[Senate Hearing 112-748]
[From the U.S. Government Publishing Office]




                                                        S. Hrg. 112-748
 
      COMPUTERIZED TRADING: WHAT SHOULD THE RULES OF THE ROAD BE?
=======================================================================



                                HEARING

                               before the

                            SUBCOMMITTEE ON

                 SECURITIES, INSURANCE, AND INVESTMENT

                                 of the

                              COMMITTEE ON

                   BANKING,HOUSING,AND URBAN AFFAIRS

                          UNITED STATES SENATE

                      ONE HUNDRED TWELFTH CONGRESS

                             SECOND SESSION

                                   ON

                     EXAMINING COMPUTERIZED TRADING

                               __________

                           SEPTEMBER 20, 2012

                               __________

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


                 Available at: http: //www.fdsys.gov /




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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  TIM JOHNSON, South Dakota, Chairman

JACK REED, Rhode Island              RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York         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                 PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia             MARK KIRK, Illinois
JEFF MERKLEY, Oregon                 JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado          ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina

                     Dwight Fettig, Staff Director

              William D. Duhnke, Republican Staff Director

                       Dawn Ratliff, Chief Clerk

                     Riker Vermilye, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor

                                 ______

         Subcommittee on Securities, Insurance, and Investment

                   JACK REED, Rhode Island, Chairman

              MIKE CRAPO, Idaho, Ranking Republican Member

CHARLES E. SCHUMER, New York         PATRICK J. TOOMEY, Pennsylvania
ROBERT MENENDEZ, New Jersey          MARK KIRK, Illinois
DANIEL K. AKAKA, Hawaii              BOB CORKER, Tennessee
HERB KOHL, Wisconsin                 JIM DeMINT, South Carolina
MARK R. WARNER, Virginia             DAVID VITTER, Louisiana
JEFF MERKLEY, Oregon                 JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado          ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
TIM JOHNSON, South Dakota

                Kara Stein, Subcommittee Staff Director

         Gregg Richard, Republican Subcommittee Staff Director

                                  (ii)


                            C O N T E N T S

                              ----------                              

                      THURSDAY, SEPTEMBER 20, 2012

                                                                   Page

Opening statement of Chairman Reed...............................     1

Opening statements, comments, or prepared statements of:
    Senator Crapo................................................     2

                               WITNESSES

David Lauer, Market Structure and High-Frequency Trading 
  Consultant, Better Markets.....................................     4
    Prepared statement...........................................    28
    Responses to written questions of:
        Senator Reed.............................................    72
        Senator Hagan............................................    73
Andrew Brooks, Head of U.S. Equity Trading, T. Rowe Price........     5
    Prepared statement...........................................    40
Chris Concannon, Partner and Executive Vice President, Virtu 
  Financial, LLC.................................................     8
    Prepared statement...........................................    46
    Responses to written questions of:
        Senator Reed.............................................    76
        Senator Hagan............................................    77
Larry Tabb, Founder and Chief Executive Officer, TABB Group......    10
    Prepared statement...........................................    49

              Additional Material Supplied for the Record

Statement of Senator Carl Levin..................................    80
Statement of Micah Hauptman, Financial Campaign Coordinator, 
  Public Citizen's Congress Watch Division.......................    83
Statement of Cameron Smith, President, Quantlab Financial, and 
  Richard Gorelick, CEO, RGM Advisors............................    94
Summary and Excerpts from ``High Frequency Trading and Price 
  Discovery'' by Terry Hendershott and Ryan Riordan..............   108

                                 (iii)


      COMPUTERIZED TRADING: WHAT SHOULD THE RULES OF THE ROAD BE?

                              ----------                              


                      THURSDAY, SEPTEMBER 20, 2012

                                       U.S. Senate,
     Subcommittee on Securities, Insurance, and Investment,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Subcommittee convened at 10:03 a.m., in room 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. I want to 
thank all of you for joining us today, especially our 
witnesses, and thank my colleague, Senator Crapo.
    As everyone in the room knows, computer trading has changed 
markets in fundamental ways, not the least of which is the 
speed at which trading now occurs. The benefits of automated 
trading for retail investors include access to real-time market 
data and being able to execute orders within a fraction of a 
second. The explicit costs of trading have also decreased. In 
one study that focused on pre- and post-decimal trading in the 
New York Stock Exchange listed stocks, average effective 
spreads decreased significantly for both small and large 
trades. The market is also more efficient, processing large 
volumes of data and more accurately setting market prices based 
on sometimes minute changes and market additions.
    However, since the May 6, 2010, Flash Crash, there have 
been a series of high-profile computer trading errors that 
highlight some of the dangers and costs of fast-moving 
computer-driven trading. In March, a computer glitch scuttled 
the initial public offering of one of the Nation's largest 
electronic exchanges, the BATS Global Markets, Inc. In May, 
computer problems at the NASDAQ Stock Market plagued the 
initial public offering of Facebook stock. And last month, the 
Knight Capital Group, a brokerage firm at the center of the 
Nation's stock market for almost a decade, nearly collapsed 
after it ran up more than $400 million of losses in minutes 
because of errant technology.
    Taken together, these failures in electronic trading appear 
to be affecting investor confidence in the U.S. market 
structure. Most of us consider American capital markets to be 
the best in the world. Our markets are known for their strength 
and resiliency, their openness and transparency, and their 
fairness to all market participants. But our marketplace has 
been evolving very quickly and it is not clear that our rules 
have kept up.
    In particular, we need to focus on whether markets have the 
ability to avoid systematic failure triggered by a computer 
problem. Are our markets still fair? Is everyone playing by the 
same set of rules? And perhaps most importantly, are our 
markets still focused on long-term capital formation and the 
creation of jobs?
    Following the Knight Capital incident in early August, the 
SEC announced it would convene a roundtable of trading 
technologists in an effort to determine if brokers and 
exchanges are in control of their trading systems. SEC 
Chairwoman Mary Shapiro said she had asked staff to, quote, 
``accelerate ongoing efforts to propose a rule that would 
require trading venues to maintain the capacity and integrity 
of their systems,'' and this roundtable is scheduled for 
October 2, 2012.
    Clearly, recent market events caused by technology-related 
issues have sharpened the debate on market infrastructure and 
the need to limit the broader impact of computer trading 
errors. However, in light of the enormous growth of high-
frequency and algorithmic trading, there is a growing consensus 
that the entire regulatory scheme surrounding high-frequency 
trading firms and their algorithms should be assessed.
    Do current regulations reflect the impact of high-frequency 
algorithms on trading? Or can computer algorithms be programmed 
to operate properly in stressed market conditions? What 
challenges face firms when they are testing and implementing 
new systems?
    In addition, just last week, on September 14, the SEC 
settled first of its kind charges against the New York Stock 
Exchange for compliance failures that gave certain customers an 
improper head start on trading information. Computer issues, 
which include both disparities in the design of the New York 
Stock Exchange hardware systems and software problems, resulted 
in some customers receiving stock pricing trading data several 
seconds ahead of the general public. The SEC order marks the 
first ever SEC financial penalty against an exchange.
    The order and fine involving the New York Stock Exchange 
highlight another set of issues I hope we can discuss at 
today's hearing. In effect, should the exchanges have control 
over the collection, aggregation, and distribution of market 
data? Should data be available to everyone at the same time, or 
should enriched data be provided more quickly to those who are 
willing to pay for it?
    We look forward to hearing your testimony on all of these 
topics. The capital markets are a public good, much like a 
highway. We need to have clear rules about the speed limits, 
who can use the HOV lanes. With our rapidly evolving capital 
market structure, we need to make it clear what the rules of 
the road are.
    Now, let me turn to my colleague, Senator Crapo, for his 
comments. Senator.

                STATEMENT OF SENATOR MIKE CRAPO

    Senator Crapo. Thank you, Mr. Chairman.
    More than half of all U.S. households, 57 million, 
according to one study, participate in our markets through 
either stocks or mutual funds, and the health and 
competitiveness of these markets have an immediate and direct 
effect on our broader economy as well as on the wealth and 
prosperity of the American people.
    Over the last several decades, new forms of competition, 
technology, global growth in trading, and broader investor 
participation have integrated and interconnected the world's 
capital markets and the financial services industry as never 
before. According to a 2010 study by James Angle of Georgetown, 
Larry Harris of the University of Southern California, and 
Chester Spatt of Carnegie Mellon, technological innovations 
have led to major improvements in market quality. Their study 
found that execution speeds have increased, making it much 
easier for retail investors to monitor execution. In addition, 
retail commissions have significantly dropped and bid/ask 
spreads have narrowed.
    However, as Chairman Reed outlined, there have been too 
many technological failures in our market infrastructures since 
the Flash Crash of 2010.
    I thank Chairman Reed for holding this important hearing on 
a topic that has clearly captured the attention of academics, 
practitioners, and regulators.
    Yesterday, Georgetown University hosted a conference on 
financial market quality and the question of what is the 
empirical evidence on the role of alternative trading systems, 
algorithmic trading, high-frequency trading, dark pools, and 
new trading technology on market quality. In October, as has 
been indicated, the SEC will be holding a technological 
roundtable to discuss how to minimize trading errors and market 
malfunctions as well as how to respond to them in real time 
when they do occur.
    As we look at ways to help fortify our markets, especially 
during times of market stress, it is important that we examine 
all of the relevant empirical evidence in order to make 
informed policy decisions. I hope the witnesses at today's 
hearing can provide some of that much needed evidence and I 
look forward to hearing their testimony.
    Thank you, Mr. Chairman.
    Chairman Reed. Thank you very much, Senator Crapo.
    Let me now introduce our panel. I want to thank the panel 
for joining us today. We are extraordinarily lucky to have such 
qualified and insightful witnesses.
    Our first witness is Mr. David Lauer. Mr. Lauer is a Market 
Structure and High-Frequency Trading Consultant at Better 
Markets. He has helped financial service firms deploy high-
performance trading infrastructure. He has also worked as a 
quantitative analyst and high-frequency trader himself. Thank 
you, Mr. Lauer.
    Mr. Larry Tabb is the founder and CEO of TABB Group. The 
financial markets research and strategic advisory firm focuses 
exclusively on capital markets. Founded in 2003, TABB Group 
analyzes financial market issues. Thank you, Mr. Tabb, for 
being here.
    Mr. Chris Concannon is currently a partner in Virtu 
Financial, where he serves as an Executive Vice President and 
is the Chief Compliance Officer at Virtu Financial BD. Prior to 
joining Virtu in 2009, Mr. Concannon spent 6 years as Executive 
Vice President of the NASDAQ OMX Group. Thank you, Chris.
    Mr. Andrew Brooks is Vice President of T. Rowe Price Group 
and T. Rowe Price Associates. He has served as head of U.S. 
equity trading for the firm since 1992. Thank you very much, 
Andy, for joining us today.
    We will begin with Mr. Lauer and then just go right down 
the panel. Please try to limit your testimony to 5 minutes. 
Your complete written testimony will be made part of the 
record, so feel free--in fact, I encourage you to summarize. 
Mr. Lauer.

 STATEMENT OF DAVID LAUER, MARKET STRUCTURE AND HIGH-FREQUENCY 
               TRADING CONSULTANT, BETTER MARKETS

    Mr. Lauer. Good morning, Chairman Reed, Ranking Member 
Crapo, and Members of the Subcommittee. Thank you for the 
invitation to Better Markets to testify today, and thank you 
very much for holding this hearing on such a critical issue to 
our financial markets and our economy.
    Better Markets is a nonprofit, nonpartisan organization 
that promotes the public interest in financial markets. I will 
not take the time to go over all that we do today, but you can 
find it at bettermarkets.com. My name is David Lauer. As you 
indicated, I am a Market Structure and High-Frequency Trading 
Consultant to Better Markets. I also consult for IEX Group, a 
new private company that is developing an investor-focused 
equity market.
    Prior to consulting, I worked as a high-frequency 
researcher and trader at two of the largest HFT firms in the 
industry. And before that, I worked at a technology vendor that 
provided high-performance hardware to many high-speed trading 
desks on Wall Street.
    I would like to start with a story and tell you about my 
experience during the Flash Crash in May of 2010. The Flash 
Crash, as you know, caused the market to drop by a trillion 
dollars, nearly a trillion dollars, and then bounce back 
inexplicably within 20 minutes. I was on the trading floor that 
day as the market crashed and I witnessed something, quite 
frankly, unthinkable. The market simply disappeared. It was 
gone. We had no idea what was happening and we had no idea what 
would happen next.
    Our firm, like other HFT firms, immediately withdrew our 
liquidity from the market because we had no idea what was 
happening. We did not trust the information from our data 
feeds. And we had no obligation to remain in the market. More 
than half of the liquidity in the stock market was pulled in a 
matter of seconds and that dramatically worsened an already 
unstable situation. Anybody who seeks to minimize the role that 
HFT played in the Flash Crash either was not on a trading floor 
that day or is incentivized to maintain the status quo.
    Remarkably, since the Flash Crash, there have been no 
substantial changes in market structure. The U.S. equity 
markets are in dire straits. We are truly in a crisis right 
now. The past decade of technology revolution on Wall Street 
has been marked by two primary trends, extreme marketplace 
fragmentation and the rapid growth of HFT as the primary 
supplier of liquidity. Complexity is the hallmark of this 
market, whether from the fragmentation of 13 exchanges and over 
50 dark pools or the interaction between algorithms listening 
to high-frequency market data. While complex systems can often 
provide elegant solutions to intractable real world problems, 
they can also spin out of control at any moment and in 
completely unexpected ways.
    There is no doubt that electronic trading has tremendous 
value to offer, enhancing the smooth functioning of the stock 
market and increasing competition, thus driving down the cost 
of trading. What we must be concerned with is whether the 
pendulum has swung too far and whether the nearly unregulated 
activity of 50 to 70 percent of the stock market should be 
allowed to continue unabated.
    A quick look at today's markets reveal that stock market 
volatility has increased. Spreads have increased. Catastrophic 
event frequency has increased. IPOs have dramatically dropped. 
And retail investors are fleeing the stock market.
    As my written testimony demonstrates, the micro structure 
of the equity market has been altered by HFT and extreme market 
fragmentation, resulting in an excessively fragile market. This 
fragility is apparent in the impact that a single firm or even 
a single computer can have on the market at large, whether 
accidental or nefarious and predatory.
    I believe the market is so fragile because of structural 
inefficiencies, including the proliferation of the maker-taker 
business model and pay for order flow deals, the disappearance 
of affirmative market making obligations, the fragmentation of 
equity markets into lit and unlit venues with little regulation 
of the unlit venues, and the rubber stamp approval of exotic 
order types without proper study or justification.
    So what are we to do? Here are my suggestions, just a few 
of them, for rules of the road. I believe we need to unify 
trading rules regardless of lit or unlit venue, and the bar 
must be raised on off-exchange execution standards. In order to 
receive a rebate from any venue, market makers must be 
registered and subject to affirmative market making 
obligations. A unique identifier should be assigned to every 
supervisory individual and attached to every quote. This would 
provide a contact person in emergencies and remove the cloak of 
anonymity that has allowed for manipulative behavior. We must 
eliminate pay for order flow practices. The SEC should pilot a 
50-millisecond minimum quote time. And strong market technology 
standards are needed and regular audits to ensure they are 
being followed.
    In addition, I would like regulators to try a novel 
approach to surveillance and enforcement inspired by the 
Internet and open access and standards. Regulators could open 
up access to market data and incentivize independent 
programmers with prizes similar to how the X Prize functions, 
or percentage of fines like their whistleblower program, to 
help design better surveillance and enforcement tools for 
regulators. This can be part of advancing the SEC's technology 
capabilities with a substantial investment in technology and 
personnel to bring the SEC into the 21st century.
    Thank you very much, and I am happy to answer any 
questions.
    Chairman Reed. Thank you very much.
    Mr. Brooks, please.

  STATEMENT OF ANDREW BROOKS, HEAD OF U.S. EQUITY TRADING, T. 
                           ROWE PRICE

    Mr. Brooks. Good morning, Chairman Reed, Ranking Member 
Crapo, and distinguished Members of the Senate Subcommittee on 
Securities, Insurance, and Investment. Thank you for the 
opportunity to testify today on behalf of T. Rowe Price 
regarding the effects of recent significant changes in trading 
technology and practices on market stability.
    My name is Andy Brooks. I am a Vice President and Head of 
U.S. Equity Trading at T. Rowe Price Associates, Incorporated. 
I joined the firm in 1980 as an equity trader. I assumed my 
current role in 1992. This is my 33rd year on the T. Rowe Price 
trading desk.
    T. Rowe Price is celebrating its 75th year anniversary of 
advising clients. We are a Baltimore-based global advisor with 
over $540 billion in assets under management as of June 30, 
2012, and more than three million client accounts. We serve 
both institutional and individual investors. We welcome the 
opportunity for discussion regarding the industry and market 
practices.
    Our firm is particularly focused on the interests of long-
term investors. We appreciate the role other types of investors 
can have in creating a dynamic marketplace. However, as we talk 
with our clients, there is a growing distrust of the casino-
like environment that the marketplace has developed over the 
past decade. We worry that the erosion of investor confidence 
can undermine our capital markets, which are so important to 
the economy, job growth, and global competitiveness. 
Reaffirming a strongly rooted commitment to fairness and 
stability in the market's infrastructure is critically 
important.
    Over the past two decades, the markets have benefited from 
innovation and from new technology and competition. Generally, 
markets open on time, close on time, and trades settle. 
However, there are problems below the surface. Here are some of 
the things we find concerning.
    Order routing practices. We question the nature of various 
order routing practices. The maker-taker model, payment for 
order flow, and internalization of orders all seem to present a 
challenge to order routing protocols. Are order routing 
practices and incentives--are they an impediment to the over-
reaching requirement to seek best execution on all trades?
    Colocation and market data arbitrage. We believe that the 
widespread use of colocation creates an uneven playing field 
that favors those who can and will pay for it. We question 
whether this has produced a market that values speed over fair 
access. In no other regulated industry is one party allowed a 
head start in exchange for payment. Our understanding is the 
current colocation practices allow for a market data arbitrage 
where some investors get quotations and trade data faster than 
others. This advantage is traded upon, causing some 
participants to believe they are victims of front running, or 
at the least, disadvantaged.
    Speed and impact on market integrity. Our sense is the 
almost myopic quest for speed has threatened the very market 
itself. It also seems to many that high-frequency trading 
strategies are designed to initiate an order to simply gauge 
the market's reaction, then quickly react and transact faster 
than other investors can. This seems inherently wrong. Our 
understanding is that the continued push for speed is not 
producing any marginal benefit to investors and, in fact, may 
be detrimental. This pursuit of speed as a priority is in 
direct conflict with the pursuit of market integrity as a 
priority.
    Inaccessible quotes and high cancellation rates. The growth 
of HFT has led to increased volume. However, whether the 
corresponding volume is good or bad deserves analysis. Volume 
does not necessarily mean liquidity for large institutional 
investors. When you combine high HFT volumes and even higher 
cancellation rates, these forces can combine to undermine 
market integrity and cause deterioration in the quality and 
depth of the order book. We feel that this volume is transitory 
and misleading.
    Challenges to the national market system. We believe the 
original construct of Regulation NMS was laudable and designed 
to encourage competition. However, we do not believe this 
regulation contemplated today's highly fragmented marketplace, 
where we have 13 different exchanges and over 50 unregulated 
dark pools. In such a fragmented market, can one really be 
confident that achieving best execution, given the explosion of 
market data traffic? We question the market's ability to 
process the overload of market data.
    Conflicts of interest. We question whether the functional 
roles of an exchange and a broker-dealer have become blurred 
over the years and could warrant regulatory guidance regarding 
the inherent conflicts of interest. It seems clear that since 
exchanges have migrated to for-profit entities, a conflict has 
arisen between seeking volume to grow revenues and their 
obligation to assure an orderly marketplace for all investors.
    HFT trading strategies. Professional proprietary traders 
often have divergent interests from those investors concerned 
about the long term. Whether the average holding period for 
such traders is measured in seconds as opposed to months or 
years, we have destabilized the market. Given recent market 
volatility, more study is warranted to assess the impact of the 
exponential growth of short-term trading strategies. Most rules 
and regulations seem to further enable those with short-term 
profit incentives, as evidenced by the proliferation of new 
order types suggested by exchanges and approved by regulators.
    Suggestions. We believe it is time to step back and examine 
the market structure and how it impacts all investors. A good 
first step might be to experiment with a number of pilot 
programs to examine different structural and rule 
modifications. We suggest a look at the appropriateness of 
colocation as a general practice and enhanced oversight of 
high-frequency trading and other strategies that might be 
unduly burdensome to overall market functionality. We would 
like to see a pilot program where all payments for order flow, 
maker-taker fees, and other inducements for order flow routing 
are eliminated. We envision a pilot where there are wider 
minimum spreads and mandated times for quotes to be displayed 
to render them truly accessible. These programs can include a 
spectrum of stocks across market caps and average trading 
volumes, among other factors. We also suggest a pilot program 
of imposing cancellation fees for unacceptable trade-to-
cancellation ratios.
    A key question is, should we foster consolidation in this 
fragmented market? At a minimum, should we raise the barrier 
for becoming an exchange? In our opinion, requiring a more 
robust testing for new software would seem to make sense.
    In conclusion, T. Rowe Price Associates appreciates all the 
efforts of the SEC and Congress as we strive to make the 
markets better and fairer for all participants. The 
consolidated audit trail, large trader ID, limit up-down 
initiatives are all improvements. We suggest any regulatory 
proposals be aligned with the goal of making the markets 
simpler, more transparent, and less focused on speed. We 
applaud the Committee's interest in making sure the right 
questions are asked. There are currently over 1,000 order types 
to express your buy and sell interest and we suggest that a 
simplified model may be more efficient for all investors.
    The issues we face are enormously complex and we certainly 
do not have all the answers. We believe it is time to revisit 
the historic responsibility to provide a fair and orderly 
market. Thank you.
    Chairman Reed. Thank you very much, Mr. Brooks.
    Mr. Concannon, please.

   STATEMENT OF CHRIS CONCANNON, PARTNER AND EXECUTIVE VICE 
                PRESIDENT, VIRTU FINANCIAL, LLC

    Mr. Concannon. Chairman Reed, Ranking Member Crapo, Members 
of the Subcommittee, I want to thank you for the opportunity to 
appear before you today. My name is Chris Concannon and I am 
the Executive Vice President of Virtu Financial.
    Virtu Financial is a global electronic market maker. We are 
a market maker on over 100 markets around the globe. We make 
markets from our offices in New York, L.A., London, Dublin, 
Singapore, and Sydney. The company's market making activity 
spans across multiple asset classes, including cash equities, 
fixed income, currencies, futures, options, energy products, 
metals, and other commodities.
    Virtu operates as a registered broker-dealer in the U.S., 
as a registered investment firm in Europe and in Asia. We are 
also a market maker on the NYSE, the NASDAQ Stock Market, the 
BATS Exchange, NYSE Arca, and NYSE Markets. And in Europe, we 
are a market maker on the London Stock Exchange, the Swiss 
Stock Exchange, Euronext, and Deutsche Bourse.
    In discussing the state of the U.S. equity market, I start 
from the premise that our equity markets are the most dynamic 
and the most efficient markets in the world. My firm trades 
across all major financial markets and no market can compare to 
the U.S. equity market in terms of pricing efficiency and 
liquidity. Over the last 4 years, I have witnessed an 
unprecedented number of claims that our markets are horribly 
broken, unfair, and dangerous. These claims tend to be short on 
facts and evidence, but long on press coverage and book deals.
    Let me be clear. Our markets are not perfect. It has flaws 
and unnecessary complexity. The U.S. equity markets is overly 
fragmented and likely over-engineered. Stocks in the U.S. trade 
electronically on 13 national securities exchanges and over 50 
dark pools. If we had a blank canvas and we were able to redraw 
our entire market structure, it would never look like the model 
that we use today.
    I would like to focus on three areas that I believe deserve 
further review: First, our choice of a single market structure 
for all listed securities; second, our market's failure to 
enhance market maker obligations; and finally, the industry's 
current risk management standards.
    First, our market is currently designed as a one-size-fits-
all. What I mean by that is that most of our major market 
structure rules do not distinguish between the size, the market 
capitalization of the listed company, or the trading 
characteristics of their stock. Our markets are designed to 
execute all stocks, regardless of shape or size, using the same 
market mechanism. A stock that trades once per day is traded in 
the same market structure as a stock that trades one million 
times per day. It is like we are putting a bicycle on the fast 
lane on a highway and wishing it luck. I believe we should 
revisit our current market structure in order to create a 
better pricing mechanism for all stocks of different shapes and 
sizes.
    My second area of focus is our market's failure to enhance 
market maker obligations. While my firm is a market maker and 
it is easier for me to call for enhanced market maker 
obligations, I fundamentally believe that we need to increase 
obligated liquidity in our markets. Flash crashes, miniflash 
crashes, and other market disruptions demonstrate the need for 
additional obligated liquidity in our market. However, I 
believe enhanced market maker obligations should be targeted 
where they are most needed, and that is in the less liquid 
stocks.
    My final area of focus is the industry's current risk 
management standards. In light of recent events, I believe that 
the industry should explore ways to improve its risk management 
standards. First, pretrade risk management limits are already 
required by the Securities and Exchange Commission under the 
market access rule. Under that rule, which has been in effect 
for over a year, firms are required to establish pretrade 
credit limits for every customer account, and more importantly, 
for the firm's own proprietary account. These credit limits are 
a firm's primary defense against unwanted trading activity by 
the firm or its clients.
    Second, the industry is currently exploring specialized 
kill switches that would be administered by the exchanges. 
These kill switches would be a systematic shut-off of a firm if 
it exceeded prescribed or preset trading limits. Kill switches 
would not be a primary defense but rather a secondary defense 
to backstop the failure of other risk management measures 
operated by the firm. Kill switches have operated effectively 
in the futures exchanges for many years. Such a kill switch 
would have severely limited the damage done on August 1.
    The third component to enhanced risk management is one of 
the most important, I believe. A simple feature referred to in 
the industry as drop copies should be required as a risk 
management tool. Drop copies are separate and distinct 
connections offered by exchanges and other markets. Drop 
copies, which are widely used by the industry, provide a real 
time echo or copy of a firm's trading activity on a given 
exchange.
    A good example of how drop copies work is if you are on 
Amazon or iTunes and you click that ``purchase'' button, you 
get a confirm that pops up in your window. At the same time, an 
email is sent to you. That is exactly how a drop copy works in 
our industry, and these drop copy emails are actually very 
helpful. I recently had my 12-year-old daughter--she actually 
became a rogue trader on iTunes. So luckily, the drop copy 
emails informed me that she was a rogue trader and I put in a 
kill switch.
    [Laughter.]
    Mr. Concannon. While I believe firms should have a robust 
process for developing and testing new software, the industry 
must have advanced risk management systems to limit the risk of 
unintended trading activity by a firm or by its clients. We 
know with certainty that software has bugs, hardware crashes, 
and networks go down. The industry must build risk protections 
that assume the worst while a robust development and testing 
process avoids the worst. Pretrade risk checks, kill switches, 
and real time drop copies protect us from the worst events.
    Thank you again for the opportunity to be here. I would be 
happy to take questions.
    Chairman Reed. Thank you very much, Mr. Concannon.
    Mr. Tabb, please.

 STATEMENT OF LARRY TABB, FOUNDER AND CHIEF EXECUTIVE OFFICER, 
                           TABB GROUP

    Mr. Tabb. Good morning, and thank you, Chairman Reed, 
Ranking Member Crapo, distinguished Senators. I am Larry Tabb, 
founder and CEO of the TABB Group, a financial markets research 
firm. We provide research and advisory services to financial 
markets firms regarding how the markets operate and how 
investors perceive the markets and the brokers who serve them. 
I am also a member of the CFTC High-Frequency Trading 
Committee. I would like to thank the Committee for this 
opportunity to present my views on computerized trading and 
equity market structure.
    Unfortunately, the structure of the U.S. equity markets has 
come under scrutiny, from high-frequency trading, to the Flash 
Crash, to Facebook and BATS IPO challenges, to the latest 
Knight Capital Group technology issue. Market professionals as 
well as the general public are concerned that the U.S. equities 
markets are not functioning effectively.
    I have submitted a 20-page paper answering the six 
questions that the Committee has defined to that end. I will 
only summarize my answer to question six. What, if any, policy 
changes should be considered by regulators, Congress, in order 
to better protect investors, maintain fair, orderly, and 
efficient markets, and facilitate capital formation?
    My first statement is do no harm. The U.S. markets are the 
deepest and most liquid on the globe. The markets are also 
complex and interrelated. Small changes can cause significant 
impact. So, first, do nothing radical. A radical shift of 
market structure will unquestionably hurt investors. Radical 
changes provide incentives to traders to analyze rule changes 
and profit off of them. This will only cease once investors 
pressure brokers and brokers develop better countermeasures. It 
can take years to restore this equilibrium.
    To that extent, what I would do, first, defragment the 
market. While we do not want to limit competition too much, 13 
equities exchanges, 50 or so ATSs, and who knows how many 
internalizing brokers is too many. Stop granting new exchanges 
and ATS licenses immediately. Determine the optimal number of 
exchanges, ATSs, and internalizing brokers, and as these 
entities go bankrupt, merge or consolidate exiting firms and 
reduce the number of licenses.
    Second, better manage broker ATS solicitations. An order 
for 50,000 shares can easily be executed in 200 trades across 
various venues. Understanding what happens to this information 
is very, very difficult. While institutions typically receive 
execution information, it is more difficult to tell where these 
orders were routed and not executed. Where these orders were 
not executed leaks information into the market. Between brokers 
soliciting the other side, ATSs routing to each other, and 
exchanges routing to ATSs, virtually all professionals that 
have wanted to trade against this order have seen it before it 
is displayed to the public.
    Third, better manage MPVs, minimum price variations. 
Currently, we have a minimum 1-cent MPV for all stocks over a 
dollar. I would follow the direction of the JOBS Act in 
implementing a test program to widen spreads for less liquid 
and smaller capitalized stocks.
    Fourth, greater transparency of order types and routing 
mechanisms. Currently, most exchanges post their order types. 
However, these descriptions are not intuitive. Exchanges, ATSs, 
ECNs, internalizers, and even brokers need to begin to provide 
greater transparency, descriptions, and concrete examples how 
each order type works, how fees and rebates are generated, 
where in the order book orders show up, how and when orders are 
routed, and how these orders change under various market 
conditions.
    Five, develop a market-wide consolidated audit trail for 
equities, futures, and options. Develop incentives that will 
facilitate the cooperation of the SEC, CFTC, and various SROs 
to ensure harmonious oversight. Develop clear rules on what 
manipulative behavior is in electronic markets. Provide 
regulators the tools and people who can understand the market, 
find the people and/or machines that are driving manipulative 
behavior, and give the regulators the power to stop, fine, and 
jail manipulators. If we had confidence that our regulators 
were able to effectively police the market, it would give the 
public more confidence that pernicious behavior was being 
flagged, challenged, and resolved. It would provide investors 
with the assurance that our markets are safe again for trading, 
investing, and raising capital.
    I would like to thank the Committee for allowing me to 
present TABB Group research and my personal thoughts on how to 
fix the U.S. equities market structure. If there are questions, 
I would enjoy answering them at this time.
    Chairman Reed. Thank you all very much for excellent 
testimony. I think what you have made very clear is this is a 
complex issue, that you have raised extraordinarily important 
questions. It is going to take us a while, I think, to come to 
the answers, but this is the first step. In fact, in 
collaboration with my colleague, I would assume we would 
entertain other hearings in this regard because this issue is 
not a one-stop and quick fix and move on.
    But in that spirit, one of the issues--I was particularly 
struck by Mr. Brooks' comments about the issue of speed in 
conflict with market integrity. And this issue has been raised 
in many different venues, even by people back home in Rhode 
Island. Are these markets just too fast now? Are we losing 
something bigger? And let me pose this to all the panelists, 
your thoughts briefly on that. We will do a 7-minute first 
round and then we will come back for a second round and more, 
and we have the luxury of asking some questions.
    So this whole issue of speed. Are things too fast, and if 
that is the case, how do you slow it down? Mr. Lauer, do you 
want to comment first, and then Mr. Brooks, and Mr. Concannon.
    Mr. Lauer. I would love to. Thank you, Senator. I think 
that the issue of speed is a critical one, absolutely. And the 
idea of slowing things down is difficult. These are, as you 
said, complex issues. I think that speed for speed's sake is 
now being well proven to create very little social welfare and 
utility.
    There is an interesting study that came out on the 
externalities of high-frequency trading and they examined two 
consecutive technology shocks which increased--or decreased 
latency from microseconds to nanoseconds. And while they found 
that it dramatically increased trading speed and the 
cancellation ratio, there was no impact on trading volume, 
spread, depth, or pricing efficiency. So I think we have found 
a limit to the benefits of speed, and this is well supported 
empirically.
    There are some ideas around. One of those is a minimum 
quote life, as I mentioned in my oral testimony and my written 
testimony, as Mr. Brooks has, as well. I think that that is an 
interesting first step and I think it is worth a pilot program. 
I completely agree with Mr. Brooks that we need to be trying 
new ideas out. We need to be going through some pilot programs 
and finding out what the impact of these things would be, 
because we can simply surmise on what the impact of a 50-
millisecond quote life would be, but we do not really have a 
perfect sense.
    That same study found that between 30 to 40 percent of 
market data was--are quotes that were put into the market and 
canceled within 50 milliseconds without being traded on, and 
the cancellation rates on quotes that are out there for less 
than 50 milliseconds is, I believe, over 96 percent. So I do 
believe that is one area that we can look at.
    Chairman Reed. Mr. Brooks, and then I am going to make sure 
everyone has a chance to answer this question.
    Mr. Brooks. Thank you. I think our sense and what we hear 
from our clients is really that the marginal return for 
investors is perhaps negative with the increasing speed. So it 
begs the question, why do we need to be faster? Who benefits 
from that? And I think our question and our concern is, who is 
the speed for? We do not think it is for investors. So that 
means someone else is interested in speed and maybe their 
interest is not as genuine, if you will, when you think about 
who are the markets supposed to serve.
    So it is a very complex issue. I appreciate the Chairman 
acknowledging that as we work together to find solutions. But 
there is a concept that speed kills on the highway. You 
referenced the highway analogy. So I think speed causes us 
great anxiety.
    Chairman Reed. Mr. Concannon, please.
    Mr. Concannon. Thank you. I think speed is--and I agree 
with the panelists that it is one of the more difficult issues 
to address, because if you do conclude that we need to regulate 
speed, we then are left with the question, at what speed should 
we all move at? And we then may move to the slowest common 
denominator in terms of speed. Speed and the ability to post a 
quote and cancel a quote, they all, in turn, are frictions in 
the market. And we have reduced frictions to the most extreme 
levels to create what is the most efficient market around the 
planet.
    We see today--we do not need a pilot--we see markets that 
we trade in that have minimum quote life, and the impact is 
spread. If you are posting a quote in the market as a market 
maker, you are taking risk. You are posting actually an option 
to the market, a free option for them to execute against you 
when the intrinsic value of that asset changes. That free 
option will be adjusted based on the life of that option, which 
ultimately is the minimum quote life. And so there is an actual 
impact to our market structure when we slow down the market.
    Do I think we have reached an equilibrium in speed? Yes. I 
do not think moving mics--one or two mics further--is adding 
any value to the investing public. But of more concern is 
slowing down the market to some common denominator.
    Chairman Reed. Thank you.
    Mr. Tabb, please.
    Mr. Tabb. My issue, my concern, is that--I agree with the 
panel that we have gotten faster than we can probably handle. 
The challenge is, how do you actually stop it, and what happens 
if you stop it?
    So the first issue would be, is, OK, so I have a 50 
millisecond or even microsecond minimum quote life. What 
happens and who manages that? So if I am a trader and I have a 
minimum quote life, am I constantly pinging the exchange to 
take me out, take me out, take me out, and they say, no, no, 
no, no, no, and I say, take me out, take me out, take me out, 
and they say, no, no, no, no, and finally 50 microseconds 
happens and then all of a sudden we have created all this 
extraneous traffic that bogs down the rest of the market, just 
all these messages to get me out and how is that managed.
    The second issue becomes, is we constantly have folks like, 
you know, Intel and IBM and Cisco and networking companies 
speeding up the clocks like with chips. Do we just say, OK, you 
cannot use the best computers anymore, and how do you manage 
that and who governs? Do we go to, like, a stock car race where 
everybody needs to trade out of the same computer, and how does 
that work and operate?
    And then once you get two or three levels behind, you know, 
behind actually operating specifically on the exchange, do I 
actually know what my customers are doing or their customers 
are doing and how do I manage that, as well?
    So there are a lot--yes, we have kind of gotten to the 
point where the market is too fast, but to a certain extent, 
maybe the answer is that the folks like Andrew need to actually 
complain to their brokers to have them do a better job of 
managing the execution of their orders. And if they do not like 
the execution, fire their broker.
    Chairman Reed. I am going to yield to Senator Crapo, but I 
have another series of questions, because I think there are 
some major issues here that the whole panel ought to address 
and I would like the comments. Just to sort of preview, one is 
the issue of fragmentation, the issue of market maker 
obligations, and there are probably a couple of others. And 
Mike, if you want to get into them, be my guest, but Senator 
Crapo, please.
    Senator Crapo. Thank you very much, Mr. Chairman.
    I have a question, first, for Mr. Concannon. What kind of a 
system does your company have in place to avoid erroneous 
events?
    Mr. Concannon. Thank you. Well, we have a number of systems 
in place, what we call filters, and filters will trigger a 
lockdown to our trading system. So if we place an order that 
the filter determines is out of range from the price of the 
market, it will stop that order from entering the market and it 
will shut down the actual trading strategy, and that works all 
day long, and it has been in existence for many years. It is 
actually a component of the SEC's market access rule, so it is 
now technically required to have in place. Every time you send 
an order, whether it is for your own account or your client's 
account, you have to filter for an erroneous order entering the 
market.
    Senator Crapo. So this is basically an industry standard at 
this point?
    Mr. Concannon. Absolutely. It is an industry standard.
    Senator Crapo. My next question is--I would like you to 
answer, Mr. Concannon, but also, I would like to have the 
entire panel weigh in on this, if you would. Yesterday, there 
was a Wall Street Journal article about order types called 
slide and hide. The article suggested this order type allows 
high-speed firms to trade ahead of less sophisticated 
investors, potentially disadvantaging them and violating 
regulatory rules. What is your perspective on this?
    Mr. Concannon. That is a great question. First of all, our 
firm does not generally allow exchanges to slide our orders. I 
do not know if you have noticed, but----
    Senator Crapo. How does this work?
    Mr. Concannon. Sure. The way it would work would be you 
would place an order that locks the market, and what that means 
is it is an order that would otherwise execute against a quote 
in the market and that order would be restricted from being 
posted and locked. So the order type, the slide order type, 
would slide your order back to what is a compliant price and 
post it at that price.
    The problem with that order type is it is not permitted for 
any broker to take an investor's order and slide it. So it is 
not actually an investor-used order. So there is no broker that 
says, I have an order that is marketable, because it will lock 
the market, and I am going to have an exchange slide it back to 
a different price. That is a violation of Best X and they 
cannot use it that way. So that order type--they would actually 
have to, because it is a marketable order, they would have to 
execute it, or execute it against the quote in the market.
    That order type is mainly used for professional traders. So 
the issue is, does that slide order used by a professional 
trader, have they read the rules that the exchange filed with 
the SEC that were published and did they understand the order 
type that they were using? It is not that investors, retail 
investors or even Mr. Brooks' firm using that order and being 
disadvantaged. His broker cannot use that order and slide his 
orders when they would otherwise execute at the market price. 
So it is really an issue of professional trader versus 
professional trader, trying to understand how the order types 
work.
    Senator Crapo. Mr. Lauer.
    Mr. Lauer. Yes. Thank you, Senator Crapo, if I may. I think 
that hide, not slide, and many other order types are great 
examples of complexity in the marketplace, and at times, not 
necessarily complexity for complexity's sake but perhaps 
unjustified complexity. I think that the bar for approving new 
order types needs to be revisited, and I think that it would be 
a great service to reinstilling some confidence in the 
marketplace if it was easier for the average person to get 
their head around what these order types mean.
    And the fact that we need so much explanation for just this 
one order type, let alone--I mean, there are, as Mr. Brooks 
said, a thousand order types if you take individual ones at 
each market center. There are so many order types that it 
just--it is something that people who are not in the business 
have a very difficult time with and there is absolutely no 
reason they should not have a difficult time with that.
    Normally, the bar for regulating and passing rules is very 
high. It demands a lot of study and justification as to the 
utility of a new rule or regulation, and I think that that same 
standard should be applied to all of these exotic order types. 
And there should be, at this point, a great amount of evidence 
as to the utility of these order types because they have been 
around for a while now. I think that that would be an 
interesting exercise to go through.
    Senator Crapo. Mr. Brooks or Mr. Tabb, do either of you 
want to weigh in?
    Mr. Brooks. Thank you. I think the only thing we might 
suggest is that we might refer to the point Mr. Lauer made, and 
that is it really has added complexity to the marketplace and 
we are wondering why. Why is someone trying to make things more 
complex? And at the Georgetown conference yesterday that you 
all referenced, there was some discussion about whether it 
would make sense to have a moratorium on approval of new order 
types until the marketplace can really come together and get 
their arms around, what are we doing here? Why do we need so 
many ways to express trading interest? And is there something 
else going on? So it is a question that is troubling and we are 
not sure what the answers are.
    Senator Crapo. Mr. Tabb.
    Mr. Tabb. I do not disagree. I think that--and in my 
written testimony, or my oral testimony, I presented, I think, 
that we need much more transparency on these order types. 
Should the SEC be looking over these in more detail? I think, 
yes. I think that many of the order types that are out there 
are not well known, even to professional investors. And I think 
that greater transparency and reducing the number would 
probably be a good thing.
    Senator Crapo. Yes, Mr. Concannon.
    Mr. Concannon. On the topic of order types, I mean, I do 
agree that we have way too many order types, but before Reg 
NMS, before that rule was installed in our marketplace, we had 
very few order types. We had market orders and limit orders. It 
was with the complexity of Reg NMS that interconnected all of 
our markets and gave us 50 dark pools that we ended up with all 
these order types.
    And I do have to disagree. I heard--I read in testimony of 
a rubber stamp approval at the SEC. I personally filed order 
types. There was no rubber stamp approval. It would take 6 
months or longer to get these order types approved, and people 
like Robert Cook and David Shulman and Bob Colby are far from 
rubber stamping order types and they have never rubber stamped 
order types. So it is a difficult process to get these things 
approved. They are analyzed. There are far too many. But those 
order types all came because of Reg NMS.
    Senator Crapo. Thank you.
    Chairman Reed. Well, thank you, Senator Crapo, and again, 
the questions are, I think, right on target and the answers are 
not only interesting, but provoke further questions.
    Let me take up some of the issues that were suggestive of 
some additional testimony. I go back to the issue of 
fragmentation, of which you all commented upon, and just give 
you an opportunity to add anything further that you might want 
to say with respect to the issue of the fragmentation.
    One of the ironies is that the national markets were put in 
place because there was an oligopoly operating, and now we 
have--have we created--sort of gone too far in the other 
direction. I think, Mr. Tabb, you could begin.
    Mr. Tabb. I think we have gone too far. I think that while 
it does not sound like a bad thing to fragment the markets and 
have multiple places to trade and have competition, every time 
a message pings off a market, a dark pool, an internalizer, it 
releases information. And so with trying to find the other side 
of the trade, information is bouncing all over the place that 
investors do not really even know that is occurring. And I 
think, to a certain extent, it disenfranchises the investor and 
leaks information.
    That said, on the other side, there are organizations who 
spend a lot of time, money, and effort building up their 
liquidity pools and their businesses. You cannot really just 
say, OK, tomorrow, they do not exist. I am not sure eminent 
domain would be a great idea.
    So the question then becomes is how do you defragment them 
and how do you do it in a fair way, and I do not know the 
answer to that, but I think we clearly have too many places to 
trade.
    Chairman Reed. Mr. Concannon.
    Mr. Concannon. Well, when we take a look at our market and 
we see 13 exchanges, 50 dark pools, you have to understand that 
in every stock, there is a bid or an offer finding its way in 
one of those liquidity zones. And what that does is it thins 
out our overall liquidity. So on a normal day, it works. On a 
day of high volatility, like May 6, that thin layer of 
liquidity is easily pierced. When it is not consolidated in one 
place, you can pierce through that liquidity and you have the 
volatility that we saw that day. So fragmentation has caused 
increased volatility, but I agree with Larry. It is very 
difficult to consolidate that market. Again, on an average day, 
there are dealers that are professionals that try and 
consolidate that market and it is a very liquid market despite 
the fragmentation. It is really those days that we have shocks 
and events.
    Chairman Reed. Mr. Brooks, do you have any comments? Mr. 
Lauer? Mr. Brooks.
    Mr. Brooks. Senator, if I might, I do not think we know the 
answer in terms of what the perfect number of exchanges or dark 
pools might be, but we do wonder and hear others question 
whether the system, with all these different venues, can 
process the data that is being generated. I mean, there is just 
an enormous amount of data, and some of that data gums up the 
system and slows it down and that is troubling.
    And, two, to pick up on Mr. Concannon's point, it is 
awfully hard to figure out the supply demand equation in the 
stock today when there are so many different places that 
trading interests reside. So if you are trying to find out if 
there is more to buy or more to sell, good luck. It is tough 
today.
    Chairman Reed. Mr. Lauer, a comment, and then I have 
another question.
    Mr. Lauer. Yes. I think that what we have seen with this 
massive fragmentation and internalization and dark pools, as 
Mr. Concannon alluded to, is what is called adverse selection. 
As order flow goes from place to place, from retail 
institutional investors, before it makes itself--before it gets 
to the lit exchange, it is picked off at every step of the way 
by internalizers, by dark pools, by high-frequency traders, 
proprietary trading desks. And, therefore, the flow that 
eventually gets to the lit exchanges is what we refer to in the 
industry as toxic flow that nobody wants to trade with. And 
what we have done is we have reduced the number of natural 
buyers and sellers in the market, as Mr. Concannon said when he 
was just answering. So I think that that has been one of the 
dramatic effects of fragmentation, internalization and dark 
pools.
    There was a study out of Rutgers that demonstrated that 
because of all the off-exchange executions, spreads are 
widening in lit exchanges by an average of 1.28 cents on the 
New York Stock Exchange, and that is a dramatic effect and it 
is a direct result of this adverse selection because it becomes 
harder to be a profitable market maker in such a scenario.
    I think that we can take a cue from other countries in this 
regard and we can raise off-exchange execution standards. We 
can say that you must meaningfully price improve in order to 
internalize, and meaningful price improvement does not mean a 
tenth of a cent. In Canada, they have one standard that says at 
least a tick size, a minimum tick size, and if the spread is 
one penny, then at least half a tick size. They also have a 
minimum order size. So if you are going to internalize or 
execute on a dark pool, it has to be an especially large order. 
That is why you have dark pools and that should be the 
reasoning behind that.
    I also think that eliminating pay for order flow is an 
important step in order to combat this adverse selection 
problem.
    Chairman Reed. Thank you. Let me raise another topic, and 
that is this issue of market making. Mr. Concannon, your firm 
is a market maker in several different venues. And related to 
this, and it might not be precisely related, is another issue 
that we hear about and was referred to in the testimony is 
people coming into markets, making a bid and then canceling it 
within fractions of a second, sort of probing, which creates 
more information but is not the traditional, what people think 
what markets are, where someone really wants to buy something 
and they are looking for the best price and when they get it, 
they are going to close the deal.
    So this whole issue of market making obligations on 
everyone, which I think you raised in your testimony, can you 
comment upon it? Then I will ask Mr. Tabb and then everyone 
else who wants to make a comment. Please.
    Mr. Concannon. Sure. I think if we go back 20 years and we 
look at our market makers, they had fairly strict obligations, 
people like specialists on the floor, but they had exceptional 
benefits. They had exclusive rights to the market and the 
incoming order, and that was worse than the benefits that they 
provided as market makers. So we made a decision and we changed 
our markets to be an all to all.
    And I do believe in some products that all to all model, 
where anyone can be a market maker or market maker obligations 
are light, at best, we lose a little bit in terms of liquidity. 
And so there are stocks that I do not necessarily think they 
need obligations and market makers all day long, every minute 
of the day, but the good majority of our market really needs to 
be supported by market makers with real obligations to be at 
the best bid or offer.
    The most important thing for me in terms of market maker 
obligations that do not exist is that not only should you be at 
the best price, but you should be at the next best price and 
one more price below that. You need to provide--a real market 
maker makes depth of liquidity markets, not just a thin layer 
at the best bidder offer.
    Chairman Reed. Mr. Tabb, your comments.
    Mr. Tabb. I agree. I think that we should have some sort of 
market maker obligations. Now, that said, market maker 
obligations is not a panacea. If we wind up having some sort of 
crash, people will not step in front of a train, catch a 
falling knife, whatever analogy you want to make. They are not 
going to go out of business because they have an obligation. 
But that said, in the general market or general interday 
volatility, I believe we should have stronger market making 
obligations.
    Chairman Reed. Thank you. Comments, Mr. Brooks, Mr. Lauer? 
Mr. Lauer.
    Mr. Lauer. Yes. Thank you, Senator. I believe that--I 
completely agree with Mr. Concannon and I think that market 
making obligations should be the cornerstone of any new 
efforts. And I believe strongly that they should be tied to 
receiving a rebate on any venue in which securities are 
transacted, be they an exchange, ATS, ECN, dark pool. Any place 
that somebody can receive a rebate, that rebate should be tied 
to an obligation to make markets.
    And as I explained in my written testimony, one of the 
better studied and more beneficial models is what is called the 
maximum spread model. I think the way obligations have been 
done in the past is normally something like a 90 percent of the 
time you need to be in the market. There are other models, but 
that is a standard one, and both Mr. Concannon and Mr. Tabb are 
correct that that would not address the issues of a crash or a 
flash crash, which is why I think we need to examine much more 
stringent market making obligations. And some studies have 
developed some models for that that do demonstrate they would 
prevent flash crashes and that the market makers in some 
instances would have to be compensated for their losses. But 
the overall improvement in social welfare far outweighs the 
cost to that compensation.
    Chairman Reed. Mr. Brooks, you have a comment, and then I 
will yield.
    Mr. Brooks. I do. Thank you. I guess our thought would be 
that if you are going to receive a benefit as a market maker, 
you have to provide one, as well.
    Chairman Reed. Thank you.
    Senator Crapo.
    Senator Crapo. Thank you, Mr. Chairman.
    As I listen to the different issues being raised here and 
the potential solutions, a question occurs to me. This is a 
broad question and I would like to ask each of you to just 
weigh in on it, if you would. What do you think the top two or 
three issues or solutions to these issues that we are 
discussing here should be, the SEC should consider in its 
October roundtable? What are the top areas of focus we should 
recommend to the SEC or see them consider? We will just start 
over here. Mr. Lauer.
    Mr. Lauer. Thank you, Senator. The roundtable is a 
technology roundtable, and as such, the number one thing should 
be market technology standards, policing, the kill switch that 
has been referred to on the panel, these types of issues. As I 
pointed out in my written testimony and my oral testimony, I 
think we should also--we need to get more creative. The SEC is, 
I believe as Senator Reed said, hopelessly outgunned. They need 
a pretty dramatic improvement in their technology capabilities. 
The market is a market based on technology. I am a 
technologist. I would never argue to move backwards. I would 
only argue to move forwards.
    But the SEC needs to take a market-wide approach to 
surveillance and enforcement. They need to build a strong 
market data plan. And if they could open access to market data, 
which is a controversial issue, they could really inspire some 
novel approaches, some creative thinking by independent 
programmers, a model that has been demonstrated time and again 
to be very successful for developing really interesting 
applications and inspiring new innovation, and that is 
something--a change in mindset that I would be very pleased to 
see.
    Senator Crapo. Thank you.
    Mr. Brooks.
    Mr. Brooks. I think our sense would be that perhaps three 
things for the technology crowd to look into. One would be 
order routing practices. Why are orders going where they are? 
What is driving that?
    Payment mechanisms, so maker-taker payment for order flow 
internalization. At some point, it is all about the money, so I 
think that is an important conversation to have regarding 
technology.
    And finally, we are concerned and our clients are concerned 
about the sense of unfair advantage that market data 
aggregators are giving to others and the sense that you get a 
view of the horse race's finish before anybody else, and I 
think technology needs to address that.
    Senator Crapo. Thank you.
    Mr. Concannon.
    Mr. Concannon. Well, obviously, this roundtable was 
scheduled because of the summer of technology mishaps that we 
experienced. I think the focus will largely be on the proper 
testing that we deploy, the processes that we put around our 
new code that we roll into production, both exchanges and 
broker-dealers.
    But I hope the focus will be more around what happens when 
something goes wrong. We will always have bugs in our code. We 
will always have network gear breakdown. We will have networks 
flat. Those all cause disruptions that we have to build risk 
management procedures around. So we will never get rid of the 
bugs. We will never get rid of the mishaps. But it is how we 
respond to them that is more critical.
    I actually think a very simple adjustment to the SEC's rule 
on market access is all that needs to be made. If we--we 
already have pretrade covered, so if everyone complied with 
pretrade, we are going to protect ourselves from what goes out 
the door. If we install these kill switches at the exchanges 
that are not that difficult to deploy, we can make the kill 
switch setting part of your market access obligation. So a 
broker has to justify his setting in the kill switch to the SEC 
when they come in and inspect.
    And the final piece that I mentioned, the drop copy piece, 
that covers your post-trade. So even if you miss something, 
even if an exchange creates risk for you because of an outage, 
you will still know on your post-trade, your drop copy, that 
there is someone trading in your name and you can check that 
against your risk procedures.
    And all three items would be part of the market access rule 
and would be all part of your procedures that you roll out for 
the SEC when they examine you.
    Senator Crapo. Thank you.
    Mr. Tabb.
    Mr. Tabb. I agree with a lot of what Mr. Concannon said 
about the kill switches and risk issues. One of the other 
issues, though, is that to a certain extent, some of these 
rules that the SEC has put in actually have not done--have not 
been specified properly and actually do not really work. And so 
I think the SEC really needs to do a better job in terms of how 
they specify some of their rules, like the direct access rule 
did not help Knight. It is supposed to be across asset class, 
but nobody has got cross-asset class capability now.
    Linked markets--it is very easy to do pretrade risk in a 
single market, but once you start trading across 50 markets, it 
becomes very hard to manage all that pretrade risk and you wind 
up with people raising their credit limits just so that they do 
not have to deal with it.
    The large trader rules were specified out of the wrong part 
of the data base that does not actually have trade data from 
the dealers. It would be nice if they actually took the time to 
actually understand what they are specifying.
    So, now, getting back to my other thought of defragmenting 
the market, so if you look at market data, the issue is if I 
have a market and I am a market maker, even if no one trades 
there, I have got to quote every name that I am going to quote. 
So if I have two markets, all of the liquidity is here but I 
decide to quote over here, as well, so I have got all of a 
sudden twice as many quotes, which is kind of on a logarithmic 
scale in terms of amount of market data. So if we start pruning 
back the number of exchanges and licenses, we will wind up 
actually minimizing some of the market data challenges.
    And last is we really do need a consolidated audit trail 
and a set of regulators that can actually look over this stuff, 
because at the end of the day, if the SEC is bringing people to 
task, we will have a little bit better confidence that they 
have their eye on the switch, you know, their eye on the wheel.
    Senator Crapo. Thank you very much.
    Mr. Lauer. Senator, if I may, just a quick comment----
    Senator Crapo. Yes.
    Mr. Lauer. ----along the lines of the consolidated audit 
trail, another important idea. The problem with the 
consolidated audit trail, while it is a fantastic idea and 
critically needed, it is years away. If we right away said, 
from now on, when you put a quote into the market, you have to 
include a unique ID number, either on a per account basis, like 
the consolidated audit trail specifies, or on a supervisory 
individual basis, and that ID number is propagated not publicly 
but down to regulators, into their market data plan, it would 
have a dramatically chilling effect on manipulative behavior 
and it would allow regulators to quickly reconstruct what 
happened within the markets. It would allow them to enforce the 
existing rules. And it would also provide a contact point to 
quickly identify what is going on in an emergency. And I 
believe, technologically, that is a very easy task for current 
exchanges and their customers to take.
    Senator Crapo. Thank you.
    Chairman Reed. Thank you very much, Senator Crapo. I have a 
few other questions. My colleague has to depart for an 
interview, but I want to thank him. I thought it was an 
excellent question, to try to focus on the SEC panel. As you 
point out, it is generally a technology focus.
    We have talked about technology, but also really important 
policy issues, the number of orders that are available, et 
cetera, and I just have two general questions. And first, Mr. 
Tabb and others that might want to comment, one of the things 
that has happened over the last several years is the 
proliferation of these dark pools and it raises the question of 
should there be a sort of uniform set of rules or conduct or 
behavior that apply to the dark pools as well as to the lit 
exchanges, and just any thoughts you might have.
    Mr. Tabb. A very good question. They are definitely 
regulated in separate ways and the exchanges would certainly 
like an even playing field. And to a certain extent, I agree 
with that.
    The one challenge academically, and to a certain extent--
and I think Mr. Brooks was talking a little bit about this, I 
think, earlier--I think it was Mr. Brooks--is that what Reg NMS 
did was infuse a single kind of market structure, a fast market 
priority over slow markets, and what winds up happening is that 
once you wind up having a trade-through rule and you wind up 
having the same priorities across markets, in effect, what 
happens is the markets become tighter, more tight, more closely 
linked together, and problems can cascade through them. And so 
by then even tying together the dark pools with the exchanges 
in a trade-through mechanism, what you are going to--you might 
even create more fragility because then everything has to work 
exactly the same way, and keeping, you know, 13 exchanges and 
50 dark pools lined up like that may be really difficult.
    One of the answers may actually be to get rid of the trade-
through rule and let markets develop a little bit more 
naturally. I think that was Mr. Brooks. Maybe it was Mr. 
Concannon was talking about that earlier. And that one market 
structure actually does not fit all. What you may want to 
actually do is actually what Mr. Lauer said, is have some sort 
of trade-at rule which basically says, you know, you cannot 
have de minimis price improvement and you need to price improve 
at least a half a tick or something like that to bring more 
liquidity into the market centers.
    But, by and large, it is a complicated--it is a complicated 
issue. I do not know what the right answer is.
    Chairman Reed. I concur.
    [Laughter.]
    Chairman Reed. Any other comments on this question, and 
then I have one more general question. Mr. Concannon.
    Mr. Concannon. Sure. I am actually fairly sympathetic to 
the exchanges' situation. They are--they do have competition in 
the market called the dark pool. They are subject to heightened 
obligations as an exchange. But dark pools are registered. They 
are registered ATSs. They are subject to Regulation ATS. So 
they do have some of the components of the exchange regulation 
on them, as well.
    I think the one thing I am a little bit cautious about is 
the innovation in our market actually came from--not from the 
traditional exchanges, but from the original ATSs in our 
market. And today, those exchanges are actually former ATSs 
that were purchased by the exchanges. So I am concerned if we 
put too much regulation in the over-the-counter market for ATSs 
or dark pools that you will dampen that innovation in a market 
that we have enjoyed for many years.
    The other concern I have around dark pools is that it is a 
place for the buy side, people like Mr. Brooks, to feel 
comfortable about how their orders are handled and traded and 
not being pushed into the displayed market where people can 
find their orders and have an impact on the market. So there is 
a protective mechanism sitting inside the dark pool that is 
valued by the buy side and needs to be protected.
    Chairman Reed. Mr. Brooks, you have a comment.
    Mr. Brooks. I do, and I appreciate that, Mr. Concannon, 
because we do need protection because our orders are larger and 
a lot of the marketplace today is trying to identify our order 
flow and trade against it. So we are paranoid about that, and 
we should be, and I would suggest we have always been paranoid 
about that. So that is not new news.
    But in a perverse way, the dark pools' execution size, I 
believe, is not much greater than the lit markets, 200 shares. 
So what it was designed for, which might be to rest and hide 
order flow but be willing to trade, not get picked off, not be 
identified, it is not really accomplishing that for the most 
part. So that begs the question of what is going on in dark 
pools, and again, I think we all are somewhat challenged by 
truly understanding what is happening there and that needs 
further examination by all parties.
    Chairman Reed. Thank you.
    If you have a quick comment, then I have one more question, 
Mr. Lauer.
    Mr. Lauer. Sure. I would just agree that I do believe that 
some unification of rules is necessary across venues. I think 
that is very important. And I think that, as I said before, the 
burden to execute on a dark pool should be much greater than 
executing on a lit exchange because you are removing 
information and liquidity from the public domain and lit 
exchanges.
    Chairman Reed. You talked about the dark pool. Let us shift 
focus to the exchanges, which now are for-profit enterprises 
with proprietary operations, et cetera. And there have been 
some questions, concerns raised about proprietary data feeds, 
customers getting advantages over other traders, and the whole 
issue I think you raised, Mr. Brooks, in terms of your 
testimony, just about the standard of behavior that grew up in 
what was a utility more than anything else and now is a for-
profit enterprise. So any comments that you might have, and I 
will begin with you, Mr. Brooks, about any things that we 
should do given the nature of these exchanges as for-profit 
vehicles and their issues of proprietary feeds, colocation, 
access. That was brought up. Any comments.
    Mr. Brooks. So, again, you have picked a very tough 
question to pose to everybody in the industry. We certainly do 
not have the answers here, but it is challenging when exchanges 
have a for-profit motive and are interested in growing volume, 
and investors are not really interested in volume. They are 
interested in liquidity. And so those are two really different 
things.
    I am certain that exchanges can be profitable and can work 
well as a for-profit enterprise, but perhaps we need to 
understand really what their role should be going forward, who 
they should be serving, and by the way, what is the role of a 
broker-dealer today. These lines, as we stated earlier, have 
really become blurred and we need some guidance here. We need 
to bring together some great minds to really think through what 
does it mean to have these different roles and how should the--
it is sort of a Glass-Steagall question. What is appropriate to 
be separate?
    We are troubled by the blurring of the lines. We are 
troubled by market data aggregation and dissemination 
selectively. Certainly, I can understand that data should be 
gathered and it can be sold and we are OK with that, but equal 
access important.
    You know, when we think about things, when we talk to 
clients and shareholders, we are interested--they are 
interested in fairness and a sense of balance, and our 
Chairman, Brian Rogers, always says, how do we get back to 
fairness and balance? And I think that is a good question to 
always be asking yourself. Are things as fair as they could be?
    You know, we have a group of terrific, dedicated traders 
every day trying to find fairness in the marketplace for our 
investors and they do not feel so good about things. Things are 
moving on us. Things are--we are getting identified. People are 
taking advantage. There is opportunity being taken away from 
investors. It is the worst I have ever seen in my career, and I 
have seen a lot, not maybe as much as you have or others, but 
we have seen a lot of different things and it is a troubling 
time.
    Chairman Reed. Other comments? Mr. Concannon.
    Mr. Concannon. I agree that it is a very difficult question 
around proprietary trading--proprietary feeds that come out of 
the exchanges. If you look around the world, most markets do 
not have a consolidated feed. It is all--Europe is all based on 
the feed that comes from the exchange and the direct exchange. 
And so, commercially, people consolidate those feeds.
    I am encouraged when we think about in the U.S. that the 
proprietary feeds are being consumed by investors. Some of the 
biggest consumers of those proprietary feeds are some of the 
retail online firms. They do push those proprietary feeds onto 
their Web site. They do do a form of consolidation. And when 
those retail orders come into the market, they are executed 
based on the proprietary feed. So there is some fairness being 
in terms of how the proprietary feeds make it out to the 
investing public and how their orders are treated under the 
proprietary feeds.
    But what that leaves me with a question, is then what is 
the value of our consolidated feeds, and I was more shocked 
that--I think the fact that they were so slow and went 
unnoticed by the industry kind of speaks volumes in terms of 
their value to the industry.
    Chairman Reed. Anyone else? Mr. Tabb.
    Mr. Tabb. Yes. I kind of agree with Chris. I think that 
most professional investors--and I am not as familiar with the 
retail side, Chris would be much more familiar with it. On the 
institutional side, most of the large brokers who are servicing 
the large institutions use proprietary feeds. A lot of their 
algos and technologies are based off that. I do not know 
necessarily who uses the consolidated, the aggregated feed, the 
sites, things like Yahoo!.
    As we start getting issues around colocation and governance 
of that speed, I am--even if we ban--let us say we ban 
proprietary feeds and we only use the aggregated SIP feed. The 
issue also then becomes is where is it being intercepted and 
read, and with the speed of light, someone who reads it in New 
Jersey is always going to get it before someone who reads it in 
California and how do you manage that. And I am not sure how 
you wind up delaying it so everybody gets it exactly at the 
same time.
    Chairman Reed. Your testimony was a good lesson in physics, 
so thank you very much.
    Mr. Lauer, you get a final comment, and then I will 
summarize.
    Mr. Lauer. Yes. I think as far as colocation goes, there is 
a case to be made for eliminating colocation. The argument that 
is often made against it is exactly what Mr. Tabb has said. I 
think that, right now, if you can think about it, though, 
colocation has a very small radius of equality. You know, it is 
a very limited area in which people are equal. So if you 
eliminate that, you at least expand the boundary and widen the 
opportunity to many more participants. You can reduce the 
costs, as well.
    I do think there is a case to be made for it. As Mr. Brooks 
said in his opening statement, which I thought was 
illuminating, there is no other regulated industry in which 
access to information is sold for an advantage by somebody who 
can act before someone else. To me, colocation in some ways 
does reek of nonpublic information. I have a server. It is 
moving very fast. I can receive a piece of market data, analyze 
it, and act on it before many people have even received that 
piece of market data. And again, in my written testimony, there 
are several studies that have demonstrated that this race to 
zero is having no effect--no beneficial effect on market 
quality.
    I think as far as the number of exchanges in the for-profit 
exchange model goes, I think what we need is a diversity of 
business models. Right now, there is pretty much only one 
business model in the marketplace. That is the maker-taker 
model. And so I think that it is--the environment is ripe for 
innovative ideas, and, of course, in my work with IEX Group, 
that is what we are working on. But I would like to see many 
more like that. So we could have different forces of 
defragmentation reducing identical business models, but coming 
up with innovative new ways that really appeal to the investor 
community rather than the trader community, and that is what 
the maker-taker model does. The incentive structure is very 
skewed toward high-speed trading and volume rather than 
liquidity, which is a major distinction that needs to be drawn.
    Chairman Reed. I have just one final question which my 
staff reminded me, and this is in the wake of the volatility we 
have seen in the oil commodities markets. The inference in a 
lot of what we talked about today were equity markets, et 
cetera, but the interaction of electronic funds trading, 
commodity markets, high-frequency trading, et cetera, raises 
another issue about volatility.
    And this always comes up in the context, I think, 
particularly of oil and commodities. Is there a way to 
manipulate these markets, and either wittingly or unwittingly, 
is there the possibility, the potential, or the reality of 
manipulation, particularly given the incentive of oil to 
everything we do? And you might want to comment, Mr. Lauer, and 
then I will ask Mr. Tabb.
    Mr. Lauer. Yes. The answer is simply, yes. Absolutely, 
there is a way to manipulate prices and markets, especially 
with the current speed of systems right now, and what we see 
sometimes, which are these what are called illiquidity 
contagions or these miniflash crashes. There is well-documented 
evidence of practices such as quote stuffing, which is to slow 
down the channel of a direct proprietary feed in order to pick 
off participants that are slower or unable to keep up with a 
high volume of data.
    It is, in fact, well documented in one study that we see 
what is called comovement of message flow within channels, 
which is a rather shocking conclusion. Channels from a 
proprietary feed perspective are alphabetically distributed 
and, therefore, completely random, and you should expect to see 
no movement in the A through C channel. You would expect to see 
comovement of stocks in the same industry or exposed to the 
same macroeconomic factors. But the idea that there is going to 
be movement on a stock because of the letter it begins with is 
perfect evidence that there is manipulation going on. That also 
leads to things like stop hunts, very manipulative behavior, 
and there is no way to figure out who is perpetrating that, 
which is one reason why I think this unique identifier attached 
to quotes is an absolutely critical issue and something that 
could be moved on very quickly.
    Chairman Reed. Mr. Tabb, you have a comment, and then I 
will conclude.
    Mr. Tabb. The way I want to answer that is yes and no. I 
think what Mr. Lauer is saying is absolutely true in the short 
term, very, very short term. I think there is an ability to 
manipulate stocks, especially in low liquid environments. But, 
generally, that manipulation is only going to take a little bit 
of--a short period of time from the electronic trading crowd, 
because, generally, the length of time they are holding a 
position is pretty short. So if they are buying 1 minute, they 
are selling the next minute. So they are only locking in small 
increments.
    That said, there are people who can push markets. The 
people who push markets actually are not the short-term 
holders. They are longer-term holders or intermediate-term 
holders because they have capital at stake. They are willing to 
push a position for, you know, days or weeks, and those tend to 
be more hedge fund-oriented type organizations. But if you are 
thinking of the traditional short-term electronic trading guy, 
I think to have an impact over a couple of minutes, yes. Impact 
over a day, pretty hard. You know, if you are going to have 
impact over a day, it has got to be somebody with much deeper 
pockets.
    Chairman Reed. Thank you.
    Gentlemen, thank you for excellent testimony. I think what 
you have really exposed is the complexity of these issues, and 
there are not just one or two. There is a series of 
interrelated issues. And I think, also, the need to begin to 
act promptly to address all of these issues, to give the 
investing public confidence that the system is operating 
fairly. I think this notion that you said very well, Mr. 
Brooks, about fairness, I mean, we have recognized benefits, 
obviously, from the increased liquidity, from the decreased 
spreads, that now we have to sort of step back and see at what 
cost and how do we make improvements, not just simply keep 
pressing along.
    I must say, though, I did get some reassurance, with a 5\1/
2\-year-old daughter, that iTunes does provide a drop copy. 
Thank you, Mr. Concannon.
    [Laughter.]
    Chairman Reed. I am making a note of that so that we have 
accomplished one objective today.
    But I think, again, just to say, this is an issue that will 
not go away. In fact, with technology, it will get even more 
complicated. I am pleased that the SEC is undertaking the 
technological roundtable, but I would like to be able to, with 
the concurrence of my colleague, Senator Crapo, do additional 
hearings, because I think you have raised some extraordinarily 
complicated issues in a very thoughtful way and we have to do a 
lot more work, along with the regulators, to come up with 
sensible responses.
    Mr. Tabb, your point, I think, is always well made. Try to 
do no harm. Try to prioritize changes that are the least 
disruptive and the most effective, and that is always good 
advice, so thank you for that.
    But, gentlemen, thank you so much. I have one other 
statement to make for the record.
    First of all, I want to thank all of our witnesses for 
testifying today.
    [Laughter.]
    Chairman Reed. We appreciate both the time and effort that 
you have made. That should be obvious. Thank you so much.
    Now, if you have additional written statements, please feel 
free to submit them. You may receive additional questions from 
my colleagues. Please respond as rapidly as possible. I will 
ask my colleagues to submit their questions no later than next 
Thursday, September 27, and please respond as quickly as 
possible to that. If any of my colleagues want to make a 
statement for the record, it will be included by unanimous 
consent in the record.
    In addition, I ask the statement of Public Citizen be 
included in the record, and hearing no objection, so ordered.
    Chairman Reed. With that, thank you very much, gentlemen. 
The hearing is adjourned.
    [Whereupon, at 11:28 a.m., the hearing was adjourned.]
    [Prepared statements, responses to written questions, and 
additional material supplied for the record follow:]
                   PREPARED STATEMENT OF DAVID LAUER
 Market Structure and High-Frequency Trading Consultant, Better Markets
                           September 20, 2012
    Good morning Chairman Reed, Ranking Member Crapo, and Members of 
the Subcommittee. Thank you for the invitation to Better Markets to 
testify today.
    Better Markets is a nonprofit, nonpartisan organization that 
promotes the public interest in the domestic and global capital and 
commodity markets. It advocates for transparency, oversight, and 
accountability with the goal of a stronger, safer financial system that 
is less prone to crisis and failure, thereby, eliminating or minimizing 
the need for more taxpayer funded bailouts. Better Markets has filed 
almost 100 comment letters in the U.S. rulemaking process related to 
implementing the financial reform law and has had dozens of meetings 
with regulators. Our Web site, www.bettermarkets.com, includes 
information on these and the many other activities of Better Markets.
    My name is David Lauer and I am a Market Structure and High-
Frequency Trading Consultant to Better Markets. I'm also consulting for 
IEX Group, Inc., a private company that is in the process of building 
an investor-owned and investor-focused U.S. equity market center. Prior 
to working with Better Markets and IEX Group, I worked as a senior 
quantitative analyst at Allston Trading and before that at Citadel 
Investment Group. Prior to my career as a researcher and trader, I 
worked at Tervela where I helped to design hardware and specialized in 
studying and understanding the complexities of the rapidly evolving 
electronic marketplace both before and after Reg NMS was implemented. I 
have a Master's degree in International Economics and Finance from 
Brandeis University. I grew up in Southern New Jersey.
Introduction
    On May 6, 2010, the U.S. stock market demonstrated some of the most 
unpredictable and disturbing behavior in its 218 year history. Over the 
course of just 20 minutes, the stock market plunged and snapped back 
up, losing and then regained nearly $1 trillion in market value. Nobody 
had ever seen anything like it. The crash began in the S&P E-Mini 
Futures market but quickly spread to and overwhelmed the equity 
markets. That day I was in the center of the storm, working on the 
high-frequency trading floor of one of the largest S&P 500 E-Mini 
Futures trading firms in the world, on the global equity trading desk.
    As I watched the market crash, I witnessed something unthinkable: 
the market simply disappeared. For what felt like an eternity, but was 
more likely 30 seconds to a minute, there were no bids or offers 
displayed in the market for major stocks and ETF's such as SPY (the S&P 
500 Index ETF).
    None of us knew what to do or what would happen next. Immediately 
before the market disappeared, our firm, like other high-frequency 
trading firms, withdrew our orders from the market because we did not 
understand what was happening, did not trust our data feeds and had no 
obligation to remain active in the market. Anybody who seeks to 
minimize the role that high-frequency trading had in the Flash Crash 
either was not on a trading floor that day or has an interest in 
maintaining the current unregulated status quo.
    When more than half of the liquidity in the stock market is able to 
be pulled from it in a matter of seconds, dramatically worsening an 
unstable situation, something is dreadfully wrong.
    U.S. equity markets are in dire straits. We are truly in a crisis. 
Over the past three decades a technological revolution has swept over 
Wall Street. In many ways, this has dramatically improved the 
efficiency of capital markets relative to past decades: reducing 
spreads and volatility, and helping them to more effectively perform 
their core functions of price discovery and capital formation. 
Regardless of the arguments about this extremely volatile issue, we 
must judge the evolution of capital markets around these 
characteristics of spread width, price volatility, price discovery and 
capital formation as well as other characteristics such as the price 
impact of large institutional orders and catastrophic event frequency.
    The past decade of this revolution has been marked by two primary 
trends: extreme marketplace fragmentation and rapid growth of high-
frequency traders as the primary suppliers of liquidity. As of today, 
there are 13 lit exchanges and more than 50 dark pools/internalization 
venues. Exchanges account for between 65 percent and 75 percent of the 
market, and the Dark Pools, with 18 tracked by Rosenblatt, account for 
12 percent-15 percent. The balance is attributed to internalization, 
including OTC block trades and wholesalers. This is a far departure 
from the stock market of the 20th century that was well understood by 
most Americans. If you were to ask the average retail trader or even 
sophisticated institutional investor what happens today when they send 
a buy or sell order to the market, few if any would be able to describe 
the labyrinthine path that order takes to be filled.
    Complexity has become the hallmark of the new electronic landscape, 
whether it is in the form of a multitude of venues and participants or 
the advanced algorithms that many of them are using to analyze incoming 
market data. While complex systems can often provide elegant solutions 
to intractable real-world problems, they can also spin out of control 
in unexpected ways. Often the interaction of these nonlinear systems is 
difficult or impossible to predict. In the U.S. equity market, we have 
seen first-hand glimpses of what can happen as overly complex systems 
interact in nonlinear ways. The incidents are becoming more common, and 
include:

    The Flash Crash in May, 2010, was set off by a single large 
        trade estimated at $4.1 billion in the S&P 500 E-Mini Futures 
        Market. The cascade led to 20 minutes of extreme volatility, 
        wiping out nearly $1 trillion of market cap before quickly and 
        inexplicably recovering. The total economic cost of this event 
        is unmeasured, but certainly huge. We were lucky it didn't 
        happen near the market close--had the U.S. market closed before 
        it recovered, the result could have been total economic 
        disaster because money would have hemorrhaged out of the stock 
        market overnight.

    In August, 2011, the stock market swung up and down by over 
        4.4 percent on four consecutive days, alternating up and down 
        days. It was wild, unprecedented volatility--only the third 
        time in history that had happened, with the second time having 
        been 3 years prior, during the crash of 2008. While the 
        European crisis was becoming a more important issue at the 
        time, this volatility was not warranted by major economic 
        changes or historic macroeconomic events. This was computer-
        driven volatility.

    ``Mini flash crashes'' occur on a near-daily basis in 
        individual stocks. Nanex has documented almost 2,000 instances 
        of individual irregularities in stocks since August 2011. \1\ 
        Single-stock circuit breakers have failed to stem the tide of 
        these incidents.
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     \1\ http://www.nanex.net/aqck/aqckIndex.html

    IPO's in Facebook and BATS (itself an Exchange) have gone 
        horribly wrong due to technological ``glitches,'' continuing to 
        sour the already languid market for IPO's and costing untold 
        numbers of jobs as companies cannot raise the capital they need 
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        to expand and hire.

    Few realize how lucky we were on Tuesday, July 30. An order 
        to sell nearly $4.1 billion in the S&P 500 E-Mini Futures 
        Market, the same size as what precipitated the Flash Crash, was 
        executed three seconds before the market closed. There simply 
        was not enough time for the waterfall of May 6, 2010, to repeat 
        itself. What happens the next time when that same order is sent 
        in a couple of minutes sooner? While some may point to this as 
        evidence that the market worked, there have not been any 
        changes in market structure since the Flash Crash other than 
        circuit breakers, which are not active in the final 25 minutes 
        of trading.

    On Wednesday, July 31, Knight Capital Group--one of the 
        largest market making firms, an official Designated Market 
        Maker on the NYSE, had a ``software glitch'' according to their 
        CEO. The result? A loss for them estimated at $440 million, 
        untold economic losses for retail investors with stop-loss 
        orders in one of the almost 140 stocks that were affected and 
        further erosion in investor confidence.

    There is no doubt that electronic trading has tremendous value to 
offer, at times enhancing the smooth functioning of the stock market 
and increasing competition, thus driving down the spread that the 
average investor has to pay to buy or sell a stock. HFT has been so 
successful that it has taken over the stock market, now accounting for 
between 50 percent-70 percent of equity market volume on any given day. 
Fortunes have been made, with estimated annual profits exceeding $21 
billion \2\ at its peak, and estimates varying but still in the 
billions of dollars today.
---------------------------------------------------------------------------
     \2\ Rob Iati, ``The Real Story of Trading Software Espionage'', 
http://advancedtrading.com/algorithms/
showArticle.jhtml?articleID=218401501, July 10, 2009.
---------------------------------------------------------------------------
    What we must be concerned with is whether the pendulum has swung 
too far, and whether the nearly unregulated activities of anywhere from 
50 percent-70 percent of stock market volume should be permitted to 
continue down this path. For the proponents of HFT to make the case 
that the market is functioning well, or that only incremental reforms 
are needed rather than wholesale changes, they must make the case 
unequivocally that the market satisfies the aforementioned 
characteristics of tightening spreads, decreasing volatility and is a 
more efficient and low-cost mechanism for price discovery and capital 
formation today than at any time in the past, and that proposed reforms 
are not even worth trying.
    Despite the large quantity of HFT-funded research touting the 
benefits of HFT (lower spreads, increased liquidity, lower volatility), 
there are also many research studies that prove the opposite. However, 
a higher-level debate on the impact of HFT on today's market should 
also consider the fact that catastrophic event frequency has increased, 
IPO's have dramatically dropped and retail investors have been fleeing 
the stock market in droves. The flight of the retail investor during a 
period of incredible stock market returns is a sure sign that this 
exodus is a result of mistrust rather than economic conditions. 
Investor confidence is nonexistent, with only 15 percent of the public 
expressing trust in the stock market in the latest Chicago Booth/
Kellogg School Financial Trust Index--8 percent lower than those that 
trust the banks! The figure that follows is one of the most disturbing 
illustrations of the flight of the retail investor:


    Historically, the correlation between market performance and net 
flows is undeniable. Despite the rally over the past 3 years, fund 
inflows have not followed. Since the Flash Crash in May 2010, over 
$283bn has flown out of the U.S. Equity markets. Over that time period, 
the S&P 500 has risen by over 21 percent.
    This trend, along with unpredictable and increasing volatility, has 
also driven companies away from the stock market. From 1990-2000, the 
average number of firms going public each year was 530. Since 2001, 
that number has plummeted to 125. When companies are able to easily go 
public and access large amounts of capital, they are able to grow, 
expand and hire. When fragility, volatility and mistrust are the 
defining characteristics of the market, companies do not see an IPO as 
a viable means to raise capital, or in their long-term best interests. 
That has been the reality in the market for over a decade, becoming 
most acute since 2008. This is the connection from the market to the 
economy and the country as a whole, and it demonstrates how changes in 
market structure are affecting nonmarket participants. The void in the 
IPO market has correlated strongly with the U.S. unemployment rate over 
the past decade.


    It's important to note that these numbers are before 2012, and the 
debacles of the BATS and Facebook IPO's. Those technology ``glitches'' 
may well end up costing us countless jobs that cannot be realized 
because companies are increasingly reluctant to use the public 
marketplace to raise funding.
    It does not make sense to address a problem before establishing 
that one exists. While it is clear that the symptoms of the problem--
increasingly frequent market disruptions, retail investor flight and a 
stagnant IPO market--are dramatically demonstrated, it is instructive 
to examine the current state of U.S. equity markets. I will seek to 
demonstrate that market quality has not been improved by high-frequency 
trading, and in fact that the market is more fragile than ever, to the 
degree that individual firms, and even individual servers, can have a 
disproportionate impact on the entire U.S. equity market and by 
extension the global market. I will also demonstrate that the new, 
fragmented market is detrimental to long-term investors. Finally I will 
propose remedies to address these problems.
Market Quality and High-Frequency Trading
    To suggest that regulatory changes are necessary to address 
problems in current market structure, it must be demonstrated that 
current market structure is not serving the needs of long-term retail 
and institutional investors, and that the current regulatory regime is 
insufficient to address problems in the market. To begin with, it must 
be demonstrated that there has been a material, adverse change in 
market structure that must be addressed.
    In an interesting paper published in 2010, \3\ Reginald Smith asked 
the question ``Is high-frequency trading inducing changes in market 
microstructure and dynamics?'' He went on to demonstrate that while 
historically, the Hurst exponent \4\ of the stock market has been 
measured at 0.5, consistent with Brownian motion and our general 
understanding of how the market functions on small time scales, since 
2005 and Reg NMS that value has been increasing. While this is 
certainly an esoteric statistical discussion, his conclusion is 
striking:
---------------------------------------------------------------------------
     \3\ Smith, Reginald, ``Is High-Frequency Trading Inducing Changes 
in Market Microstructure and Dynamics?'' (June 29, 2010). Available at: 
http://arxiv.org/PS_cache/arxiv/pdf/1006/1006.5490v1.pdf
     \4\ The Hurst exponent (H) is a measure of self-similarity, the 
autocorrelation of a time series. Computed using intraday data, it 
measures the tendency of a time series to form clusters or remain 
random. Random price oscillation is the cornerstone of our 
understanding of the stock market, and how the price discovery process 
occurs.

        we can clearly demonstrate that HFT is having an increasingly 
        large impact on the microstructure of equity trading dynamics . 
        . . this increase becomes most marked, especially in the NYSE 
        stocks, following the implementation of Reg NMS by the SEC 
        which led to the boom in HFT . . . volatility in trading 
        patterns is no longer due to just adverse events but is 
        becoming an increasingly intrinsic part of trading activity. 
        Like Internet traffic Leland, et. al. (1994), if HFT trades are 
        self-similar with H > 0.5, more participants in the market 
---------------------------------------------------------------------------
        generate more volatility, not more predictable behavior.

    This is one of several shocking conclusions that we will examine in 
this testimony. It also speaks to the detrimental impact that the 
complexity of HFT algorithms, and their nonlinear interactions, has on 
market microstructure. These algorithms are complex enough that it 
takes seasoned practitioner to understand them just in isolation, and 
nobody understands what happens as they interact with each other. The 
so-called ``Great Quant Meltdown of 2007'' \5\ from August 7-10, 2007, 
was an ominous harbinger of what was to come. Many people aren't even 
aware that there was significant turmoil in financial markets in early 
August, 2007 because of unexpected behavior of long-short quantitative 
equity funds. Many of these funds were holding the same undervalued/
overvalued securities, and suffered great losses when they did not 
revert and entered a positive feedback loop of liquidation. A full 
discussion of this is outside the scope of this testimony, but it was 
an indication that, while they were not HFT strategies, seemingly 
simple long/short quantitative strategies were not well understood by 
those who wrote them, and they certainly didn't understand the 
ramifications of their interactions with each other in the marketplace.
---------------------------------------------------------------------------
     \5\ More information on this can be found here: http://
select.nytimes.com/2007/08/18/business/18nocera.html.
---------------------------------------------------------------------------
    Many HFT strategies have been poached from other firms, or arrived 
at independently by quantitative analysts using identical techniques. 
This is one of the main reasons we have seen such a massive investment 
in technology. The sophistication of your trading strategy is no longer 
a defining characteristic of its success, rather the number of 
microseconds that it takes your software to react to a piece of market 
data has become one of the most important factors of success in the HFT 
industry.
    The implications of this are grave. As we see on a nearly regular 
basis, algorithms reacting to one another, or to manipulative behavior 
by nefarious actors, can exhibit nondeterministic behavior. The ``mini 
flash crashes'' that Nanex documents on a regular basis are excellent 
examples of this nondeterministic behavior as algorithms enter positive 
feedback loops either with themselves or in relation to other 
algorithms. Many high-frequency trading strategies rely on correlation 
of securities with other assets and use price movements in different 
securities to inform the fair-value price of another security, through 
high-, medium-, and even low-correlation relationships. On a widescale 
basis, this can have unintended and nondeterministic consequences, 
including positive feedback loops in which liquidity is rapidly 
withdrawn from the market.
    Giovanni Cespa and Thierry Foucault wrote a paper in March, 2012, 
calling this type of phenomenon an ``Illiquidity Contagion.'' \6\ They 
noted that the same type of positive feedback loop I have discussed 
here can cause a sudden drop in market liquidity, and shift the market 
to a new equilibria characterized by high illiquidity and low price 
informativeness. That a crash in the futures market could ``infect'' 
the equity market is another symptom of the increasing 
interconnectedness of global security markets--equity index futures, 
commodities, stocks/ETF's and currencies are all now being actively 
traded by high-frequency traders. Using the aforementioned historical 
correlations has the unfortunate side effect of becoming self-
reinforcing because many HFT models observe the same historical 
relationships and often trade assets in this manner. At the limit, when 
a positive feedback loop is loosed onto the markets-at-large, you can 
have a correlation=1 event--in other words, the Flash Crash.
---------------------------------------------------------------------------
     \6\ Cespa, Giovanni, and Foucault, Thierry, ``Illiquidity 
Contagion and Liquidity Crashes'' (May 8, 2012). Available at SSRN: 
http://ssrn.com/abstract=1804351.
---------------------------------------------------------------------------
    The increase in correlations is a well-documented characteristic of 
the new electronic marketplace. Correlations between stocks are as high 
as they have ever been, including during the crisis in 2008, as shown 
in this chart from Goldman Sachs:


    According to JPMorgan, this ``new normal'' of persistently high 
correlations is driven by the macroeconomic environment, the increased 
use of ETFs and index futures, and high-frequency trading. \7\ With the 
stock market moving in lock-step, this means that the traditional 
benefits of diversification that retail investors have relied on for 
decades are no longer there to protect them from dramatic moves in 
stock market indices. It also means that the market becomes a poor 
indicator of company value and performance, undermining one of its core 
functions. In addition, the increases in volatility and correlation 
drive options prices higher, which increase the hedging costs to 
businesses that pass those costs on to their customers. Furthermore, 
any increase in stock market volatility has a ``negative wealth 
effect.'' Retail investors are notoriously poor at timing market moves, 
and have a tendency to buy when the market is high and sell when it's 
low. Increasing volatility exacerbates this behavior and costs retail 
investors money.
---------------------------------------------------------------------------
     \7\ JPMorgan, ``Why We Have a Correlation Bubble'', http://
www.cboe.com/Institutional/JPMDerivativesThemesCorrelation.pdf, October 
5, 2010.
---------------------------------------------------------------------------
    It is clear that the structure of the market has changed 
dramatically since the advent of high-frequency trading, but that is 
not necessarily a bad thing. One could argue that the previous market 
structure was inefficient; the specialist model extracted unreasonably 
high rents for the service they provided, and that the benefit of 
tighter spreads in this new electronic marketplace outweighs the costs 
of a more highly correlated market. If indeed tighter spreads and lower 
volatility characterize this new, more efficient marketplace, there is 
a case to be made that the value far outweighs the cost. We are 
therefore confronted with these questions:

  1.  Are spreads tighter, and tightening? Is volatility lower, and 
        continuing to drop? Is the price discovery process efficient? 
        Is the price impact of large trades acceptable? Are companies 
        comfortable accessing capital by going public? Are regulators 
        comfortable in their understanding of market mechanics, and 
        able to effectively write new rules and enforce existing ones?

  2.  Is this the best we can do, or is there a market structure under 
        which total transaction costs to investors are even lower? Is 
        there a market structure that is more stable, and one that will 
        instill confidence for institutional and retail investors?

    The traditional mantra of the high-frequency trading industry is 
that HFT has helped to decrease trading costs by providing tighter 
spreads and lower volatility. One of the oft-cited studies in support 
of this claim was authored by employees of RGM Advisors, LLC, a 
prominent HFT firm. Another study was done by an employee of Credit 
Suisse, a major proponent of HFT. However, an increasing number of 
independent academic papers have demonstrated the opposite:

    Watson, Van Ness, and Van Ness (2012) using Dash-5 data 
        find that the average bid-ask spread from 2001-2005 was $0.022 
        (2.2 cents), while the average bid-ask spread from 2006-2010 
        was $0.027 (2.7 cents), a dramatic increase of 22.7 percent. In 
        addition they document increasing volatility as measured by the 
        standard deviation of the price of stocks, from 0.13 for 2001-
        2005 to 0.161 for 2006-2010, an increase of 23.85 percent.

    Zhang (2010) found that ``high-frequency trading is 
        positively correlated with stock price volatility after 
        controlling for firm fundamental volatility and other exogenous 
        determinants of volatility. The positive correlation is 
        stronger among the top 3,000 stocks in market capitalization 
        and among stocks with high institutional holdings. The positive 
        correlation is also stronger during periods of high market 
        uncertainty.'' \8\ Zhang finds that estimated HFT trading 
        volume is 78 percent, explaining that ``78 percent is clearly 
        excessive if HFT is meant to provide liquidity. If HFT were to 
        provide all of the market's liquidity, the volume of HFT would 
        still be at most 50 percent.'' \9\
---------------------------------------------------------------------------
     \8\ Zhang, Frank, ``High-Frequency Trading, Stock Volatility, and 
Price Discovery'' (December 2010). Available at SSRN: http://ssrn.com/
abstract=1691679.
     \9\ Ibid.

    Cartea and Penalva (2011) \10\ examine the impact of HFT on 
        financial markets using a model with three types of traders: 
        liquidity traders, market makers, and high frequency traders. 
        The finding of their model is that high frequency traders 
        increase the price impact of liquidity trades, increasing 
        (decreasing) the price at which liquidity traders buy (sell). 
        These costs increase with the size of the trade suggesting that 
        large liquidity traders (i.e., large institutional traders 
        making sizable changes to their portfolio) will be most 
        affected by HFT. The authors also propose that HFT increases 
        price volatility and doubles volume.
---------------------------------------------------------------------------
     \10\ Cartea, Alvaro, and Penalva, Jose, ``Where Is the Value in 
High Frequency Trading?'' (December 21, 2011). Available at SSRN: 
http://ssrn.com/abstract=1712765.

    Kirilenko, Kyle, Samadi, and Tuzun (2010) \11\ examine the 
        behavior of high frequency traders in E-mini S&P 500 futures 
        contracts during the events surrounding the flash crash. HFT 
        patterns surrounding the flash crash are inconsistent with 
        traditional market making. They conclude that while high 
        frequency traders may not have caused the flash crash, their 
        response to the high selling pressure exacerbated volatility. 
        (This is certainly consistent with my experience on the trading 
        floor that day.)
---------------------------------------------------------------------------
     \11\ Kirilenko, Andrei A., Kyle, Albert S., Samadi, Mehrdad, and 
Tuzun, Tugkan, ``The Flash Crash: The Impact of High Frequency Trading 
on an Electronic Market'' (May 26, 2011). Available at SSRN: http://
ssrn.com/abstract=1686004.

    Mao Ye, Chen Yao, and Jiading Gai (2012) \12\ point out two 
        effects of high frequency trading: ``First, it may enable 
        investors to seize trading opportunities. Second, it may 
        increase adverse selection problem for slow traders and 
        generate negative externality. Our results indicate that the 
        second effect dominates in the sub-millisecond environment. 
        Also, an increase in the cancellation ratio or message flow 
        also creates another negative externality. Stock exchanges need 
        to continuously upgrade trading systems to accommodate more 
        message flow. These costs, finally, are covered by fees from 
        traders. However, the current fee structure only charges 
        trades, not cancellations. Therefore, cancellation actually 
        creates an externality for traders with true intentions to 
        trade, who subsidize the traders with lots of cancellations.''
---------------------------------------------------------------------------
     \12\ Ye, Mao, Yao, Chen, and Gai, Jiading, ``The Externality of 
High Frequency Trading'' (August 31, 2012). Available at SSRN: http://
ssrn.com/abstract=206683.

    From the industry, Morgan Stanley concluded in a recent report that 
institutional orders are having a much larger impact on asset prices 
now than in the period before 2007. They found that the maximum 
percentage of average daily volume that a Volume-Weighted Average Price 
trade (a very common institutional trading strategy) can handle without 
adverse price impact has declined from 10-15 percent to around 4-5 
percent now. \13\ They believe the primary reason for this is that the 
percent of volume attributable to natural buyers and sellers has 
declined by 40 percent when comparing the volume during 2001-2006 to 
that since 2008.
---------------------------------------------------------------------------
     \13\ Crow, Charles, and Emrich, Simon, `` `Real' Trading Volume, 
Morgan Stanley Quantitative and Derivative Strategies Group'', April 
11, 2012.
---------------------------------------------------------------------------
    These studies show a clear, detrimental impact to spreads, price 
impact and volatility. Because there are other studies pointed to by 
the industry that enable them to claim the opposite, it is instructive 
to not only examine the academic literature and studies, but to look at 
the ultimate result. It is clear that long-term investors do not trust 
the market. The Morgan Stanley paper cited above concludes that the 
volume of trading attributable to institutional traders dropped from 47 
percent in the period 2001-2006 to 29 percent since 2008, a decline of 
40 percent. \14\ It is clear that long-term investors are fleeing 
equity markets at unprecedented rates. It should also be clear that 
there are severe inefficiencies in the current market structure, and 
that indeed these inefficiencies are structural--they are not going 
away without structural changes. The HFT industry continues to make 
billions of dollars each year by exploiting these structural 
inefficiencies. While there have recently been marginal declining 
returns to scale, it has not stopped the performance and technology 
race, which the HFT industry realizes is the only way that they can 
differentiate themselves from one another.
---------------------------------------------------------------------------
     \14\ Ibid.
---------------------------------------------------------------------------
Structural Inefficiencies Have Created a Fragile Marketplace
    The new electronic marketplace has several structural 
inefficiencies. These are what have permitted HFT to become a 
destructive force in the market, rather than a passive liquidity 
providing mechanism. This should not be construed to say that all HFT 
is bad, but there are 2 important points to make--the structural 
inefficiencies present in the market have created a massive 
misallocation of resources into technology that provides no social 
benefit, and structural deficiencies in market structure have allowed 
for nefarious or accidental actions to disrupt the market.
    The overriding aspect in the current market that we should fear 
most is the inordinate impact that a single market participant, or even 
a single server, can have on the market-at-large. This is a grave 
concern from any perspective. Whether we are dealing with nefarious, 
predatory behavior such as quote stuffing and pinging, or simply 
accidental mistakes such as the Knight Capital fiasco appears to be, 
one thing should be clear: The market has become more fragile than we 
should expect or accept given the tremendous advances in technology 
over the past decades.
    These structural inefficiencies have been created by the unintended 
consequences of regulations:

    The approval of the maker/taker model and Pay-For-Order-
        Flow deals.

    The disappearance of affirmative market-making obligations.

    The fragmentation of equity markets into lit and unlit 
        market centers, with little regulation of the unlit centers.

    The rubber-stamp approval of exotic order types without 
        proper study or justification.

    The unbridled latency race to zero without concern over the 
        impact on markets, and the massive investment in technology 
        required to keep pace.

    While proponents of the existing market structure will argue that 
they must be given a free market to allow capitalism and competition to 
fix any inefficiency, they ignore the fact that many of the 
inefficiencies have been created by regulation and must therefore by 
remedied by regulation. They must also be reminded of the consequences 
of unfettered, unregulated industries with negative externalities whose 
costs are not borne by the producers. In much the same way that 
polluting enterprises have to be regulated so that they bear the cost 
of negative externalities, so must HFT firms.
    In a ground-breaking study done at the University of Illinois at 
Urbana-Champaign, Mao Ye, Chen Yao, and Jiading Gai demonstrated the 
following: \15\
---------------------------------------------------------------------------
     \15\ Ye, Mao, Yao, Chen, and Gai, Jiading,`` The Externality of 
High Frequency Trading'' (August 31, 2012). Available at SSRN: http://
ssrn.com/abstract=206683.

    While aggressive investment in new technology to reduce 
        latency has obvious benefits for market participants making 
        that investment, it is unclear whether there is an associated 
        social benefit when negative externalities are properly 
---------------------------------------------------------------------------
        accounted for.

    They examined two consecutive technological shocks that 
        decreased latency from microseconds to nanoseconds. They found 
        that those shocks ``drastically increase both the trading speed 
        and the cancellation ratio, which escalates from 26:1 to 32:1. 
        However, there is no impact on trading volume, spread, depth, 
        or price efficiency.'' \16\
---------------------------------------------------------------------------
     \16\ Ibid.

    They go to conclude that ``high-frequency trading may cause 
        an adverse selection problem for slow traders'' and that this 
        effect ``dominates at the sub-millisecond level.'' \17\
---------------------------------------------------------------------------
     \17\ Ibid.

    They also demonstrate conclusive evidence for quote 
        stuffing, a practice in which the infrastructure of data feeds 
        is manipulated in order to slow down traders with inferior 
        technology and to take advantage of this. They shockingly 
        demonstrate ``clear evidence of comovement of message flow for 
        stocks in the same channel through factor regression. This 
        result is consistent with quote stuffing, because message flow 
        of a stock slows down the trading of the stock in the same 
        channel, but does not have the same effect on stocks in a 
        different channel.'' \18\ This claim is reinforced by Egginton, 
        Van Ness and Van Ness who ``find that quote stuffing is 
        pervasive with several hundred events occurring each trading 
        day and that over 74 percent of U.S. listed equity securities 
        experience at least one episode during 2010.'' \19\ Why is this 
        such a shocking conclusion? Stock symbol distribution across 
        channels is alphabetic--essentially random. You would expect 
        comovement of message flow across industries or correlated 
        stocks, but not based on an alphabetic distribution. This is 
        clear evidence of market manipulation.
---------------------------------------------------------------------------
     \18\ Ibid.
     \19\ Egginton, Jared F., Van Ness, Bonnie F., and Van Ness, Robert 
A., ``Quote Stuffing'' (March 15, 2012). Available at SSRN: http://
ssrn.com/abstract=1958281.

    Finally they demonstrate that 50ms would be a reasonable 
        ``speed limit'' for minimum quote life, as they find that 30-40 
        percent of orders are canceled within 50 milliseconds and they 
        have a trivial if any contribution to liquidity. The 
        elimination of these orders could have a $0.0000378 increase in 
        quoted spread, or 0.5 share decrease in depth within 10 cents 
        of the best bid and ask. In addition, limit order books without 
        these orders have the same variance ratio (a measure of price 
---------------------------------------------------------------------------
        discovery and efficiency) as order books with these orders.

    It seems that in the latency race to zero, it is those participants 
who are not engaged in this race that are paying the unintended costs. 
Market data feed volume has risen exponentially in recent years, and 
increasing technology investments are being borne by retail and 
institutional investors in the fees that they must pay to trade. The 
genesis of this problem was the maker-taker business model of the for-
profit exchange/ECN/ATS. This business model is designed to compensate 
those who provide liquidity by charging those who take it. Almost every 
single exchange now makes money on the spread between the rebate paid 
to liquidity providers (previously market makers, now HFT firms) and 
the fees charged to institutional and retail investors to take 
liquidity. This has created a tremendous conflict-of-interest for 
exchanges, especially now that they are publicly traded and beholden to 
shareholders (at least in the case of Nasdaq, NYSE, and eventually 
BATS). They make money through volume and churn, and have little 
incentive to maintain fair, orderly markets.
    Another consideration with the maker-taker model is the complete 
lack of viable alternatives. Exchanges have had ``glitches'' and blow 
ups, notably BATS and Nasdaq during high-profile IPO's. Yet their 
market share has not suffered because, frankly, there are no viable 
alternatives. This is not to say that there's no hope. Other efforts 
are underway to provide an alternative business model, of which I am 
devoting my expertise and time to one of those potential alternatives. 
In our current environment, a two-pronged approach is critical: 
regulators must address structural inefficiencies, transparency, level 
playing field, antifraud and related matters, while allowing private 
industry's innovation and developments to operate in a fair and open 
marketplace.
    The increasing fragmentation of the marketplace and the advent of 
pay-for-order-flow deals have led to a phenomenon called adverse 
selection. This means that profitable trades (from a market-making 
perspective) never reach the market. Retail and institutional order 
flow pass through a gauntlet of internalizers and high-frequency 
trading desks, which pick off any profitable order flow before it ever 
reaches the public, lit market. While these orders are filled within 
the NBBO, meaning that the originator of the order is no worse off on 
that particular order, market quality as a whole suffers. Natural 
buyers and sellers are virtually nonexistent under this structure, and 
the majority of the volume on the exchanges becomes ``toxic flow'' an 
industry term for orders that nobody wants to interact with. The end-
product is consistent with the Morgan Stanley report cited above, 
although for different reasons than the authors of the report would 
point to. Other countries mandate significant price improvement to 
internalize order flow, but the SEC has not.
    Dan Weaver, a professor out of Rutgers University has designed a 
research study to measure what the impact of dark pools and extreme 
fragmentation has been on the lit venues. He has found that trading in 
off-market venues such as dark pools directly impacts the spread in the 
lit markets, and that the cost of trading is 1.28 cents higher in NYSE 
lit markets because of this. \20\ Weaver goes on to say that ``as the 
percentage of internalization increases, average trades will have an 
increasing impact on prices. Finally, for all market segments, higher 
levels of internalization are associated with higher levels of return 
volatility.'' \21\ And in fact, in his literature review, Weaver 
reviews two studies that demonstrate that ``the internalizing of 
uninformed order flow by discriminating dealers reduces the number of 
uninformed orders for the nondiscriminating dealers to spread their 
informed losses over. The result of this is a widening of spread 
charged by the nondiscriminating dealer.'' \22\
---------------------------------------------------------------------------
     \20\ Weaver, Daniel G., ``Internalization and Market Quality in a 
Fragmented Market Structure'' (May 19, 2011). Available at SSRN: http:/
/ssrn.com/abstract=1846470.
     \21\ Ibid.
     \22\ Ibid.
---------------------------------------------------------------------------
    The current level of fragmentation and complexity is helpful to HFT 
firms. They are the masters of the complexity, some of the few actors 
in the market that understand the relationships and interconnectedness 
and realize high returns based on arbitrage. They also use these unlit 
venues as signaling mechanisms, and many of these venues cater to them, 
for a price.
    Adding to the complexity in the current market structure is the 
proliferation of exotic order types. While the SEC deliberates 
extensively on any rule change and regulation, the hurdle is far lower 
for new order types. It is extremely rare to have the SEC refuse an 
exchange's request for a new order type, regardless of whether the 
order type does anything to further price discovery or make markets 
more efficient.
    Many of the newest order types appear to have been designed by the 
HFT firms themselves, with little to no utility outside of their 
automated strategies. It remains completely unclear what social utility 
comes of hidden midpoint pegs, sliding, hide-and-slide, post-only, PNP, 
PL select and the rest of the alphabet soup of order types. Even 
sophisticated sell-side algorithmic trading desks rarely use anything 
other than a limit order, an order for the opening/closing auction and 
maybe a midpoint or peg order. HFT firms thrive on this contrived, 
structural complexity. They make it their business to understand these 
order types and how best to exploit them.
What Can Be Done?
    The current structure of the U.S. equity markets is demonstrably 
unwieldy, overly complex, and extremely fragile. It is subject to 
manipulation, whether nefarious or accidental, on a daily basis. 
Spreads are no longer tightening and volatility is no longer dropping. 
The price impact of large, institutional orders is rising.
    Technological mayhem is more frequent and likely to increase. These 
events are not technology ``glitches'' and ``bugs,'' as the industry 
and its allies like to dismissively refer to them as, because they 
wreak havoc on the market in multiple material ways. It is simply a 
matter of time before we have another catastrophe of the same magnitude 
or worse than the Flash Crash. The next time it happens, we may not be 
so fortunate with regard to the timing--it was only luck that the Flash 
Crash didn't start in the morning, inciting markets around the world to 
crash, or at 3:45 p.m. EST, with the market closing after the drop, but 
before it could recover. If this were to happen, there would be an 
overnight exodus from the market with disastrous consequences for the 
U.S. economy.
    In addition, until confidence in markets is restored, retail 
investors will continue to stay away, regardless of the returns they're 
missing (as has been shown over the last 2 years), and companies will 
hesitate to go public costing untold jobs.
    I'd like to start with a proposal for some concrete steps that 
regulators can take to address much of the instability and unfairness 
in capital markets:

  1.  Unify trading rules, regardless of venue--exchange, ATS, ECN and 
        dark pools should all abide by the same general rules. Require 
        substantial price improvement to internalize flow. This means 
        more than $0.001.

  2.  To receive a rebate from any venue on which securities are 
        transacted, a market participant must be a genuine registered 
        ``market maker'' subject to affirmative market making 
        obligations. All such rebates or other compensation must be 
        disclosed.

  3.  Mandate a unique identifier for every supervisory individual. 
        This ID would have to be attached to every quote submitted to 
        any venue, and provide a mechanism for regulators to associate 
        quotes with the supervisory individual on the trading desk.

  4.  Eliminate pay-for-order-flow practices.

  5.  Establish strong, clear market technology standards and regularly 
        audit firms to ensure they are being followed.

  6.  Revoke order type approval for order types that do not have a 
        clearly demonstrated utility to long-term investors and market 
        stability.

    It cannot be legitimately denied that the fragmentation of the 
equity market has added unnecessary complexity and created structural 
inefficiencies. A change of mentality is required from a regulatory 
point-of-view: from the view that there are market centers to be 
regulated to the view that there is a marketplace to be regulated, 
independent of individual market centers. Reg NMS (National Market 
System) was a first step down this path, but the mentality must be 
embraced at every level.
    Rules and regulations should apply to all actors and all venues 
where security transactions are taking place. All of the ideas referred 
to here are guided by this principle. In addition, much greater 
coordination and visibility must be achieved across asset classes. HFT 
firms trade equities, futures, FX and treasuries without blinking. It's 
near impossible to regulate the industry without a cross asset-class 
viewpoint.
    As mentioned before, the maker-taker business model leads to skewed 
incentives for exchanges and ``good times'' for liquidity providers. A 
simple change could have a dramatic impact on the quality of liquidity 
in the market and the level of volatility: any venue that offers any 
type of rebate for liquidity provision should be required to tie that 
rebate to affirmative market-making obligations. According to a review 
by Charitou and Panayides (2006), many markets around the world have 
embraced a form of this model, including the Toronto Stock Exchange, 
the London Stock Exchange, the Deutsche Bourse, Euronext, and the main 
stock markets of Sweden, Spain, Italy, Greece, Denmark, Austria, 
Finland, Norway, and Switzerland. All of them designate market makers 
with affirmative obligations to supply liquidity for at least some 
stocks. The London Stock Exchange requires market makers to register 
and to maintain quotes within a maximum spread band, and with minimum 
size.
    Another study by Bessembinder, Hao, and Lemmon (2011) concluded the 
following about the maximum spread model: \23\
---------------------------------------------------------------------------
     \23\ Bessembinder, Hendrik (Hank), Hao, Jia, and Lemmon, Michael 
L.,`` Why Designate Market Makers? Affirmative Obligations and Market 
Quality'' (June 2011). Available at SSRN: http://ssrn.com/
abstract=989061.

    A maximum spread rule will lead to a narrowing of bid-ask 
        spreads, not a widening, and that will lead ``to increased 
        trading, which can improve allocative efficiency in the 
---------------------------------------------------------------------------
        presence of information-based externalities.''

    This type of rule ``can improve social welfare'' as long as 
        the ``spread is not constrained to be less than the real 
        friction, i.e., the social cost of completing trades.''

    Such a rule can also increase the speed of price discovery 
        by encouraging more trading by both informed and uninformed 
        traders.

    Most importantly, they show that ``future flash crashes can 
        be potentially avoided, and economic efficiency enhanced, by 
        agreements calling for one or more designated market makers to 
        continue to provide liquidity during periods of enhanced 
        information asymmetries. While the DMMs would need to be 
        compensated for their losses suffered at such times, the social 
        gains from trade would exceed the costs.''

    There is no doubt that many if not all of these ideas are 
controversial. However, historically ideas such as these have not been 
so controversial. It's not clear what mechanism can be used to 
compensate DMMs for losses during severe events. It should be clear 
that it is in the public interest to have DMMs provide liquidity during 
high-stress events, so it is worth thinking creatively about whether 
the public or individual exchanges can help to backstop liquidity 
providers during these events. There is no doubt, however, that 
liquidity providers are making substantial profits, but without 
affirmative obligations to maintain markets they are shifting much of 
the risk to the public. If the market is truly a public good then it is 
incumbent on regulators to ensure that it remains stable, fair and 
orderly, rather than ensuring that exchanges continue to profit from 
the maker-taker model.
    The SEC should also maintain a database of supervisory individuals 
and assign a unique identifier to each of them. Any venue that accepts 
incoming orders can mandate the inclusion of another field that would 
contain the unique ID of the supervisory individual. While this 
information would not be propagated publicly, it would be available to 
exchange surveillance teams and to regulators. This would have a two-
pronged effect. It would allow rapid identification of individuals 
responsible for aberrant order flow, and provide the ability to quickly 
contact them and find out what is happening. In addition, it would 
remove the cloak of anonymity that participants currently enjoy, and 
thereby act as a deterrent to predatory behavior such as quote 
stuffing, stop-hunts and other manipulative behavior. The technological 
effort to implement this is not trivial, but it is not complex either. 
As someone who has worked with these applications, protocols and 
connections for nearly a decade, I can tell you that it could be 
implemented in a month or less if so mandated.
    The practice of selling retail order flow, what is commonly 
referred to as Pay-For-Order-Flow, should be ended. It exacerbates the 
problem of adverse selection discussed earlier, and removes natural 
buyers and sellers from the market. It is having a negative impact on 
market quality, with no benefit other than to the firms selling their 
order flow and to those firms able to pick out the lucrative orders 
before sending the toxic ones to market.
    Finally, the bar for order type approval should be raised to be 
similar to any regulatory or rule change. The SEC demands evidence that 
any changes benefit the market, and should do the same with exotic 
order types. As Scott Patterson demonstrates in his book, Dark Pools, 
these order types are having a poorly understood impact on markets and 
long-term investors. Many order type approvals should be revoked, and 
the burden of proof placed on the exchange to demonstrate their social 
utility.
    Additionally, I believe the SEC should consider some more creative, 
novel ideas for limited implementations or pilots to assess their 
efficacy and actual impact on the market. These ideas include:

    A 50ms minimum quote life/time-in-force

    Open up access to historical and current market data, and 
        incentivize programmers to help design better tools for 
        regulators.

    Greatly increase the SEC's technology capabilities. This 
        means a substantial investment in technology and personnel, and 
        creative thinking about market-wide surveillance.

    The SEC should consider a 50ms minimum quote life, at least on a 
pilot basis, to observe what the actual impact would be. With so much 
evidence against the utility of ``fleeting orders'' it is at least 
worth considering. This is the type of effort that could be rolled out 
quickly on a preliminary basis, in order to examine what the impact 
actually is. Not only would removing those orders help reduce the 
technology burden to firms to participate in markets, but the 
requirement to stand by a quote, at least for one-sixth of the time it 
takes to blink an eye, could help to change some of the behavior of HFT 
strategies. Claims that this would widen spreads are unsubstantiated, 
and must not be accepted until proven in a pilot program. One 
reasonable concern is the cross-asset nature of securities, and 
therefore in a broader rollout, such a program should be considered 
within a cross-asset perspective and effort.
    Finally, a dramatic change in how market data and surveillance are 
viewed should be considered. The Internet and Open Source efforts have 
taught us that open systems are nearly always preferable to closed. In 
that spirit, and under the premise that markets are a public good, 
market data feeds and tick data history should be opened up. It is 
critical to understand that many academic papers are skewed because 
they are either funded directly by the industry, or provided access to 
expensive and proprietary data by the industry. Opening up access to 
this data would have a dramatic effect.
    Access to the historical data of direct market data feeds should be 
made available freely to the public, and a prize-based incentive 
created for those who can find innovative ways of designing 
surveillance systems and algorithms. While the exchanges will surely 
argue vigorously against this idea as market data is a major profit 
engine for them, it is in the public's interest for the regulation and 
enforcement to move out of the 20th century.
    The SEC should also consider implementing a market-wide 
surveillance mechanism. In this new interconnected market, individual 
surveillance groups at market centers are not sufficient. The SEC must 
build sophisticated surveillance capabilities. They have taken a first 
step, although unfortunately a very inexplicable one. They have 
contracted with a prominent HFT firm to build a ticker plant, the first 
step towards processing and storing market-wide tick data. This is 
reminiscent of the fox guarding the hen house. This HFT firm is not in 
the business of building ticker plants. They are in the business of 
making money trading. They would not have taken this on if they did not 
believe it was in the long-term best interests of their trading profit 
center.
    In addition, there are a multitude of vendors who do this all day 
everyday--why one of them was not chosen for this contract is 
inexplicable. The SEC should consider canceling the contract with the 
HFT firm or just contract with a technology vendor, just as any other 
firm would. The SEC should also hire quantitative researchers, and 
compensate them as close as possible to industry rates, along with 
bonuses based on a percentage of the fines that they are able to 
uncover through data analysis. The SEC needs to attract top-line 
talent, and to do so they must be able to compensate competitively. 
This is an arms race that Wall Street is winning easily right now. 
While the SEC has obvious budgetary constraints, they can get creative 
about bonuses, potentially offering percent of fines, similar to their 
whistleblower program.
    The quantitative data analysis will be made much more robust with 
the unique identifiers associated with supervisory individuals 
mentioned earlier. The SEC should work very closely with individual 
surveillance teams at the exchanges, leveraging best-of-breed ideas, 
and helping those that are behind to catch-up. A market-wide 
surveillance system could eventually be expanded into a robust set of 
technology standards, tripwires/speed bumps, and other mechanisms for 
quickly detecting aberrant or nefarious behavior and immediately 
throttling or cutting off the offending firm's market access.
    Many of the ideas referenced here are not popular within the HFT 
industry. Whenever an idea is proposed that they do not agree with, 
they respond that there is no way they can operate under such rules, 
they will go out of business, spreads will blow out, the market will 
cease to function, and generally the sky will come crashing down and 
life will end as we know it. I have worked with these folks for years 
now, and I must have a much higher opinion of their capabilities than 
they do. These are some of the smartest people in the world, and they 
will figure out how to continue to make money, and compete, albeit on a 
more level playing field. Some will go out of business, as is the 
nature of capitalism, and some will thrive. In the end our markets will 
be much more stable, resilient and effective price discovery and 
capital formation mechanisms, and confidence will be restored to the 
retail and institutional investors.
                                 ______
                                 
                  PREPARED STATEMENT OF ANDREW BROOKS
               Head of U.S. Equity Trading, T. Rowe Price
                           September 20, 2012
Introduction
    Chairman Reed, Ranking Member Crapo, and distinguished Members of 
the Senate Subcommittee on Securities, Insurance, and Investment, thank 
you for the opportunity to testify today on behalf of T. Rowe Price \1\ 
regarding the effects of recent significant changes in trading 
technology and practices on market stability. My name is Andrew (Andy) 
M. Brooks. I am Vice President and Head of U.S. Equity Trading of T. 
Rowe Price Associates, Inc. I joined the firm in 1980 as an equity 
trader and assumed my current role in 1992. This is my 33rd year on the 
T. Rowe Price trading desk.
---------------------------------------------------------------------------
     \1\ T. Rowe Price Associates, Inc., a wholly owned subsidiary of 
T. Rowe Price Group, Inc., together with its advisory affiliates 
(collectively, ``T. Rowe Price''), had $541.7 billion of assets under 
management as of June 30, 2012. T. Rowe Price has a diverse, global 
client base, including institutional separate accounts;
    T. Rowe Price sponsored and sub-advised mutual funds, and high net 
worth individuals. The T. Rowe Price group of advisers includes T. Rowe 
Price Associates, Inc., T. Rowe Price International Ltd, T. Rowe Price 
Hong Kong Limited, T. Rowe Price Singapore Ltd., T. Rowe Price 
(Canada), Inc., and T. Rowe Price Advisory Services, Inc.
---------------------------------------------------------------------------
    T. Rowe Price is celebrating its 75th year of advising clients. We 
are a Baltimore-based global adviser with over $540 billion in assets 
under management as of June 30th, 2012, and more than 3 million client 
accounts. We serve both institutional and individual investors.
    We welcome the opportunity for discussion regarding the industry 
and market practices.
    Our firm is particularly focused on the interests of long-term 
investors. We appreciate the role other types of investors can have in 
creating a dynamic marketplace. However, as we talk with our clients, 
there is a growing distrust of the casino-like environment that the 
marketplace has developed over the past decade. We worry that the 
erosion of investor confidence can undermine our capital markets, which 
are so important to the economy, job growth, and global 
competitiveness. Reaffirming a strongly rooted commitment to fairness 
and stability of the market's infrastructure is critically important.
    Over the past two decades the markets have benefited from 
innovation from new technology and competition. Generally, markets open 
on time, close on time, and trades settle. However, there are problems 
below the surface.
    Here are some things we find concerning:
Order Routing Practices
    We question the nature of various order routing practices. The 
maker-taker model, payment for order flow, and internalization of 
orders all seem to present a challenge to order-routing protocols. Are 
order routing practices and incentives an impediment to the overarching 
requirement to seek best execution on all trades?
Colocation/Market Data Arbitrage
    We believe that the widespread use of colocation creates an uneven 
playing field that favors those who can and will pay for it. We 
question whether this has produced a market that values speed over fair 
access. In no other regulated industry is one party allowed a head 
start in exchange for payment. Our understanding is that current 
colocation practices allow for a market-data arbitrage where some 
investors get quotations and trade data faster than others. This 
advantage is traded upon, causing some participants to believe they are 
victims of front-running or are at least disadvantaged.
Speed and Impact on Market Integrity
    Our sense is that the almost myopic quest for speed has threatened 
the very market itself. It also seems many high frequency trading (HFT) 
strategies are designed to initiate an order to simply gauge the 
market's reaction and then quickly react and transact faster than other 
investors can. This seems inherently wrong. Our understanding is that 
the continued push for speed is not producing any marginal benefit to 
investors and in fact may be detrimental. This pursuit of speed as a 
priority is in direct conflict with the pursuit of market integrity as 
a priority.
Inaccessible Quotes and High Cancellation Rates
    The growth of HFT has lead to increased volume; however, whether 
the corresponding volume is ``good'' or ``bad'' deserves analysis. 
Volume does not necessarily mean liquidity for large institutional 
investors. When you combine high HFT volumes and even higher 
cancellation rates, these forces can combine to undermine market 
integrity and cause deterioration in the quality and depth of the order 
book. We feel that this volume is transitory and misleading.
Challenges to the National Market System (Regulation NMS)
    We believe the original construct of Regulation NMS was laudable 
and designed to encourage competition. However, we do not believe this 
regulation contemplated today's highly fragmented marketplace, where we 
have 13 different exchanges and over 50 unregulated ``dark pools.'' In 
such a fragmented market, can one really be confident in achieving best 
execution given the explosion of market data traffic? We question the 
markets' ability to process the overload of market data.
Conflicts of Interest
    We question whether the functional roles of an exchange and a 
broker-dealer have become blurred over the years and could warrant 
regulatory guidance regarding the inherent conflicts of interest. It 
seems clear that since the Exchanges have migrated to ``for-profit'' 
entities, a conflict has arisen between seeking volume to grow revenues 
and their obligation to assure an orderly marketplace for all 
investors.
HFT Trading Strategies
    Professional and proprietary traders often have divergent interests 
from those of investors concerned about the long-term. When the average 
holding period for such traders is measured in seconds as opposed to 
months or years, have we destabilized the market. Given recent market 
volatility, more study is warranted to assess the impact of the 
exponential growth of short-term trading strategies. Most rules and 
regulations seem to further enable those with short term profit 
incentives as evidenced by the proliferation of new order types 
suggested by exchanges and approved by regulators.
Suggestions
    We believe it is time is to step back and examine market structure 
and how it impacts all investors. A good first step might be to 
experiment with a number of pilot programs to examine different 
structural and rule modifications. We suggest a look at the 
appropriateness of colocation as a general practice and enhanced 
oversight of high frequency trading and other strategies that might be 
unduly burdensome to overall market functionality. We would like to see 
a pilot program where all payments for order flow, maker-taker fees, 
and other inducements for order flow routing are eliminated. We 
envision a pilot where there are wider minimum spreads and mandated 
time for quotes to be displayed to render them truly accessible. These 
programs can include a spectrum of stocks across market caps and 
average trading volumes, among other factors. We also suggest a pilot 
program of imposing cancellation fees for unacceptable trade to 
cancellation ratios. A key question is should we foster consolidation 
in this fragmented market? At a minimum, should we raise the barrier 
for becoming an exchange? In our opinion, requiring a more robust 
testing for new software would seem to make sense.
Conclusion
    T. Rowe Price appreciates all the efforts of the SEC and Congress 
as we strive to make the markets better and fairer for all 
participants. The Consolidated Audit Trail, Large Trader ID, limit up/
down initiatives are all improvements. We suggest any regulatory 
proposals be aligned with a goal of making the markets simpler, more 
transparent, and less focused on speed. We applaud the Committee's 
interest in making sure the right questions are asked.
    There are currently over 1,000 order types to express your buy and 
sell interest and we suggest that a simplified model may be more 
efficient for all investors. The issues we face are enormously complex. 
We certainly do not have all the answers. We believe that it is time to 
revisit the historical responsibility to provide a fair and orderly 
market.






                 PREPARED STATEMENT OF CHRIS CONCANNON
       Partner and Executive Vice President, Virtu Financial, LLC
                           September 20, 2012
    Chairman Reed, Ranking Member Crapo, and Members of the 
Subcommittee, I want to thank you for the opportunity to appear before 
you today. My name is Chris Concannon and I am an Executive Vice 
President for Virtu Financial, LLC.
    Virtu Financial (``Virtu'' or the ``Company'') is a global 
electronic market maker. Virtu is an active market maker on more than 
100 markets around the globe. Virtu makes markets from our six offices 
in New York, Los Angeles, London, Dublin, Sydney, and Singapore. The 
Company's market making activity spans across multiple asset classes, 
including cash equities, fixed income, currencies, futures, options, 
energy products, metals and other commodities. Virtu, through its 
subsidiaries, is directly registered as a broker dealer or investment 
firm and operates as a registered market maker on most primary markets 
around the globe. In the U.S., Virtu operates two registered broker 
dealers that are also registered as market makers or designated market 
makers on the NYSE, Nasdaq, BATS Exchange, NYSE Arca, and NYSE MKT. In 
Europe, Virtu operates a registered investment firm that is also 
registered as a market maker on the London Stock Exchange, the Swiss 
Exchange, Euronext, and the Deutsche Bourse Exchange. Obviously, Virtu 
believes in the benefits of market making and is committed to providing 
continuous, obligated liquidity in the markets we serve.
    In discussing the state of the U.S. equity market, I start from the 
premise that our equity market is the most dynamic and efficient market 
in the world. The U.S. equity market is a special asset that should be 
celebrated. Our markets are envied by Nations and financial centers 
around the globe. Our U.S. equity market is also the most liquid and 
robust pricing mechanism on the planet. My firm trades across all of 
the major financial markets and no market can compare to the U.S. 
equity market in terms of pricing efficiency and liquidity. Companies 
listed on our U.S. markets enjoy the most efficient and liquid market 
which contributes to higher returns for their investors. Over the last 
4 years, I have witnessed an unprecedented number of claims that our 
markets are horribly broken, unfair and dangerous. These claims tend to 
be short on facts and evidence, but long on press coverage and book 
deals. Our market is not perfect. And it has recently experienced some 
dramatic mishaps. But, despite its flaws, it is a market that has 
withstood the most unprecedented volatility and repricing of equity 
values in our lifetime while maintaining the same levels of pricing 
efficiency.
    Let me be clear, our market is not perfect. It has flaws and 
unnecessary complexity. The U.S. equity market is overly fragmented 
and, likely, over engineered. Stocks in the U.S. trade electronically 
on 13 national securities exchanges and over 40 dark pools. The current 
state of our equity market is not one that we would set out to design 
if we did it all over again. The U.S. equity markets began evolving 
into a fully electronic market during the 1990s. For the last decade, 
our markets have been largely automated. That means every exchange and 
every market in the U.S. is a fully automated, electronic destination. 
Virtually every order arrives at its intended exchange in electronic 
form. The automation that exists in our market today is not a new 
phenomenon. Technology has been operating our markets for the last 15 
years.
    With fragmentation and technology comes complexity. Our market is 
one of the most complex securities markets on the planet. It is not 
naturally complex. It is complex because of the number of major 
regulatory reengineering events that have taken place in the U.S. over 
the last 15 years. For example, the list of major market structure rule 
changes includes the Limit Order Display Rule, Regulation ATS, 
Decimalization, T+3 Settlement Cycle, Regulation NMS, Regulation SHO, 
Single Stock Circuit Breakers and, more recently, the Market Access 
Rule. Each of these major regulatory reengineering events required 
substantial technological enhancements to be delivered by all industry 
participants and exchanges. These were not simple software programming 
endeavors. These were all major technology projects completed across 
the industry.
    I would like to focus on three areas that I believe deserve further 
review: (1) our choice of a single market structure for all listed 
companies; (2) our markets failure to enhance market maker obligations; 
and (3) the industry's current risk management standards.
    First, our market is currently designed as a ``One-Size-Fits-All'' 
market. What I mean by this is that most of our major market structure 
rules do not distinguish between the size or market capitalization of 
the listed company, or the trading characteristic of its stock. Our 
markets are designed to execute all stocks, regardless of shape or 
size, using the same market mechanism. As the list of public companies 
continues to grow, a more diverse number of public companies trade on 
our market while subject to the same market structure. A stock that 
trades once per day is traded in the same market structure as a stock 
that trades one million times per day. Our market is solely designed 
for Cisco, Microsoft, and Bank of America and not for a stock that 
trades by appointment. I believe we should revisit our current market 
structure in order to create a better pricing mechanism for all stocks 
of different shapes and sizes. This One-Size-Fits-All approach is 
further exacerbated by an expansion of the portfolios of our largest 
investors. As institutional holdings expand further into less liquid 
stocks, like Russell 2000 stocks, our largest institutions are 
struggling to trade in our poorly designed market structure for those 
types of stocks.
    My second area of focus is on our markets' failure to enhance 
market making obligations. While my firm is a market maker and it is 
easier for me to call for enhanced market making obligations, I 
fundamentally believe that we need to increase obligated liquidity in 
our markets. Flash crashes, miniflash crashes and other market 
disruptions demonstrate the need for additional obligated liquidity in 
our market. However, I believe enhanced market maker obligations should 
be targeted where they are most needed and that is in our less liquid 
stocks. And so, my earlier point about our flawed, single market 
structure should be considered with enhanced market making obligations 
as a component of a new market model. New market models for less liquid 
stocks should be accompanied with enhanced market maker obligations.
    My final area of focus is the industry's current risk management 
standards. In light of recent events, I believe that the industry 
should explore ways to improve risk management standards. Industry 
participants have already identified several areas of risk management 
enhancements that should be implemented and could be delivered in short 
order. First, pretrade risk management limits are already required by 
the Securities and Exchange Commission (SEC) under SEC Rule 15c3-5 
(also known as the ``Market Access Rule''). Under the Market Access 
Rule, which has been in effect for over a year, firms are required to 
establish pretrade credit limits for every customer account and for the 
firm's own proprietary account. The credit limits required by the 
Market Access Rule must be administered in real-time and at all times. 
These credit limits are a firm's primary defense against unwanted 
trading activity by the firm or by its client.
    In addition, the industry is currently exploring specialized ``Kill 
switches'' that would be administered by exchanges. These ``Kill 
switches'', as currently being discussed, would provide a systematic 
shut-off of a firm if it exceeded prescribed or preset trading limits. 
``Kill switches'' would not be a primary defense, but rather, a 
secondary defense to back stop the failure of other risk management 
measures operated by a firm. Kill switches have operated effectively on 
futures exchanges in the U.S. for many years. These same trading limits 
could be implemented across all U.S. equity exchanges. Like the futures 
exchange limits, firms would be required to establish limits on each 
equity exchange. Such a kill switch would have severely limited the 
damage done on August 1st of this year.
    The last component to enhanced risk management is one of the most 
important. We believe a simple feature referred to in the industry as 
``drop copies'' should be required as a mandatory risk management tool. 
``Drop copies'' are separate and distinct connections offered by 
exchanges and other markets. Drop copies, which are widely used by the 
industry, provide a real-time echo, or copy, of a firm's trading 
activity on a given exchange. Drop copies are primarily used by the 
industry to run reconciliations that compare a firm's known trading 
activity against what the exchange believes was traded by the firm. 
This is commonly referred to as a ``Street vs. House'' comparison. If 
such a drop copy comparison is conducted in real-time by systems that 
are independent from the firm's trading system, a firm will always have 
an accurate assessment of its positions and trading activity, including 
both intended and unintended activity (See, Exhibit I).
    While I believe firms should have a robust process for developing 
and testing new software, the industry must have advanced risk 
management systems to limit the risk of unintended trading activity by 
a firm or its client. We know with certainty that software has bugs, 
hardware crashes and networks go down no matter the robustness of a 
firm's development and infrastructure process. The industry must build 
risk protections that assume the worst while a robust development and 
testing process avoids the worst. Pretrade risk checks, ``Kill 
switches'' and real-time drop copies protect us from the worst events.
    Thank you again for the opportunity to be here today to speak on 
this subject. I would be pleased to answer the Committee's questions.


                    PREPARED STATEMENT OF LARRY TABB
            Founder and Chief Executive Officer, TABB Group
                           September 20, 2012














































        RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
                        FROM DAVID LAUER

Q.1. Germany is considering legislation that would impose new 
rules on high-frequency trading. It is my understanding that 
this legislation would require traders to register with 
Germany's Federal Financial Supervisory Authority, collect fees 
from those who use high-speed trading systems excessively, and 
limit the number of orders that may be placed without a 
corresponding trade. The new rules would also grant the 
regulator the power to compel firms to detail their trading 
practices.
    Similar European-wide legislation is being considered by 
the Committee on Economic and Monetary Affairs of the European 
Parliament. These measures include a requirement for orders to 
rest on the exchange order book for a minimum of half a second 
and the testing of algorithms that allow preprogrammed trading.
    Canada began increasing the fees charged to firms that 
flood the market with orders earlier this year, with firms 
charged for all the orders they cancel, not just the trades 
they execute. Additional rules are expected to cut the amount 
of trades going to dark pools. Starting in October, the pools 
will be allowed to take orders only if they offer a 
significantly better price than the public exchange.
    What is your view of these various reform proposals? Would 
these measures make the U.S. markets more of less fair and 
efficient? Would these measures be feasible in the U.S. 
markets? Why or why not?

A.1. Adoption of several of these reforms would help make U.S. 
markets more fair and efficient. All of them are feasible, but 
that does not mean that they are advisable.
    I think many of the reform proposals are commonsense ideas 
with substantial empirical support. Requiring traders to 
register is an excellent idea and one that I continue to 
advocate for. This is part of the idea I presented in my 
written testimony requiring firms to register trading 
strategies and tag all of their orders with a strategy-level 
ID. This would deter nefarious activity and help regulators 
enforce existing regulations.
    I presented studies in my written testimony that attempt to 
quantify the negative externalities that HFT generate. Part of 
that is from excessive order rates and order cancellation 
rates. At the moment the cost of these externalities is not 
being borne by the producers. Germany and Canada's move to 
change that dynamic with cancellation fees is laudable.
    Finally, the Canadian rules are exactly the type of rules I 
argued for in my written testimony. Increasing the requirements 
for off-exchange execution is critical to restoring natural 
liquidity in the lit markets. These requirements should include 
substantial price improvement and a minimum execution size.
    I would not advocate for the European-wide legislation. I 
do not believe a Financial Transaction Tax would have the 
intended consequences. We have seen dramatic evidence of 
fleeing liquidity in those markets that have adopted this tax, 
although the market quality implications of that flight are 
still under study and may not be as dire as the liquidity 
flight would appear. A minimum resting period of a half second 
also seems extreme and not supported by empirical evidence. I 
have advocated for a pilot program to test a 50 millisecond 
holding period based on academic studies. I now believe that 
such a policy would only be advisable if it were done across 
all affected asset classes, include equities, options, and 
futures.

Q.2. In discussing the use of a ``hide not slide'' order type, 
there was testimony that stated that such an order is mainly 
used by professional traders and that it is not permitted for a 
broker to take an investor's order and slide it. Can anyone 
other than a professional trader use this order type? For 
example, can a broker-dealer acting on behalf of institutional 
investors use a ``hide not slide'' order? Why or why not?

A.2. Anyone can use this order type who has a direct connection 
to an exchange, and control over the flags that they are 
setting in the order that is sent to the exchange. A broker-
dealer can use this order type, although generally they only 
use the simplest order types when sending out orders on behalf 
of investors (or rebate-maximizing order types). Customers 
would have to specifically request that this order type is 
used, and ordinarily they would not do that.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF SENATOR HAGAN
                        FROM DAVID LAUER

Q.1. High-speed trading is an issue that has received 
considerable attention from market regulators throughout the 
world.
    On September 26, 2012, German Chancellor Angella Merkel's 
cabinet approved draft rules that would require high-speed 
traders to register with securities regulators and would 
mandate that automated orders be labeled as such when submitted 
to regulators. Can you evaluate the strengths and weaknesses of 
the approach taken by Germany?

A.1. As covered in my written testimony, I believe that 
registration of High-Frequency Traders is a simple, critical 
first step to regulating their activities. I also believe that 
the German proposal does not go far enough, as I would like to 
see registration of individual trading strategies with unique 
ID's assigned to them. These ID's should be placed in every 
order sent by these traders for regulatory tracking purposes, 
and also to support the function of enhanced, adaptive kill 
switches.

Q.2. In August, the Australian Securities & Investment 
Commission (ASIC) proposed reforms to automated share trading 
that are intended to prevent market disruptions. The proposal 
would require high-speed traders to put in place pretrade 
``filters'' and to limit or suspend automated orders that would 
``interfere with the efficiency and integrity of the market.'' 
This mandate is coupled with a fine on traders that could not 
trace orders and trading messages. Can you evaluate the 
strengths and weaknesses of the approach taken by Australia?

A.2. I believe it is important to unify risk controls across 
the industry, and Australia's efforts here are a good first 
step. What they are lacking is a centralized means of enforcing 
these regulations on a real-time basis, instead relying on 
analysis and fines after-the fact. In the U.S. most individual 
firms already have some risk controls in place, but regulators 
can do a better job of following Australia's example and unify 
these requirements. I don't believe that static kill switches 
are the answer however, and I don't believe that individual 
market centers should have this responsibility. Market activity 
cannot be analyzed by individual market centers, and therefore 
a centralized approach is necessary. The SEC can take on this 
role on a real-time basis, provided these firms are registered 
and tagging their orders with unique ID's.

Q.3. In July, Hong Kong's Securities and Futures Commission 
(SFC) released a proposal targeting automated trading. The 
SFC's proposal would require intermediaries to have 
``appropriate policies, procedures and controls . . . when they 
conduct electronic trading,'' example include pretrade risk 
management controls and post-trade monitoring. Can you evaluate 
the strengths and weaknesses of the approach taken by Hong 
Kong?

A.3. I believe Hong Kong's proposal suffers from the same 
weaknesses as Australia's. Individual firms can have an 
inordinate impact on the market, and therefore fining firms 
after-the-fact will not help to protect the market during a 
stressful event.

Q.4. Given that a wide range of countries have pursued changes 
that address computerized trading, how will the competitiveness 
of U.S. financial markets be impacted by a failure to adopt 
similar reforms?

A.4. The U.S. markets are developing a poor reputation because 
of our failure to properly regulate HFT. While some of the 
international reforms are knee-jerk reactions, and therefore 
inadvisable, many of them are sensible and will help to restore 
trust. These include registration of HFT firms, attempts to 
quantify negative externalities and shift the cost of those to 
the producer via cancellation fees, and increasing the hurdle 
for off-exchange executions.

Q.5. In an October, the Federal Reserve Bank of Chicago 
released a letter titled ``How to keep markets safe in the era 
of high-speed trading.'' The letter outlines several risk 
controls that could improve market structure and investor 
confidence. Please discuss the costs and benefits of the 
following controls:
    Intraday position limits.

A.5. This is a reasonable control, and is one most firms have 
already implemented.

Q.6. Limits on the number of orders that can be sent to an 
exchange within specified period of time.

A.6. This has similar problems to static kill switches. While 
it seems like a reasonable approach for a normally operating 
market, during times of market stress this could lead to severe 
problems.

Q.7. Automated trading is a logical extension of technology in 
a competitive market that may provide benefits such as 
increased transparency and better execution for market 
participants. What would happen to price discovery, 
transparency, and execution prices if high-speed trading ceased 
or declined?

A.7. It is important to distinguish between technology advances 
and high-frequency trading. Generally, most of the benefits to 
investors of increased liquidity and tighter spreads came 
before 2007 and the advent of high-frequency trading. In fact, 
several studies have shown increased spreads over the last 
couple of years, and no comprehensive studies have been done on 
execution costs overall. Spreads can be a poor proxy for 
execution costs, as so much liquidity in the market is fleeting 
(up to 40 percent according to one study cited in my written 
testimony). That being said, it is clear that in the near-term, 
market quality, price discovery and execution prices would all 
be harmed if high-speed trading were to cease, as it has become 
the primary supplier of liquidity in the market. We should 
instead take a measured approach to reducing nefarious 
activity, reining in certain practices, and evening the playing 
field. Many of the recommendations I make in my written 
testimony would be incremental approaches to confronting these 
issues, rather than blunt instruments such as a transaction 
tax.

Q.8. In the United States the Minimum Price Variation (MPV) for 
all stocks over one dollar is one penny. In Europe MPVs are 
less uniform.
    How do MPVs impact high-speed trading?

A.8. They have little impact on high-speed trading. Computers 
are very good at adjusting to this type of variable. They do 
help to reduce competition to high-speed traders, as smaller 
MPV's in low-priced or less liquid stock make it less 
profitable for regular market makers to provide liquidity. The 
reason is that when a market maker offers stock in a less 
liquid name, with an MPV of $0.01, a high-speed trader can 
simply step in front of them. While this may mean the 
appearance of a tighter spread, as market makers are driven out 
of business, spreads in these names widen again, and market 
depth suffers.

Q.9. What factors should be considered when determining the 
appropriate MPV?

A.9. An interesting proposal is to simply allow a firm to 
choose its own MPV, under the advice of an investment bank or 
other fiduciary. Barring this free market approach, market 
capitalization and liquidity should be the main factors.

Q.10. Should there be different MPV's for stocks of varying 
price or trading volume?

A.10. I agree that a one-size-fits-all approach to MPV has 
harmed smaller capitalization and less liquid companies. 
Alternatives should be explored and a pilot program would be an 
excellent first step.

Q.11. Several witnesses mentioned the proliferation of order 
types that are designed for high-speed traders.
    How do the order types available to trades in the United 
States compare to those available in markets abroad?

A.11. Foreign markets have a much smaller set of order types. 
Many order types are a result of Reg NMS requirements, and 
therefore other markets do not require such an extravagant set.

Q.12. How do exotic order types advantage or disadvantage 
retail investors, institutional investors, exchanges, and high-
speed traders?

A.12. High-frequency traders thrive on complexity. They make it 
their business to understand the nuances of every order type, 
and the exchanges often cater to them by providing access to 
the developers of the logic, or consulting with them when 
creating a new order type. HFT firms use exotic order types to 
segment order flow so that they don't interact with certain 
types of traders, or to play tricks to jump the queue. In 
addition, a lack of sophistication by institutional investors 
means that they can end up using order types that disadvantage 
them in terms of cost or priority.

Q.13. Please list those order types that you believe could be 
eliminated without doing harm to markets.

A.13. Post-only, PNP, PL Select, Hide-Not-Slide and the retail 
price improvement orders that have recently been approved.

Q.14. The increased fragmentation of exchanges and dark pools 
complicates the task of developing a market wide approach to 
data aggregation and analysis by regulators.
    What type of technology investments could advance the 
ability of the Securities and Exchange Commission and the 
Commodity Futures Trading Commission to better monitor markets 
and develop a market wide approach to data?

A.14. I have developed and presented a full proposal in my 
written testimony for a real-time, cross-asset monitoring 
system. This strikes me as the bare minimum that the regulators 
need to understand and stay on top of the current market. The 
Consolidated Audit Trail is important, but will fall far short 
of what is needed on a real-time basis. Markets are moving too 
quickly for regulators to always be a day or more behind. 
Regulators can take a balanced approach, including some 
investments in technology and leveraging the existing 
investments exchanges have already made. This real-time, 
market-wide surveillance system combined with a firm-level or 
strategy-level registration system would allow regulators to 
finally do their job, and enforce existing regulations 
properly.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
                      FROM CHRIS CONCANNON

Q.1. Germany is considering legislation that would impose new 
rules on high-frequency trading. It is my understanding that 
this legislation would require traders to register with 
Germany's Federal Financial Supervisory Authority, collect fees 
from those who use high speed trading systems excessively and 
limit the number of orders that may be placed without a 
corresponding trade. The new rules would also grant the 
regulator the power to compel firms to detail their trading 
practices.
    Similar European-wide legislation is being considered by 
the Committee on Economic and Monetary Affairs of the European 
Parliament. These measures include a requirement for orders to 
rest on the exchange order book for a minimum of half a second 
and the testing of algorithms that allow preprogrammed trading.
    Canada began increasing the fees charged to firms that 
flood the market with orders earlier this year, with firms 
charged for all the orders they cancel, not just the trades 
they execute. Additional rules are expected to cut the amount 
of trades going to dark pools. Starting in October, the pools 
will be allowed to take orders only if they offer a 
significantly better price than the public exchange.
    What is your view of these various reform proposals? Would 
these measures make the U.S. markets more or less fair and 
efficient? Would these measures be feasible in the U.S. 
markets? Why or why not?

A.1. Virtu Financial, LLC, (Virtu) is a global electronic 
market maker and active in more than 150 markets around the 
world. Virtu actively is actively engaged in dialogues with 
regulators around the Globe. Virtu actively supports global 
market reforms that include:

  1.  Registration requirements for active trading firms;

  2.  The ban on ``Naked-sponsored'' access;

  3.  Increased capital standards for market makers;

  4.  Implementation of market access and risk controls;

  5.  The establishment of real-time credit limits;

  6.  Limit-up/Limit-down Trading Controls;

  7.  The establishment of exchange kill switches;

  8.  Modernization of the U.S. surveillance systems and 
        mechanism; and

  9.  Enhanced market making obligations.

    However, rules or restrictions which limit technology or 
alter micromarket structure should be studied and have a 
measurable benefit. Our current market complexity was the 
result of micromarket structure changes implemented over the 
last 15 years. Those changes were not adequately studied and 
were driven by other initiatives.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF SENATOR HAGAN
                      FROM CHRIS CONCANNON

Q.1. Automated trading is a logical extension of technology in 
a competitive market that may provide benefits such as 
increased transparency and better execution for market 
participants. What would happen to price discovery, 
transparency, and execution prices if high-speed trading ceased 
or declined?

A.1. Our markets converted to automated markets 15 years ago. 
Since that conversion was made, trading costs of declined 
materially for all investors large and small. During this 
evolutionary change that benefited investors, our market 
intermediaries had to change as well. Our markets' market 
makers are automated out of the need to survive in an automated 
world. The elimination or decline of our electronic liquidity 
providers would directly impact price discovery and execution 
quality. Investors would ultimately be harmed by introducing 
unnecessary frictions into our markets.

Q.2. Several witnesses mentioned the proliferation of order 
types that are designed for high-speed traders. How do the 
order types available to traders in the United States compare 
to those available in markets abroad?

A.2. The implementation of regulatory changes over the last 15 
years, such as Regulation ATS and Regulation NMS, has resulting 
in greater market fragmentation and increased market 
complexity. It is this unique fragmentation and market 
complexity that has resulted in the proliferation of order 
types in the United States.

Q.3. In the United States the Minimum Price Variation (MPV) for 
all stocks over one dollar is one penny. In Europe MPVs are 
less uniform.
    How do MPVs impact high-speed trading?

A.3. MPVs impact all trading participants. MPVs set the minimum 
spread for quoting and trading of an instrument. Therefore, 
MPVs determine the price that all investors pay, both large and 
small, when entering or exiting the market. An MPV set too high 
will introduce substantial costs to investors. An MPV set too 
low can lower displayed liquidity and cause the appearance of 
increased price volatility.

Q.4. What factors should be considered when determining the 
appropriate MPV?

A.4. As I stated in my written testimony, our market is 
currently designed as a ``one size fits all'' market. More 
regulatory flexibility around MPV and other market structure 
features should be considered in order to accommodate the wide 
spectrum of publicly traded stocks in our market.

Q.5. Should there be different MPV's for stocks of varying 
price or trading volume?

A.5. Yes. ``One size fits all'' market structures are not 
appropriate.

Q.6. Several witnesses mentioned the proliferation of order 
types that are designed for high-speed traders.
    How do the order types available to trades in the United 
States compare to those available in markets abroad?

A.6. U.S. markets are highly complex and fragmented as a result 
of regulatory changes. Market participants have requested a 
variety of order types to address their unique needs to deal 
with this highly complex and fragmented market. These order 
types are filed with the Securities and Exchange Commission and 
approved by the SEC.

Q.7. How do exotic order types advantage or disadvantage retail 
investors, institutional investors, exchanges, and high-speed 
traders?

A.7. A variety of order types have been designed and made 
available to investors, both retail, institutional, and 
professional. These order types, which range from simple to 
complex, have been designed, delivered, and accessible to meet 
the unique needs of these investors.

Q.8. Please list those order types that you believe could be 
eliminated without doing harm to markets.

A.8. Because many order types have been designed to meet the 
unique needs of investors both large and small, such an 
analysis would require the solicitation of views from a very 
broad audience to ensure that certain order types are not 
mistakenly eliminated.

Q.9. The increased fragmentation of exchanges and dark pools 
complicates the task of developing a market wide approach to 
data aggregation and analysis by regulators.
    What type of technology investments could advance the 
ability of the Securities Exchange Commission and the Commodity 
Futures Trading Commission to better monitor markets and 
develop a market wide approach to data?

A.9. The two agencies seem to recognize that market structure 
and technology advancement issues present challenges to 
monitoring our modern markets. Consequently, the agencies have 
been openly discussing these market surveillance issues with 
interested parties including Virtu. We believe the design and 
implementation of a multimarket surveillance system is very 
achievable and will deliver the long term benefits needed to 
protect our markets.
              Additional Material Supplied for the Record
                    STATEMENT OF SENATOR CARL LEVIN
    I would like to thank Chairman Jack Reed, Ranking Member Crapo, and 
all my colleagues on the Securities, Insurance, and Investment 
Subcommittee for holding this hearing.
    Millions of American workers and their pension funds have long put 
their savings into the U.S. capital markets in hopes of a better 
retirement and better future. In recent years, though, a number of 
headline-grabbing events have raised serious questions about our 
markets in the minds of ordinary Americans, sophisticated investors, 
policy makers, and regulators.

    Are our markets too fragile and vulnerable to collapse?

    Are our markets fair for all investors?

    And are investors, who we need to fund the growth and 
        development of our companies and our economy, fearful about 
        subjecting their savings to these markets?

    Nearly 2 years ago, some of you joined with members of the 
Permanent Subcommittee on Investigations, which I chair, in a joint 
hearing to examine the efficiency, stability, and integrity of the U.S. 
capital markets. At that hearing, held in the wake of the so-called 
Flash Crash, experts raised a number of important issues, and we 
highlighted a number of potential regulatory improvements.
    I am pleased that the SEC took some steps to limit dangerous holes 
in our market regulation, such as unlimited, unsupervised direct market 
access. And just recently, the SEC finally issued a rule that will 
someday create a consolidated audit trail. These and other recent steps 
are a good start, but they are little more than Band-Aids. As anyone 
who has watched or participated in the markets in recent years knows, 
more must be done.
    It is time for a broad reexamination of the actual workings of our 
markets. When the horse and buggy gave way to the automobile, our 
national infrastructure needed an upgrade. During these tumultuous 
times, while we as a country learned how to take advantage of this 
great new innovation, there were innumerable horrific accidents: cars 
running into older horse-drawn vehicles; cars running off the edges of 
unpaved roads; and cars simply crashing into one another.
    What our country learned is that everything needed an upgrade. The 
roads themselves needed upgrades. They needed to be wider and more 
stable to bear the heavier traffic. The cars themselves needed to be 
safer. And the drivers needed an upgrade. They needed to adopt and 
follow ``rules of the road,'' like when to make a left hand turn and 
what to do when an emergency vehicle drives by. These upgrades needed 
to be enforced. Roads need to be inspected, as did the cars driving on 
them. Drivers needed to be tested, and police officers needed to ensure 
that drivers followed the rules.
    As the cars got faster over the next several decades, the benefits 
and needs for upgrades grew as well. We needed seatbelts and airbags. 
Roads needed to be wider, straighter, and bridges sturdier. Drivers 
needed to be smarter too. Those driving unique vehicles, like tractor 
trailers and busses, needed further training. And enforcement also 
needed upgrades. Because police officers can't be everywhere at once, 
speed cameras and red-light cameras have started to pop up.
    The goals of all of these innovations were simple: (1) minimize the 
number of crashes, and (2) make the crashes that do occur less harmful.
    In recent years, our capital markets have undergone a 
transformation that is no less stunning. The old New York Stock 
Exchange floor has been hollowed out. The screaming that once typified 
the floor is now replaced with the whir of computers. Traditional 
market makers have given way to computer trading firms with servers 
located right next to the computers of the trading venues.
    Computerized traders use automated trading systems to very quickly 
place and cancel orders--more than 90 percent are canceled--to make 
markets and arbitrage very small price differences between markets. In 
this very competitive industry, milliseconds can be the difference 
between millions in profits and significant losses. Because of that, 
computerized trading firms now pay thousands of dollars a year for the 
right to special proprietary data feeds from exchanges and other 
execution venues. Many rent space, for another hefty sum, to collocate 
their servers at execution venues. Doing this reduces the response time 
by a few milliseconds, which is worth millions of dollars to these 
firms. Orders to buy or sell stock are diced by computers into small 
bits, routed in milliseconds to any of several dozen venues, and 
executed in fractions of a second. All while other computerized trading 
programs are looking to sniff out those orders, and sneak in front of 
them for a profit.
    Investors who hold onto stocks for weeks, months, and years 
comprise less of the market than ever, giving way to computer trading 
programs holding onto stocks for fractions of a second.
    It is not surprising that this rapid development has resulted in 
more than our share of crashes, the most notable of which was the Flash 
Crash. And there are plenty of lessons to be learned from just that 
event.
    But, since then, numerous other crashes and technological errors 
have roiled the markets. Many investors were shocked to see the failure 
of the IPO of BATS Global Markets. BATS is itself a major exchange on 
which investors trade more than 500 million shares a day. Yet, due to a 
computer glitch on BATS's own systems, its IPO went haywire and 
ultimately had to be shelved.
    Just a few months later, another high profile IPO faced a different 
set of technical glitches. This time, trading glitches at Nasdaq left 
investors who tried to buy shares of Facebook, one of the most well-
known and valuable IPOs in recent memory, with no idea whether their 
trade had been completed for hours, and, reportedly in some cases, 
days. Now, Facebook stock is worth barely half of its initial value, 
and lawsuits continue to be filed as Nasdaq, the underwriters, and 
investors fight over the damage.
    Still another computerized trading error occurred last month. This 
time, Knight Capital, one of the largest market makers, nearly 
collapsed when a rogue trading program went unchecked for just about 40 
minutes. Despite new rules intended to stop wild price swings, millions 
of unintended trades flung prices and volumes in about 150 stocks all 
out of whack. Ultimately, a seemingly small programming glitch cost 
Knight about $440 million and forced them to sell off a 73 percent 
stake in the company, nearly wiping out existing shareholders.
    These accidental trades were one of the first significant tests of 
the rules that the SEC put in place after the Flash Crash. Most of 
those protections weren't triggered. While this is certainly a warning 
to other firms about the dangers of a single software error, it should 
also be a warning to regulators about the strength and security of our 
markets.
    And these incidents don't include the dozens of ``mini-crashes'' 
that have occurred in single issuers. For a company and their 
employees, it must be more than a bit discomforting to watch your stock 
price spike and plummet over minutes, often for no discernible reason. 
It's past time for some more upgrades.
    Regulators don't yet have effective systems to stop catastrophic 
collapses, and they lack the ability to see all of the activity that's 
occurring in all of the venues in a way that lets them understand 
what's going on. The consolidated audit trail was proposed years ago. 
It doesn't cover nearly enough activity, and is still years away from 
being a reality.
    Regulators don't seem to know what the traders are really doing. 
While so-called ``naked access,'' wherein traders are given unfettered 
access to the trading markets without real oversight, is banned, there 
are still no driving tests for these traders. There are still no 
licenses for these traders, unless they opt into them.
    System failures are not the only concerns with our markets. There 
are very real questions about whether our U.S. capital markets are 
fair. Since the joint PSI/Securities Subcommittee hearing in 2010, 
there have been a number of high-profile instances where some market 
participants have been given preferences over ordinary investors, and 
where our opaque market structure has allowed trading abuses that have 
victimized unwitting investors to go otherwise undetected.
    Recently, the Wall Street Journal reported how some exchanges have 
created special order types that allow sophisticated algorithmic 
traders to jump the line and take advantage of ordinary investors. In 
some cases, exchanges are creating order types for sophisticated 
traders to use that are designed not to trade. Some are hidden from 
few. These orders aren't about maintaining fair and transparent 
markets. Just the opposite.
    Also recently, the NYSE settled charges by the SEC that it sent its 
data feeds to certain customers faster than the data it provided to 
other market participants. Collectively, these reports show that some 
traders seem to be given a leg up on the rest of us. They get 
information faster. They process it faster. And they are given tools to 
take advantage of that information to the detriment of the rest of the 
market.
    One of the more offensive examples of this type of favoritism is in 
so-called ``flash orders,'' where a venue ``flashes'' an order to a 
select group of favored customers before showing that order to the rest 
of its members. What's to prevent one of those favored customers from 
taking advantage of that information to the detriment of the customer 
whose order was flashed? Not much. Senator Schumer and I, and others, 
have called for the banning of this practice. But, years later, that 
still hasn't happened.
    There are other fairness risks. Given the complexity of order 
routing, and the incentives of the current ``maker/taker'' model, 
brokers are often faced with a conflict of interest. They can send an 
order to a venue with the best price, or they can send it to the venue 
which gives them the most profit. If these decisions were made by 
humans, we could ask them why they make particular decisions. But they 
aren't. These decisions are buried deep within the codes of smart order 
routers. Institutional traders and ordinary investors alike should 
wonder whether the smart order router is really working for them or 
their broker. To be sure, many brokers are fulfilling their duties to 
their customers and getting the best executions, but how is the 
customer to know? How is a regulator going to know?
    Another significant challenge is the lack of transparency in the 
off-exchange trading venues. In a case last year, the SEC fined 
Pipeline Trading Systems, a dark pool operator, for trading in front of 
customers, taking advantage of their role in the center of the 
marketplace. While Pipeline was supposed to be matching up buyers and 
sellers, it was secretly trading against its customers, often for a 
profit. Is this type of activity happening at other dark pools? Most of 
them disclose that the firm itself may take the other side of a trade. 
So should it be ok if the customer knows that he's likely to be taken 
advantage of? What's his alternative? Is it to post the order on the 
New York Stock Exchange and be taken advantage of there?
    I look forward to today's hearing, and we should all look forward 
to pressing our regulators to address these questions. For more than a 
century, American markets have been the envy of investors across the 
world. We must continue to examine the regulations and structure that 
has been put in place to ensure that today's equity market is fair for 
all and has the right protections in place to prevent technical 
glitches from causing a collapse.
    Once again, I wish to thank Chairman Reed and Ranking Member Crapo 
for holding this important hearing today. I hope this hearing will lead 
to a strengthening of our markets to ensure that they remain the best 
in the world in coming years.
  STATEMENT OF MICAH HAUPTMAN, FINANCIAL CAMPAIGN COORDINATOR, PUBLIC 
                   CITIZEN'S CONGRESS WATCH DIVISION






















STATEMENT OF CAMERON SMITH, PRESIDENT, QUANTLAB FINANCIAL, AND RICHARD 
                      GORELICK, CEO, RGM ADVISORS




























     SUMMARY AND EXCERPTS FROM ``HIGH FREQUENCY TRADING AND PRICE 
           DISCOVERY'' BY TERRY HENDERSHOTT AND RYAN RIORDAN


