[Senate Hearing 113-477]
[From the U.S. Government Publishing Office]
S. Hrg. 113-477
HIGH FREQUENCY TRADING'S IMPACT ON THE ECONOMY
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HEARING
before the
SUBCOMMITTEE ON
SECURITIES, INSURANCE, AND INVESTMENT
of the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED THIRTEENTH CONGRESS
SECOND SESSION
ON
EXAMINING THE VALUE, BENEFITS, RISKS, BURDENS, AND CONCERNS HIGH
FREQUENCY TRADING CREATES FOR THE ECONOMY AND THE MARKETPLACE
__________
JUNE 18, 2014
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Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
TIM JOHNSON, South Dakota, Chairman
JACK REED, Rhode Island MIKE CRAPO, Idaho
CHARLES E. SCHUMER, New York RICHARD C. SHELBY, Alabama
ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee
SHERROD BROWN, Ohio DAVID VITTER, Louisiana
JON TESTER, Montana MIKE JOHANNS, Nebraska
MARK R. WARNER, Virginia PATRICK J. TOOMEY, Pennsylvania
JEFF MERKLEY, Oregon MARK KIRK, Illinois
KAY HAGAN, North Carolina JERRY MORAN, Kansas
JOE MANCHIN III, West Virginia TOM COBURN, Oklahoma
ELIZABETH WARREN, Massachusetts DEAN HELLER, Nevada
HEIDI HEITKAMP, North Dakota
Charles Yi, Staff Director
Gregg Richard, Republican Staff Director
Dawn Ratliff, Chief Clerk
Taylor Reed, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
______
Subcommittee on Securities, Insurance, and Investment
MARK R. WARNER, Virginia, Chairman
MIKE JOHANNS, Nebraska, Ranking Republican Member
JACK REED, Rhode Island BOB CORKER, Tennessee
CHARLES E. SCHUMER, New York RICHARD C. SHELBY, Alabama
ROBERT MENENDEZ, New Jersey DAVID VITTER, Louisiana
JON TESTER, Montana PATRICK J. TOOMEY, Pennsylvania
KAY HAGAN, North Carolina MARK KIRK, Illinois
ELIZABETH WARREN, Massachusetts TOM COBURN, Oklahoma
HEIDI HEITKAMP, North Dakota
Milan Dalal, Subcommittee Staff Director
Bryan Blom, Republican Subcommittee Staff Directorr
(ii)
C O N T E N T S
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WEDNESDAY, JUNE 18, 2014
Page
Opening statement of Chairman Warner............................. 1
Opening statements, comments, or prepared statements of:
Senator Johanns.............................................. 3
WITNESSES
Hal S. Scott, Nomura Professor and Director, Program on
International Financial Systems, Harvard Law School............ 5
Prepared statement........................................... 30
Jeffrey M. Solomon, Chief Executive Officer, Cowen and Company,
LLC, and Cochair, Equity Capital Formation Task Force.......... 7
Prepared statement........................................... 36
Andrew M. Brooks, Vice President and Head of U.S. Equity Trading,
T. Rowe Price Associates, Inc.................................. 9
Prepared statement........................................... 69
Additional Material Supplied for the Record
Illustrations of miniflash crashes from May 13, 2014, submitted
by Chairman Warner............................................. 72
Statement submitted by Greg Mills, Head of Global Equities
Division, RBC Capital Markets.................................. 75
(iii)
HIGH FREQUENCY TRADING'S IMPACT ON THE ECONOMY
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WEDNESDAY, JUNE 18, 2014
U.S. Senate,
Subcommittee on Securities, Insurance, and
Investment,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Subcommittee met at 10:01 a.m., in room 538, Dirksen
Senate Office Building, Hon. Mark R. Warner, Chairman of the
Subcommittee, presiding.
OPENING STATEMENT OF CHAIRMAN MARK R. WARNER
Chairman Warner. This hearing will come to order.
I want to thank Senator Johanns' staff for working with our
office today in putting together today's hearings. I want to
thank our witnesses, who I will come to introduce in a couple
of moments.
I do feel, as I was mentioning a little bit yesterday, this
is not the first hearing or even the first hearing this week on
this subject. We perhaps were front-run a little bit yesterday
by Senator Levin's activities, but we think we can build upon
his good work as the Senate takes a look at this very important
issue.
Yesterday, Senator Levin's hearing really focused on
potential conflicts of interest between brokers and investors.
Our hope will be that this hearing will take a larger, macro
view of the effects of high frequency trading on the economy
and the marketplace.
Over the past few decades, we have seen remarkable
technological progress and innovation in our securities markets
coupled with substantial regulatory reform. Now, some of these
advances and reforms, including decimalization, have brought
considerable rewards for individual investors by narrowing
spreads and increasing liquidity. Most trades today can happen
within fractions of a second, providing good prices and
counterparties for those seeking to buy equities around the
world.
But, at the same time, we have seen increased volatility
and periodic dislocation. I think we all remember the flash
crash a while back, but perhaps what did not get as much
attention is that this--that was not the only incident. Just
last month, on May 13, we had a series of mini flash crashes in
a series of individual stocks. Such events do little to
engender confidence and, indeed, may hinder investment in the
stock market, adversely affecting the broader economy,
particularly as it affects small cap stocks.
Gains in liquidity, I know, for most folks on the street
are seen as the holy grail, but we have to ask ourselves at
some point, at what price this increased liquidity, and does
sometimes simply progress and technological innovation bear
other costs that need to be examined?
Some critics of current U.S. market structure place the
blame on high frequency trading. For purposes of today's
hearing, we are going to define high frequency trading to
include computerized algorithmic trading of a number of
varieties to essentially address when a computer is making a
decision based on a program as opposed to a human.
In recent months, I know there has been a lot of renewed
attention on this subject given to the publication of Michael
Lewis's book, Flash Boys. And, I know many of my colleagues and
I have growing concerns with what is happening in our markets
that is leading to this erosion of confidence.
There are a few reforms that I would like to see the SEC
implement to help strengthen confidence in the economy. First,
and I think Senator Johanns will speak to this, as well,
conducting a tick size pilot. As a former venture capitalist, I
have concerns over front-running that impairs the ability of
small companies to find adequate liquidity for their shares in
the marketplace. This activity can adversely affect
underwriting decisions or even the choice to go public, which
obviously harms capital formation in its beginning.
Chairman White recently announced that the Commission is
trying to finalize details of a potential pilot. I believe it
should be for an adequate length of time, preferably more than
a year, to capture enough data. It should also cover all of the
trading venues, lit and dark, to ensure collection of accurate
data.
Second, the SEC must expedite the implementation of a
consolidated audit trail. Way back in May of 2010, a day after
the infamous flash crash, then-Senator Ted Kaufman took to the
floor. He talked about that challenge, and he and I both went
to then-Senator Chris Dodd, who was Chair of this Committee, to
require the SEC to report to Congress on the need for a
consolidated audit trail, better order screening, and the risk
posed by high frequency trading.
Unfortunately, more than 4 years later, we have seen little
progress on our request, especially on the issue of the
consolidated audit trail. The SEC has issued two extensions to
the SROs and FINRA, delaying a proposal until September 30 of
this year at the earliest. However, having this in place will
help regulators decipher what is happening in the market, so we
need to implement this ASAP, and I hope the SEC is listening.
Chairman White recently posed some reforms to enhance
transparency in the market, and I thank her for moving on that,
and it is clear that the SEC and the CFDC have a monumental
task in policing our markets and they need full funding. I will
continue to advocate for that as long as I am in this position.
Again, I look forward to hearing from our witnesses. I am
going to move to Senator Johanns for his statement, and then,
with the willingness of my colleagues, go ahead and introduce
the panel and get to the testimony.
Senator Johanns.
STATEMENT OF SENATOR MIKE JOHANNS
Senator Johanns. Mr. Chairman, let me start out and say to
the witnesses, thanks for being here. We appreciate it. I look
forward to this hearing.
I also want to thank the Chairman for holding this hearing
on high frequency trading. No doubt about it, it is getting
attention these days, if not a lot of noise.
One thing that I probably need to be reminded about, as I
think about my last months in the U.S. Senate, is if I have the
capacity to write a book and get on ``60 Minutes'', I will
probably get a lot of Congressional attention and I will be
back here, sitting where you are sitting.
[Laughter.]
Senator Johanns. Maybe I can even convince Mr. Lewis to
write a book about the need for housing finance reform or the
overreach of EPA regulations. Both of those need attention.
Now, the spotlight is shining brighter. We all acknowledge
that. The issue of high frequency trading, though, is not a new
concept.
So, as I said, I look forward to the witnesses talking
about the impact of high frequency trading on our economy,
asking and answering questions, does the practice help or does
it hurt investors?
Now, it does seem to me that retail investors really have
never had it better. Costs are low. There seems to be ample
competition. Market access is very easy these days. I
definitely do not think the markets are rigged, as some have
suggested.
However, I also believe that we cannot simply ignore
certain market structure issues. We should always be
encouraging liquidity. After all, why have a market if
liquidity is not a part of it? We should be encouraging
fairness. We should be encouraging transparency in the
marketplace. We need to ensure that the U.S. remains the envy
of the world when it comes to capital markets. I would just put
out there, I do not think anyone does it better.
I also want to associate myself with comments made by
Chairman Mary Jo White, who I have a lot of confidence in. She
recently, in a public speech, said this, and I am quoting, ``We
should not roll back the technology clock or prohibit
algorithmic trading, but should assess the extent to which
computer-driven trading may be working against investors rather
than for them.'' There is a lot said in that quote.
America has always encouraged innovation. We want fastest.
We want strongest. We want most powerful. I can relate to this.
Growing up on a dairy farm in Northern Iowa in the 1950s and
then becoming Secretary of Agriculture, I have seen a lot of
change in that arena. The equipment and technology now is so
much faster. It is so much smarter. The combines are so far
advanced over what we were doing. It is unbelievable, what has
happened in that arena. Who benefits from that? The consumer
benefits from that, because they have a supply of food that is
just unparalleled in the world and pay less of their disposable
income. Technology is a good thing. Our financial trading
systems have, obviously, gone through a remarkable, if not
similar, evolution.
I think everyone here today is concerned with investor
confidence. So, from the witnesses today, I would like to hear
how small investors and small companies are affected in today's
trading world. How do they fare?
As I said earlier, it seems that technology developments
over the last several years have benefited retail investors by
making the equity markets more accessible and affordable for
the moms and the pops in Nebraska. But, investors are also,
understandably, concerned when news stories suggest that the
deck is somehow stacked, that the stock market has become an
insider's game, that it cannot be trusted. So, I hope that we
can talk about these real or perceived problems today.
Also, I am concerned with investor confidence in the small
cap company space. The goal for every stock is liquidity. Can
you market that stock? While the market seems to work fine for
a large, if not blue chip, stock, the smaller public companies
have not fared as well.
I know there has been discussion about widening tick sizes
for smaller emerging growth companies. There was legislation on
the House side that directs the SEC to issue a pilot program to
test whether wider trading increments will promote more active
trading and boost liquidity for smaller companies.
Interestingly enough, this House bill passed 412 to four. I do
believe that is part of what spurred the SEC to act. A House
vote of 412 to four on a complex piece of legislation is almost
unheard of, a remarkable result.
So, I would like to get the panel's thoughts on the pilot
program and also hear about any other special market structure
reform ideas that will benefit the small investor, the Main
Street companies, those folks who are trying to find their
place in this market.
Mr. Chairman, a great hearing today. I compliment you for
calling it. Some very, very important issues that can have
significant economic consequences to our States and to our
country. Thank you very much.
Chairman Warner. Thank you, Senator Johanns.
We have been joined by Senator Reed, who was longtime Chair
of this Subcommittee, and Senator Warren, who brings,
obviously, a wealth of knowledge to this subject. And, with
their discretion, I am going to go ahead and introduce the
witnesses and we can get started.
First, Mr. Hal Scott is the Nomura Professor at Harvard Law
School, where he has taught since 1975, and Director ofthe
Committee on Capital Markets Regulation. Professor Scott
teaches courses on capital market regulation, international
finance and securities regulation. He is currently Director of
Lazard and a member of the Bretton Woods Committee and a past
Governor of the American Stock Exchange. It is my
understanding, as well, is he taught Senator Reed----
Senator Reed. He did, without any effect.
[Laughter.]
Chairman Warner. ----and has worked with, obviously, a
colleague of Senator Warren's. When I was there, I did not have
a chance to take one of his courses, but I look forward to his
testimony.
Mr. Jeffrey Solomon is Chief Executive Officer of Cowen and
Company and a Director of the Cowen Group. Mr. Solomon is
responsible for overseeing all of Cowen and Company's business,
including investment banking, capital market sales, and trading
and research. Mr. Solomon is also amember of the Committee on
Capital Markets Regulation as well as the Cochair of the Equity
Capital Formation Task Force, a group of professionals from
across America's start-up and small cap company ecosystems.
Thank you and welcome, Mr. Solomon.
And, Mr. Andrew Brooks is Vice President of T. Rowe Price,
where he is head of U.S. Equity Trading. He joined the firm in
1980 as an equity trader and assumed his current role in 1992.
Mr. Brooks is currently a member of the Investment Company
Institute Equity Markets Advisory Committee--that is a
mouthful--and is on the board of the National Organization of
Investment Professionals. Welcome, Mr. Brooks.
So, we will get to the testimony. Professor Scott.
STATEMENT OF HAL S. SCOTT, NOMURA PROFESSOR AND DIRECTOR,
PROGRAM ON INTERNATIONAL FINANCIAL SYSTEMS, HARVARD LAW SCHOOL
Mr. Scott. Thank you, Chairman Warner, Ranking Member
Johanns, and Members of the Subcommittee, for permitting me to
testify before you today on the impact of high frequency
trading on investor confidence and capital formation in U.S.
equity markets. I am testifying in my own capacity and do not
purport to represent the view of any organizations with which I
am affiliated.
High frequency trading, or HFT, is a topic that has
generated significant attention in recent years, intensifying
more recently with the publication of Michael Lewis's book,
Flash Boys. It is my intention to provide a thoughtful response
to a debate that has sometimes been fraught with frenzied
emotion.
Let me be clear at the outset. The emergence of high
frequency trading activity in and of itself has not negatively
affected our secondary markets. Our secondary markets remain
strong, with roughly 50 percent of global exchange trading
occurring on U.S. exchanges. With roughly half of this volume
generated by HFT firms, the increased liquidity provided by
HFTs lead to decreased costs of stock issuance, thus improving
capital formation. And, of course, improved capital formation
for our businesses leads to higher growth in the real economy.
Transaction costs for retail and institutional investors
have also been in continual decline over the past 10 years, as
evidenced by current bid-ask spreads, and have fallen by 50
percent since 2006 and brokerage commissions that are at
historic lows. Retail investors can now trade for less than $10
a trade.
Since many retail investors access the equity markets
indirectly through institutional funds or advisors, like mutual
funds, institutional costs are highly relevant to retail
investors, as well. Leading financial economists find that the
average transaction costs for institutional orders are also at
an all-time low.
Investor confidence in our markets also remains strong.
Since the 2010 Flash Crash, there has been a net inflow of more
than $50 billion in holdings of U.S.-listed companies and a
total net inflow of nearly $500 billion in all exchange-traded
products. Clearly, investors are not fleeing from our equity
markets due to perceived threats of high frequency trading.
Moreover, experts have found that high frequency trading
has not caused an increase in stock market volatility, although
I think we will go around a little bit on that. And, the SEC
has also largely addressed future Flash Crash concerns by
implementing single stock circuit breakers and revising
marketwide circuit breakers that will temporarily halt trading
if price movements become too volatile.
Critics of HFT have questioned the fairness of allowing
certain traders to benefit from their physical proximity to an
exchange, known as colocation, and have access to faster data
feeds. However, the SEC requires exchanges to offer such access
to all market participants at the same cost, and remember, a
large number of retail investors trade through these
institutions who have such access. Over 90 percent of market
participants have access to such services, including retail
investors indirectly.
Thus, it is hard to argue that the U.S. equity market is
broken as a result of the emergence of high frequency trading.
Nonetheless, there is always room for targeted improvement of
the current regulatory structure, and I would now like to
present a few specific proposals.
First, regulators should consider mandating and harmonizing
exchange-level so-called kill switched. A kill switch is a
mechanism that would halt a particular firm's trading activity
when a preestablished exposure threshold has been breached,
thus stopping erroneous orders and preventing any further
uncontrolled accumulation of positions. This would act against
a single firm.
Second, they might consider addressing the volume of order
message traffic generally, which can create market instability,
by establishing order-to-trade ratios, and regulators should
consider charging fees for extreme message traffic in
particular circumstances.
Third, regulators should consider abolishing immunity that
exchanges have from liabilities for losses from market
disruptions based on their SRO status, which might better align
the exchanges' incentives to limit potentially risky trading
that could pose widespread operational risk.
And, I also endorse the idea, and I think it is quite
important, of a much better audit trail, the CAT effort that
the SEC is underway with, and I agree with Senator Warner that
they should act sooner rather than later on that, because
knowing what happens is the key to all of our understanding,
and that audit trail will help give us knowledge that we
currently do not have about how trading is actually being
conducted.
In concluding my remarks, I wish to reiterate that the
strength of U.S. equity markets has positively affected capital
formation, and by extension, promoted job creation. Any changes
in HFT regulation should be based on a factually careful
assessment of abuses and regulation to fix them without harming
the overall performance of our markets.
Thank you, and I look forward to your questions.
Chairman Warner. Thank you, Professor Scott.
Mr. Solomon.
STATEMENT OF JEFFREY M. SOLOMON, CHIEF EXECUTIVE OFFICER, COWEN
AND COMPANY, LLC, AND COCHAIR, EQUITY CAPITAL FORMATION TASK
FORCE
Mr. Solomon. Good morning, Chairman Warner, Ranking Member
Johanns, and the Members of the Subcommittee. Thank you for
inviting me to speak today regarding high frequency trading's
impact on the economy.
My name is Jeffrey Solomon and I am the Chief Executive
Officer at Cowen and Company, an emerging growth investment
bank focused on servicing growth-oriented companies in key
sectors of our economy. Along with Scott Cooper, the Chief
Operating Officer of Andreessen Horowitz, I am also the Cochair
of the Equity Capital Formation Task Force. And, interestingly,
I have spent most of my career as an institutional investor in
equities, so I understand this issue from many sides.
Over the past year, there has been significant debate about
the economic impact of HFT, high frequency trading, on the
equity capital markets in the United States and how the rise in
their trading activity has introduced increased market risk and
volatility. We would argue that the debate surrounding HFT is
actually symptomatic of a more complex market structure that
encourages potentially counterproductive trading behavior,
behavior that limits true market depth and trading volume in
many stocks and hinders investors' ability to buy and sell
those stocks in small cap companies, in particular.
This has resulted in reduced availability of capital for
small public companies to expand their businesses and create
valuable private sector jobs. As such, any debate about the
pros and cons of HFT really needs to address the structure of
the equity market that has given rise to its existence.
The rise in electronic trading and the regulations that
followed resulted in new market structure for equities that was
intended to benefit investors, and today, our market's
structure is marked by speed of execution, lower transaction
costs, and sub-penny increments, a dynamic which works well
enough in highly liquid large cap stocks, but fosters opacity
and liquidity in small cap stocks. For investors in small cap
stocks, true price discovery is far more important than speed
of execution.
As a result, it has become more costly and difficult for
institutional investors, who are the primary providers of
growth capital to emerging companies, to invest, trade, and
make markets in small caps. Companies with market caps of $750
million and below represent only 2 percent of the daily trading
volume in the United States, and, on average, are only 30
percent held by institutions. Without meaningful institutional
ownership, capital formation for small companies has declined
to levels well below historic levels and has impeded price
appreciation for many individual investors, as well.
While the JOBS Act had made it easier for emerging growth
companies to go public--the number of IPOs has increased since
its passage--little has been done to improve the quality of
secondary market trading in small stocks. And, to address these
concerns, the Equity Capital Formation Task Force presented its
findings and recommendations to the United States Treasury in a
report which sets out two areas for consideration.
One is to encourage increased liquidity in small cap stocks
by fostering a simpler, more orderly market structure for small
cap stocks, and to expand capital for small cap and micro cap
companies by completing regulatory changes outlined in the JOBS
Act in accordance with Reg A Plus. These recommendations are
designed to enhance capital formation for small companies while
balancing the needs of investor protection and preserving many
of the important improvements made to market structure that
investors have enjoyed since the advent of decimalization.
In order to improve market structure, we have recommended
that the SEC implement a well designed pilot program that
allows for a true empirical test on the effects of both wider
spreads and limited trading increments in small caps, which we
believe will encourage fundamental buyers and sellers to
meaningfully engage with each other. By designing a pilot that
requires all market participants to cluster their bids and
offers at fewer discrete increments, and by limiting the
ability of certain market participants to, quote-unquote,
``price improve'' in sub-penny increments, we will be able to
observe whether or not the volume and depth necessary to
enhance liquidity in small caps will improve. Improved trading
liquidity begets cheaper and more efficient access to capital
for these companies, and improved access to capital translates
into increased job creation in the private sector.
One of the most important aspects of designing a successful
pilot program is ensuring that such a pilot program is allowed
to operate for a long enough period for time to gather
meaningful data around whether or not the changes to the market
structure are having desired effects. We strongly believe that
market participants, especially those that use algorithms and
trade frequently, will need time to adjust their trading
practices and/or business models in order to adopt to the new
market structure. However, just as they adopted to
decimalization and other market structure changes over the past
15 years, we are confident that they will adapt to these
proposed market changes in the small cap market, as well.
It appears as if the SEC, under the leadership of
Chairwoman White, has made a strong commitment to enhancing
overall liquidity of the capital markets in general and for
small companies, more importantly. The Task Force supports the
data-driven results oriented approach that the Commission has
espoused publicly over the last 9 months. Our members continue
to advocate that a one-size-fits-all market structure does not
meet the needs of any market participants.
We praise Congress on the passage of the JOBS Act, which
demonstrated that a well-drafted legislation and regulation can
meet the dual needs of fostering increased formation for
capital while maintaining investor protection. Now is the time
to create momentum, or to capitalize on the momentum created by
the JOBS Act to take additional steps to further the growth of
America's most promising private and public growth companies.
We owe it to those Americans seeking jobs and those companies
creating those jobs to try and adjust a small part of the
market structure in order to improve access to capital.
I thank you for this time and I welcome your questions and
dialogue.
Chairman Warner. Thank you, Mr. Solomon.
Mr. Brooks.
STATEMENT OF ANDREW M. BROOKS, VICE PRESIDENT AND HEAD OF U.S.
EQUITY TRADING, T. ROWE PRICE ASSOCIATES, INC.
Mr. Brooks. Good morning. Chairman Warner, Ranking Member
Johanns, and distinguished Members of the Senate Subcommittee
on Securities, Insurance, and Investment, thank you for the
opportunity to testify today on behalf of T. Rowe Price
regarding the impact of high frequency trading on the economy.
My name is Andy Brooks. I am a Vice President and Head of
U.S. Equity Trading at T. Rowe Price. This is my 34th year on
the trading desk at T. Rowe Price. T. Rowe Price was founded in
1937 and is a Baltimore-based advisor, serving more than 10
million individual and institutional investor accounts.
Since I last testified before this Committee in September
of 2012, we have seen considerable turnover in Congress, this
Committee, and at the U.S. Securities and Exchange Commission.
However, there has been little change in addressing the issues
discussed 21 months ago, although we do applaud the SEC's
efforts in implementing limit up, limit down controls and
developing the consolidated audit trail. Additionally, we are
encouraged by Chair Mary Jo White's recent comments suggesting
a heightened focus on improving market structure. And, we
appreciate this Committee's continued interest in improving our
markets.
However, order routing practices, payment for order flow,
maker/taker pricing, market data arbitrage, and the myopic
quest for speed are all issues that remain unaddressed. In
addition, we have grown increasingly concerned about the growth
of dark pools and the challenges of the direct fast feed
operating alongside the slow security information processor
feed.
Although this hearing is focused on HFT, we believe HFT is
merely symptomatic of larger market structure problems. We are
cautious not to lump all electronic trading into the class of
HFT, and, further, we do not believe that all HFT is
detrimental to the market. We are supportive of genuine market
making. However, we acknowledge there are predatory strategies
in the marketplace that have been enabled by our overly complex
and fragmented trading markets. Those parties utilizing such
strategies are exploiting market structure issues to their
benefit and to the overall market's and individual investors'
detriment.
We question whether the functional roles of an exchange and
a broker-dealer have become blurred over the years, creating
inherent conflicts of interest that may warrant regulatory
action. It seems clear that since the exchanges have migrated
to for-profit models, a conflict has arisen between the pursuit
of volume and resulting revenue and the obligation to assure an
orderly marketplace for all investors. The fact that 11
exchanges and over 50 dark pools operate on a given day seems
to create a model that is susceptible to manipulative
practices.
If a market participant's sole function is to interposition
themselves between buyers and sellers, we question the value of
such a role and believe it puts an unneeded strain on the
system. It begs the question as to whether investors were
better served when the exchanges functioned more akin to a
public utility. Should exchanges with de minimis market share
enjoy the regulatory protection that is offered by their status
as exchanges or should they be ignored?
Additionally, innovations in technology and competition,
including HFT, have increased market complexity and
fragmentation and have diluted an investor's ability to gauge
best execution. For example, in the race to increase market
share, exchanges in alternative trading venues continue to
offer various order types to compete for investor order flow.
Many of these types facilitate strategies that can benefit
certain market participants at the expense of long-term
investors, and while seemingly appropriate, often, such order
types are used in connection with predatory trading strategies.
We are supportive of incremental efforts, such as recent
initiatives by the New York Stock Exchange to eliminate 12
order types from their offerings.
We also believe that increased intraday volatility over the
past year is just symptomatic of an overly complex market.
Though commission rates and spreads have been reduced,
volatility continues to be alarmingly high. It was refreshing
to see a recent report from RBC Capital Markets examining the
impact of intraday volatility and exposing the high cost to
investors. Most academics only look at close to close market
volatility.
Increased market complexity results in a lack of investor
confidence. A recent Gallup Poll noted that American household
ownership of stocks continues to trend well below historic
norms. One can never be sure what drives investor behavior, but
it seems clear to us that we need to do a better job of earning
investors' confidence in our markets. Those investors who have
stayed on the sidelines in recent years, for whatever reason,
have missed out on significant equity returns. We worry that
the erosion of investor confidence can undermine our capital
markets, which are so important to the economy, job growth, and
global competitiveness.
Over the past two decades, the markets have benefited from
innovations in technology and competition. Generally, markets
open at 9:30, they close at 4, and trades settle efficiently
and seamlessly.
Vibrant and robust markets function best when there are
varied investment opinions, styles, and approaches. However,
given the myriad of ways to engage in the markets, we feel that
investors would benefit from an increased focus on market
structure, particularly features that enable predatory and
manipulative practices. Disruptive HFT strategies are akin to a
tax loophole that has been exploited and needs to be closed.
Market participants utilizing such strategies are essentially
making a riskless bet on the market, like a gambler who places
a bet on a race that has already been won and for which he
knows the outcome.
In the spirit of advancing the interests of all investors,
we might make the following suggestions. We envision a pilot
program where all payments for order flow, maker/taker fees,
and other inducements for order flow routing are eliminated. We
also envision a pilot that incorporates wider minimum spreads
and some version of a ``trade at'' rule, which we believe would
lead to genuine price improvement. These programs should
include a spectrum of stocks across market caps, average
trading volumes, among other factors.
Additionally, we would advocate for a pilot program that
would mandate minimum trade sizes for dark pools. Dark pools
were originally constructed to encourage larger trading
interests, and it seems perverse that many venues on the lit
markets, or exchanges, have a larger average trade size than
dark pools.
HFT and market structure issues were recently brought into
the public spotlight by Michael Lewis and his book, Flash Boys.
Sometimes, it takes a storyteller like Mr. Lewis to bring
attention needed to an issue, and we hope that all parties
involved will come together and seize this opportunity to
improve our markets. Again, we would advocate for pilot
programs to test and ultimately implement measured, yet
significant, changes.
On behalf of T. Rowe Price, our clients, and shareholders,
I want to thank the Committee for this opportunity to share our
views on how we can together make our markets as good as they
can be.
Chairman Warner. Thank you, gentlemen. Very good testimony.
I am going to ask you to put 5 minutes on the clock for
each of us. I will try to be brief. I would ask you to be
fairly brief in your responses, so I am going to try to get as
many questions as I can in my time.
I have a particular bias, as a former venture capitalist,
on the notion of small cap stocks, and would point out to my
colleagues that data by the Kauffman Foundation has pointed out
that literally, I think, 80 percent of all net new jobs that
have been created in the last 30 years in America have come
from startup enterprises. So, how we accelerate that is, I
think, a policy focus that we would all share.
Professor Scott and Mr. Brooks, do you share Mr. Solomon's
belief that there should be some level of differentiation
between small cap and larger caps and pilots like the tick size
pilot moving forward? Other suggestions? Professor Scott.
Mr. Scott. Well, I am a member of Jeff's Task Force and I
do agree with----
Chairman Warner. Press your microphone button.
Mr. Scott. I am a member of Jeff's Task Force and endorse
the recommendations for a pilot study on increasing the tick
size for small caps. I think the result will be to show that
with more trading and more liquidity, you know, we will
encourage small caps. But, I think it is important to do a
pilot study. There is a lot of controversy around this question
as to whether increasing the tick size will really increase
trading and we need to find out. So, I am certainly in favor of
the pilot program.
Chairman Warner. Do you believe that the basic premise that
HFTs potentially could disadvantage small cap stocks at this
point? Do you think--I guess, obviously, you are on that
Committee, but I took that as----
Mr. Scott. I am not sure I see a connection between HFT per
se and disadvantaging small caps. I think what we need to do is
increase the tick size and see what results, even with high
frequency traders as they might adjust to trading in such an
environment. Maybe they will trade less, OK, with a bigger tick
differential. But, that will be their adjustment to an
increased tick size.
Chairman Warner. Mr. Brooks, and then we will let Mr.
Solomon have a----
Mr. Brooks. Senator, my sense is that this pilot program is
way overdue. We have been talking about it for a long time. I
think there is vigorous debate about whether--what will happen
as an outcome, and I think it is time to try. You know, we are
very interested in increasing displayed liquidity, especially
in small cap stocks, and I think a larger tick size, the cost--
the barrier to entry for someone who is trying to interposition
themselves there will grow and perhaps they will be discouraged
from playing in that sandbox. Greater displayed liquidity, I
think, would be good for investors and would attract, perhaps,
more interest, investor interest in those names.
You know, at the heart of the issue is trying to figure out
a mechanism to allow someone to tell the story of small
companies, to promote small stocks, promote in a good way, to
tell the story about the growth and the potential. We have
removed so many incentives for brokers and others, financial
advisors, to tell the story of a stock that it has made it hard
for people to figure out why they should care about small
companies.
Mr. Solomon. Listen, we have written extensively about it
and I totally agree. I think one thing, to augment what
Professor Scott said, is it is not just wider spreads. It is
wider spreads and limited trading increments, and this is
really important. There are a lot of small cap stocks that
trade at wider than a penny. What we have talked about here is
having a minimum bid and offer.
So, when a stock trades wide and all of a sudden there is
interest or displayed liquidity, all of a sudden, it rushes to
a penny, and that precludes institutional investors like Andy,
who make up a significant portion of the net worth of American
households invested in stocks. They cannot get access to the
small companies that exhibit the best growth, because by the
time he shows up to buy a meaningful stake, it is reduced to a
penny and they are just waiting for him to sit there and
indicate size so they can pick him off.
And, so, what we have said is, if you forced people to
cluster at bids and offers, fewer of them, at five-cent
increments, there are only 20 places where you can cluster in
between each dollar. And, you limit the trading at the bid, at
the offer, or one price in the middle. That should be ample for
any fundamental buyer and seller to do price discovery and it
limits this game or casino type behavior we have seen with sub-
penny price improvement.
Chairman Warner. Let me get one last question in, and I am
going to take as a quick nod, yes, that we ought to move
forward and keep the pressure on the SEC to move on their
consolidated audit trail efforts.
Mr. Solomon. Yes.
Mr. Brooks. Yes.
Chairman Warner. Let me try to get Mr. Solomon and
Professor Scott's comments. Mr. Brooks has got a fairly
aggressive outline of reforms, including, for example, the
pilot of getting rid of some of the, what appears to be
inherent conflicts on the maker/taker circumstances that we all
discussed. You have got some general agreement. Would each of
you go as far as Mr. Brooks has gone, Professor Scott and then
Mr. Solomon.
Mr. Solomon. Go ahead. You are up.
Mr. Scott. He wants to defer to me. I am not--I do not
think so. I am not ready for pilot studies yet on these issues.
I think the first step is that we should get the SEC study done
and see what they come up with on these issues, and we should
hope that they act expeditiously. I might say in their defense
that they have had a lot on their plate for the last several
years and they have gotten around a market structure now and I
think they are going full bore on it. So, I think we need to
get a lot more information about the problems, focus in on what
the abuses are.
I also think we have to be careful about pilot studies.
While I endorse Jeff's pilot study, we can confuse the market a
lot with a lot of pilot studies going on at the same time,
where different stocks trade in different ways. And, so, we
have to be very careful, it seems to me, about--and, then, when
you design a pilot study, you have to have a control. So, some
people are not going to be trading under the pilot. Other
people will. We do not know exactly how the SEC will devise
their pilot, but if you do not have that, then you do not have
a controlled experiment. So, it--and it all depends on how you
design this pilot, OK.
So, I am not ready for pilots on this issue. I think on
tick size, we have had a lot of discussion over several years.
A lot of work has been done on it. SEC has studied it
intensively, and I think we are ready for a pilot. I do not
think we are ready for pilots on these other issues.
Mr. Solomon. So, I think we designed our proposals here to
engage in--within the context of the existing maker/taker
regime. So, we have said that this only is 2 percent of the
daily average trading volume, so the people that are making a
fair amount of money trading large volumes should not be
impacted by a small cap stock because it is not a significant
portion of their revenue.
On the issue of maker/taker, it is not--if you were setting
up a market structure from scratch, I think we can acknowledge
that it is not the most ideal economic way to incent behavior.
But, it is what it is, in part because we got here through
regulation. And, if we are going to undo maker/taker, we had
better have a pretty good idea of how we are going to incent
buyers and sellers to meet and how that is going to occur
before we pull that plug or we will see a material drop in
liquidity, simply because people will have to adjust their
business models.
Chairman Warner. I would simply say, I concur with
Professor Scott, the SEC has got a lot on their plate, one of
the reasons why I support full funding, but we also have to see
the kind of--we need to see the action from them.
Senator Johanns.
Senator Johanns. Thank you, Mr. Chairman.
Every one of you presented fascinating testimony,
interesting testimony, and I think it raised so many
complicated issues. So, let me, if I might, take a step back
here and ask you about your preference in terms of how we
approach this, because if we just spent the next hour writing
down the significant issues, I will bet you we could not get it
done in that hour. And, I am trying to figure out process-wise
what is the best approach here, because the one thing we do not
want to do is mess up a system that has done some awfully good
things. Now, there may be some issues, and I do not want to
necessarily debate that.
Process-wise--Professor, I will start with you--would it be
your preference that we look to the Chairman of the SEC, the
SEC itself, to start working through these issues, identify
approaches, and use its regulatory powers to deal with these
issues, or would you rather have Congress try to--you know how
we are functioning these days--would you rather have Congress
grab a hold of this issue and see what we can do here? And, we
have broad shoulders. You can tell us what you think and we
will not be offended, I promise you.
Mr. Scott. Senator, I have dealt with a lot of complexity
in my life. This is one of the most complex areas you will ever
encounter. When you go through particular questions of this
trade or that trade and who is getting an advantage and how it
works, it is very complicated.
Senator Johanns. Yes.
Mr. Scott. And, I think that says caution to legislation
before we have the experts, OK, do their best job to formulate
what the problems are and what the solutions are. And, I think
your role for the time being is to make sure that the SEC goes
forward on this. And, by the way, I am one that thinks the SEC
should be adequately funded to do these kinds of jobs. I think
it is totally unfair to the SEC to put a lot on their plate and
not give them the money to do it.
Senator Johanns. OK.
Mr. Scott. So, I think, you know, let us have the SEC do
it. You keep the pressure on for them to do it and you review
their findings.
Senator Johanns. Mr. Solomon.
Mr. Solomon. I think it is a very complex issue, but I
think there is actually a relatively few number of changes you
can make, and I think, well within an hour, you could have it
laid out. It is actually pretty straightforward if you start
with some basic premise, which is simpler--simpler markets.
Simpler markets foster better behavior from fundamental buyers
and sellers. We have just got a market structure that basically
has gotten away from, do you want to own this at this price? Do
you want to sell this at this price? And----
Senator Johanns. But, let me ask you about that. You talked
about sub-penny price improvement. Tell me, just as
straightforward as you can, does Mr. Brooks win with that?
Mr. Solomon. No.
Senator Johanns. Who is the winner and who is the loser
when you do that?
Mr. Solomon. So, sub-penny price improvement is what
enables electronic market makers to aggregate retail order flow
and give them the execution inside the national best bid and
offer. So, if the regime requires you to give a retail order or
individual order an execution at the best bid and offer when it
hits the floor, or when it actually gets displayed, the best
way to ensure you do that is to crawl inside whatever bid and
offer there is by a tenth of a penny.
Andy and his compatriots on the institutional side do not
benefit from that because they are not individual orders. So,
his ability to get an--he can stand there at the bid, and sit
or stand there on the offer, and a lot of shares can trade at
the bid and the offer and he does not get a fill. That is a
problem, because a lot of folks, or a lot of other
intermediaries are aggregating positions or selling positions
in the hopes of being able to sell to him at a price higher or
buy it from him at a price lower----
Senator Johanns. And----
Mr. Solomon. ----and that is what is happening with sub--
that is where sub-pennying becomes a very difficult market
issue.
Senator Johanns. Right. As an individual investor, then, do
I benefit?
Mr. Solomon. So, you benefit in a couple of ways. So, you
certainly benefit by having five-dollar commissions. This is
the maker/taker regime is what underpins cheap execution.
Senator Johanns. Yes.
Mr. Solomon. We question whether or not you actually
benefit, because if you buy individual--most individuals are
owning stocks that are in the growth range. We have seen what
the disparity is in terms of individual ownership. Seventy
percent--if you go to sub-$250 million companies, it is, like,
85 percent owned by individuals. The only reason to own those
stocks is because you think they are going to go higher and
because--and, what makes them go higher? Institutional
involvement. So, there is--now, the market is biased against
getting people like Andy involved in small cap stocks. So,
while you may have gotten a five-dollar execution, did you--
and, you may have actually given up the opportunity for price
improvement.
Senator Johanns. But, I may want the five-dollar execution.
Mr. Solomon. Mm-hmm.
Senator Johanns. You know, I remember the good old days
when this did not exist and I had a few stocks and I called a
broker and they charged me an arm and a leg and said, ``I will
settle up with you in 7 days,'' and I am kind of going, wait a
second. I think I lost on that deal.
Mr. Solomon. So, there is a middle ground.
Senator Johanns. And, the fact that you are telling me,
``But, Mike, your stock might have gone up,'' is not very
reassuring to me. I want a five-dollar trade. What is wrong
with that?
Mr. Solomon. There is nothing wrong with wanting five-
dollar trades, and we think there is enough competition in the
marketplace that people will compete on commission. Listen, we
should not be competing on commissions as a way to drive
revenues. We should be competing on investment ideas. So, go to
your broker that gives you--that shows you over a period of
time that they can consistently make you money. Then commission
dollars actually do not matter that much, and we--but we should
not have----
Senator Johanns. What if I am a rugged individualist, and
quite honestly, I do not want to deal with a broker.
Mr. Solomon. OK.
Senator Johanns. I want to go someplace. I want to pay my
five dollars for a trade. I want to give--I want to get access
to all of the information they can give me. I want to dig into
it. I want to study it. And, I am not alone. And, I am using me
as a hypothetical here because I do not buy and sell or trade.
I do not trade stocks. But, having said that, millions of
Americans have warmed up to this idea and they like it.
Mr. Solomon. Which is fine. There will still be people that
offer cheap execution because we have got a lot of benefits.
So, I think it is fine. There will still be cheap execution.
What is missing in this, though, is a little bit of
balance, because Andy manages a bunch of money in your 401(k)
or in your pension, I mean, all these other areas, all these
other ways that you access the market, and he is being
precluded from participating in growth in a vital part of the
American economy because the current market structure is overly
focused on cheap execution or cheap commissions.
And, I think there is a balance here, which is why we have
said there is a different regime, potentially, that could go on
for the smaller companies. There is not a one-size-fits-all
answer here. Five-dollar executions are great. I use them. I
love them. But, you do not have to give that up and still
foster capital formation and encourage price discovery.
Senator Johanns. I have exhausted my time, but I do have
one question. What percentage of trades on a given day or a
given month would be the five-dollar execution versus the Andys
of the world?
Mr. Solomon. I do not think I have that information. I
think one of the challenges that the exchanges and the SEC is
determining is what actually constitutes a retail order flow.
Senator Johanns. OK.
Mr. Solomon. That is a hotly debated discussion point,
because there is--I think people feel like if we are really,
truly protecting individual investors, everybody is on board
with that. But, there are people who masquerade around as
individual investors who are really high frequency or
professional traders who are accessing their five-dollar
trading accounts, and that does not quite seem like it is
right. And so it is very difficult, actually, to know. I cannot
tell--and, by the way, everything trades in hundred lots today,
so it is really hard to be able to discern between an
institutional order and a retail order. There is no real way to
capture that data, to the best of my knowledge.
Senator Johanns. Thank you, Mr. Chairman.
Chairman Warner. I think you raised a good point, Senator
Johanns. The question I would have, and I am going to let
Senator Warren get an extra couple minutes, is just that would
that rugged individualist who gets the five-dollar trade be
offended if somebody in that tiny spread is making perhaps
inappropriate profits because you have got the incentives
misaligned? But, I imagine maybe Senator Warren might go down
that direction.
Senator Warren.
Senator Warren. So, thank you, Mr. Chairman, and thank you
all for being here.
And, I do. I want to pick up on that line. The question for
me is not so much about the cost savings from all electronic
trading, it is the question about the so-called high frequency
traders. And, for me, the term ``high frequency trading'' seems
wrong. You know, this is not trading. Traders have good days
and bad days. Some days, they make good trades and they make
lots of money, and some days, they have bad trades and they
lose a lot of money.
But, high frequency traders have only good days. In its
recent IPO filing, the high frequency trading firm Virtu
reported that it had been trading for 1,238 days and it had
made money on 1,237 of those days. Now, I do not know what
happened on the one bad day, but I assume a computer somewhere
got fired.
The question is that high frequency trading firms are not
making money by taking on risks. They are making money by
charging a very small fee to investors, and the question is
whether they are charging that fee in return for providing a
valuable service, or they are charging that fee by just
skimming a little money off the top of every trade.
So, let me start there. Mr. Brooks, the defenders of high
frequency trading often claim that they provide liquidity to
the market. There is always someone willing to buy whatever it
is that investor is selling. What is your view on that?
Mr. Brooks. That is a great question, Senator. I think our
view is that is a convenient answer by them. You know, the
markets functioned pretty well prior to high frequency trading
strategies being adopted. You know, if 95 out of 100 times that
you have said you want to buy 100 shares of GE you canceled
that trade, that expression of trading interest before anybody
can get to you, I sort of question the true intent of what you
are doing.
Now, I think it is important to be clear, some high
frequency trading strategies are legitimate. They are market
making. They are statistical arbitrage. They are buying stocks
in a basket against an index or something like that. But, a lot
of these strategies really, our understanding--and by the way,
I agree with both Mr. Solomon and Professor Scott, this market
subject is incredibly complex--but, so much of what a high
frequency trading strategy might be is to act, to draw a
reaction, and then to profit from your reaction. So, they flank
you. They pivot around you. They really have no intention of
trading. They just sort of want to see what you are going to
do, and once they know what you are going to do, they can step
in front of you.
Senator Warren. Right. So, you would argue this is not
adding liquidity to the marketplace----
Mr. Brooks. We think there is a huge difference between
liquidity and volume. They trump the liquidity side and we are,
like, wow. Before you guys came along, we seemed to be fine, or
seemed to be better, in some respects.
And, I do think it is important here to identify that
retail investors declare victory. You are in great shape. The
five-dollar trade, instant access, awesome. But, a big part of
your portfolio, of your nest egg, might be invested with people
like us. And, in that part of the market, it is not such a good
trade because you have people that are taking advantage of your
being in a market for a longer period of time. When you are
buying 100 shares, you are there for 2 seconds and you are
done. You declare victory. You go home. It is great.
But, let us say you have a million shares to buy. I might
be there all day, and all day, those other interlopers, if you
will, have an opportunity to step in front of, take advantage
of, sniff out our order, all those kinds of things. And, that
is troubling to the market. That is where we could be better.
Mr. Solomon. I also think, by the way, that there are--the
liquidity providers are there when it is convenient for them to
be there. So, I would ask the question, are they really
providing liquidity, because I know if I am an individual
investor and I want to sell and I am in a line with everybody
else, they have no obligation to be there. In fact, arguably,
when that starts to happen in the market, the thing that
concerns me most is all a lot of these algorithms look and
tradeoff the same trends. So, if we start to get one-sided in
the market in the other direction, they will widen their bids
and offers and then we no longer have a market that is--has a
responsibility to provide liquidity, a buyer of last resort.
Senator Warren. So, if I am following you, Mr. Solomon, you
are saying that they are really adding volatility to the
market, volume to the market, without adding true liquidity to
the market.
Mr. Solomon. It can be true liquidity. It is just not true
liquidity when you might actually need to get true liquidity,
because there is no obligation. So, they will trade as long as
there is liquidity, and we have seen in small caps, for
example, when there is no activity, they do not trade until
there is activity. Then, they trade. And, so, that is not
really providing that liquidity. That is, like, moths to the
flame. There is a flame. Let us fly there.
And, so, that is not real adding--it looks to the casual
observer as if there is a lot of volume, but is there real
fundamental buyers and sellers or is it just a bunch of people
crawling in there when they think there are real buyers and
sellers around and creating activity that really does not add
to the ability for Andy to aggregate a position or sell a
position when he actually needs to do it.
And, I worry about the stability of the marketplace because
when there is going to be--there will be, it is a matter of
when--when there is selling, I wonder who is going to be there
to actually buy it, because in the old days, we may not have
liked the New York Stock Exchange and the things that they did
and the money they made, but they stood there and bought stocks
in 1987, down big, but they bought them and the market opened
the next day.
And here, I am a little bit concerned, particularly around
the Flash Crash. What happened there? You do not really need to
do a lot of studying. A lot of algorithms said, oh, my God,
this is unusual. I am going to widen my bids and offers because
I do not understand what is happening. And then everybody did
it. And, so, we are no better today in that regard than we were
in 2010.
And, I think, that is actually the challenge in market
structure, as opposed to whether HFT is good or bad. It is the
market structure we live in, and HFT, sometimes it helps,
sometimes it does not, but we are not in a good place market
structure-wise.
Senator Warren. All right. So, thank you, and--good.
Actually, if I can just answer it, because the other argument
you often hear is one about speed, that it speeds up the
transactions. Mr. Brooks.
Mr. Brooks. So, our view on speed is, you know, if your
request for speed is singularly focused, I think it is
reckless. And, what we have been led to understand about market
structure and the quest for speed is when you are interested in
speed, you remove safeguards and you remove some of the
infrastructure and the underpinnings of the market. And, so,
fortunately, we put in--the SEC put in the limit up, limit
down, and some marketwide circuit breakers and that has been
great. But, both the Flash Crash and Knight Capital situation
were maybe driven by speed, and if that is the case, that is
not good for anybody.
As investors, it is rare--it is rare that speed is
important to us. Our average holding period is, like, 3 years.
Why do I really care what is going to happen in a nanosecond?
Senator Warren. Well, I was going to say----
Mr. Brooks. I do not.
Senator Warren. ----I take it the speed difference we are
talking about is measured is milliseconds----
Mr. Brooks. You cannot even blink----
Senator Warren. ----not in 7 days.
Mr. Brooks. It is milliseconds, is right.
Senator Warren. Yes.
Mr. Brooks. It is nanoseconds. And, that advantage, that
speed advantage, if it destabilizes, it seems to us that that
is wrong. That is not right, and we ought to push back on that.
Our view is, we really ought to just slow down, not walk away
from technology, but let us take a deep breath here and really
look at what we have, and I appreciate Professor Scott's
admonition about the complexity of the market. But, we have got
to make some progress.
You know, my boss says to me, ``I do not really care how
fast you are moving toward the goal, but please move in the
right direction, will you?'' If I am not moving in the right
direction, I am in trouble. We have not been moving in the
right direction. Oh, my God, we have got Dodd-Frank, we have
got Volcker, we have got blah, blah, blah, all these things out
there. They are always there. There is always a reason why you
cannot do it today.
You know, we used to have a fellow that worked for us who
used to talk about the phrase, ``Today is the hardest day to
invest.'' There is always something that might preclude you
from doing something. Today is the hardest day to go after
difficult market problems, because, gee whiz, I have got
something else I have got to worry about.
Can we just start to make some progress? Please. We do not
have the answers. Pilot programs give you the opportunity to
generate data. Let the academics run wild, try and figure it
out. Move in very incremental, careful ways. It is right, you
have to have a control. You have got to know what you are
trying to study and measure for. But, we can do that, and I
think we can do that in a constructive way.
Senator Warren. Well, I want to say, thank you very much,
Mr. Chairman, on this. You know, high frequency trading reminds
me a little of the scam in office space. You know, you take
just a little bit of money from every trade in the hope that no
one will complain. But, taking a little bit of money from
zillions of trades adds up to billions of dollars in profits
for these high frequency traders, and billions of dollars in
losses for our retirement funds and our mutual funds and
everybody else in the marketplace. It also means a tilt in the
playing field for those who do not have the information or do
not have the access to the speed, or who are not big enough to
play in this game.
So, I want to see the SEC, the State agencies push forward
in their investigations, and I think we should continue to do
the same.
Thank you, Mr. Chairman.
Chairman Warner. Thank you, Senator.
We will actually get another--let us each take another
question. I have got another question, if you want to take
another quick shot at this.
I just--I was in the technology business for a long time.
The last thing you want to appear, particularly sitting in a
chairman's seat, is like a Luddite. But, I do kind of--do feel
at times there may have been some--and I want Professor Scott
to give a rebuttal to this a little bit--that technology for
the sake of technology, when speed becomes so quintessentially
important, when the opportunity to colocate becomes an
advantage that clearly larger firms have over smaller, and the
ability to get your--where you locate your exchange becomes
such a--the real estate decision becomes such a critical
question.
And, I know that, Professor Scott, you said that the
volatility has not increased. I actually thought that the
intraday--again, volatility has gone up 5x since 1996. I want
you to kind of mention that.
And, I do, and I do not know if any of you cited this
study, but the study that shows the millennials are investing
in the market at a lower percentage than anyone else. Now, is
that a question of just financial uncertainty or is there--you
would think, from the generation that would be more technology
competent, there would be more willingness to accept this, but
there seems to be perhaps a wariness amongst young folks that
perhaps the system is being gamed.
Comments? Thoughts?
Mr. Scott. I would like to say at the outset that when we
talk about the market, we are talking about lots of different
trading systems in that market. And, one of the stories of
Flash Boys was the attempt to design a better market, IEX. So,
there is maker/taker, there is taker/maker out there. So, part
of what we have to think about when we look at this is what are
people gravitating to? If you give them taker/maker, are they
using that system, or do they find something else that is wrong
with it? So, the market is not just one thing that is working
in the same direction, a lot of different trading systems, a
lot of different ways to trade.
All right. Now, let me address your question, Senator, on
volatility. There are many ways to measure it, OK. You can do
it intraday, in which it is going up. You can do it day to day,
week to week. I would say long-term investors who are key to
the capital formation of our country are less interested in the
amount of intraday volatility, you know, except for those
people who are out sitting there on E*TRADE just trying to make
a profit in 1 day. We are talking about long-term investors,
and it seems to me that their horizon on volatility is shorter
than intraday.
The second thing I would say on volatility is that the CBOE
Volatility Index, so-called VIX, has fallen to its lowest
levels since 2007. What they measure is the 30-day expected
volatility of the S&P 500. So, there is still a different
measure that shows very low volatility.
Whatever the volatility is, or is not, it remains to be
seen what high frequency trading's impact is on that
volatility, because volatility--and this comes back to a
question you asked--is driven by a lot of factors, only part of
which, and maybe even a small part of which, may be trading
system. We have been, since 2008, in a state of high
uncertainty as to the future of our economy, OK, and that in
and of itself--OK, every day, oh, I think we are OK, no, we are
not OK, we have got this data, we have got that data--that kind
of environment, where you are not certain of where we are
going, produces volatility. And, so, I think the question, is
the volatility coming from high frequency trading or it is
coming from something else.
On all of these issues, we need more understanding, more
transparency, more information, OK, which is, hopefully, the
SEC is going to provide.
Now, in terms of the millennials issue, so, you know, the
question is, are younger people in this country increasingly
sort of afraid to invest in the market? When those people were
questioned, only 5 percent of them actually said that they had
an aggressive risk tolerance. So, what these people are saying
is that we are very conservative. We have a risk aversion. That
5 percent is a pretty low number. And, so, you have to then
ask, well, why are they risk averse? Is it because there are
high frequency traders operating out there? I do not think so.
It is because of the nature of what we have seen in the market
and great uncertainty about our economic future. And, I think,
that is what is preventing people from investing.
Now, that being said, Japan has had a longstanding problem
of not getting people into their markets, and I think some
people might analyze the reason for that as that the people do
not trust the fairness of that market. So, we should not
neglect fairness as a possible explanation, but there are
powerful economic fundamentals here, in my view, that have been
driving volatility and been driving less investor confidence.
Chairman Warner. Thank you. We will go to Senator Reed and
then back to Senator Johanns.
Senator Reed. Well, thank you very much, Mr. Chairman, and
thank you, gentlemen, for your testimony. I apologize. I had to
be down at the Defense Appropriations hearing with Secretary
Hagel and the Chairman of the Joint Chiefs of Staff.
But, Mr. Brooks, in 2012, you were here before and
testifying and----
Mr. Brooks. Nice to see you again, Senator.
Senator Reed. Yes, sir, and it'sgood to see Professor
Scott. As I said, previously, he led me to great intellectual
waters, but I did not understand how to drink, so thank you.
But, in 2012, before the publication of Mr. Lewis's book,
you mentioned that there were many investors that were sort of
turned off by the casino-type environment that they sensed,
rightly or wrongly, and your clients, has that distrust,
mistrust, or cynicism grown in the last 2 years?
Mr. Brooks. I do not know whether it has grown, but I also
do not think it has abated. So, you know, we talked about the
percentage of the households in this country that have exposure
to the stocks at sort of 16-year lows and the millennials. I do
not know what draws people to a market or away from investing,
but that is not a good thing. You cannot save for your
retirement if you do not generate some sort of return. So, we
are pretty concerned about this whole issue.
The job of trying to affirm a market's reasonableness, its
fairness, its transparency, seems to us to be ongoing, and we
have sort of--we are not doing a good enough job there
collectively as an industry and everybody to try and affirm the
reasonableness and fairness of our market. So, we continue to
be concerned about that issue.
Senator Reed. I think everyone has commented that high
frequency trading has provided some significant advantages to
marketplace liquidity, and in some cases probably narrowing
price spreads, et cetera, but, again, going to particularly
this popular perception argument that some of it seems to be
algorithms that are cleverly designed to essentially not make
economic investments, but to exploit sort of timing gaps in the
system and other gaps in the system. You know, one of the
things that is referred to is the sort of algorithms that will
send out a huge number of bids and then cancel the bids, not
because of the market activity, just simply because that is how
they think they can move a price just a few basis points and
then make the right move. That seems to me to be behavior that
does not add to the economic value of the country, but it
certainly makes some people very wealthy.
Mr. Brooks. We would agree with that, and sort of following
up on what Professor Scott was talking about, intraday
volatility, institutional investors who are really aggregated
retail--it is everybody together, because that is who we
represent--we do care about intraday volatility because it is
in that environment that we are trading. It is in that
environment that we are making our investment to hold something
for 5 years. And, if a trading strategy--if someone has been
able to exacerbate that volatility between 9:30 and 4, I would
argue it is causing longer-term investors a higher cost.
Senator Warren sort of talked about a tax. That is sort of
a tax on the system. All the money that the high frequency
crowd is taking out--they are not taking risk overnight, they
are flat every day, they never lose money--all the profits they
are making are coming from someone else. That might be the
longer-term investors, everybody in their 401(k)s, their 529
plans, et cetera.
So, we are very concerned about intraday volatility and
that is why we would like to see some pilot programs to
examine, can we constrain that a little bit? Can we make the
markets a little deeper, a little more transparent to bring
that intraday volatility in, narrow it? We do not have the
answer until we try.
Mr. Solomon. We agree with that----
Senator Reed. Let me go to Mr. Solomon, and then I will ask
Professor Scott just to comment on the general sort of
discussion that we have initiated with Mr. Brooks. Mr. Solomon.
Mr. Solomon. Yes, Senator. We agree completely. Actually,
we are very much on the same side here. The intraday volatility
in single stocks has actually, in some instances, never been
higher. When a buyer shows up, the stock lifts inexplicably,
and when a seller shows up, the stock drops inexplicably. So, I
do not really think there are a lot of good measures for single
stock volatility.
I think, with all due respect to the Professor, I do not
think the VIX has anything to do with this. The VIX is an
irrelevant--it just looks at overall market volatility and all
it says is that, you know, generally speaking, people are, you
know, sanguine about the overall market, in general,
macroeconomically, even with all the worries. They are
generally sanguine. When they are not sanguine, the VIX will be
40. But, it does not impact what happens in single stocks.
There are some definite issues here that are exacerbated by
the market structure, and high frequency--some high frequency
traders that do engage in flash trading behavior, in
particular, are harmful, I mean, and I do not think there is
anybody that can argue about that.
But, if you look at the reason why people flash, it is
because a lot of the trading goes on in the dark. So, dark
pools are, by their definition, not transparent. So, if you
want to trade in a dark pool, well, you need a way to light
that dark pool, and one of the ways you can light that dark
pool is by flash trading and seeing where the bids and offers
are. And, the question is whether or not dark pool operators
encourage that kind of behavior or discourage that kind of
behavior.
At Cowen, we do not run a dark pool and we are not
interested in running a dark pool. We have access to a lot of
different liquidity providers and we have developed algorithms
to help folks like Andy access pockets of liquidity and combat
that kind of behavior. So, there are some market clearing
mechanisms that allow you to deal with that. But, in general,
if you do not have the kind of algorithms we have to combat
that kind of behavior, you are at a significant disadvantage.
I would also say, when people talk about speed, there are
plenty of analogies we could use about speed and what it does.
We can all say that the National Highway System increased the
productivity of this country in ways that even President
Eisenhower could not imagine. But, we have speed limits. Every
car on the highway can go faster than it is allowed to go. So,
it is OK for regulators and legislators to say, we know you can
go faster. We know you can make improvements in efficiencies of
your engines. But, we think that this is the right speed to
encourage the right kind of economic behavior and protect
investors.
So, I do not think you are actually being a Luddite at all
by asking the question, just because we can go faster, should
we go faster, and there are plenty of examples like that one
that suggest we might not be better.
Senator Reed. Thank you. Thank you very much. Just a last
word, if I may prevail upon my colleagues.
Senator Johanns. Sure. Go ahead.
Senator Reed. Thank you, Mike.
Professor, please. And, welcome. Good to see you.
Mr. Scott. Thank you, Senator. I think we need to keep our
eye on the ball. The ball is, you know, what is best for people
who are trading in this market and what do they care about, and
in turn, what is best for our economy? So, we talked about
three different elements in the market. We talked about
volatility. We talked about liquidity. We talked about
transaction costs. OK.
So, on volatility, I have already said, people disagree on
this. It depends how you measure volatility, OK. I still am of
the view where maybe traders get rewarded for a little less
volatility during the day. Does a long-term investor really
care about intraday volatility? The people who are trading for
them may care because they get compensated on basically how
they do. But, for the long-term investor, I have to say, I am
in TIAA-CREF and I could care less about intraday market
volatility.
Now, the second part of it is liquidity, OK. People are
obviously interested in being able to trade in and out of their
stock positions when they want to. This is retail and
institutional. And, here again, we have a lot of data, all
right, an economist that says, liquidity overall in this market
is an all-time best. And, yet, Jeff, OK, when he deals with
small cap stocks, he does not see that because we are measuring
the overall market, which is dominated by large cap stocks. So,
if we have a liquidity problem, I think it is targeted--should
be targeted, and I think Jeff would agree with this, at trying
to get more liquidity in small cap stocks. We do not have that
liquidity. Therefore, people do not want to invest in them.
Therefore, we do not have capital formation.
And, the third thing is transaction costs, and this goes
back to Senator Johanns' questions or observations. You know,
retail costs, I think everybody would agree, are at an all-time
low. Nobody here, I think, has said that is not the case. On
the institutional side, we have studies by financial
economists--there was just a recent study by Angel, Harris,
Chester Spatt, they are all pretty well recognized financial
economists, who say the average transaction cost for an
institutional order of one million shares for a $30 stock is at
a historic low of 40 basis points, OK. So, we have to reconcile
that conclusion with what Mr. Brooks is observing. I am not
saying Mr. Brooks is not observing higher transaction costs,
but here is a pretty well respected group of financial
economists who are saying it is at an all-time low.
So, I come back to Senator Johanns' process question,
really. There are a lot of differences of opinions on these
issues, OK, and it is, in my view, the SEC's first role to sort
this out, write a good report for our country, including for
this Committee or for the greater Senate Committee and the
House, and then we will have something, OK, to look at and
react to.
So, I think, again, we should not be legislating now on
these issues. We should be fact finding and the primary fact
finder should be the SEC. And, by the way, Senator Reed, when
you were out of the room, I am very much in favor of the SEC
having adequate funding to do this and other things.
Senator Reed. Thank you very much. Thank you, gentlemen.
Senator Johanns. Go ahead.
Mr. Brooks. Could I possibly respond to----
Senator Johanns. Mr. Brooks, you wanted to----
Mr. Brooks. So, there are lots of studies out there talking
about transaction costs, and you can pretty much find a study
to match any opinion you want to espouse. There is an RBC study
out saying that intraday volatility costs are now perhaps
higher than ever, and we are seeing that in our trading. And, I
know Professor Angel and he is a good guy and he does good
work, but it depends what you are examining, and so that is a
very complicated subject, too, talking about transaction costs.
Two other things we have all sort of talked about here
today are conflicts of interest and complexity, and we could be
better if we could eliminate conflicts of interest and reduce
complexity, and I want to just tell you a quick story, a
trading story.
So, one day a few years ago, T. Rowe Price, we had 2.5
million shares to trade in a number of different stocks and we
picked a broker and they were about our number 7th broker on
the day in terms of the business we did. That 2.5 million
shares got represented out to the marketplace as 750 million
shares of interest, 300-to-one. So, we had 2.5 million shares
to buy. It got displayed in different times, different ways, as
750 million shares, simply to get 2.5 million shares executed.
Now, was that a great trading strategy? The numbers looked
pretty good. The reality is, we have 11 exchanges and 50-plus
dark pools. That complexity, that myriad of--that spider web
out there of where you have to go to trade today has created
all kinds of challenges for every investor, and it is that
issue that we need to try and focus on. How crazy is it that
you have to go to so many different places to say, anybody
there? Anybody want to trade? Anybody care today? We are
really--we are obfuscating things, and people have been able to
figure out ways to profit from that that really cause them to
take no risk.
Mr. Solomon. I am willing to bet that that was a large
capitalization stock, too.
Mr. Brooks. They were across the spectrum, actually.
Mr. Solomon. Right. And, so, if you look at what happens in
small cap stocks--sometimes, you know, it is like--we call it
the Hotel California. If you own a small cap stock, you can
check out any time you like, but you can never leave. And, that
is a problem when it comes to capital formation.
And, we talk--prior to the JOBS Act, which was to get
companies to think about going public, private companies, we
seem to have established a really good regime in the Congress
where we can do good legislation that balances investor
protections and creates a forum for capital formation. But,
once these companies are public, who is actually sponsoring
them and how is that trading occurring?
And, we are in a period now where we have a number of new
companies, and we would love to give them the right kind of
experience to encourage further investment in capital-intensive
businesses from your venture capital friends who right now, if
you look at the last 10 years of venture capital investment in
this country, it is disproportionately in companies that do not
hire lots of people, or are not capital intensive. We do not
back semiconductor manufacturing companies in this country
anymore. That is a problem.
And, so, if you need access to capital beyond the venture
spectrum, you have to find it in the public markets, and this
is what we are talking about. There needs to be that liquidity.
Chairman Warner. Senator Johanns gets his question.
Senator Johanns. Maybe more of an observation than a
question, and here would be my observation. I came to this
hearing today wondering about the process question--that is why
I asked it first out of the box--just simply because we, years
and years ago, created an SEC. We gave them authorities. We
have looked at that from time to time. We have broadened their
authority and we have said to them, we want you to be the
experts. We want you to understand this marketplace and report
to us on what is working and what is not working.
And, I leave this hearing today more and more convinced
that if there is direction from Congress, it should be
direction to the SEC to go out there and find the facts, report
back, do the pilot program--which, incidentally, I have no
problem with.
The second observation is this. What traders are doing is
not illegal. If they are out there buying and selling and doing
what they are doing within the laws that are currently on the
books, they have a right to do that. And, it occurs to me, Mr.
Brooks, that they have kind of outsmarted you, not because you
are less intelligent than they are, but they watch you like a
hawk and all of a sudden they are starting to figure some
things out and they are just a second ahead of you and it is
profitable.
Now, I would not be smart enough to do that. I guess if I
were that smart, I would be doing that instead of what I am
doing now, right?
Chairman Warner. You are not running for reelection,
though, right?
Senator Johanns. Yes.
[Laughter.]
Senator Johanns. I will not be doing that in my next life.
All I am saying to you is before we head out there in a
free marketplace and start defining behavior to be illegal, we
should be darn sure about what we are doing, because it could
have some economic consequences.
Now, I want you to go out and give me the very best deal,
and I do not think I am invested in your company whatsoever,
but I do have a retirement program here that I have got some
money in, and I tell you what, I look at the statement and I
say, way to go. Good job. You are making more money for me. I
want you to do that.
But, having said that, again, I think we need to be very
thoughtful about when we proclaim behavior to be illegal in a
free market system, and that one, I must admit, I want more
information on. I want more fact finding. I want to understand
who wins, who loses, what is the consequences. And, I do not
think we are anywhere near there at this point.
Like I said, I leave this hearing with somewhat the same
impression I came to the hearing with, and that is we need the
SEC out there to lead this effort. We need to encourage them,
fund them, do those things. And then a future Congress--this
will happen after I am gone--needs to be careful and thoughtful
about how they are going to figure this out, because just
because they are making money does not warrant us jumping in
and saying, that behavior is illegal. You are making money.
That has got to be illegal behavior.
Mr. Brooks. Senator, I think that is a--your point is well
made. I do not think we are saying this behavior is illegal,
but it might not be fair. It might not be right. It might not
be ethical. So, if someone gets an information advantage about
my trade and they get it--they get knowledge of a trade that is
going to happen, and it happens and they are able to profit
from that knowledge before the rest of the market can, when it
is really marketwide knowledge that should be shared, I am not
sure that advantage is right.
I have no problem with people making money. I mean, we are
a for-profit enterprise. This is America. We believe in that.
But, when you take an unfair advantage or you found an unfair
advantage and you have exploited that, I think that maybe the
SEC needs to gut-check that and come back and say, maybe we can
tweak things, because that is not fair.
That is why I think the tax loophole analogy is a good one.
You know, we respect people that found ways to avoid paying
taxes, but if it is a loophole, it often needs to be closed.
And, we think that some of these predatory practices are, in
fact, not fair and not right and they should not be allowed to
go on. It is not that they are illegal, but they have an unfair
advantage.
You know, my mother used to say to me, ``Just because you
can do it does not mean it is right,'' and I think that is
important.
Senator Johanns. You know, and I got the same lesson.
Mr. Brooks. Yes, sir.
Senator Johanns. I got the same lesson, and I do not agree
with the philosophy you espouse, and I hope I live by that
philosophy. But, again, highly technical, critical that we get
good information from the SEC, critical that we understand what
the consequences of our actions might be, because at the end of
the day, there will be consequences. And what we stop here may
open something up over here that we do not like any better.
Like I said, I just think we need to be very careful, very
thoughtful.
I have not read the book. I am sure it is a great read. Mr.
Lewis is a fascinating author. But, having said that, this is
very serious business, and if there is anything I take from
this hearing and three outstanding panelists, in my judgment,
is we need to be thoughtful about where we head from here.
Mr. Solomon. This is why we have advocated for pilots. I
think if there is one consensus, we have all said that there
should be pilots and we should observe those pilots and make
changes based on the information we gather from that.
I will just say, there is a little bit of a difference at
the SEC now than there was when the JOBS Act was passed.
Chairwoman White has really made this a priority. She is data-
driven. She is going to do a lot of analytics. And, she has
been very consistent in her commentary, as have the other
Commissioners. So, I do think that we can maybe get some
answers from them.
But, I will say that the first thing that came out that was
required--the JOBS Act required the SEC to look at market
structure, and I would encourage you to read that report and
see if you learned anything from that. And, I would say, part
of the reason why we formed the Equity Capital Formation Task
Force is we looked at that report and said, it did not tell us
anything. So, we have to advocate for them to actually tell us
something that is helpful.
And, I am hopeful that under this leadership of Chairwoman
White that we will get a different outcome, but I think it is
Congress' responsibility to ensure that we get that output, and
that is part of the reason why I am here, at least.
Chairman Warner. Let me--and, again, I appreciate
everybody's comments and, I think, the very good questions.
And, I think, Senator Johanns and I have worked on a lot of
things together. We get the conflict. We have got the value-add
to the economy of the retail investor being able to get that
cheaper price.
But, I do think the notion, and I am a proud free market
advocate and proud of my experience longer in business than I
have been in politics, but there is this notion in the market,
you take risks and you take your lumps and you take your wins.
Something that is inherently--a track record that says if 99.9
percent of the days in a trading exchange you make money--and
it is not just an HFT, I recall some of the large cap banks who
had those same records--it creates at least something that is
echoing what you have said. We need more data.
And, I come back to the fact, May 13, not May 13 in 2010,
but May 13 in 2014, Xerox and Lorillard, this was the--we had a
miniflash crash. And, if we were to have another one of these
incidents, the tendency would be, as you know, Senator, we
might overreact too quickly. So, the fact that we are 4 years
after the first Flash Crash--and I remember the previous Chair
of the SEC, asking her what happened, and months and months
later, they were still trying to find out--the fact that we do
not have that consolidated audit trail information done--I
mean, I am for adequate funding for the SEC, as well, but at
some point, the priority--this needs to be a higher priority.
And, I do think we have a role to nudge the SEC to act, to make
this a higher priority, to urge our colleagues on both sides of
the aisle to get the SEC the resources they need to do their
job, number one.
I think, at least, I, and I think you have concurred on the
tick size, the pilot, the notion of small caps. We want to try
to accelerate that.
But, there are--I think Mr. Brooks has raised some
fundamental questions about this notion of fairness here that
we do not have all the appropriate data to kind of make that
judgment. And, my concern will be, if we do not have that data
soon, another incident will happen, and, my gosh, because of
the complexity, Congress trying to line-by-line legislate this
would not be a pretty activity.
All right, Professor Scott. Briefly, because we are about
to bring the hearing to an end.
Mr. Scott. I just want to put in a plug. Our committee has
got a full-scale project to examine all these market structure
issues and we will be doing so over the next 9 months. So, I
want to say, the SEC is not the only organization out there
that is going to be studying market structure. Our committee is
doing it. I am sure there will be others for you to look at and
sort of weigh those other studies against whatever the SEC----
Chairman Warner. And, I would say this. One of the things I
think this Subcommittee needs to do, since we have this as our
jurisdiction, and Senator Levin had some of the folks
yesterday, but, you know, we need to have some folks--back to
Mr. Brooks' point about how many exchanges there are out there
competing, it should be very, very small. You would have to
search out these very, very small exchanges. On the other hand,
in the notion of a market, they need to have their say in this
Committee, as well.
I want to thank all the witnesses for very focused answers
and appreciate your contribution. Senator Johanns, thanks for
your contribution, as well.
The hearing is adjourned.
[Whereupon, at 11:29 a.m., the hearing was adjourned.]
[Prepared statements and additional material supplied for
the record follow:]
PREPARED STATEMENT OF HAL S. SCOTT
Nomura Professor and Director, Program on International Financial
Systems, Harvard Law School
June 18, 2014
Thank you, Chairman Warner, Ranking Member Johanns, and Members of
the Subcommittee for permitting me to testify before you today on the
impact of high frequency trading on investor confidence and capital
formation in U.S. equity markets. I am testifying in my own capacity
and do not purport to represent the views of any organizations with
which I am affiliated, although some of my testimony is based on the
work of the Committee on Capital Markets Regulation (CCMR). On the
whole, high frequency-trading increases liquidity in our equity capital
markets. The increased liquidity leads to decreased costs of stock
issuance, thus improving capital formation. And of course, improved
capital formation for our businesses leads to higher growth in the real
economy.
The Committee was formed in 2005 to address the issue of
competitiveness in our primary public equity capital markets and issued
a report in 2006 detailing the threats to our primary markets and
suggestions for improvement. \1\ Just as regulatory changes can lead to
competitiveness concerns in our primary markets, the same is true of
our secondary markets. Therefore, any changes in our secondary market
trading must be assessed for their competitive implications,
particularly given the current relative competitive strength of our
secondary markets vis-a-vis those abroad.
---------------------------------------------------------------------------
\1\ Comm. On Capital Mkts. Reg., Interim Report of the Committee
on Capital Markets Regulation (Nov. 30, 2006), http://
www.capmktsreg.org/pdfs/11.30Committee_Interim_ReportREV2pdf.
---------------------------------------------------------------------------
The CCMR tracks, on a quarterly basis, 13 measures of the
competitiveness of the U.S. public equity market. \2\ We have found
that while the competitiveness of our primary markets has suffered over
the past 6 years, our secondary markets remain strong with roughly 50
percent of global exchange trading occurring on U.S. exchanges. \3\ The
CCMR is currently undertaking a review of market structure issues with
a focus on dark pools, internalization, decimalization, exchange backup
systems, and the subject of today's hearings, high frequency trading.
---------------------------------------------------------------------------
\2\ Comm. on Capital Mkts. Reg., Competitiveness Measures, http://
www.capmktsreg.org/educationresearch/competitiveness-measures/
\3\ Id.
---------------------------------------------------------------------------
``High frequency trading'' or ``HFT'' is a topic that has generated
significant attention in recent years and increasingly in the last few
months. The widespread public interest in this topic was intensified
following the 2010 ``flash crash'' and more recently, with the
publication of Michael Lewis' book Flash Boys, which has ignited a
general attack on HFT's place in the U.S. capital markets. But policy
cannot be made on the basis of a journalistic tale that makes for a
best seller--rather it must be informed by verifiable facts. This is
largely why we are here today and my intention is to provide a
thoughtful response to a debate that has been at times fraught with
frenzied emotion.
Let me be clear at the outset, that I believe the net effect of HFT
activity in our equity markets has been positive. Transaction costs are
at historic lows, liquidity is at historic highs, and volatility has
stabilized. These features of today's market not only benefit both
retail and institutional investors, but also positively affect capital
formation, and by extension, promote job creation. The fact that HFT is
the subject of a best-selling book and has generated vocal opposition
both within the financial industry and across the American public more
broadly, does not, in itself, justify drastic regulatory change. There
is nothing new about the advantages of speed to traders. You may recall
that the Rothschilds used carrier pigeons to bring them news of the
outcome of battles in the Napoleonic wars. \4\ While the speed with
which they obtained this information gave the Rothschilds an advantage,
the markets generally benefited from the speed by which the new
information got into the market, even if those who actually traded with
the Rothschilds were at a disadvantage.
---------------------------------------------------------------------------
\4\ Mary Blume, ``The Hallowed History of the Carrier Pigeon'',
New York Times, Jan. 30, 2004.
---------------------------------------------------------------------------
My primary concern is that the recent frenzy over HFTs draws
attention away from other important market structure issues. For
example, as a member of the Equity Capital Formation Task Force, along
with my fellow panelist Mr. Solomon, I have been highly supportive of a
tick-size pilot program for small cap stocks and have been encouraged
by the SEC's recent commitment to conduct such a program. \5\ That
being said, to the extent that public concern over HFTs reduces
investor confidence, our capital markets will suffer. But in my
opinion, any reduction in confidence would not be based on the facts.
Given the recent volumes in trading, there is little evidence that
people have lost confidence in our markets.
---------------------------------------------------------------------------
\5\ See Letter from Hal S. Scott to Joseph Dear, Chairman, Inv.
Adv. Comm., U.S. Sec. and Exch. Comm. (Jan. 23, 2014), available at
http://www.equitycapitalformationtaskforce.com/files/
H%20Scott%20IAC%20letter%202014%2001%2023.pdf.
---------------------------------------------------------------------------
Critics of HFT point to the $261 billion that retail investors have
pulled from equity mutual funds since the 2010 ``flash crash'' as
evidence that investors have lost confidence in our equity markets. \6\
However, retail investors have simply moved their investments to
exchange traded products, which of course trade in U.S. equity markets.
The net effect is investor inflows of almost $500 billion since the
2010 flash crash. \7\ In 2012 alone, there were net inflows of $57
billion in securities trading in U.S. equity markets. \8\ If investors
were indeed overly concerned by HFT then they wouldn't have added such
substantial amounts to their capital at risk in our equity markets.
---------------------------------------------------------------------------
\6\ Justin Schack, ``HFT Is Not Driving Investors From the Stock
Market'', Fin. Times, May 10, 2013.
\7\ Id.
\8\ Id.
---------------------------------------------------------------------------
Another common misconception regarding HFT and our current equity
market structure is that HFTs have somehow caused an increase in
transaction costs for individual retail investors. In fact, transaction
costs for retail investors are at historic lows, as evidenced by
current bid-ask spreads and retail brokerage commissions. Since 2006,
the average effective bid-ask spread on NYSE-listed stocks has dropped
in half, from over 3 cents to roughly 1.5. \9\ Retail brokerage
commissions are also at all-time lows; the average commission charged
by the three major retail brokers is approximately $10 per trade. \10\
Given the reduction in spreads and commissions, the net cost of a given
trade has dropped dramatically for retail investors. According to the
Tabb Group, 7 years ago retail investors' effective payments on
executed trades were roughly 130 percent of the NBBO spread (the
difference between the national best bid and offer). Since then they
have dropped to less than 100 percent, so the average retail investor
receives a better price on a trade than the best price available on an
exchange. \11\ In short, it is a great time to be a retail investor.
---------------------------------------------------------------------------
\9\ See James J. Angel, Lawrence E. Harris, and Chester S. Spatt,
``Equity Trading in the 21st Century: An Update'', June 21, 2013.
\10\ Id.
\11\ See ``The Citadel Conversation'', Q1 2013, available at
https://www.citadelsecurities.com/_files/uploads/sites/2/2013/06/The-
Citadel-Conversation-with-Larry-Tabb-and-Jamil-Nazarali.pdf.
---------------------------------------------------------------------------
However, bear in mind that retail investors only directly account
for approximately 15-20 percent of daily stock market volume. \12\
Since many retail investors access the equity markets indirectly
through institutional funds or advisors (such as mutual funds, pension
funds, or private wealth advisors), institutional cost reduction is
highly relevant to retail investors as well. In 1950, over 90 percent
of U.S. equities were held directly by households. \13\ That number has
dropped to less than 40 percent in 2013 \14\ and this is primarily
high-net worth individuals. Household ownership of mutual funds has
risen from 5.7 percent in 1980 to 46.3 percent in 2013 constituting 90
percent of mutual fund assets. \15\ Collectively mutual funds own 30
percent of the U.S. stock market capitalization. \16\ Clearly, what is
good for institutional investors is also beneficial for the small
investor.
---------------------------------------------------------------------------
\12\ Rosenblatt Securities estimate.
\13\ B. Friedman, ``Economic Implications of Changing Share
Ownership'', Journal of Portfolio Management 22 (Spring 1996).
\14\ Board of Governors of the Federal Reserve System, Flow-of-
Funds Accounts (2013).
\15\ Investment Company Institute, 2013 Factbook.
\16\ Id.
---------------------------------------------------------------------------
The institutional investors that primarily trade on behalf of the
small investor constitute roughly 25-35 percent of average daily stock
trading volume in the U.S. \17\ And today institutional trading costs
are historically low. Based on institutional trade data compiled by
leading finance academics, the average transaction cost for an
institutional order of 1 million shares for a $30 stock is at a
historic low of 40 basis points. \18\ This includes additional costs
associated with price movement from information leakage. The costs of
trading these large orders can exceed bid/ask spreads if there is
information leakage that a large order is being placed and the price of
the trade subsequently moves against the buyer. To prevent this,
institutional traders split large orders into small orders for
execution to avoid tipping off other market participants that a large
order has entered the market. Neither retail nor institutional
investors appear to have suffered from the increase in HFT trading
activity. If anything, market participants are experiencing the best
trading conditions ever seen.
---------------------------------------------------------------------------
\17\ Rosenblatt Securities estimate.
\18\ See James J. Angel, Lawrence E. Harris, and Chester S. Spatt,
``Equity Trading in the 21st Century: An Update'', June 21, 2013.
---------------------------------------------------------------------------
In addition to transaction costs, market volatility and more
importantly severe market dislocations are also a primary concern for
all investors. Critics of HFT contend that HFT strategies have led to a
significant increase in stock market volatility caused merely by HFT
trading activity, rather than changes to the fundamentals of stocks.
However, respected market structure experts continue to believe that
volatility is largely driven by macroeconomic concerns and not HFT
activity. Stock market volatility, as proxied by the CBOE Volatility
Index (VIX), understandably rose during the heart of the financial
crisis, but has since fallen to its lowest levels in seven years.
Intraday volatility of individual stocks also remains low. Professor
Larry Harris has found that there is no clear pattern that stock market
volatility or the intraday volatility of individual stocks has
accompanied the rise of HFT. \19\ And while the extreme volatility
experienced during the flash crash in 2010 was a significant market
disruption that should not be repeated, the SEC has largely addressed
this concern by implementing single-stock circuit breakers and revising
marketwide circuit breakers that will temporarily halt trading if price
movements become too volatile.
---------------------------------------------------------------------------
\19\ Id.
---------------------------------------------------------------------------
Thus, it is hard to argue that the U.S. equity market is ``broken''
as a result of the emergence of HFT activity. Nonetheless, there is
always room for targeted improvement of the current regulatory
structure, including with respect to certain practices of HFT traders.
But we should proceed cautiously and thoughtfully so as not to chill
legitimate market functions. There are risks to implementing any
changes which must be assessed--for example, bid/offer spreads could
widen or exchange volumes (and with it liquidity) could drop.
As a first step, we must precisely identify what practices warrant
further regulatory scrutiny. Defining high frequency trading is far
from straightforward. For example, many institutional traders place
relatively small trades with high frequency, but whether this is a
unique and potentially abusive investment strategy or whether this is
simply an optimal trading strategy that has evolved with automated
trading (e.g., to execute a large block trade without exposing the size
of the order), is a baseline question. Technological advances mean that
modern trading is done electronically with orders no longer being given
to a broker on an exchange floor. And trading is getting faster every
year. We can't put the genie back in the bottle; Mary Jo White recently
acknowledged that ``the SEC should not roll back the technology
clock.'' \20\
---------------------------------------------------------------------------
\20\ Mary Jo White, Chair, U.S. Sec. and Exch. Comm., ``Enhancing
Our Equity Market Structure'', Speech at Sandler O'Neill & Partners,
L.P. Global Exchange and Brokerage Conference (Jun. 5, 2014).
---------------------------------------------------------------------------
At the same time, there are certainly many general risks that come
with automated and faster trading. We need to make sure our rules keep
up with industry technology. Regulation has not kept pace with
technological advances. As Mary Jo White acknowledged, ``many market
structure rules and industry practices were developed with manual
markets in mind.'' \21\ We have seen other significant changes in
response to modern technology before--for example, following the
October '87 crash, when the NYSE implemented marketwide circuit
breakers in response to the recommendations of a presidential task
force. \22\
---------------------------------------------------------------------------
\21\ Id.
\22\ See NYSE Circuit Breakers, available at https://
usequities.nyx.com/markets/nyse-equities/circuitbreakers.
---------------------------------------------------------------------------
Market instability is something everyone agrees we need to avoid,
to the extent possible. In our fast-paced world, our markets are
particularly susceptible both to fat finger mistakes and errors, as
well as intentional, manipulative behavior by certain market
participants. The incredible speed at which we now trade can exacerbate
errors, and quickly.
We need to ensure the safety and soundness of our markets.
Fortunately, as I have previously mentioned, the SEC and securities
industry have already taken a number of steps to address this topic.
For example, in addition to circuit breakers, the SEC has issued
requirements for market participants to address technology risks
through the Market Access Rule and proposed Regulation SCI. The
Consolidated Audit Trail is expected to be operational in 2016 and will
provide the SEC comprehensive data regarding the routing and execution
of orders, allowing regulators to better prevent, identify and respond
to any firms engaged in harmful practices.
Critics of HFT contend that HFT firms have access to proprietary
data feeds from the exchanges that provide them with information before
other traders, allowing them to ``front run'' the market. However, it
is important to be clear that trading on information that is publicly
available is different than a broker trading ahead of a customer, which
is patently illegal. Michael Lewis points out examples in which he
claims that HFT traders obtain an advantage in the market when brokers
trade only a small portion of a larger customer order with the HFT to
gain a rebate on that small portion. The HFT then uses the information
from the small order to trade ahead of the remainder of the customer's
order, thus resulting in the broker's customer receiving an inferior
price for the remainder of the order. However, the flaw in these
examples is that brokers actually route customer orders in a manner
that ensures that their customers' orders arrive at various trading
platforms at the exact same time, so customers receive the best price
for their full order. Such routing practices are consistent with
brokers' legal requirement to seek the best execution reasonably
available for their customers' orders. Specific examples are described
in the appendix.
Additionally, there is growing public interest in a practice called
``colocation,'' which refers to traders locating their data servers in
the same physical space as exchanges to facilitate faster trading and
profits, which along with proprietary data feeds gave rise to latency
arbitrage. In general, latency arbitrage entails the ability of HFTs to
synthesize quotes from all exchanges faster than other market
participants, thus enabling HFTs to trade on those quotes at a profit.
One could argue that this activity closes the gap between divergent
prices in similar ways as other forms of arbitrage. While critics
question the ``fairness'' of allowing certain traders to benefit from
their physical proximity to an exchange or access to proprietary data
feeds, proponents of the practice point out that the SEC does not allow
exchanges to discriminate in offering these services. If an exchange
offers proprietary data feeds or colocation to any traders, it is
required to offer access to all other market participants, both HFT
firms and non-HFT firms, at the same cost. Under this system, every
market participant has an opportunity to colocate. If the exchanges no
longer offered this access to anyone, either by choice or prohibition,
a race would ensue to acquire the real estate adjacent to the exchange,
which could actually limit access to many market participants. One
might even view colocation as the modern incarnation of market makers
vying for position on an exchange floor. Furthermore, 90 percent of all
trades are now executed by colocated traders with access to proprietary
data feeds, which includes institutional investors acting on behalf of
retail investors. \23\
---------------------------------------------------------------------------
\23\ Rosenblatt Securities estimate.
---------------------------------------------------------------------------
Another issue to consider is the increasing technology ``arms
race'' occurring among HFTs. To beat out competitors, HFTs invest more
heavily in powerful and expensive technology to gain an edge over the
competition. But increased competition among HFTs may further reduce
costs for the rest of the market as HFT margins decline. The TABB Group
estimates that HFT revenues in the U.S. have dropped from $7.2 billion
in 2009 to $1.3 billion in 2014. \24\
---------------------------------------------------------------------------
\24\ TABB Forum, ``No, Michael Lewis, the U.S. Equities Market Is
Not Rigged'', http://tabforum.com/opinions/no-michael-lewis-the-us-
equities-market-is-not-rigged.
---------------------------------------------------------------------------
Much discussion recently has also revolved around the ``maker-
taker'' pricing system that developed roughly 17 years ago, well before
the rise of HFTs. \25\ On a trading platform with ``maker-taker''
pricing, the liquidity taker pays a fee and the liquidity provider
receives a rebate. The first venue to introduce maker-taker pricing was
Island ECN in 1997. \26\ While some have introduced various criticisms
of maker-taker pricing, this is neither a system nor a problem created
by HFTs. The maker-taker pricing system can exist in low frequency
trading environments and HFT environments alike.
---------------------------------------------------------------------------
\25\ See Larry Harris, ``Maker-Taker Pricing Effects on Market
Quotations'', Aug. 30, 2013.
\26\ Id.
---------------------------------------------------------------------------
Finally, I note that certain critics of HFTs are also highly
critical of the ``dark pools'' where these traders, along with other
institutional investors, increasingly trade. It is estimated that 15
percent of stocks are now executed in dark pools, where information
about orders is not publicly displayed. \27\ Critics suggest that dark
trading inhibits the pricing function of secondary markets, and also
question their opacity more generally. It is important to note,
however, that neither dark pools nor market fragmentation more
generally are ``problems'' that arose because of HFT. The automation of
equity trading following the SEC's adoption of Regulation National
Market System (Reg NMS) in 2005 led to a fragmentation of execution
venues, including SEC registered exchanges as well as alternative
trading venues like dark pools. Thus dark pools and fragmentation were
partly the result of regulation. In addition though, there were general
market forces at work. Buy-side traders who questioned whether their
trades were being front-run on traditional exchanges turned to dark
pools because of the protection that dark trading brings from potential
front-running. One key benefit to dark pools is that orders are not
displayed, thus it is difficult to front-run them or to know when large
blocks are being bid and offered. Furthermore, it is important to
remember that a Reg NMS stock can only be traded in the dark if it is
executed at a price that is equal to or better than the best publicly
available price on an exchange. In addition, dark pools are required to
offer post-trade transparency, as executed stocks are publicly reported
in real time. While proposals to further reform dark pools, for
example, by requiring disclosure of trading practices or fee structures
or imposing antidiscrimination rules, may warrant further attention,
such reforms are unrelated to HFT and outside the scope of my testimony
today.
---------------------------------------------------------------------------
\27\ James J. Angel, Lawrence E. Harris, and Chester S. Spatt,
``Equity Trading in the 21st Century: An Update'', June 21, 2013.
---------------------------------------------------------------------------
I would now like to present a few specific proposals that I believe
could be helpful in ensuring the safety and security of our automated
world.
First, regulators should consider mandating and harmonizing
exchange-level kill switches. A kill switch is a mechanism that would
halt a firm's trading activity when a preestablished exposure threshold
has been breached, thus stopping erroneous orders and preventing any
further uncontrolled accumulation of positions. For example, if a
trading firm typically only holds $1,000,000 in shares of NASDAQ-traded
stock during any point in the trading day, it could be required to
implement a kill switch at 5 times that exposure-level, or $5,000,000
in shares of NASDAQ-traded stocks. If the threshold is breached,
further trading would be prevented and the firm's open orders on NASDAQ
would be halted. It is important that such kill switches be mandatory
at the exchange level. This would serve to further mitigate volatility
related to errant algorithms or ``fat finger'' errors.
Second, we might consider addressing the volume of order message
traffic, which can create market instability, by establishing order-to-
trade ratios. Electronic order instructions are used to direct the
placement, cancellation and correction of orders. Since 2005, order
flow has increased by 1,000 percent while trade volume has increased by
only 20 percent. \28\ As was experienced during the 2010 flash crash, a
spike in orders and cancellations can exacerbate market volatility and
overwhelm the exchanges' infrastructure. The current market structure
only places costs on trade executions, thereby allowing market
participants to generate excessive order-message traffic without
internalizing the costs of the negative externalities just described.
Regulators should assess why order volumes have increased and consider
charging fees for extreme message traffic, keeping in mind that any
order-to-trade ratios should depend on the liquidity of the stock.
---------------------------------------------------------------------------
\28\ See Gary Cohn, Op-Ed, ``The Responsible Way To Rein in Super-
Fast Trading'', Wall Street Journal, Mar. 20, 2014; and James J. Angel,
Lawrence E. Harris, and Chester S. Spatt, ``Equity Trading in the 21st
Century: An Update'', June 21, 2013.
---------------------------------------------------------------------------
Third, regulators should consider abolishing immunity that
exchanges have from liabilities for losses from market disruptions
based on their SRO status. For example, NASDAQ received immunity from
liability for half-a-billion dollars of losses incurred by brokers from
the Facebook trading glitch because it claimed it was acting in its
SRO, and not its for-profit, capacity. If immunity does not apply to
activities related to smart routing and other technology offerings,
this might better align the exchanges' incentives to limit potentially
risky trading activity that could pose widespread operational risk.
In addition to the proposals discussed above, I wanted to address
two recent suggestions by Mary Jo White. First, the SEC staff is
working to develop a recommendation for an antidisruptive trading rule.
\29\ In theory, such a rule has potential as a targeted solution aimed
at aggressive short-term traders. However, ``the devil is in the
details.'' While such a rule would be aimed at active proprietary
traders during specific, short time periods when the markets are most
vulnerable, basic questions will need to be addressed, such as which
traders should be restricted, during which time periods, and for which
activities. There may be some clear-cut cases, where for instance it
would be easy to craft a rule that says: ``don't short further during a
period where stock's value has declined by x.'' But it is perhaps not
as clear-cut as to whether we should impose an affirmative market-
making obligation during periods of stress. None of this is to say an
antidisruptive trading rule is undesirable; however, it would need to
be formulated carefully.
---------------------------------------------------------------------------
\29\ See Mary Jo White, Chair, U.S. Sec. and Exch. Comm.,
``Enhancing Our Equity Market Structure'', Speech at Sandler O'Neill &
Partners, L.P. Global Exchange and Brokerage Conference (Jun. 5, 2014).
---------------------------------------------------------------------------
White has also asked her staff to propose a recommendation that
would subject unregistered active proprietary traders to the SEC's rule
as dealers. \30\ Again, such a rule could potentially be an effective
tool in monitoring and regulating the behavior of harmful trading
practices. But it may be difficult to identify which ``unregistered
active proprietary traders'' should be subject to broker-dealer
requirements. We have seen similar difficulties in the new practice of
designating ``swap dealers'' under Dodd-Frank. Furthermore, a number of
these entities may be subject to oversight already. The SEC should
ensure that any registration requirements are streamlined and
coordinated.
---------------------------------------------------------------------------
\30\ Id.
---------------------------------------------------------------------------
Finally, I'd like to address the topic of decimalization. As I
mentioned up front, I eagerly await the specifics of the SEC's pilot
program on tick sizes. I would hope that the SEC pays particular
attention when applying different metrics to different types of
securities covered by the program, so as not to introduce additional
operational risk through increasingly complex trading rules for these
stocks. For example, I understand the SEC is considering dividing the
pilot into three groups of stocks, which trade at different increments
and may or may not be subject to the ``trade at'' rule. \31\ I
encourage the SEC to keep in mind the safety and soundness of our
equity markets when finalizing the design for this pilot.
---------------------------------------------------------------------------
\31\ A trade-at rule requires brokers and dark pools to route
trades to public exchanges, unless they can execute the trades at a
meaningfully better price than available in a public market. It is
unclear how the SEC would define a meaningfully better price.
---------------------------------------------------------------------------
Thank you and I look forward to your questions.
APPENDIX
The following are specific examples of allegedly predatory trading
behavior by HFTs from Flash Boys. I follow with a response to the
perceived problem posed by the example.
Example 1: On pages 74-75, the example has a customer wishing to
purchase 100,000 shares of XYZ Company at $25 per share. In this
example, 100 shares are offered on BATS for $25 and 10,000 shares are
offered by other sellers on each of ten more exchanges. Lewis suggests
that the broker's router will send the buy order to BATS first to
receive a rebate offered by BATS, even though BATS is only offering 100
shares. However, the problem then arises that once the BATS trade is
executed, the other 100,000 shares available may disappear before they
can be purchased.
This example fails to recognize how brokers actually route customer
trades in order to satisfy their ``best execution'' requirement, which
precedes Reg NMS. In practice, brokers will send orders to acquire the
100 shares on BATS and 10,000 shares on the ten other exchanges at the
same time. In fact, brokers have flexibility to actually send the order
for 100,000 shares of XYZ Company to the other exchanges slightly
before they send the 100 share order to BATS, if the broker reasonably
believes this will achieve a lower fill price for the customer's
complete order for XYZ Company.
Example 2: On pages 137-138, the example has a customer wishing to
purchase shares of IBM through a broker (Goldman Sachs in this
example). In this example, the broker is required to purchase 100
shares on BATS for $19.99 before purchasing 500 shares on the NYSE for
$20.00 due to Reg NMS. As a result, the same problem then arises that
once the BATS trade is executed, the other 500 shares available may
disappear before they can be purchased.
Again, the broker would route the 600 IBM share order to both
exchanges simultaneously. The broker even has the flexibility to route
the 500 share order to the NYSE before the 100 share order to BATS, if
the broker reasonably believes this would achieve a lower fill price
for the customer's order for IBM.
Example 3: On page 222-223, the example has a customer wishing to
purchase 100,000 shares of P&G through a broker (Bank of America in
this example). The customer is willing to pay up to $82.97. The broker
first pings IEX looking to buy 100 shares, but then fails to send a
larger order subsequently. In this example, Lewis suggests that a
seller of 100,000 shares at $82.96 could have existed at IEX, which the
broker missed. Instead the broker pings IEX with multiple 100 share
orders, thus ``goos[ing] up the price.''
The flaw with this example is that the broker does not know that
there is really a ``seller waiting on it'' for 100,000 shares.
Furthermore, if the entire 100,000 share order had been sent, and only
1,000 was executed (since the example states that there are only 1,000
shares listed), the broker would have revealed the entire size of the
order, thus dramatically ``goosing'' up the stock much more than the
100 share pings.
______
PREPARED STATEMENT OF JEFFREY M. SOLOMON
Chief Executive Officer, Cowen and Company, LLC, and Cochair, Equity
Capital Formation Task Force
June 18, 2014
Over the past few years, there has been significant debate about
the economic impact of High Frequency Trading (HFT) on the Equity
Capital Markets in the United States. Much of this discussion focuses
on the specific activities of these market participants and how the
rise in their trading activity has introduced increased risk and
volatility--even within the inner workings of equity market function.
In other words, memories of the May 2010 ``Flash Crash'' are still
fresh in the minds of market participants and fears of a repeat event
are prevalent.
However, HFT, in and of itself, is not the root cause of increased
market risk. Indeed, we would argue that the challenges surrounding HFT
are actually a symptom of a more complex market structure that promotes
and encourages potentially counterproductive trading behavior--behavior
that reduces the availability of capital for smaller capitalization
companies to expand their business and reduces liquidity for investors.
As such, any debate about the pros and cons of HFT really needs to
address the structure of the equity market that has given rise to its
existence.
Today's market structure has evolved over the past decade and half
as a result of several regulatory changes regarding trading increments,
fair access and order routing changes just to name a few. To be clear,
each of these changes was well intended and has had positive effects on
market participants. Yet there are a significant number of market
participants who have grown increasingly skeptical that the sum total
of these changes has actually resulted in a market that is holistically
better or worse.
Rather than debate that point, we are encouraging lawmakers and
regulators to explore and implement modifications to the current market
structure to further improve equity market function. In doing so, our
aim should be to accomplish objectives that further enhance the capital
markets in the United States, which are still the best in the world,
but are increasingly under siege as other global marketplaces evolve.
These goals should be clearly defined in their objectives, observable
in their outcomes, and easily modified as additional data around market
performance is gathered.
To be clear, if we remain stagnant in our approach to equity market
structure in this country, we are increasingly putting our economic
growth and private sector job creation at risk. Conversely,
improvements to the equity market function will not only improve the
market experience for all participants, but it will continue to foster
the kind of economic activity that has been the hallmark of the
American Experience since the outset of the Industrial Revolution.
Later in this testimony, we will lay out specific observations around
market structure that we strongly believe are inhibiting capital
formation in industries that are vital to the continued economic growth
of the United States.
In making assessments about market structure, we have encouraged
regulators and legislators to be balanced and thoughtful in their
approach, while attempting to implement change. With just about any
market-developed convention, there are both positive and negative
aspects to the presence of electronically driven trading firms that
utilize algorithmic-based programs to identify profit opportunities and
execute upon them. One such positive is that many market participants
who engage in High Frequency Trading are able to generate profits at
very thin trading spreads. This attribute has led to a significant
reduction in transaction processing and execution costs which has
translated into lower commissions paid by all market participants.
However, in the quest to accomplish this goal, we have created a
highly fragmented marketplace that is quite hostile to the vital
functions necessary to promote the capital formation that leads to
private sector job growth. Not only has there been a substantial
decline in small company IPOs over the past decade-and-a-half
(transactions raising $60 million or less), but many small-cap public
companies have also suffered from a lack of capital formation which has
inhibited their ability to raise capital efficiently leading to limited
job creation, innovation, and investment opportunities stemming from
startups and small companies.
For this reason, a group of market participants representing a
cross section of the startup and small-cap company ecosystem formed the
Equity Capital Formation (ECF) Task Force to examine the challenges
that America's startups and small-cap companies face in raising equity
capital in the current public market environment and develop
recommendations for policy makers that will help such companies gain
greater access to the capital they need to grow their businesses,
create new industries, provide increased competition to the markets,
and ultimately create private sector job growth.
The attached report from the ECF Task Force, ``From the On-ramp to
the Freeway: Refueling Job Creation and Growth by Reconnecting
Investors With Small-Cap Companies'', was presented to the United
States Treasury in November, 2013, and sets out two areas for
consideration: (1) the implementation of a pilot program aimed at
increasing liquidity in small-cap stocks by fostering a simpler, more
orderly market structure for trading small-cap stocks and (2) the
expansion of access to capital for small startups and micro-cap
companies by completing the regulatory changes outlined in the JOBS Act
relative to Regulation A+ and resolve conflicts with state laws. These
recommendations are designed to enhance capital formation for small
companies while balancing the needs of investor protection and
preserving many of the important improvements made to the market
structure to which we have become accustomed.
The United States' one-size-fits-all capital markets ecosystem
makes capital formation for small-cap companies challenging. Today's
market structure is marked by speed of execution, lower transaction
costs and sub-penny increments, which favors liquid, large-cap stocks
and inadvertently fosters illiquidity in small-cap stocks where the
benefits of High Frequency Trading are less obvious. As we discuss in
the attached report, for many small-cap investors, true price discovery
and market depth are of greater importance than speed of execution.
Indeed, the current market structure which favors speed over price
discovery is highlighted as a key reason why institutional investors,
who are the primary providers of capital for small companies, have
remained on the sidelines--forgoing investment in this critical
ecosystem because the risk of position illiquidity is too great.
A well-designed pilot trading program that allows for a true
empirical test of the effects of wider spreads and limited increments
in small-cap stocks will encourage fundamental buyers and sellers to
meaningfully engage with each other, bringing the volume and depth
necessary to enhance liquidity in the small-cap market. These proposed
recommendations would extend to approximately 2 percent of the average
daily market volume and would certainly be worth the upside of greatly
expanded economic activity. Importantly, long-term market structure
changes in the small-cap market will cause other market participants to
adjust their trading practices and/or business models accordingly.
The health of the U.S. capital markets system is critical to
driving private sector job growth and by extension, America's future
prosperity. As stewards of this system and the public interest,
policymakers and market participants have a duty to ensure that our
markets remain fair and orderly, and that their benefits reach the
largest number of Americans possible.
We have the opportunity to reexamine the current market structure
as it relates to small companies and address some of the remaining
barriers to accessing growth capital to further support the momentum
generated by the success of the JOBS Act. We can support the growth of
America's most promising private and public growth companies by
allowing them to access the capital markets to fund their growth,
create new industries and provide increased competition to the markets.
We owe it to those seeking jobs and those small companies creating
opportunities to try to adjust a small part of the market in order to
bring job opportunities to those hard working individuals. And we can
do it without sacrificing many of the benefits that many investors
enjoy that were brought about by the advent of the current
electronically driven market structure.
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PREPARED STATEMENT OF ANDREW M. BROOKS
Vice President and Head of U.S. Equity Trading, T. Rowe Price
Associates, Inc.
June 18, 2014
Introduction
Chairman Warner, Ranking Member Johanns, and distinguished Members
of the Senate Subcommittee on Securities, Insurance, and Investment,
thank you for the opportunity to testify today on behalf of T. Rowe
Price \1\ regarding the impact of high frequency trading (HFT) on the
economy. My name is Andrew (Andy) M. Brooks. I am Vice President and
Head of U.S. Equity Trading of T. Rowe Price Associates, Inc. I joined
the firm in 1980 as an equity trader and assumed my current role in
1992. This is my 34th year on the T. Rowe Price trading desk.
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\1\ T. Rowe Price Associates, Inc., a wholly owned subsidiary of
T. Rowe Price Group, Inc., together with its advisory affiliates
(collectively, ``T. Rowe Price''), had $711.4 billion of assets under
management as of March 31, 2014. T. Rowe Price has a diverse, global
client base, including institutional separate accounts; T. Rowe Price
sponsored and sub-advised mutual funds, and high net worth individuals.
The T. Rowe Price group of advisers includes T. Rowe Price Associates,
Inc., T. Rowe Price International Ltd, T. Rowe Price Hong Kong Limited,
T. Rowe Price Singapore Ltd., T. Rowe Price (Canada), Inc., and T. Rowe
Price Advisory Services, Inc.
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T. Rowe Price, founded in 1937, is a Baltimore-based global adviser
with $711.4 billion in assets under management as of March 31, 2014 and
serving more than 10 million individual and institutional investor
accounts.
We welcome the opportunity for discussion regarding the industry
and market practices.
Since I last testified before this Committee in September 2012, we
have seen considerable turnover in Congress, this Committee, and at the
U.S. Securities and Exchange Commission (``SEC'', or the
``Commission''); however, there has been little change in addressing
the issues discussed 21 months ago, although we do applaud the SEC's
efforts in implementing limit up and limit down controls and developing
the Consolidated Audit Trail. Additionally, we are encouraged by Chair
Mary Jo White's recent comments suggesting a heightened focus on
improving market structure and we appreciate this Committee's continued
interest in improving our markets. However, order routing practices,
payment for order flow, maker/taker pricing, market data arbitrage, and
the myopic quest for speed are all issues that remain unaddressed. In
addition, we have grown increasingly concerned about the growth of dark
pools and the challenges of the direct ``fast'' feed operating
alongside the ``slow'' Securities Information Processor (SIP) feed. We
recognize that change in Washington is constant, but would like to
emphasize the fact that the fundamental market structure issues we face
as an industry are ever evolving and are incapable of being resolved
without regulatory intervention.
Although this hearing is focused on HFT, we believe HFT is merely
symptomatic of larger market structure problems. We are cautious not to
lump all electronic trading into the class of HFT and further, we do
not believe that all HFT is detrimental to the market. We are
supportive of genuine market making; however, we acknowledge that there
are predatory strategies in the marketplace that have been enabled by
our overly complex and fragmented trading markets. Those parties
utilizing such strategies are exploiting market structure issues to
their benefit and to the overall market's and individual investor's
detriment.
We question whether the functional roles of an exchange and a
broker-dealer have become blurred over the years creating inherent
conflicts of interest that may warrant regulatory action. It seems
clear that since the exchanges have migrated to ``for-profit'' models,
a conflict has arisen between the pursuit of volume (and the resulting
revenue) and the obligation to assure an orderly marketplace for all
investors. The fact that 11 exchanges and over 50 dark pools operate on
a given day seems to create a model that is susceptible to manipulative
behaviors. If a market participant's sole function is to interposition
themselves between buyers and sellers we question the value of such a
role and believe that it puts an unneeded strain on the system. It begs
the question as to whether investors were better served when exchanges
functioned more akin to a public utility. Should exchanges with de
minimus market share enjoy the regulatory protection that is offered by
their status as exchanges, or should they be ignored?
Additionally, innovations in technology and competition, including
HFT, have increased market complexity and fragmentation and have
diluted an investor's ability to gauge best execution. For example, in
the race for increased market share, exchanges and alternative trading
venues continue to offer various types of orders to compete for
investor order flow. Many of these order types facilitate strategies
that can benefit certain market participants at the expense of long-
term investors and, while seemingly appropriate, often such order types
are used in connection with predatory trading strategies. We are
supportive of incremental efforts, such as a recent initiative by the
New York Stock Exchange to eliminate 12 order types from their
offerings.
We also believe that increased intraday volatility over the past
few years is symptomatic of an overly complex market. Though commission
rates and spreads have been reduced, intraday volatility continues to
be alarmingly high. It was refreshing to see a recent report from RBC
Capital Markets \2\ examining the impact of intraday volatility and
exposing the high costs to investors. Most academics only look at close
to close market volatility.
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\2\ Bain, S., Mudassir, S., Hadiaris, J., and Liscombe, M. (2014).
RBC Capital Markets, ``The Impact of Intraday Volatility on Investor
Costs: Insights Into the Evolution of Market Structure'', RBC Capital
Markets.
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Increased market complexity results in a lack of investor
confidence. Our firm is particularly focused on the interests of long-
term investors although we appreciate the role other types of investors
can have in creating a dynamic marketplace. A recent Gallup poll noted
that American household ownership of stocks continues to trend well
below historic norms. \3\ One can never be sure what drives investor
behavior, but it seems clear to us that we need to do a better job of
earning investor's confidence in the market. Those investors who have
stayed on the sidelines in recent years, for whatever reason, have
missed out on significant equity returns. We worry that the erosion of
investor confidence can undermine our capital markets, which are so
important to the economy, job growth, and global competitiveness. Re-
affirming a strongly rooted commitment to fairness and stability of the
market's infrastructure is critically important.
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\3\ ``U.S. Stock Ownership Stays at Record Low''. (n.d.). ``U.S.
Stock Ownership Stays at Record Low''. Retrieved June 17, 2014, from
http://www.gallup.com/poll/162353/stock-ownership-stays-record-
low.aspx.
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Over the past two decades the markets have benefited from
innovations in technology and competition. Generally, markets open at
9:30 a.m., close at 4:00 p.m., and trades settle efficiently and
seamlessly. The markets function in an orderly fashion, but if one were
designing a market from scratch we doubt that we would end up with the
overly complex structure we have today.
Vibrant and robust markets function best when there are varied
investment opinions, styles, and approaches. However, given the myriad
of ways to engage in the markets, we feel that investors would benefit
from an increased focus on market structure, particularly features that
enable predatory and manipulative practices. We applaud looking into an
enhanced oversight of HFT and other high frequency strategies and
conflicts of interest in our current market structure. Disruptive HFT
strategies are akin to a tax loophole that has been exploited and needs
to be closed. Market participants utilizing such strategies are
essentially making a riskless bet on the market, like a gambler who
places a bet on a race that's already been run and for which he knows
the outcome.
Suggestions
In the spirit of advancing the interests of all investors we might
make the following suggestions:
A good first step might be to experiment with a number of pilot
programs to examine different structural and rule modifications. We
envision a pilot program where all payments for order flow, maker-taker
fees, and other inducements for order flow routing are eliminated. We
also envision a pilot that incorporates wider minimum spreads and some
version of a ``trade at'' rule, which we believe would lead to genuine
price improvement. These programs should include a spectrum of stocks
across market caps and average trading volumes, among other factors.
Additionally, we would advocate for a pilot program that would mandate
minimum trade sizes for ``dark pools.'' ``Dark pools'' were originally
constructed to encourage larger trading interests and it seems perverse
that many venues on the ``lit'' markets or exchanges have a larger
average trade size than ``dark pools''.
HFT and market structure issues were recently brought into the
public spotlight by Michael Lewis and his book Flash Boys. \4\
Sometimes it takes a storyteller like Mr. Lewis to bring the attention
needed to an issue, and we hope that all parties involved will come
together and seize this opportunity to improve our markets. Again, we
would advocate for pilot programs to test and ultimately implement
measured yet significant changes. At the end of the day we are here
because of our firm commitment to all investors to ensure that the
capital markets perform the functions for which they were designed-
capital formation for companies and investment opportunities for both
institutions and individuals.
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\4\ Lewis, M. (2014). Flash Boys: A Wall Street Revolt. New York:
W.W. Norton & Company, Inc.
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On behalf of T. Rowe Price, our clients, and shareholders, I want
to thank the Committee for the opportunity to share our views on how we
can, together, make our markets as good as they can be.
Additional Material Supplied for the Record
ILLUSTRATIONS OF MINIFLASH CRASHES FROM MAY 13, 2014, SUBMITTED BY
CHAIRMAN WARNER
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STATEMENT SUBMITTED BY GREG MILLS, HEAD OF GLOBAL EQUITIES DIVISION,
RBC CAPITAL MARKETS
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