Coburn, and Members of the Subcommittees
for the opportunity to speak here today. I am pleased to
participate on behalf of Invesco at this hearing examining
efficiency, stability, and integrity of the U.S. capital
markets. Invesco is a leading independent global asset
management firm with operations in 20 countries and assets
under management of approximately $620 billion.
In the interest of time, I will keep my comments brief, but
I have submitted for the record a more detailed statement.
An efficient and effective capital formation process is
essential to the growth and vitality of the U.S. economy. The
most important aspect of the capital formation process is that
it attracts long-term investors' capital. To accomplish that,
it is critically important that the primary and secondary
capital markets which facilitate the capital formation process
are transparent, effective, and fair. To that end, it is
essential that sensible, consistent rules and regulations are
in place to govern the markets and that regulators have the
tools necessary to ensure the stability and integrity of those
markets. Long-term investor confidence is the key to robust
securities markets.
To be clear, investors both retail and institutional are
better off now than they were just a few years ago. Competition
in today's market, which was virtually absent 5 years ago, has
spurred innovation and enhanced investor access. Trading costs,
certainly in the most liquid securities, has been reduced and
investors have more choice and control in how they execute
their orders.
With that said, over the past several years, long-term
investor confidence has been challenged by a series of
scandals, financial crises, economic tumult, including most
recently the Flash Crash of May 6. In order to recover long-
term investor confidence, regulators must ensure that
securities markets are highly competitive and efficient as well
as transparent, and above all else, fair.
While we laud the gains made in the last years, today's
market structure is far from perfect. The events of May 6
brought to the forefront several inefficiencies in the current
market structure and highlighted the interdependencies of
equity, options, and futures markets. Perhaps most
significantly, the events of May 6 underscored the absence of
an effective mechanism to dampen volatility at the single stock
level. The lack of consistency and synchronization of rules
which govern trading at the various exchanges, the outsize
impact trading algorithms and small market orders can have on
the prices of securities in times of duress, and perhaps not
surprisingly, the fact that market-making mechanisms in place
today provide virtually no liquidity to investors in times of
market stress.
Ruling all instability and volatility from the equity
markets is neither possible nor appropriate. However,
establishing mechanisms to address extreme price moves in the
markets and volatility related to inefficient market structure
will be critical in promoting investor confidence in markets
going forward. Many of these issues have been addressed or are
in the process of being addressed by the regulators. That said,
the potential for another May 6 will not entirely be removed
from these actions alone. The SEC, CFTC, and SROs must be
coordinated, diligent, and measured in their efforts to create
sensible regulation designed to minimize the inefficiencies in
market structure and advance surveillance and enforcement
capabilities to thwart nefarious behavior.
There are today at least 13 for-profit exchanges.
Competition between exchanges is fierce, resulting in new
innovations and different ways for investors to seek and
provide liquidity. This is a welcome development from our
perspective, provided that the rules and regulations which
govern the various exchanges are consistent and not incongruent
with the goals of fairness and equal access for investors.
One potential concern we have about exchange competition is
that it has ignited an electronic arms race where speed appears
to be the singular objective. While Invesco believes that speed
is an important variable to consider in execution of trades, we
believe price is the most important variable. Buying stocks at
the right price, which is determined through a robust price
discovery process, is what long-term investing is all about.
There is a point where speed and robust price discovery
diverge, a concept that must be understood by exchanges as they
race to trade in increments of one-billionth of a second.
There are today also 40 different trading venues, including
dark pools, and over 200 broker-dealers who internalize
customer orders. This vast network of exchanges and venues has
resulted in a very complicated web of conflicted order routing
and execution practices by broker-dealer and execution venues.
We believe that investors need improved information about
order routing and execution processes to make better informed
decisions. Today, as much as 50 to 60 percent of the trading
activity in the U.S. equity markets is attributed to high-
frequency traders, HFT. Given the recent ascendence of HFT,
there is not a lot known about their practices and very little
regulatory oversight.
Invesco believes that there are many beneficial high-
frequency trading strategies and participants which provide
valuable liquidity and efficiencies to the market. On the other
hand, we are concerned that some strategies could be considered
as improper or manipulative activity. Some of these strategies,
such as the so-called ``order anticipation'' or ``momentum
ignition'' strategies, provide no real liquidity to the markets
or utility in any way. Rather, they prey on institutional
retail orders, creating an unnecessary tax to investors. While
there has been a recent case brought by regulators against this
kind of improper activity, we are concerned that the ability of
regulators to monitor and detect nefarious behavior by these
participants is not where it needs to be.
Additionally, regulators must address the increasing number
of order cancellations in the securities markets. It has been
theorized that as many as 95 percent of all orders entered by
high-frequency traders are subsequently canceled. Order
cancellations relating to making markets is one thing, but
orders sent to the market with no intention of being traded is
quite another--before they are canceled is quite another. These
orders tax the markets' technological infrastructure and under
the right circumstances could overwhelm the systems' capacities
to process orders, causing massive system failures and trading
disruption.
Invesco believes that efficient trading markets require
many different types of investors and participants to thrive.
That said, it is noteworthy that where the interests of long-
term investors and short-term trading professionals diverge,
the SEC has repeatedly emphasized its duty to uphold the
interest of long-term investors. We need to ensure that there
are no abusive practices within high-frequency trading or, for
that matter, any other participant in the marketplace which
contravene the interest of long-term investors.
I thank you for the opportunity to speak here today and I
look forward to answering your questions.
Chairman Reed. Thank you very much, Mr. Cronin.
Mr. Luparello, please.
STATEMENT OF STEVE LUPARELLO, VICE CHAIRMAN, FINANCIAL INDUSTRY
REGULATORY AUTHORITY
Mr. Luparello. Chairman Reed, Chairman Levin, thank you for
the opportunity to testify today. My name is Steve Luparello
and I serve as Vice Chairman of the Financial Industry
Regulatory Authority. Also known as FINRA, we are the primary
independent regulator for securities brokerage firms doing
business in the United States. In addition to our work
overseeing firms and brokers, FINRA performs market regulation
under contract for a number of market centers in the United
States. Through this work, FINRA is responsible for aggregating
and regulating approximately 80 percent of U.S. equity trading.
FINRA's activities are overseen by the SEC, which approves all
FINRA rules and has oversight authority over FINRA operations.
Over the last several years, how and where trading occurs
has evolved rapidly, as has execution speed, particularly with
equity trading. High-frequency trading, dark pools, and direct
access are now commonplace and have contributed to the
fragmented markets that exist today. Fragmentation and
increased competition have resulted in narrow quotation spreads
and a high level of liquidity when markets are operating
smoothly. However, it can also result in the fast electronic
removal of liquidity when markets are stressed, as we all
observed on May 6.
The events of that day identified several areas where
regulators could take steps to reduce the impact of extreme
market volatility and provide increased transparency and
predictability in restoring order to the markets following such
events. FINRA has participated in these discussions with the
U.S. exchanges, under the leadership and direction of the SEC,
to establish and implement a number of important changes, as
described in my written statement.
While the disruption on May 6 focused attention on high-
frequency and algorithmic trading, FINRA had already been
scrutinizing trading activity to find attempts to use these
technologies to implement manipulative strategies. In
September, we fined a New York brokerage firm, Trillium
Brokerage Services, and suspended and fined several individuals
at the firm for the use of illicit high-frequency trading
strategy. Trillium entered numerous layered, non-bona fide
market moving orders to generate selling and buying interest in
specific stocks. By creating a false appearance of buy or sell-
side pressure, this strategy induced other market participants
to enter orders to execute against Trillium limit orders. As a
result of this improper strategy, Trillium's traders obtained
advantageous prices that otherwise would not have been
available to them.
FINRA is able to pursue instances of this and other illegal
trading strategies in the markets we regulate. However, due to
the limitation of current audit trails, the risk of missing
instances of manipulation, wash sales, abusive short selling,
and other improper gaming strategies is still unacceptably
large.
With the drop in exchange barriers to entry along with
increased competition and connectivity among exchanges and
other execution venues, it is clear that market quality can no
longer be ensured by a single exchange acting in a siloed
fashion. As the SEC correctly recognized in its recent
proposal, this evolution of equity markets has created an
environment where a consolidated audit trail is now essential
to ensuring proper surveillance of and investor confidence in
these markets.
FINRA strongly supports the establishment of a consolidated
audit trail as a critical step to enhance regulators' ability
to conduct surveillance of trading activity across multiple
markets. In fact, it is very plausible that certain market
participants, knowing the extent of current regulatory
fragmentation, now consciously spread their trading activity
across several markets in an effort to exploit this
fragmentation and avoid detection.
Based on our experience developing and operating the Order
Audit Trail System, or OATS, FINRA believes the key aspects
necessary to ensuring an effective, comprehensive, and
efficient consolidated audit trail are uniform data, reliable
data, and timely access to that data by the SROs and the SEC.
We also believe that the most effective, efficient, and timely
way to achieve the goals of the consolidated audit trail is to
expand existing systems, such as OATS, and to consolidate
exchange data with discrete new data, such as large trader
information, into a central repository. Building off existing
systems would significantly reduce both the cost and time
required for implementation of a fully consolidated audit trail
and integration of that audit trail into surveillance systems.
Significant changes in the financial markets in recent
years have necessitated adaptation by regulators across a wide
spectrum of issues. Both technological and policy developments
have made the practice of regulating the markets a more complex
task.
The SEC has correctly identified one of the most pressing
challenges for regulators conducting market surveillance. We
are all hampered by the lack of a comprehensive, sufficiently
granular, and robust consolidated audit trail across the
equities markets. FINRA stands ready to work with Congress, the
Commission, and our fellow SROs to help bring about a
consolidated and enhanced audit trail that will facilitate more
effective surveillance for the protection of investors and for
market integrity.
Again, thank you for the opportunity to share our views. I
would be happy to answer any questions that you have.
Chairman Reed. Thank you very much, gentlemen, for your
testimony.
I just want to recognize Senator Coons has joined us. As
soon as I conclude and Senator Levin concludes, we will
recognize him for questions.
I have questions for all the panelists, but let me first
focus on the market participants, Mr. Peterffy, Narang, and
Cronin. My presumption is that you would feel that the
regulators do not have all the information they need at this
time. From your perspective, what forms of information, market
intelligence, et cetera, should they have? And you have
listened to both Chairman Schapiro and Chairman Gensler about
what they are doing in terms of a consolidated audit trail.
Your comments on whether that is adequate, sufficient, or
additions. Mr. Peterffy.
Mr. Peterffy. I agree that they do not have all the
surveillance tools that they need. However, I do not think that
we should wait for the two or three or 4 years to get this
consolidated audit trail for $4 billion. I think that as of
tomorrow, they could order U.S. registered brokers to keep an
audit trail of their own orders, and most of all, to record the
name of the beneficial interest associated with each order.
Then if anything happens in the market, they would just go ask
the broker, via the exchange, who did this trade? Please send
order details tomorrow. It does not cost anything to do that.
It can be done today.
Chairman Reed. Thank you.
Mr. Peterffy. Thank you.
Chairman Reed. Mr. Narang, your comments?
Mr. Narang. So in terms of what data, I think, the
regulatory bodies could benefit from, I think, absolutely, I
support the acquisition of data that helps the regulators
engaged in forensic analysis of various types, such as the
audit trail, such as the large trader reporting requirement,
and I say that as somebody who would certainly be affected by
at least one of those.
So that said, I think that there are some lesser known
items that could be rather useful, as well. Many people have
pointed to the analogy that I think one of you, in fact, said
earlier, that the regulators are akin to a moped on a highway
dominated by hundred mile-an-hour race cars. The way I would
rephrase that in terms of data requirements is that the
regulators very much need to be able to see the markets in the
same way that its most active participants see it.
So what that means is that they need not just direct data
from the exchanges rather than the consolidated view that they
see right now via the so-called SIP, or the Standard
Information Processor. Those are consolidated feeds. The
regulators need the direct data from the exchanges, but they
need better than that. They need to be able to synchronize that
data in the same way that a high-frequency trader, for
instance, would. And that means that they cannot just rely on
the time stamps that the exchanges put on their data in order
to synchronize them. They need to collect that data over high-
speed telecommunications networks themselves and self-time
stamp it.
Then, furthermore, both Ms. Schapiro and Mr. Gensler noted
the fact that they do not have the ability to efficiently build
order books from that quotation data. I think that that is
something that is a prerequisite if you are going to have the
capability to police modern traders. You know, technologies are
out there--firms like ours possess them, for instance--that
allow you to very, very efficiently construct order books from
quotation data.
Now, the data itself is just the starting point. One of the
things that makes me nervous is that the SEC barley has the
ability, as far as I can understand, to analyze the data that
it already possesses. So adding a hundred to a thousand times
more information to that mix is not going to really help
matters if their analytical capabilities are not augmented at
the same time. And the main thing that the analytical
capabilities are missing, as was rightfully alluded to earlier,
is the ability to analyze securities based on their
correlation.
A tremendous amount--I would say the majority--of the
volume that occurs in today's markets is premised upon the fact
that securities, both within the same markets and across
markets, have semi-stable correlations to each other, so that
when price discovery happens in one instrument, it must
propagate to other instruments that are correlated to it, and
regulators currently have no clue how that works and have no
tools to analyze those effects. Those effects are now
structural issues and I think that the regulators need to have
analytical tools that endow them with those capabilities.
Chairman Reed. Thank you.
Mr. Cronin, your comments, please, and then I will
recognize Chairman Levin.
Mr. Cronin. Yes, sir. I would quickly add that I agree that
having the information from a regulatory standpoint is helpful.
I do tend to agree that being able to analyze the data is
fundamental. The other point that is important is that the
regulators have to be able to coordinate the information. It
seems to me that having the data, even having the ability to
analyze, in the absence of pulling all the pieces together is
not going to get us where we need to be. This will be an
effective deterrent to the extent that it is in place, but as
Mr. Peterffy says, I do not agree that we have the kind of time
that it sounds like it is going to take. I am not sure we have
the financial appetite, either, but this is something that
needs to happen.
Chairman Reed. Thank you. There will be a second round. Let
me recognize Chairman Levin.
Chairman Levin. Thank you, Senator Reed.
Mr. Peterffy, you described your worst nightmare, and I
think every member of the panel heard that description of your
nightmare. I am wondering whether or not the other members
believe, as you do, that the nightmare is plausible.
Mr. Angel. It definitely could happen, that our market is
very complex and there are all kinds of things which can go
wrong and Murphy's Law will strike. There will come a time when
on a day of heavy trading volume, whether because of some
malevolent action, some benign action, or some programming
error, something is going to go haywire. This is the nature of
complex electronic systems. And just like sometimes our
computers crash, our computerized stock network will, as well,
and we need to have good safeguards in place to protect us the
next time it happens.
Chairman Levin. This was not so much a crash based on some
glitch; this was an intentional effort on the part of somebody
who had as little as $30 to $50 million and a few computers and
a couple programmers. In any event, you would agree that that
nightmare scenario is plausible?
Mr. Angel. Yes.
Chairman Levin. Mr. Narang, would you say that you believe
it is plausible?
Mr. Narang. No. I believe it is extraordinarily
implausible, and I will explain why. I think there is no doubt
that a larger trader could impact the market, but the
attribution of that nightmare scenario to a high-frequency
trader that controls only $30 to $50 million in capital is
utterly preposterous on its face. You can do the math.
You can statistically estimate, as we have done, and we
have shared our findings with the SEC that, for instance, the
trade by Waddell and Reed on May 6, the $4.1 billion trade,
very likely had a price impact of around 2.7 to 2.9 percent,
OK, with a reasonable degree of confidence. If you extrapolate
from that what a $30 million to $50 million capitalized firm
could have done on that same day at that same time, you come up
with about three basis points, or three-hundredths of a percent
of impact. So it is entirely implausible. A firm like that
would exhaust its entire capital base before the market would
even notice the movement.
Chairman Levin. OK. Mr. Cronin, do you believe a scenario
like that is plausible?
Mr. Cronin. Plausible, yes. Three hundred shares took it
from $52 to $100,000.
Chairman Levin. OK. Mr. Luparello.
Mr. Luparello. I will fall somewhere between my fellow
panelists. I would say it is implausible, but it is not
impossible. I think there are structures in place around risk
controls in terms of the firms that provide access to the
marketplace. It is not a comforting thing just to rely on risk
controls of broker-dealers. I think the steps that the SEC has
taken in the adoption of its rule around controlling access
will go a great way to making that scenario even more
implausible and nearly impossible.
Chairman Levin. OK. Now, Mr. Peterffy, do you want to
comment on Mr. Narang's comment?
Mr. Peterffy. Yes. You see, with naked access, you do not
need to have any capital to send in orders. You send in the
orders. The orders are not even seen by the broker. You only
need the money the next day, when the clearing broker gets
these trades and he says, where is the money? Well, in this
scenario, there is a lot of money there because there are
imbedded profits as the trader sells them down. But even if
there is no money there, it is too late the next day to
discover that all this should not have happened. That is why
naked access is a problem and that is why these trades should
be screened. Now----
Chairman Levin. Let me go through your remedies.
Mr. Peterffy. Yes.
Chairman Levin. I am over my time----
Senator Coons. You are fine.
Chairman Levin. Well, this may take a few minutes, so I am
happy to come back to it.
I would like to go through the remedies, because whether it
is plausible, implausible but possible, or at least that much,
there are a number of remedies for this that Mr. Peterffy has
suggested. One of them is that the ability to submit orders to
exchanges should be restricted to brokers that are clearing
members. That is one of the suggestions that you make. I am
wondering if anybody wants to comment on that, and also on the
other suggestion that relates to this, that brokers who are not
members of the clearinghouse are allowed to send orders
directly to an exchange with the permission or the arrangement
of a clearing member broker. They give their permission. All
these 5,000 brokers that are not members of the clearinghouse
can send orders directly, and you would prohibit that.
Mr. Peterffy. Yes.
Chairman Levin. OK. So there are two suggestions there.
Now, let me start with you, Professor Angel. What do you think
of those ideas?
Mr. Angel. There are a lot of subtleties involved with the
proposal to ban anyone but clearing members from putting orders
directly into the exchange. Given the economies of scale in
clearing, there has been quite a consolidation in the business,
so what that would do would be limit direct access only to the
very largest Wall Street firms. Do we really want to encourage
that kind of consolidation in the industry? So that is one
thing to think about.
Also, I could see a clearing member actually providing
naked access, and I support the SEC's proposals to get rid of
so-called naked access, where a broker is providing a direct
pipe without screening the orders first. I think that is the
most important thing here, that we have to have the right risk
controls in place so that the people who are responsible for
the trades know what they are sending into the markets.
Chairman Levin. Even if they are doing it through a
clearing broker, not being a clearing broker themselves?
Mr. Angel. Right. There has to be--you need to have the
risk controls in place.
Chairman Levin. OK. So, Mr. Narang, your comment on that
suggestion.
Mr. Narang. Yes. I would like to comment on that suggestion
and I would also like to comment on Mr. Peterffy's refutation
of my refutation. So----
Chairman Levin. You know what that is going to produce,
though.
Mr. Narang. What is that?
Chairman Levin. You know what the next production will be
of that: a refutation of your refutation.
Mr. Narang. Correct.
Chairman Levin. Happily, my time will be up perhaps before
that happens.
[Laughter.]
Mr. Narang. So first of all, I fail to see the need for
additional remedies. I think that Mr. Peterffy's scenario, by
his own admission, was based on a situation where naked access
or sponsored access are in place. We are already at the stage
where a ban on sponsored access has been posted to the Federal
Register and is due to go into effect within 7 months.
Chairman Levin. Would you make that effective immediately?
Mr. Narang. No, I cannot say that I fully----
Chairman Levin. Based on an emergency argument that Mr.
Peterffy suggested?
Mr. Narang. I cannot say that I fully endorse the ban on
sponsored access. I can see some of the rationale behind it,
but I think that there are some little-known issues that are
peripheral to that that are anticompetitive but I think are
perhaps above the scope of this hearing.
As for the refutation----
Chairman Levin. Nothing is above the scope of this hearing.
[Laughter.]
Mr. Narang. If you want to keep us for a few hours longer,
I am happy to comment on it.
As far as the comment about the capital not needing to be
there and risk checks not being applied, that is a little bit
misleading because all that naked access means is that risk
checks are not done on a pretrade basis. They are still
absolutely done on a posttrade basis and there is not much
latency between the time a trade occurs and the time----
Chairman Levin. That was the ``next morning'' comment.
Mr. Narang. No, it is not--no. By posttrade, it does not
mean next morning. Posttrade means as soon as the trade
happens, your buying power is reduced, OK.
Chairman Levin. Do you agree with that?
Mr. Narang. Brokerage firms monitor your day trade buying
power.
Mr. Peterffy. No, I do not. The fact is that there are many
little brokers who provide naked access. There is nobody
policing whether they do any screening of orders or not. So
some of them, I assume, do posttrade screening. Many of them
probably do not.
Chairman Levin. OK. I interrupted you, Mr. Narang.
Mr. Narang. I do not know of any who do not. I think that
is a rather hypothetical statement. The point is that posttrade
risk checks are nearly universal and adequately prevent people
from exceeding their buying power.
Chairman Levin. OK. Very quickly, Mr. Cronin, because I am
way over my time.
Mr. Cronin. I am just amused, listening to the whole thing.
Like all long-term investors, we get hung up in listening to
some of this discussion and kind of scratch our heads and say,
you know what, guys? When we are talking about naked access and
that kind of thing, we are kind of losing sight of what the
goal of the structure and the integrity of markets is. There
have to be rules in place to prevent nefarious activity. If we
think there is a chance that shutting the door today can
contain that, I think we should shut the door today and move
on. There are more important things for the world to worry
about than the naked and unfiltered access.
Chairman Levin. Thank you. Mr. Luparello.
Mr. Luparello. I would have to say Mr. Peterffy's scenario
is based on an assumption that a clearing firm is not managing
intraday risk. So the idea that only clearing firms should be
allowed to trade in that context would be, I think, an odd
solution. I do not want to say that every clearing firm is
perfect at managing intraday risk, but their economic
livelihood is staked on it. Again, I would go back to the
recent rulemaking by the Commission which puts some real teeth
in what that monitoring means, but as a general matter,
clearing firms monitor intraday risk because it is what keeps
them open day after day.
Chairman Levin. And would you make that rule immediately
effective?
Mr. Luparello. I would not. I would assume that there is a
fair amount of disruption that would go with that, and in the
rare scenario that a clearing firm was mismanaging its intraday
risk, to have that much dislocation in that short a period of
time, I would worry that the costs would outweigh the benefits.
Chairman Levin. Thank you.
Chairman Reed. Thank you, Chairman Levin.
We have been joined by Senator Coons, who is the worthy
successor to Senator Ted Kaufman, who was one of the, I think,
great--I think the right word would be ``and persistent''
analysts of the whole issue of high-frequency trading's impact
on markets, and thank you, Senator Coons, for joining us.
Chairman Levin. And made a major contribution----
Chairman Reed. A major contribution.
Chairman Levin. ----to the bill. I know Senator Kaufman was
right in the middle of that famous outbreak, also for the
Permanent Subcommittee, an extraordinary contributor to our
efforts. And we know that you are right in that capability, as
well.
Senator Coons. Well, thank you, Senator Reed, and, Chairman
Levin, I hope to be Senator Kaufman's successor in interest
both in subject matter interest and interest in terms of
representing both the people of Delaware and our country.
Senator Kaufman did a great deal of work, I think, to ensure
the stability, the transparency, the fairness, and liquidity of
our markets following one of the greatest market dislocations
we have known. I will report back to him that I had the
opportunity to hear one of the first cases of refutation
arbitrage that I think I have ever seen in testimony. And I
just wanted to focus on a sort of simple question, I think.
Markets' fundamental role in our economy, in my view, is
capital formation and serving and protecting long-term
investors, and that is sort of part of the purpose of the
transparency, fairness, and stability. So my question first to
you, Mr. Cronin, if I might, to what degree are you concerned
that the markets are no longer serving those functions and that
high-frequency trading is detracting from price discovery in a
way that undermines those core goals of our markets?
Mr. Cronin. As I said, Senator, the overall function of the
market is much better for investors today than it was, say, 5
years ago. Competition has been enhanced. Our ability to have
more control over our orders has clearly been enhanced. And we
have seen a reduction in transaction costs.
Now, I will say that that has not been a universal
experience. Transaction cost reduction clearly in the top 200
names, I think, given the ubiquitous liquidity that is
available now is clear. When we move down the market cap curve,
it is not as clear that this market structure is serving the
smaller companies in the formation process as well as it could
otherwise. So I am confident that the market structure is
better today. It can always be better. It will always probably
be the case that it could be better.
To the extent that high-frequency trading has entered the
market, frankly, we are fairly agnostic. To the extent that the
activity has liquidity and does not cause undue dislocation on
a given day or week, we are OK. But the problem is that we do
not believe that the regulators have the appropriate tools to
really understand all the things that go on. We are pretty
smart, and we understand a lot that goes on, and I am sure that
there are areas that we cannot possibly understand today. So
what does concern me is I think there are nefarious activities
and participants who are out there who today are taking
advantage of investors. That is wrong. If you bring nothing to
the party in terms of liquidity or, you know, efficiencies, you
shouldn't tax investors. There is no purpose for that.
So we have some concerns about high frequency, but we would
have concerns about any participant who is trying to manipulate
the market. So we would not single them out necessarily.
Senator Coons. So then just two follow-up questions, and I
might ask the members of the panel in my time left to comment
on both of these. Some propose there is an IPO crisis that in
part is a consequence or an outcome of these short-term
strategies. What linkage do you see between all the dynamics of
market fragmentation and the difficulties identified here,
particularly in the market sectors that maybe you do not
participate in but others? And what is the impact of that on
innovation and capital formation for IPOs?
Then just the follow-on question, should high-frequency
traders who act like market makers be subject to additional
regulations that would help solve that specific problem? If you
would, please, Professor.
Mr. Angel. Thank you, Senator. I am very glad you are
cognizant of the IPO crisis because I think it has serious
implications for the long-term growth and stability of our
economy. I do not think that high-frequency trading as such is
at the root of it. There are many other things in our economy
ranging from Sarbanes-Oxley 404, the litigation environment,
and other market structure changes that we can talk about if
you have a few more hours.
The thing about high-frequency trading is that there is
both good and bad computerized trading. All investors these
days are using computers basically to do what they used to do
manually. And a lot of this is good for the market. For
example, a lot of so-called high-frequency traders follow the
old strategy of buy on the dip, sell on the rebound. That helps
to stabilize prices. And one of the things that happened on May
6th was when the data feeds got scrambled and those people said
we cannot trust our data feeds, those people who were
stabilizing the market stepped aside and other traders kept on
going, causing the market mechanism to fail.
So some high-frequency traders are really good. Others help
keep prices in line with each other. If Coke gets out of line
with Pepsi, they step in to make sure that those prices stay in
sort of the same correlated path. So a lot of what they do is
good. I will not say everything they do is good. But we cannot
just say, ``Ew, high-frequency trading is bad.'' You know,
there are some strategies that may be harmful to the market,
but the bulk of them are actually doing things that help the
market.
However, I do think we need to pay attention to the smaller
cap side of the market because what we have done is we have
collapsed transaction costs. We have a one-size-fits-all market
mentality at the SEC, and I am convinced that smaller companies
actually need a different market mechanism and that having a
market mechanism with a very small bid-ask spread for those
companies is not necessarily the best market mechanism. And I
think we really need to pay a lot of attention to how small
companies come to market and how hospitable the market is to
them, because that is where our future growth lies and that is
where we have a serious crisis on our hands.
Senator Coons. Thank you. I am over time, so if any other
members of the panel who want to comment could keep it just on
that one question, I would appreciate it.
Chairman Reed. Yes, but take your time, Senator.
Mr. Peterffy. High-frequency traders are not by themselves
good or bad. When they provide liquidity, they are good; when
they take liquidity, they are not so good. I think this would
be very simple to regulate; namely, when a high-frequency
trader provides liquidity, it puts in a bid or an offer that
does not take up any other bid or offer. Then that is a useful
activity and, therefore, they should be encouraged to do so.
They could even be incentivized to become market makers because
that is what market makers do. And when they are taking
liquidity, which is basically a way of probably front-running
statistical relationships that will come back in line, then
they should--their order should be slowed by--I suggested a
tenth of a second.
Mr. Narang. I would like to comment on your question
earlier about the capital formation process and more generally
about the social utility of high-frequency trading, because
many people have raised that issue.
I would like to point out that when an investor buys shares
of a company in the open market, the proceeds of that purchase
go to the seller. They do not go to the company that the stock
is written on. No capital is raised for the firm in question
when an investor purchases share of that security. In other
words, no capital formation happens in the secondary market.
The capital formation is the job of the primary market.
The role of the secondary market is exclusively to
encourage investors to participate in the primary market by
providing them with liquidity. So when you are planning the
desirable attributes for a secondary market to have, I firmly
believe that there are few, if any, attributes that can trump
liquidity. That is the overriding social purpose of a secondary
market. It is to support the capital-raising function that
occurs in the primary market.
So to the extent that you believe that high-frequency
trading is a fixture of our markets in terms of liquidity
provision, then you would have to argue that it serves just as
much, if not more of a social value than investing in company
shares than the secondary market does.
Second of all, on the notion of obligations, my major
concern there is that obligations really put us on a slippery
slope toward the two-tier market that we had in the 1990s. I
think our goal or your goal as policy makers ought to be to
keep the good features of the market that have occurred as the
markets have evolved and, you know, address or ameliorate the
bad ones. In terms of the bad features, we are talking about
mostly unbridled fragmentation.
In terms of the good features, I do not think that anyone
disputes the fact that markets have gotten more liquid and that
spreads have gotten tighter and transaction costs have gone
down, and virtually no one disputes the notion that that has
happened because the market-making function has been opened up
to competition. The two-tiered system that we had was
dismantled. Going back to that system would be
counterproductive.
Furthermore, I cannot think of any empirical evidence that
market maker obligations actually matter in practice. Take the
example of May 6th. On May 6th, there was a corner of our
industry known as the wholesaling industry which executes the
bulk of all retail order flow. Virtually every firm in that
industry shut down for business during the Flash Crash and
dumped its shares onto the market. That is the one corner of
our industry that does have obligations. So it shows you how
effective obligations are.
And in 1987, during the great crash in October, Black
Monday, market makers took a lot of heat for many, many months
in the press after that event for, quote-unquote, putting their
hands down and refusing to take orders.
So the point is that even if you are obligated 99.9 percent
of the time to provide liquidity, the 0.1 percent of the time
where you will choose not to is precisely at those moments
where the market needs it most. So obligations, there is no
empirical evidence that such a thing will work. There is
empirical evidence that people who request obligations will
also request certain privileges that go along with them.
Senator Coons. Well put. Thank you.
Mr. Cronin. Well, that is a question with a lot of
different dimensions. I think that I will try to condense my
thoughts to this:
There is always confusion of volume and liquidity in the
market. There is without a doubt much more liquidity in the top
200 names than there has been certainly historically. But I am
not sure that another 100 million shares trading in Citigroup
qualifies as real liquidity in the marketplace. In fact, I do
not think it qualifies at all.
So I do think, again, if we were to look at the market in
terms of all of the different components of the market, there
is clearly the top part which has been functioning and served
us very well by the current structure. It is very much less
clear in terms of transaction costs--and believe me, we have
done the analysis--that the market structure currently is
serving the other parts of the market very well.
So I think if there were value in market making--and I
think historically market making has been an important part of
the efficient market structure--then it is certainly worthy of
consideration. I get that nobody wants to catch falling knives.
No question about it. We have seen it time and again. However,
we are putting in place circuit breakers; we are putting in
place some other things that I think could be helpful in those
calamitous events that make the provision of liquidity, albeit
probably on the small end, at least at some level more orderly
and fair than it has been historically, and maybe there is some
value in that going forward.
Senator Coons. Thank you.
Mr. Luparello.
Mr. Luparello. It was multipart and there have been
multipart responses, so I will just ally myself with the last
bit that Mr. Cronin said. I do think there is a place for
mandatory liquidity in the marketplace. I think Mr. Narang is
right that that mandatory liquidity has not stepped in the way
of moving trains, but Kevin is also correct that those trains
with certain circuit breakers can only move so far.
So as policy makers continue to analyze the place of high-
frequency traders in the marketplace and analyze that tradeoff
of in theory liquidity and volatility, I think one of the
aspects that has to be looked at in there is: How productive is
that liquidity? And how can you put some mandatory obligations
back on certain participants in the marketplace?
Senator Coons. Great. Thank you. Thank you very much to the
panel.
Thank you, Mr. Chairman.
Chairman Reed. Thank you, Senator.
Let me just start the second round briefly, and then I will
turn it over to Chairman Levin to conclude the hearing.
It strikes me that one of the, I think, consistent themes
of all the panel has been that high-frequency trading has
provided some efficiencies in the marketplace, has utility to
the marketplace, et cetera. But there are high-frequency
trading strategies that are dangerous and disruptive and
harmful to investors.
And the other point, I think, that emerges is that at this
juncture the regulators do not have the ability to understand,
even with all the data, these different strategies, and that
their focus should be on, let us say, the unfortunate
strategies or the perverse strategies, whatever the
terminology. Mr. Narang and Mr. Cronin, quickly, is that a fair
summary of where you think we are?
Mr. Narang. First of all, let me say that I certainly agree
that there exist high-frequency strategies that perhaps have
less social utility than others. I do not now of any high-
frequency strategies that are in use or that could even be
hypothetically conceived of that are destabilizing to the
market system in some way. And the reason I say that is simply
a recognition of the fact that virtually every high-frequency
trading firm that is out there controls very, very little
capital. The largest high-frequency trading firms in the world
would not even be medium-sized hedge funds in terms of the
capital they control.
So the point is it takes capital to move markets. Markets
move because of buying pressure or selling pressure. The buying
pressure or selling pressure in any fixed unit of time that is
sufficiently long is roughly equal for a high-frequency trading
firm. That is what makes them have high frequency. The high
frequency refers to their holding period. So if your holding
period is only 1 minute, what that means is that in a minute on
average you buy and sell the same number of shares. You cannot
have a protracted or permanent effect on a stock's price when
you do that.
So that virtually rules out the possibility of
destabilization, barring some hitherto unknown accidental bug
that occurs. But I think your question focused more on
intentionality, so from an intentionality perspective, I would
say that, yes, high-frequency strategies, like any other
strategies, run the gamut in terms of what value they provide.
But I do not know that markets should be policed based on some
sort of subjective assessment about how much value a
participant is adding to the market. I think that all that
should happen is that rules should be obeyed, that, you know,
make sure there is a level playing field, and that the markets
are fair.
What I will tell you is that even though I am a high-
frequency trader, there are definitely unfair aspects of the
market structure today that favor certain participants over
others.
Chairman Reed. Well, thank you. First of all, I think you
have illustrated there are at least two issues at play here:
stability of the markets and fairness of the markets.
Mr. Narang. Yes.
Chairman Reed. The markets could be very stable but very
unfair to participants, some participants, and grossly
overcompensating on this, but I think it is an important point.
But, Mr. Cronin and Mr. Peterffy, just your quick comments,
and then I want to----
Mr. Cronin. So I would submit there is one other dimension
other than buy and sell, and that is quote.
Chairman Reed. Right.
Mr. Cronin. Why are there participants allegedly quoting
one stock 4,000 times in a second? What is the intention there?
So I do believe that there is activity that goes on that is
trying to get institutional or retail orders to react without,
in fact, taking the risk of taking an offering or hitting a
bid. I think that is out there, and it certainly needs to be
looked at.
Chairman Reed. Mr. Peterffy, please. Quickly.
Mr. Peterffy. The risk of systemic disaster caused by
disruptive trades is very real. There is no justification for
continuing naked access. We should stop it now. It costs
nothing to stop it. Only irresponsible, undercapitalized
brokers support naked access, and there is no justification for
continuing it.
Chairman Reed. Thank you.
Mr. Peterffy. If I may just say, I have never heard of Mr.
Narang before, and as far as I know, his reputation is
impeccable.
[Laughter.]
Chairman Reed. Well, thank you very much.
Mr. Narang. I second that thought.
Chairman Reed. One of the interesting things about this
hearing is it has raised more questions than it has answered,
and that is a good hearing in my book, because this is a very
extraordinarily complicated topic, and you have all shed so
much light on it.
There is one other issue here, and that is, Mr. Narang made
the point that, you know, primary markets form capital.
Professor Angel made the point that the primary market, the
IPOs, seem to be diminishing, the public companies are
diminishing, et cetera. So is there a contradiction between
this very successful, if you will, secondary market, highly
liquid, et cetera, but the fact that it is not generating the
kind of capital formation that puts people to work, i.e., the
classic, which always--I did not understand and I probably
still do not, the real economy versus the financial economy?
And we talk about high-frequency trading and naked access, you
know, that is the financial. The real economy is: Do I have a
job? Do I have capital to expand my business, et cetera?
So if you can just comment briefly on that, Professor
Angel.
Mr. Angel. Sure. We have--I call it the best of times and
the worst of times, just like in Charles Dickens. For the most
liquid stocks, the big stocks, it really is the best of times.
By almost any measurable dimension of market quality, the
market for Microsoft, IBM, and Citigroup is very liquid, very
cheap, very fast. It works really well. But when you get into
the smaller stocks, you have liquidity drying up. I mean, it is
better than it was 10 years ago, but still a lot of smaller
companies just say, hey, it is not worth it to access the
capital markets, whether because it is the high cost of being a
public company with all the compliance requirements or the fact
that the capital market is not recognizing the value of these
enterprises.
Now, we need good secondary markets to provide exits for
the people who buy in the primary market. But we also need the
IPO market to provide exits for the entrepreneurs who build the
companies, and we really need to pay a lot of attention to what
is going wrong here. There is no one magic bullet here. But it
is a serious crisis.
Chairman Reed. Well, Mr. Narang, very quickly.
Mr. Narang. I appreciate it. I think that the Committee
would be well served to solicit the testimony of venture
capitalists on this topic, and I am confident that what they
would tell you is that the main reason why companies are not
seeking to go the IPO route is because the stock market has
been roughly flat for the past 10 years, and a better exit for
companies is to sell their firm to Google or some other big
public company than to list themselves. So, in other words,
economic conditions clearly have a lot more to do with the
state of affairs when it comes to listing companies than, you
know, the health of the secondary market.
The second thing I would say is that it has also been
shown, I believe, that other exchanges across the world are
perhaps more competitive than the United States because of
regulations such as Sarbanes-Oxley and other regulations that
you have to comply with if you are listed in the United States.
So that is another thing that I think ought to be studied.
Chairman Reed. Thank you all very much for excellent
testimony and participation.
Chairman Levin, thank you.
Chairman Levin. OK. Thank you again, Senator Reed, for all
you have done in this area and for today's hearing, too. Doing
this jointly with you and your staff has been very, very useful
to us, and I hope also to the Senate, in its considerations.
I have some additional questions which I am going to be
asking of you, so let me start with Mr. Luparello and then go
down the line. I think most of you, if not all of you, have
said that the trading across multiple market venues has made it
necessary for the regulators to have information from those
same venues in order to effectively regulate or police
potentially manipulative trading. They just cannot look at
activity on their own trading platform.
First of all, do you agree with that?
Mr. Luparello. A hundred percent.
Chairman Levin. Does anyone disagree with that?
[Witnesses shaking heads.]
Chairman Levin. OK. So I will shorten that.
Now, when it comes to the manipulative trading that exists
in the view of some, I think many, between platforms, including
phony bids and layering strategies or other strategies, let me
start now with you, Mr. Cronin. Have you observed what appears
to be manipulative, same-day trading between platforms?
Mr. Cronin. I have not directly. Anecdotally, certainly I
have heard about different things, but not really so much
across platforms. For example, if you are talking about the
futures exchange relative to the underlying, I have not.
Chairman Levin. OK. But you have heard anecdotally about
such----
Mr. Cronin. Yes.
Chairman Levin. OK. Mr. Narang.
Mr. Narang. Look, there is little doubt that that stuff
happens. You know, I was a treasury market maker in the mid-
1990s making markets on long bonds for a primary dealer, and it
was very common in those days for traders to ``paint the
screens''; in other words, to show buying interest on the
screens when, in fact, they were sellers. That is not a new
practice, and it really has nothing to do with computers or
automation. In fact, I would hasten to add that those sorts of
strategies really are the domain of human beings because they
cannot be modeled, they cannot be simulated. You cannot model
the effect of what would happen if you show a large quote. And
that is why, you know, everyone--I was a little bit disturbed
when the Trillium example which everyone points to occurred,
and it was immediately blamed on high-frequency traders.
Trillium was a firm, as far as I understand, that consisted of
human day traders, and the fact that they held their positions
on an intraday basis should not immediately paint everybody who
does that with a bad brush. The point is that these sorts of
strategies are psychological in nature, and humans have no--
computers have no capacity to run those sorts of things. That
is on a theoretical level.
On a practical level, one of the benefits to the market of
computerized trading that is not discussed very much is the
fact that it leaves a very, very concrete paper trail. So the
forensic analysis is readily doable when algorithmic traders
are participating in the market. So because of that, you know,
computerized algorithms have a very concrete recipe that is
written down. It is discoverable; it can be subpoenaed. So it
would be remarkably foolish for somebody who is intending to
engage in manipulative activity to do that with an algorithm.
That is something that is best done by human beings, and for
all practical purposes, I know of no example that has been
discovered thus far of manipulative activity being done by a
computer.
Chairman Levin. Putting aside how it was done--that was not
part of my question.
Mr. Narang. Sure.
Chairman Levin. My question was whether or not----
Mr. Narang. I have no doubt that it is done, but I do not
know of any concrete examples.
Chairman Levin. OK. So you have not observed manipulative
same-day trading between platforms?
Mr. Narang. No, but I would virtually guarantee that it
occurs.
Chairman Levin. OK. Mr. Peterffy.
Mr. Peterffy. We see that happening all the time, but I do
not believe that that should be such a great concern. It is
bad, but we have much, much worse situations to deal with at
this time. But I am suggesting here that each broker keep on
record the identity of a person associated with each order so
if there are any orders that are questionable, they can be
easily identified by the regulators across the different
exchanges.
Chairman Levin. Let me call on Professor Angel before I go
back to that point. Do you have a comment on my last question
about whether or not you believe that manipulative same-day
trading between platforms exists?
Mr. Angel. Well, there are two types of manipulation. There
is the old-fashioned manipulation like order ignition where you
dump a big sell order in the market trying to push the price
down to scare other people and trigger all the stop orders.
That does not really depend on the platform. And, indeed, a lot
of traders do not pay any attention to the platform. They just
send an order to someone like Mr. Peterffy, and his very good
smart router figures out where to get best execution for that
order.
There is a lot of trading, a lot of good trading, and a lot
of manipulative trading that does not really pay attention to
the platforms.
Now, is somebody actually trying to say, OK, I am going to
put this order into this exchange versus that exchange because
nobody will notice?
Chairman Levin. The regulators do not have such automatic
access.
Mr. Angel. Well, actually the Intermarket Surveillance
Group feed actually does consolidate the data. So if somebody
is trading, the folks over at FINRA can very quickly through an
electronic blue sheet figure out who did what. They just cannot
put together the order books to figure out the strategies, and
that is why they need better data.
Chairman Levin. And that is why it takes an awful lot of
time to put together these studies and these analyses?
Mr. Luparello. That is certainly one of the reasons. But
another reason is that the quality of data we get for the
purposes of running surveillance is fragmented and incomplete,
and that prevents us from looking at activity across markets.
Chairman Levin. And that is what I want to ask you about
next. That fragmented and incomplete information, what is not
included in the information, is the beneficial owner or the
person putting the order in. Is that correct?
Mr. Luparello. It is a variety of things. At this point,
you still have the equities markets being regulated somewhat in
siloed fashion. We are in the process of aggregating our
current regulation of the over-the-counter market and NASDAQ
and adding in the New York Stock Exchange regulated markets,
which will give us a much closer to complete picture of the
equities trading. But options markets are still done in a
siloed fashion, and options and equities obviously are still
done in that way. So a consolidated audit trail I think is the
necessary step to getting to an ability to look at these things
happening across markets on a real-time basis.
Chairman Levin. And are broker-dealers required to report
the executing broker or the customer information?
Mr. Luparello. At this point executing broker, but not
customer information.
Chairman Levin. At this point.
Mr. Luparello. At this point.
Chairman Levin. Is that useful?
Mr. Luparello. Customer information is certainly useful, I
think especially if you are looking at it not from maybe
necessarily every customer but certainly at the large trader
thresholds that the SEC has proposed. It is certainly a very
useful bit of information for everybody.
Chairman Levin. And is that in the works?
Mr. Luparello. Well, I think Chairman Schapiro alluded to
developments in the consolidated audit trail that I cannot
speak to but one would hope that anything that came out of
consolidated audit trail was not just the merger of the data at
the executing level, but the inclusion of some level of more
granular customer data.
Chairman Levin. And what about the stock exchanges? You do
not look at them, right?
Mr. Luparello. No, we do.
Chairman Levin. Do you get that same information from them?
Mr. Luparello. Yes. The way it currently works and the way
it would work in a consolidated audit trail is the merger of
the data not just at the executing levels but also the exchange
order books, and that is absolutely essential.
Chairman Levin. And that is where the name of the customer
would be useful as well?
Mr. Luparello. Yes, absolutely.
Chairman Levin. OK. Does anyone want to comment on that?
Mr. Cronin. Can I just add on the customer information?
Chairman Levin. Yes.
Mr. Cronin. While we completely support the idea of having
the information in the regulators' hands, obviously that is
very sensitive and privileged information that if there was any
leakage of could have very bad consequence to our clients and
shareholders, so we would just make sure, while this data is
being collected and for the right purposes, that it is secure
and that we do not read about WikiLeaks or anything else with
our positions because that would be catastrophic to our
clients.
Chairman Levin. OK. But subject to that, you would agree
with Mr. Luparello that----
Mr. Cronin. Yes.
Chairman Levin. ----the regulators have got to have access
to that information?
Mr. Cronin. Yes.
Chairman Levin. OK. Mr. Luparello, is FINRA currently
investigating activities involving foreign-owned accounts that
are held at U.S. broker-dealers located in other countries?
Mr. Luparello. Our jurisdictional limitations make that
difficult and it is an area that we are quite concerned about.
Broker-dealers obviously have customers, some based in the
U.S., some based abroad. In addition, sometimes those customers
are just a holding entity that sits above a network of other
customers. Since our jurisdiction only goes to the broker-
dealer and our ability to compel that first level of
information, investigations that we have get stopped at that
level, and if there is an ongoing concern of illegal conduct,
that will result in a referral to the SEC.
Chairman Levin. All right. But you basically have
difficulty investigating foreign accounts that you suspect of
trading abuses--for the reasons you give, and also because you
cannot get clients' names.
Mr. Luparello. Yes. Well, we can get clients' names in the
course of an investigation. So if we are doing an
investigation, we will ask the firm for client names. They will
provide that to us. Our ability to compel either financial
information or testimony from customers is what limits us, and
that is true whether they are domestic customers or
international customers. Obviously, the ability of the SEC,
then, to reach those international customers creates yet
another layer of complexity.
Chairman Levin. On the same point about foreign banks, Mr.
Luparello, is it true that foreign banks that open accounts
with U.S. broker-dealers are not required to disclose the names
of their customers to U.S. broker-dealers?
Mr. Luparello. U.S. broker-dealers have an obligation to
know their customer and that comes out in a variety of
different other requirements including, importantly, antimoney
laundering. What exact requirements those U.S. broker-dealers
have to know not just the customer but the customer of a
customer is an area that has been somewhat vague over the
years.
I think, again, I would point to what the Commission has
put forward in terms of its rulemaking, it is mostly around
sponsor and naked access, but could potentially be used to add
some greater teeth to those ``know your customer'' requirements
because there is that concern that actually the customer of the
broker-dealer is just a holding entity for the real customer
sitting behind that. That construct actually exists in the
U.S., too, and in some master/subaccount scenarios that we try
to look through to have the customer of the customer be treated
as a customer of the broker-dealer. I think there is both
further interpretive rulemaking and enforcement that needs to
be done in that area.
Chairman Levin. Mr. Narang, you made reference to certain
unfair aspects that exist to some participants. Can you expand
on what those unfair aspects are?
Mr. Narang. Yes. They are a little bit esoteric, but I will
do my best. Basically, in the United States equity markets, the
vast majority of exchanges observe what is known as price/time
priority. That means that orders that arrive at the exchange at
a particular price get first priority to execute against
inbound orders based on their arrival time. If your order
arrives before mine, then somebody who wants to trade at that
price actively will give you a fill before they give me a fill.
Now, because of some technicalities associated with
Regulation NMS, particularly in Rule 611, the so-called Order
Protection Rule, the long-term investors who are attempting to
trade and form a new price in the process very often lose their
priority to certain proprietary trading firms that have the
ability to utilize a specialized kind of order known as
intermarket sweep orders. And so what happens is that price/
time priority gets violated.
Now, you can empirically calculate what price/time priority
is worth. It is worth a lot of money. So there is a massive
transfer of wealth underway from long-term investors who are
executing the VWAP algorithms or just old-fashioned techniques
into the pockets of certain high-frequency traders who actively
utilize that capability.
I do not think that those high-frequency trading firms
should be faulted for utilizing that capability because there
is no intentionality behind that. What happens is that when a
long-term investor goes to take an offer and post a bid at the
new price, the exchange will hold up that bid until the price
is formed by somebody who is using an ISO order. So the user of
the ISO order does not need to know why it is happening. They
just need to know that there is a two-cent spread now and they
want to tighten the spread.
So the high-frequency trader who is doing that is acting in
the interests of the market as well as his own interests, but
that is not a fair proposition. That is one of the few unfair
aspects of market structure that I know about. The other is the
tiering of rebates. The exchanges tend to give much higher
liquidity rebates--not all of them, the BATS Exchange is a
notable exception--but many other exchanges give higher
rebates, liquidity rebates, to their most active traders than
they do to smaller traders, and I think that is an
anticompetitive practice and ought to be seriously examined.
By and large, I do not want to give the impression that the
equities market is unfair. I think that this is one of the
fairest markets in the world and one of the most well
functioning. That does not mean it is perfect.
The glitch in Rule 611 that I mentioned to you is the very
same glitch that is responsible for all the market
fragmentation that we have seen. This very same rule is what
causes exchanges to route orders to other exchanges rather than
posting them if they appear to walk the exchange's notion of
the national best bidder offer. That creates an economic
incentive for new exchanges to spring up that never existed
before Regulation NMS went into effect because they have the
ability to virtually be guaranteed to get order flow from other
exchanges. That is why the market centers have proliferated to
the extent that they have since Regulation NMS went into effect
in 2007.
Chairman Levin. Thank you. Just one last question of Mr.
Luparello. Our first panel was asked a question by me about--
and I believe you were here during that question--about what
appeared to be an attempted short squeeze by Goldman traders
using credit default swaps that bet against mortgage-backed
securities. You were here during that?
Mr. Luparello. I was.
Chairman Levin. If a FINRA member were to attempt a short
squeeze, was unsuccessful in it--this, to me, is an intended
manipulation--would FINRA typically investigate this activity
to determine whether it violated FINRA rules, such as the FINRA
rule about, quote, ``high standards of commercial honor and
just and equitable principles of trade''?
Mr. Luparello. Absolutely. That scenario, and I was not
privy to the facts before this, and I think there is probably a
question about whether those were securities at the time, but
that fact pattern in the current environment--trading practices
that had a specific manipulative intent behind them,
irrespective of the success or failure of that, would be
something that would be investigated and we would think could,
with the right facts, run afoul of our rules.
Chairman Levin. Does anybody want to add anything before we
bring our hearing to a close?
Mr. Angel. I would just like to thank the Chairman for
investigating these very important issues. I was very impressed
by the eloquence and basically high quality of your opening
speech and I just want to urge you to keep up the good work.
Chairman Levin. Well, I am glad we gave you that
opportunity to say that.
[Laughter.]
Chairman Levin. Does anybody else want to--no, I had better
stop while I am ahead.
[Laughter.]
Chairman Levin. Thank you all. We have a good number of
letters from two exchanges, which we will make part of the
record.
There may be some questions that we would like to ask each
of you for the record that may come to you. You are not
obligated to answer them, but we sure would appreciate your
answers.
We will stand adjourned, again, with our thanks to each of
you, not just for your testimony and your direct answers, but
also for very graciously being allowed to be moved about to
satisfy a very crazy Senate schedule. I will not say it is
unusual. Crazy is usual. But thank you.
[Whereupon, at 6:20 p.m., the hearing was adjourned.]
[Prepared statements, responses to written questions, and
additional material supplied for the record follow:]
PREPARED STATEMENT OF CHAIRMAN CARL LEVIN
Today, U.S. capital markets, which traditionally have been the envy
of the world, are fractured, vulnerable to system failures and trading
abuses, and are operating with oversight blindspots. The very markets
we rely on to jump start our economy and invest in America's future are
susceptible to market dysfunctions that jeopardize investor confidence.
I would like to thank Chairman Jack Reed, his ranking Member
Senator Bunning, and all our colleagues from the Securities, Insurance,
and Investment Subcommittee who have already held hearings on these
issues and welcomed our Subcommittee to join with them today to shine a
light on problems that threaten U.S. market stability and integrity.
Fractured Markets. The first fact we need to grapple with is that
our markets have changed enormously in the last 5 years. In the past,
most U.S. listed stocks were traded on the New York Stock Exchange or
the Nasdaq. Seven years ago, the New York Stock Exchange alone
accounted for about 80 percent of the trades in its listed stocks. But
today, less than 25 percent of the New York Stock Exchange listed
stocks are traded there. What happened? Stock trading now takes place,
not on one or two, but 13 stock exchanges.
This chart, Exhibit 1, shows how the U.S. stock market has
fractured. Stock trading now takes place on 13 exchanges as well as
multiple off-exchange trading venues, including 3 Electronic
Communication Networks, 36 so-called ``dark pools,'' and over 200
registered ``broker-dealer internalizers.''
Electronic Communication Networks or ECNs are computerized networks
that enable their participants to post public quotes to buy or sell
stock without going through a formal exchange. Dark pools, by contrast,
are electronic networks that are closed to the public and allow pool
members to buy and sell stock without fully disclosing to each other
either their identities or the details of their prospective trades. A
broker-dealer internalizer is a system set up by a regulated broker-
dealer to execute trades with or among its own clients without sending
those trades outside of the firm. These off-exchange venues are
increasing their trading volumes, most use high speed electronic
trading, and they escape much of the regulation that applies to formal
stock exchanges.
These new trading venues didn't appear out of thin air. They are
largely the result of Regulation NMS which the SEC issued in 2005. Some
call the resulting new world of on and off exchange trading a model of
competition. Others call it a free-for-all that defies oversight and is
ripe for system failures and trading abuses. In reality, both
descriptions have some truth. Trading competition has led to lower
trading costs and faster trading, but it has also opened the door to
new problems.
System Failures. One of those problems involves system failures, of
which the May 6 flash crash is the most famous recent example. On that
day, out of the blue, the futures market suddenly collapsed and dragged
the Dow Jones Industrial Average down nearly 700 points, wiping out
billions of dollars of value in a few minutes for no apparent reason.
Both the futures and stock markets recovered in about 20 minutes, but
left investors and traders in shock. After 5 months of study, a joint
CFTC-SEC report has concluded that the crash was essentially triggered
by one large sell order placed in a volatile futures market using an
algorithm that set off a cascade of out-of-control computerized trading
in futures, equities, and options. That one futures order, placed at
the wrong time, in the wrong way set off a chain reaction that damaged
confidence in U.S. financial markets.
In some ways, the May 6 crash was a high-speed version of the 1987
market crash, where a sudden decline in the futures market led to a
corresponding collapse in the broad stock market which led, in turn, to
crashes in individual stocks. And it is not the only type of system
failure affecting our financial markets. So-called ``mini flash
crashes,'' in which one stock suddenly plummets in value for no
apparent reason have become commonplace. On June 2, 2010, for example,
shares in Diebold Inc., a large Ohio corporation, suddenly dropped from
about $28 to $18 per share. The stock recovered, but the company was
left trying to understand and explain what happened. Even after the SEC
initiated a pilot circuit breaker program after the May 6 crash, at
least 15 other companies have had similar experiences, including Nucor,
Intel, and Cisco. A former senior Nasdaq executive told the
Subcommittee that the Nasdaq exchange has experienced single-stock
flash crashes 5-6 times per week. The New York Stock Exchange and FINRA
told us these crashes are commonplace and attribute them to various
glitches in computerized trading programs.
Single-stock crashes might seem to be a minor problem, but what
happens if the security that crashes is a basket of stocks or
commodities? On November 29, 2010, 3 of the top 5 equities traded by
volume were actually baskets of stocks. If a basket of stocks or
commodities crashes in value, what happens to the underlying financial
instruments? Uncontrolled electronic trading and cascading price
declines in multiple trading venues, including in futures, options, and
equities markets, could be the result--another May 6th.
Many investors, by the way, are not waiting around to find out if
our regulators have fixed the problem. According to the Investment
Company Institute, each month since May, more investors have fled our
markets, pulling billions of dollars of U.S. investments.
Trading Abuses. System failures are not the only problem raised by
our fractured markets. Another problem is their increased vulnerability
to trading abuses. Traders today buy and sell stock on and off
exchange, simultaneously trading in multiple venues. Traders have told
my Subcommittee that orders in some stock venues are being used to
affect prices in other stock venues; and that futures trades on CFTC-
regulated markets are being used to affect prices on SEC-regulated
options and stock markets. Some traders are also using high speed
trading programs to execute their strategies, sometimes submitting and
then cancelling thousands of phony orders to affect prices.
To get a sense of the trading activity today, take a look at this
stack of paper. This stack, nearly 5 inches high, contains the actual
message traffic generated in the futures, options, and equity markets
with respect to one major U.S. stock over the course of one second of
time. One stock, in one second, produced over 29,000 orders, order
modifications, order executions, and cancellations in all three
markets. This stack shows in black and white how traders are now
analyzing trades in all three markets at once, evidencing how the
futures, options, and equity markets are interconnected. Imagine the
same stack multiplied countless times, filling this entire hearing
room, and the interconnectedness of the markets as well as the
potential for system failures and trading abuses becomes alarmingly
clear.
One well known trader, Karl Denninger, recently made this public
comment about U.S. trading activity:
Folks, this crap is totally out of hand. And it's now a daily
game that's being played by the machines, which are the only
things that can react with this sort of speed, and they're
guaranteed to screw you, the average investor or trader. Go
ahead, keep thinking you can invest. (Emphasis omitted.)
Regulatory Barriers. While fractured markets and high speed trading
are causing new problems and forms of manipulation, they are also
leaving our regulators far behind. Traders are equipped today with the
latest, fastest technology. Our regulators are riding the equivalent of
mopeds going 20 mph chasing traders whose cars are going 100 mph.
Our regulators are confronting at least four challenges. The first
is the fact that each trading venue today has its own infrastructure,
rules, and surveillance practices. Besides the expense and inefficiency
involved, no regulatory agency has a complete collection of trade data
from all the venues, much less a single integrated data flow allowing
regulators to see how orders and trades in one venue may affect prices
in another.
Second, even if regulators had an integrated data flow, the current
data systems fail to identify key information, including the names of
the executing broker and customer making the trades. That means
regulators can't use the electronic records to, for example, trace
trading by one person or set up alerts to flag trades. Instead, before
any trading analysis can start, regulators have to figure out the
broker and customer behind each trade. Patterns of manipulation are
hidden.
The third problem is that the SEC has no minimum standards for
automated market surveillance by Self-Regulatory Organizations (SROs),
and the quality of those efforts is apparently all over the map. Recent
SEC examinations of certain exchanges have found, for example, some
ineffective surveillance systems that were unable to detect basic
manipulations or used such restrictive criteria that they failed to
flag suspect activity, exchanges that failed to review some
surveillance alerts, and exchanges with only rudimentary or under-
budgeted investigative, examination, and enforcement programs.
The fourth problem is that the SEC and CFTC have not set up
procedures to coordinate their screening of market data to see if
trades in one agency's markets are affecting prices in the other's
markets. Given the strong relationships between the futures, options,
and equities markets, joint measures to detect intermarket trading
abuses are essential.
The impact of the regulatory and technology barriers is
demonstrated by the fact that it took the CFTC and SEC 5 months of
intense work to figure out what happened over a few minutes on May 6.
In addition, over the past 5 years, there have been few meaningful
single day price manipulation cases. One recent case involves a small
trading firm, Trillium Trading LLC, which apparently used phony trading
orders to bid up the price of several stocks. In that case, FINRA found
that, over a 3-month period in 2006 and early 2007, Trillium submitted
phony orders in over 46,000 manipulations, netting gains of about
$575,000. Apparently, the victims of the price manipulation got annoyed
enough to research the manipulative trading and hand over the data to
FINRA. Even then it took FINRA 4 years to reconstruct the order books,
prove who was behind the trades, and resolve the matter. Trillium and
its executives recently settled the case by agreeing to pay over $2.2
million in fines and disgorgements.
Traders and regulators have told my Subcommittee that Trillium is
not the only company that has engaged or is engaging in price
manipulation in U.S. financial markets. In fact, one of the more
chilling examples involves suspect trading involving traders located in
China. Are overseas traders trying to manipulate U.S. stocks? Our
regulators are currently unequipped to find out.
Solutions. The May 6 flash crash and the Trillium case provide
powerful warnings that we need to strengthen U.S. oversight of our
financial markets to restore investor confidence. Much needs to be
done. Recent actions by the SEC to prohibit phony quotes, impose single
issue circuit breakers, and set up a consolidated audit trail are
important advances. But there is a long, long way to go, particularly
with respect to coordinating market protections and surveillance across
market venues, and across the futures, options, and equities markets.
There also needs to be a greater sense of urgency. The SEC's
proposed consolidated audit trail is expected to take years to put into
place and won't cover all the relevant products and markets. Requiring
executing broker and customer information--an essential component to
effective oversight--is in limbo pending completion of the consolidated
audit trail, as is integrating the trade data from multiple trading
venues. Integrating trading data and market surveillance of the
futures, options, and equities markets by the CFTC and SEC isn't even
on the drawing board.
I hope this hearing will help inject greater urgency into
strengthening U.S. oversight of our fractured, high speed markets to
restore investor confidence.
Exhibits 1-5 Submitted by Chairman Carl Levin
PREPARED STATEMENT OF MARY L. SCHAPIRO
Chairman, Securities and Exchange Commission
December 8, 2010
Chairmen Reed and Levin, Ranking Members Bunning and Coburn, and
Members of the Subcommittees: Thank you for the opportunity to testify
on behalf of the Securities and Exchange Commission concerning the U.S.
equity market structure.
Market structure encompasses all aspects of the organization of a
market, including the number and types of venues that trade a financial
product and the rules by which they operate. Although these issues can
be complex and the rules technical, a stable, fair, and efficient
market structure is the backbone of the equity markets and an important
engine of our economy.
My testimony today will note some important recent market structure
developments and discuss the Commission's ongoing review of our market
structure. In particular, we have undertaken a broad-based appraisal of
both the strengths and weaknesses of our current equity market
structure. This review includes an evaluation of recent market
structure performance and an assessment of whether market structure
rules have kept pace with recent significant changes in trading
technology and practices. The goal of this evaluation is to effectively
address any market structure weaknesses while preserving its strengths.
As will be described below, the Commission has recently moved to
enhance regulators' capacity to monitor trading across all trading
venues and to enforce the securities laws and regulations and self-
regulatory organization (SRO) rules. These initiatives include
publishing for public comment one proposal that would mandate the
development and implementation of a consolidated audit trail system and
another that would require large trader reporting.
In addition, the SEC published a concept release on equity market
structure in January 2010 (the ``Concept Release''). The Concept
Release described the current market structure and then broadly
requested comment from the public on three categories of issues: (1)
the quality of performance of the current market structure, (2) high
frequency trading, and (3) undisplayed liquidity in all its forms.
The Commission has received more than 200 comments on the Concept
Release. A number of commenters identified benefits of the current
market structure, in particular noting that it has fostered competition
among trading venues and liquidity providers that has lowered spreads
and brokerage commissions. These investors cautioned against regulatory
changes that might lead to unintended consequences. Other commenters,
however, raised concerns about the quality of price discovery and
questioned whether the current market structure continues to offer a
level playing field to investors in which all can participate
meaningfully and fairly. These commenters suggested a variety of
initiatives to address their concerns.
Following up on the written comments, the Commission hosted a
public roundtable on market structure in June. The roundtable
participants, who included listed companies, investors, exchanges,
market makers, high frequency traders, broker-dealers, agency-only
brokers, and economists, offered a wide range of perspectives and
recommendations. The debate at the roundtable was spirited and
extremely helpful to the Commission in its efforts to obtain a deep
understanding of complex policy issues.
The Commission's job in the coming months will be to evaluate these
issues in a responsible, timely, and comprehensive fashion, with
particular focus on obtaining the appropriate data and analysis to
support our decisions to proceed with or to table any particular
initiative. A few basic principles will guide our actions.
I. Guiding Principles
A. Capital Formation and Investor Protection
At its most basic level, market structure must achieve two critical
objectives: serving the interests of companies in efficient capital
formation and the interests of investors in attaining their financial
goals. Efficient capital formation and strong investor protection in
our equity markets will promote economic growth and jobs, as well as
the ability of individual Americans to realize economic security and
invest for things such as retirement and college.
Equity markets support these objectives by helping to turn the
savings of investors into capital for business, enabling a flow of
funds from investors to entrepreneurs and back again through dividends
and capital gains. Those who purchase stock in an initial public
offering, for example, can have confidence that they will be able to
sell that stock at a fair and efficient price in the secondary market
when they need or want to do so. The values assigned to stocks in the
secondary market, moreover, play an important role in the ability of
companies to raise additional funding.
Healthy equity markets allocate capital efficiently and help ensure
that investors and companies are able to reap the rewards of their
efforts. If, however, the equity market structure breaks down--if it
fails to provide the necessary fairness, stability, and efficiency--
investors and companies may pull back, raising costs and reducing
growth.
In sum, the interests of companies and investors lie at the heart
of market structure. All of the securities industry professionals and
entities that act as intermediaries between companies and investors
play vitally important roles in our equity market structure, but their
roles ultimately must serve the ends of capital formation and investor
protection.
B. Competition and Price Discovery
To achieve efficient capital formation and strong investor
protection, a market structure must secure the dual benefits of
competition and effective price discovery. Competition among multiple
markets and market making firms can benefit investors through
specialized trading services, lower fees, and narrow spreads. When many
markets and firms compete for order flow in the same stock, however,
any structural inefficiencies can lead to order flow fragmentation and
concerns about the quality of price discovery. If price discovery were
to be impaired, it could cause the price of a company's stock to
deviate from true consensus values and lead to excessive volatility
that is harmful to both investors and companies.
Section 11A of the Exchange Act directs the Commission to
facilitate a national market system that achieves multiple objectives,
including: competition among markets and broker-dealers, efficient
execution of securities transactions, price transparency, best
execution of investor orders, and an opportunity, consistent with other
objectives, for investor orders to meet directly.
The Commission's market structure task is further complicated by
the continual change that characterizes modern financial markets. Even
if an optimally balanced market structure were achieved at any
particular time, the dynamic forces of technology and competition are
sure to generate new market conditions that will effectively--and
sometimes rapidly--alter the balance. As a result, the Commission must
regularly review its rules to assess whether they have kept pace with
changing market conditions.
Our ongoing market structure review is focused on current, and
potential future, market conditions, not those that existed in the
past, and on whether the current rules continue to foster an
appropriately balanced market structure that achieves all of the
Exchange Act's objectives.
C. Surveillance, Inspection, and Enforcement
A final guiding principle for the Commission's market structure
program is a recognition that the right rules are meaningless if they
are not followed and enforced. All industry participants must know that
the regulators are closely monitoring compliance and will take
enforcement action against those who violate the rules. Consequently,
the Commission is focused on obtaining the tools and resources
necessary to better surveil trading, inspect regulated entities, and
enforce the rules in today's highly automated, high speed and high
volume markets.
II. Recent Market Structure Developments
A. Technology
The U.S. equity market structure has changed dramatically in recent
years. A decade ago, most of the volume in stocks was executed
manually, whether on the floor of an exchange or over the telephone
between traders. Now nearly all orders are executed by fully automated
systems at great speed. The fastest exchanges and trading venues are
now able to accept, execute, and send a response to orders in less than
one thousandth of a second.
Speed is not the only thing that has changed. As little as 5 years
ago, the great majority of U.S. equities capitalization was traded on a
listing market--the New York Stock Exchange (NYSE)--that executed
nearly 80 percent or more of volume in those stocks. Today, the NYSE
executes approximately 26 percent of the volume in its listed stocks.
The remaining volume is split among 13 public exchanges, more than 30
dark pools, 3 electronic communication networks (ECNs), and more than
200 internalizing broker-dealers. Currently, approximately 30 percent
of volume in U.S.-listed equities is executed in venues that do not
display their liquidity or make it generally available to the public,
reflecting an increase over the last year.
The evolution of trading technologies has dramatically increased
the speed, capacity, and sophistication of the trading functions that
are available to market participants. The new electronic market
structure has opened the door for entirely new types of professional
market participants. Today, proprietary trading firms play a dominant
role by providing liquidity through the use of highly sophisticated
trading systems capable of submitting many thousands of orders in a
single second. These high frequency trading firms can generate more
than a million trades in a single day and now account for more than 50
percent of equity market volume.
B. May 6 Trading Disruption
On May 6, 2010, two weeks after the end of the 90-day comment
period for the Concept Release, the U.S. equity markets experienced one
of the most significant price declines and reversals since 1929. While
the decline in prices in broad market indexes on May 6 was not as steep
and as persistent as the decline in October 1987--when trading was
slower and less reliant on technology--the broad market indexes,
including the Dow Jones Industrial Average and S&P 500, dropped more
than 5 percent in 5 minutes, only to almost entirely reverse the
decline in a subsequent few minutes. Approximately 15 percent of stocks
suffered even more severe declines and reversals of 10 percent or
worse. These include two of the 10 largest capitalization stocks, which
declined 36.7 percent and 19.5 percent, during the half-hour
disruption, only to recover nearly their full value.
At the worst end of the spectrum, 326 securities suffered declines
of more than 60 percent from their 2:40 p.m. prices, leading the
exchanges to ``break'' or cancel more than 20,000 trades. Many of these
broken trades were executed at absurd prices of one penny or less per
share. Nearly 70 percent of these broken trades were in exchange-traded
funds (ETFs), whose pricing integrity depends in significant part on
the price integrity of individual stocks and the activities of
professional liquidity providing firms.
In September, the staffs of the SEC and the Commodity Futures
Trading Commission (CFTC) published their second joint report on their
inquiry into the day's events. Producing the report required an
extraordinary amount of staff resources. On the securities side in
particular, much of the time and effort was devoted to collecting and
then painstakingly sifting through the data necessary to reconstruct
trading. These efforts highlighted the pressing need for enhanced data
functionalities in the securities markets.
The joint report lays out the multiple factors that in our view
significantly contributed to the liquidity failure and disruptive
trading on that day, outlining the complex interplay of multiple
factors across the securities and futures markets. This interplay is
significant because it demonstrates the need for a multifaceted
regulatory response that addresses the full scope of the risks in a
comprehensive and responsible way.
C. Investor Views About Market Structure
Since the events of May 6, some investors are questioning the
integrity and fairness of the U.S. market structure. Many individual
investors, for example, have submitted comments to the Commission that
are highly critical of the current market structure. Retail broker-
dealers have told us that their customers--individual investors--have
pulled back from participating in the equity markets since May 6. Some
institutional investors also have submitted comments outlining their
market structure concerns after May 6. These concerns included the
transitory nature of a large percentage of liquidity, an uneven playing
field created by data latency and colocation, and trading tactics
employed to detect the presence of large blocks and trade ahead of
them.
On the other hand, many institutional investors (such as mutual
funds and pension funds who often represent the interests of many
individuals investing indirectly in equities) who commented on the
Concept Release believed that their trading costs had declined in
recent years, that technology had fostered competition among trading
venues and liquidity providers, improved the efficiency of trading,
narrowed spreads, and that their brokerage commissions have never been
lower. These investors highlighted important benefits in the current
market structure that should be preserved.
III. Responding to Developments in Market Structure Under Existing
Authority
A principal lesson of the financial crisis is that, because today's
financial markets and their participants are dynamic, fast-moving, and
innovative, the regulators who oversee them must continuously improve
their knowledge and skills to regulate effectively. In response to the
ever-changing nature of our financial system, the SEC's Office of
Compliance, Investigations and Examinations (OCIE) and our Division of
Enforcement have adopted new approaches to promote fair, orderly and
efficient operation of the markets.
A vigorous examination program not only reduces the opportunities
for wrongdoing and fraud, but also provides early warning about
emerging trends and potential weaknesses in compliance programs. As
described in more detail below, over the past year, we have begun
reforming OCIE in response to developing Wall Street practices and
lessons learned from recent fraud investigations.
Enforcement is another critical element to fair and effective
markets. Swift and vigorous prosecution of emerging schemes designed to
circumvent the law is at the heart of the agency's efforts to promote
investor confidence in the integrity of the marketplace.
A. Market Surveillance and Inspections
In response to the dramatic changes that recently have developed in
our markets, the Commission is employing an interdisciplinary approach
designed to bring together subject matter experts from across the
agency to identify, analyze and address issues that arise.
Recognizing the sweeping industry and market changes that have
occurred in the past few years, OCIE, under new leadership, recently
completed a critical self-assessment of its national examination
program, not only of SROs, but also of broker-dealers and other
regulated entities. As a result of that self-assessment, OCIE
determined that it needed to develop a more risk-focused strategic plan
to address SRO oversight of individual market centers.
OCIE is in the process of implementing its new SRO examination
program this year. In addition to its ongoing examination
responsibilities, OCIE staff currently is conducting risk assessment
evaluations of each of the 13 registered exchanges and the options and
equities markets that they operate. This assessment has been informed
by recent market events, including the events of May 6, and will
include an overview of key risk areas including conflicts of interest,
corporate governance, regulatory structure, and market oversight and
surveillance.
OCIE expects to use the findings of these examinations to create a
comprehensive risk matrix for each of the exchanges and use that risk-
based approach to inform future examinations. In addition, the exam
findings will provide the SEC with the ability to address cross-market
issues more holistically, by, for example, articulating common risk
factors and better practices that can be adopted by all markets.
B. Enforcement Response
While market structure is primarily a regulatory challenge, an
enforcement response is available and appropriate where market
participants violate the law. The SEC's Division of Enforcement is
devoting significant investigative resources to determine whether
various market participants have engaged in conduct that unlawfully
exploited the fragmentation of the markets, intentionally contributed
to market volatility or manipulated the price and volume of securities
at the expense of innocent investors.
The Enforcement Division's Market Abuse Unit is one of five
specialized units established earlier this year to conduct specialized
investigations and develop expertise in particularly high risk program
areas. The Market Abuse Unit is helping to coordinate the Commission's
enforcement response to complex abusive trading practices and market
participants seeking unlawfully to exploit current market structure.
The Unit is planning an Analysis and Detection Center, to be staffed,
budget permitting, with specialists having expertise in algorithmic
trading strategies, trading abuse, quantitative analysis, market
structure and data architecture. By concentrating expertise in these
areas, the Division of Enforcement can more efficiently and effectively
identify potentially abusive trading practices that pose the greatest
risk of harm to investors.
Investigating manipulation cases is often difficult, particularly
given the speed and volume with which trading is occurring in today's
markets. The Enforcement Division is committed to discovering
manipulation schemes at their incipient stages. The SEC has had recent
success, for example, through close coordination with criminal
authorities, who are able to use law enforcement techniques that are
proactive, and may yield stronger evidence of scienter--or manipulative
intent.
That said, while traditional law enforcement approaches to
investigating manipulation schemes are often effective, they alone are
insufficient to police today's markets for potentially manipulative
practices involving high frequency, algorithmic and large volume
trading. The Commission needs significant upgrades to our systems and
analytical resources to be able to effectively identify manipulations
as they occur in today's markets. For example, we need the tools that
will enable us to keep up with market participants who are placing
thousands of orders per second.
Similarly, the fragmentation of trading at different market centers
means trading data often has format, compatibility and clock-
synchronization differences, making it difficult to quickly identify a
complete picture of a single trader's market activities on a timely
basis. The prevalence of high-volume trading through direct market
access providers requires that investigative staff trace the trading
back through multiple layers of intermediaries to identify the original
trader. Because the staff must manually evaluate each layer of data
before it can request the next, the lack of advanced data analysis
tools can both delay our investigations and make it more difficult to
identify the trader whose conduct is of ultimate interest. Enforcement
staff is currently focusing on whether certain trading practices occur
that potentially give rise to Federal securities law violations. Such
practices include layering or spoofing, improper order cancellation
activities or ``quote stuffing,'' the use of order anticipation and
momentum ignition strategies undertaken for a manipulative purpose,
passive market making practices that incentivize possible manipulative
quoting activity, abusive colocation and data latency arbitrage
activity in potential violation of Regulation NMS, use of Direct Market
Access arrangements to conceal manipulative trading activity and
conduit entity market manipulation.
We must stress that our investigative efforts in these areas at
this stage are fact finding in nature and the pendency of an
investigation does not mean that the Commission or its staff has
determined that abuses have occurred. It is premature to predict
whether enforcement actions will result from these matters, but the
sustained specialized knowledge and insights we gain will inform the
agency's regulation and lead to greater efficiency and effectiveness in
our investigations.
IV. Steps to Strengthen the Equity Market Structure
It is vital that the rules that govern market structure and market
participant behavior support equity markets that warrant the full
confidence of investors and listed companies. The Commission recently
has adopted a number of important initiatives to further this goal:
Less than 2 weeks after May 6, the Commission posted for
comment proposed exchange rules that would halt trading for
certain individual stocks if their price moved 10 percent in a
5 minute period. Barely more than 6 weeks after the event,
exchanges began putting in place a pilot uniform circuit
breaker program for S&P 500 stocks. In September, the program
was extended to stocks in the Russell 1000 Index and specified
exchange-traded products. The aim of this program is to halt
trading under disorderly market conditions, which in turn
should help restore investor confidence by ensuring that
markets operate only when they can effectively carry out their
critical price-discovery functions.
In September, the Commission approved pilot exchange rules
designed to bring order and transparency to the process of
breaking ``clearly erroneous'' trades. On May 6, nearly 20,000
trades were invalidated for stocks that traded 60 percent or
more away from their price at 2:40 PM. That 60 percent
benchmark, however, was set after the fact. We now have
consistent rules in place governing clearly erroneous trades
that will apply to any future disruption.
In November, the Commission approved exchange rules to
enhance the quotation standards for market makers. In
particular, the new rules eliminate ``stub quotes''--a bid to
buy or an offer to sell a stock at a price so far away from the
prevailing market that it is not intended to be executed, such
as a bid to buy at a penny or an offer to sell at $100,000.
Executions against stub quotes represented a significant
proportion of the trades that were executed at extreme prices
on May 6 and were subsequently broken.
Also in November, the Commission took an important step to
promote market stability by adopting a new market access rule.
Broker-dealers that access the markets themselves or offer
market access to customers will be required to put in place
appropriate pretrade risk management controls and supervisory
procedures. The rule effectively prohibits broker-dealers from
providing customers with ``unfiltered'' access to an exchange
or alternative trading system. By helping ensure that broker-
dealers appropriately control the risks of market access, the
rule should prevent broker-dealers from engaging in practices
that threaten the financial condition of other market
participants and clearing organizations, as well as the
integrity of trading on the securities markets.
In addition to these adopted rules, the Commission has proposed
large trader reporting requirements and a consolidated audit trail
system to improve our ability to regulate the equity markets. These
proposals would tremendously enhance regulators' ability to identify
significant market participants, collect information on their activity,
and analyze their trading behavior. Both of these initiatives seek to
address significant shortcomings in the agency's present ability to
collect and monitor data in an efficient and scalable manner and to
address discrete market structure problems.
Today, there is not any standardized, automated system to collect
data across the various trading venues, products and market
participants. Each market has its own individual and often incomplete
data collection system, and as a result, regulators tracking suspicious
activity or reconstructing an unusual event must obtain and merge a
sometimes immense volume of disparate data from a number of different
markets. And even then, the data does not always reveal who traded
which security, and when. To obtain individual trader information the
SEC must make a series of manual requests that can take days or even
weeks to fulfill. In brief, the Commission's tools for collecting data
and surveilling our markets do not incorporate the technology currently
used by those we regulate.
The proposed consolidated audit trail rule would require the
exchanges and FINRA to jointly develop a national market system (NMS)
plan to create, implement, and maintain a consolidated audit trail in
the form of a newly created central repository. The information would
capture each step in the life of the order, from receipt or origination
of an order, through the modification, cancellation, routing and
execution of an order. Notably, this information would include
information identifying the ``ultimate customer'' who generated the
order. And, it would require members to ``tag'' each order with a
unique order identifier that would stay with that order throughout its
life.
If implemented, the consolidated audit trail would, for the first
time, allow SROs and the Commission to track trade data across multiple
markets, products and participants simultaneously. It would allow us to
rapidly reconstruct trading activity and to more quickly analyze both
suspicious trading behavior and unusual market events. It is important
to recognize, however, that the consolidated audit trail is a major
change in the technology infrastructure for our equity markets, and
thus will require some time to fully implement. In addition, in order
to fully use this new infrastructure, the Commission's own technology
and human resources will need to be expanded well beyond their current
levels.
We also are examining the circuit breaker mechanisms that directly
limit price volatility. These include the recently adopted circuit
breakers for individual stocks, as well as the longstanding broad
market circuit breakers that apply across the securities and futures
markets. While they have worked well, the individual stock circuit
breakers adopted since May 6 may need to be further enhanced. They were
important first steps that could be implemented quickly to address the
worst aspects of excessive volatility, and as such were approved on a
pilot basis. Now that we have some experience with them, however, we
better understand some of their limitations and shortcomings.
For example, we are working with the exchanges to consider a limit
up/limit down procedure that would directly prohibit trades outside
specified parameters, while allowing trading to continue within those
parameters. Such a procedure could prevent many anomalous trades from
ever occurring, as well as limiting the disruptive effect of those that
do occur.
In addition to these new circuit breakers for individual
securities, the futures and securities markets long have had circuit
breakers for the broad market that, when triggered, pause trading in
futures, stocks, and options. None were triggered, however, during the
severe market disruption on May 6. We are assessing whether various
aspects of the broad market circuit breakers need to be modified or
updated in light of today's market structure.
We also are examining a wide range of other market structure
issues. These include the Commission's proposals with respect to flash
orders and undisplayed liquidity, issues arising out of May 6 (such as
large order execution algorithms that can operate in unexpected ways
and the role of registered market makers), and the broad policy issues
raised in the Concept Release.
One of these is the issue of competition and fragmentation. As
previously noted, trading volume in U.S.-listed stocks is split among
many different venues. These include exchanges that display quotations
that are made widely available to the public and nonpublic markets that
do not display quotations at all. These venues offer a wide range of
choices that many investors value highly to meet their diverse needs.
The emergence of multiple trading venues that offer investors the
benefits of greater competition also has made our market structure more
complex. Market participants use a multitude of information sources and
routing strategies in their efforts to obtain best execution of orders
across all the different venues. The venues, in turn, compete
vigorously to attract this order flow by, among other things,
distributing proprietary market data feeds that are separate from the
consolidated data feeds that are made widely available to the public.
We are assessing initiatives to improve transparency of order handling
and execution practices that were supported by many commenters on the
Concept Release.
In addition, orders executed in nonpublic trading venues such as
dark pools and internalizing broker-dealers now account for nearly 30
percent of volume, up from approximately 25 percent 1 year ago. We are
considering the effect of these venues on public price discovery and
market stability. Many institutional investors value the opportunity to
trade in dark venues because of a fear that trading in the public
markets in large sizes will cause prices to run away from them. We will
explore all aspects of this issue to reach a balanced conclusion. At
the end of the day, investors of all types must have confidence that
our market structure provides high-quality price discovery and the
tools they need to meet their investment objectives in a fair and
efficient manner.
In sum, we must look comprehensively at the issues, identify if and
where the current market structure is not fulfilling its guiding
principles, and take appropriate steps in a balanced way that also
preserves the strengths of the current market structure. As noted
above, the Commission's guiding principle must be to encourage a market
structure that promotes capital formation and protects investors. We
must also be mindful of the need for strong empirical analysis to
support our actions, and of the potentially significant risk of harm to
the markets that might arise from unintended consequences. In addition,
we must continue to support and staff these and other market structure
initiatives with appropriate levels of expertise.
V. Conclusion
The structure of today's markets offers many advantages to
investors. We should not attempt to turn the clock back to the days of
trading crowds on exchange floors. But we must continue to carefully
analyze the issues raised by our Concept Release and by the events of
May 6 to determine whether our market structure rules have kept pace
with the new trading realities and to identify whether there are ways
to improve our markets, provide additional transparency and increase
investor protections.
As we move ahead, we look forward to working closely with Congress
to continue addressing these critical market structure issues.
Thank you for inviting me here to discuss the developments in
market structure. I look forward to answering your questions.
______
PREPARED STATEMENT OF GARY GENSLER
Chairman, Commodity Futures Trading Commission
December 8, 2010
Good afternoon Chairman Reed, Chairman Levin, Ranking Member
Bunning, Ranking Member Coburn, and Members of the Subcommittee on
Securities, Insurance, and Investment and the Permanent Subcommittee on
Investigations. I thank you for inviting me to today's hearing. I am
pleased to testify alongside Securities and Exchange Commission (SEC)
Chairman Mary Schapiro. This is our seventh time testifying together,
and our third on issues related to the May 6 market events.
Since we last testified before the Subcommittee, staff from the
Commodity Futures Trading Commission (CFTC) and SEC released a
supplemental report on October 1 on the unusual market events of May 6,
2010. As outlined in the joint staff report, there were three chapters
of the May 6 market events:
very fragile and uncertain markets due in part to the
unsettling news concerning the European debt crisis;
a liquidity crisis in the E-Mini S&P 500 futures contracts
(E-Mini) and related index securities; and
a liquidity crisis in individual securities.
The events of that day highlighted many aspects of our markets, but
two that I want to specifically focus on. One is how interconnected our
markets are and the second is the role of technology in our markets.
Before I talk about the overall nature of our markets today, though we
have put this in previous reports, I want to mention some of the events
during that critical half hour on May 6.
At around 2:30 p.m. that day, in markets that were already frail
and volatile, a large fundamental trader came into the E-Mini market to
hedge about $4.1 billion of equity market exposure by selling 75,000
futures contracts, using an executing broker to execute the
transaction. The trader chose to put the entire order into an automated
execution algorithm. The trader chose to use an algorithm without
establishing a price limit or a minimum time for execution of the
order; instead, the order was executed based upon an aggregate target
of 9 percent of the trading volume calculated over the execution
period. Once the order was entered into the algorithm, it stayed on
auto-pilot to be executed in its entirety even if the market fell
rapidly.
This particular half hour highlighted cross-market linkages between
securities, futures, and other derivatives marketplaces that are
enabled by technology. Traders can employ automated trading systems to
detect and take advantage of differences in prices of related markets.
Cross-market trading strategies are about buying in one market and
selling in another market products that are highly correlated. For
instance, it may be something traded in the futures market that is
indexed to the stock market and separately trading in the stock market
itself. Where small disparities in the prices arise--even for just
milliseconds--market participants try to profit from those differences
in what economists and financial experts call arbitrage.
During the critical 13-minute period on May 6, cross-market
arbitrageurs transferred the price declines in the E-mini futures
market produced in part by the large fundamental seller to the equities
markets by opportunistically buying the E-Mini and simultaneously
selling the S&P 500 SPDR exchange traded fund (SPY) and baskets of
underlying stocks in the S&P 500 Index. Subsequently, prices in the SPY
and individual securities rapidly fell. After a critical 5-second pause
in trading of the E-mini in the futures market, the prices of the E-
mini began to rise. During that period, as the price of the E-mini
rose, the cross-market linkages resulted in a rise in the price of the
SPY.
Though the markets for the E-mini and the broad market SPY began to
rise, there was a liquidity crisis in individual securities as well.
Technology
CFTC-regulated markets have rapidly transitioned from face-to-face
to electronic trading, where 88 percent of trades are executed
electronically. The move from trading on the floor of an exchange to
electronic trading introduced significant changes in trading methods,
spawning dramatic increases in automated execution, algorithmic market
making and high frequency trading.
Automated Execution
Executing firms that have direct access to an exchange's electronic
trading platform provide investors with automated execution of large
orders. These programs often are used to divide a large trade into many
small trades with the goal of achieving the best average price.
Automated execution is widely used by large investors, such as pension
funds and asset managers, to acquire or hedge their exposures in
different markets, including cash, futures, or options.
Algorithmic Market Making
Algorithmic market making broadly consists of placing limit orders,
either as offers to sell above the current market price or bids to buy
below the current market price. The goal of this strategy is to earn
the bid-offer spread on lots of transactions. Algorithmic market makers
generally do not access the markets in the same way that investors
using algorithmic execution do. They tend to design their own
algorithms to quickly, often in a manner of microseconds, get their
orders into the trading platforms.
High Frequency Trading
High frequency trading typically refers to trading activity that
employs extremely fast automated programs for generating, routing,
canceling, and executing orders in electronic markets. They often act
as algorithmic market makers, but they do other things as well, such as
cross-market arbitrage, for example. Another high frequency trading
strategy is referred to as ``sniping.'' This strategy submits and
quickly cancels orders, looking for hidden pockets of liquidity.
Surveillance and Safeguards
The CFTC's surveillance program works to promote market integrity
and protect against fraud, manipulation, and other abuses. In the ever
changing market environment, it is important that regulators have
access to data, coordinate across agencies, trading platforms and self-
regulatory organizations and have effective market mechanisms and
pretrade safeguards.
Data
By the morning of May 7, the CFTC had all of the transaction and
open position data for trading on May 6. We are fortunate to receive
futures data every day. Because of the events of May 6, we also asked
for full order book data, which we do not normally do. We do not have
the resources to collect or examine order books on a daily basis, but,
given the events of May 6, we reviewed that day's order books. This was
a tremendous effort to collect and analyze an enormous data file that
included more than 14 million messages just for 1 day in the lead month
of the E-Mini.
Though we do get daily futures data, it is currently missing an
important bit of information: We receive traders' account numbers, but
we do not get the identity of the owner or controller of that account.
Over time, CFTC staff has manually identified traders associated with a
significant number of the more active trading accounts. The Commission
published a proposed rule in July of this year that will, if finalized,
require automated identification of account ownership and control.
Though our interviews with traders did not suggest that on May 6
the swaps marketplace played a significant role, it may have on other
days and may in the future. That is why I think it is very important
that Congress has given regulators the authority to require swap
dealers to provide swaps data to trade repositories that must make the
data available to regulators. The CFTC has a rule out for public
comment that would allow us to see all the data in the swaps markets
that we see in the futures markets. Additionally, the CFTC will need to
establish data linkages between swaps and futures data to conduct
financial risk surveillance, market surveillance, economic analysis,
and enforcement investigations across markets.
Coordination With Regulators, Exchanges, and Self-Regulatory
Organizations
The CFTC is coordinating closely with the SEC on a policy level. We
coordinated in providing recommendations to Congress on harmonizing our
regulations. We also are closely coordinating on rulemakings to
implement the Dodd-Frank Wall Street Reform and Consumer Protection
Act.
Importantly, we are working together on surveillance and data
sharing. For instance, after the events of May 6, CFTC staff promptly
shared position and transaction information directly with the SEC.
Though coordination between the regulators is important, it is
every bit as important that there be coordination between the exchanges
and self-regulatory organizations, who conduct front-line market
surveillance. The securities, options and futures exchanges have an
intermarket working group to address surveillance concerns.
Futures exchanges utilize computer surveillance systems that enable
their investigators to conduct focused reviews of exception reports and
create customized, ad hoc queries of trade data to identify instances
of possible trade practice rule violations. The largest exchange also
uses specific computerized pattern detection algorithms to identify
trading patterns associated with several major types of violations. The
exchanges monitor the basis relationship between cash and futures for
both broad based index and single stock futures and look for anomalies.
The CFTC also has been developing automated surveillance programs
to detect prohibited trading activity and identify large price changes
and large position changes. We have only just begun this process. We
have significant more work to do to adequately automate surveillance in
the futures market--not to mention the swaps market. The Commission
will require additional resources to complete this project.
Pretrade Safeguards
Both CME Globex and the ICE trading systems have automatic safety
features--termed ``pretrade risk management functionality''--to protect
against errors in the entry of orders and extreme price swings. These
features help ensure fair and orderly markets. These pretrade risk
management safeguards include: (1) price bands; (2) maximum order size;
(3) protections against market stop loss orders; and (4) stop logic
functionality, or market pauses that prevent cascading stop orders.
This is what was triggered on May 6 and coincided with the bottom of
the E-mini. Exchanges also require executing brokers to have pretrade
credit limitations to ensure that traders have the financial resources
to complete transactions.
One rulemaking that the Commission proposed on December 1 requires
futures exchanges to have effective risk controls to reduce the
potential for market disruptions and ensure orderly market conditions.
To prevent market disruptions due to sudden volatile price movements,
the proposed rule requires futures exchanges to have effective risk
controls in place. This includes pauses or halts to trading in the
event of extraordinary price movements that may result in distorted
prices or trigger market disruptions.
Implementing Enhancements to the CFTC's Regulatory Program
Though the Commission draws on more than 70 years of experience
regulating futures, the events of May 6 and the Dodd-Frank Act present
new challenges, responsibilities, and authorities.
Joint Advisory Committee
The CFTC and SEC--with Congressional authorization--established the
CFTC-SEC Joint Advisory Committee on Emerging Regulatory Issues. The
first task of this Advisory Committee is to evaluate the events of May
6 and make recommendations to both agencies to improve market
structures and regulations. The Advisory Committee has met four times
thus far, and we are targeting to reconvene in late January. Amongst
the areas we have asked them to address are the design of existing
broad market circuit-breakers and pretrade risk management safeguards.
CFTC staff is working with SEC staff to review and recommend
potential revisions to the design of broad market circuit-breakers in
light of today's interconnected markets and changes in technology.
Disruptive Trading Practice
The Dodd-Frank Act gives the CFTC specific authority to restrict
disruptive trading practices. The Act specifically prohibits three
trading practices: (1) violating bids or offers; (2) intentional or
reckless disregard for the orderly execution of transactions during the
closing period; and (3) spoofing (bidding or offering with the intent
to cancel the bid or offer before execution). In addition, Congress
gave the Commission the authority to write rules and regulations that
are reasonably necessary to prohibit trading practices that are
disruptive of fair and orderly markets.
On October 26, 2010, the CFTC published an advanced notice of
proposed rulemaking seeking public comments on disruptive trading
practices and the appropriate exercise of our rulemaking authority in
this area. Specifically, the Commission solicited public input on the
intersection of algorithmic and high frequency trading with possible
market abuses and asked whether--outside of the closing period--there
should be an obligation on executing brokers.
Resources
Before I close, I will address the resource needs of the CFTC. The
futures marketplace that the CFTC oversees is currently a $33 trillion
industry in notional amount. The swaps market that the Dodd-Frank Act
tasks the CFTC with regulating has a far larger notional amount as well
as more complexity. Based upon figures compiled by the Office of the
Comptroller of the Currency, the largest 25 bank holding companies
currently have $277 trillion notional amount of swaps.
The CFTC's current funding is far less than what is required to
properly fulfill our significantly expanded role. The CFTC requires
additional resources to enhance its surveillance program, prevent
market disruptions similar to those experienced on May 6 and implement
the Dodd-Frank Act.
The President requested $261 million for the CFTC in his fiscal
year 2011 budget. This included $216 million and 745 full-time
employees for pre-Dodd-Frank authorities and $45 million to provide
half of the staff estimated at that time needed to implement Dodd-
Frank. The House Appropriations Subcommittee with jurisdiction over the
CFTC matched the President's request. The Senate Appropriations
Subcommittee with jurisdiction over the CFTC boosted that amount to
$286 million. We are currently operating under a continuing resolution
that provides funding at an annualized level of $169 million. To fully
implement the Dodd-Frank reforms, the Commission will require
approximately 400 additional staff over the level needed to fulfill our
pre-Dodd-Frank mission.
I again thank you for inviting me to testify today. I look forward
to your questions.
______
PREPARED STATEMENT OF JAMES J. ANGEL
Associate Professor of Finance, McDonough School of Business,
Georgetown University
December 8, 2010
I wish to thank the Subcommittee for investigating these important
questions in market structure. My name is James J. Angel and I study
the nuts and bolts details of financial markets at Georgetown
University. I have visited over 50 financial exchanges around the
world. I am also the former Chair of the Nasdaq Economic Advisory Board
and I am currently a public member of the board of directors of the
Direct Edge Stock Exchanges. \1\ I am a coinventor of two patents
relating to trading technology. I am also the guy who warned the SEC in
writing five times before the ``Flash Crash'' that our markets are
vulnerable to such big glitches. \2\
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\1\ These remarks are my own and do not necessarily represent
those of Georgetown University or the Direct Edge stock exchanges.
\2\ See the Appendix for details.
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Another Flash Crash can happen again, and we need to take steps to
fix our fragmented regulatory system to prevent another one from
further damaging our capital markets. Here's why:
The market is a complex network
Our financial market is not a single exchange with a wooden trading
floor, but a complex network linking numerous participants trading many
different types of linked products including exchange-traded equities,
options, and futures as well as over-the-counter instruments. This
network includes not only numerous trading platforms but a vast
infrastructure of supporting services. Participants include:
Equity exchanges
Option exchanges
Futures exchanges
Automated trading systems operated by broker-dealers
Proprietary trading systems operated by broker-dealers
Proprietary trading systems operated by other investors
Algorithm providers
Data vendors
Telecommunications providers
Data centers
Analytics providers
Settlement organizations such as DTCC
Stock transfer agencies
Banks
Proxy service firms
Professional traders
Money managers
Hedge funds
Retail investors
Media
Problems anywhere in the network can disrupt the entire market
A problem anywhere in the network can lead to a disruption. For
example, on Monday, September 8, 2008, the South Florida Sun Sentinel
erroneously published an old story that United Airlines had filed for
bankruptcy--an event that had occurred in 2002. \3\ Some investors
thought that United Airlines was filing for bankruptcy again, and the
stock of the new United Airlines temporarily plummeted more than 75
percent before recovering. Power outages and telecom problems can also
disrupt the market.
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\3\ See, http://www.upi.com/Business_News/2008/09/08/United-
Airlines-hit-by-5-year-old-news/UPI-66501220903137/.
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Most of the time our market network has enough redundancy to
prevent a failure in one location from disrupting the whole network.
Minor problems at one exchange or other part of the system are routine
occurrences. Equity exchanges routinely declare ``self help'' when
there are problems with other exchanges. Under normal conditions,
market participants just trade around the problem and it never makes
the news. On May 6, 2010, the market buckled under the flow of data and
seemingly minor problems in data feeds cascaded into a chaotic partial
failure of the entire network.
Our market network performs really well--most of the time
By most measurable standards, our market network is working better
than ever before. Our automated markets provide fast, low cost
executions. Total trading volume and displayed liquidity have jumped
dramatically in recent years. This can be seen in the attached study I
performed with Larry Harris of USC and Chester Spatt of Carnegie-
Mellon, both former chief economists at the SEC. However, in that
study, which was submitted to the SEC, we also warned of the danger of
misfiring algorithms that could cause a meltdown--or a melt up of the
market. \4\
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\4\ Indeed, some stocks on May 6 did melt up. A trade in Sotheby's
was printed at $100,000 per share. The study can be seen at http://
www.sec.gov/comments/s7-02-10/s70210-54.pdf.
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Our market network has finite capacity
Just like any human system, our market network can only handle so
much activity before it has problems with traffic jams. When the flow
of data through a computer network overflows its capacity, strange
things begin to happen. As the market is quite complex, bottlenecks can
occur in unexpected places. Dealing with the capacity limitations of
the network is not as simple as making sure that the equity exchanges
have lots of spare computer capacity--the SEC does a pretty good job of
that. As the network involves many unregulated entities, such as data
vendors and IT providers as well as investors themselves, it is
virtually impossible for the SEC or any regulator to force every
network participant to maintain ludicrously high levels of excess
capacity. This is especially true since network participants will
rationally resist sizing their systems for once-a-decade data tsunamis.
Instead, we need to have well thought out safeguards for dealing with
these extreme events, which occur regularly in our financial markets.
The Flash Crash was exacerbated by bad market data
If traders don't have good price data, they can't trade. Many of
the most important participants in our markets are known as ``liquidity
providers'' who buy on the dips and sell on the rebound. They perform
an important stabilizing role in markets. In the old days, they were
known as specialists and hung out on those old wooden trading floors.
Now they do their job with computers that hang out in stock exchange
data centers in what is known as ``colocation.'' This kind of ``high
frequency'' trading is a thin margin business with a lot of
competition. These traders typically earn a small fraction of a penny
per share, but they make money by trading in high volumes. These
liquidity providers depend upon accurate data. If they detect that
there is a malfunction in their data feeds, they do the rational thing
and stop trading until they can figure out what is going wrong. As the
SEC and CFTC noted in their report on the Flash Crash:
As such, data integrity was cited by the firms we interviewed
as their number one concern. To protect against trading on
erroneous data, firms implement automated stops that are
triggered when the data received appears questionable. \5\
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\5\ Findings Regarding the Market Events of May 6, 2010: Report of
the Staffs of the CFTC and SEC to the Joint Advisory Committee on
Emerging Regulatory Issues, http://www.sec.gov/news/studies/2010/
marketevents-report.pdf, p. 35.
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This is what happened on May 6:
Heavy trading activity led to traffic jams in market data.
In the words of the Wall Street Journal's Scott Patterson,
``The market infrastructure was fried.'' \6\
---------------------------------------------------------------------------
\6\ Oral remarks at the Dow Jones Expert Series, Nasdaq Market
Site, October 27, 2010.
Important market participants detected problems in the
accuracy of their market data, and stopped trading. This led to
---------------------------------------------------------------------------
a decrease in liquidity.
Other market participants that did not detect the data
problems kept trading. There were few buyers in the market when
their sell orders arrived, causing prices to plummet
temporarily.
Flash Crashes are not new
Financial market history contains many events in which the market
was overwhelmed by the flow of data and the market mechanism broke
down. Many of these events happened long before computers. On May 3,
1906, the New York Times headline blared ``Stocks Break and Recover. On
August 9, 1919, the New York Times reported a ``sharp break'' in
prices. As in the Flash Crash, there were problems in getting prices
out to the public: ``In the break, prices quoted on the ticker tape
were once again far behind the market . . . '' Soon there was an upturn
and prices recovered.
System problems in times of stress are not new
Market history contains numerous examples of system problems that
occurred during times of market stress. These problems were both a
result of the level of market activity and a cause of additional
confusion in the market. In the crash of 1929, the ticker tape ran
several hours late, adding to the confusion and panic. Investors did
not know whether their orders had been executed or at what price. In
the crash of 1987, there were, in the SEC's words, ``large scale
breakdowns in automated trading systems.'' \7\ Among other problems,
the printers on the NYSE jammed, so that order tickets could not be
printed.
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\7\ http://www.sec.gov/news/studies/tradrep.htm
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Market tsunamis are regular events, so we need to be prepared for the
next one
On May 6, the market network was so overwhelmed with the flood of
data that it broke down and started spewing out bad prices. This is not
the first time, nor will it be the last time. Market history teaches us
that these extreme but infrequent events happen regularly. We need to
be prepared for the next market tsunami. It is impractical to mandate
an extreme amount of overcapacity throughout the extended market
network. Instead, we should put safeguards in place so that when the
next one hits, our market deals with the overflow of activity in a
fail-safe manner.
We need safeguards for individual stocks as well as for the whole
market network
Crude ``circuit breakers'' were put in place after the crash of
1987. \8\ If the Flash Crash of 2010 had occurred just a few minutes
earlier and been a little steeper, a 1 hour trading halt would have
occurred. Thank God that didn't happen! Imagine the public panic that
would have occurred when the news got out that the market crashed and
then shut down. The public may well have thought that the fall in
prices was a fundamental result of bad news stemming from the situation
in Greece, and there may have been even more panic selling when the
market reopened. Our close brush with doom on May 6, 2010, shows us how
poorly the post-1987 circuit-breakers were designed. We need to
seriously rethink the marketwide as well as stock specific safeguards.
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\8\ See, http://www.nyse.com/press/circuit_breakers.html for the
current circuit breaker levels.
---------------------------------------------------------------------------
We also have mini-disruptions in individuals stocks with
distressing regularity. The crude stock-by-stock circuit breakers that
were imposed after the Flash Crash are an important first step, but
there is much more refinement that needs to take place. The safeguards
need to cover all stocks, and they need to be in effect during the open
and the close. We need to fix the erroneous trade problem that has led
to many false alarms after the circuit breakers were implemented.
The current circuit breaker designs are based on price, which is
good, but we should also have circuit breakers that are based on data
integrity. When the data feeds can't keep up with the market, we need
to slow down the market so we can catch up. This will nip the problems
in the bud before prices go crazy.
The safeguards need to be integrated across the entire market network
Currently, our fragmented regulatory system treats each exchange as
an independent Self Regulatory Organization. There is no real time
supervision of the entire market network. There is no entity that can
call a timeout when there is some network problem that may not have
been anticipated in the circuit breaker design. Somebody needs to be
monitoring the system in real time and that somebody needs to have the
authority to call a timeout when things go crazy. I think that FINRA is
the obvious candidate to be that somebody.
We need to worry less about a fragmented market than about fragmented
regulation
Some market participants grumble about the complexity and
``fragmentation'' of today's markets. Yes, today's market is far more
complex than the days of old, but it works much better. Most of our
technology today, from the automobile to the word processor, contains
far more complicated technology than before, and most of the time works
far better.
One can think of the stock market of a few years ago as being
similar to a manual typewriter. We upgraded it to an electric
typewriter, and then to a word processor. On May 6, 2010, that word
processor went into short spasm that highlighted many of the flaws I
previously warned the SEC about. However, that does not mean that we
should throw out the word processor and go back to a manual typewriter.
It means we need to put safeguards in place to make sure that it
doesn't happen again.
Even though the technology of our markets has improved dramatically
in recent years, our regulatory system is still stuck in the manual
typewriter days of the early twentieth century. There are literally
hundreds of financial regulatory agencies at the State and Federal
levels. None of them have the big picture in their in-baskets. Each of
them has a fairly narrow mandate.
In the 1975 ``National Market System'' amendments to the Securities
Exchange Act, Congress mandated a competitive market structure. The SEC
has dutifully implemented this. However, Congress has not thought
through how to regulate our interconnected financial markets. The Dodd-
Frank bill did not meaningfully address the dysfunctional fragmentation
in our regulatory system.
We need regulators who understand the entire market
Although the SEC has many dedicated and intelligent public
servants, as an organization it does not really understand the entire
market network. The Commission is a specialist agency with a narrow
mandate that focuses on ``securities.'' Other related financial
products (futures, insurance, and loan products) are left to other
State and Federal agencies, which leads to gaps as well as overlaps in
the regulation. If we think of our market network as a body, the SEC is
perhaps, a cardiologist who might very well ignore the patient's lung
cancer as it assumes that other doctors treat it. \9\ And since the
cardiologist and the oncologist and in different granite towers, the
cancer is ignored.
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\9\ In a discussion once with an SEC staffer a few years ago, I
raised a concern about systemic risk. I was immediately and
emphatically told that systemic risk was not in the SEC's mandate and
that it was the Fed's job to worry about it.
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The regulators need better market intelligence
One of the frightening aspects of the Flash Crash was how long it
took the regulators to piece together what happened, and how their
reports still displayed a lack of a deep understanding of the
significance of the facts they uncovered. We need regulators who really
understand the market network and have access to the data and resources
they need to properly nurture and supervise our markets.
The regulators need good funding
We have been penny wise and pound foolish with respect to funding
the SEC. The SEC's total cumulative budget since its founding has been,
in today's dollars, about $18 billion. That is less than half of
investor losses in the Madoff scandal. We need good cops on the beat to
keep the crooks out. We need to hire enough good people to do the job
right, and make sure they have the right tools to do the job. We also
need to be able to pay them enough to attract and keep good people. The
pay level of SEC officials is very far below their private sector
counterparts. SEC salaries should be benchmarked close enough to the
private sector so that they can get the right people.
One solution: De facto integration in our financial capitals
The SEC is sequestered in a granite tower on F Street in
Washington, hundreds of miles away from the heart of the markets that
it attempts to regulate. The CFTC is in a different granite tower two
miles away from the SEC in Lafayette Centre. The banking regulators are
spread all over. Congress seemed unwilling to address the dysfunctional
structure of our fragmented regulatory morass in the recent Dodd-Frank
bill.
However, there is an administrative solution to the fragmentation
of our regulatory system that would not require massive legislation: If
you want the regulators to work together, house them in close physical
proximity. House all of the Federal financial regulators in one
building with common shared facilities for security, food service,
information technology, and so forth. In this way, it will become easy
for regulators in the different agencies to literally work closely with
each other. It will also make it easier for agencies to make use of the
already existing Intergovernmental Personnel Act (IPA) mobility program
to rotate employees through the different agencies. Increasing the
rotation of employees through the different regulatory agencies will
improve the thinking of regulatory agencies by making the agencies more
cognizant of the entire market network rather than the narrow piece
that their agency regulates.
Second, locate this facility in the heart of our financial markets
in New York City. Even though we live in an electronically linked
world, physical proximity still matters. Being in the heart of the
financial system makes it easier for the regulators to actually
interact with the people in the markets. I know from my own experience
that it is hard to understand markets from my ivory tower office. I
learn about markets by taking every opportunity I can to make on-site
visits to market practitioners. It is very important for the regulators
to get out of their granite towers and interact with the financial
markets, and it will be much easier if they are located closer to the
markets they are regulating. It will also be easier for them to invite
market practitioners in to visit them as well.
Closeness to the markets is one of the reasons why trading firms
still congregate in the New York City area. Notice that NASDAQ, which
operates an all electronic market, moved its headquarters to New York
when it realized that its key employees were spending so much time
shuttling between Washington and New York. Pipeline Trading, which was
founded by scientists from Los Alamos, New Mexico, set up shop in New
York because that is the heart of the financial markets.
Locating the bulk of our regulators in New York means that the
regulatory agencies will draw from a labor pool that understands
financial markets and has good market experience. I understand that it
is hard right now for the regulators to attract good people to move to
DC. The agencies thus draw from a labor pool of Government regulators
who are well meaning but don't have the background or experience needed
for the job.
The falling number of public companies is a major problem!
Although not a focus of this hearing, there is another market-
structure related problem that cries out for serious attention: The
number of listed U.S. companies has fallen sharply over the last
decade. At the end of 1997, before the dot-com bubble went crazy, there
were 8,201 operating domestic companies listed on the NYSE, NASDAQ, and
AMEX exchanges. At the end of 2009, only 4,439. \10\
---------------------------------------------------------------------------
\10\ This data comes from the Center for Research in Securities
Prices (CRSP) database for common stocks of U.S. companies listed on
U.S. exchanges.
---------------------------------------------------------------------------
By the end of October, 2010, there were only 3,964 companies in the
Wilshire 5000 index, an index which include all domestic companies
listed on our exchanges. \11\
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\11\ http://www.wilshire.com/Indexes/Broad/Wilshire5000/
Characteristics.html, accessed December 5, 2010.
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While private equity firms have picked up some of the slack, they
are not a substitute for vibrant capital markets. Indeed, private
equity investors need the public markets in order to be able to exit
their investments. Without an exit strategy, investors won't invest in
the first place.
Fewer public companies = fewer jobs
In rough numbers, if we assume that half of the roughly 4,000
missing companies are now private or part of larger public companies,
that still leaves about 2,000 missing U.S. companies. If each of those
missing companies employed 1,000 workers, that is two million fewer
jobs. Two million more jobs would slash over 1 percent off of our
unemployment rate.
We have made it too expensive to be a public company
There are several causes for the declining number of public
companies: For one thing, it has become very expensive to be a public
company compared with a private company. The compliance burdens on
public companies, such as Sarbanes Oxley 404 compliance is one
problem. The Dodd-Frank law exempted tiny companies from this 404
burden, but the burden remains for the majority of exchange listed
companies. The cost and risk of litigation exposure is another--the
cost of directors and officers insurance for a public company is
several times higher than the premium for a similar sized private
company.
Our market structure is not welcoming to small companies
Market structure issues are also involved. Our markets provide
great service to large companies, but it is not clear that the best
market structure for big companies is also best for smaller companies.
However, SEC policy over the last two decades has been to make the
trading of smaller stocks the same as for larger stocks. There is no
such thing as a ``one size fits all'' market, but the SEC does not seem
to understand this. Small companies are lost and ignored by the market
as an unintended consequence of many of the market structure changes of
the last 20 years. We should encourage experimentation with different
market models for smaller stocks. \12\
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\12\ For the record, I strongly disagree with the allegations in
the Litan and Bradley study that blame the proliferation of index
products such as ETFs for the decline in public companies. ``Choking
the Recovery: Why New Growth Companies Aren't Going Public and
Unrecognized Risks of Future Market Disruptions''; http://
www.kauffman.org/uploadedFiles/etf_study_11-8-10.pdf. Although I do not
agree with all of its recommendations, the Grant Thornton report is
also worth noting: A Wake Up Call for America by David Weild and Edward
Kim; http://www.grantthornton.com/staticfiles/GTCom/
Public%20companies%20and%20capital%20markets/gt_wakeup_call_.pdf
---------------------------------------------------------------------------
Considerable attention needs to be applied to this problem. Smaller
companies are the engine of innovation and economic growth. Without
good capital markets nurture these companies of tomorrow, we will
condemn our Nation to economic stagnation.
Appendix: Written Submissions to the SEC Regarding Market Glitches
Prior to May 6, 2010
Warning Number 1
In my May 5, 2009, comments presented at the SEC Roundtable on
short selling (http://www.sec.gov/comments/4-581/4581-2.pdf), I warned
on page 3 that we would have more high speed meltdowns like the one
that affected Dendreon in April 2009:
We need a shock absorber to prevent another Dendreon.
Those calling for a return of some type of uptick rule are
expressing a legitimate concern. They intuitively grasp that
there is something wrong with short-term price formation in our
markets today. The recent incident with Dendreon (DNDN) on
April 28, 2009, demonstrates the need for a shock absorber. The
company was about to make an announcement regarding the
effectiveness of its prostate drug Provenge. The stock plunged
69 percent in less than 2 minutes. \13\ After the news was
revealed, the stock quickly returned to its previous levels.
Investors who had placed stop loss orders to protect themselves
found that their orders were executed at very unfavorable
prices. Why did the stock plunge? It is too early to tell. Was
it a ``fat fingers'' mistake in which an investor hit the wrong
button? Did an algorithm misfire? Was it a chaotic interaction
between dueling algorithms? Did a long seller panic and dump
too many shares too fast? Was there a deliberate ``bear raid''
manipulation going on from informed traders hoping to push the
price down so they could trigger stop loss orders and scoop up
shares cheaply? Or was it just the case that the market was
very thin just before the news announcement and a few large
sell orders exhausted the available liquidity, triggering the
selloff? Regardless of the reason, the incident demonstrates
the need for a shock absorber to deal with extreme situations.
---------------------------------------------------------------------------
\13\ Ortega, Edward, Nasdaq Will Let Stand Dendreon Trades Under
Review http://www.bloomberg.com/apps/
news?pid=newsarchive&sid=a314cxKBoGHI
The era in which humans traded with humans is long gone. Now
computers trade with other computers in the blink of an
electron. Most other developed equity markets around the world
have some kind of procedure for dealing with extreme
situations. Whether it is a price limit, a trading halt, or a
special quote mechanism, the United States needs to install a
shock absorber to deal with excessive volatility. One of the
main purposes of the stock market is to provide good price
discovery. If the price discovery mechanism appears to be
---------------------------------------------------------------------------
broken, it will reduce investor confidence in the market.
Unfortunately, merely reimposing the old useless uptick rule or
forcing a preborrow for shorted shares will not solve the
problem of excessive intraday volatility. What is needed is to
think outside the box of ``lets get the short sellers'' to the
more useful question of ``what kind of shock absorber works
best in our modern markets?''
It is certainly not obvious what form such a shock absorber
should take. One thing that is clear is that the 1939 uptick
rule will not achieve the objective of reducing excess
volatility. Installing a broken shock absorber from a 1939
Chevrolet Coupe into our 2009 Corvette market will not do the
job. What would make sense is a dampener similar to the
exchanges' proposal. The beauty of the exchange's circuit-
breaker with restriction idea is that it does not interfere
with normal market operations under normal conditions. It only
kicks in when needed, at times when the market is under stress.
Perhaps a more gradual shock absorber would make more sense.
For example, one approach would be:
At prices at or above 5 percent below the previous close:
No restrictions
At prices below 5 percent below the previous close: Hard
preborrow for short sales
At prices 10 percent below the previous close: price test
for short sales
If the price hits 20 percent below the previous close:
Automatic 10 minute trading halt. The stock would reopen with
the usual opening auction after market surveillance has
determined that there are no pending news announcements.
I urge the Commission to begin consultation with the industry
to develop one that fits the unique and competitive nature of
our markets. If nothing is done, there will be more Dendreons.
Warning Number 2
In my comment letter of June 19, 2009 (http://www.sec.gov/comments/
s7-08-09/s70809-3758.pdf), I stated on page 2:
Our electronic markets lack a shock absorber.
Most electronic exchanges around the world have automated
systems in place to deal with extreme events. We don't. High
speed algorithmic trading has brought amazing liquidity and low
transactions costs to the markets, but it also brings the risk
of market disruption at warp speed.
Our markets are vulnerable to short-term fluctuations that can
result in prices that do not reflect the market's consensus of
the value of the stock. The disruption in the trading of
Dendreon (DND) on April 28, 2009, that I referred to in my
remarks at the Roundtable is a smoking gun. (My remarks are
repeated at the end of this comment letter for you convenience
as well.)
The stock plunged for no apparent reason, and by the time the
humans halted trading the damage was done. Many investors who
had placed stop-loss orders discovered that their orders had
been filled at very low prices. Furthermore, incidents like
these bring up suspicions of foul play, and these suspicions
hurt our capital markets. When investors think that market
manipulation is unpunished, they will withdraw from our capital
markets, reducing their usefulness to our society.
Short selling is not the only cause of short term market
disruptions.
A burst of short selling can cause a ``Dendreon moment'', but
so can long selling. Markets can also be disrupted on the up
side as well. In considering what to do about situations like
this, the Commission should consider the broader needs of the
market for a shock absorber to deal with excessive short-term
volatility.
The Commission should actively consider shock absorbers that
deal with ALL price disruptions, not just ones triggered by
short sales. One time-tested model to consider is the
``volatility interruption'' used by Deutsche Borse. \14\ When
the stock moves outside of a reference range, trading is halted
for a period of time and trading then restarts with a call
auction.
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\14\ http://deutsche-boerse.com/dbag/dispatch/en/binary/
gdb_content_pool/imported_files/public_files/10_downloads/
31_trading_member/10_Products_and_Functionalities/20_Stocks/
50_Xetra_Market_Model/marktmodell_aktien.pdf
We need not follow the Deutsche Borse model exactly. Short
orders at prices below the previous opening or closing price
could be excluded from the restarting auction (with appropriate
exemptions for market makers and arbitrageurs). After trading
restarts, restrictions should be placed on short sales at
prices 5 percent or more below the previous opening or closing
price to maintain fair and orderly trading. These could include
---------------------------------------------------------------------------
(1) preborrowing requirements or a bid test.
Any changes should be carefully studied with a transparent
pilot experiment.
Before the Commission institutes any such changes, it should
experiment carefully as it did with the original Regulation SHO
pilot. In this way, the Commission could adopt the best of the
different proposals after carefully examining their impact.
Warning Number 3
In my September 21, 2009 comment letter to the SEC on short selling
(http://www.sec.gov/comments/s7-08-09/s70809-4658.pdf), I stated on
page 1:
The big picture is that today's warp speed computerized markets
contain the potential for another financial catastrophe at warp
speed. If an algorithm at a large financial institution
misfires, whether because of an honest malfunction or sabotage,
it could create an enormous critical chain reaction that would
cause a tsunami of economic destruction within milliseconds.
Yet we currently rely on slow humans at our exchanges to make
decisions. We need automated circuit breakers that function on
a stock by stock basis that will kick in instantly when
something goes haywire. To date, the SEC has taken the same
approach to such warnings as FEMA took to warnings that New
Orleans was vulnerable to a Category 5 hurricane. Do we need a
Category 5 meltdown in the equity market before the SEC moves
to take action to prevent such a preventable calamity? The
individual exchanges cannot act on their own because of the
competitive fragmented nature of our modern markets. If a
single exchange halts trading, it stands at a competitive
disadvantage to its competitors. Dealing with this threat
requires intelligent coordinated action by the SEC.
Warning Number 4
In my joint study with former SEC chief economists Lawrence Harris
and Chester Spatt (http://www.sec.gov/comments/s7-02-10/s70210-54.pdf),
we stated on page 47:
8.3 Misfiring algorithms
In a related area, we are also concerned that, even without
naked access, the risk control procedures at a brokerage firm
may fail to react in a timely manner when a trading system
malfunctions. In the worst case scenario, a computerized
trading system at a large brokerage firm sends a large number
of erroneous sell orders in a large number of stocks, creating
a positive feedback loop through the triggering of stop orders,
option replication strategies, and margin liquidations. In the
minutes it takes humans at the exchanges to react to the
situation, billions of dollars of damage may be done.
Currently our exchanges have no automatic systems that would
halt trading in a particular stock or for the entire market
during extraordinary events. It is our understanding that the
circuit breakers instituted after the Crash of 1987 would be
manually implemented, which could take several minutes. These
circuit breakers are triggered only by changes in the Dow Jones
Industrial average, so severe damage could be done to other
groups of stocks, and the circuit breakers would not kick in.
Also, a misfiring algorithm could also create a ``melt-up'' as
well. We recommend that the exchanges and clearinghouses
examine the risk and take appropriate actions. Perhaps the
issue most simply could be addressed by requiring that all
computer systems that submit orders pass their orders through
an independent box that quickly counts them and their sizes to
ensure that they do not collectively violate preset activity
parameters.
Warning Number 5
In my comment letter of April 30, 2010 (http://www.sec.gov/
comments/s7-02-10/s70210-172.pdf), I stated on page 5 (Italic text is
in the original):
High frequency technology requires high frequency circuit
breakers.
There is one risk that HFT imposes on the market that must be
addressed by the Commission. With so much activity driven by
automated computer systems, there is a risk that something will
go extremely wrong at high speed. For example, a runaway algo
at a large firm could trigger a large series of sell orders
across multiple assets, triggering other sell orders and
causing major disruptions with losses in the billions. With the
global linkage of cash and derivative markets around the world,
it would be extremely difficult to go back after the fact and
bust the appropriate trades, leading to years of litigation.
The uncertainty and confusion would cause serious damage. Even
more troubling is the prospect that such a glitch could be
caused intentionally, either by a disgruntled employee or a
terrorist.
All market participants have the right incentives to prevent
this from happening. The brokerage firms and exchanges have
filters in place designed to catch ``fat fingers'' and other
mistakes. However, the never ending quest for higher speed also
creates incentives for them to cut corners and eliminate time
consuming safeguards that might slow their response time. In
today's competitive market place, no one market center can take
all the needed actions alone. There needs to be coordinated
guidance from the Commission on this issue.
No human system is perfect. Despite all of the correct
incentives and precautions, airplanes sometimes crash.
Eventually there will be some big glitch. We need a marketwide
circuit breaker that is activated automatically in real time.
It is my understanding that the crude marketwide circuit
breakers imposed after the crash of 1987 are currently operated
manually. In the minute or so it takes for humans to respond to
a machine meltdown, billions of dollars of damages could occur.
\15\ The April 28, 2009, incident involving Dendreon is an
example of what can go wrong. The stock lost over half its
value for no apparent reason in less than 2 minutes before the
humans could stop trading. When trading resumed, the stock
returned to its previous value. Many investors who had placed
stop orders experienced severe losses from trades that were not
busted. Almost exactly 1 year later, on April 27, 2010, a
botched basket trade resulted in the need to bust clearly
erroneous trades in over 80 different stocks. It is extremely
messy to attempt to bust erroneous trades after the fact,
especially if multiple instruments in multiple asset classes
traded on multiple exchanges in multiple countries are
involved. For example, an investor may sell stock that was
purchased during the malfunction only to find that the purchase
was busted but not the later sale, leading to an inadvertent
naked short position. We need a real time circuit breaker that
can stop the market before extreme damage occurs.
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\15\ See, Bernard S. Donefer, ``Algos Gone Wild: Risk in the World
of Automated Trading Strategies'', Journal of Trading 5(2), Spring 2010
pp. 31-34 http://www.iijournals.com/doi/abs/10.3905/JOT.2010.5.2.031
The Commission should consider imposing an automated marketwide
trading halt in any instrument that falls 10 percent in a short
period of time. The stock would then reopen using the opening
auction after humans have examined the situation to make sure
---------------------------------------------------------------------------
that the stock can be reopened in a fair and orderly manner.
If this Commission fails to act on this risk after asking so
many questions about HFT in this Release, this Commission and
its staff will be blamed for ignoring this risk when the
inevitable big glitch occurs.
PREPARED STATEMENT OF THOMAS PETERFFY
Chairman and Chief Executive Officer, Interactive Brokers Group
December 8, 2010
A. Introduction
Chairman Reed, Chairman Levin, Ranking Member Bunning, Ranking
Member Coburn, and Senators, thank you for inviting me here to discuss
some of the issues facing the Nation's securities and futures markets
and what we might do to address these issues.
I am the Chairman and CEO of the Interactive Brokers Group.
Interactive Brokers is a technology-focused brokerage firm that
provides sophisticated investors and institutions with access to
securities and futures trading in the U.S. and across the world.
Interactive Brokers also has a large market making business, in which
we provide liquidity on stock, options and futures exchanges. We are an
$8 billion company by market capitalization and our customers hold
about $21 billion dollars with us, and so you might say we have a lot
of ``skin in the game'' in terms of our interest in the health of the
U.S. markets. We have some serious concerns that I would like to share
with you.
B. The Interconnected Securities and Futures Markets of the U.S.
Continue To Be Vulnerable to Major Disruption
To begin, I would like to tell you about my worst nightmare:
Consider a high frequency trading--or ``HFT''--operation with as
little as $30 to $50 million dollars. This HFT firm consists of a few
computers, a couple of programmers, and maybe a 3-month track record of
high volume, computerized trading with modest gains or losses.
Many such high frequency trading operations exist today scattered
around the world. They gain direct, unfiltered access to U.S. exchanges
via what is called Sponsored Access, wherein the sponsoring, often
undercapitalized, U.S. broker will essentially lend out its exchange
membership for a fee and under that broker's membership, the high-
frequency trading operation is able to do an unlimited number of
transactions without any prescreening by the sponsoring broker (i.e.,
the sponsoring broker does not see the orders before the HFT firm
executes them).
One day, at 3:45 p.m., the HFT firm's computers start sending
orders to sell large capitalization stocks and Exchange-Traded Funds
(ETFs). The circuit breakers are not in effect after 3:35 p.m., but
even if they were, perhaps our HFT firm would try to mediate its orders
to avoid triggering the circuit breakers. As the HFT firm's selling
continues, the market decline accelerates and spreads to the futures
and options markets. As the close of trading approaches, many other
sellers jump in, including day traders trying to go home flat, traders
with stop orders in the system, and securities and futures brokers
liquidating undermargined customer accounts. \1\ With the right
pressure applied, the market might easily close down 30 percent for the
day.
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\1\ There is a new short sale restriction scheduled to become
effective in March 2011, which restricts short sales from hitting the
bid if a certain downward threshold has been reached. In the case of a
sponsored account, one wonders how this rule would be enforced. If the
high frequency trading firm does not label short sales as such, the
market damage will be done and the violation only detected, if at all,
some time after the event.
---------------------------------------------------------------------------
The next morning, scared investors and brokers holding
undermargined accounts all have to run for the exits and sell into the
cascading circuit breakers. Undercapitalized brokers fail. Other HFTs
and hedge funds that were long going into the decline, fail, and their
clearing brokers fail. Clearinghouses may be threatened, as more and
more positions must be liquidated for margin reasons. There will be a
great many losers, but the HFT firm that started it all will garner
huge profits when it covers its short positions during the fire sale.
Its gains will be moved quickly to offshore accounts before the
regulators figure out who did it.
In the other, almost-as-bad scenario, when the market opens the
next day it realizes it was duped. No external event or news is seen
justifying the prior day's break, and the source of the orders has been
isolated. In this scenario, the market rallies sharply, climbing 40
percent the next morning. The HFT firm's sell orders that caused the
original decline become massive losers, losses that the broker
sponsoring the access (and its clearing broker) cannot cover.
Bankruptcies follow.
Under either scenario, many innocent, ordinary investors will be
caught by the huge downdraft or updraft and confidence in the stability
and integrity of our markets will suffer further.
Unfortunately, what I have just described is very plausible. It
could be an attempted manipulation by an HFT firm with a goal of simple
profit. It could be an intentional act by a terrorist or anarchist, or
by a dissatisfied employee of a hedge fund or broker or HFT firm. Or it
could be caused by a simple computer bug.
So the question becomes, what can we do to prevent these and other,
less dramatic abuses?
C. Recommendations
I. The SEC's New Rules Banning Certain Forms of Sponsored Access and
Requiring Risk Management Procedures Should Be Strengthened and
Should Be Made Effective Immediately, by Emergency Order if
Necessary. The CFTC Should Also Adopt Similar Rules.
The SEC recently approved new rules banning certain forms of
sponsored access and requiring brokers to implement new risk management
procedures, but the rules do not go into practical effect until mid-
July 2011, seven months from now. A great deal could happen between now
and then.
In addition, the regulations are somewhat vague and seem to leave
enough discretion to brokers that some might allow orders to be sent to
market that are beyond the financial wherewithal of the customer.
Finally, although the new rules prevent customers from sending
orders directly to an exchange using sponsored access, about 5,000
brokers that are not members of the clearing house are still allowed to
send orders directly to an exchange, with no prefiltering or credit
review by the clearing member broker that is ultimately financially
responsible.
These gaps need to be closed. First, the SEC should make the new
rules (or at least the important, operational portions of them)
effective very shortly, by emergency order if necessary and hopefully
by the end of the year.
Second, the regulations should be clarified to require that the
clearing broker that is financially responsible for a particular
customer's orders must set a specific credit limit for that customer.
This credit limit must not exceed the smaller of: (1) the customer's
stated capital (as reasonably relied upon by the broker); or (2) the
assets on deposit with the broker plus 10 percent of the broker's
capital.
The broker should calculate the margin requirements on the
customer's existing positions in real time and reject any order that,
if executed, would cause the customer's margin requirements to exceed
the prescribed credit limit. This is an elementary risk management tool
that most reputable brokers already use, and all reputable brokers
should use.
Finally, the ability to submit orders to exchanges should be
restricted to brokers that are clearing members. Thinly capitalized
firms or firms with poor risk management systems may register as
broker-dealers, become exchange members, and send orders directly to
the exchange, for which another broker--the clearing broker--ultimately
will be responsible. And yet that clearing broker whose capital is at
risk is not required to see or to credit check these orders before
execution. This is a huge risk management gap that must be closed.
II. The SEC Should Approve and Accelerate Its Proposed Audit Trail
Rules. The CFTC Should Adopt Coordinated Rules and Use the Same
Unique Beneficial Owner Codes so That the Agencies Can
Effectively Share Surveillance Information. As a Stopgap Until
These Systems Are Fully Developed, the Commissions Should
Require Clearing Brokers To Create Basic Audit Trails,
Including Beneficial Owner Information.
Manipulation and insider trading are frequent and appear to be on
the upswing, and the SEC and the CFTC need real-time consolidated audit
trail information, including most importantly the identity of the
underlying beneficial owner behind each trade.
The SEC has proposed comprehensive rules providing for the creation
of a single, consolidated audit trail, but these rules have not yet
been approved and will not become fully effective for at least 2 years,
and probably more like three or four including the extensions of time
that the industry undoubtedly will request.
The SEC should approve its proposed audit trail rules and shorten
the timeframe for implementation substantially. But as a stopgap, the
SEC should issue a very basic order, effective in no greater than 90
days, requiring that clearing brokers maintain a basic audit trail,
including the identity of the underlying beneficial owner behind each
order for which the clearing broker is responsible. The information
would have to be provided to the Commission and relevant SROs on
demand, perhaps using existing systems.
Having immediate access to the identity of the underlying traders
behind each order by a simple request to the clearing broker will be a
marked improvement over the current system until the full-blown, cross-
market consolidated audit trail comes on line in 2 or 3 or 4 years. \2\
---------------------------------------------------------------------------
\2\ The ultimate goal of the proposed consolidated audit trail is
to allow regulators to view order and trade information in time-
sequence in order to be able to replay actual market events. Due to
calibration difficulties and inherent latencies in communications, it
will be impossible to precisely recreate market events. In any event,
we usually know what happened but do not know who did it. The presence
of quickly accessible data identifying rule violators would serve as a
deterrent.
---------------------------------------------------------------------------
When the consolidated audit trail system does come on line, the SEC
and CFTC should have similar or identical systems. Most importantly,
the unique large trader and beneficial owner codes that would be issued
by the central audit trail processor should be the same across the
securities and futures markets so that cross market activity can be
monitored effectively.
III. To Improve Liquidity and Transparency and Help Prevent Future
Crashes, Off-Exchange Trading of Exchange-Listed Products
Should Be Limited or Prohibited.
An observer from another planet, here to study our financial
regulation, would have some difficulty understanding the following
proposition: In the wake of Dodd-Frank, equity-based ``Over-the-
Counter'' derivatives must trade on exchanges, so long as similar
products are listed there. Yet ``Exchange-Listed Securities'' remain
free to trade over-the-counter. This is bureaucracy at its best, or
perhaps at its worst.
In the current U.S. equity markets, brokers ``internalize'' stock
trades by trading against their customers' orders directly or selling
them to another firm to do so (thus avoiding the exchanges). The trades
are then printed to the tape and put up at the clearinghouse. Brokers
are supposed to provide best execution even when they internalize or
sell their order flow, but best execution is vaguely defined and
essentially unenforced. \3\ Brokers in the U.S. must post reports
showing where they route their customers' orders, but it is clear that
most brokers do not care what is reflected in those reports.
---------------------------------------------------------------------------
\3\ The internalizers are supposedly matching the best prices
prevailing at the exchanges, so that they can argue that their
customers get best execution. This is subject to serious doubt,
however. Transaction Auditing Group, Inc., a third-party provider of
transaction analysis, has consistently determined that Interactive
Brokers' U.S. stock and options executions are significantly better
than the industry (on average 28 cents better per 100 shares in the
most recent 6-month period studied). Rather than internalize its
customers' orders, Interactive Brokers simply routes each order, or
parts of an order, to the exchange or market with the best price for
that order, and quickly reroutes if another market becomes more
favorable.
---------------------------------------------------------------------------
It should be shocking that according to the Rule 606 reports
mandated by the SEC, no major online broker, with the exception of our
company Interactive Brokers, sends more than 5 percent of its orders to
organized exchanges. More than 95 percent of their orders go to
internalizers!
The fact is that when exchange-listed products are traded off of
the exchanges, liquidity on the exchanges dries up. As fewer orders are
sent to exchanges, fewer market makers compete for those orders or
quote in size because they get nothing out of it. Exchanges become
illiquid and are unable to withstand supply and demand imbalances. This
causes confidence-draining mini-crashes in single stocks from time to
time, but becomes disastrous on days where a major market event occurs.
On such days, the internalizers suddenly dump their orders on the
exchanges because the internalizers are afraid to take on large
positions, but there is no liquidity on the exchanges to deal with the
orders sent there.
Congress or the SEC should prohibit off-exchange trading of
exchange-listed securities or limit it to large institutions trading
very large size. This is essential to restore liquidity and confidence
in our markets.
IV. The Existing Circuit Breakers Must Be Modified and Must Be
Effective at All Times While Markets Are Open.
First, the current circuit breakers in the equity markets are only
in effect from 9:45 a.m. until 3:45 p.m., leaving the volatile opening
and closing periods of trading uncovered. The circuit breakers should
be in effect at all times that the market is open.
Second, the circuit breakers do not kick in until a price moves 10
percent in a 5-minute period. This allows prices to move 2 percent per
minute indefinitely without ever triggering the circuit breakers
(allowing the market to move, for example, nearly 80 percent in 40
minutes). This needs to be changed.
Circuit breakers should first take effect at a price 10 percent up
or down from the prior day's close. When a circuit breaker is
triggered, trading would not be halted, but no trades would be allowed
for 5 minutes at any price further than 10 percent from the prior
close. In a falling market, for example, trades at prices above 10
percent down would still be allowed during the 5-minute circuit breaker
period, thus allowing the stock to bounce but preventing it from
falling any further for 5 minutes. \4\
---------------------------------------------------------------------------
\4\ ``Mini-crashes'' continue to occur even with the recently
enacted circuit breakers in the equity markets. This is because the
primary listing market for each equity security has to calculate
throughout the day whether the circuit breaker has been tripped for
that security and then notify the secondary markets if the circuit
breaker has been tripped. But between the time that such electronic
notification is made by the primary market and the time that the
secondary markets can react to it, the security can continue to trade
on the secondary markets at prices well outside the circuit breaker. If
the circuit breakers instead were set at 10 percent, 20 percent, 30
percent, etc., away from the prior day's close, the secondary markets
would not need to wait for notice from the primary market that a
circuit breaker was triggered (because they could calculate the circuit
breaker triggers themselves by comparing trade prices throughout the
day with the prior day's close).
---------------------------------------------------------------------------
After 5 minutes, the stock would be able to trade freely again,
except that another circuit breaker would take effect at 20 percent
down from the prior day's close, for another 5 minutes. The process
would be repeated at 30 percent down from the prior close, 40 percent,
and so on.
In addition to these individual circuit breakers, there would be a
marketwide circuit breaker that would take effect if at any time more
than 10 percent of National Market System stocks had tripped the 20
percent price band. If this overall circuit breaker were triggered in a
down market, then the 10 percent of NMS stocks already trading outside
the 20 percent price band would not be allowed to trade at any price
lower than their day's low to that point. Stocks that had not yet
traded below 20 percent down from the prior close would be allowed to
trade at any price down to 20 percent but no further. The price limits
would last for the rest of the trading day.
The current circuit breakers in the futures markets should be
augmented with the same marketwide circuit breaker. Thus, when 10
percent of NMS stocks traded outside the 20 percent band, futures
markets would limit the move in related index contracts by calculating
the maximum allowed price move of each index component (including some
index components that would be allowed to trade down 20 percent and
some that might already have broken that band and thus would be allowed
to trade down to their day's low) and than applying these individual
component limits to the fair value of the lead futures contract.
Likewise, functionally equivalent restrictions would have to be
applied to other equity-based derivatives markets (such as exchange-
traded options).
______
PREPARED STATEMENT OF MANOJ NARANG
Chief Executive Officer, Tradeworx Inc.
December 8, 2010
My name is Manoj Narang, and I'm the CEO of Tradeworx Inc., a
financial technology firm that provides hardware and software solutions
to investors interested in ultra-high-performance trading. In addition
to supporting outside clients with our technology, we operate a
proprietary trading practice which utilizes the same technology to
engage in high-frequency trading strategies. We also manage money in
lower-turnover quantitative strategies for outside investors. All of
our strategies involve technology-driven trading based on statistical
arbitrage.
I'd like to begin by expressing my gratitude for the opportunity to
share my insights and perspectives in today's hearing, and by
recognizing that small firms like Tradeworx are not often accorded such
an opportunity.
Restoring Investor Confidence in the Markets
My prepared remarks focus on the topic of restoring investor
confidence in our markets. It is self-evident that markets depend on
confidence in order to function smoothly, and there is no denying that
the confidence of investors was severely shaken on May 6. It is this
loss of confidence that transformed the Flash Crash from just another
chapter of the ongoing credit crisis into the far-reaching referendum
on market structure that it has become. Ever since May 6, investors
have been plagued by the nagging suspicion that the regulatory
authorities are unable to understand the inner workings of the market,
or to meaningfully assess the practices of its most active
participants.
For the past 2 years, the public has been treated to endless debate
about market structure issues. Are prices posted by market-makers fair,
or are they subject to widespread manipulation? What impact do rebates
or elevated cancellation rates have on liquidity? Why is speed
important to the business of market-making? How do the equities,
options, and futures markets influence and interact with each other?
The public should not be forced to accept anecdotal or speculative
answers to such questions when definitive answers can be had by
analyzing data. Firms such as Tradeworx have the ability to produce
objective and factual answers to questions of this sort with only
minutes of effort. While we have shared our insights with the SEC,
there is no substitute for the regulators having these sorts of
capabilities on their own.
Regulation NMS
Another key obstacle to restoring the confidence of investors is
that the markets have become too complicated for ordinary investors to
understand. The U.S. Equity Market sports the most complex and
fragmented market structure known to mankind. The regulators deserve
their share of the blame: their magnum opus--Regulation NMS--was 10
years in the making and spans over 520 pages. For perspective, consider
that in competitive games like chess, extraordinary complexity arises
from just a handful of rules. It should surprise nobody that an
undertaking of this magnitude would overreach and backfire. Nor should
it surprise anyone that the Byzantine structure it foisted upon the
market would generate paranoia among investors, fueling the perception
that the system is somehow ``rigged'' against them.
Remarkably, the most complex and problematic part of the regulation
adds almost no value to the market in practice. I'm referring to Rule
611, which is designed to keep prices at the different exchanges
synchronized with each other. Consider that the stocks SPY and IVV,
both of which track the S&P 500 index, have a 99.9 percent correlation
with each other when their prices are sampled at subsecond intervals,
despite the fact that there is no regulation to keep their prices in
sync. This is compelling evidence that arbitrage alone is more than
sufficient to keep prices in line with each other.
Unfortunately, 99.9 percent was not good enough for policy makers.
With Reg NMS, the SEC decided to keep prices in line by decree, rather
than by the traditional mechanism, arbitrage. Never mind that the
underlying idea violates the laws of physics--exchanges can never
perfectly incorporate each other's information, because information
takes time to transmit.
The market continues to pay a steep price for this overreach.
Rather than minimizing fragmentation, which was its stated objective,
the regulation has directly encouraged it, giving upstart exchanges an
economic incentive they never before enjoyed by virtually guaranteeing
that they will get orders routed to them by other exchanges. Rather
than limiting the role of arbitrage, the regulation has diverted its
focus from keeping prices in check to exploiting the shortcomings of
the regulation itself, often to the detriment of long-term investors.
To top it off, the rule has managed to ignite a massive technology arms
race, by making the speed of information transmission a more critical
issue than it ever was previously.
Now that the regulators clearly have the mandate to create even
more rules, I fear we are doomed to repeat our past mistakes. Once
again, superfluous proposals which solve nonexistent problems abound.
It is easy to conjure up gimmicks such as ``speed limits'' on order
cancellations, but it is also trivially easy to demonstrate how they
will backfire and harm long-term investors. When lawyers with minimal
trading expertise devise such rules, they should recognize that world-
class engineers with a profit motive will be there to exploit them. Who
do you think will wind up with the upper hand?
Adding ever-more expansive regulations to a system which is already
hopelessly complex is guaranteed to backfire by inviting unintended
consequences. This will not restore investor confidence in our markets.
Fixing flaws in the existing regulations will.
There is plenty of low-hanging fruit to be picked here, starting
with the provision of Rule 611 which prohibits exchanges from posting
orders which lock the quotes of other exchanges. Of all the provisions
of Reg NMS, this is the most utterly useless, the most exploitable, and
the most flagrantly damaging.
Were this one superfluous provision to be relaxed, trading venues
would cease their unabated proliferation, and fragmentation would
likely begin a steady reversal. Volumes would start migrating back from
dark pools to the lit exchanges. Message traffic and excessive order
cancellations would decline. Proprietary traders would cease to have
the ability to jump in front of investor orders. The wind would be
taken out of the sails of the high-tech arms race. All of this could be
accomplished while leaving the vast majority of Reg NMS intact and
without altering the framework of the national market system in a
meaningful way. I hope to have the opportunity to elaborate on these
topics at today's hearing, and I ask that the entirety of my written
remarks be included in the record.
______
PREPARED STATEMENT OF KEVIN CRONIN
Global Head of Equity Trading, Invesco Ltd.
December 8, 2010
Thank you, Chairman Reed, Ranking Member Bunning, Chairman Levin,
Ranking Member Coburn, and Members of the Senate Subcommittee on
Securities, Insurance, and Investment and the Senate Permanent
Subcommittee on Investigations for the opportunity to speak here today,
I am pleased to participate on behalf of Invesco at this hearing
examining the efficiency, stability and integrity of the U.S. capital
markets, Invesco is a leading independent global asset management firm
with operations in 20 countries and assets under management of
approximately $620 billion.
An efficient and effective capital formation process is essential
to the growth and vitality of the U.S. economy. The most important
aspect of the capital formation process is that it attracts long-term
investors' capital. To accomplish this, it is critically important that
the primary and secondary capital markets which facilitate the capital
formation process are transparent and working in the best interests of
investors. To that end, it is essential that sensible, consistent rules
and regulations are in place governing the markets and that regulators
have the tools to ensure fairness and integrity in the markets. Such a
foundation fosters the confidence of long-term investors to provide the
capital necessary for companies to create new and innovative services,
products and technologies which in turn create additional jobs and
advance our standards of living. We therefore commend the Subcommittees
for holding this hearing to examine these critical issues.
Unfortunately, over the past several years long-term investor
confidence has been undermined by a series of scandals, financial
crises and economic tumult, including most recently the ``flash crash''
of May 6th. In order to recover long-term investor confidence, it is
incumbent upon regulators to ensure that the securities markets are
highly competitive and efficient as well as transparent and fair. The
regulatory structure that governs the securities markets must
encourage, rather than impede, liquidity, transparency, and price
discovery. Consistent with these goals, Invesco strongly supports
regulatory efforts to address issues that may impact the fair and
orderly operation of the securities markets and investor confidence in
those markets.
To be clear, investors, both retail and institutional, are better
off now than they were just a few years ago. Competition in today's
markets, which was virtually absent 5 years ago, has spurred trading
innovation and enhanced investor access. Trading costs, certainly in
the most liquid of securities, have been reduced and investors have
more choice and control in how they execute their trades. Advances in
technology have increased the overall efficiency of trading. These
gains, however, haven't come without accompanying challenges. Some of
these challenges were highlighted by the market events of May 6 and
others are broader market structure issues that were raised in the
SEC's concept release on market structure.
The Market Events of May 6th
The events of May 6 brought to the forefront several inefficiencies
in the current market structure and highlighted the interdependency of
the equity, options and futures markets, particularly the connection
between price discovery for the broader stock market and activity in
the futures markets. Perhaps most significantly, the events of May 6
underscored the absence of an effective mechanism to dampen volatility
at the single-stock level; the lack of consistency and synchronization
of rules which govern trading at the various exchanges; the lack of
clearly defined rules on the handling of clearly erroneous trades; the
outsized impact trading algorithms and small market orders can have in
the prices of securities in times of duress; and the fact that the
market making mechanisms in place today provide virtually no liquidity
to investors in times of market stress.
Several of these issues have already been addressed by regulators,
including the need to establish mechanisms in single stocks to address
extreme price moves and better procedures for resolving clearly
erroneous trades. In addition, discussions are ongoing among regulators
and market participants regarding the inconsistent practices of
exchanges when dealing with major price movements. Invesco is a
diversified investment manager and as such we participate in trading in
many types of securities on many different exchanges and market venues.
We believe it would serve our investors' interests as well as other
long-term investors' interests to have better coordination, both at the
regulator and exchange levels, between the options, futures, equities,
and credit markets.
Establishing Mechanisms To Address Extreme Price Moves
Removing all instability and volatility from the equity markets is
neither possible nor appropriate. However, establishing mechanisms to
address extreme price moves in the markets and volatility related to
inefficient market structure will be critical in preventing a repeat of
the May 6 market event.
Circuit Breaker Rules and Clearly Erroneous Rules
Invesco supported the single stock circuit breaker proposals as a
means to immediately mitigate the impact of sudden market volatility by
implementing a trading pause for individual securities in times of
market stress. As the circuit breakers are set to expire soon we would
strongly encourage replacing them with a so-called ``limit up/limit
down'' regime. Circuit breakers require a trading halt when the
threshold price is reached which can be confusing and inefficient for
investors. As we have seen over the past few months, the single stock
circuit breakers have been triggered a number of times due to system
errors or gaps in liquidity that cause an unnecessary disruption of
trading. We believe a limit up/limit down regime would be a more
effective means of accomplishing the same goal of having a more orderly
process in place in times of duress.
One thing is clear, whether the answer is circuit breakers or limit
up/down, there absolutely must be coordination among futures, options
and equity exchanges to ensure a consistent approach to extreme market
movements.
The integrity of trading data is critical given the speed and
volume of trading in the markets. Invesco therefore has strongly
supported amendments to the rules relating to clearly erroneous
executions to clarify the process for breaking erroneous trades and to
provide uniform treatment across the exchanges for clearly erroneous
execution reviews. We believe, however, the whole notion of taking
trades off the tape is generally detrimental to investor confidence. We
would propose that the exchanges instead clearly define and articulate
the parameters that constitute erroneous trades and then program their
systems to detect and reject trades outside of those parameters. We
believe uncertainty surrounding the clearly erroneous rules and the
risks associated with entering orders during the drop in stock prices
likely contributed to the rapid and dramatic price declines on May 6.
Ensuring that only good trades are reported to the tape will provide
investors and liquidity providers an increased level of confidence
regarding the trading data they need to participate in good and bad
markets.
Use of Market Orders
As was clearly illustrated by the events of May 6, when there is a
vacuum of liquidity, smaller market orders can have an outsized impact
on the prices of securities. As an institution, we have long understood
the significant risk of using market orders particularly as the market
has become more fragmented. We abandoned their use many years ago in
favor of marketable limit and limit orders. In light of the events of
May 6 and the continuing issues small market orders have had in the
market (i.e., electing newly imposed single-stock circuit breakers on
WPO, CSCO, C, APC, and others), Invesco strongly supports the
examination of the current practices surrounding the use of market
orders, particularly the use of ``stop loss'' orders. There can be
nothing more erosive to the confidence of investors in the efficient
workings of the market than to watch a small market order take a stock
from $50 to $100,000.
Trading Algorithms
The Joint CFTC-SEC Advisoty Committee report on the market events
on May 6th clearly shed negative light on the use of trading
algorithms, particularly in times of market duress. While we agree that
using a price agnostic algorithm in any environment incurs significant
risk, we believe trading algorithms, when appropriately employed, can
be highly effective tools in our best execution process. Algorithms
allow us to approach our trades from a number of different pursuits
giving us the speed, anonymity and access to liquidity that we need to
be effective for our clients. That said if regulators feel compelled to
act with respect to algorithms, we would encourage them to focus their
efforts on broker dealer and venue order routing practices and any
potential manipulative practices being employed by market participants
through the use of algorithms.
Responsibilities of Market Makers
The role of traditional liquidity providers such as market makers
has taken on more significance since the events of May 6, as the sudden
absence of liquidity in the markets played a critical role in the
severe decline in stock prices. We recognize that the obligations
market makers have in times of market duress likely succumb to innate
self-preservation instincts--after all catching falling knives is
generally not a good idea. Several ideas have been put forth to improve
the operation of market makers that are worthy of further examination,
including increasing obligations surrounding best price, depth of
markets, and the maximum quoted spread obligation. Similarly, there
should be an examination of the incentives that market makers currently
have to make reasonable two-sided markets. Given the introduction of
single stock circuit breakers and more clarity around the handling of
clearly erroneous trades, it would appear that some of the risk of
making markets in volatile times has been reduced. In any event, the
goal of our capital markets has to be the provision of fair and orderly
markets in good times and bad. We believe that market makers who have
appropriate incentive and obligations are an important aspect of that.
Ensuring May 6th Doesn't Happen Again
While many of the steps being taken by the various regulators and
exchanges will greatly reduce the potential for another May 6th--the
risk will not be entirely removed from these actions alone. The SEC,
CFTC, and SROs must be coordinated, diligent and measured in their
efforts to create sensible regulation designed to minimize
inefficiencies in market structure and advance surveillance and
enforcement capabilities to thwart nefarious behavior.
One idea which deserves further consideration in that regard is the
consolidated audit trail ( CAT) or a similar solution to provide
regulators the data they need to surveil markets on a timely basis. The
proposed CAT would provide regulators with timely access to order and
execution information for all securities within the National Market
System (NMS). This would give regulators the ability to perform timely,
detailed analysis of single stock or general market activity which
would greatly enhance existing oversight and enforcement capability.
Our expectation is that all information collected within the CAT or
equivalent system will be absolutely secure with no possibility for
leakage or manipulation and that the costs to create and maintain the
CAT (or equivalent) will be much more reasonable than some of the
published estimates.
Beyond May 6th
While the events of May 6th highlighted some of the challenges of
the current market structure they did not reveal all of them.
Regulators should not lose sight of the broader market structure issues
raised by the SEC's concept release examining the structure of the U.S.
equity markets, including the adequacy of information provided to
investors about their orders, the impact of high frequency trading, and
nondisplayed liquidity. These issues are equally critical to investors'
ability to trade efficiently under the current market structure.
Fragmentation
There are today at least 13 for-profit exchanges. Competition
between exchanges is fierce resulting in new innovations and different
ways for investors to seek and provide liquidity. This is a welcome
development from our perspective provided that the rules and
regulations which govern the various exchanges are consistent and not
incongruent with the goals of fairness and equal access for investors.
We believe that the notion of exchanges having their own SROs is
outdated and potentially disruptive to the efficient operation of
securities markets. Therefore Invesco would support a move to a single
SRO for all exchanges. It is interesting to note that exchange
competition has also spurred an electronic arms race where the race to
microseconds will soon cede to nanoseconds. It has also dramatically
changed the revenue models of exchanges to a point where so called
``maker-taker'' models thrive and fees for cancelled trades are
routinely waived for the most active participants.
While Invesco believes that speed is an important variable to
consider in the execution of trades, it is clearly not the only one
which long-term investors should consider as they seek best execution.
Some of our fundamental fund managers may take months to research a
particular company before they are ready to buy its stock; buying those
shares in one-millionth of a second isn't exactly the manager's top
priority. Buying the shares at the ``right'' price which is understood
through a robust price discovery process wherein there is real
understanding about the underlying supply and demand in the shares is
much more appealing. If this happens in seconds or days is at best a
secondary consideration. Invesco believes that there is a point where
speed and robust price discovery diverge--a concept that must be
understood by exchanges as they race to trading in one-billionth of a
second.
There are also 40 different trading venues/dark pools and over 200
broker dealers who internalize customer order flow in the market today.
The nondisplayed liquidity traded in dark pools and with internalizing
broker-dealers is estimated to be as much as 30 percent of the shares
traded in the U.S. This fragmentation has the potential to seriously
undermine the price discovery process essential to efficient market
structure. As an institutional investor with larger-sized orders,
Invesco utilizes dark pools and institutional crossing networks as
essential elements of our best execution process. While our use of
these venues may contribute to the fragmentation of the markets, until
we create a more efficient market structure for the execution of
institutional sized orders, these venues allow institutional investors
to avoid transacting with market participants who seek to profit from
the impact of the public display of large orders to the detriment of
funds and their shareholders.
This vast network of exchanges and venues has resulted in a very
complicated web of conflicted order routing and execution practices by
broker dealers and execution venues. Institutions like Invesco are in a
position to get the routing data from broker-dealers and trading venues
to perform an analysis of the effectiveness of trading in the various
venues. However we are concerned that many investors do not have this
level of transparency. We believe that improved information about order
routing and execution practices would allow investors to make better
informed investment decisions.
High Frequency Trading
Today as much as 50-60 percent of trading activity in U.S. equity
markets is attributed to High Frequency Traders (HFT). Given the recent
ascendance of HFT there is not a lot known about their practices and
very little regulatory oversight. It can certainly be argued that some
high frequency trading activity provides real liquidity to the markets.
In fact, Invesco believes there are many beneficial high frequency
trading strategies and participants which provide valuable liquidity
and efficiencies to the markets. For example strategies such as
statistical arbitrage help maintain pricing efficiencies in the
markets. On the other hand, we are concerned that some strategies could
be considered as improper or manipulative activity. Some of these
strategies, such as the so-called order anticipation or momentum
ignition strategies provide no real liquidity or utility to the
markets, rather they prey on institutional and retail orders creating
an unnecessary tax on investors.
While there has been a recent case brought by regulators against
this kind of improper activity, we are concerned that the ability of
regulators to monitor and detect nefarious behavior by these market
participants is lacking. We therefore believe there is an immediate
need for more information about high frequency traders and the
practices of high frequency trading firms.
Additionally, regulators must address the increasing number of
order cancellations in the securities markets. It has been theorized
that as many as 95 percent of all orders entered by high frequency
traders are subsequently cancelled. Order cancellations related to
making markets is one thing, but orders sent to the market with no
intention of being executed before they are cancelled is quite another.
These orders tax the market's technological infrastructure and under
the right circumstances could overwhelm the systems capability to
process orders causing massive system failures and trading disruptions.
Efficient trading markets require many different types of investors
and participants to thrive. It is important to note that where the
interests of long-term investors and short-term professional traders
diverge, the SEC has repeatedly emphasized that its duty is to uphold
the interests of long-term investors. We need to ensure that there are
no abusive practices within high frequency trading which contravene the
interests of long-term investing.
Conclusion
We believe investors, both retail and institutional, are better off
now than they were just a few years ago. That said long-term investor
confidence is critical to the efficient operation of the capital
formation process in the U.S. To restore potentially damaged investor
confidence, regulators must ensure that the securities markets are
highly competitive, transparent and efficient and that the regulatory
structure that governs the securities markets is consistent, congruent
and encourages, rather than impedes, liquidity, transparency, and price
discovery.
______
PREPARED STATEMENT OF STEVE LUPARELLO
Vice Chairman, Financial Industry Regulatory Authority
December 8, 2010
Chairman Reed, Chairman Levin, Ranking Member Bunning, Ranking
Member Coburn, and Members of the Subcommittees: I am Steve Luparello,
Vice Chairman of the Financial Industry Regulatory Authority, or FINRA.
On behalf of FINRA, I would like to thank you for the opportunity to
testify today on the important issues of how markets and trading have
evolved, and how we can enhance the information regulators receive to
ensure market integrity and the protection of investors.
I'd like to commend Chairmen Schapiro and Gensler for their
leadership in spearheading the coordinated review of market activity
after the events of May 6. We appreciated the opportunity to
collaborate with the SEC and other SROs to identify measures that could
be taken quickly to significantly reduce the chances of a recurrence of
the market disruption that occurred that day. FINRA's Chairman, Rick
Ketchum, serves on the CFTC-SEC Joint Advisory Committee on Emerging
Regulatory Issues that is continuing its work to identify additional
steps regulators may take to respond to the lessons of May 6.
FINRA
The Financial Industry Regulatory Authority (FINRA) is the largest
independent regulator for all securities firms doing business in the
United States. FINRA provides the first line of oversight for broker-
dealers, and, through its comprehensive regulatory oversight programs,
regulates both the firms and professionals that sell securities in the
United States and the U.S. securities markets. FINRA oversees
approximately 4,600 brokerage firms, 166,000 branch offices and 636,000
registered securities representatives. FINRA touches virtually every
aspect of the securities business--from registering and educating
industry participants to examining securities firms; writing rules and
enforcing those rules and the Federal securities laws; informing and
educating the investing public; providing trade reporting and other
industry utilities and administering the largest dispute resolution
forum for investors and registered firms.
In addition, FINRA conducts surveillance of over-the-counter (OTC)
trading in equities and debt, and provides market surveillance,
investigatory and related regulatory services for equities and options
traded on U.S. exchanges, including the New York Stock Exchange, NYSE
Arca, NYSE Amex, NASDAQ, NASDAQ Options Market, NASDAQ OMX
Philadelphia, NASDAQ OMX BX, BATS Equities and Options, and The
International Securities Exchange. Through this work, FINRA is
responsible for aggregating and providing market surveillance for
approximately 80 percent of U.S. equity trading.
FINRA's activities are overseen by the Securities and Exchange
Commission (SEC), which approves all FINRA rules and has oversight
authority over FINRA operations.
Response to May 6
During the last several years, how and where trading occurs has
evolved rapidly, as has execution speed, particularly with respect to
equity trading. High-frequency trading, dark pools and direct access
are now commonplace--and have contributed to the more fragmented
markets that exist today. 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 can also result in the fast electronic removal of
liquidity when markets are stressed, as we observed on May 6.
The events of May 6 identified several areas in which regulators
could be more proactive in preventing or reducing the impact of extreme
market volatility, as well as provide additional transparency and
predictability in restoring order to the markets following such events.
FINRA has been pleased to participate in these discussions with the
U.S. equities and options exchanges, under the leadership and direction
of the SEC, to establish and implement a number of important changes.
First, in June 2010, as a result of this coordinated effort, a
framework for marketwide, stock-by-stock circuit-breaker rules and
protocols was established and implemented on a pilot basis. Under these
pilot rules, a single-stock circuit breaker is triggered if the price
of a security changes by 10 percent within a rolling 5-minute period.
If triggered, all markets pause trading in the security for at least 5
minutes, and then the primary listing market employs its standard
auction process to determine the opening print after the 5-minute pause
period.
The pilot commenced with securities included in the S&P 500 Index
and then was expanded in September 2010 to the Russell 1000 Index and
certain exchange traded products. Where there is extreme volatility in
a stock, this solution provides for a pause in trading that will allow
market participants to better evaluate the trading that has occurred,
correct any erroneous ``fat finger'' orders and provide for a more
transparent, organized opportunity to offset the order imbalances that
may have caused the volatility. FINRA and the exchanges, with the SEC,
have been monitoring continuously the application and effectiveness of
the pilot to determine whether expansion to additional securities is
appropriate and whether adopting or incorporating other mechanisms,
such as a limit up/limit down procedure that would directly prevent
trades outside of specified parameters, would be a more efficient and
effective permanent approach.
Similarly, new rules were established to improve the consistency
and transparency surrounding the process for breaking erroneous trades,
particularly with respect to events like those that occurred May 6,
which impacted multiple stocks within a very short time frame. In
September, FINRA and the exchanges, in coordination with SEC staff,
adopted on a pilot basis new rules to establish standards for breaking
trades following multistock events. For events involving between 5 and
20 stocks, FINRA and the exchanges will break trades at least 10
percent away from the reference price (typically the consolidated last
sale), and for events involving 20 or more stocks, at least 30 percent
away from the reference price. These rules provide more certainty to
market participants as to when and at what prices trades will be broken
by FINRA and the exchanges, facilitating a more transparent and orderly
resolution of multistock events.
Most recently, in November 2010, the SEC approved FINRA and
exchange rules to strengthen the minimum quotation standards for market
makers and effectively prohibit what have been called ``stub quotes''
in the U.S. equity markets--quotes to buy or sell stocks at prices so
far away from the prevailing market that they are not intended to be
executed. Executions against stub quotes represented a significant
proportion of the trades that were executed at extreme prices on May 6,
and subsequently broken. The new rules require market makers to
maintain continuous two-sided quotations throughout the trading day
within a certain percentage of the NBBO, thereby prohibiting the use of
extreme stub quotes.
Through the CFTC-SEC Joint Advisory Committee, deliberations
continue about potential additional measures regulators may institute
in the wake of May 6. FINRA is committed to working with our fellow
regulators, through the Committee and in other ways, to continue this
analysis.
Lastly, it is worth noting that the SEC also recently adopted rules
preventing unfiltered market access, as well as requiring brokers with
market access to have risk management controls and supervisory
procedures to help prevent erroneous orders, ensure compliance with
regulatory requirements and enforce credit or capital thresholds. FINRA
has consistently taken the approach that brokers sponsoring market
access have a responsibility to ensure that proper screens are in place
before providing access to firms, including those who may use high-
frequency or algorithmic trading strategies. FINRA has questioned
brokers providing access to determine whether they have fulfilled their
obligations to understand the ownership of firms to whom they are
providing access and what is being done with algorithms used through
those agreements. FINRA will continue to examine the firms it regulates
for compliance in this area, analyze whether enhancements to our
supervision rules are warranted and enforce the new SEC requirements
vigorously.
High-Frequency Trading and the Trillium Case
While the disruption on May 6 focused significant attention on
high-frequency traders and algorithmic trading in today's highly
automated marketplace, FINRA had already been scrutinizing trading
activity closely in order to detect attempts to use these technologies
to implement manipulative trading strategies. In today's fragmented
trading environment, it is very plausible that market participants will
spread their activity across multiple markets and accounts in an
attempt to avoid detection of trading abuses such as wash sales,
frontrunning, insider trading, marking the close and open, and
manipulative trading strategies like layering. FINRA is aggressively
pursuing these types of illegal trading practices that inappropriately
undermine legitimate market trading.
In September, FINRA fined a New York brokerage firm--Trillium
Brokerage Services--over $1 million and suspended several traders at
the firm for using an illicit high-frequency trading strategy.
Trillium, through nine proprietary traders, entered numerous layered,
non-bona fide market moving orders to generate selling or buying
interest in specific stocks. By entering the non-bona fide orders,
often in substantial size relative to a stock's overall legitimate
pending order volume, Trillium traders created a false appearance of
buy- or sell-side pressure.
This trading strategy induced other market participants to enter
orders to execute against limit orders previously entered by the
Trillium traders. Once their orders were filled, the Trillium traders
would then immediately cancel orders that had only been designed to
create the false appearance of market activity. As a result of this
improper high-frequency trading strategy, Trillium's traders obtained
advantageous prices that otherwise would not have been available to
them. Trillium's traders bought and sold NASDAQ securities in over
46,000 instances, reaping nearly $575,000 in improper profits. Other
market participants were unaware that they were acting on the
illegitimate, layered orders entered by Trillium traders.
In addition to the nine traders, FINRA also took action against
Trillium's Director of Trading and its Chief Compliance Officer. The 11
individuals were suspended from the securities industry or as
principals for periods ranging from 6 months to 2 years. FINRA levied a
total of $802,500 in fines against the individuals, ranging from
$12,500 to $220,000, and required the traders to pay out disgorgements
totaling roughly $292,000.
While FINRA is able to pursue instances of these illegal trading
strategies on markets we regulate as well as through the cooperative
information-sharing efforts of market surveillance staffs, the risk of
missing instances of manipulation, wash sales, abusive short selling
and other improper ``gaming strategies'' is still unacceptably large.
While FINRA's ability to aggregate an increasing share of regulatory
data for surveillance purposes is a strong step in the right direction,
establishing a consolidated audit trail is the key to enhancing
regulators' abilities to detect these activities. This would allow
FINRA and the exchanges to more efficiently detect violations and adapt
surveillance programs to new scenarios.
FINRA Market Regulation
In addition to performing its own regulatory obligations to conduct
surveillance of over-the-counter (OTC) trading in equities and debt,
FINRA increasingly is providing surveillance and related regulatory
services for equities and options traded on U.S. exchanges. FINRA is
responsible for insider-trading surveillance for all exchange-listed
equity securities across all U.S. exchanges, regardless of the market
on which a trade is executed. FINRA is responsible for surveillance of
NASDAQ OMX, originally as a sister subsidiary when NASDAQ was part of
NASD and now under contract, and subsequently NASDAQ OMX BX (formerly
the Boston Stock Exchange) and NASDAQ OMX PHLX (formerly the
Philadelphia Stock Exchange) (collectively NASDAQ). In June 2010, FINRA
became responsible for surveillance of the NYSE Euronext's three U.S.
exchanges, the New York Stock Exchange (NYSE), NYSE ARCA and NYSE AMEX
(collectively the NYSE). FINRA also provides regulatory services to the
International Securities Exchange, the Boston Options Exchange, the
BATS Y and Z Exchanges and the EDGA and EDGX Exchanges.
As a result, FINRA presently is responsible for conducting
posttrade market surveillance of approximately 80 percent of the equity
share volume and 30-35 percent of the option contract volume traded on
U.S. exchanges. With the recent addition of the NYSE, FINRA has started
an integration process that will combine for the first time detailed
trading data from FINRA, NASDAQ and the NYSE in one data center. With
this aggregated data, FINRA will be able to conduct comprehensive,
cross-market surveillance of 80 percent of the equity market.
FINRA uses a variety of sophisticated online and offline
surveillance techniques and programs to detect potential violations and
reconstruct market activity using trade, quote and order information
that is captured daily. Specifically, FINRA's Market Regulation
Department is comprised of approximately 440 employees that are
organized into roughly 70 specialized teams of subject matter experts
for certain rules and trading activity. These teams conduct
investigations based on alerts generated by over 300 surveillance
patterns that are designed to detect particular threat scenarios by
canvassing some or all of the one billion or more market events that
are captured by FINRA each day. FINRA also provides interpretive
guidance on a variety of trading issues and rules, investigates market-
related complaints from investors, broker-dealers and other parties,
and conducts market and trading-related preventive compliance
activities.
Consolidated Audit Trail
With the growth in the number of registered exchanges and
alternative trading systems, increased competition among trading venues
and market structure policy compelling connectivity among exchanges and
between exchanges and other execution venues, it is clear that market
quality can no longer be ensured by a single exchange acting in a
siloed fashion. In fact, as noted earlier, it is plausible that certain
market participants, knowing the extent of current regulatory
fragmentation, now consciously spread their trading activity across
several markets in an effort to exploit this fragmentation and avoid
detection. As the SEC recognized with its recent rule proposal, that
evolution of the U.S. equity markets and the technological advances in
trading systems have created an environment where a consolidated audit
trail is now essential to ensuring the proper surveillance of the
securities markets and the confidence of investors in those markets.
In its proposal to adopt a consolidated audit trail, the SEC
correctly identified the challenges that exist in conducting market
surveillance with today's regulatory audit trails. FINRA agrees with
the SEC on those issues and strongly supports the establishment of a
consolidated audit trail as a critical step to enhance regulators'
ability to conduct surveillance of trading activity across multiple
markets.
The events of May 6 also have demonstrated the need for SROs and
the SEC to have direct and more timely access to consolidated audit
trail data. As the Commission noted in its proposal, the SEC's and
SROs' inability to timely and efficiently access the patchwork of audit
trail data that currently exists creates delays in identifying
potential market abuses and creating market reconstructions. Thus,
FINRA believes the key aspects necessary for ensuring an effective,
comprehensive and efficient consolidated audit trail are: uniform data
(both data format and data content across markets); reliable data; and
timely access to the data by SROs and the SEC.
In terms of implementation, FINRA believes the most effective,
efficient and timely way to achieve the goals of a consolidated audit
trail is to expand existing systems, such as FINRA's Order Audit Trail
System (OATS), and consolidate this information with exchange data and
discrete new data, such as large trader information, into a central
repository. Building off existing systems would significantly reduce
both the cost (to the industry, and ultimately, investors) and the time
for implementation of a fully consolidated audit trail and integration
of that audit trail into surveillance systems.
Because market participants already have systems in place to comply
with OATS requirements, programming changes needed for an entirely new
system are substantially greater than expanding existing protocols. In
addition, FINRA recently received SEC approval to expand OATS beyond
NASDAQ-listed issues to include all exchange-listed issues, further
enhancing the benefits of leveraging OATS for a consolidated audit
trail.
FINRA also believes that the practicality, costs and benefits
associated with incorporating a broad array of real-time data into the
consolidated audit trail should be considered carefully. In many cases,
information may be extremely difficult to provide accurately on a real-
time basis. In addition, there are many types of information that have
limited real-time regulatory benefit, due to the time needed to
validate and analyze data to detect complex, violative trading
activity. It has also been FINRA's experience that the quality of real-
time data can degrade during significant market events due to capacity
and other issues.
In terms of the content of any consolidated audit trail, FINRA's
experience has shown that there are certain critical elements necessary
to conduct effective surveillance across multiple markets. As an
initial matter, it is essential that each market participant be
required to report the same data elements in a uniform way. Moreover,
consolidated data is only useful if each reporting entity uses the same
timekeeping system. FINRA also believes that each broker-dealer must
have a unique identifier that remains the same regardless of the market
on which the participant is trading, and that those identifiers should
be more granular than at the firm level. Similarly, FINRA agrees with
the SEC that each customer of a firm should have a unique identifier
that is constant across all firms through which the customer trades.
Based on our experience developing and operating OATS, FINRA has a
unique perspective on many of the specific issues and questions raised
in the SEC's proposal. We have provided detailed comments to the
Commission and are committed to working with them as consideration of
the proposal moves forward.
Conclusion
Changes in financial markets in recent years have necessitated
adaptation by regulators across a wide spectrum of issues. Both
technological and policy developments have driven changes in the
markets that make the practice of regulating them a more complex task.
FINRA continually reviews its programs and technology to ensure
that our approach reflects the realities of today's markets. May 6
clearly demonstrated areas where regulators should alter rules going
forward to avoid a repeat of the events of that day. As noted above,
several coordinated rulemakings have been implemented and consideration
of additional steps continues.
The SEC has correctly identified one of the most pressing issues
that faces regulators conducting market surveillance--that we are all
hampered by the lack of a comprehensive, sufficiently granular and
robust consolidated audit trail across the equity markets. It is vital
that we consolidate audit trail data in one place so that abusive
trading practices can be more readily identified. FINRA stands ready to
work with Congress, the Commission and other SROs to help bring about a
consolidated and enhanced audit trail that will facilitate more
effective surveillance for the protection of investors and market
integrity.
Again, I appreciate the opportunity to share our views. I would be
happy to answer any questions you may have.
RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
FROM MARY L. SCHAPIRO
Q.1. Will the consolidated audit trail and large trader
reporting requirements proposed by the SEC be coordinated with
the CFTC so that ``unique tags'' and customer identification
information you described in your testimony would be the same
across the securities and futures markets? Why or why not?
A.1. The scope of the consolidated audit trail (CAT) and large
trader reporting proposals currently under consideration by the
Commission is limited to certain securities products,
specifically NMS securities. I believe these proposals are a
critical first step towards enabling the Commission to better
carry out its oversight of the securities markets and to
perform market analysis in a more timely fashion, whether on
one market or across markets. I anticipate that over time the
scope of the CAT will be expanded to include other types of
securities, including debt and OTC equities. I also hope the
CAT ultimately will include information on related futures
products, and we will work with the CFTC toward this end. Due
to the enormity of this project even when just focusing on
equities, however, we felt it was more feasible--and made more
sense--to utilize a phased approach that started with equities
and built out from there.
Further, I note that the newly created Office of Financial
Research (OFR) is considering implementing a rule pursuant to
which all legal entities in the financial industry would be
assigned unique identifiers. Such a system could be of
significant benefit to regulators worldwide, as each market
participant could readily be identified using a single
reference code regardless of the jurisdiction or product market
in which the market participant was engaging. Such a system
also could be of significant benefit to the private sector, as
market participants would have a common identification system
for all counterparties and reference entities, and would no
longer have to use multiple identification systems.
The CAT rule as proposed is written to ensure that market
participants have sufficient flexibility to use the unique
identifier assigned under such a rule to comply with the
proposed CAT requirements. Thus, the Commission and the CFTC
could use the common set of identifiers if such identifiers are
mandated by the OFR.
Q.2. In regard to the proposed consolidated audit trail, what
is the benefit of establishing a new audit trail system as
opposed to building on an existing system such at FINRA's Order
Audit Trail System?
A.2. Although FINRA's Order Audit Trail System is one of
several existing technologies that could be used to expedite
the CAT implementation process, other technologies are
currently available that can leverage the resources, speed, and
accuracy of existing business practices and normalize and
consolidate different data sets in real time. Each available
technology has benefits and drawbacks that require careful
analysis and balancing before selection.
We are also considering some interim steps to improve the
current audit trail systems, and our large trader reporting
rule will be a useful first step. That said, we feel it is
critical to remain focused on creating an audit trail that
directly addresses today's problems, can be expanded to include
all types of financial products, and will remain useful as we
tackle tomorrow's problems.
Q.3. Should there be serious consideration of removing the SRO
function out of the individual exchanges and placing it into a
single SRO? Should this consideration be extended to include a
single SRO responsible for the equities as well as the futures
markets? Could that possibly be a way to reduce the regulatory
fragmentation that Professor Angel discussed in his testimony?
A.3. Because the structure of our securities markets and their
regulation is complex, there invariably can be room for
improvement. The establishment of a single SRO to supervise all
securities markets, however, would not necessarily be a simple
solution to regulatory fragmentation. Congressional action
likely would be required to change our system of self-
regulation to create a new ``super SRO.'' Moreover, there could
be collateral consequences to removing the SRO function from
each exchange and placing it into a single SRO. For example,
exchanges have varying market structures and do not necessarily
trade the same types of securities, and personnel at each
exchange have experience with that exchange's particular
structure, rules, systems, and listed products. As an SRO, each
exchange is required to submit its proposed rule changes with
the Commission, among other obligations under the Exchange Act.
If there were a single SRO, the personnel at that SRO would
have to acquire the expertise to oversee all exchanges and the
single SRO also would have to submit proposed rule changes to
the Commission for each exchange.
In a number of ways, the exchanges and FINRA already have
been working together to create a more efficient regulatory
system that is consistent with the Exchange Act. For example,
NYSE Euronext and its three subsidiary exchanges, NYSE, NYSE
Amex and NYSE Arca, recently entered into a regulatory services
agreement in which FINRA now conducts a substantial portion of
regulation on behalf of these three exchanges, with each
exchange retaining full regulatory responsibility in the event
that FINRA fails to perform appropriately. Other exchanges also
have entered into regulatory services agreements with FINRA
with respect to aspects of their regulatory programs. Further,
the exchanges and FINRA have entered into Commission-approved
delegation plans in which a number of SROs delegate to a single
SRO full regulatory responsibility for particular matters,
i.e., oversight of one or more common rules. SROs are members
of the Intermarket Surveillance Group and, as such, their
respective staff and Commission staff meet regularly on matters
that reach across SROs. Also, the Commission recently proposed
a consolidated audit trail that would provide the SROs and the
Commission with data allowing them to conduct cross-market
surveillance when regulatory issues arise.
The current system of self-regulation is based on the
notion that each securities market is in the best position to
monitor and understand the activity in its market and to
respond to rapidly changing conditions and business practices.
We will continue, however, to work with the SROs to reduce
regulatory fragmentation wherever possible, while maintaining
the benefits of regulatory expertise and focus in each market.
------
RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN LEVIN
FROM MARY L. SCHAPIRO
Q.1. My Subcommittee staff has reviewed a number of the
examination reports produced by the Securities and Exchange
Commission staff to evaluate the market surveillance programs
at some exchanges. The reports show wide variations and some
serious deficiencies in the ability of some exchanges to
conduct basic surveillance.
For example, one report, which took 3 years to complete,
from January 2007 to April 2010, found the exchange's trading
surveillance program was generally ineffective for monitoring
trading on its system and had problems reviewing trades to
detect even the most basic manipulations such as wash sales. It
found that the exchange was also operating without a dedicated
regulatory budget. A second examination report found that
another exchange had failed to develop effective automated
surveillance programs to monitor trading activity on its
market, and was only in the early stages of developing
investigative, examination, and enforcement programs. Other
reports were equally troubling.
These report findings were issued during the same years
trading volume was exploding on the new exchanges, and market
participants were developing software to trade across markets
in fractions of a second.
(a) Do you find these examination findings troubling, and
does the SEC have any plans to develop minimum standards for
market surveillance efforts at the exchanges?
(b) You testified that you envision the consolidated audit
trail being used by exchanges and other SROs to help monitor
the markets. Given the deficiencies your examination staff has
identified, do you have confidence in the capability of the
SROs and exchanges to make use of the new data or will new
capabilities need to be developed?
(c) Please describe any efforts undertaken by the SEC to
improve and coordinate trading surveillance and enforcement
efforts by its exchanges and SROs, in particular with respect
to trades that may influence prices on more than one market.
A.1. Both the examination staff responsible for these reports
and I do find these results troubling.
As a general matter, Commission staff devotes significant
examination resources both to identifying deficiencies at SROs,
as well as to ensure that the SROs take adequate remedial
actions to address those deficiencies. Without speaking to any
specific matter, I can tell you that referrals to our
Enforcement Division have in fact been made in connection with
certain past SRO examinations. In addition, and again without
speaking to any specific matters, what is contained in an
examination report may not reflect the full universe of steps
that the Commission or its staff have taken in connection with
its oversight function. For example, the staff supplements its
examination efforts with regular meetings with the SROs,
surprise on-site reviews, staff compliance letters to all SROs
on specific risk topics, and reviews of SRO surveillance plans
for certain rule proposals.
The staff uses these efforts to help establish and
communicate general standards for SRO market surveillance, as
well as tailored guidance to specific SROs when appropriate. As
noted below, we have revised our SRO examination program to
better address evolving market risks, and will continue to
evaluate the standards for market surveillance--and the methods
of communicating those standards--in light of the evolving
risks.
We recognized that our SRO and exchange exam program needed
to change to adapt to new market realities, and it in fact is
changing. Recently, we consolidated the SRO inspection function
into one group singularly responsible for SRO inspections, the
Office of Market Oversight (Market Oversight). Market Oversight
is headed by a new Associate Director with significant SRO,
policy, and enforcement experience.
We also recognized that market developments, such as high
frequency trading and increased market fragmentation, required
us to adjust our examination program to address newly emerging
areas of risk. As a result, we have made fundamental structural
changes in the way we approach and conduct SRO examinations,
including looking at how SROs surveil for potentially abusive
high frequency, high quote or other algorithmic trading
strategies. In November 2010, the heads of our Division of
Trading and Markets and Office of Compliance, Inspections and
Examinations (OCIE) sent a letter to all the SROs specifically
requesting that they conduct a thorough review of its data
feeds as well as its regulation and surveillance of its
members' order and trading practices to ensure compliance with
the securities laws.
In addition, Market Oversight has developed an examination
plan for Fiscal Year 2011 that includes assessments of each of
the 15 registered exchanges and 22 options and equities markets
that they operate. The assessments have been informed by recent
market events, including the events of May 6, and will include
an overview of key risk areas, including market oversight and
surveillance. OCIE expects to take the findings of these
assessments to create a comprehensive risk matrix for each of
the exchanges and use that risk-based approach to inform future
inspections of each of the SRO ``complexes.''
At the same time, though I am recused from FINRA issues, I
was informed in preparation for this hearing that OCIE will be
conducting an in-depth examination of FINRA, including all of
the items articulated in Dodd-Frank Section 964. As part of the
FINRA review, I was informed that staff will be building on an
examination of FINRA's surveillance programs that it started
last year. Specifically, staff will be using the information
garnered in its initial examination to focus on FINRA
surveillances related to high frequency trading strategies,
high quote traffic strategies, and other algorithmic trading
such as spoofing and layering.
In terms of the timing of our SRO examinations, SRO
examinations have historically been resource intensive reviews
that, while appropriate in some cases, occasionally resulted in
unnecessary delays. OCIE intends to focus future inspections on
high risk areas that can be completed within 180 days after
conducting the onsite portion of our examinations. In addition,
OCIE and our Trading and Markets Division are leveraging their
resources and using other methods of overseeing the SROs, such
as sending compliance letters to all SROs on cross-market
issues.
We previously worked with the SROs to better regulate
certain cross-market issues, and we expect to continue that
process as appropriate in the future. For example, pursuant to
a staff recommendation in an examination sweep, the SROs have
worked together to better manage market fragmentation and
allocate regulatory responsibility for insider trading
surveillance. The SROs also continue to work together through
the Intermarket Surveillance Group, which was formed in 1983 to
improve the detection of intermarket securities fraud and share
regulatory concerns.
Finally, if approved, I believe that a consolidated audit
trail will dramatically improve market regulation. The new data
will allow for the development of new regulatory capabilities,
including improved risk assessment and more precise, effective,
and comprehensive surveillance, examination, and enforcement
efforts. The SROs and the Commission will need to work
collaboratively to take full advantage of the proposed audit
trail, and I am committed to making sure that happens.
Q.2. FINRA recently announced a settlement regarding same-day
manipulations by Trillium Trading LLC. According to the
settlement, during a 3 month period about 4 years ago, Trillium
traders manipulated the market by combining legitimate and
phony orders to bid up the prices of some stocks. Trillium's
traders used this manipulation strategy more than 46,000 times,
netting profits of more than $575,000. After several years and
thousands of hours of investigation, FINRA settled the case,
and both Trillium and its executives paid $2.2 million in fines
and disgorgement.
(a) How many trading manipulation actions have been brought
or settled by the SEC in the last 5 years?
(b) How many of these involved same-day manipulations?
(c) What factors inhibit the SEC's ability to investigate
and pursue these cases, including any legal standards?
(d) Please provide the same information for actions brought
or settled by your exchanges or SROs.
A.2. The Commission's Enforcement Division is devoting
significant resources to investigating whether various market
participants have engaged in conduct that unlawfully exploits
the fragmentation of the markets, intentionally contributes to
market volatility or uses high-frequency trading strategies to
manipulate the price and volume of securities at the expense of
innocent investors. The Division's new Market Abuse Unit is
helping to coordinate the Commission's enforcement response to
complex abusive trading practices. Practices that are the focus
of our Enforcement staff include layering or spoofing, improper
order cancellation activities or ``quote stuffing,'' the use of
order anticipation and momentum ignition strategies undertaken
for a manipulative purpose, passive market making practices
that incentivize possible manipulative quoting activity,
abusive colocation and data latency arbitrage activity in
potential violation of Regulation NMS, use of Direct Market
Access arrangements to conceal manipulative trading activity
and conduit entity market manipulation.
In the last 5 years, the Commission has filed approximately
200 enforcement actions where the staff classified the primary
type of misconduct as market manipulation. The Commission does
not track manipulation cases according to whether the conduct
occurred intraday or over a period of time. The enforcement
actions the Commission filed that involved manipulative conduct
included misconduct such as account intrusions, wash trades,
matched orders, kickback manipulations, and ``pump-and-dump''
schemes. For the most part, the filed actions allege misconduct
over a period of time, though certain of the misconduct
occurred both intraday and over a lengthier period,
particularly in cases involving matched orders and wash trades.
In addition, in certain cases that were coordinated with the
criminal authorities, the Commission has filed enforcement
actions that halted intraday manipulation schemes in their
incipient stages as the result of undercover operations
undertaken by criminal authorities.
During the last 5 years, registered exchanges and self-
regulatory organizations brought 47 proceedings involving
trading manipulations, 32 of which they characterized as same-
day manipulations. This includes information from NYSE AMEX,
NYSE ARCA, BATS, Boston Options Exchange, C2 Options Exchange,
CBOE, CBSX, Chicago Stock Exchange (CHX), Direct Edge, FINRA,
the International Securities Exchange, NASDAQ OMX, NASDAQ BX
OMX, NASDAQ PHLX OMX, the National Stock Exchange (NSX), and
NYSE.
There are a number of factors that make these cases
challenging to investigate, particularly given current
technology-driven trading practices.
First, the volume of data creates extraordinary resource
challenges. The Commission needs similar technological and
human analytical resources as those possessed by the firms that
are placing thousands of orders per second. For example, the
Enforcement Division's Market Abuse Unit currently has
vacancies for specialists with current industry knowledge that
the unit has not been able to fill due to current budget
constraints. The unit's planned Analysis and Detection Center,
if able to be staffed by these specialists, would coordinate
trading abuse investigations with the Division's investigative
staff and would generate specialized insight into other abusive
high frequency and algorithmic trading practices. To perform
these functions, the specialists will need advanced data
analysis applications, better hardware and access to greater
third party databases and information warehouses.
Second, the fragmentation of trading at different market
centers, including exchanges, dark pools, broker-dealer
internalizers, and direct market access providers requires data
collection--often with format and compatibility differences--
from a variety of market centers.
Third, because of the prevalence of high-volume trading
through direct market access providers, our investigators often
must trace the conduct back through multiple layers of broker-
dealers to identify the original trader. This can both delay
our investigation and also serve to obscure the true identity
of the trader at interest.
Fourth, the use of algorithmic code to direct trading
decisions presents multiple challenges. We must ensure that
historical versions of algorithmic code are maintained so that
we preserve the ability to study high-frequency trading
instructions, which could contain important and unique evidence
of scienter. In addition, it requires resources to analyze
computer code in the course of our investigations.
The consolidated audit trail and large-trader reporting
initiatives, if adopted, will help address some of these
challenges. Ultimately, only when we have: (1) comprehensive
and accessible data sources; (2) adequate technology resources;
and (3) additional personnel with the appropriate backgrounds
and skills will it become easier to detect and stop technology-
driven market abuse.
Q.3. On May 6, much like the crash of 1987, a fall in the price
for a broad futures product triggered severe price drops in the
equities markets, including in individual stocks.
(a) Given the connection between the futures and stock
markets, would it make sense for the SEC and CFTC to coordinate
and ensure that circuit breakers or other stabilization
measures, such as a limit up/limit down function, apply
consistently across all markets in similar financial
instruments (futures, options, and equities)?
(b) If so, are there any efforts underway to do that now?
A.3. It does make sense to seek to coordinate such efforts
between the Commission and the CFTC, and we have been doing so.
SEC and CFTC staffs worked closely together on both the
preliminary and final joint staff reports that set forth their
findings regarding the events of May 6, and presented those
reports to the agencies' Joint Advisory Committee comprised of
prominent experts that was created to advise both agencies on
emerging regulatory issues.
Some of the initial regulatory actions taken by the
Commission after May 6--for example, the pilot programs with
respect to single stock circuit breakers and the enhanced
procedures for breaking clearly erroneous trades, as well as
the approval of SRO rules banning of stub quotes--were designed
to quickly address regulatory concerns unique to the securities
markets. As noted in the staff reports, on May 6 the futures
markets already had mechanisms in place such as limits and
trading pauses applicable to futures contracts, and some
restrictions on how far from the midmarket a participant can
quote.
As the Commission moves forward with a more comprehensive
and permanent set of regulatory responses to the events of May
6, such as a possible limit up/limit down mechanism applicable
to individual securities, we will consult regularly with CFTC
staff. And in some areas, such as the modernization of the
cross-market circuit breakers put in place after the 1987
market crash, SEC and CFTC staffs have been working closely
together--and will continue to do so--to help assure a
consistent mechanism is applied across the futures and
securities markets.
Q.4. Exchanges, traders, and SROs have told us that the
equities markets have been experiencing mini-crashes in single
stocks regularly for years. Since the pilot circuit breaker
took effect in June, there have been at least 18 instances of
the triggers going off. In some instances, trades were still
reported at prices outside of the circuit breaker's range.
(a) Why hasn't the pilot program prevented these mini-
crashes?
(b) How does the SEC plan to improve the functioning of the
stabilization measures to prevent trades from occurring outside
of their bands?
A.4. While the individual stock circuit breakers have helped
limit the extent of price moves in the securities to which they
apply, I believe our experience with the pilot program shows
that improvements to that mechanism are warranted.
For the actively traded stocks included in the circuit
breaker pilot, to date we have observed 20 instances of stocks
experiencing a sudden price move that triggered an individual
circuit-breaker halt. In a few cases, these price moves were
attributable to significant news concerning the company. In
many others, they were attributable to mistakes in order
submission or trade reporting. To trigger the circuit breaker,
the price of the security, as reflected in an executed trade,
must move 10 percent or more over a 5-minute period. As such,
there must be an executed trade outside of the circuit breaker
parameters in order to trigger the circuit breaker for that
stock, which explains, at least in part, why trades are still
being reported outside of the circuit breaker parameters.
One way to improve the individual stock circuit breakers
may be to replace or enhance them with a ``limit up/limit
down'' mechanism. One of the advantages of this approach is
that it could prevent trades from occurring outside of a
designated price band that is tied to the current market price,
and thus prevent ``mini-crashes'' outside of that range. At the
same time, it could be less restrictive than a circuit breaker
because it would not halt trading within the applicable price
band. Recourse to a trading pause could be maintained to
accommodate more fundamental price moves. At present,
Commission staff is actively working with the exchanges on a
proposal for a limit up/limit down mechanism, and I would
expect a proposal to be published for comment in the near
future.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR COBURN
FROM MARY L. SCHAPIRO
Q.1. How much money will the SEC spend in the next year to
comply with Dodd-Frank?
How many employees at the SEC are working on the new Dodd-
Frank requirements?
A.1. So far, the SEC has proceeded with the first stages of
implementation of the Dodd-Frank Act without additional
funding. This has largely involved performing studies,
analysis, and the writing of rules. These tasks have taken
staff time from other responsibilities, and have been done
almost entirely with existing staff. To accomplish minimal
Dodd-Frank Act implementation (hiring six people and initial IT
expenditures) in FY2011 would require an estimated $14.6
million.
To fully carry out its new responsibilities for oversight
of over-the-counter derivatives, private fund advisers, credit
rating agencies, and other areas of the financial industry, the
SEC will indeed require additional resources. In FY2012, we
estimate a requirement for 468 new staff, of which many would
need to be expert in derivatives, hedge funds, data analytics,
credit ratings, or other new or expanded responsibility areas.
We also will need to invest in IT systems to facilitate the
registration of additional entities and capture and analyze
data on these new markets. The agency's overall cost estimate
for Dodd-Frank in FY2012 is approximately $123 million.
Q.2. Your proposal for a Consolidated Audit Trail reflects an
enormous cost--$4 billion, with an ongoing cost of nearly $2.1
billion per year. That is $15 billion over the next 5 years.
However, during our hearing, you stated your belief that the
SEC could ``dramatically reduce the cost and the timetables of
implementation.''
(a) When do you expect to issue a revised proposal with the
new cost and timetables for implementation?
(b) How and when would you plan to use the data available
in this new database?
(c) What, if any of this information, do you currently have
access to?
(d) How would you balance the need for transparency with
the need for businesses to maintain some privacy?
(e) Your proposal emphasizes real-time data, instead of
data that arrives at the end of the day. Can you give an
example for when the SEC would use real-time data differently
than end-of-day data?
A.2. On May 26, 2010, the Commission proposed Rule 613 to
establish a Consolidated Audit Trail (CAT). The Commission
received many thoughtful comments on the proposal that
addressed a wide range of issues, including the way in which
audit trail data would be provided to the central repository,
the scope of the required data elements, and suggestions on how
to reduce implementation costs. Commission staff has been
actively considering the comments it received in response to
the proposal, following up with a range of market participants
and technology providers, and preparing a recommendation for
the Commission for the adoption of the rule. I currently expect
the Commission will consider the staff's recommendation for
adoption of the rule, including the implementation timetable
and revised cost estimates, in the first half of this year.
Though the full realization of the benefits of a CAT would
not come until a proposal is fully implemented, upon
implementation I expect we would begin to realize the benefits
of the data almost immediately. For example:
surveillances of the markets should be
significantly enhanced by being more focused, less
manually intensive, and better able to detect cross-
market issues;
examinations should be informed by better risk
assessments, and more exam work could be done without
burdening registrants with time-consuming document
requests; and
enforcement investigations should be more efficient
and less reliant on the production of information by
respondents.
In short, the CAT data would be tremendously useful both to
the SEC as well as the national securities exchanges and
national securities associations (``self-regulatory
organizations'' or ``SROs'').
Currently, there is no single database of comprehensive and
readily accessible securities order and execution data
available to the Commission. Instead, the Commission must
obtain and merge together a very large volume of disparate data
from numerous different market participants, a process which
takes a significant amount of time and effort.
The Commission staff itself does not have immediate access
to the individual SRO's audit trail information, and instead
must specifically request that an SRO produce the audit trail
information that it has. Though the SRO audit trails vary,
generally they collect information covering order receipt and
origination, order terms, order transmissions, and order
modifications, cancellations and execution. The audit trail
information is collected through submissions from SRO members
by the end of each business day or, in certain cases, upon
request by the regulating entity. Significantly, the SRO audit
trails do not collect beneficial owner information (as the CAT
proposes to do), a critical limitation that makes the process
of identifying the ultimate customer responsible for the
transaction at issue both extremely labor intensive and time
consuming.
Moreover, information provided to the Commission from the
individual audit trails of the various SROs does not provide a
view of trading activity occurring across multiple markets. An
SRO's audit trail information effectively ends when an order is
routed to another exchange. As a result, key pieces of
information about the life of an order may not be captured--or
easily tracked--if an order is routed from one exchange to
another, or from one broker-dealer to an exchange. As a result,
regulators cannot readily piece together activity related to
the same order or customer occurring across several markets to
determine whether violative conduct has occurred.
Commission staff currently obtains information about orders
or trades directly from broker-dealers through the Electronic
Bluesheet System (EBS) under Rule 17a-25, and from equity
cleared reports. However, the information provided through
these systems is limited in detail and scope. For example, EBS
data does not include the time of execution, and often does not
include the identity of the beneficial owner. Commission staff
often must make multiple requests to broker-dealers to obtain
sufficient order information--such as information identifying
the customer submitting an order, the person with investment
discretion for the order, or the beneficial owner--to be able
to adequately analyze trading. Again, collecting, interpreting
and analyzing diverse data sources such as these are labor
intensive and time consuming.
I believe that implementation of a consolidated audit trail
would significantly improve the comprehensiveness and
timeliness of the data the Commission needs in order to
efficiently and effectively regulate today's markets.
Transparency and privacy are both important considerations
as we consider the CAT proposal. To meet the need for
transparency, the proposal would require that specified order
information for all equities and options be collected from the
SROs and their members and reported to a central repository. At
the same time, the proposal would include provisions designed
to address the legitimate privacy concerns of market
participants. Access to audit trail information would be
strictly limited to regulators, and the proposed rule provides
that the SROs may access and use the consolidated audit trail
data only for regulatory--and not commercial--purposes. The
proposed rule also requires that the SROs maintain policies and
procedures to assure the confidentiality of all information
submitted to, and maintained by, the central repository.
Regarding your question about real time data, end-of-day
reporting, coupled with the current laborious process of
identifying the ultimate customer responsible for a particular
securities transaction that may take weeks or even months, can
impact effective oversight by hindering the ability of SRO
regulatory staff to identify manipulative activity close in
time to when it is occurring, and respond quickly to instances
of potential manipulation. As a fundamental matter, our markets
work in real time, and I therefore think regulators overseeing
the markets should seek, when feasible, to work in real time as
well. That is already happening today as the exchanges use real
time data to monitor and control order flow and to run certain
surveillances. I believe that these current efforts would
benefit from the detailed and cross-market data in a real time
CAT. I also believe new monitoring and surveillance efforts
will be developed to take advantage of the consolidated data,
as the CAT proposal requires the SROs to develop and implement
enhanced surveillances to make use of the CAT data. For
example, cross-market order flow could be monitored in real-
time for potential problems, which could then be expeditiously
addressed, potentially preventing further damage and future
problems.
------
RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
FROM JAMES J. ANGEL
Q.1. Does the increased reliance in the market on dark pools
and other types of ``undisplayed liquidity'' have the potential
for negatively affecting public price discovery? If so, does
this have the potential of making our markets less efficient?
Does it make the markets more prone to bouts of episodic
volatility as we saw on May 6?
A.1. Price discovery is one of the most important features of
our public markets. It is important that investors be able to
find counterparties to their trades and reach agreement on an
appropriate price. There is a concern that if too much trading
occurs ``in the dark,'' then market quality may deteriorate.
How much trading can occur in the dark before price
discovery deteriorates? Statisticians point out that one does
not need to measure every member of a population in order to
measure it. We only need a statistically valid sample, which
can be a rather small fraction of the total population. For
example, public opinion polls typically only use a few thousand
people to get a sense of the opinion of the whole U.S.
population.
There can also be too little trading in dark pools as well
as too much. Dark pools allow market participants to provide
some conditional liquidity that they may not want to provide
unconditionally. For example, a firm may want to act as a
market maker by providing liquidity to retail investors, but
wants to avoid trading against sophisticated high-speed
traders. If the firm were to post quotes in the public markets,
it may get picked off by the high-speed sharpshooters. The firm
may gladly add liquidity to a dark pool that caters to retail
investors, giving them better executions than they would get in
the public markets.
I don't know precisely how much is too much or too little
dark pool participation rates. This is a question that calls
for careful empirical research done. I suspect that we are far
from the point of having too much activity in dark pools. In
general, by most measurable standards, the quality of the U.S
equity market has increased in recent years at the same time as
activity in dark pools has increased. \1\
---------------------------------------------------------------------------
\1\ For details on how U.S. market quality has improved over the
last decade, see my study (joint with Larry Harris and Chester Spatt)
Equity Trading in the 21st Century, available at http://
papers.ssrn.com/sol3/papers.cfm?abstract_id=1584026.
---------------------------------------------------------------------------
By the way, there is really no such thing in the U.S. as a
completely ``dark pool'' because the moment a trade takes
place, a flashbulb goes off and the price and volume of the
trade are instantly public information. Investors thus know
almost immediately the prices at which trades are taking place
in the market, which certainly helps in price discovery. Dark
pools are only dark before trades, not afterward.
With respect to increasing the risk of disruptions such as
May 6, I do not believe that they present any more risk than
other market participants. There is always the risk that a
computer glitch may occur that destabilizes the market network.
This can occur anywhere in the market network. However,
additional trading platforms such as dark pools may provide
additional liquidity and additional trading capacity that may
ameliorate market disruptions.
Q.2. In your testimony you argued that both marketwide and
stock-by-stock circuit breakers should be redesigned and that
these circuit breakers should be based on ``data integrity'' as
well as those based on price. Can you elaborate on this? What
would such circuit breakers look like, what data would they
monitor, and how would the system effectively determine the
integrity of that data? Why wouldn't these circuit breakers be
just as prone to errors as those based on price?
A.2. One of the key lessons of May 6 is the importance of data
integrity. The SEC/CFTC report clearly stated that the reason
given by many firms for pulling out on May 6 was that they were
experiencing data integrity problems. The report also indicated
that computerized trading firms perform a variety of tests on
market data and pause trading when they detect the possibility
of problems with the price feeds, either because of extreme
movements in price or when different data feeds disagree. It
makes sense to design data integrity pauses based on what the
industry is already doing. It would make sense to pause the
market under the same conditions that cause the important
liquidity providers to pause. Not doing so runs the risk that
the market will experience another May 6th event in which
technical issues push the liquidity providers to the side, but
other orders are still allowed to execute at bad prices.
A quick look at trade data shows the kind of problems that
were experienced on May 6. The following table shows 25 seconds
of normal trading in Accenture on May 6 just before the crash:
------------------------------------------------------------------------
Time Venue Size Price
------------------------------------------------------------------------
2:30:01 PM..................... NASDAQ........... 100 41.52
2:30:03 PM..................... NYSE............. 200 41.51
2:30:06 PM..................... ADF.............. 200 41.5115
2:30:12 PM..................... NYSE............. 100 41.52
2:30:12 PM..................... NYSE............. 100 41.52
2:30:12 PM..................... NYSE............. 100 41.52
2:30:15 PM..................... NYSE............. 100 41.52
2:30:19 PM..................... NASDAQ BX........ 200 41.52
2:30:19 PM..................... NASDAQ BX........ 100 41.52
2:30:19 PM..................... ADF.............. 100 41.52
2:30:19 PM..................... ADF.............. 100 41.52
2:30:20 PM..................... NYSEARCA......... 100 41.52
2:30:20 PM..................... NYSE............. 100 41.52
2:30:20 PM..................... ISE.............. 100 41.52
2:30:20 PM..................... NATIONAL......... 100 41.52
2:30:20 PM..................... ADF.............. 100 41.52
2:30:22 PM..................... ADF.............. 500 41.5201
2:30:25 PM..................... ADF.............. 4700 41.53
2:30:25 PM..................... ADF.............. 300 41.53
------------------------------------------------------------------------
Note that the prices are usually the same on each market,
and when they change the amount of the change is usually less
than one cent.
Market quality began to deteriorate. Here are 5 seconds in
Accenture showing that reported trades on different exchanges
are getting farther and farther apart in price. Note that there
are large jumps in price between trades during the same second:
------------------------------------------------------------------------
Time Venue Size Price
------------------------------------------------------------------------
2:46:51 PM..................... NASDAQ........... 400 38.13
2:46:51 PM..................... NASDAQ........... 100 39.01
2:46:51 PM..................... NYSE............. 200 39.12
2:46:51 PM..................... NYSE............. 100 39.12
2:46:51 PM..................... NYSEARCA......... 100 39.02
2:46:51 PM..................... NYSE............. 200 39.55
2:46:51 PM..................... ISE.............. 100 39.02
2:46:51 PM..................... NYSE............. 100 39.56
2:46:51 PM..................... NYSE............. 100 39.62
2:46:51 PM..................... ISE.............. 100 39.02
2:46:51 PM..................... NYSE............. 200 39.61
2:46:51 PM..................... NYSE............. 300 39.61
2:46:51 PM..................... NYSE............. 100 39.53
2:46:52 PM..................... NYSE............. 100 39.36
2:46:52 PM..................... NYSE............. 100 39.36
2:46:52 PM..................... NYSE............. 200 39.16
2:46:53 PM..................... NASDAQ........... 300 39.11
2:46:53 PM..................... ISE.............. 100 39.04
2:46:54 PM..................... NASDAQ........... 500 38.00
2:46:55 PM..................... NYSEARCA......... 100 38.13
2:46:55 PM..................... NYSEARCA......... 100 38.13
2:46:55 PM..................... NYSEARCA......... 100 38.13
2:46:55 PM..................... NYSEARCA......... 609 38.00
------------------------------------------------------------------------
The markets continued to disintegrate. Here are 2 seconds
showing the disconnection of the market centers:
------------------------------------------------------------------------
Time Venue Size Price
------------------------------------------------------------------------
2:47:47 PM..................... NASDAQ........... 100 34.61
2:47:47 PM..................... NYSEARCA......... 151 32.62
2:47:47 PM..................... NYSEARCA......... 3780 32.62
2:47:47 PM..................... NASDAQ........... 100 32.40
2:47:47 PM..................... NASDAQ........... 100 33.69
2:47:47 PM..................... NASDAQ........... 100 33.69
2:47:47 PM..................... NASDAQ........... 100 33.69
2:47:47 PM..................... NASDAQ........... 100 32.40
2:47:47 PM..................... NASDAQ........... 200 31.91
2:47:47 PM..................... CBOE............. 100 31.80
2:47:47 PM..................... NASDAQ........... 150 31.79
2:47:47 PM..................... NYSEARCA......... 100 39.10
2:47:48 PM..................... NASDAQ........... 155 31.26
2:47:48 PM..................... NASDAQ........... 145 31.26
2:47:48 PM..................... NASDAQ........... 100 30.79
2:47:48 PM..................... CBOE............. 100 31.60
2:47:48 PM..................... NASDAQ BX........ 300 33.34
2:47:48 PM..................... NASDAQ BX........ 170 31.72
2:47:48 PM..................... ADF.............. 100 32.125
2:47:48 PM..................... NASDAQ........... 100 29.34
2:47:48 PM..................... CBOE............. 100 30.92
2:47:48 PM..................... NASDAQ........... 186 28.12
------------------------------------------------------------------------
A few seconds later we hit the well-known Armageddon:
------------------------------------------------------------------------
Time Venue Size Price
------------------------------------------------------------------------
2:47:54 PM..................... NASDAQ........... 100 1.84
2:47:54 PM..................... NASDAQ........... 100 0.01
2:47:54 PM..................... CBOE............. 100 0.01
2:47:54 PM..................... NASDAQ........... 100 1.74
2:47:54 PM..................... CBOE............. 100 0.01
2:47:54 PM..................... NASDAQ........... 100 1.54
2:47:54 PM..................... NASDAQ........... 100 1.44
2:47:54 PM..................... NASDAQ........... 100 1.34
2:47:54 PM..................... NASDAQ........... 100 1.24
2:47:54 PM..................... CBOE............. 100 0.01
2:47:54 PM..................... NASDAQ........... 100 1.14
------------------------------------------------------------------------
Later more normal conditions returned:
------------------------------------------------------------------------
Time Venue Size Price
------------------------------------------------------------------------
2:59:35 PM..................... BATS............. 100 40.68
2:59:35 PM..................... NYSE............. 200 40.68
2:59:37 PM..................... NYSE............. 100 40.69
2:59:37 PM..................... ISE.............. 100 40.68
2:59:37 PM..................... NYSE............. 100 40.69
2:59:40 PM..................... ADF.............. 100 40.69
2:59:44 PM..................... ADF.............. 100 40.70
2:59:45 PM..................... BATS............. 100 40.69
2:59:45 PM..................... BATS............. 200 40.69
2:59:45 PM..................... BATS............. 100 40.69
2:59:45 PM..................... NYSE............. 100 40.69
2:59:45 PM..................... BATS............. 100 40.69
2:59:46 PM..................... NYSEARCA......... 100 40.68
2:59:46 PM..................... BATS............. 100 40.68
2:59:46 PM..................... NYSE............. 100 40.68
2:59:49 PM..................... BATS............. 100 40.68
2:59:49 PM..................... NYSE............. 100 40.68
------------------------------------------------------------------------
A data integrity pause could be one in which the market
supervisor monitors the quality of the data feed and calls a 5
minute halt when any one of a number of anomalous situations
occur. These situations could include:
Price gap between exchanges greater than 5 cents.
Price jump of +/- 10 percent in 5 minutes or less
(current circuit breaker)
Price discrepancy between data feeds, such as the
direct feed from an exchange and the consolidated
quote.
Crossed or locked market quotes
Bid-ask spread larger than some amount
These pauses should be done on a stock by stock basis, as
the exchanges often run different stocks on different
computers. For example, symbols AAAA through CZZZ may be on one
server, DAAA through FZZZ on another, and so forth. By pausing
only those stocks that are experiencing problems, overall
disruptions to the market are minimized.
There are two types of errors in circuit breakers: One type
of error is to not halt trading when it is clear that the
market mechanism is misfiring. The other type of error is to
halt trading when the market should not be halted. We have seen
both types of errors in the last year.
Clearly, data integrity pauses would be subject to both
Type I and Type II errors. However, it is my belief that
including such pauses would prevent more serious breaches of
the type we saw on May 6.
Careful consideration needs to be paid to the design of
these systems, especially since they will be called upon at
times when the market is under great stress and when the need
for good price discovery is most important. The basic goal of
circuit breakers is to maintain fair and orderly markets by
stopping the market when the market mechanism is likely to be
producing incorrect prices. This maintains the integrity of the
market and prevents trades that have to be busted later.
The marketwide circuit breakers instituted after the Crash
of 1987 were based on the notion that stopping the entire
market after a large drop in prices would provide time for
investors to assess what was happening in the market, to
assimilate any new information that had arrived, and to bring
additional liquidity to the market. In the Crash of 1987, the
market mechanism could not keep up with the flood of trading,
much as the market mechanism could not keep up with the flow of
activity in the Flash Crash of 2010.
We learned on May 6 that a disruption can occur for
technical reasons. Imagine what would have happened on May 6 if
the drop had been just a little more severe and a few minutes
earlier. It would have triggered the 1 hour trading halt,
causing headlines around the world: ``Stock market crashes.
Trading Halted!'' Many investors may have interpreted the event
as signaling fundamental news, and additional panic selling may
have occurred in other markets still open, such as the bond and
currency markets. Furthermore, the closed market may have led
to more panic selling when the market reopened.
The stock-by-stock circuit breakers imposed in some stocks
after May 6 were a step forward, but they need to be refined.
Such protection needs to be applied to all stocks, not just the
ones in the current pilot. Also, methods need to be found to
prevent erroneous trades from occurring and triggering the
circuit breakers when they should not be triggered.
Q.3. What is your view on limit up/limit down price banding
idea referred to in Chairman Schapiro's testimony?
A.3. I think that the limit up/limit down idea is conceptually
appealing because it looks like a method for preventing
erroneous trades: Just don't let any trades take place outside
of a given band. However, it has a fatal flaw that will result
in many complaints to the regulators. In a limit up/limit down
system, there is a price band within which trades are allowed
to occur. For example, if the reference price is $10 and the
band is 10 percent, then trades could occur anywhere between $9
and $11. The system automatically rejects any trades outside
the band.
Clearly, there are times when the price should move outside
the band because new information has arrived. All limit up/
limit down mechanisms allow for an eventual reset in the
trading band. At some exchanges, the trading band is set for
the entire day and resets the next day. Some of the proposals
currently circulating call for a faster reset of the band,
perhaps after several minutes.
Alas, a limit up/limit down system does not stop trading
and thus allows unsophisticated retail investors to trade at
what is demonstrably not the fair price of the asset. This will
cause an enormous number of complaints from retail investors to
the regulators and to legislators. Here is an example:
The current band is from $9 to $11. News comes out that a
takeover offer has been made at $20 per share. Buyers
immediately start buying and quickly push the price up to the
limit. The stock is stuck at the limit with orders to buy at
$11 but no sellers at that price. At some point, the band will
be reset so the stock can trade at its new fair and higher
price. However, an unsophisticated retail investor who submits
a market sell order during this time will be executed at $11.
Shortly thereafter, the band resets and the price jumps. The
investor feels that he or she has been taken advantage of and
complains to the regulators as well as to their congressional
representatives.
If any such system is put in place, it should be tested in
a carefully controlled pilot experiment that investigates
different sized bands and different reset periods.
Q.4. Many claim that one of the benefits of high-frequency
traders is that they supply needed liquidity to the market. Yet
the events of May 6 seem to show that this liquidity is
fleeting and disappears when it is needed most. As such, do the
events of May 6 demonstrate that this liquidity is only
illusionary? If so, what, if anything, should be done to ensure
that the liquidity high-frequency traders claim to offer is
there in bad times as well as the good?
A.4. The SEC/CFTC report investigated why these firms stopped
trading. \2\ The report stated on page 35 ``As such, data
integrity was cited by the firms we interviewed as their number
one concern. To protect against trading on erroneous data,
firms implement automated stops that are triggered when the
data received appears questionable.'' And on page 36:
``Whenever data integrity was questioned for any reason, firms
temporarily paused trading in either the offending security, or
in a group of securities.''
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\2\ http://www.sec.gov/news/studies/2010/marketevents-report.pdf
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Indeed, it is quite reasonable for these firms to stop
trading when they detect the possibility of machine
malfunctions. They cannot know where the malfunctions are
occurring, and if they trade based on bad data they could lose
enormous amounts of money in a short time and cause havoc in
the rest of the market.
The implication is simple: If we want these firms to keep
providing liquidity when the market is under stress, we need to
make sure that the market has data integrity when the market is
under stress. This is another reason to have data integrity
pauses as discussed above.
I am not a fan of rules that try to force market makers to
trade when they don't want to trade. Imposing such costs will
result in fewer firms willing to make markets. Even if there
are such rules, firms will try to get around them when the
market is under stress. This was especially apparent in the
Crash of 1987 when there were widespread accusations that
NASDAQ market makers and NYSE specialists were not living up to
their market maker obligations at that time.
Markets that have affirmative obligations for market makers
generally also give market makers special privileges in their
systems, such as special access to the market unavailable to
others. This gave them an edge that offset the cost of their
affirmative obligations. For example, the old NASDAQ system did
not allow customer limit orders to compete directly with dealer
quotes. Market structure changes over the last decade have
eliminated these advantages, which has led to a decline in the
number of traditional market makers. Any proposal to impose
obligations should also be very clear as to what special
privileges will be given to market makers in compensation.
One way to improve the liquidity provided by market makers
is to permit the issuers to contract directly with and pay
market makers for providing liquidity. This would allow the
firm to compensate market makers for the expected losses they
would experience by providing liquidity at times when they
would otherwise choose not to do so. This system, which is used
in Europe, is not currently permitted under current FINRA
rules. Our rules should be changed to permit experimentation
with this approach.
Q.5. What are the economic tradeoffs that need to be considered
in placing curbs on the use of high-frequency trading in the
markets? What might such curbs look like?
A.5. Traders use fast computers for a number of applications,
many of which are beneficial to the market such as market
making and arbitrage. \3\ Any curbs on high-frequency trading
run the risk of curbing such beneficial trading more than any
harmful trading. I personally do not see a need for curbs on
all high-frequency trading as such, and would want to see good
empirical data demonstrating harm before imposing any curbs.
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\3\ For more details on the beneficial as well as harmful uses of
high-frequency trading, see my joint work with Douglas McCabe available
at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1737887.
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There are numerous potential curbs on high-frequency
trading. Abusive strategies such as spoofing should be curbed
by an enforcement regime good enough that any spoofers are
quickly caught and sanctioned.
Excessive cancellations impose bandwidth costs on other
market participants who must process all the data generated.
One simple curb would be a speed limit on the number of quote
updates in a given security in a given time. If a market
participant cancels more than 200 orders per second in a given
stock in a given exchange, then that exchange would reject all
orders in that stock from that participant for the next 5
seconds.
Another approach is economic rather than regulatory.
Surveillance costs increase with the amount of message traffic.
As we consider the design and funding of the new consolidated
audit trail system, part of the cost allocation could be based
on the amount of message traffic generated by a given
participant.
I am not in favor of requiring orders to have a minimum
time in force for the following reason. There are times when it
is appropriate for a long-term investor to cancel a legitimate
order, even if it was just placed a nanosecond ago. For
example, a patient mutual fund may be trying to accumulate
shares by placing buy orders at the current bid. It uses a
computer algorithm that places orders at the bid. When the
algorithm senses that the price is going down (perhaps by
seeing the bid fall on another exchange), it cancels the order
at the bid and replaces it with a new order at the new lower
bid. If this mutual fund was unable to cancel the order when
the market moves, it will be picked off by sharp-shooting high-
frequency traders. The result is that the mutual fund will
experience higher transactions costs when filling its orders.
Q.6. Should there be serious consideration of removing the SRO
function out of the individual exchanges and placing it into a
single SRO? Should this consideration be extended to include a
single SRO responsible for the equities as well as the futures
markets? Could that possible be a way to reduce the regulatory
fragmentation that many of the witnesses, including you,
mentioned in their testimony?
A.6. Yes, we should consider separating the operation of a
trading platform from that of enforcing our securities laws.
The business of running a trading platform is very different
from the business of enforcing Federal securities laws. Our
financial markets have changed dramatically since the SRO model
was adopted in the Securities Exchange Act of 1934. In 1934,
the deputizing of the NYSE made sense as the NYSE was by far
the dominant force in the U.S. equity market. This no longer
makes sense in our more modern and competitive markets.
Exchanges currently have two types of regulatory
responsibilities under section 6(b)1 of the Securities Exchange
Act of 1934: They must be able to enforce compliance with their
own rules as well as national securities laws. Clearly
exchanges have a clear commercial interest to enforce their own
rules. Calling on them to enforce national securities laws is
more problematic. How should the duties be divided among the
exchanges? Traditionally, the listing exchange bore the bulk of
the responsibility. However, this does not work well in a
competitive environment. It is not fair to have one exchange do
all the regulation and then charge the other exchanges. It is
almost impossible to allocate the costs in such a way as to
avoid either over or under charging the other exchanges.
Different regulatory functions naturally reside in
different places. The exchanges naturally have an incentive to
enforce their own rules. However, a manipulative trading
strategy may involve numerous different instruments traded in
numerous venues. It makes sense for a marketwide regulator such
as FINRA to surveil for trading abuses, paid for fairly with a
charge on transactions similar to the SEC fee.
The idea of a single SRO for all financial products
(including securities, commodities, and insurance) is very
appealing and should be seriously explored.
------
RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
FROM THOMAS PETERFFY
Q.1. Many claim that one of the benefits of high-frequency
traders is that they supply needed liquidity to the market. Yet
the events of May 6 seem to show that this liquidity is
fleeting and disappears when it is needed most. As such, do the
events of May 6 demonstrate that this liquidity is only
illusionary? If so, what, if anything, should be done to ensure
that the liquidity high-frequency traders claim to offer is
there in bad times as well as the good?
A.1. There are hundreds of high frequency trading (HFT)
operations that exist today and more will come into being in
the future. They employ different strategies and practices that
change often. Some provide liquidity most of the time while
others take liquidity. Some trade continuously throughout the
day, while some wait for opportunities to arise in the markets.
I would suggest two alternatives that would increase
liquidity and reduce abusive trading on the part of HFTs.
A. A simpler but less beneficial solution would be to delay
all orders, regardless of their origin, to the
exchanges' matching engines by a tenth of a second when
those orders take liquidity (i.e., buy orders priced at
the best offer or above and sell orders priced at the
best bid or below). This would decrease the ability of
HFTs to take liquidity and in turn increase liquidity
providers' willingness to provide liquidity.
B. A more encompassing alternative would be to delay the
transmission of ALL orders to the exchanges' matching
engines, with the sole exception of quotes transmitted
by market makers for products in which they are
registered and have undertaken the obligation of
providing quotes of minimum size and width, depending
on market conditions, on a continuous basis. This
measure would incentivize HFTs to become regulated
market makers, and reaffirm the obligations and
incentives of currently registered market makers to
continue in their function.
Either alternative that is chosen should apply to all
stock, option and futures markets.
Q.2. What are the economic tradeoffs that need to be considered
in placing curbs on the use of high-frequency trading in the
markets? What might such curbs look like?
A.2. With the growing participation of HFTs, the interaction in
the market place between: (a) market makers and customers, and
(b) customers with each other, have diminished (i.e., HFTs are
stepping in the middle of these trades). Anecdotal evidence
points to HFT annual revenues of $2 to $5 billion. Some of this
comes from traditional market makers who have lost some of
their business to HFTs but the bulk comes from institutional
and retail customers. Accordingly, reduced HFT participation
would benefit customers. HFTs are large customers of certain
brokers and of the exchanges and pay substantial exchange fees.
Any reduction of HFT activity would have a negative impact on
exchange revenues. It would also reduce the income of their
brokers that tend to be small, undercapitalized firms.
Proposed curbs on HFT activity that are often mentioned in
the press include the prohibition of canceling orders for a
certain period of time, limiting the number of submitted orders
to some multiple of orders actually executed, or financial
penalties for frequent order submission. However, all these
measures would act to reduce liquidity. Either of the proposals
outlined in (A) and (B) above would be a much more constructive
approach to channeling HFT activity into a more productive use
while still allowing HFTs to participate actively in markets.
Q.3. Should there be serious consideration of removing the SRO
function out of the individual exchanges and placing it into a
single SRO? Should this consideration be extended to include a
single SRO responsible for the equities as well as the futures
markets? Could that possibly be a way to reduce the regulatory
fragmentation that several of the witnesses mentioned in their
testimony?
A.3. YES, DEFINITELY!
Additional Material Supplied for the Record
Letter Submitted by Timothy B. Henseler, Deputy Director, Securities
and Exchange Commission