[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

                              ----------                              

                      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\
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \3\ See, http://www.upi.com/Business_News/2008/09/08/United-
Airlines-hit-by-5-year-old-news/UPI-66501220903137/.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
     \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.

---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \7\ http://www.sec.gov/news/studies/tradrep.htm
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
     \11\ http://www.wilshire.com/Indexes/Broad/Wilshire5000/
Characteristics.html, accessed December 5, 2010.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
     \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.''
---------------------------------------------------------------------------
     \2\ http://www.sec.gov/news/studies/2010/marketevents-report.pdf 
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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

        
        
        
        
        
        
