    [Senate Hearing 113-413]
    [From the U.S. Government Publishing Office]

                                                            S. Hrg. 113-413

                      CONFLICTS OF INTEREST, INVESTOR LOSS
                         OF CONFIDENCE, AND HIGH SPEED
                         TRADING IN U.S. STOCK MARKETS

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

                                    HEARING

                                   before the

                    PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

                                     of the

                                  COMMITTEE ON
                   HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS
                              UNITED STATES SENATE

                        ONE HUNDRED THIRTEENTH CONGRESS

                                 SECOND SESSION

                                   __________

                                 JUNE 17, 2014

                                   __________

             Available via the World Wide Web: http://www.fdsys.gov

                           Printed for the use of the
            Committee on Homeland Security and Governmental Affairs

                                     ______

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            COMMITTEE ON HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS

                      THOMAS R. CARPER, Delaware Chairman
    CARL LEVIN, Michigan                 TOM COBURN, Oklahoma
    MARK L. PRYOR, Arkansas              JOHN McCAIN, Arizona
    MARY L. LANDRIEU, Louisiana          RON JOHNSON, Wisconsin
    CLAIRE McCASKILL, Missouri           ROB PORTMAN, Ohio
    JON TESTER, Montana                  RAND PAUL, Kentucky
    MARK BEGICH, Alaska                  MICHAEL B. ENZI, Wyoming
    TAMMY BALDWIN, Wisconsin             KELLY AYOTTE, New Hampshire
    HEIDI HEITKAMP, North Dakota

                       Richard J. Kessler, Staff Director
                   Keith B. Ashdown, Minority Staff Director
                         Laura W. Kilbride, Chief Clerk
                       Lauren M. Corcoran, Hearing Clerk

                    PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

                         CARL LEVIN, Michigan Chairman
    MARK L. PRYOR, Arkansas              JOHN McCAIN, Arizona
    MARY L. LANDRIEU, Louisiana          RON JOHNSON, Wisconsin
    CLAIRE McCASKILL, Missouri           ROB PORTMAN, Ohio
    JON TESTER, Montana                  RAND PAUL, Kentucky
    TAMMY BALDWIN, Wisconsin             KELLY AYOTTE, New Hampshire
    HEIDI HEITKAMP, North Dakota

                Elise J. Bean, Staff Director and Chief Counsel
                          Daniel J. Goshorn,  Counsel
           Henry J. Kerner, Minority Staff Director and Chief Counsel
                     Jack Thorlin, Counsel to the Minority
                 Brad M. Patout, Senior Advisor to the Minority
               Scott Wittmann, Research Assistant to the Minority
                         Mary D. Robertson, Chief Clerk

                                C O N T E N T S

                                     ------
    Opening statements:
                                                                       Page
        Senator Levin................................................     1
        Senator McCain...............................................     4
        Senator Johnson..............................................     6
    Prepared statements:
        Senator Levin................................................    55
        Senator McCain...............................................    59

                                   WITNESSES
                             Tuesday, June 17, 2014

    Robert H. Battalio, Professor of Finance, Mendoza College of
      Business, University of Notre Dame, Notre Dame, Indiana........     7
    Bradley Katsuyama, President and Chief Executive Officer, IEX
      Group, Inc., New York, New York................................     9
    Thomas W. Farley, President, New York Stock Exchange, New York,
      New York.......................................................    31
    Joseph P. Ratterman, Chief Executive Officer, BATS Global
      Markets, Inc., Lenexa, Kansas..................................    33
    Joseph P. Brennan, Principal and Head of Global Equity Index
      Group, The Vanguard Group, Inc., Malvern, Pennsylvania.........    35
    Steven Quick, Senior Vice President, Trader Group, TD Ameritrade,
      Omaha, Nebraska................................................    36

                         Alphabetical List of Witnesses

    Battalio, Robert H.:
        Testimony....................................................     7
        Prepared statement...........................................    61
    Brennan, Joseph P.:
        Testimony....................................................    35
        Prepared statement...........................................    87
    Farley, Thomas W.:
        Testimony....................................................    31
        Prepared statement...........................................    77
    Katsuyama, Bradley:
        Testimony....................................................     9
        Prepared statement...........................................    69
    Quick, Steven:
        Testimony....................................................    36
        Prepared statement...........................................    93
    Ratterman, Joseph P.:
        Testimony....................................................    33
        Prepared statement...........................................    79

                                    APPENDIX
                                  EXHIBIT LIST

    1.a.  GMaker-Taker Conflict, chart prepared by the Permanent
      Subcommittee on Investigations.................................   102
      b.  GPayment for Order Flow Conflict, chart prepared by the
      Permanent Subcommittee on Investigations.......................   103
      c.  GConflict for Brokers Trading for Institutional Investors,
      chart prepared by the Permanent Subcommittee on Investigations.   104
      d.  GConflicts for Retail Brokers Trading for Retail Investors,
      chart prepared by the Permanent Subcommittee on Investigations.   105
    2. GLetter from the Securities and Exchange Commission to the
      Senate Permanent Subcommittee on Investigations, dated June 18,
      2014, regarding the impact of high-frequency trading on the
      efficiency, stability, and integrity of the U.S. capital
      markets........................................................   106
    3. GLetter from the Securities and Exchange Commission to the
      Senate Permanent Subcommittee on Investigations, dated August
      5, 2014, regarding conflicts of interest in the U.S. equities
      markets, including ``maker-taker'' fee schedules and payment
      for order flow by wholesale brokers to retail..................   123
    4. GLetter from TD Ameritrade, dated June 19, 2014, clarifying
      June 17, 2014 testimony of Steven Quick........................   125
    5. GResponse of Steven Quick, TD Ameritrade, Inc., to
      supplemental questions for the record of Senator Carl Levin....   126
    6. GResponse of Joe Ratterman, BATS Global Markets, Inc., to
      supplemental questions for the record of Senator Carl Levin....   127
    7. GResponse of Thomas Farley, NYSE Group, to supplemental
      questions for the record of Senator Carl Levin.................   128
    8. GResponse of Joseph Brennan, The Vanguard Group, Inc., to
      supplemental questions for the record of Senator Carl Levin....   129

                      CONFLICTS OF INTEREST, INVESTOR LOSS
                         OF CONFIDENCE, AND HIGH SPEED
                         TRADING IN U.S. STOCK MARKETS

                                  ----------

                             TUESDAY, JUNE 17, 2014

                                       U.S. Senate,
                  Permanent Subcommittee on Investigations,
                        of the Committee on Homeland Security
                                      and Governmental Affairs,
                                                        Washington, DC.
        The subcommittee met, pursuant to notice, at 9:35 a.m., in
    room SH-216, Hart Senate Office Building, Hon. Carl Levin,
    Chairman of the Subcommittee, presiding.
        Present: Senators Levin, McCain, and Johnson.
        Staff present: Elise J. Bean, Staff Director and Chief
    Counsel; Mary D. Robertson, Chief Clerk; Daniel J. Goshorn,
    Senior Counsel; Joseph Bryan, Robert Heckert, and Timothy
    Everett (Sen. Levin); Adam Henderson, Professional Staff
    Member; Henry J. Kerner, Staff Director and Chief Counsel to
    the Minority; Jack Thorlin, Counsel to the Minority; Brad M.
    Patout, Senior Advisor to the Minority; Scott Wittmann,
    Research Assistant to the Minority; John Lin, Law Clerk to the
    Minority; Joel Churches, Detailee (IRS); Admad Sarsour,
    Detailee (FDIC); Jacob Rogers, Law Clerk; Rebecca Pskowski, Law
    Clerk; Michael Avi-Yonah, Intern; Amy Dreisiger, Law Clerk;
    Owen Dunn, Law Clerk; Josh Katz and Richard Drucker (Sen.
    Levin); Ritika Rodrigues and Meris Petek (Sen. Johnson); and
    Myles Matteson (Sen. Ayotte).

                   OPENING STATEMENT OF SENATOR LEVIN

        Senator Levin. Good morning, everybody. Most Americans'
    image of the U.S. stock market is shaped by a single room: the
    trading floor of the New York Stock Exchange, where traders
    await a ceremonial bell to kick off the day's activity, then
    trade shares worth millions on scraps of paper.
        In reality, most shares are traded not on a floor in
    Manhattan, but in racks of computer servers in New Jersey.
    Trades happen not at the speed of a human scribbling on paper,
    but in the milliseconds it takes for an order to travel through
    fiberoptic cables. And, increasingly, the money made on stock
    markets comes not from thoroughly assessing companies for their
    investment potential, but from exploiting infinitesimal
    advantages at unfathomable speeds, earning billions off price
    differences measured in pennies.
        We are in the era of high-speed trading. I am troubled, as
    are many, by some of its hallmarks. It is an era of market
    instability, as we saw in the 2010 ``flash crash,'' which this
    Subcommittee and the Senate Banking Committee explored in a
    joint hearing, and in several market disruptions since that
    flash crash. It is an era in which stock market players buy the
    right to locate their trading computers closer and closer to
    the computers of stock exchanges--conferring a minuscule speed
    advantage yielding massive profits. It is an era in which
    millions of trade orders are placed, and then canceled, in a
    single second, raising the question of whether much of what we
    call the market is, in fact, an illusion.
        Many, including this Senator, question whether the rise of
    high-speed trading is, overall, a good thing for markets and
    investors. But without question, this era has seen a rise of
    conflicts of interest. These conflicts will be my focus today.
    Other Senators may focus on this or other aspects of high-speed
    trading.
        New technologies should not erase enduring values.
    Financial markets cannot survive on technology alone. They
    require a much older concept: trust. And trust is eroding.
    Conflicts of interest damage investors and markets--first, by
    depriving investors of the certainty that brokers are placing
    the interests of their clients first and foremost; and, second,
    by feeding a growing belief that the markets are simply not
    fair.
        In fact, polling shows that roughly two-thirds of Americans
    believe the stock market unfairly benefits some at the expense
    of others. This distrust may be a factor in the fact that just
    over half of Americans, according to a Gallup survey earlier
    this year, own stock or mutual funds, which is down from more
    than two-thirds of Americans who owned stock or mutual funds in
    2002. That lack of faith--if allowed to fester and grow--will
    undermine a very important public purpose of stock markets: to
    efficiently raise capital so that businesses may grow, create
    new jobs, and add to America's prosperity.
        In previous hearings and investigations, this Subcommittee
    has shown that our financial markets have become plagued by
    conflicts of interest. We have uncovered investment banks
    willing to create securities based on junk assets, tout them to
    their clients, and then bet against those same securities,
    making a fortune at the expense of their clients. We have seen
    credit rating agencies assign artificially high ratings to
    securities in order to keep or gain business. Now, with that
    history in mind, those who argue that the conflicts we will
    explore at this hearing are manageable or acceptable have a
    mighty high burden of proof.
        What seems to your average investor to be a simple stock
    market trade is usually a complicated series of transactions
    involving multiple parties, complex technology, and an ever-
    increasing number of order types and payment arrangements.
    There are retail brokers, like the ones found in Main Street
    offices across the country and on TV advertisements. There are
    wholesale brokers who buy orders from retail brokers. And there
    are dozens of trading venues where shares are bought and sold.
    Most Americans know the New York Stock Exchange, but there are
    now 11 public exchanges, plus more than 40 alternative trading
    venues including ``dark pools,'' which are essentially private
    exchanges run by financial institutions.
        As that complex structure has emerged, so have a number of
    conflicts of interest. I will focus on two. The first conflict
    occurs when a retail broker chooses a wholesale broker to
    execute trades. The second occurs when a broker, acting on
    behalf of either a retail client or an institutional investor
    that manages pension funds and retirement accounts, chooses a
    trading venue, often a public exchange, to execute a trade. At
    both of these decision points, the party making the decision
    should only be influenced by the best interest of the investor.
    That is what ethics demands, and it is what the law requires.
        But there is another factor in play. At both decision
    points, the current structure gives brokers an incentive to
    place their own interests ahead of the interests of their
    clients. And here is how.
        The first conflict, which is illustrated in that chart,\1\
    occurs when retail brokers receive payments from wholesale
    brokers for their orders. This money, known as ``payment for
    order flow,'' can add up to untold millions, and almost every
    retail broker keeps these payments rather than passing them on
    to clients. The reasons wholesale brokers are willing to pay
    for order flow are complex, but one big one is that wholesale
    brokers can fill many of those orders out of their own
    inventory and profit from the trade--a practice known as
    ``internalizing.''
    ---------------------------------------------------------------------------
        \1\ The chart titled ``Payment for Order Flow Conflict,'' appears
    in the Appendix on page 103.
    ---------------------------------------------------------------------------
        The second conflict, shown on the second chart,\2\ arises
    when a broker decides to use a public trading venue and then
    chooses which venue it will send orders to for execution. Under
    what is known as the ``maker-taker'' arrangement, there is an
    incentive for the broker to choose the trading venue based on
    the broker's financial interest, rather than the client's.
    ---------------------------------------------------------------------------
        \2\ The chart titled ``Maker-Taker Conflict,'' appears in the
    Appendix on page 102.
    ---------------------------------------------------------------------------
        Now, ``maker-taker'' can be complicated, but here is a
    simplified explanation. When a broker makes an offer on an
    exchange to buy or sell a stock at a certain price, the broker
    is classified as a ``maker,'' and most exchanges will pay the
    broker a rebate when that offer to buy or sell is accepted. A
    broker who accepts a maker's offer to buy or sell is called a
    ``taker'' and will generally pay a fee to the trading venue.
    The important thing to remember is that brokers, by maximizing
    maker rebates and by avoiding taker fees, can add millions of
    dollars to their bottom line, giving them a powerful incentive
    to send the order to the trading venue that is in their best
    interest even if it is not in their client's best interest.
        It is significant that earlier this year, speculation that
    regulators were considering restrictions on payment for order
    flow sent shares of some brokerage firms significantly lower.
        Obviously, there is a lot of money at stake in preserving
    these conflicts of interest.
        Even if firms disclose these payments, disclosure does not
    excuse them from their legal and ethical obligations to
    clients. Their legal obligation is to provide clients with what
    is known as ``best execution.'' Whether they are meeting that
    obligation is a subjective judgment. The outcome of this
    subjective judgment affects the way tens of millions of trades
    are executed.
        Now, some who profit from these payments argue that seeking
    this revenue does not interfere with their obligation to seek
    best execution. However, one of our witnesses today, Professor
    Robert Battalio of the University of Notre Dame, has done
    research indicating that when, given a choice, four leading
    retail brokers send their orders to the markets offering the
    biggest rebates at every opportunity. The research further
    suggests that exchanges offering the highest rebates do not, in
    fact, offer the best execution for clients. These brokers argue
    that they can pocket these rebates while still meeting their
    obligation to provide clients with best execution. So while
    they make a subjective judgment as to which trading venue
    provides best execution, on tens of millions of trades a year,
    that subjective judgment always just happens to also result in
    the biggest payment to brokers. I find it hard to believe that
    this is a coincidence.
        Many market participants are worried about the conflicts of
    interest embedded in the current market structure. In addition
    to Professor Battalio, today's first panel will include Bradley
    Katsuyama, the president and CEO of IEX and a prominent Wall
    Street advocate for market reform. Our second panel will
    include four witnesses. They are Thomas W. Farley of the New
    York Stock Exchange, whose corporate owners have described
    conflicts as having a ``corrosive impact'' on stock markets.
    The next person on the second panel is Joseph Ratterman of BATS
    Global Markets, which operates exchanges that compete with the
    New York Stock Exchange and has a different view. The third
    witness on the second panel is Joseph Brennan of Vanguard
    Group, a major mutual fund company that has expressed concerns
    about these conflicts. And the fourth witness on the second
    panel is Steven Quirk of TD Ameritrade, a retail broker that
    derives significant revenue from payment for order flow from
    wholesale brokers and rebates that they receive from exchanges.
        The duty of lawmakers and financial regulators is to look
    out for the interests of investors and the wider public. There
    is significant evidence that these conflicts can damage
    retirement savings, pension holdings, and other investments on
    which Americans rely. And even Americans without a single share
    of stock or a mutual fund account have something at stake
    because stock markets exist to foster investment, growth, and
    job creation. Conflicts of interest jeopardize that vital
    function.
        Americans do not shy from innovation or technology; indeed,
    we embrace them. But Americans are understandably suspicious
    when technology can be turned against them and their families'
    financial interests. They are rightly concerned when technology
    and innovation are used to undermine basic, enduring principles
    such as trust and duty to a client. Our goal is to advance the
    protection of investors and our free markets by promoting those
    enduring values.
        I want to thank Senator McCain and his staff for their
    close cooperation in this matter, as has always been the case
    in all matters. Senator McCain.

                  OPENING STATEMENT OF SENATOR McCAIN

        Senator McCain. Thank you very much, Mr. Chairman, and I
    think this is a very important hearing, and I appreciate the
    hard work that you and your excellent staff have done on it.
    And I want to thank the witnesses for being here today.
        When Michael Lewis' book ``Flash Boys'' came out, the
    public knew very little about high-frequency trading. Important
    questions were raised: Is the stock market ``rigged'' by
    unethical high-speed traders with faster access to market
    information, advanced technology, and sophisticated trading
    algorithms? Is high-frequency trading adding costs for other
    traders without contributing any real value to the market? Will
    stock markets face another flash crash like in 2010 when the
    Dow Jones temporarily lost $1 trillion in market value in 20
    minutes?
        These concerns about high-frequency trading have fueled
    suspicions that Wall Street may well have become the ultimate
    insiders' game, where the average investor can no longer
    meaningfully participate. Consumers see firms that can make
    trades in fractions of a second using cutting-edge technology
    and wonder if the stock exchanges are still a place where their
    interests matter. Hopefully, this hearing will shed light on
    the high-frequency trading practices used on Wall Street and
    help restore confidence in our financial system.
        The Subcommittee interviewed many industry participants,
    academic researchers, and key financial regulators. While the
    problems facing the market are complex, we can address them
    with a few commonsense solutions. For example, one of the most
    predatory high-frequency trading practices depends on the
    unintended consequences of the SEC's Regulation National Market
    System, or Reg NMS. That regulation essentially mandated that
    investment firms must buy or sell stocks at the best price
    available. While that might sound like a reasonable
    requirement, high-frequency trading firms can take advantage of
    the rule by putting out offers to buy or sell small amounts of
    stock at attractive prices. When a large investor, seeking to
    make a big order, accepts the high-frequency trading firm's
    offer because it is the best price available, the high-
    frequency trader can predict that the large investor will have
    to go to another exchange to purchase the rest of his order.
    The high-frequency trader can then race ahead of that investor
    to the other exchanges, buy up all available shares, and sell
    them to the large investor at a higher price. Changing Reg NMS
    so that investment firms are no longer legally required to take
    the high-frequency traders' bait is an easy, clear first step
    to cleaning up the worst high-frequency trading practices.
        Another key tactic used by high-frequency trading firms is
    co-location. This practice involves trading firms literally
    renting space for their computers in the same room as the
    computers that run the stock exchanges so that they can receive
    market information directly from the exchanges' computers as
    fast as possible. The investors that do not buy this direct
    connection to the exchanges receive market data via a
    government-established system using out-of-date technology
    called the Securities Information Processor that compiles
    market data much more slowly. But as experts told the
    Subcommittee, there is no reason why public data feeds like the
    Securities Information Processor cannot be improved so that
    they are effectively as fast as private data feeds acquired
    through co-location. Updating the technology in the Securities
    Information Processor is another helpful measure that can be
    quickly adopted to shore up consumer confidence in the market.
        In addition to high-frequency trading, ``Flash Boys'' also
    described how stock exchanges often pay rebates, as Senator
    Levin pointed out, to stockbrokers to entice them to trade on
    those exchanges. Those rebates, again, as Senator Levin pointed
    out, called ``maker-taker payments,'' create an apparent
    conflict of interest for the stockbrokers, who must choose
    between sending their clients' orders to exchanges offering a
    higher rebate or to exchanges that would fill the orders as
    quickly as possible. While many trading firms argue that those
    payments spur more market activity and reduce costs for
    consumers, some experts have argued that these benefits are
    minimal and that investors are harmed by their brokers'
    conflict of interest.
        The Subcommittee has found that there is a lack of publicly
    available data regarding maker-taker payments, leading to
    difficulties in determining whether the payments actually have
    an adverse effect on the market. A logical first step would be
    to have more transparency in the payments, allowing neutral
    researchers to study the issue in greater detail.
        I hope this hearing will educate the public about high-
    frequency trading and broker conflicts of interest, and I hope
    that as a result of this hearing and the information that we
    will obtain from our expert witnesses that action will be taken
    to restore investor confidence, which has clearly been eroded
    in recent months, especially since the publication of Michael
    Lewis' book.
        I thank you, Mr. Chairman.
        Senator Levin. Thank you very much.
        Senator Johnson.

                  OPENING STATEMENT OF SENATOR JOHNSON

        Senator Johnson. Thank you, Mr. Chairman. I also want to
    thank you for holding this hearing. It was very interesting
    getting prepared for it.
        Both Chairman Levin and Senator McCain mentioned the word
    ``complex,'' and there is no doubt about it. What is happening
    in terms of trading is highly complex.
        From my standpoint, having been an individual investor, I
    think the primary solution is increased competition and
    transparency so that we really understand what is happening.
    But because it is complex, it is difficult to fully understand.
    I am hoping this hearing will really lay out the reality of the
    situation, and, again, as an individual investor who has bought
    stocks for literally decades, the competition has increased in
    the marketplace. I used to pay hundreds of dollars to buy 100
    shares of stock. Now I pay about $10.
        So I really do hope that this hearing conveys exactly what
    is happening in the marketplace, what benefits have come to
    consumers over the years, what dangers may be out there, but
    the bottom line is that this hearing should be about restoring
    confidence. I do not think it restores confidence if we try and
    create a state of fear and set up straw men in terms of the
    bogeymen out there trying to game the system. The best way to
    ensure confidence and to ensure best price, is through maximum
    competition and transparency in the marketplace. I am hoping
    that is certainly what this hearing reveals, and, again, I just
    want to thank all the witnesses. I am looking forward to the
    testimony.
        Senator Levin. Thank you, Senator Johnson.
        We will now call our first panel of witnesses for this
    morning's hearing: Professor Robert Battalio, Professor of
    Finance at the Mendoza College of Business at the University of
    Notre Dame in Notre Dame, Indiana; and Bradley Katsuyama,
    President and CEO of the IEX Group in New York.
        I appreciate both of you being with us this morning, and we
    look forward to your testimony. And pursuant to Rule 6, all
    witnesses who testify before the Subcommittee are required to
    be sworn. So at this time, I would ask both of you to please
    stand and raise your right hand. Do you swear that the
    testimony you are about to give before this Subcommittee will
    be the truth, the whole truth, and nothing but the truth, so
    help you, God?
        Mr. Battalio. I do.
        Mr. Katsuyama. I do.
        Senator Levin. We will be using a timing system today.
    Please be aware that 1 minute before the red light comes on,
    you will see the light change from green to yellow, giving you
    an opportunity to conclude your remarks. All of your written
    testimony will be printed in the record in its entirety, and we
    would ask that you try to limit your oral testimony to 5
    minutes.
        Professor Battalio, we will have you go first. Thank you
    again for coming today and for your work.

       TESTIMONY OF ROBERT H. BATTALIO,\1\ PROFESSOR OF FINANCE,
     MENDOZA COLLEGE OF BUSINESS, UNIVERSITY OF NOTRE DAME, NOTRE
                             DAME, INDIANA

        Mr. Battalio. Good morning. Chairman Levin and Ranking
    Member McCain, thank you for inviting me to testify today. It
    is an honor to have the opportunity to present my views on
    conflicts of interest in U.S. equity markets to the Senate
    Permanent Subcommittee on Investigations. My expertise is the
    relationship between order flow inducements offered by dealers
    and exchanges and the quality of trade execution.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. Battalio appears in the Appendix
    on page 61.
    ---------------------------------------------------------------------------
        Before discussing my current research with Shane Corwin and
    Robert Jennings, I would like to provide a bit of context.
    Orders used by retail investors can be broadly classified into
    two categories.
        Investors who want to trade quickly at the best available
    price use marketable orders. These orders demand or take
    liquidity from the market. Investors who are willing to buy or
    sell stock but not at the prices that are currently prevailing
    in the marketplace use nonmarketable or standing orders to
    express their trading interests. Nonmarketable orders do not
    immediately execute when they arrive in the market. Exchanges
    use electronic order books to keep track of their nonmarketable
    orders, and they typically use price-time priority to determine
    which nonmarketable order trades when a marketable order
    arrives. The nonmarketable orders resting on the electronic
    books make or supply liquidity for other market participants.
        Several exchanges use make or liquidity rebates to attract
    nonmarketable orders. A make rebate is paid to an investor or
    her broker when her nonmarketable order trades. To fund the
    make rebates, the same exchanges charge marketable orders a
    take fee when they trade with nonmarketable orders. As a result
    of competition, exchanges offering high make rebates also tend
    to charge high take fees, and those offering low make rebates
    tend to charge low take fees.
        The incentives created by the maker-taker fee structure
    suggest marketable orders will tend to be first routed to
    venues that have low take fees and, thus, low make rebates. As
    a result, nonmarketable orders on high-fee, high-rebate venues
    are likely to trade last at a given price and, thus, can miss
    out on profitable trading opportunities. All else equal, this
    suggests that the likelihood that nonmarketable orders trade is
    lowest on the exchanges with the high make rebates.
        NASD Notice to Members 01-22 states that brokers must take
    into account differences in the likelihood of execution when
    determining where to route nonmarketable orders and that
    brokers must not allow inducements to interfere with the duty
    of best execution. The conflict of interest associated with
    make-take fee schedules arises from the fact that most brokers
    do not pass fees and rebates directly through to their
    customers, but instead charge fixed commission rates that
    reflect fees, rebates, and other costs of doing business.
        Thus, while investors prefer that their orders be routed to
    the venue offering the highest possibility of trade, a broker
    may have an incentive to route orders to the venue offering the
    highest liquidity rebate. It may seem that economics and
    competition should align the incentives of a broker and its
    customers; however, this alignment of incentives is hampered by
    an important agency problem. Brokers that maximize rebates may
    be able to charge lower commissions. If investors choose
    brokers based primarily on commissions--perhaps because they
    lack the sophistication and/or the necessary information to
    evaluate limit order execution quality--it may be profit
    maximizing for brokers to focus on liquidity rebates rather
    than the likelihood of execution when deciding where to route
    their nonmarketable orders. Unfortunately, investors whose
    orders do not execute do not receive the benefit of the low
    commission.
        In our paper, we examine two issues. We begin by exploring
    whether make rebates appear to influence the routing decisions
    of retail brokers. We present evidence from SEC-mandated Rule
    606 filings that four popular retail brokers route
    nonmarketable orders in a manner that is consistent with the
    goal of maximizing make rebates. Our Rule 606 data are from the
    fourth quarter of 2012, but subsequent Rule 606 filings suggest
    these brokers have not significantly altered their routing of
    nonmarketable orders.
        After establishing that rebates appear to impact the order
    routing decisions of some brokers, we next analyzed the
    relationship between make rebates and several measures of
    execution quality, including the likelihood that and the
    conditions in which nonmarketable orders trade. Our analysis
    makes use of a proprietary data set of nonmarketable orders
    that represent about 1.5 percent of average daily volume and a
    publicly available data base that contains all trades and
    quotes.
        As hypothesized, we find that nonmarketable orders routed
    to venues with low make rebates are more likely to trade, trade
    faster, and suffer less adverse selection than nonmarketable
    orders routed to venues with high make rebates. Our results
    suggest that when deciding where to route nonmarketable orders,
    situations frequently arise in which brokers must decide
    whether to maximize the likelihood of an execution or to
    maximize make rebates.
        Thanks for the opportunity to discuss my research with
    Shane and Bob today.
        Senator Levin. Thank you very much, Professor Battalio.
        Mr. Katsuyama.

        TESTIMONY OF BRADLEY KATSUYAMA,\1\ PRESIDENT AND CHIEF
         EXECUTIVE OFFICER, IEX GROUP, INC., NEW YORK, NEW YORK

        Mr. Katsuyama. Good morning, Chairman Levin, Ranking Member
    McCain, Senators, staff, ladies and gentlemen. Thank you for
    the opportunity to participate in this hearing and share our
    thoughts on issues affecting the U.S. equity markets. My name
    is Brad Katsuyama, and I am the President and CEO of IEX Group.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. Katsuyama appears in the Appendix
    on page 69.
    ---------------------------------------------------------------------------
        Since October 2013, IEX has been operating as an
    alternative trading system for U.S. equities, and we intend to
    pursue registration as a national securities exchange with the
    Securities and Exchange Commission later this year.
        IEX was founded on the premise of institutionalizing
    fairness in the market through the use of technology and by
    offering a balanced, simplified, and transparent market model.
    IEX believes strongly in a market's responsibility to ensure
    just and equitable principles of trade as required by Section 6
    of the Securities and Exchange Act of 1934.
        With that in mind, IEX deliberately sought to build a
    platform that would eliminate conflicts of interest in the
    operation of our market. Specifically, IEX is owned by a
    consortium of mutual funds, hedge funds, family offices, and
    individuals, but only has registered broker-dealers as trading
    participants. IEX does not pay rebates or provide any other
    payment for order flow, and as a result, we have a very limited
    number of order types.
        IEX has instituted a time buffer that applies to all of our
    trading participants to neutralize certain structural
    inefficiencies that we have discovered. IEX uses direct market
    data feeds from all U.S. exchanges rather than the slower SIP
    to price orders and trades in our market. And IEX was the first
    ATS to publicly publish our confidential form ATS in an effort
    to promote transparency.
        It is important to recognize that IEX was created within
    the current regulatory framework, serving as evidence that the
    spirit of the rules governing our current market do allow for
    innovative free market solutions to emerge. We believe that the
    U.S. equity markets have improved dramatically over the past 20
    years as participants can now trade less expensively and faster
    than they did in the past. But we believe this was mainly due
    to the inevitable improvements that technology has delivered
    across many industries, with financial markets being no
    exception.
        Despite those benefits, it has become apparent to our team
    and our supporters that the U.S. equity markets are also far
    from perfect, and these imperfections that we have discovered
    over the last several years are the reason we started IEX and
    the reason I am sitting here today.
        We believe that the number of independent equity trading
    destinations across exchanges, dark pools, and other
    internalizers, each having their own unique technology,
    products, rule sets, and pricing schedules, creates a
    tremendous amount of complexity. This complexity, combined with
    the lack of clear language disclosure, has created structural
    inefficiencies which allow unfair advantages and disadvantages
    to various market participants.
        This complexity has also put the health and stability of
    the overall market at risk without contributing to the market's
    ability to serve its core function--capital formation.
        There are four main conflicts of interest that we would
    like to highlight.
        First, due to the complex fee and rebate structure of
    trading venues, brokers have perverse incentives when deciding
    where and how to route customer trades. Many high-quality
    studies, including the one from Professor Battalio, have
    demonstrated the direct relationship between a broker
    attempting to harvest rebates and worse execution quality for
    their customers. Based on our team's prior experience, we can
    confirm these findings.
        Second, to avoid high fees for taking liquidity on
    exchanges, many of the largest brokers created their own
    private dark pools to internalize order flow, in the process
    isolating client orders away from the broader market. Although
    many of these broker pools are interconnected, at times brokers
    are unwilling to route orders to other broker pools to avoid
    improving the performance of a competitor, even though it may
    be in the best interests of their client to do so.
        Third, trading venues, including exchanges and dark pools,
    naturally seek to maximize profits by increasing their own
    trading volumes, and as a result, there are many predatory,
    high-volume trading strategies that are left unattended--
    intermediating between venues--as certain market centers
    prioritize market share over protecting the interests of client
    orders.
        And, fourth, markets that offer co-location and different
    speeds of market data and connectivity have a direct conflict
    in the profits garnered from selling these services versus the
    structural inefficiency created when those same products enable
    a participant to trade faster than the market itself to the
    detriment of any participant who relies on the market to fairly
    price trades.
        Although many of these issues are deeply embedded in our
    market structure, IEX believes that the best policies to
    address these conflicts are those that promote transparency and
    disclosure. The SEC's Midas website and FINRA's ATS reporting
    rule are recent positive steps, and we would encourage further
    pursuit of transparency, specifically these three points:
    first, standardization of data collection and reporting;
    second, disclosure of both routing and trading information in a
    standardized form between brokers and clients; and, third, full
    disclosure of rules, products, and services from all market
    centers.
        The most important implication of transparency is that it
    brings accountability to all participants in our market.
    Heightened forced transparency will give participants the
    information they need to ask critical questions and to make
    better decisions. This will allow the market to self-regulate.
        We respectfully ask that if Congress or the Commission
    looks to further modify the structure of the equity markets,
    careful consideration is given to deciding which issues are
    better solved through regulation and which issues are better
    addressed through free market solutions.
        In closing, IEX would like to echo SEC Chair White's recent
    statement that, ``The secondary markets exist for investors and
    public companies, and their interests must be paramount.'' As
    the financial services work through this period of change, none
    of us should forget why the market exists in the first place.
        Thank you.
        Senator Levin. Thank you very much, Mr. Katsuyama.
        Let us try a first round of 8 minutes, if that is all
    right, and we will have as many rounds as we need. And that is
    true with both panels. We have four votes that are going to
    begin at 11 o'clock. I will stay here at least through the
    first two votes and miss those votes as currently planned, and
    others can come and make the votes should they wish.
        Professor Battalio, let us talk about the nonmarketable
    orders. These are the ones that do not have an immediate match
    and that add or make liquidity.
        Now, under the maker-taker pricing, most exchanges are
    willing to pay brokers for sending them nonmarketable orders.
    Is that correct so far?
        Mr. Battalio. Yes, sir. Very good.
        Senator Levin. Some retail brokers send virtually all
    nonmarketable orders to exchanges that pay a rebate. Is that
    correct?
        Mr. Battalio. That also appears to be true.
        Senator Levin. OK. Now, your paper looked at where retail
    brokers routed nonmarketable customer orders and stated that
    Ameritrade, E*Trade, Fidelity, and Scottrade route orders in a
    way that suggests that they may be focused on liquidity
    rebates. How often did those retail brokers route nonmarketable
    orders to the exchange offering the highest rebate?
        Mr. Battalio. Those four brokers--well, three of the four
    brokers either route things called--the SEC reports are not
    good enough to distinguish between marketable and nonmarketable
    limit orders, OK? But based on an assumption that is pretty
    solid, three of the four either route limit orders to people
    that pay for order flow--and those are probably marketable
    orders--or to the high-fee venue, nowhere else.
        Senator Levin. And the high-fee venue are the exchanges.
        Mr. Battalio. It is one venue offering the high make
    rebate.
        Senator Levin. All right. So when it comes to order flow,
    they go to the wholesale brokers generally. Is that correct?
        Mr. Battalio. With the marketable stuff, they go to the
    wholesalers.
        Senator Levin. With the marketable stuff, and they are paid
    for that.
        Mr. Battalio. Yes, sir.
        Senator Levin. And they always go to the high rebate
    exchange----
        Mr. Battalio. The one high----
        Senator Levin [continuing]. For the nonmarketable ones?
        Mr. Battalio. Yes, sir.
        Senator Levin. OK. Now, your paper assessed whether the
    decision by retail brokers to route nonmarketable customer
    orders to exchanges that pay the highest rebate was consistent
    with the broker's obligation to obtain best execution of their
    customers' orders. And this is now quoting from your paper:
    ``The results of our analysis suggest that routing all
    nonmarketable orders to a single exchange that offers the
    highest liquidity rebates is inconsistent with maximizing
    nonmarketable order execution quality.'' Is that quote correct?
        Mr. Battalio. Yes, sir.
        Senator Levin. All right. Now, the decision, your paper
    says, ``to use a single venue that offered the high liquidity
    rebates does not appear to be consistent with the objective of
    obtaining best execution.'' Did I quote you correctly?
        Mr. Battalio. Yes. It results in diminished fill rates.
        Senator Levin. All right. That is the reason why, but,
    nonetheless, I quoted you accurately.
        Mr. Battalio. Exactly.
        Senator Levin. All right. Now, is that then evidence of a
    conflict that harms consumers?
        Mr. Battalio. We certainly think that the routing could be
    done better, yes.
        Senator Levin. Well, to put it in terms that I understand,
    is that then evidence of a conflict that would harm consumers?
        Mr. Battalio. Yes, sir.
        Senator Levin. And your data then shows and your conclusion
    shows that the highest rebate and best execution do not go
    together.
        Mr. Battalio. Yes, sir. In certain circumstances, they do
    not go together. Not always, but in certain circumstances.
        Senator Levin. Would that be in most circumstances where
    these orders are routed to an exchange?
        Mr. Battalio. So in the most actively traded stocks where
    the lines to trade are the biggest, that is where it matters
    the most.
        Senator Levin. And that would be true, what I just said?
        Mr. Battalio. Yes.
        Senator Levin. Now, Mr. Katsuyama, I expect that some of
    the retail brokers that are named in Professor Battalio's paper
    would claim that the fact that they directed all of their
    nonmarketable orders to the exchange that pays them the most is
    not inconsistent with providing best execution to their
    customers. What is your view of that?
        Mr. Katsuyama. So from a practitioner's standpoint, prior
    to IEX, I worked and ran trading at a large broker-dealer. You
    know, I think there are two ways to look at it. The first is
    that the exchange that pays the highest rebate will have the
    longest queue because people that are posting liquidity let us
    just say on the bid, they want the rebate, so more people will
    line up because of that inducement.
        The first thing to consider--that getting in the longest
    line will lower your probability of getting filled because
    there are more people in front of you in line. The second thing
    to consider is the inducement of, let us say in this instance,
    the seller. Where is the seller most likely to go when selling
    stock, looking to sell stock on the bid? The seller is most
    likely to go to the place that either pays them a rebate or
    definitely to attempt to avoid those who charge the highest
    fees. So getting in the longest line, posting in the highest
    rebate venue, exposes you to larger competition, reducing the
    probability of fill, and it also makes you the least likely
    venue to get filled on because the seller on the other side of
    the order is not incentivized to go there first.
        So it hurts you in two ways. We have run a series of tests
    on this using our own capital back when I was at RBC, and the
    tests confirmed the findings that Professor Battalio outlined
    in his paper.
        Senator Levin. And can you repeat that finding in your
    words?
        Mr. Katsuyama. Sure, that routing specifically with the
    goal of maximizing your rebate lowers the probability of
    getting filled and leads to adverse execution quality or worse
    execution quality for the client's order who you are
    representing or even your own order if a bank is routing on its
    own behalf.
        Senator Levin. Does that create a conflict of interest?
        Mr. Katsuyama. Yes.
        Senator Levin. Let me just go back to Professor Battalio
    for one moment. Is best execution a subjective determination,
    at least in part?
        Mr. Battalio. At least in particular. We would argue more
    so subjective for market orders because a lot of determinants
    go into figuring out whether you have a good trade price or
    not. With standing orders or these nonmarketable limits, it
    seems like getting filled is paramount. And we came across the
    Nasdaq Notice to Members 01-22 after we submitted this draft to
    a journal, and we will incorporate--and we will certainly use
    that to buttress what best execution means for nonmarketable
    limits. Fill rate is paramount.
        Senator Levin. But are there also subjective factors in
    that determination for both?
        Mr. Battalio. You are pushing the bounds of what I----
        Senator Levin. All right. If you cannot answer it, you
    cannot answer it.
        Mr. Battalio. I cannot answer it.
        Senator Levin. Mr. Katsuyama.
        Mr. Katsuyama. Can you repeat the question?
        Senator Levin. Are there subjective factors in determining
    which market to go to for the ones for the orders which are
    non--let me get the right word here--the nonmarketable?
        Mr. Katsuyama. Sure. So at times there are. For example, if
    there are--if you are establishing a new price, meaning that
    you will be the only person on the bid at that price, bidding
    on an exchange that pays a high rebate, since you are the only
    person on the bid, it is justifiable; it makes sense. If you
    are joining a queue that is very thick, that has multiple
    exchanges represented, and you choose to get at the end of the
    longest line to get a rebate, I would say that that would be a
    conflict.
        Senator Levin. Would that be a subjective factor? Are there
    subjective factors in that determination?
        Mr. Katsuyama. Yes. It is based on what is currently on the
    bid, which would primarily be determined by the stock. So there
    are factors where, a broker looking to get a rebate is not
    necessarily in conflict with their duty to their client. So it
    is subjective based on the conditions of the stock when you
    come into--sorry if this is a complicated answer, but based on
    what is happening in the stock, there are different decision
    points, and there are times when you could be getting the
    highest rebate, but also serving your client's interest.
        Senator Levin. And there are times when that is not true.
        Mr. Katsuyama. Yes.
        Senator Levin. Senator Johnson.
        Senator Johnson. Thank you, Mr. Chairman.
        Professor Battalio, I am hearing terms--``adverse execution
    quality,'' ``conflict of interest,'' ``dark pools.'' It all
    sounds pretty sinister. What I want is an example of a trade,
    so we can really put this all in perspective. So let us talk
    about 100 shares at $20, just a retail customer placing that
    with a broker. Now, if you are using one of the online brokers,
    it is costing you $10.
        Mr. Battalio. Yes.
        Senator Johnson. So if you are basically buying $2,000
    worth of stock, you are paying $10 to buy $2,000 worth of
    stock. Twenty years ago, I know I would be paying $20, $30
    commission, correct?
        Mr. Battalio. Yes.
        Senator Johnson. Now we are paying $10. So if this is going
    into one of these dark pools or if this is to go into one of
    these maker-taker arrangements, how much additional money could
    it cost the consumer if there is a conflict of interest, if it
    is routed to a situation where there is a higher maker-taker
    fee?
        Mr. Battalio. So imagine you have two orders to buy--one
    here, one there. This one is the high-fee venue; this is the
    low-fee venue. Only one trades. So they want to buy at $10. One
    is going to trade, and then the price is going to rise to $20.
    Which one trades? The one on the low-fee venue.
        Senator Johnson. First of all, how many times in the stock
    market do you try and buy a stock for $10 and it goes up to
    $20?
        Mr. Battalio. OK, make it go to $11, $10.50.
        Senator Johnson. I mean, again, realistically, when I put
    in a trade, I say I want to buy a stock. I have made a decision
    that this company is worth $20 a share. And I put in an order
    for 100 shares. I am going to get that executed at $20, aren't
    I?
        Mr. Battalio. So Goldman Sachs and others have done studies
    kind of with better data than we have, so data is a big problem
    to do these types of analyses. To really get at what you asked,
    we need to have data that we do not have. All right? So Goldman
    Sachs, the claim would be that you would lose three basis
    points, five basis points over the course of a day by making an
    inferior order routing----
        Senator Johnson. No, no. I am talking about a retail
    investor like myself, I buy 100 shares of stock at $20. I am
    going to pay $2,000 to buy the stock. OK? I am going to get
    that stock at $20, aren't I? If I put in an order that I say I
    want to buy that stock at $20, I get it at $20.
        Mr. Battalio. No. It will not trade. One person----
        Senator Johnson. So what do I--well, if an order----
        Mr. Battalio. You are going to cancel----
        Senator Johnson [continuing]. Is on the books----
        Mr. Battalio. You are going to cancel and chase the market
    up. That is the point. Does this happen always? No.
        Senator Johnson. Listen, I cannot remember a trade that I
    have put in where I say I want to buy 100 shares at $20 where I
    do not get it at $20, because I put in a stop loss. I am only
    going to buy it at $20.
        Mr. Battalio. So your trade----
        Senator Johnson. And I get it at $20.
        Mr. Battalio. You are trading volatile stocks that do not
    have long queues. That is my answer to you. The data----
        Senator Johnson. That is what most people do. So, anyway,
    again, I am trying to get--forget the price movement, OK? Let
    us talk about just the dollar value of this maker-taker fee. On
    a $2,000 trade, how much is that maker-taker fee? On 100 shares
    of stock at $20 a share, how much is that maker-taker fee?
        Mr. Battalio. Thirty cents per hundred.
        Senator Johnson. Thirty cents per hundred what, dollars or
    shares?
        Mr. Battalio. Shares.
        Senator Johnson. So if there is a maker-taker fee that is
    just outrageous at, what, 50 cents?
        Mr. Battalio. The maximum is 30 cents per hundred that they
    can charge, the taker fee.
        Senator Johnson. For a hundred shares. So we are talking
    about on a $2,000 trade that is a conflict of interest, a
    broker is going to push a trade into a maker-taker arrangement
    where he gets 30 cents----
        Mr. Battalio. So an accurate----
        Senator Johnson [continuing]. Versus what--I mean, what is
    the high range of this: 30 to 50, 30 cents to--what is the
    range of pricing on this maker-taker arrangement per hundred
    shares?
        Mr. Battalio. Negative 14 cents, maybe, to 32 cents per
    hundred. These are all per hundred.
        Senator Johnson. So you have a maximum range of 40 cents,
    so if I am doing a $2,000 trade, you are concerned about a
    conflict of interest where I might have to pay an additional 40
    cents on a $2,000 trade. Is that what this is about really?
        Mr. Battalio. No. It is about the fact that you did not get
    to trade. So your assumption that you trade is wrong.
        Senator Johnson. But I always have been able to trade.
        Mr. Battalio. Maybe you have.
        Senator Johnson. How many times do people not get to trade?
        Mr. Battalio. The difference for certain types of stocks in
    certain circumstances, the difference in fill rate is 25
    percent. Sanford Bernstein puts out reports since 2010
    highlighting the stocks in which this type of routing has a
    huge impact on whether or not you trade at a price.
        Senator Johnson. Now, how much of that is the institutional
    investor and the high-frequency trader versus the standard
    retail guy that--again, I am looking--I am a very long-term
    investor, and I am looking at a stock, and I go, really, I
    think this thing is worth $20 and I am willing to buy it at
    $20, but if not, no harm, no foul. So there are definitely
    different investors, right? So when you are talking about 25
    percent of trades not being executed--is that in all the
    institutional, the very high volume, or is that really
    individuals like myself that say--I want to buy that hundred
    shares of stock, I will pay any price, or I will put a stop
    order and say I am only going to buy it at $20?
        Mr. Battalio. So is Schwab a retail broker? Because they do
    not make this decision. They do not do what these four brokers
    do. Interactive brokers, a retail----
        Senator Johnson. So let me ask you, how many--and I will
    surely ask in the next panel, of those folks. How many trades
    in to retail brokers like Schwab, like TD Ameritrade do not get
    executed? Do you have any idea on that?
        Mr. Battalio. We have asked for their data, and they have
    never responded to give us the data. We cannot answer.
        Senator Johnson. So where did you get your data from then?
        Mr. Battalio. From a major iBank.
        Senator Johnson. And, again, what is the data on?
        Mr. Battalio. Orders. They get routed to two different
    venues. They show up at the marketplace at exactly the same
    time, and we watch what happens. And then we use data from the
    entire marketplace, all trades and quotes.
        Senator Johnson. So I did see TD Ameritrade revealed how
    much they are making on these maker and taker, this order flow
    fee, something like $200 million. It sounds like an awful lot
    of money, but isn't it true that the market trades almost $27
    trillion per year?
        Mr. Battalio. Sure.
        Senator Johnson. So what is $200 million in relation to $27
    trillion----
        Mr. Battalio. We are not----
        Senator Johnson [continuing]. As a percentage?
        Mr. Battalio. What we are here to speak to is the poor
    investor, not like you, that wanted to buy at $10 and did not
    get to because the market moved away and the broker chose to
    route--make sure that--so the broker routed the order----
        Senator Johnson. Again, I am trying to figure out how----
        Senator Levin. Let him finish.
        Senator Johnson [continuing]. Often that is. OK. I am
    sorry.
        Senator Levin. Do you want to finish the answer?
        Mr. Battalio. With better data I could answer that. In our
    data set, it can be as big as 25 percent difference in getting
    the trade done.
        Senator Johnson. OK. I will just finish by saying what I am
    concerned about is, again, just creating this sinister
    atmosphere with words like ``dark pool'' and ``conflict of
    interest,'' and what we are talking about literally, I think,
    is 30 or 40 cents on a $2,000 trade or maybe a $30,000--or a
    $3,000 trade. I mean, we are really talking about minuscule
    amounts. And, again, what I am looking at is over time of
    investing, I have looked at my cost of a trade going from
    hundreds of dollars down to $10. And now we are arguing over if
    it should be $10.30 or $10.40. I do not know. I am just trying
    to put it into perspective and trying to figure out where the
    problem is here that I guess we are talking about potentially
    government regulation intervention, which I think might have
    very harmful unintended consequences versus letting the free
    market competitive system drive transparency, drive
    competition, and that is what has happened certainly over my
    lifetime of investing over 20 years. It has gotten, from my
    standpoint, more transparent and a whole lot cheaper.
        Mr. Battalio. I am not arguing with that.
        Senator Johnson. OK. Well, thank you. I will be back.
        Senator Levin. Thank you.
        Senator McCain.
        Senator McCain. Do you want to give a more elaborate
    response to that really this hearing does not matter, either
    you, Mr. Battalio, or you, Mr. Katsuyama?
        Mr. Katsuyama. So I guess just to respond to that--the fact
    that it is 30 cents for a hundred shares and it is a $2,000
    trade, I think that is exactly the point. I mean, we are
    talking about conflicts where there is evidence that their
    brokers are routing to get this 30 cents, and they are
    representing a $2,000 order. It can be used on both sides of
    the argument. You can view it as trivial, but you can view the
    trivial nature of why is the broker doing that in the first
    place if they are representing a $2,000 trade? So it is one
    where the conflicts are real, and I think that even though the
    harm is diffuse, there are more retail investors invested in
    large pension funds and mutual funds who also are affected by
    this practice.
        So I think that, just trying to say that since it is a
    small amount it could be used to deny that the conflict exists,
    is wrong. I think that it needs to be a principle-based
    argument.
        The other part on costs, costs have come down. Of course
    they have. Technology has delivered that cost reduction. There
    is a Harvard Business Review study titled, ``How to Win a Price
    War,'' and it talked about ``electronic brokers are changing
    the competitive terrain of financial services with their
    extraordinarily low [-priced] brokerage services. The
    prevailing price for discount trades has fallen from $30 to $15
    to $8 in the past few years.'' That report was written in 2000.
    So when you look at the costs of technology since the year
    2000, it has fallen even further.
        So I think that it is one where competitive forces--I agree
    with the fact that competitive forces should be setting prices.
    The problem is that the inducement is so great, we do have a
    prisoner's dilemma, where if every exchange pays an exchange
    rebate, the one that moves away from the exchange rebate if
    brokers are still incentivized to go after that rebate--they
    will lose market share.
        So I do think when you look at payments, it is something to
    say there is a known conflict in the market and lets just
    address it. The size of the conflict relative to the notional
    amount traded is not a reason just to ignore the issue.
        Senator McCain. And with that increasing technology, hasn't
    that facilitated to a significant increase in volume of trades
    as well?
        Mr. Katsuyama. I think the fact that advances in technology
    have been harnessed by certain participants, that is part of
    free market competitive forces, and there is absolutely nothing
    wrong with that. I think the challenge that the market was
    faced with was one of the biggest confusions out there is that
    the person that buys co-location and pays for this service has
    an unfair advantage versus the person sitting at home trading
    over a retail account. There will always be asymmetries----
        Senator McCain. See, I think that is the key to this
    problem, that there are certain players that have made this an
    unlevel playing field, whether it is 30 cents or whatever.
        Mr. Katsuyama. Sure. In order for the person at home to get
    disadvantaged by the person that has spent all of the money on
    high-speed technology, in order for them to be disadvantaged,
    they have to trade, and that trade has to happen on a market.
    The market's responsibility, at least in our view, is that
    knowing that different parties will have different access to
    technology and different levels of resources, different levels
    of information; but when the trade happens, that the condition
    with which this trade happens is done--is fair, meaning that we
    have no bias one way or another what happens when this trade
    occurs. And the problem is that as technology has evolved, the
    exchange or the dark pool, the market itself should have
    advanced their own technology to ensure that we are investing
    in technology and building solutions with technology that
    maintains this fairness. And the problem is that as the markets
    have evolved, people got in the business of selling technology.
    People got in the business of actually enabling participants
    rather than creating and maintaining their neutrality. And I
    think as that happened, the conditions for fair trading
    changed. When your participants understand the market, what is
    happening in the market, faster than the market itself, that
    creates a pretty significant situation that we believe is
    unfair.
        Senator McCain. Well, sir, many commentators, including the
    editors of the Wall Street Journal, have noted that Reg NMS has
    enabled or exacerbated a number of predatory, high-frequency
    trading practices. Do you think that Reg NMS should be
    reformed? And if so, what would you recommend?
        Mr. Katsuyama. Sure. So I think Reg NMS, the spirit of Reg
    NMS, as was indicated, makes sense. You have multiple
    competitive markets, and you want to try to attempt to tie them
    all together. I think if you eliminate some of the conflicts in
    how orders are routed, that brokers have invested heavily in
    technology that can get around this issue of liquidity
    disappearing. At RBC we had this problem from 2007 to 2009, and
    then we solved the problem. So I think that free market
    solutions can emerge to address the issues with Reg NMS. I
    think undoing Reg NMS runs the risk of, again, further
    unintended consequences, how exactly do you address those?
        I think that it is something that definitely warrants
    review. It just depends on what regulation comes out of
    redefining what Reg NMS does, and that is something that
    obviously I cannot comment on.
        Senator McCain. Do you have any suggestions, Mr. Battalio?
        Mr. Battalio. If you do anything to Reg NMS, do it with a
    pilot study and study it very carefully.
        Senator McCain. Have you got other solutions to this issue?
        Mr. Battalio. With regard to high-frequency trading, that
    is not something I have extensively studied, no.
        Senator McCain. Mr. Katsuyama, Michael Lewis in his ``60
    Minutes'' interview regarding his excellent book, ``Flash
    Boys,'' said that the stock market is ``rigged.'' Is that an
    accurate description?
        Mr. Katsuyama. We have discovered that investors are
    systematically disadvantaged in the way that the markets have
    been set up. I think ``rigged'' is a word that can be used to
    describe that. I think it is loaded. But I think at the same
    time, the investment process is not broken. I am still an
    investor in this market. You know, ``rigged,'' what it did is
    it kind of gave our critics and people who are part of the
    problem a reason to talk about something else other than what
    we were actually talking about, which are these--a much more
    precise way to put it or a much more precise question, which is
    these systematic disadvantages and how they are created.
        So, it was a distraction, which was unfortunate. I guess
    the interesting part is that the people who took most offense
    to that word were people on Wall Street. We have a tendency to
    talk to ourselves on Wall Street, and I think that the response
    we have seen from the general public is anything but. The claim
    that we hurt investor confidence in the things that we brought
    to light everything that we have seen I think would be exactly
    the opposite of that in terms of the general public and their
    reaction to what we have said and what we have done.
        Senator McCain. On this issue of co-location, how do you
    address something like that? Somebody rents a place or rents a
    computer somewhere, they are free to do that. That is America.
    How do you address that issue since co-location seems to be one
    of the facilitating aspects of this whole system?
        Mr. Katsuyama. Sure. I do not think you can regulate co-
    location. If you say to an exchange you cannot sell space next
    to your matching engine, cottage industries will pop up and buy
    real eState across the street from the exchange and throw
    cables over the fence. So I think it is every market's choice
    to decide how they would like to set their market up.
        At IEX, what we have done is we have introduced almost the
    opposite of co-location where we have put 350 microseconds of
    latency in between us and all of our customers, which
    essentially means that we have coiled 38 miles of cable in a
    data center, and we do that for all of our participants. The
    opposite of getting close is pushing everyone an equal distance
    away.
        Senator McCain. I understand what you have done, but what
    is the remedy to this?
        Mr. Katsuyama. I think the remedy is, we keep harping on
    transparency and disclosure, and I think that there are
    distinctive----
        Senator McCain. It should be disclosed if they are co-
    locating.
        Mr. Katsuyama. It should be disclosed, but also things like
    anonymous listings of participants on venues, meaning does one
    participant represent 35 percent of your trading volume or 50
    percent of your trading volume on any dark pool or exchange?
    And if they do, do they represent 50 percent of the volume on
    every other market? Because if they are an outsize portion of
    your own order flow, then that would indicate something.
        Are the message rates across certain participants so much
    higher than others? I think that we lack, as Professor Battalio
    said, the data. What we learned--and we learned from
    experience, we learned from talking in the industry, but we
    lack the data. And I think, again, the SEC's Midas website, the
    FINRA ATS report, we learned a lot in basically two attempts to
    provide clearer understanding of what is happening in the
    market. We could learn so much more.
        The thing about co-location is that, just discussing and
    understanding what the advantage is of being 5 or 10
    microseconds away from a matching engine, you get information
    quickly, and you can react quickly to getting information. As
    we push that boundary farther out to 350 microseconds, what we
    found is that we did have certain high-frequencing traders that
    did show up to IEX. But the number of those high-frequency
    traders was small, right now three. There are dozens and dozens
    of firms who have decided not to connect. I cannot speculate as
    to why that is, but clearly we have taken away something that
    some high-frequency trading firms they found valuable.
        So it is every market's choice to do something. It becomes
    a very hard practice to regulate. But I think with the
    increased transparency and disclosure, people can make better
    decisions on whether they want to trade in venues that do offer
    such services.
        Senator McCain. Thank you.
        Thank you, Mr. Chairman.
        Senator Levin. Thank you very much, Senator McCain.
        You made reference to disclosure on things like co-
    location, but when it comes to the best execution obligation, I
    gather that cannot be waived. Is that correct?
        Mr. Katsuyama. Yes, absolutely. Best execution, I think it
    might need some further refinement. It is a pretty subjective--
    I guess it is a pretty subjective term. I think it is used
    fairly liberally. One thing that we definitely think----
        Senator Levin. That is a legal obligation. Is that correct?
        Mr. Katsuyama. It is.
        Senator Levin. So you cannot disclose--``we do not engage
    in best execution in this firm.'' That does not fly. Is that
    correct?
        Mr. Katsuyama. That would not fly, no.
        Senator Levin. Do you agree with that, Professor?
        Mr. Battalio. Yes, sir.
        Senator Levin. Going back to best execution as to who
    determined--did I interrupt you?
        Mr. Katsuyama. No.
        Senator Levin. Who determines best execution for a broker?
    Is it the broker himself?
        Mr. Battalio. The broker, my understanding, is supposed
    to--based on what I read--have monthly meetings and just
    evaluate where they are routing, can it be done better where
    should we alter things around the edges?
        Senator Levin. But it is the broker who determines best
    execution?
        Mr. Battalio. Yes.
        Mr. Katsuyama. Yes.
        Senator Levin. OK. Now, I believe, Mr. Katsuyama, that you
    indicated that the maker-taker system creates a conflict of
    interest, and I think the testimony of both of you is that this
    is a significant matter. Let me just ask you, Mr. Katsuyama,
    should the maker-taker system be eliminated?
        Mr. Katsuyama. I think that steps should be taken to
    address what happens to the market if it is eliminated. I know
    that a pilot study has been proposed----
        Senator Levin. You mean--say that again?
        Mr. Katsuyama. The pilot study that has been proposed, I
    think that it should have----
        Senator Levin. Which eliminates it?
        Mr. Katsuyama. Which eliminates maker-taker in certain
    stocks, I think that it should be given the chance to prove
    that eliminating maker-taker will not harm the quality of the
    markets.
        Senator Levin. All right.
        Mr. Katsuyama. So, yes, I definitely think that that step
    should be taken. It should be analyzed, and then we should----
        Senator Levin. At least that step ought to be taken.
        Mr. Katsuyama. Definitely.
        Senator Levin. Professor.
        Mr. Battalio. I am not a risk taker. I am an academic.
        Senator Levin. OK.
        Mr. Battalio. So my view would be maybe not push to
    eliminate maker-taker because you might push things underground
    into the soft-dollar world where it would be even less able to
    kind of see what people are doing.
        Senator Levin. OK.
        Mr. Battalio. So our view would be, with Shane Corwin and
    Jennings, perhaps what you should do is push disclosure back
    onto the broker so it is easier to tell, so you do not have to
    do the studies we just did to map how is your broker doing
    regarding routing your orders. Since the SEC took a first step
    with this in 2000 and 2001, we think that you could do a better
    job of that now.
        Senator Levin. Would you support that test case that Mr.
    Katsuyama talked about?
        Mr. Battalio. If you insist of doing away with maker----
        Senator Levin. Not me. I am not----
        Mr. Battalio. A pilot is----
        Senator Levin. A lot of other people are insisting on it,
    and I happen to agree with that, but it is not----
        Mr. Battalio. A pilot is better than going all-in.
        Senator Levin. All right. Some have argued that the maker-
    taker system is beneficial and that it has led to tighter
    spreads, and I think you indicated, did you not, Mr. Katsuyama,
    that that was technology that did that long before----
        Mr. Katsuyama. Yes, I think decimalization and technology
    both contributed to the lowering of spreads.
        Senator Levin. All right. Now, does IEX make a similar
    distinction that some high-frequency trading may be predatory?
        Mr. Katsuyama. So I think not all high-frequency trading is
    predatory, but some practices are, yes.
        Senator Levin. Do you make a distinction that some high-
    frequency trading may be predatory?
        Mr. Katsuyama. Yes.
        Senator Levin. And that that would hurt regular investors
    while others may benefit the market?
        Mr. Katsuyama. Yes.
        Senator Levin. And has the maker-taker system led to the
    creation of more exchanges in trading markets and more complex
    order types, Mr. Katsuyama?
        Mr. Katsuyama. Yes.
        Senator Levin. Has the proliferation of trading venues and
    order types created opportunities for predatory high-frequency
    traders to take advantage of investors?
        Mr. Katsuyama. At times, yes.
        Senator Levin. And what are those opportunities? What kinds
    of opportunities?
        Mr. Katsuyama. Sure. I think given the structure, a quick
    example is if there are 10,000 shares on offer to sell Intel at
    $21 a share, a high-frequency trading firm could be offering
    stock across multiple markets. One of those markets where they
    are offering stock might be what is called a taker-maker venue
    that actually charges someone to post liquidity and will pay a
    rebate to the other side of the trade who comes to access that
    liquidity. So this inducement, what it does is it--if a broker
    is going to follow that inducement, it causes them to route
    orders and remove liquidity from Intel, in a very predictable
    and systematic way, starting at the highest rebate market for
    taking liquidity and working its way down to the venue charging
    the highest fee. This predictable pattern of routing leads to
    lower fill rates and ultimately worse execution for the client
    being represented.
        So, it is a combination of fast technology, a combination
    of inducements, and a combination of the broker falling for
    those inducements. So that would be a series of events.
        Senator Levin. You have been quoted as saying that people
    have lost confidence that the markets are fair and that they
    are working in their best interest. Would charging a standard
    fee, regardless of whether the order adds or removes liquidity,
    increase investors' confidence that they are getting a fair
    deal?
        Mr. Katsuyama. I think it is a step--at IEX we charge a
    flat fee, regardless of whether you are making or taking. Price
    competition is something that is hard to regulate, so if some
    people want to charge a lesser or higher fee and justify it
    through their service, I think that is acceptable. But I think
    eliminating a conflict, most of the general public do not even
    know this conflict exists. I think that as we talk through it,
    as we try to regain the trust of the general public, talking
    through these issues and admitting to the fact that they exist,
    and then addressing these conflicts, that is the way to restore
    that confidence. So I think that, yes, addressing this issue
    will help restore confidence, or at least it is a step in the
    right direction.
        Senator Levin. And eliminating the conflict would help
    restore confidence?
        Mr. Katsuyama. Without question.
        Senator Levin. Professor.
        Mr. Battalio. Yes, sir.
        Senator Levin. Would it?
        Mr. Battalio. Yes, sir.
        Senator Levin. Critics of your paper, Professor, said that
    the data that you used to assess whether retail brokers were
    getting best execution does not accurately reflect typical
    retail order flow and that your results cannot be generalized
    to judge the best execution performance of retail brokers. How
    do you respond to that?
        Mr. Battalio. In a couple ways. So those critics seem to
    kind of ignore the back third of our paper where we use all
    trades and all quotes in the U.S. equity market over the same
    time horizon to demonstrate the results that we find with our
    limited data generalized to the marketplace.
        Second, as we have been pushing the paper around, we have
    seen lots and lots--we wrote the major exchange that operates
    two different fee structures, and they showed us that for the
    retail orders resting on their exchange for a couple weeks,
    they get the same results we get. You know, Sanford Bernstein,
    we came across a report, same results we get.
        So you can argue that our most detailed data analysis comes
    from specialized data, but the results generalize with a lot of
    different data sets. So we are quite comfortable.
        Senator Levin. Now, would you be willing to run your
    analysis using data from the retail brokerages identified in
    your paper if they were willing to give you that?
        Mr. Battalio. Of course. Anybody. The hard part for an
    academic, we spent 2 years asking for data to test this,
    because people--and it is just very, very hard. So, yes, that
    is a standing offer that we make. It has become--we thought we
    were going to be able to work with a guy who is starting to do
    this with institutions, and, unfortunately, the sell side is
    pushing back and threatening. So the executing venues have
    threatened that if this guy shares data with us, they will stop
    doing business with their buy side clients. So it is very hard
    to get data to do the analysis that we did. We were very lucky
    to find these data.
        Senator Levin. Some argue that 30 cents on an order is a
    tiny, minuscule amount, you have given a very strong answer or
    response to that, by the way, in terms of the orders that are
    not filled. And, also, Mr. Katsuyama, you have given a pretty
    strong answer to that as well. These 30 cents also add up to
    hundreds of millions of dollars for a broker, do they not?
        Mr. Battalio. Yes, they do. Compare the payment revenue of
    the brokers that do this practice to the ones that do not, and
    you will see a marked difference at the aggregate.
        Senator Levin. Mr. Katsuyama.
        Mr. Katsuyama. Yes, I think it is----
        Senator Levin. It is a big revenue source for the broker,
    is it not?
        Mr. Katsuyama. Yes. Well, some brokers. I think we cannot
    paint them all in the same brush. Some brokers end up paying
    the high take fee, and that high take fee is subsidizing
    payments to other players. So some are hurt worse and some
    benefit, depending on who the broker is.
        Senator Levin. Thank you.
        Senator Johnson.
        Senator Johnson. Thank you. I have a little more time here,
    so I do want to go back and really explore exactly what is
    happening and exactly what type of harm could be happening.
        When you are talking about 25 percent of trades that just
    simply are not executed, can you describe that a little bit
    more to me in terms of the volatility of that, what is being
    missed? And aren't those trades basically because people put in
    stop orders and say, ``I will buy a stock at this price''? I
    mean, just tell me how that does not work?
        Mr. Battalio. So you have people that maybe place an order
    before they go to work, and they say, I want to buy a share of
    stock at $20, a hundred shares of stock at $20, and it is just
    a standing order--not a stop or anything like that, just a
    standing order. What we identify in our paper is that some
    brokers are routing that order so that they trade last at a
    price. And so if throughout the day the market goes through
    your limit price, you trade. It does not matter where you were
    routed. That is true a large part of the time. Right? And that
    would be, what I would argue, that is your trading experience.
    OK.
        But some stocks are much less volatile throughout the
    trading day, and not all of the people looking to trade at a
    price get to trade. Some do not, and they miss out. Why?
    Because the price trades a little bit and moves up. The ones
    that do not trade missed out.
        Senator Johnson. So, I mean, part of the problem is some
    investors have a lot of time to just be watching this in real
    time 100 percent of the time.
        Mr. Battalio. That is right.
        Senator Johnson. Most investors, like myself, you look at
    it about once a year, and you put a trade. So that is always
    going to be the case, right? I mean, if you were watching this
    100 percent of the time, if you were putting in the right type
    of order, you could make sure that you were going to have an
    executed trade, just about, I mean, couldn't you? Can't you, as
    an investor, make sure that you get that stock purchased no
    matter what?
        Mr. Battalio. Not if all the interest at a given price does
    not trade, no, because of the way they route. They are putting
    you at the back of the line at a price all the time. And so if
    the line does not fully exhaust, you go wanting.
        And is this--this happens in certain--is this all stocks
    all the time? No. But measurable time, 10, 20 percent of the
    time, certain stocks, yes.
        Senator Johnson. Again, I am trying to get my head around
    the magnitude of this problem.
        Mr. Battalio. OK. I guess----
        Senator Johnson. Because it is true--I mean, we are using
    all these sinister figures, and I agree with the Senators, this
    is about restoring confidence in the market. And I am concerned
    by throwing out those types of terms and making it seem like
    everybody is in this business and they are just really trying
    to stick it to the individual retail investor. That is not what
    I have seen. I am not saying----
        Mr. Battalio. And I would hope----
        Senator Johnson [continuing]. That I have been pleased with
    the transparency within the investment banking community during
    my lifetime. But it just seems like we are moving in the right
    direction, greater competition, lower prices, far easier
    trading today than it was 20 years ago where you just kind of
    call your broker and you did not know what was pulling off. Now
    you have the computer. Now you can plug it in, and say how come
    I did not get that--right now it is almost instantaneous, isn't
    it, on online brokers? You put in an order----
        Mr. Battalio. Or a market order, yes.
        Senator Johnson [continuing]. And, boom, it comes right
    back.
        Mr. Battalio. For a market order, yes. And I am not going
    to sit here and argue that we have not made great gains over
    the past 20 years. That is not what our paper is about. Our
    paper--and we are not crying ``Fire'' in a theater.
        Senator Johnson. Well----
        Mr. Battalio. No. Have you read our paper carefully? I
    think we are very caveated, OK? We are pointing out certain
    circumstances where routing only to the high-fee venue is going
    to disadvantage investors. So statements that get made like,
    ``We employ sophisticated order routing technology and
    processes to seek best execution for client orders,'' how can
    that be if you are routing always to the high-fee venue? That
    is what got us interested as academics in this problem.
        Senator Johnson. And, again, you may not be shouting
    ``Fire,'' but I think the way that it is recorded in the press,
    I think it really is. Do you disagree with that?
        Mr. Battalio. I think there are some people out there
    yelling ``Fire,'' but I would hope that we would not be
    characterized----
        Senator Johnson. Good. So, again, that is what I appreciate
    about this hearing. It is about trying to lay out the reality
    of the situation, put this all in perspective. And, again, I
    want to get back to the overall dollar value of these maker and
    taker arrangements, that type of thing, in relationship to
    total trades----
        Mr. Battalio. All right. So I can give you----
        Senator Johnson [continuing]. In terms of--if at all
    possible, if you had some sort of historical perspective in
    terms of how much trading commissions there were 20 years ago
    versus what we are talking about today.
        Mr. Battalio. I will give you one stat, and then I will
    give it to Brad. So if you eliminated all the rebates and
    inducements, Bernstein Research predicts that one broker would
    have a 16-percent earning-per-share decline.
        Senator Johnson. But what----
        Mr. Battalio. That is real time now, and then I have to say
    I do not know the answer to your question and give it to Brad.
        Mr. Katsuyama. I think there is no question that price per
    trade has come down with technology. I think that--again, I
    read this last time. I will read it again. Harvard Business
    Review report, which is titled, ``How to Win a Price War,''
    talks about ``electronic brokers are changing the competitive
    terrain of financial services with their extraordinarily low-
    priced brokerage services. The prevailing price for discount
    trades has fallen from $30 to $15 to $8 in the past few
    years.'' And that report was written in the year 2000. Here we
    are in 2014, and my tech team sent me this, but the price of a
    gigabyte worth of storage in 2000 was $10, today it is 10
    cents. So when we talk about lower fees, lower commissions,
    yes, they have come down. But they stopped going down, and I
    think that they could probably come down further. The notion
    that if a payment goes away then the price will go up, I think
    that would be hard to justify. And, again, as you said,
    competitive forces will force that out of the market. If you
    double your price per share or price to trade, then new
    entrants will come into the market.
        So I think that it is one where they have come down, but
    that is not an excuse, I think, for what is happening right
    now.
        Senator Johnson. Are there competitors in the marketplace
    that actually conduct trades the way you want to see the trades
    conducted? And compare those to some of the online models of
    companies that we are familiar with what they provide with
    their service. Because, one of the things I value in the online
    is I have got research, There is just an awful lot within those
    online platforms that are very helpful to a competitor--or to
    an investor.
        Mr. Katsuyama. Sure.
        Senator Johnson. Do those competitive systems have similar
    types of things? Is that part of the reason--again, I am a
    business guy. It does not bother me that people make money.
    They need to make money to provide different products and
    services.
        Mr. Katsuyama. So, I am not as familiar with each
    individual retail platform, what they offer. I do know
    Interactive Brokers routes in a way that would be consistent
    with how I would route. You know, they are connected to IEX.
    They trade with us. So I think that there are examples, and
    they have been pretty vocal about that. I look at institutional
    brokers. As Professor Battalio has noted, my experience at RBC
    or Bernstein or even working with the people at Goldman Sachs,
    people have spent a tremendous amount of time in understanding
    this conflict, where you can route for a rebate and not harm
    your client and where you route for a rebate and you do harm
    your client. And it is one where, because it can toggle--for
    example, there are 100,000 shares on offer in Intel at $21
    [inaggregate, across the markets], and a market will pay me a
    rebate to route there and is offering 10,000 shares, and I have
    200 shares to buy, I can route it there, buy the 200, get the
    rebate, and no one is harmed. If I have 100,000 shares to buy,
    I cannot route the 100,000 to that one venue that is going to
    pay me because they are only showing 10,000, because I will
    ruin my experience with the rest of the venues, because of the
    signals.
        So there are times when you can get a rebate and fulfill
    your obligation, and there are times where you cannot, and I
    think it is up to every broker to understand where that
    inflection point is and to be very transparent in terms of how
    they route.
        Senator Johnson. So I guess my point is if those companies
    are already present in the marketplace that trade the way you
    are suggesting without a conflict of interest, so that an
    individual investor, if they are buying $2,000 worth of stock,
    does not have to worry about being charged 40 cents versus 30
    cents--OK?--those platforms exist, those competitors--the
    marketplace, the free market competitive system have already
    provided that investing model with that level of transparency.
    And kind of getting back to part of your opening statement, you
    said, well, this is a question of whether we need government
    regulation to force the transparency, the competition, or the
    free market competitive systems doing it.
        I guess based on your answer, you are saying the free
    market competitive system has already reacted to it, and that
    possibility exists. If you are concerned--as an individual
    investor, you are concerned about not being able to have your
    trade executed or paying another 10 cents on a $2,000 trade,
    there are people out there and they just need to do a little
    more advertising so Americans understand it, right? Or maybe
    this hearing will help out and more investors will take a look
    at finding companies like yours.
        Mr. Katsuyama. So, yes, I totally agree with you. I think
    that, first off, you have to----
        Senator Johnson. I like that answer.
        Mr. Katsuyama. First off, you have to make people aware
    that the conflict does exist, and you have to educate them on
    what that conflict means to them, and now they can make a
    better informed decision versus before, when they did not even
    know that the conflict existed in the first place. I think
    disclosure and transparency will let people make better
    decisions, and then the market sorts it out. It is one where
    with increased disclosure and increased transparency, everyone
    knows exactly how the game works and things still happen. Then
    you can kind of look back and say, OK, I guess the inducement
    was enough or warranted the fact that they made this decision.
    But right now a lot of it is opaque.
        And as Professor Battalio noted, it is really, really hard
    to get data, and the data you get is not standardized. So it is
    very hard to synchronize data across multiple places because
    the data comes back, I have seen client data where they have
    got them from different brokers or even brokers from different
    venues, and it is coming back in all sorts of forms. So I think
    that standardization and transparency, forced disclosure,
    people will just ultimately make better decisions. That is the
    most proactive way to advance this discussion.
        Senator Johnson. OK. Thank you.
        Thanks, Mr. Chairman.
        Senator Levin. Professor, do you have a comment?
        Mr. Battalio. So the reason this is an agency problem was
    first pushed for----
        Senator Levin. When you say ``agency,'' what do you mean?
        Mr. Battalio. Agency--and I will describe. So two former
    chief economists, Chester Spatt and Larry Harris--OK, Larry was
    around with Reg NMS, so was Chester--and then a guy who is on
    the board of Direct Edge, Jim Angel, put forth--it is their
    theory that we test in our paper, and they claim that the
    retail investors, maybe not you, are able to shop on
    commission. So the broker that offers the lowest commission
    will get the retail trade. OK? The brokers that maximize
    rebates are able to offer the lowest commissions. In fact,
    anecdotal evidence suggests that Interactive Brokers, at least
    during our sample period, had a higher commission than these
    other four brokers. So these four brokers attract the retail
    investor by offering low commission, and the retail investor
    trusts the broker because of the best execution obligations,
    and it does not have the tools--you could look at our paper and
    decide how hard it is to figure out what we did. They do not
    have the tools to understand, gee, in this instance did my
    broker route to the right venue to maximize the likelihood of
    execution like NASD 01-22 says? That is the agency problem.
        You can shop on commission. You cannot evaluate the
    execution quality. And so they are doing things that may
    compromise execution quality. They have the lowest commission.
    And they are going to attract a swath of customers that way.
        And if you talk to people on the board of Interactive
    Brokers, they will complain about this. So certainly
    competition is forcing commissions lower, but people who do the
    practice of routing all the nonmarketable to the high-fee venue
    and selling the marketable to the wholesalers, they get more
    revenue that could be used to push back through commissions,
    right? And so it is hard--this would be a case where maybe the
    market cannot fix things unless you can educate the investor to
    evaluate this decision of routing nonmarketable orders, which
    is tough.
        Senator Levin. So you are saying maybe it cannot be solved
    in this case----
        Mr. Battalio. I am all about free markets, trust me.
        Senator Levin. Of course. In this case, it may not and has
    not so far worked, is what you are saying.
        Mr. Battalio. That is what we think.
        Senator Levin. Do you agree with that, Mr. Katsuyama?
        Mr. Katsuyama. IEX is a new venue. Before the SEC published
    the Midas data and before FINRA had their ATS reporting rule,
    we had no idea how we compared to other markets. So other
    markets would make claims that could or could not be
    substantiated. So as you are competing, how do you compete in a
    market that is completely opaque and, is primarily dictated by
    word of mouth or self-generated reports? I do not think we
    fully had a chance to solve this problem from an industry
    standpoint because the data was just not available for people
    to make good decisions, or better decisions.
        Senator Levin. But do you think the average investor can
    make a decision on where a broker is going to get best
    execution?
        Mr. Katsuyama. That is a good question. I would say
    probably not. But the key part is that the people that do spend
    the time to look at it, some people in the media are very
    sophisticated. They understand the heart of this issue. And I
    think that as they report on things that are happening as the
    retail investors who do look at it start to make decisions, it
    does create the right amount of momentum so that someone who
    does not have time or inclination to understand market
    structure understands that people are looking out for their
    best interests and they can make decisions that way.
        Senator Levin. How do they make a judgment on best
    execution, is it a subjective judgment? How does your average
    investor just looking at the fees, the commission, think that
    is lower, that is pretty attractive? This is what the professor
    is saying. Is that not right, Professor?
        Mr. Battalio. That is correct.
        Senator Levin. So now how does that average investor do
    what you think needs to be done, make some kind of assessment
    on best execution? How does he do that?
        Mr. Katsuyama. Sure. You have to put in the requisite
    amount of time to understand it, to make that judgment. Most
    people will not. So, again, I think that the more that this is
    discussed and reported on, hopefully the venues that are doing
    the right things get the right amount of credit.
        Senator Levin. If transparency is the answer, should the
    government force transparency?
        Mr. Katsuyama. I do believe there are cases where that
    would definitely help.
        Senator Levin. The government actually would have to force
    transparency?
        Mr. Katsuyama. I think outlining the types of metrics that
    need to be reported and the way those metrics need to be
    calculated and presented would definitely be helpful, yes.
        Mr. Battalio. The government has done this one, and it is
    not a big step, what they would have to do to kind of clean
    things up.
        Senator Levin. But the market has not done that yet. It
    would take the government forcing that. Is that correct?
        Mr. Katsuyama. There has been no attempt by the market to
    try to solve this issue and just standardize across themselves
    and to say let us make this easier for people to understand. We
    have not seen evidence that that is happening.
        Mr. Battalio. And indeed----
        Senator Levin. And, therefore?
        Mr. Katsuyama. And, therefore, I think the government would
    be very helpful in helping to get the industry to coordinate to
    a level to make these issues easier to identify.
        Senator Levin. And it would be helpful if the government
    required that?
        Mr. Katsuyama. Yes.
        Senator Levin. Thank you.
        Mr. Battalio. The options market tried to do it on a
    voluntary basis back in 2010, and the numbers they put out were
    garbage, mostly, so yes.
        Senator Johnson. Just a quick comment. Again, as an
    individual investor, the way I evaluate best execution is I put
    in an order for $20, I got it for $20. Again, this is so
    incredibly complex, and there are so many esoteric terms of art
    here. You have got to bring it back--I am trying to bring it
    back to just the simplicity of what is happening in the
    marketplace with individual retail investors, and if I put in
    an order for 100 shares at $20 and if I get it and I am only
    paying $10, I am reasonably satisfied.
        Now, occassionally, there may be some very strange
    circumstances where I do not get that share, but I kind of
    shrug and go, OK, well, I did not get it. Maybe there is some
    harm, but I am highly concerned about government interference
    in the marketplace. If there is a very minimal amount of
    transparency legislation in terms of this is the data that we
    want everybody to report, again, minimal, not a huge overall
    regulation that harms the market, that is something I would be
    willing to support.
        But, again, I really want to put this in perspective, what
    is the real harm being caused, and let us make sure we do not
    do more harm in trying to solve a problem that right now this
    is really a solution looking for a problem in many respects.
        Mr. Katsuyama. Yes, I definitely would say that focusing on
    disclosure will create the least amount of harm and
    implementation risk rather than diving into things such as co-
    location and the actual mechanics of the market. So, if we are
    going to move forward, I think that----
        Senator Levin. Professor.
        Mr. Battalio. I agree 100 percent.
        Senator Levin. OK, with what he just said.
        Mr. Battalio. Yes, and what Mr. Johnson said.
        Senator Levin. OK. That you want to have disclosure, you
    want to have transparency, but you would agree it may take
    government action to get that transparency?
        Mr. Battalio. Yes, and push it back on to the brokers.
        Senator Levin. Push it on the--thank you.
        Senator McCain. And this is just a minor issue that we
    should not be concerned about in the overall scheme of things.
    Is that correct?
        Mr. Battalio. My view is the reason academics are around
    and reporters are around is if the retail investors cannot
    understand it, we study it, bring it to light, and then things
    get cleaned up, somewhat.
        Senator McCain. Is it a serious issue?
        Mr. Battalio. We think it is. But we also think it is an
    easy one to fix.
        Senator McCain. Thank you.
        Senator Levin. Mr. Katsuyama, is this a significant issue?
        Mr. Katsuyama. I think it is significant it is a principle-
    based issue. I think that you can try to minimize it by trying
    to relate how much it is pennies, etc., and people are holding
    stocks for years. But this is a principle-based issue, and it
    comes down to the foundation of why the markets exist and
    people's trust in those markets. Trust is really about saying:
    ``Without me paying attention, I believe that the right things
    are happening in my best interests,'' and when you find out
    that they are not, those are instances which undermines trust.
        In your opening statement, discussing the fact that we have
    had a tremendous rally from 2009, yet the amount of households
    owning equities [participating in that rally] has not followed
    that trend. So, I would argue that a series of events over the
    last number of years have lead to a decrease in investor
    confidence which led us to quit our jobs and start IEX. And I
    think that, from an investor confidence standpoint, my hope is
    that March 31 [publication date of Michael Lewis' ``Flash
    Boys''] becomes a low point. We have received a tremendous
    amount--thousands and thousands of calls and emails and letters
    from people who are actually looking to get back into the
    market.
        If there are people that feel like we did the wrong thing
    by speaking about it, we have not heard from them, we have not
    heard from the general public. We have gotten a lot of anger
    from Wall Street--not all--but, again, people embedded in the
    status quo do not want to see change happening. And I think
    that those who do want change have been very supportive of us.
        Senator Levin. Thank you. Thank you both. I appreciate your
    coming.
        Mr. Katsuyama. Thanks a lot.
        Mr. Battalio. Thank you.
        Senator Levin. Let us see. What time is it now? Have the
    votes started? I think the votes have started.
        We are checking to see if the votes have begun. Again, I am
    going to stay here through these first two roll call votes, so
    my colleagues here, you can adjust how you wish.
        We will now call our second panel of witnesses: Thomas
    Farley, the President of the New York Stock Exchange Group in
    New York; Joseph Ratterman, Chief Executive Officer of BATS
    Global Markets in Lenexa, Kansas; Joseph Brennan, Principal and
    Head of Global Equity Index Group at the Vanguard Group in
    Malvern, Pennsylvania; and Steven Quirk, Senior Vice President
    of the Trader Group at TD Ameritrade in Omaha, Nebraska.
        We appreciate all of you being here today, and under our
    Rule 6, as I think you heard, all of our witnesses are required
    to be sworn, so we would ask you to please stand and raise your
    right hands. Do you swear that the testimony you are about to
    give to this Subcommittee will be the truth, the whole truth,
    and nothing but the truth, so help you, God?
        Mr. Farley. I do.
        Mr. Ratterman. I do.
        Mr. Brennan. I do.
        Mr. Quirk. I do.
        Senator Levin. Thank you, and we will use, again, the
    timing system. A minute before the red light comes on, you will
    see the light change from green to yellow, giving you an
    opportunity to conclude your remarks. Your written testimony
    will be printed in the record in its entirety. Please try to
    limit your oral testimony to no more than 5 minutes.
        Mr. Farley, we are going to have you go first, followed by
    Mr. Ratterman, then Mr. Brennan, and then Mr. Quirk. Thank you
    all for being with us.

      TESTIMONY OF THOMAS W. FARLEY,\1\ PRESIDENT, NEW YORK STOCK
                      EXCHANGE, NEW YORK, NEW YORK

        Mr. Farley. Thank you. Chairman Levin and Senator Johnson,
    we appreciate your interest in the regulatory structure of the
    U.S. capital markets. My name is Tom Farley, and I am the
    President of the New York Stock Exchange. I have been in the
    business of running exchanges for most of my career including
    as President and COO of ICE Futures US--formerly the New York
    Board of Trade.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. Farley appears in the Appendix on
    page 77.
    ---------------------------------------------------------------------------
        As market operators, we have come to the view that the U.S.
    equities market is highly fragmented--making it overly complex
    and opaque. The regulations and structures in place today
    incentivize participants to make it more complex and more
    opaque. Numerous surveys and recent history have shown that
    this structure does not contribute to investor confidence or
    high systems reliability.
        As the dominant rule setting the boundaries of equity
    market structure, Regulation NMS set out to accomplish several
    objectives. The first was to increase competition among markets
    and among orders. While the rule did an excellent job of
    increasing competition among markets, we believe competition of
    orders has been severely damaged, particularly in recent years,
    due to the record level of off-exchange trading and increased
    levels of order fragmentation. In fact, just last week, off-
    exchange trading reached a record high of 40.5 percent across
    all Regulation NMS securities. This means that despite someone
    taking a risk to establish the National Best Bid or Offer on a
    displayed market--fully regulated exchange--brokers decided to
    execute the trade away from the displayed, or fully regulated,
    market 40 percent of the time rather than rewarding the people
    who established the NBBO--national best bid or offer--with an
    execution. We find this troubling and damaging to price
    discovery.
        The second objective of Regulation NMS was to design a
    structure to the benefit of long-term investors and public
    companies. Long-term investors have benefited in many ways from
    the implementation of Regulation NMS; however, data now shows
    that some of these benefits, such as lower costs, might be
    reversing. In addition, we consistently hear from large
    institutional investors that there are too many conflicts in
    the current market structure and that they would like to see
    those conflicts eliminated or, at least, reduced.
        Perhaps most importantly, we hear from listed companies and
    entrepreneurs that they believe the market is not designed for
    them but rather for the trading community, and as a result,
    they have lost confidence in the market. Newly listed companies
    via the IPO process are the lifeblood of our economy and our
    markets.
        The New York Stock Exchange will take a leadership role in
    bringing about beneficial change. Our goal is simple: reduce
    the level of complexity and fragmentation of the U.S. stock
    market. To accomplish this goal, there are several unilateral
    steps that we are committing to take and that we would welcome
    our industry colleagues to also adopt. To start, we are self-
    imposing a 6-month moratorium on any new, or novel, order types
    that further segment the market. In addition, we have already
    announced the elimination of more than a dozen existing order
    types. We believe these are first steps toward reducing
    complexity and toward a more efficient market structure, and we
    will look for other steps that we can take along these lines.
        At an industry level, we are seeking support for the
    elimination of maker-taker pricing and the use of rebates.
    Broad adoption of this policy would reduce the conflicts
    inherent in such pricing schema and further reduce complexity
    through fewer order types and fewer venues. In conjunction with
    the elimination of maker-taker and rebates, we believe
    regulation should require that deference be given to displayed
    quotes on fully regulated exchanges. There is risk involved in
    displaying a quote on such a venue, and we believe strongly
    that the person taking that risk should be rewarded with an
    execution at that price. Unfortunately, in today's environment,
    those displayed quotes are used to inform trading on dark
    markets which are not contributing to the price discovery
    process. The original investors who posted these public quotes
    are all too often left with no trade at all. Several countries,
    including Canada and Australia fairly recently, have adopted
    rules that establish this type of primacy of public quotes. In
    the cases of Canada and Australia, the regulators have
    established that this policy has simplified and even improved
    their markets.
        Last, as you heard on the first panel this morning, there
    are questions as to whether or not some market participants are
    able to build an advantage over others by using high-speed data
    feeds and co-location services. While it should be noted that
    both of these services are regulated and made available to all
    investors equally, we believe that if something results in a
    loss of investor confidence, we should find a way to change it.
    NYSE is willing to put all options on the table as it pertains
    to the delivery of market data; however, we highlight that this
    cannot be done in a vacuum, and any changes must be applied
    equally to all exchange and dark pool venues.
        Thank you for your time, and I look forward to answering
    any questions you may have.
        Senator Levin. Thank you very much, Mr. Farley.
        Mr. Ratterman.

     TESTIMONY OF JOSEPH P. RATTERMAN,\1\ CHIEF EXECUTIVE OFFICER,
               BATS GLOBAL MARKETS, INC., LENEXA, KANSAS

        Mr. Ratterman. Good morning. My name is Joe Ratterman,
    Chief Executive Officer of BATS Global Markets and one of the
    founding employees. I want to thank Chairman Levin, Ranking
    Member McCain, and Senator Johnson for inviting me to
    participate in today's proceedings.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. Ratterman appears in the Appendix
    on page 79.
    ---------------------------------------------------------------------------
        I was encouraged with the sentiments recently expressed by
    SEC Chairman Mary Lou White who said that our markets are ``not
    broken, let alone rigged.'' I agree with her. The automation of
    the U.S. equity markets has resulted in significant
    enhancements in market quality for long-term investors.
    Importantly, however, I also recognize that our markets are not
    perfect and that efforts to improve them should never let up
    and never cease. Our current market structure is a product of
    Congress' 1975 amendments to the Exchange Act and subsequent
    rulemaking by the SEC to implement a national market system.
        The SEC, working in significant part through the exchanges
    and other SROs, has created a system that allows market
    competition while at the same time, and just as vital,
    fostering price competition.
        Today our equity markets are widely considered to be the
    most liquid, transparent, efficient, and competitive in the
    world. Costs for long-term investors in U.S. equities are among
    the lowest globally and declining. These gains have been noted
    by investors and experts alike.
        In April 2010, Vanguard confirmed estimates of declining
    trading costs over the previous 10 to 15 years, ranging from a
    reduction of 35 percent to more than 60 percent, savings which
    flowed directly to investors in the former of higher returns.
        Three respected economists recently found that between 2001
    and 2013, the spread paid by investors had decreased by more
    than 70 percent for NYSE-listed stocks.
        In April 2014, BlackRock noted that, since 1998,
    institutional trading costs had declined and are among the
    lowest in the world.
        Earlier this month, ITG reported between 2009 and 2013,
    implementation shortfall costs decreased from roughly 45 basis
    points to 40 basis points, following a drop from 63 basis
    points in 2003.
        Further, our market is able to handle volume and message
    traffic considered astronomical only a short time ago. The
    efficient operation of our market structure throughout stress
    of the 2007-09 financial crisis indicates the systemic risks
    that have been reduced as a result.
        Efforts to address infrastructure risks since the flash
    crash of 2010 are producing further beneficial results. For
    example, the number of erroneous executions occurring on our
    markets is pace this year to be nearly 85 percent lower than
    the previous 5-year average, results that stem from the success
    of the recently enacted limit-up/limit-down plan.
        In addition, exchange systems issues as measured by self-
    help declarations have dropped by more than 80 percent since
    the first years after Regulation NMS. We must, nonetheless,
    remain squarely focused on improving market quality and
    stability in a coherent and responsible way. We are also keenly
    aware that investor confidence is important not only to help
    Americans realize their investment and retirement goals, but it
    plays directly into the overall health of our country's
    economy.
        Simply put, when investors are confident enough to put
    their hard-earned capital to work in our stock market,
    entrepreneurs and corporations can grow and thrive as well. As
    such, we are fully supportive of the SEC's plan for a
    comprehensive market structure review, and we look forward to
    actively participated in that process.
        Among other things, I see the following four areas as
    offering potential benefits without disrupting existing market
    quality gains.
        First, institutional investors could benefit from
    incremental transparency related to the ATSs that their brokers
    route orders to, including the publication of Form ATS, which
    some of the ATSs have already done. Consistent and thorough
    reporting standards will create the greatest level of investor
    confidence, so additional regulatory direction may be required
    here.
        Second, I support reviewing current SEC rules designed to
    provide execution quality and routing transparency. For
    example, Rule 606 could be amended to require disclosure about
    the routing of institutional orders as well as separate
    disclosures regarding the routing of marketable versus
    nonmarketable orders.
        Third, to strengthen the confidence of the investing public
    in market data, I continue to support initiatives to make the
    SIPs, also known as consolidated tapes, as fast as possible.
    This is a position that BATS has advocated since becoming an
    exchange in 2008.
        And, finally, I support the eliminate of the ban on locked
    markets, part of Reg NMS, which we believe is a primary driver
    of excessive complexity in our national market system.
        Thank you for the opportunity to appear before you today,
    and I would be happy to answer your questions.
        Senator Levin. Thank you very much, Mr. Ratterman.
        Mr. Brennan.

    TESTIMONY OF JOSEPH P. BRENNAN,\1\ PRINCIPAL AND HEAD OF GLOBAL
        EQUITY INDEX GROUP, THE VANGUARD GROUP, INC., MALVERN,
                              PENNSYLVANIA

        Mr. Brennan. Thank you, Chairman Levin, Ranking Member
    McCain, and Members of the Subcommittee for inviting me to
    participate today. My name is Joe Brennan. At Vanguard, I am
    responsible for overseeing the management of our equity index
    mutual funds.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. Brennan appears in the Appendix
    on page 87.
    ---------------------------------------------------------------------------
        Vanguard serves more than 20 million investors who entrust
    us with $2.6 trillion of their retirement and education
    savings. Vanguard's core mission is simple: to take a stand for
    all investors, to treat them fairly, and to give them the best
    chance for investment success.
        Before getting into specific comments on potential
    improvements to our current equity market structure, I would
    like to make two fundamental points.
        First, the markets are not rigged. We have a high degree of
    confidence in the markets as a safe place for investors to
    place their assets.
        Second, all investors have benefited from improvements to
    our equity market structure. Through regulatory initiatives
    over the past two decades, most notably Regulation NMS, our
    equity markets have evolved to a competitive marketplace that
    is connected through highly advanced technology. Over time,
    this structure has led to lower transaction costs for all
    market participants. Individual investors who access the equity
    markets through asset managers like Vanguard have benefited
    from the market structure improvements that have been made over
    the past 20 years. Additional improvements can be made, and we
    are very pleased to discuss those issues with the Committee
    today.
        We also commend SEC Chairman White for initiating a
    comprehensive review of ways to further strengthen the markets.
    We look forward to working with the Commission in this regard.
        I will now briefly discuss a topic that has garnered
    considerable public attention recently: high-frequency trading.
    While the term ``high-frequency trading'' has become shorthand
    for disruptive trading, there is a significant amount of
    legitimate activity, such as market making, which also falls
    under this broad umbrella. Today's market structure contains
    many venues in which trades can be executed. Professional
    traders and technology are the yarn that knits these venues
    together.
        Our efforts should not be focused on banning high-frequency
    trading; rather, we suggest examining our market structure
    holistically to ensure it is providing the incentives for the
    type of activity we would like to see.
        To accomplish this goal, Vanguard supports efforts by
    regulators to comprehensively reevaluate Reg NMS. As time has
    passed and the markets have changed, most would agree that it
    is time to reassess whether this regulation continues to
    further the goals of our national market system. We would
    suggest the most important goal of a national market system is
    to create a structure that encourages market participants to
    publicly display limit orders. Such a structure promotes price
    discovery and lowers transactions costs for all investors.
        In that light, Vanguard supports regulatory efforts to
    revisit the current maker-taker pricing model of the exchanges.
    Fundamentally, it is important to understand that these models
    did not develop from any nefarious intent. They are the
    exchanges' response to the proliferation of market centers
    enabled by Reg NMS and a way for the exchanges to continue to
    attract liquidity. However, the models have become unnecessary
    complex, and the decision to submit orders to the public
    markets should not be driven by the desire to capture a rebate
    or avoid a fee.
        Any reevaluation of the maker-taker models must be
    connected to an analysis of other ways to encourage publicly
    displayed orders. Specifically, we support a pilot of a
    ``Trade-At'' rule under Reg NMS. Today a market center can
    execute an order at the best publicly displayed price without
    actually contributing to the public price discovery process.
    Generally speaking, those that publicly display their interest
    first should be first in line for any execution at that price
    across the markets.
        A well-designed pilot of a ``Trade-At'' rule under Reg NMS
    could help strike the appropriate balance between promoting
    public competition of orders while still encouraging
    competition among a variety of market centers. Regulators and
    industry participants have been working diligently over the
    past few years to take steps to continuously improve the manner
    in which our markets operate. The equity markets are extremely
    complex, and it is vitally important to examine all of the
    potential consequences of any changes to our structure.
        We believe the SEC and FINRA are well equipped to continue
    to evaluate ways to improve our markets, and we commend them
    for the work they have already performed.
        I thank you for allowing me to participate in this
    discussion, and I welcome your questions.
        Senator Levin. Thank you very much, Mr. Brennan.
        Mr. Quirk.

      TESTIMONY OF STEVEN QUIRK,\1\ SENIOR VICE PRESIDENT, TRADER
                 GROUP, TD AMERITRADE, OMAHA, NEBRASKA

        Mr. Quirk. Good morning, Chairman Levin, Ranking Member
    McCain, and Members of the Subcommittee. My name is Steve
    Quirk. I am Senior Vice President with TD Ameritrade. I
    appreciate the opportunity to appear before you today. I
    thought I would spend a brief moment on TD Ameritrade and the
    clients that we serve so you have a better understanding of
    what we do.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. Quick appears in the Appendix on
    page 93.
    ---------------------------------------------------------------------------
        We are a financial services company serving primarily
    retail investors. We have over 6 million client accounts with
    $600 billion in assets, including custodial services for 4,500
    individual representative registered investment advisors and
    their clients. We are based in Omaha, Nebraska, and we were one
    of the first firms to offer discounted commissions to retail
    investors. Since our founding in 1975, we have also pioneered
    innovations such as touch-tone trading, Internet trading, and
    most recently mobile trading.
        We have been on a quest to level the playing field between
    Wall Street and Main Street investors for almost 40 years. As a
    result of that, our clients have entrusted us with
    approximately a quarter trillion in net new assets since 2007.
    We interact with these clients daily and do third-party surveys
    to better understand their market sentiment. Based on this and
    other data, we do believe that the current U.S. equity market
    structure has never been better for those retail investors. In
    fact, the number of our firm's accounts that are trading is up
    31 percent on a year-over-year basis.
        Our retail clients tell us they want their entire orders
    filled quickly and inexpensively at the price quoted or better.
    In each of those areas, we have seen significant improvement in
    the last decade, as detailed in the written testimony.
        When it comes to order routing, brokerage firms have two
    options: they can internalize and trade against that, or they
    can route that to the market centers and destinations. Based on
    our open architecture and unbiased and unconflicted business
    model, we believe it is in the best interest of our clients to
    send their orders to a mix of market centers, including
    exchanges, wholesale market makers, and ECNs. While these
    market destinations serve a variety of purposes, we think they
    are all vital in driving the competition, which ultimately
    benefits investors.
        The Subcommittee has asked for our views on conflict of
    interests for brokers obligated to obtain best execution for
    client orders but also receive payments or rebates based on
    where that flow is directed. We strongly believe that with
    compliance with best execution obligations and proper
    disclosure, brokers can effectively manage any conflict that
    may arise from payments. Furthermore, we strongly believe that
    we effectively manage any such conflict.
        Brokers are required to seek the most favorable terms
    reasonably available under the circumstances for client orders.
    At our firm we consider the opportunity to obtain a better
    price than currently quoted, the speed of execution, and the
    likelihood of execution, amongst other factors when making that
    assessment.
        We also give our clients a choice. Their orders can be
    routed using our proprietary order routing logic, or they can
    choose from a list of direct routing destinations.
        Finally, we work with multiple market destinations. Rather
    than internalize our client flow, we believe that routing all
    orders to the market is more transparent and better aligned
    with the needs of our clients. We select these market centers
    based on rigorous due diligence where execution quality is the
    top priority. After, and only after, a market satisfies our
    standards for best execution do we consider transaction costs
    or revenue opportunities. This process complies with SEC rules
    enacted after thoroughly reviewing this issue on numerous
    occasions.
        The payments or rebates that brokers receive are
    transparently disclosed as an average per share in our
    quarterly 606 reports; they are also on our account Statements
    and are on confirmations, which are all required by SEC rules.
        Finally, we have provided the Subcommittee with a list of
    recommendations that we believe could enhance our Nation's
    current market structure without compromising many of the
    benefits retail investors have realized in the past years. Just
    as we constantly seek to improve our client experience, our
    industry should do the same. But let us not lose sight or
    compromise many of the improvements that have been made.
        We appreciate the opportunity to be part of the
    conversation. Thank you.
        Senator Levin. Thank you very much, Mr. Quirk.
        Let me start first with you, Mr. Farley. Jeff Sprecher, the
    head of the Intercontinental Exchange, which owns the New York
    Stock Exchange, which you represent here today, has said that
    the maker-taker system misaligns the interests of brokers and
    their customers and hurts everyone in the market. ``We should
    get rid of it,'' he said. Do you agree with him?
        Mr. Farley. Yes. Jeff also says--and let me start by
    saying, Senator, that the U.S. capital markets are indeed the
    best in the world, but for 225 years the New York Stock
    Exchange has advocated on behalf of customers and stood for
    improving markets and not just accepting a flawed status quo.
        To answer your question directly, there are really two
    areas where we are most concerned about the markets today: one
    is the appearance of conflicts, primarily because we think that
    undermines confidence in the markets; and the second is undue
    cost and complexity in the markets that we have heard a lot
    about today. Maker-taker gets to the heart of both of those
    issues and concerns that we have, and it is for those reasons
    that we have advocated eliminating maker-taker in its entirety
    in the equity markets in this country.
        Senator Levin. Well, very significant testimony when an
    exchange which has been here as long as you have been here
    makes that point. And you have said in your testimony that we
    are seeking support for the elimination of maker-taker pricing
    and the use of rebates. And then you said, ``Broad adoption of
    this policy would reduce the conflicts inherent in such pricing
    schema . . .'' Explain that now to the Subcommittee. I happen
    to agree with you that those conflicts are inherent, but tell
    us in your words why elimination of the maker-taker pricing
    would reduce conflicts that are inherent in such pricing.
        Mr. Farley. Sure. And if I may, if I could just provide a
    little bit of context, I came from a company called
    Intercontinental Exchange, and we agreed to acquire the New
    York Stock Exchange on Thanksgiving of 2012. And so we came to
    this with a perspective of other markets like the futures
    markets, which are deep and liquid and people generally will
    acknowledge that those markets function properly. And there is
    no such thing in those markets as maker-taker pricing, for
    example. So it was something we very quickly wanted to
    understand more about.
        The first thing that we noticed was that the maker-taker
    schema results in many more order types in the equities markets
    than you have in other markets, such as, for example, the
    futures markets. And many of those order types are simply in
    existence to help market participants capture the maker-taker
    spread.
        And so we realized while this pricing schema introduces a
    good deal of complexity, with respect to the conflicts issue
    that you described in particular, it has been frustrating to us
    that in a period of rising stock prices we have not seen more
    participation in the equities markets from investors. In fact,
    data shows that the participation in terms of percentage
    participation of U.S. citizens is at a 16-year low. And we
    think a reason for that, an important reason for that, is just
    confidence in the markets. Markets rely on confidence. We
    cannot say that enough.
        And irrespective of whether or not there is an actual
    conflict or a conflict that is resulting in some sort of bad
    behavior, the appearance of conflict matters. And it is for
    that reason that we look at maker-taker pricing, and we say
    there may be an appearance of conflict there if a broker-
    dealer's interests are not aligned with their customers, and
    that is something that can potentially arise with maker-taker
    pricing.
        Senator Levin. Well, the appearance of a conflict is
    obviously important because of the confidence issue and also
    because underneath the appearance there may be more than an
    appearance. But your testimony actually is even clearer than
    that. As you say, you support elimination of maker-taker
    pricing and the use of rebates, and that broad adoption of that
    policy would reduce the conflicts inherent--you use the word
    ``inherent.'' Explain that.
        Mr. Farley. So any reasonable business person does not like
    to be in a position of having their interests not aligned with
    their customers'. When you have maker-taker pricing, there are
    examples, as Professor Battalio described this morning, where a
    broker-dealer has an incentive to post a price on a high-make
    rebate venue even if the execution quality on that particular
    venue is not as high as another venue. That arises specifically
    because of--or it is certainly exacerbated because of maker-
    taker pricing.
        Senator Levin. And that is why there is a conflict inherent
    in that pricing schema.
        Mr. Farley. That is right.
        Senator Levin. Now, Mr. Ratterman, I will give you a chance
    now to--first of all, before we ask you to comment or react to
    that, you said earlier this year, I believe, that businesses
    offer incentives for customers to be in their ecosystem all the
    time. Who are the customers you were referring to? Are they
    brokers?
        Mr. Ratterman. Yes, our customers are all brokers.
        Senator Levin. All right. Now, let me give you an
    opportunity to respond to Mr. Farley's testimony.
        Mr. Ratterman. Sure. So from my perspective, in our firm we
    do not believe that there should be a ban on maker-taker. We
    are certainly open, if there is a pilot, to looking at the
    data, but my answer stems from my concern for the potential
    benefits and spread reduction that maker-taker may have
    produced over the last 10 or 15 years, not for any commercial
    purpose about the way we run our exchange. Our exchange is in
    the business of matching buyers and sellers, fair and orderly
    markets. When we have a trade, we are going to deserve revenue
    for that trade as it happens. How we do that, there is today a
    significant amount of flexibility, and I believe that
    flexibility has allowed for innovation in pricing and markets,
    and that incrementally the rebates that are offered in many
    cases to market makers to take the risk to put bids and offers
    in the market has yielded tighter spreads over time.
        I also do not believe that eliminating maker-taker would
    eliminate a conflict. I am thinking, as Senator Johnson walked
    through an example earlier, a broker's evaluation of a trade,
    examining where he would get a rebate for 30 cents or maybe pay
    15 cents, he is looking at a spread of 45 cents in relation to
    the likelihood or not likelihood of getting an execution where
    he actually does get paid, and when he does not trade or his
    order does not fill, there is no commission to the broker.
        So by eliminating maker-taker, you would only compress the
    range of the conflict, but the conflict would still exist as
    long as there is differential pricing between exchanges. So I
    think the only way to potentially eliminate the conflict then
    is to mandate exchange pricing at a fixed level for all
    exchanges all the time.
        So the conflict will remain unless there is a significant
    intervention, and I believe disclosure, as we have talked about
    earlier today in the hearing, is the right answer to provide
    the information so that not only brokers but their customers
    can evaluate whether these conflicts have actually been managed
    well in favor of the client or not. But I do not see any path
    by which the elimination of the conflict can be achieved.
        Senator Levin. Mr. Farley, do you want to comment on that?
        Mr. Farley. Sure.
        Senator Levin. Can we reduce the conflict that is inherent
    that you talked about? And can we reduce the appearance by
    removing the maker-taker pricing? Or have you changed your mind
    after hearing Mr. Ratterman? [Laughter.]
        Mr. Farley. I actually found more areas of agreement with
    Mr. Ratterman than maybe I would have otherwise expected from
    the way his answer started. I think he--if I am putting words
    in your mouth, Joe, correct me. But he said, look, that may
    reduce the conflict, but it would not eliminate it. And so we
    are both agreeing directionally that it would have an impact on
    conflict or the appearance of conflict in the market.
        But I also want to highlight that, again, the reasons why
    we have been focused on this are twofold: one is around this
    conflict issue, and the second is around complexity in the
    markets, additional order types and venues. And it is worth
    noting that, at the New York Stock Exchange, I have three
    equities trading venues, Mr. Ratterman has four. We have a
    competitor that also has four. A lot of those venues exist
    really principally because of maker-taker pricing, and those
    venues are creating different pricing schemas using maker-taker
    pricing for our customers.
        And then, finally, and I will conclude briefly, I agree
    with Mr. Ratterman about another point he made, which is that
    we have to be careful about the elimination of maker-taker to
    make sure that there are not wider spreads on fully regulated
    exchanges, which is why it is very important to us that such a
    move would be tightly coupled with giving what we call primacy
    of the public quote on lit exchanges to the participants who
    made those quotes. And that is something that does not exist
    today, and people are able to trade in dark markets at the same
    price as is posted on an exchange.
        Senator Levin. And reducing the conflict would be valuable
    even if you cannot eliminate it?
        Mr. Farley. Yes.
        Senator Levin. Mr. Sprecher, your boss, in January said the
    following: ``The price that we see as a bid-offer price in the
    market is really not the price because there are rebates and
    other discounts that are applied. . . . So we do not have a
    view of the actual price which I think is to a certain degree
    false advertising when you have a public ticker.''
        Do you agree that maker-taker fees are distorting market
    prices?
        Mr. Farley. I agree with what Jeff said. He is my boss,
    after all.
        Senator Levin. If he were not your boss--he is not
    listening. [Laughter.]
        Do you believe that maker-taker fees are distorting market
    prices?
        Mr. Farley. Well, if I can just address the comment that
    Jeff made, I think it is a matter of fact that posted prices on
    exchanges--and also there are posted prices that go out through
    our own raw data feeds or public feeds--do not include the fees
    associated with them. So that is accurate that they do not
    include all-in prices.
        So to the extent somebody is viewing that data and assuming
    that it does include the various make rebates and take fees,
    from their perspective it would be distorted. If somebody
    understands that it is not included, they are just receiving a
    different data set.
        Senator Levin. Did anything that you hear Mr. Ratterman say
    change your view that the maker-taker schema, as you put it,
    creates an inherent conflict?
        Mr. Farley. No.
        Senator Levin. Now, Mr. Sprecher also said the following,
    Mr. Farley, that maker-taker ``creates false liquidity.'' Do
    you agree with that?
        Mr. Farley. I suppose I have a slightly different
    perspective on it.
        Senator Levin. Give us your perspective.
        Mr. Farley. So, again, I come from a career mostly spent in
    the futures markets, and the type of liquidity and market
    making we most value comes from participants who will show up
    and buy from sellers and sell to buyers and actually engage in
    risk transference where they will hold a position for a period
    in time.
        Fairly new to the equities markets now--a year and a half
    in--what I see is there is a whole swath of market making that
    is essentially stitching back the 50-plus venues you mentioned
    earlier this morning, and there are many examples of
    participants who are buying and selling at the exact same price
    at the exact same time on different venues, in part to capture
    maker-taker rebates. That is a different form of liquidity. I
    would choose different words than Jeff did, ``false
    liquidity,'' but it is not as valuable as the type of liquidity
    that we have always valued at ICE in building markets.
        Senator Levin. It is a different kind of liquidity which is
    not as valuable as the kind of liquidity which is created where
    there is a real shifting of risk.
        Mr. Farley. No question. And it is a blanket of cost on the
    industry, stitching back together those--50 is a conservative
    number, but stitching back together those 50 venues.
        Senator Levin. I think we have all heard about a recent
    survey of equity market participants that suggested that the
    majority of those surveyed thought that the equity markets were
    not fair for all participants. Is there a lack of confidence?
    Would you agree, Mr. Farley? And do the conflict of interests
    fuel that lack of confidence?
        Mr. Farley. I look at statistics such as the one that I
    believe you cited, Senator, that two-thirds of Americans had
    equities in their account not too long ago, maybe a decade ago,
    and now it is half; that participation in the equities markets
    is at a 16-year low; and I look at that empirical data. I also
    look at the anecdotal data, and I am sure you, like I, have
    conversation about the equity markets with your friends and
    family. I grew up down the road here in P.G. County, and when I
    go back home, inevitably people ask me, ``What is going on in
    the equities markets? Tell me about these high-frequency
    traders.'' And there is a sense, it is unfortunate, but there
    is a sense that we do not have as much confidence in the
    markets as we once had, which is why we as the New York Stock
    Exchange, from the moment ICE agreed to acquire the New York
    Stock Exchange, has been standing for what can we do to
    increase confidence, what can we do to simplify the markets.
    Because as simple as you can make--to inspire confidence, you
    would to make the market as simple as you possibly can and as
    transparent as you possibly can.
        Senator Levin. And as free of conflict of interests as you
    possibly can?
        Mr. Farley. Yes.
        Senator Levin. Mr. Brennan, your main business is
    investment management, and you offer mutual funds and other
    investment opportunities for your customers. Do you believe
    that the maker-taker pricing creates a conflict of interest
    between a broker's duty to seek best execution and the money a
    broker can make by pursuing rebates?
        Mr. Brennan. Yes, we think the maker-taker pricing model
    creates an appearance of a conflict of interest and adds
    additional complexity to the market. We are in favor, as we
    have stated, of looking at maker-taker as part of a
    comprehensive review of Reg NMS in our market structure.
        Senator Levin. Do you think that that should be eliminated?
        Mr. Brennan. I think we should test any changes with a
    pilot. I am not sure elimination is the answer. I think pilots
    and data-driven analysis are the best way to really make
    decisions on changes in market structure.
        Senator Levin. And the pilot would be to remove maker-taker
    in a particular pilot area?
        Mr. Brennan. Sure. I think----
        Senator Levin. What area would you suggest that maker-taker
    be eliminated on a pilot basis? How would you describe the
    pilot or how would you define the pilot area?
        Mr. Brennan. I think experts at the SEC should work with
    industry participants to define the pilot. I think all market
    participants should be involved in the definition of the pilot.
        Senator Levin. And the reason that you want to move in that
    direction is because you believe, and your company believes
    that there is an appearance of a conflict?
        Mr. Brennan. Yes, maker-taker does create an appearance of
    a conflict. I think we are all in agreement.
        Senator Levin. Now, Mr. Brennan, some of the conflicts that
    we discussed today are the result of payments that are a penny
    a share or a few cents a share. Why does it matter to you that
    a conflict or an appearance of a conflict be removed if it is a
    few pennies a transaction?
        Mr. Brennan. Well, we generally stand for what is in the
    best interests of our clients, and we are--for transparency and
    a fair market, and conflicts--eliminating conflicts and
    reducing conflict of interests in our market is something that
    would benefit our clients.
        Senator Levin. Does it also create a problem for you to
    check on execution?
        Mr. Brennan. It does not create a problem for us.
        Senator Levin. Do you spend time looking at the execution
    of brokers?
        Mr. Brennan. Yes, so----
        Senator Levin. If maker-taker were eliminated, would that
    result in less time being spent by you and your company
    reviewing the execution of brokers?
        Mr. Brennan. Our approach to our counterparties is probably
    four- or five-fold.
        Senator Levin. When you say ``counterparties,'' who----
        Mr. Brennan. Brokers, to the use of brokers, our choice of
    brokers. We have a lot of choices in who we can transact with.
    We really scour the marketplace looking for the best place to
    execute our transactions. We have highly skilled traders who
    manage our portfolios on behalf of our clients. And we have
    choice to eliminate a broker if they are not living up to our
    needs.
        Along with that skill and expertise, we also have a trust
    but verify mode of operation where post-trade analytics are
    performed to see that our brokers are actually living up to our
    requirements.
        Senator Levin. And I think your company told our staff that
    monitoring brokers to ensure or try to ensure best execution is
    a significant effort and that they would rather not have to do
    so in a conflicted environment. Is that true?
        Mr. Brennan. We think it would be a significant effort,
    whether maker-taker existed or not. To be honest, we do a lot
    of trading, $1 billion, $2 billion of trading a day, 6 million
    trades a year. I think we owe it to our clients to do
    everything to ensure their execution is top-notch.
        Senator Levin. And even though the amount of money per
    transaction may be 30 cents, or whatever it is, is that still
    true? Do you worry about that being added to a transaction?
        Mr. Brennan. The 30 mil cap?
        Senator Levin. Yes.
        Mr. Brennan. Yes, so that is a pricing model, and that is a
    cap on a pricing model. What actually happens with our
    transactions is not necessarily 30 mils. We have a lot of
    control over our trades. We do not just hand them over to a
    broker.
        Senator Levin. You spend time, as you said, reviewing this.
        Mr. Brennan. We spend time in the actual trading and the
    review of the trades.
        Senator Levin. And the review of them.
        Mr. Brennan. Yes.
        Senator Levin. And if there were less of a conflicted
    environment, would you have less need to review?
        Mr. Brennan. I think we would still review, to be honest
    with you.
        Senator Levin. But would you rather be in a nonconflicted
    environment?
        Mr. Brennan. It might make the complexity and the review
    process a little easier in the data that comes back.
        Senator Levin. Would you rather review the trading in a
    nonconflicted environment?
        Mr. Brennan. Sure.
        Senator Levin. Now, as a retail broker, does Vanguard
    accept payments from wholesale brokers, so-called payments for
    order flow?
        Mr. Brennan. Vanguard has a retail brokerage. That is not
    the area of the company that I am associated with.
        Senator Levin. Do you know whether or not Vanguard accepts
    payments from wholesale brokers?
        Mr. Brennan. Vanguard in its retail brokerage does not
    accept payments for equity flow.
        Senator Levin. Do you know why?
        Mr. Brennan. We would have to talk to that area of our
    company. I am quite separate from our retail broker.
        Senator Levin. All right. Here is what the person in that
    area told our staff. Tell me whether or not you disagree with
    this. They told us that they could make money by selling their
    retail order flow, but they believe accepting payments would
    create a conflict, so they do not do so.
        Do you have any reason to not believe that or----
        Mr. Brennan. I have not talked to the person that runs that
    area of our company, so I cannot confirm or deny that.
        Senator Levin. That would be fine. Would you take back to
    your company that request?
        Mr. Brennan. Sure.
        Senator Levin. And give us an answer for the record----
        Mr. Brennan. Absolutely.
        Senator Levin [continuing]. As to whether or not what the
    staff Vanguard folks told us that they believe accepting
    payments would create a conflict, so they do not do so? Would
    you let us know for the record if that, in fact, is the case?
        Mr. Brennan. Yes, sir.
        Senator Levin. Mr. Quirk, I understand that your company,
    TD Ameritrade, sends marketable orders which would incur a fee
    if sent to an exchange to a wholesale broker-dealer. Is that
    correct?
        Mr. Quirk. That is correct.
        Senator Levin. And that the broker-dealer pays Ameritrade
    for those orders. Is that correct?
        Mr. Quirk. That is correct.
        Senator Levin. And that you send nonmarketable orders,
    which are the ones that are eligible for rebates to exchanges.
    Is that correct?
        Mr. Quirk. That is correct.
        Senator Levin. And is it correct that TD Ameritrade
    receives payment either from a wholesale broker as payment for
    order flow or from an exchange as a rebate on nearly every
    trade completed?
        Mr. Quirk. I would not say on every trade completed----
        Senator Levin. I said ``nearly every.''
        Mr. Quirk. Nearly every trade, yes.
        Senator Levin. All right. On nearly every trade, TD
    Ameritrade receives two payments: one is the commission paid by
    the customer, and another is from the venue where the trade is
    executed. Who decides whether an exchange or a wholesaler has
    provided best execution? Is it TD Ameritrade itself? Do you
    make that decision?
        Mr. Quirk. We would have committees that would make that
    decision.
        Senator Levin. So a best execution committee?
        Mr. Quirk. We do. We have a best execution committee.
        Senator Levin. All right. Can different brokers reach
    different conclusions about which venue offers the best
    execution?
        Mr. Quirk. Yes, I think--yes. The answer to the question is
    yes. But I think what is going to drive the decision as to what
    is the best execution is the client, and what I mean by that is
    if a retail client puts in a market order, they are telling us
    they want a quick, timely execution at or better, at the
    current price or better, in its entirety.
        Senator Levin. If there is a market order?
        Mr. Quirk. If it is a market order.
        Senator Levin. Other than that?
        Mr. Quirk. If it is a limit order, they are telling you
    they want that order to be visible. They have picked a price,
    they have determined where their interested in purchasing that
    stock, and they want it to be visible.
        Senator Levin. But basically the question is still the
    same: Could different brokers reach different conclusions about
    which venue offers the best execution?
        Mr. Quirk. Yes, but I think the determinant factor would be
    what is in the best interests of their client or what is their
    client looking for. Our clients are not going to look like, for
    example, your clients, so we are going to have different needs
    with respect to execution.
        Senator Levin. But the answer to the question is different
    brokers, even with the same clients, can reach different
    conclusions about the best venue. That is why you have a
    committee.
        Mr. Quirk. Yes.
        Senator Levin. Would you all agree with that? Are you
    shaking your heads yes, that different brokers----
        Mr. Ratterman. Yes.
        Senator Levin [continuing]. Can reach different conclusions
    as to which venue offers the best execution?
        Mr. Farley. Yes.
        Mr. Brennan. Yes.
        Senator Levin. All right. Now, for Mr. Quirk, back in 2009,
    Chris Nagy, who is TD Ameritrade's managing director of order
    routing strategy, said the following: ``With maker-taker, there
    is a higher cost to retail investors.''
        Now, that is not your position today. Is that correct?
        Mr. Quirk. No, and I do not know what that is in reference
    to.
        Senator Levin. All right. But that is not your position
    today.
        Mr. Quirk. No.
        Senator Levin. And he also--that was in Forbes Magazine,
    September 10, 2009, and he was the managing director of order
    routing strategy, and he said the following in the September
    21, 2009, edition of Securities Technology Monitor: ``We felt
    it would become deleterious to the retail investor if maker-
    taker were allowed to proliferate.'' That was in 2009. Is that
    your position?
        Mr. Quirk. No, it is not.
        Senator Levin. Do you know what changed?
        Mr. Quirk. I do not know what his position was, so I
    actually was not involved with the order routing.
        Senator Levin. Were you there in 2009?
        Mr. Quirk. I was there, but not in this capacity.
        Senator Levin. OK. Do some trading venues, Mr. Quirk, offer
    higher rebates than others?
        Mr. Quirk. Yes.
        Senator Levin. Is the size of the rebate offered by an
    exchange a factor in determining where you route nonmarketable
    customer orders?
        Mr. Quirk. The way that our committees and the people
    responsible for order routing approach this is they start with
    the best execution, and they would go through a list of
    variables that we should consider as hurdles. And in order to
    get to a point where the revenue sharing is even considered,
    those hurdles have to be cleared.
        Senator Levin. And the revenue sharing that you are talking
    about is the rebate?
        Mr. Quirk. Correct, sir.
        Senator Levin. When you get to that point----
        Mr. Quirk. Yes.
        Senator Levin [continuing]. After you say you have looked
    at the other factors, and then you look at the rebate issue, my
    question is: Is the size of the rebate offered by an exchange a
    factor in determining where you route those nonmarketable
    customer orders?
        Mr. Quirk. Yes. It would be the last factor. All things
    being equal, that would be a factor.
        Senator Levin. And so the greater the rebate, that would be
    where you would go if it is otherwise best market.
        Mr. Quirk. Yes.
        Senator Levin. How many trades does Ameritrade route to
    exchanges in a typical quarter?
        Mr. Quirk. We route--about 37 percent of our flow would go
    to an exchange on a daily basis, so I am assuming that 40--I
    will call it 40 percent of, let us call it, 400,000 trades a
    day, so we are talking about----
        Senator Levin. 150,000 trades a day?
        Mr. Quirk. 150,000 trades a day times--you said a quarter,
    right? So that is going to be about--let us see.
        Senator Levin. Well, a week it would be about--let us round
    it off, say half a million a week?
        Mr. Quirk. Yes.
        Senator Levin. And so maybe in a month that would be about
    2 million. A quarter that would be about 8 million. How does
    that sound?
        Mr. Quirk. That sounds good.
        Senator Levin. Round it off, OK.
        Mr. Quirk. We did about 90 million trades last year.
        Senator Levin. OK. Well, then, why would it be only 8
    million?
        Mr. Quirk. You asked----
        Senator Levin. Well, that is through exchanges.
        Mr. Quirk. Yes, and you asked per quarter.
        Senator Levin. OK. So that is about 8 million, to exchanges
    in a typical quarter.
        Now, we looked at your Form 606 quarterly order routing
    disclosures for the quarter that was covered in the Battalio
    paper, and I am going to have to go vote. I apologize. We are
    going to have to recess here for about 15 minutes. That will
    give you all a chance to do something else that you might need
    to do.
        We will reconvene at 12:15. Thank you all.
        [Recess.]
        Senator Levin. We will come back into session. We thank our
    witnesses for their patience and understanding with the Senate.
        Let me pick up where we left off, Mr. Quirk. I guess we
    were talking about how many trades Ameritrade routes to
    exchanges in a typical quarter, and I think we rounded it off
    to about 8 million, something like that. Is that correct?
        Mr. Quirk. That is correct.
        Senator Levin. Now, we looked at your Form 606 quarterly
    order routing disclosures for the quarter covered in the
    Battalio paper, and according to those disclosures, for the
    quarter covered in that paper, which was the fourth quarter of
    2012, TD Ameritrade directed all nonmarketable customer orders
    to one venue in that quarter, Direct Edge. Is that correct?
        Mr. Quirk. That is correct.
        Senator Levin. Now, among all the exchanges, Direct Edge
    paid the highest rebate during the fourth quarter of 2012,
    which is, again, the period covered by the Battalio paper, and
    you say that the orders, it was your policy, are directed first
    and foremost on the basis of best execution. But as we have
    learned today, best execution is a subjective judgment.
        So your subjective judgment as to which market provided
    best execution for tens of millions of customer orders a year,
    about 8 million in a quarter, allowed you to route all of the
    orders to the market that paid you the most. Now, I find that
    to be, frankly, a pretty incredible coincidence.
        Now, you directed all your orders for that quarter to
    Direct Edge because what you have said is that that exchange
    offered your company the best execution. The disclosure did not
    show a single order being directed to the New York Stock
    Exchange, for instance.
        So, Mr. Farley, was the New York Stock Exchange just
    consistently worse than Direct Edge in getting best execution
    on retail orders?
        Mr. Farley. No.
        Senator Levin. And, Mr. Quirk, how much did TD Ameritrade
    receive in rebates from exchanges last year for routing orders
    to venues that pay maker rebates? Do you know how much you made
    just from payment for order flow and rebates?
        Mr. Quirk. I can estimate it was based on what we have
    discussed. It would be about $80 million.\1\
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 4, June 19, 2014 letter from TD Ameritrade to
    the Permanent Subcommittee on Investigations, revising $80 million to
    $36 million, which appears in the Appendix on page 125.
    ---------------------------------------------------------------------------
        Senator Levin. About $80 million?
        Mr. Quirk. Yes.
        Senator Levin. And that would be just the part that goes to
    the venues that pay maker rebates?
        Mr. Quirk. Maker-taker.
        Senator Levin. Maker-taker, right. Well, how much did TD
    Ameritrade pay in fees to exchanges last year for routing
    orders to venues that charge taker fees?
        Mr. Quirk. I do not know the answer to that question, but I
    can get it.
        Senator Levin. Well, I think it is close to zero, isn't it?
        Mr. Quirk. No, it is not close to zero, but I do not know
    what the answer is. It would not be significant.
        Senator Levin. All right. Will you get the answer for the
    record?
        Mr. Quirk. Yes.
        Senator Levin. So, anyway, for virtually every trade, your
    customers you say were better off by your routing their orders
    to the exchange that paid you a rebate rather than a venue that
    TD Ameritrade would have had to have paid a fee. Is that true?
        Mr. Quirk. I would say in the subsequent 24 months, you
    will note in our 606s that we have routed to a number of
    exchanges in one quarter, and some of those exchanges would not
    be the exchanges which were paying the highest rate.
        Senator Levin. Well, let me go into that. In your 606
    disclosures, for the first quarter of 2014, TD Ameritrade
    routed all disclosed nonmarketable orders to either Direct Edge
    or Lavaflow, the exchanges that appear from our review of your
    disclosures to have offered the highest rebates available in
    the market. Is that true?
        Mr. Quirk. That would be true.
        Senator Levin. And so, again, your subjective judgment as
    to which market provided best execution for tens of millions of
    customer orders virtually always led you to route orders to the
    markets that paid you the most.
        Mr. Quirk. No, it would not have always led us----
        Senator Levin. I said ``virtually always.''
        Mr. Quirk. Virtually, yes.
        Senator Levin. Senator McCain.
        Senator McCain. I want to thank the witnesses for coming.
        Mr. Ratterman and Mr. Farley, what effect would banning
    maker-taker payments have on your stock exchanges? Mr.
    Ratterman?
        Mr. Ratterman. Thank you, Senator McCain. The effect would
    have us, as a commercial operation, change the way in which we
    charge our broker-dealer customers to access our market. As I
    mentioned earlier today, we take on the order of 2 cents for
    every hundred shares traded as revenue for conducting the
    services of an exchange. So if you take away the maker-taker
    rebate, we will simply reconfigure the pricing mechanism that
    we have so that we can continue to operate our business. So it
    is not fundamental to the way we do business, and so related to
    your question, we would simply adjust our pricing to whatever
    framework that the law allowed.
        Senator McCain. Mr. Farley.
        Mr. Farley. We would have fewer order types, which would
    reduce complexity in the market. We would likely have fewer
    venues, Senator, as well. We have three separate equities
    trading venues, and we would not need all three of those in a
    world where we did not have maker-taker, and I suspect some of
    our competitors would also reduce the number of venues they
    have.
        However, I do want to point out that if we ban maker-taker
    in isolation, it is also probable that more business would move
    away from fully regulated exchanges into dark markets.
    Therefore, we would need to couple it with what is called a
    trade-at provision, which would establish the primacy of public
    quotes.
        Senator McCain. I guess I have a question for all four of
    you. In your business and ours, perception is reality and
    reality is perception. And I think you would agree that we
    would not be having this hearing if it was not for significant
    questions out there about whether you do business fairly or
    unfairly, if there is favoritism, if there is, even as was
    charged in Michael Lewis' book, that there is real corruption.
    I think you would agree that there is a problem out there.
    Would you agree with that, all of you? Or you do not think
    there is a problem of public perception?
        Well, first of all, I guess beginning with you, Mr. Farley,
    and going down the line here, do you believe there is a public
    perception problem? And if there is, what do you think we ought
    to do? What measures ought to be taken? If you think there is
    no PR problem out there, then just say, ``I do not think there
    is a problem.'' But if you think there is a problem, what do
    you think we ought to do?
        Mr. Farley. Markets are built on confidence and perception,
    as you point out, and I think the perception could be a lot
    better, the perception of the equities markets in this country.
    We are talking a lot about trading businesses. At the New York
    Stock Exchange, the most important part of our business is
    actually our listings business--in other words, that part of
    our business where entrepreneurs come to market to raise
    capital to help create jobs, and that is built entirely on
    perception. And so we want to do whatever we can to improve the
    perception of the equities markets.
        We have proffered several suggestions. We actually think
    doing away with maker-taker, coupling it with a trade-at rule
    would improve perception by itself because of some of the
    aftereffects, reducing complexity, reducing order types,
    reducing messaging, reducing venues. And when you bring that
    sort of simplicity to the markets, that breeds confidence
    because people can understand it. It is more tangible.
        Senator McCain. Would co-location be part of that reform? I
    think we all would agree transparency is. Would co-location,
    elimination of that, also be a positive effect or no effect?
        Mr. Farley. Eliminating co-location would go in the other
    direction. I actually think that would be a perception problem.
    But bringing more transparency to the practice of co-location I
    think is a great idea, to whatever extent we can.
        Senator McCain. Mr. Ratterman.
        Mr. Ratterman. In my mind there is no question that these
    questions about market structure have entered into the
    mainstream and that people are wondering how the markets work.
    I think that to address that, maybe a few things.
        First, there are probably some areas of immediate
    transparency that can be brought into the market, and I think
    we are seeing market forces to some extent start to do that.
    IEX and Credit Suisse and Goldman Sachs I believe are three
    dark pool operators that have all released their Form ATS as an
    example. Prior to recent months, those were forms that were not
    made available to the public.
        So I think you are seeing a trend in the direction of
    transparency. In our testimony we have talked about areas of
    Rule 606 and 605 and other areas of operation of dark pools
    where transparency, I think, would yield a lot of insights and
    potentially some additional confidence in the markets. So that
    is the immediate response.
        The medium-term response I believe is to let the SEC do the
    holistic review that SEC Chairman White has articulated to the
    industry. This holistic review will be fully comprehensive. It
    will cover every tenet of market structure as we understand it
    today, put everything on the table. And some things will
    undoubtedly change through that process. They will find ways to
    optimize and improve what are already some pretty good
    attributes for today's market. But also, even things that we do
    not change, there will be a recent mark where the regulator
    will have said, ``We looked at this, we got the data, we have
    concluded that this is a good tenet of market structure, and we
    are going to leave it in place.''
        And so I think every element of our market structure will
    be addressed in this holistic review, and nothing will be left
    out. And I think that process will be very healthy for our
    markets.
        Senator McCain. Mr. Brennan.
        Mr. Brennan. Thanks, Senator McCain. As to whether the
    markets--there is a perception problem or not and a confidence
    issue, the only thing I can judge that on is generally our
    business and our customers and our clients. At Vanguard we have
    seen record interest over the last few years in our products.
    The majority of the flows we have seen have been into our
    equity market-based products. Vanguard had $138 billion of
    client assets come in the door last year and $76 billion in the
    first 5 months of this year. And, again, the vast majority of
    those sums have been going to our equity products.
        Senator McCain. Well, Mr. Brennan, I think it is like the
    old story of a guy in a small town who said to the other guy,
    ``What are you going to do on Saturday night?'' And he says,
    ``I am going to the poker game.'' He said, ``Why are you doing
    that? Because you know the game is crooked.'' And the guy said,
    ``It is the only game in town.''
        So, Mr. Brennan, I do not accept your allegation that
    everything is fine. But if that is your view, I respect it, but
    I do not agree with it.
        Mr. Quirk.
        Mr. Quirk. I would probably have a closer view to Mr.
    Brennan's. When I discuss the view, I am going to discuss the
    view of our 6 million clients and just tell you in the
    behaviors that they have exhibited in the last couple years,
    again, it would be consistent with Mr. Brennan's. We have seen,
    trading accounts increase 31 percent, and we have a proprietary
    index which we created a couple years ago which indicates how
    much exposure people are taking in the market. In other words,
    are they participating in the rally that has happened over the
    course of the last couple years? And a significant portion of
    them have.
        That being said, I would agree with you that there is a
    perception problem in a segment of these clients. Those would
    be the clients that are probably closest to this. Most of mom-
    and-pop, really these terms do not mean anything to them. ``Co-
    location'' and ``HFT,'' they are just terms to them.
        The problem for us is in that segment trying to make sure,
    as I think Senator Johnson pointed out, that we do not spook
    them. We do not want them to think that they are being treated
    unfairly.
        Senator McCain. Thank you. I thank the witnesses.
        Thank you, Mr. Chairman.
        Senator Levin. Thank you, Senator McCain.
        Mr. Brennan, earlier this year, you said that some high-
    frequency traders play a role in knitting back together a
    fragmented market structure, but that other high-frequency
    traders ``may be unfairly taxing the system through their
    behaviors.''
        Now, when you mentioned that some high-frequency traders
    unfairly taxed the system, were you talking about firms that
    engage in practices like rebate arbitrage where they try to
    capture rebates without actually providing liquidity?
        Mr. Brennan. That would be one example, yes.
        Senator Levin. And, therefore, the maker-taker system
    contributes to that problem.
        Mr. Brennan. I think the market structure as a whole has
    improved dramatically over the past 20 years.
        Senator Levin. I am talking about the part that has not
    improved. I am talking about what you just said, that some
    high-frequency traders unfairly tax the system and that you
    agreed, you were referring to those firms that engage in rebate
    arbitrage. And then I just asked you whether or not the maker-
    taker system is obviously, by definition, contributing to that
    problem.
        Mr. Brennan. I think the maker-taker in combination with
    the lack of a trade-at, in combination with differential data
    speeds contribute to potential issues.
        Senator Levin. And can you have rebate arbitrage without
    rebates?
        Mr. Brennan. No.
        Senator Levin. So, therefore, rebates contribute to the
    problem. I did not say it is the whole problem. I am just
    saying, does it contribute to the problem?
        Mr. Brennan. Yes.
        Senator Levin. Mr. Quirk, I think you were critical of the
    Battalio testimony, and I am wondering whether you would be
    willing to provide Professor Battalio with TD Ameritrade's
    order routing data so that he could analyze it.
        Mr. Quirk. Yes, we were actually asked by Professor
    Battalio after his paper was published or the draft of that
    paper was published if we would be willing to share data, and I
    think we would be willing to share data. Of course, with
    security, we would have to ensure that that was not going
    anywhere.
        Senator Levin. And when you were asked, what was your
    answer?
        Mr. Quirk. To be honest with you, I am not entirely sure. I
    believe that he was told that it was being considered, but I am
    not certain.
        Senator Levin. Let me conclude by very briefly saying the
    following:
        We have had a good hearing today, I think a very
    constructive hearing, a very illuminating hearing. And we have
    heard a consistent message, and that is that there is a lack of
    confidence in the markets. The conflict of interests that we
    have discussed contribute to that lack of confidence. Both the
    actual conflicts as well as the appearance of conflicts
    contribute to that lack of confidence. And they may lead also
    to regular investors, average investors, being worse off. That
    is what Professor Battalio told us today, and what his study
    shows.
        All these problems should be and can be addressed, and one
    of the ways we have got to do it is to remove the conflict of
    interests. This Subcommittee has looked at other conflicts,
    some of which have been very dramatic, in earlier hearings, and
    we have to rid our market of conflicts of interest to the
    extent it is humanly possible if we are going to restore
    confidence in our markets. And it is very important that we do
    have confidence in our markets.
        And so hopefully the regulatory agencies are going to take
    action. SEC Chairman White, as a number of you have mentioned,
    has said that they are going to look at structural issues, long
    overdue, and hopefully they will not take as long as they take
    on a whole lot of other things that sometimes just fester at
    the agency, the regulatory agency, for years.
        And I think there may be also a role for Congress. These
    things sometimes happen, hopefully more often than not through
    the operations of a free market, but some of them just do not
    happen without government saying, ``You have got to change your
    ways, folks. You have got to take Steps A and B if you are
    going to restore confidence.''
        Now, we may disagree perhaps as to what those steps are,
    but there are steps which must be taken either by regulators or
    by Congress to deal with conflicts and to deal with the other
    kinds of problems which exist in the current market, because it
    is clear there can be improvements.
        We very much appreciate your testimony. We are sorry that
    it was interrupted by two votes of the Senate, but that is the
    way our life works around here. I wish we could pass a law to
    end interruptions in hearings or have some regulatory agency
    perhaps figure out a way that we could avoid these kind of
    interruptions. But that is not yet in the cards.
        Thank you all. We will stand adjourned.
        [Whereupon, at 12:44 p.m., the Subcommittee was adjourned.]

                                A P P E N D I X

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