[Senate Hearing 113-478]
[From the U.S. Government Publishing Office]
S. Hrg. 113-478
THE ROLE OF REGULATION IN SHAPING EQUITY MARKET STRUCTURE AND
ELECTRONIC TRADING
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED THIRTEENTH CONGRESS
SECOND SESSION
ON
EXAMINING THE INFLUENCE OF REGULATION ON THE GROWTH OF MARKET
STRUCTURE, THE SYSTEMS AND OPERATION OF MARKET PARTICIPANTS AND THE
DEVELOPMENT OF BUSINESS PRACTICES RELATED TO HIGH-FREQUENCY TRADING,
ELECTRONIC MARKETS AND AUTOMATED TRADING
__________
JULY 8, 2014
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
Available at: http: //www.fdsys.gov /
______
U.S. GOVERNMENT PUBLISHING OFFICE
91-300 PDF WASHINGTON : 2015
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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
Laura Swanson, Deputy Staff Director
Glen Sears, Deputy Policy Director
Brett Hewitt, Policy Analyst and Legislative Assistant
Greg Dean, Republican Chief Counsel
Jelena McWilliams, Republican Senior Counsel
Dawn Ratliff, Chief Clerk
Taylor Reed, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
(ii)
C O N T E N T S
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TUESDAY, JULY 8, 2014
Page
Opening statement of Chairman Johnson............................ 1
Opening statements, comments, or prepared statements of:
Senator Crapo................................................ 2
Senator Heller............................................... 3
Senator Reed
Prepared statement....................................... 41
WITNESSES
Jeffrey Sprecher, Chairman and CEO, Intercontinental Exchange,
Inc............................................................ 4
Prepared statement........................................... 41
Kenneth C. Griffin, Founder and Chief Executive Officer, Citadel
LLC............................................................ 5
Prepared statement........................................... 43
Kevin Cronin, Global Head of Trading, Invesco, Ltd............... 6
Prepared statement........................................... 48
James J. Angel, Ph.D., CFA, Associate Professor of Finance,
Georgetown University McDonough School of Business............. 8
Prepared statement........................................... 51
Tom Wittman, Executive Vice President and Global Head of
Equities, NASDAQ OMX Group, Inc................................ 23
Prepared statement........................................... 60
Joe Ratterman, Chief Executive Officer, BATS Global Markets, Inc. 24
Prepared statement........................................... 62
Response to written question of:
Senator Brown............................................ 123
David Lauer, President and Managing Partner, KOR Group LLC....... 26
Prepared statement........................................... 69
(iii)
THE ROLE OF REGULATION IN SHAPING EQUITY MARKET STRUCTURE AND
ELECTRONIC TRADING
----------
TUESDAY, JULY 8, 2014
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:04 a.m., in room SD-538, Dirksen
Senate Office Building, Hon. Tim Johnson, Chairman of the
Committee, presiding.
OPENING STATEMENT OF CHAIRMAN TIM JOHNSON
Chairman Johnson. I call this hearing to order. Good
morning. Today the Committee will examine equity market
structure. It is a complicated topic, and a whole new
vocabulary is needed to understand market structure and
electronic trading. Words like ``dark pool,'' ``high-frequency
trading,'' and ``data feed'' are pieces to understanding the
market puzzle. Even experts disagree on the details of how the
markets work and what issues and problems exist.
In less than a decade, the stock market has moved from
being dominated by two exchanges to an extremely competitive
but fragmented marketplace with 11 stock exchanges and over 40
private alternative trading centers, increasing complexity and
instability in the system. However, many rules and market
conventions date back to the days of less complex markets.
The regulatory environment has to recognize the new
electronic trading landscape, one where institutions,
individuals, market makers, and traders interact at high-speed
over dozens of connected markets. The benefits of lower costs
and more efficient trading are important, but fairness and
market resilience are also vital and should continue to be
examined.
Additionally, while we have seen a sizable stock market
rally since the Flash Crash 4 years ago, we also hear reports
of declining stock market investment and loss of faith by
individual investors. Many reasons have been suggested, but
doubts about market integrity and market stability are heard
too often.
Although many market participants call for reform, they
often disagree as to where that reform should occur. Any path
to reform must be built on good data and the goals of
preserving a competitive market and the interests of long-term
investors, while protecting the market from future disruptions.
I am encouraged to see the SEC move forward with a
comprehensive review of market structure and an initiative for
small company stocks that recognizes one size does not fit all.
But pilots and reviews are just a first step. I want to see
urgent and thorough attention given to the market structure
review so that any corrective measures that would help restore
trust in the fairness of our markets are taken as quickly as
possible.
I look forward to the witnesses' testimony today as the
Committee examines whether today's market structure has the
right kind and amount of regulation to maintain a stable,
competitive, and efficient marketplace and what additional
measures would be useful.
With that, I turn to Ranking Member Crapo for his opening
statement.
STATEMENT OF SENATOR MIKE CRAPO
Senator Crapo. Thank you, Mr. Chairman.
The U.S. capital markets are vital to the continued growth
of our economy. I have repeatedly stressed the need for the
U.S. financial system and markets to remain the preferred
destination for investors throughout the world. This hearing
will examine the role of regulation in shaping today's markets
as well as whether these markets are as resilient and stable as
they should be, given the rising different types of technology
and automated trading.
Recent news about the practices of certain market
participants and automated trading has raised concerns as to
whether the stock market is rigged against small investors. SEC
Chair White recently stated her view that the market is not
rigged, but there is a need to review the current equity market
structure, and such a review should be disciplined and
conducted in a data-driven manner.
While much has been made recently of the potential dangers
of automated trading, what is often forgotten is that
technology and innovation has benefited investors by leading to
tighter spreads, lower costs, and more efficient markets.
Today an individual retail investor has an easier time
participating in our stock market than at any time in the
history of these markets. With fees under $10 a trade, the
spreads between bid and ask prices for most stocks as narrow as
they have ever been, and with trading being done in a matter of
sub-seconds rather than minutes, retail investors have been
able to enjoy greater involvement in and access to the markets.
To continue this level of investor participation, we must
ensure that the markets have the resiliency and the
capabilities to handle the evolving speed and complexity of
today's trading world. I am encouraged by speeches and comments
given by SEC Chair White and other SEC Commissioners
acknowledging both the positive and negative roles that SEC
regulations played in shaping today's market structure, as well
as an appetite to address unintended consequences of those
regulations.
As evidenced by today's testimony and by the academic
discussions of the U.S. markets, many of the concerns raised by
market participants and investors are the outgrowth of the SEC
Regulation NMS and the overall patchwork approach to market
trading infrastructure and stability taken by the SEC in the
past.
It is important and prudent for regulators to periodically
review the regulations to ensure that they are still
appropriate in today's automated world. However, any such
holistic review of regulations should be based on empirical
analysis, should be data driven, and incorporate the input of
market participants, industry, and the investors who make the
investments. Everyone should have a seat at the table in this
important discussion, and everyone must be willing to roll up
their sleeves to find the right solutions.
I am particularly interested in the panel's views on
whether the benefits to the market participants and investors
from the rapid expansion of various trading venues and
increased competition have been outweighed by the strain to the
market infrastructure. I am also interested in what can be done
to build better markets for smaller companies. And what further
measures do market participants and trading venues need to take
to minimize market disruptions and increase the resiliency and
durability of the systems?
Investor confidence is the key. Our markets cannot afford
another Flash Crash or major market disruption. I look forward
to hearing from today's panelists about their thoughts on
potential enhancement to market structure and integrity and
hope to hear from them about what changes they believe are
appropriate.
Thank you, Mr. Chairman.
Chairman Johnson. Thank you, Senator Crapo.
Would any of my colleagues like to make a brief opening
statement?
Senator Heller. Chairman Johnson?
Chairman Johnson. Senator Heller.
STATEMENT OF SENATOR DEAN HELLER
Senator Heller. Thank you very much. Mr. Chairman, also
thanks to the Ranking Member for this hearing today. I want you
to know that in my previous life I worked as a trader on the
Pacific Stock Exchange, specifically the L.A. Floor, which goes
to show you how old I am. That floor, because of progress, does
not even exist anymore. Needless to say, I may be one of only a
handful of Senators here serving currently that has passed the
Series 7 exam.
Recently, SEC Chair Mary Jo White stated that ``the U.S.
markets are the strongest and most reliable in the world'' and
that ``the retail investor is very well served by the current
market structure,'' and I end the quote with that. While I have
concerns about the potential bubbles in the equity market
caused by quantitative easing, structurally today's markets are
very beneficial for retail investors with spreads for many
stocks, typically a penny or less, and access to markets has
never been easier, and commissions to trade are at all-time
lows.
While there has been much debate about the new methods of
trading, I would caution any desires to roll back the
technology clock. With every new Internet-based technology, I
believe that we must ensure proper safeguards while maintaining
an environment that continues to promote new financial
technologies and innovative growth.
U.S. markets have changed greatly since I left the trading
floor, and this hearing will help the public better understand
today's competitive modern markets, and I look forward to
hearing from our witnesses on what can be done to increase
investors' confidence and further promote market stability.
Mr. Chairman, thank you for the opening statement.
Chairman Johnson. Thank you.
Would anybody else like to make a brief opening statement?
Senator Moran. Mr. Chairman?
Chairman Johnson. Yes.
Senator Moran. Mr. Chairman, thank you. I just want to
welcome fellow Kansan Joe Ratterman who will be on the second
panel testifying this afternoon. I appreciate you including him
in today's hearing.
Chairman Johnson. Yes. Before we begin, I would like to
apologize to my colleagues and the witnesses on the second
panel, but I will have to excuse myself after the first panel
due to a prior engagement. I thank my good friend Senator Reed
for agreeing to take over the gavel for the second panel and
will follow up with the witnesses later if I have any further
questions.
With that, I would now like to introduce our witnesses on
the first panel.
Mr. Jeffrey Sprecher is the Chairman and Chief Executive
Officer at Intercontinental Exchange.
Mr. Kenneth Griffin is the Chief Executive Officer at
Citadel.
Mr. Kevin Cronin is Global Head of Trading at Invesco.
Dr. James Angel is an Associate Professor of Finance at the
Georgetown University McDonough School of Business.
Mr. Sprecher, please begin your testimony.
STATEMENT OF JEFFREY SPRECHER, CHAIRMAN AND CEO,
INTERCONTINENTAL EXCHANGE, INC.
Mr. Sprecher. Chairman Johnson, thank you for having me,
along with Ranking Member Crapo and the Members of the
Committee. I appreciate the opportunity to testify.
By way of background, in just 14 years my company, which is
known as ICE, grew from a startup in Atlanta to become one of
the world's largest marketplaces, and today we operate 11
exchanges and 5 clearinghouses in the United States, Canada,
the United Kingdom, continental Europe, and Asia; and most
recently we acquired the New York Stock Exchange. None of this
would have been possible for us without our ability to raise
funds in the U.S. capital markets, which I believe are the best
in the world for entrepreneurs like me that seek to build
companies. And much of our growth can be attributed to trying
to make capital raising and risk management more accessible and
more transparent. We have inevitably faced head winds as a
result of challenging the status quo, but we believe very
strongly in that vision.
The United States has a number of regulatory policies that
were intended to improve markets but, we believe, need to be
revisited in light of evolving industry practices. And so we
offer five recommendations that we hope can be quickly adopted.
Number one, we believe we should enhance order competition
by giving deference to regulated, transparent trading centers
where orders compete with one another and contribute to
providing price discovery information to all others.
Second, we would eliminate and ban maker-taker pricing
schemes at trading venues. Rebates that were once used to
encourage participants to quote have evolved and now add too
much order complexity and add the potential for conflicts of
interest in our market.
Third, we would lower the statutory minimum cap on exchange
fees that exist within Regulation NMS. So in combination with
giving deference to regulated and transparent markets and
eliminating maker-taker rebates, we believe that the SEC should
require lower maximum fees, including on my company, the New
York Stock Exchange.
Fourth, we should revamp the current market data delivery
system to promote fairness. We support the SEC's examination of
the current Securities Information Processors and the
proprietary data feeds to adopt new policies.
And, last, we should require increased transparency by
having the SEC demand that all trading centers report trade
executions in real time and all routing practices be disclosed
by trading centers and the brokers who touch customer orders.
So, in summary, my firm's proposed solutions are based on
reducing complexity, reducing conflicts of interest, and
treating people fairly when investing in the U.S. markets.
Thank you again for inviting me to testify, and I look
forward to answering your questions.
Chairman Johnson. Thank you.
Mr. Griffin, please begin your testimony.
STATEMENT OF KENNETH C. GRIFFIN, FOUNDER AND CHIEF EXECUTIVE
OFFICER, CITADEL LLC
Mr. Griffin. Chairman Johnson, Ranking Member Crapo,
Members of the Committee, I am Kenneth Griffin, the founder and
CEO of Citadel. I appreciate the opportunity to be here today
to testify.
Citadel's experience as both an institutional investor and
a leading market maker gives us deep insight into the strength,
structure, and resilience of our markets today. I can say
without hesitation that the U.S. equity markets are the
fairest, most transparent, resilient, and competitive markets
in the world.
Over the past two decades, a wave of innovation has swept
through the markets in response to new technologies and
thoughtful regulation. Simply put, today's markets are faster,
they are better, and they are incredibly competitive. The cost
of trading has plummeted for investors.
That said, we can further improve our equity markets. In my
written testimony I have included a more detailed list of
suggestions, but I would like to highlight a few.
First, we can and should take steps to increase the
resiliency of our markets. The SEC should require mandatory
exchange-level kill switches and ensure that exchanges have
clear authority and responsibility to block and stop aberrant
activity before it adversely impacts the markets. The activity
of a large number of market participants intersects on
exchanges, and exchanges are thus best positioned to
efficiently and constantly oversee trading activity.
Second, we believe the SEC should require brokers to
publicly report consistent, standardized execution quality
metrics in a way that allows retail investors to easily compare
performance. We can empower retail investors with information
about brokers' execution quality and position them to make
informed choices. We recommend that the SEC require all
execution quality reports to be comprehensive, understandable,
and made available for at least 3 years. Investors can then
track the quality of executions over time and hold their
brokers accountable.
Third, dark pools should be subject to the same anti-
discrimination rules that our securities exchanges are subject
to and should be required to offer fair and impartial access to
all market participants. In recent years, increasing amounts of
trading have taken place on dark pools. While public quotes on
exchanges are available to all investors, this is not
necessarily the case for liquidity present on dark pools. In
fact, dark pools may refuse access, give execution priority,
and charge different fees to different market participants.
Dark pools should only be allowed to determine execution
priority based on the characteristics of an order, such as
price, size, and time of arrival, and should not be allowed to
allocate executions based upon the identity of the
participants.
For example, broker preferencing is a practice that could
return our markets to the old boys' network of prior decades
when who you were and who you know mattered more than the
merits of your order.
Fourth, I agree with Jeff that the maximum fee of 30 cents
per 100 shares that is charged to access exchange liquidity is
now significantly greater than the cost of providing matching
services by the exchanges and should be reduced to reflect
today's competitive reality. We believe a reduction in the
minimum tick size for the most liquid low-priced securities,
combined with a reduction in the maximum permitted access fee,
would best serve the interests of all investors.
There are other important steps that we should take to
enhance market quality, improve market resilience, and
strengthen investor protections. However, we must pursue this
agenda without sacrificing the extraordinary achievements we
have made for investors in terms of market efficiency, lower
costs, increased transparency, increased fairness, and
competitiveness over the prior two decades.
Thank you for the opportunity to testify before this
Committee today. We commend the Committee and the SEC for
taking a data-driven and comprehensive review of U.S. equity
markets and look forward to a robust dialogue. And I would be
happy to answer your questions.
Chairman Johnson. Thank you.
Mr. Cronin, please proceed.
STATEMENT OF KEVIN CRONIN, GLOBAL HEAD OF TRADING, INVESCO,
LTD.
Mr. Cronin. Thank you very much for the opportunity to be
here today on behalf of Invesco, a global asset management firm
with $790 billion of assets under management. We serve
individuals who are saving for their retirement and other
personal financial needs. These are long-term investors, and
they are the cornerstone of our Nation's capital formation
process. Retaining their confidence is fundamental to well-
functioning U.S. equity markets.
We need to make sure that those markets are highly liquid,
transparent, fair, stable, and efficient. Due to regulatory
changes and developments in technology, there is robust
competition among exchanges and alternative execution venues.
These changes have benefited investors in the former of lower
commissions, spreads, and implicit transaction costs, which
have in turn enhanced the liquidity in the markets.
But there are unintended consequences which have unleveled
the playing field. These include:
Market fragmentation. Markets have become too complex and
fragmented, not because they need to be but, rather, because we
have allowed them to become so. This complexity has contributed
to a number of technological mishaps which shake investor
confidence. Sophisticated participants can get an unfair
advantage over ordinary investors, for example, when exchanges
sell direct data feeds that allow certain market participants
to more quickly act on trading information.
Fragmentation also means that the rules governing
securities exchanges are very different for those governing
alternative trading venues, including dark pools. Determining
which execution venue will lead to the best trading outcome can
be very difficult even for a firm like Invesco.
Conflicts of interest. As much as 35 to 40 percent of all
trading activity today now takes place away from the exchanges,
which has weakened the robust price discovery that is an
essential element of an efficient market. The movement away
from the exchanges is partly the result of broker-dealer
routing practices such as internalization and the proliferation
of alternative trading venues. Much of this is due to two
inherent conflicts of interest.
The first is the broker-dealer's interest in capturing
liquidity rebates associated with the so-called maker-taker
pricing model and other inducements, including payments for
order flow.
The second is a broker-dealer's interest in avoiding paying
access fees to take liquidity from other trading venues. A
broker tries to keep as many trades as possible within its own
internalized system, including its own dark pools. This can
driven order-routing decisions that may be at odds with their
clients' best execution interest.
High-frequency trading. High-frequency trading is not bad
in itself, but there are certain strategies that can be unfair.
These strategies have arisen as a result of technology, market
fragmentation, and a lack of uniform regulation. Also, high-
frequency trading appears to focus primarily on large-cap
securities. This increases trading volumes, but it is not clear
that it creates real liquidity. Moreover, while market makers
historically have provided valuable liquidity for mid- and
small-cap stocks, they have not benefited from the evolution of
market structure.
To be clear, there is much about today's markets that
benefit all investors. However, Invesco advocates that
regulators take steps to address certain unintended
consequences. To restore a level playing field in the markets,
and to restore investor confidence in the fairness and
transparency of the markets, we recommend: requiring broker-
dealers to provide greater disclosure about order routing;
ensuring the market data is fairly disseminated to all
participants; eliminating the maker-taker pricing model and
reducing access fee caps; harmonizing the regulation of all
trading venues; requiring that all high-frequency traders be
effectively regulated; instituting a pilot program for a
comprehensive trade-at rule; and facilitating market-making
activities for mid- and small-cap stocks.
Thank you again for your attention to these important
issues, and I look forward to answering any questions that you
may have.
Chairman Johnson. Thank you.
Professor Angel, please begin your testimony.
STATEMENT OF JAMES J. ANGEL, Ph.D., CFA, ASSOCIATE PROFESSOR OF
FINANCE, GEORGETOWN UNIVERSITY McDONOUGH SCHOOL OF BUSINESS
Mr. Angel. Thank you. And, first of all, I want to thank
the Committee because you are asking exactly the right
questions. If you get regulation right, the regulators will get
the details right, and you will not have to worry about whether
the kill switches are properly designed or not.
The problem is we have a very fragmented and broken
regulatory structure. We have literally hundreds of different
financial regulatory agencies at the State and Federal levels,
and they do not always play nicely together. Stuff falls
between the cracks. There are turf battles. Nobody with a clean
sheet of paper would design a regulatory structure like we have
now.
Let me give you just a few examples of this dysfunction.
And, first of all, I want to state very clearly it is not the
fault of the people who work at the regulatory agencies. Most
of them are very smart, hard-working people, diligently trying
to do what Congress has told them to do.
But look at the JOBS Act, a bipartisan bill to create jobs.
Everything in the JOBS Act could have been done by the SEC with
its own pre-existing authority, but they chose not to. You
know, as an institution, they were incapable of understanding
the problems and acting on them in a timely manner.
If you look at the implementation of the Volcker rule,
there are four different agencies trying to figure out how to
implement it.
If you look at the Flash Crash, look at how long it took to
try to figure out what happened in that situation. And there is
controversy that they still have not figured it out.
But when we have a regulatory system that cannot enforce
existing laws, when investors complain to the SEC about obvious
rule violations and nothing happens, that zaps investor
confidence more than anything else.
In my written remarks, I provide a few details about a case
of which I have some personal knowledge, the case of W2007
Grace Acquisition I. To make a long story short, for over a
year there has been an issue proceeding at the Commission as to
whether this company should be required to file financial
statements. You know, under the rule, if they have more than
300 shareholders of record, they should be filing financial
statements.
Well, you would think that the SEC would be able to count
to 300 in less than a year, and, you know, there are many other
apparent violations going on there, but when investors report
rule violations, legal violations, and nothing happens, that
kills investor confidence.
Now, as far as the equity market structure goes, what we
have today is pretty much what Congress ordered in 1975 in the
National Market System Amendments to our Exchange Act. Congress
said: Give us competition among exchanges, between exchanges
and off-exchange trading platforms, a place where investors can
trade with each other without going through a dealer. And so
what we have today is something that is an open architecture
market, and that is a good thing. Any innovator can plug in a
new system if they think they have a better solution, because
the trading problem has not yet been solved. Trading is a lot
more than just matching limit orders. And we need a system
where we can continue to have a lot more innovation and
experimentation.
Now, the rest of the world, if you look around the world,
they are copying our market structure. You know, they are going
to a competitive system where you have for-profit exchanges,
because if you do not want a monopoly, you need competition. If
you want competition, profit is a great motive. But they are
not copying our regulatory structure.
Now, there are a lot of market practices that are very
controversial. I would like to add that using high-speed
computers is neither good nor bad. Some of the strategies, like
market making and ETF arbitrage, help low-frequency retail
investors like me. Others, you know, like order ignition and
excess cancellation strategies, are harmful and should be
curtailed.
We need regulators who are smart enough to understand what
is going on, to know the difference between the good and the
bad, and have the resources to get the bad out while keeping
the good in.
Now, as far as technical stability goes, we are in trouble.
Our market is a complex technological system. There is nothing
we can do about that. That is the modern world. And complex
technological systems fail in weird and strange ways. Most of
the regulatory focus has been on making individual parts work
well, but not in dealing with what happens when the parts do
not work together nicely. So more work needs to be done there.
So there is a lot more that needs to be done, but the most
important thing Congress can do is start the process of overall
structural reform. But in the meantime, what you can do is you
can make sure that our regulators have the resources they need
to do their job. If you look at how much we have spent on the
SEC since the beginning of time, it is less than investors have
lost from one Bernie Madoff. But you need to monitor them to
make sure that they spend those resources properly. You need to
make sure that they have enough people with degrees in
economics, business, engineering, computer science. You need to
make sure they have more people who have passed the Series 7,
they have more people with real work experience, more people
who are CFAs or CPAs. They have got enough lawyers. They need
people with market experience.
So I have got plenty of other things, but I would like to
finish up by saying, hey, if we do not fix regulation, we will
be saddled with a system which is more expensive than it has to
be, both in terms of direct cost to the taxpayer as well as
compliance costs; we will have a system which will not protect
investors as well as it should; we will have a system that will
not permit capital formation, and that means less jobs.
Thank you very much.
Chairman Johnson. Thank you all.
As we begin questions, I will ask the Clerk to put 5
minutes on the clock for each Member.
Mr. Sprecher, as the operator of equity and derivatives
markets while maintaining a competitive marketplace, what can
the equity markets learn from the derivatives markets?
Mr. Sprecher. That is a very good question. I think the
main difference in U.S. equity markets and U.S. commodity and
derivatives markets is that in U.S. commodity and derivatives
markets, investors can choose where they trade. While we all
have talked a lot about the competition in U.S. stocks with
many different trading venues, the reality is neither you nor I
can choose where our orders are routed. And as a result of
that, we have third parties that are making those decisions for
us, oftentimes potentially not in our best interest.
What we have seen in the commodities markets is that when
investors have a choice, they want obviously low transaction
costs, honest brokers, and also they want to find the most
buyers and sellers. So they tend to gravitate to a fewer number
of highly competitive exchanges and trading venues. It is
competitive but it is not fragmented.
In the equity markets, because you and I and even
institutional managers like Mr. Cronin do not have an
opportunity to choose where we trade, consequently we have a
lot of other interests that cause fragmentation.
Chairman Johnson. Mr. Griffin, do you think market-maker
obligations should be revisited?
Mr. Griffin. Market makers have obligations that are
mandated by each exchange on which they trade, and today in the
U.S. equities market, if you are a NASDAQ market maker, for
example, you must provide a continuous two-way quote.
The largest market makers also have a commercial reality
that they service the important retail investors, institutional
investors in the United States, and those investors have a very
high expectation of continuous liquidity being provided, and it
is done so by the largest market makers.
Chairman Johnson. Mr. Cronin, what do you think?
Mr. Cronin. Market makers are invaluable participants in
the market structure. Efficient markets are made from the
participation of all kinds of different participants. While I
might recommend that investors like ourselves are probably the
most important component, having a robust market-making
structure is very important as well. We are concerned that the
one-size-fits-all proposition that the market structure is
today does not appropriately address the needs of mid-cap and
small-cap stocks. So as part of our recommendations, we would
like to work with regulators and market makers and other market
participants to really get to some ideas that will facilitate
that.
Today we know that there are a lot of people who portend to
be market makers, but it is unclear to us whether this is
really just trading volume or if it is real liquidity. And we
need to ensure that our markets are liquid at all levels and
all market capitalizations.
Chairman Johnson. Professor Angel, what are we learning
about market structure from recent regulatory actions?
Mr. Angel. Any particular actions you are interested in,
sir? I could talk a lot on this.
[Laughter.]
Chairman Johnson. The most significant actions.
Mr. Angel. OK. The most significant actions were the
tremendous changes in market structure that have occurred over
the last 15 years. Twenty years ago, we had a very different
market structure for small-cap companies. The old NASDAQ world
was very different from the old NYSE world, and listing
companies had a choice. But now over the years, you know, a
very well meaning Commission, through a series of decisions,
has now given us a one-size-fits-all market where the market
structure for tiny little companies is basically the same as
for large-cap companies. And what we are learning is that one
size does not fit all.
One of the reasons why we have half as many U.S. companies
listed on our exchanges is our public markets are no longer
welcoming to small- and mid-cap companies. And, you know, I
think this is a problem for capital formation and for job
growth going forward.
Chairman Johnson. Mr. Cronin, many have pointed out that
additional disclosure by non-exchange trading centers would be
helpful. What kind of additional disclosure would influence
your trading decisions?
Mr. Cronin. Well, there are two dimensions of that. One is
about the execution facility itself, so we would like to know
as much as we can about the order-routing practices of those
facilities, the kinds of order types that reside within them,
who the people who are interacting in these various dark pools,
for example, are. That helps us determine whether or not we
want to use those destinations, so we need to have that
information.
The second part gets to the executions itself. We need more
information to ensure that the execution quality that we need
to achieve for our clients is sufficient enough to really make
those determinations. Today we do not have enough information.
As it was recommended by Mr. Griffin, there is more of a
requirement that should be made standardized to all
participants in the marketplace.
Chairman Johnson. Senator Crapo.
Senator Crapo. Thank you, Mr. Chairman.
This question is addressed to the whole panel, and
basically I am just asking you to prioritize for me. Given your
respective roles and work, where do you think the greatest
weakness in today's market structure is? And if you do not want
to limit it to one thing, that is OK. But where should we look
at the greatest weakness to focus right now? Mr. Sprecher?
Mr. Sprecher. The market is too complex. While we all
support competition--and, in fact, I would not be here in front
of you if--I started with nothing and have built one of the
largest exchanges in the world, so I am pro-competition. But
there is a difference between competing to get you, the
investor, the best price and simply all the intermediaries,
exchanges included, trying to split up commission dollars. It
is great that we compete for those commission dollars, but we
have lost track of getting the best price for a company that is
trying to raise capital and an investor that would like to meet
a company. And I think if we just look at holistic practices to
do the right thing for investors, we will land on the right
public policy.
Senator Crapo. Thank you.
Mr. Griffin?
Mr. Griffin. In my opinion, the issue of complexity is
dwarfed by the issue of resilience. The impact of the Flash
Crash or the events that took place in Knight securities dwarf
the day-to-day issues around complexity in the marketplace. And
putting in place the appropriate infrastructure that allows for
the market to not undergo moments of chaos and panic is of the
utmost importance to protecting the confidence that we should
all have in the functioning of the U.S. equity markets.
Senator Crapo. Thank you.
Mr. Cronin?
Mr. Cronin. My biggest concern probably gets around
investor confidence. As I suggested earlier, investor
confidence is the key that we are all really trying to solve
for. All good things come from higher levels of confidence from
market participants. Where I get concerned is there are certain
elements of our market that are not where they should be. So,
for example, the price discovery mechanism, which has
historically defined our markets as the most robust and best in
the world, has been under assault because so much activity is
now trading away from those markets. We think that, frankly,
why we supported Regulation NMS is because we thought it would
facilitate more price discovery, that there would be more
interest in institutions and other investors in posting their
bids and offers. And we are concerned that that has not
happened and that there is at this point really not a lot of
incentive for activities to facilitate more posting of bids and
offers. So we are concerned about price discovery.
If I may, the other thing that is concerning to us is just
making sure that the markets are fair. Here is a low--you know,
high-impact, sort of low-effort kind of thing that we can do.
If there is unfair dissemination of data, let us make the
dissemination of data fair. Right? I think everybody would
agree that if there are smart people who can process that data
at speeds that none of us can comprehend, that is fine. But in
the first instance, let us make sure that everybody gets the
data at the same time. That would seem to be a very good
fundamental start.
Senator Crapo. Thank you.
Dr. Angel?
Mr. Angel. The biggest problem is that our regulatory
structure as a whole is too slow, too cumbersome, and just does
not really understand what is going on in the markets quickly
enough to craft appropriate solutions, that instead what we get
are hyper-complex rules like NMS that just add to the
complexity of the markets without solving the underlying
problems.
Senator Crapo. Thank you. I actually have questions on each
of these issues, the complexity, the resiliency, the
disclosure, and so forth. I am going to have time for one more
question, and so I am actually going to pick resiliency. And so
I will come back to you, Mr. Griffin, on that, and others can
jump in on this if we have time, too. But this issue has been
mentioned already. What further changes do we, the SEC,
industry stakeholders, or others need to undertake to
strengthen market integrity and prevent future market
disruptions like the Knight trading error or the Flash Crash?
Do you want to start, Mr. Griffin?
Mr. Griffin. I do. So if we look at both the Flash Crash
and what took place at Knight, it concerned orders of undue
size or quantity entering the market without appropriate checks
and balances. The broker-dealers that route orders into
America's exchanges need to have solid and robust fail-safes to
prevent such orders from being routed into the marketplace.
But of equal importance, the exchanges should act as the
last line of defense to prevent such orders from entering the
marketplace and creating disruption. We need both the broker-
dealer community and the exchange community to work hand in
hand to prevent aberrant orders from having an undue and
unfortunate, in fact, devastating impact on investor
confidence.
Senator Crapo. Thank you. I am out of time. I know, Dr.
Angel, you wanted to give a quick response. Could I do that?
Mr. Angel. Yes. And, in addition, we know that sooner or
later all systems break in some unanticipated way. So what we
need is a market-wide holistic view of the entire national
market system. Current rules and current thinking is to make
sure every individual little widget keeps working. But what
happens when they are all working individually but they do not
as a system work properly? And so what we need is better
thinking about what happens when the next tsunami of market
information, you know, overwhelms the market and it starts
behaving erratically?
That is where insufficient work has been done and a lot
more needs to be done to, you know, prevent the next disruption
from turning into a catastrophe.
Senator Crapo. Thank you.
Chairman Johnson. Senator Warren.
Senator Warren. Thank you, Mr. Chairman.
At a Subcommittee hearing a few weeks ago, I noted that
high-frequency trading is not really trading in the traditional
sense. While regular traders have days when they make money and
days when they lose money, high-frequency traders almost never
lose money. In its recent IPO filing, the high-frequency
trading firm Virtue disclosed that in its 1,238 trading days,
it had made money on 1,237 of those days. That means that in
nearly 5 years of trading, the company had come out ahead on
its trades every single day save one.
Now, that is not trading. High-frequency traders are not
making money by taking on risk. They are making money by
effectively charging a small fee to investors on millions of
transactions. And in that circumstance, the question is whether
they are providing a valuable service in return for that fee or
they are just skimming money off the top of these trades.
So at a prior hearing, I asked Andrew Brooks, the head of
equity trading for T. Rowe Price, and Jeffrey Solomon, CEO of
the investment bank Cowen and Company, a simple question: Does
high-frequency trading provide any valuable service in exchange
for the money it sucked out of the markets? And they both said
no. In particular, they disputed the often repeated claim that
high-frequency trading is valuable because it provides
liquidity to the market. So I want to push on the liquidity
question since they had rightly raised it.
Mr. Griffin, your company has run a fund for several years
called the ``Tactical Trading fund,'' and this fund relies
primarily on high-frequency trading strategies, and it has been
very profitable. Just for context, can you tell me what the
average holding period for securities is in that fund?
Mr. Griffin. So, Senator Warren, I am not sure of the
source of the information that you have on our Tactical fund,
but our Tactical fund's largest source of profitability, to the
best of my recollection, over the last several years has been
from fundamental equity long/short trading.
Senator Warren. So you are saying you do not do high-
frequency trading?
Mr. Griffin. No, I am not. I am saying that within our
Tactical fund----
Senator Warren. Well, do you have a fund that does high-
frequency trading?
Mr. Griffin. The Tactical fund conducts high-frequency
trading but conducts it along with a variety of other trading
activities.
Senator Warren. So you are saying it is just a mixed fund
at this point, and it was never a high-frequency trading fund
primarily or exclusively?
Mr. Griffin. Starting from roughly January 1, 2009, it has
been a mixed fund with equities being the single largest
allocation of risk capital, equities trading through----
Senator Warren. All right. So let me ask the question a
different way, and I will just ask Mr. Cronin about this
question. At an earlier hearing, Mr. Brooks, the head of
trading at T. Rowe Price, said their average hold time was
about 3 years. So my question is: What is the average hold time
for a high-frequency trading fund? Mr. Cronin?
Mr. Cronin. I do not have personal knowledge but I know it
is one heck of a lot less than 3 years.
Senator Warren. Under a month?
Mr. Cronin. Under a month, probably under----
Senator Warren. Under a day?
Mr. Cronin. Under a minute.
Senator Warren. Under a minute, OK.
Mr. Cronin. Yes.
Senator Warren. OK. So I want to ask the question then
about liquidity. If you are buying a stock and turning it
around and selling it within a minute, within a second later to
someone else, how does that provide liquidity to the markets?
Couldn't the original seller have just sold the stock to the
ultimate buyer 1 minute later?
Mr. Cronin. We are worried about excessive intermediation
in the markets. We are also worried that we are probably all
not in a great position to truly understand all of the HFT
activities that take place. It might be easy for me to say that
some of it is good and some of it is bad. I think we should not
be in the business of conjecture. We should be in the business
of data.
We recommend that there be a specific regulatory regime
that is in charge of high-frequency trading so that we can all
be better informed.
Senator Warren. Well, Mr. Cronin, I appreciate that, and I
appreciate that you want to see more regulation here, and that
is something we certainly should talk about. But I at least
want to ask the question how it is that--this is the principal
claim for high-frequency trading, is that it provides liquidity
in the marketplace. And all I am saying is it takes place in a
very short space where someone jumps in ahead of a trade and
buys and then turns around and sells. And I am trying to figure
out how that adds more liquidity to a market if that seller
would have found that buyer, only found them a nanosecond later
or 2 seconds later.
Mr. Cronin. Senator, that is why we make a distinction
between trading volume, which is exactly what you describe, and
real liquidity. Liquidity provision is a far, far different
concept, and that is what we are trying to protect and promote.
But some of these high-frequency trading strategies are
inconsistent with that.
Senator Warren. All right. I am out of time. Thank you, Mr.
Chairman.
Chairman Johnson. Senator Shelby.
Senator Shelby. Thank you, Mr. Chairman.
Mr. Sprecher, you mentioned that the market is too complex.
Is that because of the electronic growth, the use of
electronics as we have seen a technological change? I have seen
it in my 28 years here on the Banking Committee, and you have
seen it in the marketplace. Is it too complex because of that?
Or is it too complex because of what?
Mr. Sprecher. I think there are actually two reasons. One
is that because the decision where your trade goes is made by a
third party, it is legal, lawful, and accepted right now that
that third party can route that trade to their own wholly owned
trading venue where they can make additional profit,
theoretically. So we have now seen every major broker-dealer
either create their own dark pool or come up with some
relationship with another market maker that would allow them to
participate in trading. So that is number one. It is the person
that makes the routing decision.
Second, Regulation NMS, which was intended to try to bring
the markets together as a single whole, suggests that any new
entrepreneur like me that starts a venue, everybody must
connect to it. So it is a law that says if you open a story,
everybody must walk through your store and at least check on
shopping there. So it makes--it lowers the bar for entering the
market, and as a consequence, we have a lot of trading venues.
Senator Shelby. Dark pools, Mr. Griffin. Dark pools have
grown, according to my information, from approximately 16
percent of all trades in 2008 to over 40 percent of all trades
last month. Why have they grown so fast? And is it--it is
obviously lucrative, but what is driving all this? Is it
technology?
Mr. Griffin. So, Senator, the exact statistics that you
have are somewhat off. The numbers that you referred to are
probably an approximation of the proportion of trading that
takes place off exchanges, both at retail-oriented wholesale
market makers, such as Citadel, and on dark pools. So retail
orders in the United States are handled differently than most
other orders. A handful of market makers compete vigorously for
this order flow and, based on their execution quality, are
allocated more or less order flow by the various major retail
brokerage houses.
American retail investors benefit from the trading acumen
of the wholesale market-making community. Dark pools, which are
generally run by the large broker-dealers, were created to
facilitate block trading and to provide a low-cost means of
trading in competition with the exchanges.
Now, over the years we have seen the rise of algorithmic
trading. Large block trades occur less frequently. Large trades
are broken into small trades of hundreds of shares--100 shares,
200 shares, 300 shares at a time--and these trades are still
executed in dark pools.
I would concur with Mr. Sprecher that the dark pools do add
a layer of complexity to the marketplace. They are not subject
to the same anti-discrimination provisions of the exchanges. We
should level the playing field between the exchanges and the
dark pools, and the dark pools that compete on the merits
should have vibrant businesses.
Senator Shelby. I assume you are familiar with this, and if
you are not, tell me. On June 25th, just a few weeks ago, the
SEC announced a 1-year tick size pilot program in conjunction
with FINRA which would allow some small capitalization
companies to trade in 5-cent increments instead of the
traditional 1-penny increments. Commissioner Piwowar of the SEC
has been advocating for such an initiative, saying in January,
and I will quote him:
As the one-size-fits-all approach to market structure is not
currently working for small capitalization companies, I support
such a pilot and would like to see it implemented.
What is the effect of this? Are you familiar with that, Mr.
Griffin?
Mr. Griffin. I am.
Senator Shelby. Good.
Mr. Griffin. My personal belief is that the larger tick
size will actually erode liquidity. As the tick size increases,
transaction costs go up, and investors shy away from trading
equities with a high transaction cost.
But here is the good news. We will know the answer at some
point in the next 1 to 2 years when the SEC completes the
study, and I applaud the SEC's data-driven approach to
analyzing what is taking place in our equity markets.
One thing to keep in mind is that smaller issues in the
United States are suffering from the consequence of the rapid
rise of concentration of holdings by large asset managers. The
gentleman to my left, for example, speaks to how they manage--
was is 700 and change billion?
Mr. Cronin. $790 billion
Mr. Griffin. $790 billion. It is difficult for an
institution that manages $790 billion to focus on investing its
resources, its time and energy on the issuers that have a
market capitalization of a few hundred million. So we need to
think about how do we encourage the development of more mutual
funds and more investment vehicles that specialize in growth
opportunity stocks and in the small-cap and mid-cap issuer
space.
Senator Shelby. I think both the gentlemen want to comment.
Mr. Cronin. Yes, Senator Shelby, thank you. So I would just
add, institutions like Invesco do want to have more ownership
of small company stocks. What prevents us from doing that is
that the way that they trade does not facilitate liquidity in a
way that makes it allowable for us to invest in more. We have a
number of funds that are focused on small-cap stocks, so we
recommend--and we were very happy to see that there was a pilot
program, because we actually think the opposite might happen.
We do not worry about spread. The 5-cent spread is not what
determines the value of implementing an idea in our portfolio.
The very fact that you have more people willing to post bids
and offers might well incur, frankly, from an institutional
perspective, far less cost. So we are very encouraged that the
pilot is taking place and very happy to see what the results
are.
Senator Shelby. Professor, have you got a comment, quickly?
Mr. Angel. Yes. I am strongly in favor of evidence-based
regulation. We should have a culture of innovation and
experimentation so that the SEC is regularly running pilots on
a variety of things to see what happens. It is far better to
have hard data to know what we are doing rather than to just
say, well, I think it is a good idea.
Senator Shelby. Thank you, Mr. Chairman.
Chairman Johnson. Senator Menendez.
Senator Menendez. Thank you, Mr. Chairman. Thank you all
for your testimony.
It seems to me that to make our equity markets the best
place in the world to have investors invest in companies to
raise capital, the SEC in trading venues has to balance some
fundamental market structure tensions. Notably, investors
receive better information about market prices when they have
more transparency regarding pre-trade quotes and post-trade
prices. But there may also be times when investors obtain
better execution for their own trades by providing less
transparency to the market.
For example, if an institutional investor wants to sell a
large block of shares, it might be concerned about its sell
orders driving down market prices before it has completed the
sale of the entire block. So what I would like to hear from the
panel is what do you think is the appropriate way to balance
this tension between wanting to know about everyone else's
trades, but sometimes not wanting anyone else to know about
your own.
Mr. Sprecher. Thank you. I talk to my staff a lot about the
fact that everybody wants to know how much everybody else is
paid----
[Laughter.]
Mr. Sprecher.----but nobody wants to disclose what they
make after they negotiate their raise.
I think you have hit on a very salient point. We have been
advocating that in today's world where the smart order routers
are breaking big trades up into little digestible bites, there
is very little difference between you and I as a retail trader
and Mr. Cronin as an institutional trader in terms of what the
exchange and the matching engines see. We see little bits and
bytes. But it is fair that a large institution should have the
opportunity to find another large institution and do a large-
size trade without moving the market.
And so I think if we could develop a standard by which we
had an agreed trade size that would be somehow excluded from
being in the public markets, that would be a fair tradeoff.
Right now there is no such differentiation, and so we see tiny
little trades being traded off exchange.
Senator Menendez. Anyone else? Does anyone else believe--do
we have the right balance here?
Mr. Angel. This is a very difficult issue that people have
been debating for years. What is the right amount of
transparency? And this is why I think experimentation is the
answer, because we all have ideas on how it should work and how
we think it should work, but, you know, the proof is in the
pudding. So, you know, I think that we should experiment with
different transparency regimes to see what happens.
Senator Menendez. Mr. Cronin.
Mr. Cronin. Senator, as a large institutional investor, I
can tell you that our responsibility is to make sure that our
clients' best interests are protected. To facilitate that, we
need different kinds of execution venues that allow us to trade
large blocks. As you might guess, when you have 500 shares to
buy, it is a fair different way you approach the order than
when you have 5 million shares to buy. So we have to balance
trying to make sure that the price discovery process is as
robust as it can be. And, by the way, we are more than happy to
trade in the public markets, but we have to balance all the
different complications that the market structure brings to us.
For example, there are a number of participants in the
marketplace who would love to get wind of that 5-million-share
orders you might guess and try to take advantage of that. We
are trying to protect and preserve as much value of our
transactions into our clients' hands as possible. So we need
tools like dark pools. Dark pools have lost their way to be
clear, when the average trade size is 200 shares when it was
proposed to be a block trading system, something is broken. Our
belief system around what is broken is that brokers have a
conflict of interest in how they route our orders. They break
them up into tiny pieces, as Mr. Sprecher describes, but they
also send them to destinations which actually are serving to
maximize their own economic best interests but may not be
serving our best execution interest.
So we would encourage more disclosure around that practice.
We have advocated for getting rid of these incentives like
maker-taker which promote activities which may be incongruent
with our shareholders, and other things that will promote
fairness and integrity.
The last point is that we need to make sure that there are
incentives for people like us to post our bids and offers in
the markets. That robust price discovery mechanism must be
protected.
Senator Menendez. Let me ask you all, is competition
between trading venues currently producing the right balance
for investors? And if not, what do you think should change?
Mr. Sprecher. I think it has gone too far, honestly. I
think data that we have seen showed that years ago there was a
low point in terms of execution costs, but more recently the
true cost of execution has been increasing as the markets have
fragmented and people are no longer able to find the best price
for their shares.
Senator Menendez. Anyone else?
Mr. Griffin. I think to add to that answer, though, we have
seen a disruptive innovation in the form of Regulation NMS. The
arc of disruptive innovation is generally the rapid entry of
many new competitors. We have seen many new exchanges form
since the introduction of Regulation NMS. We have seen many new
market-making firms come into being since the introduction of
Regulation NMS. And what are we seeing today? We are seeing
rationalization. We have seen an exchange just recently cease
to function. They shut down their business.
We have seen countless high-frequency trading firms shut
their doors because of their inability to generate profits. We
are seeing the arc of disruptive innovation play out, and we
will see a logical rationalization of our markets take place on
the back of this. It takes time. It is hard to imagine how much
the equity markets have changed in just 7 years, in the blink
of an eye. And so I think that many of the issues that we are
concerned about will be addressed as competition plays out in a
fair and orderly way over the years to come.
Senator Menendez. Thank you, Mr. Chairman.
Chairman Johnson. Senator Johanns.
Senator Johanns. Thank you, Mr. Chairman, and thank you to
all the witnesses.
Let me, if I might, just follow up with a question or two
on the high-frequency trading issue. Let us say that this
Committee finds that high-frequency trading is not doing much,
if anything, for liquidity. Maybe we find that we cannot figure
out where it is benefiting the market. Would anybody on the
panel recommend that we ban it, just say you cannot do it
anymore? Just a simple, straightforward yes or no.
Mr. Griffin. No, absolutely not. And can I add just a few
sentences?
Senator Johanns. Sure.
Mr. Griffin. All right. What has been lost in the dialogue
around high-frequency trading today is the important role that
it places--that it facilitates fairness between the prices of
securities in the marketplace. When you buy or sell an S&P 500
futures contract, you are buying and selling 500 underlying
stocks in one fell swoop. And somebody needs to keep the market
in Chicago in line with the markets in New York, and that is
done by high-frequency trading firms, who literally buy and
sell 500 stocks when the futures move in price.
When you trade XLF or spy or the diamonds or any number of
ETFs, you do not ask yourself what is the underlying net asset
value of that ETF. You know the price that you are going to
tradeoff at is fair because the high-frequency trading firms
continuously arbitrage between the ETFs, which are a very
important retail trading vehicle and the underlying common
stocks. This all happens, in fact, at an incredibly low cost in
the context of our capital markets.
Senator Johanns. Mr. Cronin, would you suggest we ban it?
Mr. Cronin. I would not suggest that we ban it because I
think it is too prescriptive that high-frequency is all one
kind of behavior. I think as Mr. Griffin describes, there are
kinds of trading activities that are pursued by firms that
would be defined as high frequency which are very helpful to
efficiencies in markets. There are others which probably are
harmful. We need to be in the business of being able to
understand which is which.
Senator Johanns. Professor?
Mr. Angel. I would not ban high-speed trading. There has
always been a race for speed, and even if you put in speed
bumps, people will race to be as fast as they can to jump
around those bumps. Some of the high-speed traders, as was
pointed out, do good things. I am a retail investor. When I buy
an exchange-traded fund, I trust that the price of that fund
will match the stocks that it represents. Those arbitrageurs,
those high-frequency traders doing that in and out, buy and
sell, are making sure that those prices are aligned.
Senator Johanns. So the panel is unanimous on that.
That kind of takes me to my next point. Pre-2005, if you
were an exchange, man, thing were pretty darn good, right? I
mean, virtually everything is moving through the exchanges and
life is good and you are happy and why be more innovative. You
have got all the business, right?
Isn't part of what we are seeing here the fact that people
are looking for a better way, a faster way? Mr. Cronin, on
behalf of your clients, you want these options. You want dark
pools. You want a whole host of opportunities to maximize the
return on your clients' investment and, to be very honest about
it, maximize your income. And somebody made a point here that I
think is a very valid point, and that point is this: We work in
a very cumbersome way here. Even if we were firing on all eight
cylinders, which I would argue we are not these days, we are
cumbersome. We were meant to be cumbersome. Our Founders wanted
us to be cumbersome.
Isn't this whole debate and trying to figure out what best
to do best left with the regulators? And focus on that
question. Wouldn't we be better to make sure that they are
properly empowered, which I would argue they are, and then do
evidence-based regulation to try to figure out what is the best
approach? Professor, I will start with you and go across the
table.
Mr. Angel. I agree 100 percent that, you know, if the
regulators are capable, we should trust them. And, indeed, they
do have adequate authority to do what they need to do. But do
they have the adequate resources, you know, not just the
monetary resources but the human capital resources? I think you
need to monitor them closely to make sure that they have the
ability to do their job well.
Senator Johanns. I am out of time. If I could just ask each
of you to give me one or two sentences, and if you want me to
know more about this, call me, OK?
Mr. Cronin. Yes, I think there is a balance to be struck
between the regulators and market participants. I think that is
how we manage the good things that regulation can bring, but at
the same time manage the unintended consequences which we all
fear.
Mr. Griffin. I concur with your sentiments.
Senator Johanns. OK. Thank you.
Mr. Sprecher. I think the market participants themselves
have an obligation to take on some this. That is why we have
been very open about wanting to make changes.
Senator Johanns. And others are doing the same, such as TD
Ameritrade has indicated they----
Mr. Sprecher. Well, there is actually pretty much unanimity
on this panel with a number of things that we all agree should
be done.
Senator Johanns. Thank you.
Chairman Johnson. Senator Brown.
Senator Brown. Thank you, Mr. Chairman. There are a number
of people--and I assume the four of you are among them--who
object to the characterization of our financial markets as
being ``rigged'' against ordinary investors. But the concerns
raised about equity markets coincide with accusations of
manipulation in LIBOR and the foreign exchange setting. My
Subcommittee has done hearings on aluminum and zinc and gold
and silver and oil and electricity markets, what has played
there. Professor Angel notes in his written testimony that the
lack of financial crisis-related prosecutions has also
undermined investor confidence, and I would hope--and I am not
asking for a response on this part, but I would hope that you
would at least understand, regardless of agreement or
disagreement, that consumers and investors and users feel that
certain well-connected institutions enjoy special privileges in
the financial markets. Again, whether you agree or disagree
with that, I hope you at least understand that large numbers of
people in all those groups feel that way.
Mr. Sprecher, my question or first set of questions is
directed at you. You have been outspoken about high-frequency
trading. We appreciate your sharing constructive solutions as
you have. But since at least 2012, former high-frequency
traders have been expressing concerns about exotic order types
that technically comply with SEC regs but which allow high-
frequency traders to jump the queue and exploit price
advantages that come from latencies. The New York Stock
Exchange has actively sought to address the issue by announcing
in May it was eliminating 15 order types, if that number is
correct; however, ICE estimates there could be as many as 100
different order types. I have heard concerns that the stock
exchange continues to allow high-frequency traders to use some
predatory order types, like Post No Preference Blind, in which
high-frequency traders' bids remain blocked from the market and
then, as I said, jump to the head of the queue.
Mr. Sprecher, when is the stock exchange going to terminate
hidden order types like Post No Preferences Blind? The critics
have been saying for more than 2 years that it helps high-
frequency traders. What are you going to do?
Mr. Sprecher. Well, we have owned the stock exchange for 7
months. I have been the Chairman for maybe 3 months, and as you
say, I am uncomfortable with having all these order types. I do
not understand why we have them, and I have started
unilaterally eliminating them.
The problem that we have is that orders today are--
decisions on where orders go are not made by humans. They are
made by computers that are so-called smart order routers. And
many of these order types exist to attract the orders, and I am
trying to balance cleaning up my own house--I live in a glass
house, and I am trying to clean it up before I criticize
others. At the same time, I cannot make the New York Stock
Exchange go to zero. It would be bad for this country for the
New York Stock Exchange to no longer have trading activity.
So it is why I have been outspoken. I hope that other
exchange leaders will follow my lead. I would like to get us
all working together to eliminate these types. I would be happy
if we can do it as a private sector initiative. I would be
happy if the SEC ordered us to get rid of them. I would be
happy if Congress took action. Any way we can reduce them, I
would be happy.
Senator Brown. So if you came back here 6 months from now,
ICE would have owned the New York Stock Exchange for a little
over a year then. You would have been its CEO for 9 months by
then. What number would--where will we see progress? How do we
quantify that and measure that?
Mr. Sprecher. Well, let me say this: I very much appreciate
the IEX exchange, which is the exchange that is the subject of
the ``Flash Boys'' book. They have four order types. I would
love to get the four order types. They also have less than 1
percent market share. It shows me how four order types are
dealt with in the market. I cannot take the New York Stock
Exchange to 1 percent, but I appreciate your allowing me to
talk about this publicly to you all and to the camera and a
microphone, because I think that I need to put pressure on all
my colleagues to follow my lead.
Senator Brown. Mr. Cronin, in my last couple of minutes,
let me ask you a question. One broker-dealer testified before
Senator Levin's Subcommittee that virtually all the trades
eligible for rebates in the first quarter of this year,
numbering in the millions, as you know, were executed through
the trading venues that offered the highest rebates. You said
in your testimony:
Investors are given only limited insight in how and where
broker-dealers route their orders. As a consequence, it is very
difficult for investors to make informed decisions about the
quality of executions they have received.
You have a duty, as you know, to act in the best interests
of your clients to protect the retirement savings of millions
of working Americans. How can you be sure you are meeting this
obligation without that information?
Mr. Cronin. Yes, sir. So we spend a lot of time and energy,
as you might guess, trying to make those determinations.
Transaction cost analysis, which is what we perform to
understand how our trades have been handled, is not perfect,
right? And it has evolved pretty dramatically over the years,
and I think we have a very good sense of where we are with
respect to the quality of executions we receive. But we could
do better. We could get more information that would be helpful
to us.
For example, most of the transaction cost analysis
information we get is just about the trades that we have
received. Well, if you thought about it, our trades go to a
number of destinations before they actually receive an
execution. We have been trying to get the brokers to give us
more information about where exactly the trades went that they
did not get executed, because, quite frankly, you might find
that you are giving up a lot of information to all these
different destinations that orders get routed to that actually
give you no benefit whatsoever.
So we have been very vocal about the issue of the conflicts
of interest that drive where brokers route orders. We think
removing this conflict of interest is critical. But in the
first instance, making sure that we have the right amount of
information to make determinations is also a very, very
important concept for us.
Senator Brown. Thank you.
Thank you, Mr. Chairman.
Chairman Johnson. Senator Kirk.
Senator Kirk. Thank you, Mr. Chairman.
I would like to ask Mr. Griffin a question. This is a copy
of ``Flash Boys.'' When Michael Lewis wrote this, you being a
leader in high-frequency trading, describe your conversation
with Lewis when he wrote this book.
Mr. Griffin. I have never spoken to Michael Lewis about
this book.
Senator Kirk. So he never called you?
Mr. Griffin. He did not.
Senator Kirk. All right. Thank you.
Thank you, Mr. Chairman.
Senator Reed. [Presiding.] Thank you, Senator Kirk.
I was not here for the first panel because of a classified
hearing with respect to the situation in Iraq and Afghanistan,
and I respect the panel and thank them for their testimony. But
if you are ready to move forward to the second panel--or is
there anyone else seeking to be recognized?
[No response.]
Senator Reed. In that case, gentlemen, thank you so much
for your participation, and I am sure we will be back again and
engage again on this issue.
At this point I would like to ask the second panel to come
forward and take their seats, please. Thank you.
[Pause.]
Senator Reed. Let me at this time introduce the second
panel.
Our first witness is Mr. Thomas Wittman. He is the
Executive Vice President and Global Head of Equities at NASDAQ
OMX Group. Thank you, Mr. Wittman.
Next we will have Mr. Ratterman. Mr. Ratterman is the Chief
Executive Officer at BATS Global Markets. Thank you.
And, finally, Mr. David Lauer is the President and Managing
Partner at KOR Group.
Gentlemen, thank you all very much, and, Mr. Wittman, you
can begin your testimony, please.
STATEMENT OF TOM WITTMAN, EXECUTIVE VICE PRESIDENT AND GLOBAL
HEAD OF EQUITIES, NASDAQ OMX GROUP, INC.
Mr. Wittman. Thank you, Senator Reed and Ranking Member
Crapo, for the opportunity to testify today.
As my testimony points out, the efforts of SEC Chair Mary
Jo White are to be commended, and we agree with many of her
recent actions. You have my full testimony, but I wanted to
quickly summarize my key points, and there are four.
Number one, the lit exchanges play a critical and
indispensable role in the U.S. economy. Public companies and
investors both need price discovery to feel that the market is
working for them. Exchange listed public companies use stock
issuances to expand their businesses and create jobs.
Number two, market structure needs to be re-examined with a
goal to improve transparency and reduce fragmentation. It is
clear from the debate that investors and listed companies view
the current market structure as an impediment.
Number three, we must act deliberately to encourage
transparency and price discovery so the best markets in the
world can continue to be the engine for economic growth and job
creation. The stakes are high.
Number four, all venues that trade stocks need to be
brought into a system of well-conceived regulation and
oversight. One idea that we are considering, which was not
included in my written testimony, is whether there are ways to
capture unique trading experience and needs of participants in
dark venues. We want to look at the feasibility of translating
those experiences and benefits into a more transparent and
regulated NASDAQ venue.
We intend to proceed with this and other innovations
because at NASDAQ we are committed to making the markets work
better. NASDAQ is passionate about the role we play in capital
formation and improving the performance of our marketplace. The
SRO model and the U.S. market structure have been effective in
protecting investors, but as technology and trading have
evolved, so too must the regulatory environment in which
markets operate.
We look forward to working with this Committee. Thank you
for your invitation to testify. I look forward to your
questions.
Senator Reed. Thank you very much.
Mr. Ratterman, please.
STATEMENT OF JOE RATTERMAN, CHIEF EXECUTIVE OFFICER, BATS
GLOBAL MARKETS, INC.
Mr. Ratterman. Thank you and good morning. My name is Joe
Ratterman, Chief Executive Officer of BATS Global Markets and
one of the original founding employees. I would like to thank
Chairman Johnson, Ranking Member Crapo, Senator Reed, and the
entire Senate Banking Committee for inviting me to participate
in today's hearing.
Let me say at the outset that I was encouraged by SEC Chair
White's recent comments that our markets are ``not broken, let
alone rigged.'' I strongly agree with the Chair and appreciate
her leadership in this area. The automation of the U.S. equity
markets has resulted in significant enhancements in market
quality for long-term investors. However, I also recognize that
our markets are not perfect and that our efforts to improve
them should never cease.
Our current market structure is largely the product of
Congress' 1975 amendments to the Exchange Act and subsequent
rulemaking by the SEC to implement a national market system as
well as advancements in technology that have made our equity
markets capable of processing order messages in timeframes
unthinkable even a decade ago. The increases in speed and
improvements in latency found in today's markets have served to
mitigate risk which benefits all investors in the form of lower
risk premium, expressed as tighter spreads and lower
transaction costs.
Today our equity markets are widely considered the most
liquid, transparent, efficient, and competitive in the world.
Costs for long-term investors in the U.S. equities are among
the lowest globally and declining. The gains are quantifiable
and have been noted by investors and experts alike.
In April 2010, Vanguard confirmed estimates of declining
trading costs over the previous 10 to 15 years, ranging from a
reduction of 35 percent to more than 60 percent, savings which
flow directly to investors in the form of higher returns.
Three respected economists recently found that, between
2001 and 2013, the spread paid by investors had decreased by
more than 70 percent for NYSE-listed stocks. In April 2014,
Blackrock noted since 1998, institutional trading costs have
declined and are among the lowest in the world. And just last
month, ITG reported that between 2009 and 2013, implementation
shortfall costs decreased from roughly 45 basis points to 40
basis points, following a drop from 63 basis points in 2003.
Moreover, the efficient operation of our market structure
throughout the stress of the 2007-09 financial crisis indicates
the systemic risks that have been reduced as a result of
advancements in technology.
Efforts to address infrastructure risk since the Flash
Crash of 2010 are producing further beneficial results. For
example, the number of erroneous executions occurring on our
markets is on pace this year to be nearly 85 percent lower than
the previous 5-year average, results related to the recently
enacted limit up/limit down rule. In addition, exchange system
issues as measured by self-help declarations have dropped by
more than 80 percent since the first years after Regulation
NMS.
We must, nonetheless, remain squarely focused on improving
market quality and stability in a coherent and responsible way.
We are also keenly aware that investor confidence is important
not only to helping Americans realize their investment and
retirement goals, but it plays directly into the overall health
of our country's economy. Simply put, when investors are
confident enough to put their hard-earned capital to work in
our stock market, entrepreneurs and corporations can grow and
thrive as well. As such, we are fully supportive of the SEC's
plan for a comprehensive market structure review, and we look
forward to actively participating in that process.
Among other things, I see the following four areas as
offering potential benefits without disrupting existing market
quality gains.
First, institutional investors could benefit from
incremental transparency related to the ATSs that their brokers
route orders to, including the publication of Form ATS, which
some of the ATSs have already voluntarily disclosed. Consistent
and thorough reporting standards will create the greatest level
of investor confidence, so additional regulatory direction may
be required here.
Second, I support reviewing current SEC rules designed to
provide execution quality and routing transparency. For
example, Rule 606 could be amended to require disclosure about
the routing of institutional orders as well as separate
disclosures regarding the routing of marketable versus non-
marketable orders and specific broker execution quality data.
Third, I continue to support initiatives to make the SIPs,
also known as the ``consolidated tape,'' as fast as possible to
address any perceptions of unfairness that can affect investor
confidence. BATS has advocated this position since becoming an
exchange in 2008.
And, finally, I support eliminating the ban on locked
markets, which is a primary driver of excessive complexity in
our national market system.
Thank you for the opportunity to appear before you today. I
applaud the Banking Committee's oversight efforts and would be
happy to answer any questions.
Senator Reed. Thank you very much.
Mr. Lauer, please.
STATEMENT OF DAVID LAUER, PRESIDENT AND MANAGING PARTNER, KOR
GROUP LLC
Mr. Lauer. Good morning, Senator Reed, Ranking Member
Crapo, and Members of the Committee. Thank you for inviting KOR
Group here to testify today.
KOR Group is a market structure research and consulting
firm focused on data-driven analysis. Healthy Markets is our
nonprofit initiative that seeks to build consensus on a
coalition of firms in the industry on substantive market
structure reforms.
My name is David Lauer, and I am the president and managing
partner of KOR Group. My background is in technology
architecture and high-performance computing. I have designed
and operated high-frequency, low-latency trading platforms. I
have filed detailed written testimony and will only touch upon
the key points here.
In our industry, we are used to hearing that ``past
performance is not indicative of future returns.'' The same
could be said about past technology failures. As much as we
like to think we're learning from our mistakes, past technology
failures tell us very little about the next crisis on the
horizon. To think otherwise is called the ``fallacy of the
broken part.''
I will begin by stating the obvious: Complex systems fail.
They must be designed to degrade gracefully, not to crash.
Technology should be invisible. Today's markets are
characterized by interconnectedness and speed. Regulations
since 1975 have not only created complexity in technology,
connectivity, and order routing, but have also created
intractable conflicts of interest. It should be no wonder that
we are confront concerns about market integrity in such a
conflicted environment. It is only by peeling back some
regulations and refining others that we can hope to simplify
market structure, increase market efficiency, and prevent
catastrophic technology failures.
Complexity is not necessarily bad, but unnecessary
complexity certainly is. Today SROs still follow rules under
the Exchange Act of 1934. It should come as little surprise
that these rules are antiquated, a product of a time when
electricity had reached just 70 percent of households, not an
era in which a gigabyte of data can be transmitted around the
world in seconds.
SROs are now for-profit organizations, owned either by
public shareholders or broker-dealers, and in so many instances
they act in their shareholders' interests and not for fair and
efficient markets. Consider, as I do in my written testimony,
the following actions which SROs have either neglected to take
or have only taken as a consequence of regulatory intervention
or catastrophic failure.
Firstly, why aren't exchange server clocks synchronized to
each other? How can regulators understand or surveil markets
with this? And why is regulation needed to make this happen?
Why wasn't the SIP infrastructure improved the same way as
direct feed technologies? This need was identified by the SEC
as early as 2001.
Why haven't order types been re-examined industrywide
through a retrospective review? Why isn't detailed, objective
market data available to academics? And why haven't SROs
mandated industrywide disaster testing?
In each case, the need is obvious and the failure to act
absurd. We also have antiquated best execution standards that
allow brokers to operate their own dark pools while routing 90
percent of their customers' orders through them. The consequent
level of fragmentation and off-exchange trading should not be
surprising.
Fragmentation, conflicts of interest, payment for order
flow, internalization, and maker-taker have collectively
increased off-exchange trading and adverse selection on lit
markets, making lit markets more fragile and less stable. This
condition can be remedied by strengthening best-X, re-examining
maker-taker, and considering a trade-at rule.
On a more systemic level, one of the greatest risks to
market integrity is from regulators who lack the data and tools
to understand or keep up with the rapid pace of technology
change in markets. At the heart of this struggle is a shortage
of appropriate technology resourcing and a failure to embrace
the language and ideas of complexity and systems theory. This
in turn contributes to the public perception that our industry
is operating with reckless abandon and little policing.
Regulators need to embrace technology-centric regulation and
systems theory and to revamp the SRO structure to make it more
efficient, less conflicted, and more data driven.
I have also been invited to follow up on the
recommendations from my 2012 Senate testimony. At the time I
advocated for market-wide surveillance and broad access to data
to be driven by regulators. Unfortunately, MIDAS misses more
than half of the activity in markets and lacks participant IDs.
No centralized data store has been made available to academics,
and the consolidated audit trail remains on the distant
horizon.
If the SEC had built the system I advocated for in 2012, it
could have been operational for a year by now and would have
given regulators an ability to surveil and study markets that
is years ahead of their current approach.
There is no issue that is more critical to ensuring market
integrity than proper access to data for study and
surveillance, and there is no reason this cannot be done
quickly.
My testimony also called for a mandate requiring SROs to
demonstrate the utility of order types or retire them. While
the NYSE recently acted, the SEC only announced a nascent
effort on this issue last week.
I would like to thank the Committee for inviting me to
testify and hold this hearing, and I applaud the SEC for
initiating a comprehensive review of market structure and for
the scope and ambition of Chair White's speeches last month. I
urge regulators to undertake a review that addresses not just
the rules that govern trading but also the staffing
requirements and mind-set necessary to do so properly. And I
urge Congress to fund regulators appropriately to ensure they
can succeed.
Thank you. I am happy to answer questions.
Senator Reed. Well, thank you very much, Mr. Lauer, and let
me begin with you. I recall that hearing--Senator Crapo and I
presided over it--and we asked you specifically to go back and
review. And what you said then is even more relevant today with
subsequent events that have taken place.
Looking at your testimony, one point among many leaped out:
``It should be concerning to anyone reading this that there is
no algorithmic, cross asset-class surveillance being performed
right now. This leaves little doubt that there is market
manipulation taking place. Bad actors know that nobody is
watching. There is no issue that is more critical to ensuring
market integrity than proper access to data for study and
surveillance, and no issue that is more readily and easily
solved. It is time to stop making excuses.''
Would you like to elaborate on that?
Mr. Lauer. So last month I was invited to testify before
the CFTC Technology Advisory Committee by Commissioner O'Malia
on how to do surveillance in the 21st century, and I included
my testimony there in my submission for the Committee here. In
it, I have outlined a system that can be built relatively
quickly. Certainly in the private sector, it is something that
most firms have a form of. And it can combine futures data,
options and equities data into a cloud-based platform in which
you could have algorithmic analytics running.
I am very concerned--and I have yet to talk to somebody in
the industry who does not concur--that there is, of course,
something going on in cross asset class trading because nobody
is watching, and why anybody would expect otherwise, you know,
I cannot understand. I think that when you look at the primary
issue there, I believe it is regulatory agencies working
together, and I think that that is the main concern. So the SEC
and CFTC should be collaborating on a surveillance platform.
There is no participant in the markets, especially in HFT, who
sees things in only an equity silo. You are looking at equities
in futures and options and all sorts of other data. The
regulators should be, too.
Senator Reed. Thank you very much.
Let me ask both Mr. Wittman and Mr. Ratterman a question.
You both in your positions have the very difficult challenge of
balancing technology, which you all indicated provides
significant advantages in terms of prices and liquidity, with
the possibility of error. And as Mr. Lauer said, complicated
things break, and so we have to assume that.
Given Chair White's speech, what other message might you
sort of identify and emphasize with respect to the structural
integrity of your markets? And let me start with Mr. Wittman,
then ask Mr. Ratterman to comment.
Mr. Wittman. Thank you, Senator. My background is
technology. I spent my first 10 or 12 years writing software in
our equity environment under the Philadelphia Stock Exchange,
so I understand technology and the process.
As the previous panel explained, you know, with
fragmentation, I think with technology you can do just about
anything. But with the more fragmented markets as they are
getting now, it has become more of a challenge. I think with
Regulation SCI that the SEC has talked about, I think that is a
good step forward for exchanges, and, quite frankly, any
platform that executes an order should come under those same
Regulation SCI restrictions when those are implemented. I think
that is a great first step.
Senator Reed. Thank you.
Mr. Ratterman, please.
Mr. Ratterman. So as an exchange operator, we do take
technology very seriously. We try to do everything we can
within our own systems to provide redundancy at each step of
the way, whether it be an order handler, a matching engine, the
routing infrastructure, even within data centers having
technology in two different places, and all that goes a long
way to making sure that within our market center we stay
stable. But that is not good enough, and I think that what we
have today in today's equity market structure is a competitive
landscape where, when my systems might fail, then NASDAQ's
systems would pick up. And that is something that was
instituted with Regulation NMS that has worked extremely well.
In my testimony I talked about the number of times that an
exchange declares self-help on another exchange having gone
down. So it has worked over the years to allow the market to
route their orders around the failing node in this connected
network, and the number of instances of those failures has come
down and is continuing to come down.
So I support the current competitive landscape because no
matter how much we think about redundancy and build disparate
data centers across the country, if something in our technology
fails in real time, NASDAQ or NYSE can pick up the load, and
customers rarely really notice the impact of that.
Senator Reed. Thank you, Mr. Ratterman. My time has just
about expired. I will entertain a second round. Let me now
recognize Senator Crapo. Senator?
Senator Crapo. Thank you, Senator Reed.
Mr. Wittman, according to reports, the JOBS Act has been
very helpful in aiding companies enter our capital and equity
markets. But there is still a lot of concern that smaller
companies are unable to tap into our equity markets.
Given your role as a listing exchange, could you give us
some of your thoughts on what can be done to help smaller
companies IPO? And what can be done to help small-cap companies
succeed in today's secondary markets?
Mr. Wittman. Sure. There are probably two parts to the
answer to that, and one is the recent move by the SEC with the
tick size pilot to try to liquefy those less liquid small-cap
names. So we look forward to that program and measuring the
effectiveness of that program to see how that works.
Also, NASDAQ has initiated an alternative way to bring
companies to the listed market through our private markets
program. So with those two efforts, I think that we will watch
the growth of those newly small-cap companies come to market.
Senator Crapo. Thank you very much.
This second question is addressed to all three Members of
the panel. I would like you, if you would, please, to discuss
with me what the proper role, if any, there is for dark pools
in today's markets, especially for institutional investors. Is
there a role for dark pools? Or should we look at eliminating
them?
Mr. Lauer. I would say that the proper role for dark pools
is probably how they were originally envisioned, which is as
crossing networks for block trades, a way for institutional
investors to put interest out there without tipping their hand
to the market, not as a place that is extremely fragmented with
order sizes that are the same as or smaller than the lit
markets.
Senator Crapo. Mr. Ratterman.
Mr. Ratterman. I believe that there is a definition place
in our market infrastructure for dark pools. As Mr. Cronin
commented on the previous panel, as a representative of the
institutional investors, you cannot do large size in a
displayed market at all times, and we would like to encourage
more trading on exchange. But the fact is that a large order
will impact the price adversely, and so having choices to place
your orders in pools that do not display bids and offers and
move the price before you are able to get your trade done is an
important facility in today's marketplace.
I believe that transparency, as referenced on the first
panel, is something that could go a long way to helping improve
the cohesiveness between displayed and non-displayed markets
that transparency around the rules within the engine,
transparency around the pricing, and fairness amongst
participants, and those dark pools would go a long way to
taking away some of the mystique about a dark pool. But the
fact is that dark pools are a necessary, important part of the
institutional trading tool set.
Senator Crapo. Thank you.
Mr. Wittman?
Mr. Wittman. Yes, so in short, you know, we agree with the
use of dark pools for institutional block size trading. But
over the years, we have seen those facilities being used for
more than just the facilitating of large block trading. The
average trade size is now down in the 200 shares range.
So, you know, we believe there should be more transparency
there. We think that the addition of all these dark pools helps
fragment liquidity, which in the end hurts our listed companies
and listed companies on exchanges. So block size is fine, but
the proliferation of the use beyond that is beginning to be
worrisome.
Senator Crapo. So am I hearing that it would be appropriate
or encouraged to prohibit smaller than the large block size
transaction? And is part of the answer as simple as figuring
out what that size is and prohibiting dark pools from engaging
in that sector of business?
Mr. Ratterman. I will go first and say that I am not sure
that I would support that. I think large institutions have a
long history now of breaking their orders up into small sizes,
and so even though the average execution size in a dark pool is
a small number of shares typically, some number of those
executions are a result of larger sizes that have been broken
up and sent to the dark pools, the same way they would have
been sent to the exchanges. And so careful regulation here to
make sure that we do not inadvertently take away tools from the
institution given that so much of their infrastructure has
probably already been designed to break up their large orders
given the way the markets work.
Mr. Lauer. I think that prohibition in this type of top-
down regulation can be dangerous. We can see unintended
consequences from it. One thing that we are pushing with the
Healthy Markets platform is for a trade-at rule and for pilot
tests around the trade-at rule. I agree with Mr. Cronin from
the earlier panel that a comprehensive trade-at pilot would
help us to see what the effects would be from imposing a burden
to execute off-exchange for small orders. And what it says is
if you are going to damage the price discovery process on the
lit markets by displaying your interest off-exchange and
executing off-exchange, there has to be significant price
improvement, with an exclusion for block trades. And I think
that when you see the change in behavior that that will
encourage and the change in the dynamics of the types of orders
that reach lit markets, it would be healthier for both the dark
venues trying to facilitate block trades and the lit markets
trying to improve liquidity.
Senator Crapo. Thank you.
Senator Reed. Thank you, Senator Crapo.
Senator Warren, please.
Senator Warren. Thank you, Mr. Chairman.
So we have been talking about investor confidence, the
importance of investor confidence. But there is obviously a
real problem here.
According to a survey conducted last December by the
University of Chicago's Booth School of Business and
Northwestern University's Kellogg School of Management, only
about 15 percent of Americans trust the stock market. That is
one in seven. And just to give some comparison, about 35
percent of the public said they trusted banks and about 17
percent said they trusted large corporations. Fifteen percent
is not a good number. And this matters because people are not
going to invest in the stock market if they do not trust it.
And, in fact, that is exactly what the data seem to show.
Historically, when stocks are going up, net flows into the
stock market are going up. People want to get into the market
when they see that it is rising. When interest rates are low,
that effect should be even stronger. But that is not what
happened in 2012 and part of 2013. Interest rates were low. The
market was shooting up. And net flows were actually down. And
according to survey data from Gallup, the percentage of the
public with money invested in the stock market is steadily
declining over time.
So trust in the stock market is not the only thing that
explains this trend. There are certainly other things going on.
But it is also certainly a contributing factor. Lack of trust
in the stock market means less capital for growing companies,
slower growth in the economy, slower job growth, and it means
that fewer Americans have an opportunity to share in the wealth
that is created by a rising stock market, and that further
increases the disconnect between Wall Street and everybody
else.
Now, we have talked some about it. Michael Lewis made
headlines when he said that the stock market was rigged. And
there was a lot of debate over whether he was technically
correct. But when a company can claim to be trading on stocks
and come out ahead 1,237 days out of 1,238 days, you can see
why some people think the game is rigged for the big buys to
make money and everybody else to lose.
So I would like to get your views on this. Mr. Wittman, let
us start with you. What steps do you think are needed to
improve public trust in the stock market?
Mr. Wittman. Well, I think hearings like these where people
can listen in and hear the comments from the experts I think is
helpful. I think, you know, with some of the failures that have
been alluded to and have been talked about on the panel, the
previous panel, I think are some of the issues that investors
worry and care about. But I believe the exchanges are working
toward improving those situations, as Joe alluded to in his
remarks about self-help and stability and resilience.
Senator Warren. Mr. Wittman, I presume, though, that you
have been doing this over some period of time, and what we see
is confidence in the market seems to be going down, and
people's willingness to invest their money in the market seems
to be going down.
Mr. Wittman. I am not 100 percent sure that the confidence
in the market and the decline in investments are tied
completely together, though, myself. So I am not sure if that
is a true correlation.
Senator Warren. All right, although people are certainly
reporting that they do not have confidence in the market and
that they are over time investing less and less money. And that
is certainly what the flows seem to show. So I do not know what
evidence you have to the contrary, but it seems to me something
needs to be done here.
Maybe you have an idea, Mr. Ratterman. What are your views
on how we can increase investor confidence?
Mr. Ratterman. Two primary points. One is, luckily, the one
that is underway right now, and that is, SEC Chair White's plan
for a holistic review of the equity markets. By my
understanding, that is completely comprehensive and covers
every tenet of market structure that we have today. And while
it may take some time to go through methodically, and as we
have talked about before, you know, a data-driven approach,
what I see is the ability for the regulator, along with
industry, to touch every single point of our market structure
and determine whether it could be improved or maybe it is fine
the way it is. But one way or another, at the end of this
holistic review, it will have touched every single element of
our market structure from a fresh pair of eyes. So I am
encouraged that we have not done that in many, many years, and
that will be a nice point in time to mark that we have looked
and we have assessed. And communication about that process I
think can go a long way.
And then, too, as a subset of, you know, that holistic
review and some of our recommendations is just more
transparency--transparency around how dark pools operate,
transparency around how order execution quality is being
achieved by different brokers. I think the increased
transparency around these elements will go a long way as well.
Senator Warren. Mr. Chairman, I am over time, but would it
be all right if, instead of a second round, I just asked Mr.
Lauer to go ahead.
Mr. Lauer. Thank you, Senator Warren. So I think that I
agree that more openness and more transparency is the first
step and the most obvious step, and we have proposed many
different enhancements to current disclosures and refinements
of current disclosures. Rule 605 and 606 were developed in 2000
and 2001, and they no longer pertain to the current market. So
we need to see more transparency.
I think we need to see more data-driven analysis. We keep
talking about data-driven analysis, but the facilities, the
tools to facilitate that data-driven analysis have not kept up
with the times. Regulators are still using data sets that just
do not pertain to current markets, do not have the right kind
of time stamps and clock resolution. And these things might
sound too mechanical and wonky for the average person, but they
hear lots of things. They hear about feeds that are gamed
because of latencies, and they hear about high-frequency
trading, trading on these time scales, and there seems to be
little public indication that regulators are able to keep up
with that and are able to study markets.
So if regulators could take a different approach, an open
approach where they facilitate access to people in the industry
and academics to study that data and come out with reports that
can conclusively demonstrate the health of the markets, I think
that would go a long way. On top of that, the markets need to
get out of the news. I said in my opening statement that
technology should be invisible. If regulators and SROs can
embrace the complexity theory and understand that technology is
going to fail and design around that, have the systems degrade
gracefully, they could stay out of the news. And I think that
would go a long way toward improving confidence.
Senator Warren. Well, I want to thank you all. I do not
think we can overstate the importance of investor confidence,
and that means investors have got to believe that these markets
work. And they are not going to believe it so long as you
continue to stay in the news, and continue to stay in the news
with this kind of evidence that the market works for the big
guys but not for anybody else. So I appreciate your work on
this. Thank you.
Senator Reed. Senator Shelby.
Senator Shelby. Thank you.
What percentage of the market trades are so-called e-retail
as opposed to institutional trading, roughly? Mr. Wittman?
Mr. Wittman. I believe the stats have retail at around 40
to 42 percent, but I can get back to you with the exact----
Senator Shelby. Would you furnish that for the record?
Senator Shelby. But it is a high percentage of
institutional trades versus say if I was trading retail trades.
Mr. Wittman. Well, an institutional carveout besides the
other trading that takes place between professionals and market
makers. So you have retail, you have institutional, and you
have got the professional that trade with each other. So I am
not sure if the institutional makes up the balance or if others
on the panel have an answer on that.
Senator Shelby. But do you basically agree that confidence
or integrity in the market is key to the markets?
Mr. Wittman. I do, and I think I said that in my oral
statement, yes.
Senator Shelby. Whether it is retail investors or even if
it is institutional investors.
Mr. Wittman. I agree.
Senator Shelby. They have got to believe there is integrity
in the market.
Mr. Wittman. I agree, yes.
Senator Shelby. Do you agree with that, Mr. Ratterman?
Mr. Ratterman. I do.
Mr. Lauer. Yes.
Senator Shelby. What has been driving the so-called dark
pools' or private pools' growth in the market from 16 percent
of all trades in 2008 to over 40 percent as of last month? Is
it because of money? Because they can make more money doing it
privately as opposed to going through the exchange with
transparency?
Mr. Wittman. I will categorize that into two buckets, and I
think Mr. Griffin talked about it a bit on the first panel. The
two buckets for what I consider dark would be, you know, retail
internalization, and then another set was institutional, and I
would call it almost cost avoidance, avoiding probably the take
fees from exchanges. So those two buckets. So profitability and
probably cost avoidance would be the two top points in there
which create this fragmented market structure, lack of
transparency.
Senator Shelby. Of course, we all know that technology has
changed just about everything, not just the capital markets,
but it has changed it tremendously. But when you have the high-
frequency trades--and this is a result of technology and
growth, we know that--it does give these people a certain edge.
I mean, they might hold a stock for 2 seconds or a split second
and they make money out of it, and people are looking for the
best investment in the market. But how do retail people--say if
I wanted to buy some stock in the market, how do I compete with
that? Or do I?
Mr. Lauer. You do not.
Senator Shelby. You do not. That answers that. You agree
with that.
Mr. Lauer. I agree. It is----
Senator Shelby. You cannot compete with it, can you?
Mr. Lauer. No. There is no sense in it. Your holding period
is months or years.
Senator Shelby. Does that go back to the issue of
confidence, people say, well, gosh, I cannot compete with these
people in the marketplace? Does that erode the capital markets?
Or does it just keep the retailers out?
Mr. Lauer. I am not sure from that angle that that erodes
confidence, but I do think that an amount of uncertainty or
misunderstanding about the nature of high-frequency trading and
the confidentiality with which those firms treat everything
that they do. I mean, obviously their code is confidential, but
there has been very little publicity or in-depth understanding
until very recently about what high-frequency trading even is
and how varied the trading activity is that occurs under this
umbrella term. So I think that from a retail perspective, if
you do not quite understand it and you hear about dark pools
and--you know, it used to be that the market was easy to
understand. Your order made it to a guy down on a floor.
Senator Shelby. Do you agree that dark pools, the term
``dark pools'' has a negative connotation with the average
person?
Mr. Lauer. I think that the connotation has become
negative, and when you look at what the Attorney General
discovered recently, there is not--that is not unfounded. And I
think that when you look at the tremendous conflicts of
interest with brokers operating their own dark pools and the
conflicts of interest in the payment for order flow model, the
retail internalization, and the way that retail brokers make
routing decisions, and the fact that there is no enough
transparency and accurate transparency into those broker
routing practices, all of that contributes to increasing
concern and increasing tension on the retail trader side.
Senator Shelby. Mr. Wittman, let me ask you this question.
I do not know how you regulate or overregulate, or whatever you
do to block trades. I mean, we have had block trades. We have
great institutional trading of pension funds, of endowments
from universities, everything else, and they have always had
block trades. How do we not fool with that, not mess with that,
yet try to bring some confidence into the market?
Mr. Wittman. Well, the whole institutional side of the
business has changed a lot in the last 5 years. I think they
have learned to try to adapt to the current marketplace, as Joe
pointed out. They take these larger orders now, and they are
trying to put them on exchanges, in dark pools, to try to get
their executions and try not to impact the market. So I think
the days of seeing, you know, a million share block go up on a
TRF are not coming back anytime soon, unless there is
regulation in place which allows them to find the counterparty
more easily and print that. But I do not see that anytime soon.
Senator Shelby. Mr. Ratterman?
Mr. Ratterman. So in today's matrix of trading venues,
there are two locations where large block trades can happen and
do typically, and Liquidnet and ITG POSIT are two examples of
large block trading venues. And the average trade size, as I
understand it, can be as high as 30,000 or 40,000 shares on
Liquidnet.
So there are opportunities, and this goes back to, I think,
the competition and the choice that is offered institutional
investors, if they want to try and find a large counterparty to
their trade, they can try to advertise, if you will, in a place
like Liquidnet or ITG. If they do not feel confident that they
can find that large counterparty, they can break their order up
into small pieces and put them on exchanges or dark pools.
It is a very challenging task, especially in small- and
mid-size stocks, to find a counterparty, and in reality, given
that everybody has adopted to today's market structure, the
other large size has already been broken up before it can find
a counterparty, and so people have simply adopted to the way
that the markets have brought some of the benefits of
competition, but the challenge of fragmentation is that these
orders are not coming to the market in their original large
size very often.
Senator Shelby. Mr. Lauer?
Mr. Lauer. Yes, I completely agree. I think the main issue
with that is fragmentation, and when you have broker-operated
dark pools and brokers incentivized to rest these large orders
in their dark pools, you have all of these shallow pools
sitting around and nobody able to find each other. ``Ships
passing in the night'' it has been called.
Senator Shelby. One last question. My time has gone, but
how do you discern and differentiate between people looking for
the edge in the marketplace, which they all are, as
manipulation of the market itself? They are probably two
different things. Sometimes maybe it is murky. Mr. Wittman?
Mr. Wittman. Yes, you know, your question takes me toward
the HFT angle a bit and Senator Warren's comments earlier. You
know, with HFT, I would look at it more as high-frequency
market making. You have got to take a look at not that they are
latency sensitive if they are HFT labeled, but what are they
actually doing with their algorithms? Are they doing something
nefarious? Are they doing something across markets? Are they
trying to push a market or do something else in the equity
market? We have the opportunity to run and equity and options
markets, so what are the relationships between what they do in
equities and options?
So it is not the fact that they are latency sensitive or
they have got a tag of HFT. They are putting capital at risk.
They are making markets for others to trade at on exchange,
which is different than a dark pool. They are not accessible.
So I think that is what the difference is. We have got to take
a look at from a surveillance perspective, what are their
algorithms doing, how are they behaving, and look at that
behavior.
Mr. Lauer. I think surveillance is just a critical issue,
and it is something that has been very underinvested in, and
even with the amount of investment, there has not been
innovation. So one of the ideas that I put forward in 2012 was
to have an open platform where people could design manipulation
detection algorithms for prizes, and you would have
participants competing over better and better algorithms to
find that type of behavior, and either there could be a stake
put up or they could have a percentage of fines collected. I
think creative solutions like that--and I am sure there are
better ones out there--are the way--that is the way forward in
trying to understand the activity in the market. It is not
going to come from individual regulators or even individual
people. It has got to come from the marketplace and from the
expertise that you have from practitioners. You know, if you
had--you cannot tell me that regulators, for example, can
understand nuanced mathematical manipulation across the
treasury yield curve, for example, but there are certainly
practitioners out there who could. The same could be said for
cross asset class manipulation as well.
Senator Shelby. But all markets would work better with
integrity and a perception of integrity in the market, would
they not?
Mr. Ratterman. I absolutely agree. Perception is vital to
people's confidence. Whether it is actually as solid as people
think or if they think it is not, the perception is what drives
the investment decision.
If you do not mind, I would just like to throw out three
additional points here. One is that I do believe that we have a
competition amongst regulators with regards to surveillance,
and maybe that is not talked about enough. But each of NASDAQ
and NYSE and BATS and Chicago in the equity markets--those are
the four equity market operators--have their own separate
surveillance technologies, each of which has been developed
independently and looking for not only on-market but across-
market surveillance problems.
In addition--and I would like to give more credit to the
SEC's MIDAS system and Gregg Berman and their efforts there.
You know, that system has actually taken every single direct
feed from every single electronic book as well as the SIPs, the
consolidated tape, and has done comparative analysis of the
numbers and the flow and been able to produce what I think are
some very insightful discoveries about the functioning of our
equity markets.
Then, finally, while it is taking probably longer than it
should, there is an effort by the industry the SEC led with the
SROs to create the consolidated audit trail. That will get
done. It will have all the data so that multiple regulators can
peek inside for true cross-market surveillance with a
competitive angle to it. So I see a lot of light down the road.
Senator Shelby. Thank you, Mr. Chairman.
Senator Reed. Thank you very much.
Mr. Lauer, in your 2012 testimony and again today, you
talked about the central role that has to be developed for
comprehensive surveillance. Do you believe that we need an
legislative initiative to give the SEC the authority to do
that? Or is that something within their authority today?
Mr. Lauer. I cannot say I know the regulatory authority
rules well enough, but it does seem like something needs to be
done to get different agencies working together. Whether that
is legislative or through FSOC and OFR or just sitting them
around the table, I think it is a critical issue.
Senator Reed. And Mr. Ratterman has made comments about
MIDAS, and I think you in your testimony also commented on
MIDAS. Can I have your view?
Mr. Lauer. Yes, and I do not mean to denigrate the work
that the SEC is doing, but there is no arguing with the fact
that MIDAS is missing over half of the activity just in
equities markets. They do not receive the resting orders on
dark pools, hidden orders on lit exchanges, immediate or cancel
orders that do not interact with liquidity on lit exchanges,
certain characteristics of exotic order types. There are no
participant IDs. It is a system that any private firm would
build in order to study markets, and that is exactly what
happened, is that it was built by a private firm, an HFT firm
that also builds out infrastructure. And I do not, you know,
say that in any way other than to say they probably understood
the technology best, but in my mind regulators should have
better technology than participants. And I think that when you
are talking about feeling confident and comfortable that
regulators are on the beat and are on top of things, that is
one of those areas in which you would have expected them to do
more than just build what any other private firm has.
Senator Reed. And I will make the obvious point that the
regulators have a much more limited IT budget than any one of
the participants. We tried to fix that a little bit, but we
have not gone as far as we think we must.
An interesting point, and it goes to this discussion of
Senator Shelby and Senator Warren, about confidence in the
market. The market has changed. I mean, the old-fashioned,
nostalgic view of the stock market is capital formation. That
is where you form capital, which ultimately created jobs. And
now it is about trading.
John Bogle, who will know more about this stuff than I will
ever, made a speech a few months ago, in April, and he said,
you know, the numbers tell the story: $56 trillion per year in
trading volume as investors buy from and sell to one another,
minute after minute, day after day, year after year. That $56
trillion of trading volume dwarfs the capital formation total
of $270 billion. Result: Short-term trading on the Wall Street
casino represents 99.5 percent of the market's activity, and
long-term capital formation, which is the small investor
putting money in hoping that someday it will pay for college
for the kids is just a sideshow, really. And that I think is
becoming a reality that people appreciate. They are looking at
this--and high-frequency traders are the ones that have got the
most sort of attention at the moment because of the book and
because of other things, but the market itself is--you know, as
he says, it is a casino. And I think people are getting that
impression.
Then, of course, you have got two recent suits by FINRA and
by the Attorney General of New York questioning the operations
in dark pools.
So all this is coming together for the perception that--as
I say, this skepticism about the market working for long-term
capital formation, which is--so I will just get your comments,
Mr. Lauer, and then----
Mr. Lauer. Yeah, I agree. I think it is unfortunate----
Senator Reed. And I must say the FINRA--the FINRA was a
settlement without acknowledging any malfunction. The suit by
Schneiderman is an allegation now. It has not been concluded.
Mr. Lauer. Yes, I agree with you, Senator Reed. I think it
is unfortunate, the perception of the industry. I know a lot of
people in it. They work really hard, and, you know, a lot of
people are trying their best to help fix things or to make it a
little simpler, reduce complexity. But there is an ongoing
debate over market structure, and you have several different
parties, but there are people in the industry, very well
regarded, who understand markets and do not think that things
are right. They think that there are problems that need to be
fixed. Even people who think that markets are better than they
have ever been agree that there are serious problems that need
to be addressed.
And so when that is the message that comes out, it is no
wonder that perception is where it is, and I think that if we
had more data, if there were much clearer answers, the issues
that we were debating would not be as severe. We would be able
to have clearer answers, and that is the frustration, because I
know the answers are out there. It just seems like the data is
not being analyzed.
Senator Reed. Mr. Ratterman, please.
Mr. Ratterman. Senator Reed, I think you are right to point
out the difference not only in function but in the notional
side of capital formation versus price formation. And, you
know, from my perspective, as both an operator of an exchange
as well as an individual investor, I look at those as very
different activities, and I try not to conflate them.
You know, when I think about capital formation, I think
about small companies trying to raise money to, you know, grow
their operations or, you know, whatever they are going to do
down the road. And they need that money from investors, and
investors typically would be institutional investors that are
providing the funds for these growth companies, I think, as
opposed to individual investors. I myself am just too risk
averse to want to invest in an IPO. I would rather see a track
record before I invest.
So I think that market structure is probably maybe one
element of maybe a friction for capital formation and the fact
that maybe small-cap and medium-cap stocks are not as well
handled in today's one-size-fits-all market structure. Things
like the tick size could potentially, you know, help
institutional investors feel a bit more confident to enter and
exit a position in a small-cap stock, which would then
encourage small-cap companies to come to market.
I think there might be other things to look at as well. You
know, it could be that the weight of being a public company,
given other regulation, completely outside the equity markets,
Sarbanes-Oxley compliance, et cetera, you know, may be a factor
in determining whether a company goes public or not. I am not
saying you should do away with Sarbanes-Oxley. I am just saying
that there is a balance between the security of a company who
has gone through those rigors and the weight that it carries in
the decision to go public or not to go public.
So when I look at price formation as the larger of the two
notional values, you know, I look at it as an individual
investor. When I go to trade a stock that I can see a track
record, there is somebody standing there day in and day out
willing to take the other side of my trade, and that is the
trading, I think, that happens in the secondary markets that is
beneficial to the investor who is not risk averse--who is risk
averse, who does not want to invest in IPOs, but wants to
invest in companies with a track record. That is where you can
go and find the standing market day in and day out.
Senator Reed. Mr. Wittman, please.
Mr. Wittman. The amount of trading that is taking place in
the top 50 or 100 issues, it is all consolidated up in those
names. So the more, I think, that we see trading take place
off-exchange, the less liquidity we are going to have in these
lower small-cap names. The exchanges are providing indicative
prices to the public. They are on-screen. But for the most
part, when it comes to customer flow, that flow is executing
off of an exchange. It is using indicative pricing from the
U.S. exchanges and executing off-exchange and reporting through
a trade reporting facility, which in the end I think is going
to hurt the capital formation and price discovery.
Senator Reed. Thank you.
Senator Crapo, any questions?
Senator Crapo. No.
Senator Reed. There are no further questions. Gentlemen,
thank you for your excellent testimony, and this hearing is
adjourned. Thank you.
[Whereupon, at 12:11 p.m., the hearing was adjourned.]
[Prepared statements and responses to written questions
supplied for the record follow:]
PREPARED STATEMENT OF SENATOR JACK REED
Thank you, Mr. Chairman. In 2012, Senator Crapo and I, as the then
Ranking Member and Chair of the Securities Subcommittee, held two
hearings on Computerized Trading, taking a critical look at what the
rules of the road should be. And in one sense, not much appears to have
changed because we're still asking the questions we asked back then.
Are our markets still fair? Is everyone playing by the same set of
rules? And are our markets focused on long-term capital formation and
the creation of jobs?
Given the complexity of our markets and the pace at which
technology is advancing, these are questions we will ask with
regularity in order to ensure that we continue to harness the
advantages of technology and minimize, to the best of our ability, the
errors that technology can magnify in our markets. Our capital markets
are a public good, much like our interstate highway system. While no
analogy is perfect, I do believe that we need clearer rules of the road
here in our markets, and as the markets continue to evolve, the
regulators and we must keep pace to ensure that our markets are fair,
accessible, and effective.
Before I conclude, I would like to apologize ahead of time for
missing the first panel of witnesses due to a closed hearing on the
situation in Iraq and Afghanistan in the Armed Services Committee, on
which I also serve. I will, however, return for the second panel of
witnesses before the Banking Committee today. Thank you, Mr. Chairman.
______
PREPARED STATEMENT OF JEFFREY SPRECHER
Chairman and CEO, Intercontinental Exchange, Inc.
July 8, 2014
Chairman Johnson, Ranking Member Crapo and Members of the
Committee, my name is Jeff Sprecher and I am the founder, Chairman and
Chief Executive Officer of Intercontinental Exchange, or ICE. We very
much appreciate the opportunity to appear before you today to share
with you our views on the U.S. equity markets.
As background, ICE was established in 2000 as an over-the-counter
(OTC) marketplace with the goal of providing transparency and a level
playing field for the previously opaque, fragmented energy market. In
the past 14 years, we have grown our business substantially from a
startup company in Atlanta to a global company with 11 exchanges and
five central clearing houses in the United States, Europe and Asia.
Much of our growth can be attributed to solving complicated
problems by investing in existing businesses and making them more
efficient and transparent to the benefit of our clients and the broader
marketplace. We have inevitably faced headwinds as a result of
challenging the status quo but believe strongly that our vision,
together with our ability to work with regulators and customers, is
what has allowed us to be here today.
In November of last year, ICE completed its acquisition of NYSE
Euronext. I quickly learned that operating an equities exchange comes
with a much higher profile given the public price discovery function it
performs. Combined with the New York Stock Exchange's role in the
global capital markets, we understand the strong public interest and
economic importance of well-functioning markets. Meeting with
participants from every corner of the securities market, it is clear
that the business has changed in less than 10 years. While some of this
change has been beneficial, the equities market has become far more
complex and fragmented than participants want it to be, and that we
believe it needs to be. We believe competition among trading venues is
important to markets, but also that there are other equally important
factors, such as the ability of buyers and sellers in a marketplace to
meet and compete with each other.
Although we may not all agree on the details of an equities market
structure, I think there are a few points of agreement among the
panelists today worth highlighting. First, the capital markets are a
critical tool that businesses need to permit investment in new
companies and to expand existing ones. Second, one of the most
important factors in maintaining a strong capital market is the trust
and confidence of issuers and investors that the market will be fair.
And third, in our current markets, investors--particularly individual
retail investors--enjoy greatly improved, cost-efficient access to the
stock market.
ICE, however, believes that because markets are not stagnant, there
are improvements that can be made in response to the market's evolution
that will benefit investors and market intermediaries if we simplify
the structure and realign incentives to improve the fairness of markets
to investors.
There are several issues we have raised and continue to question.
For example, we do not believe it is fair that some investors are
permitted to trade in dark markets without either first interacting
with lit markets or providing some tangible benefit to the investor
such as meaningful price improvement or size improvement. We question
whether the maker-taker pricing model used by trading venues to
compensate liquidity providers adds to the complexity problem and
increases the appearance of conflicts of interest that brokers face in
executing trades on behalf of clients. We also have concerns about the
rising level of fragmentation and believe that the increased technology
cost and risks that are born from maintaining connections to as many as
60 trading centers is unnecessary and ultimately increases costs to
investors.
While Regulation NMS sought to increase competition among markets
and consequently increased fragmentation, the costs associated with
maintaining access to each venue, retaining technologists and
regulatory staff, and developing increasingly sophisticated risk
controls are passed on to investors and result in unnecessary systemic
risk. The fragmentation also decreases competition among orders. Orders
routed to and executed in dark trading centers do not interact or
compete with other orders, which detracts from the price discovery
function that participants in lit markets provide. The lack of order
competition in a fragmented market negatively impacts markets in the
form of less liquidity, information leakage and wider spreads.\1\
---------------------------------------------------------------------------
\1\ Securities Exchange Act Release No. 51808, 70 FR 37,533, 37,608
n.990 (June 29, 2005) (Reg. NMS Adopting Release); Request for Comments
on Measures to Improve Disclosure of Mutual Fund Transaction Costs,
Investment Company Act Release No. 26,313, 68 FR 74,820, 74,822 (Dec.
24, 2003); Daniel G. Weaver Study available at: http://www.sec.gov/
comments/s7-02-10/s70210-127.pdf. John McCrank, ``Dark Markets May Be
More Harmful than High-Frequency Trading'', Reuters, April 6, 2014
(http://www.reuters.com/article/2014/04/06/us-dark-markets-analysis-
idUSBREA3508V20140406).
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Excessive complexity also hurts market confidence and I believe
deters some investors and entrepreneurs from accessing the public
markets. Although there has been an uptick in IPOs recently,
entrepreneurs don't seem as positive about taking their company public
as they used to be, which limits job creation and economic growth. And
investing in the market is the best available option that millions of
Americans have to grow their savings. We need a resilient, long-term
investor base that believes the markets are fair, operate on a
sufficiently robust infrastructure and have minimal intraday
volatility. And maintaining minimal intraday volatility is often a
result of sufficient order competition.
As we highlight below, there are several items that we believe, if
addressed, would help fix many of the cracks that have been brought to
our attention since entering the equities business. However, the goal
of our recommendations is largely grounded in the same goals as
Regulation NMS: To increase competition among individual markets and
competition among individual orders; and to minimize the transaction
costs of long-term investors and thereby reduce the cost of capital for
listed companies.\2\ While NMS achieved its goal of increasing
competition among markets,\3\ the pendulum has swung too far at the
cost of less competition among orders.
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\2\ Securities Exchange Act Release No. 51808 (June 9, 2005), 70 FR
37498, 37501 (June 29, 2005) (Reg. NMS Adopting Release).
\3\ There are currently 13 equities exchanges, none of which
maintains more than 20 percent of consolidated average daily volume.
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To correct these trends and rebalance the tradeoffs of yesterday,
we believe now is the time to take action to build the confidence of
individual investors and companies seeking to access the public markets
and to bring back the balance set out in the Securities Exchange Act of
1934.
While we should move forward expeditiously with pilot programs,
where data gathering and analysis is necessary, my firm has outlined
the following recommendations for the industry that we believe should
be quickly adopted:
1. We should enhance order competition by giving deference to
regulated, transparent trading centers where orders compete and
contribute to public price discovery information. Limited
exceptions could apply for those with unique circumstances.
2. We should eliminate and ban maker-taker pricing schemes at
trading venues. Rebates that were used to encourage
participants to quote on regulated, transparent markets add to
complexity and the appearance of conflicts of interest.
3. We should lower the statutory maximum cap on exchange fees.
Regulation NMS set a cap of what regulated transparent markets
can charge to access a quote. In combination with giving
deference to regulated, transparent markets and eliminating
maker-taker rebates, we believe that the SEC should require
lowered exchange access fees.
4. We should revamp the current market data delivery system. We
support the SEC taking a closer look at the current Securities
Information Processors and proprietary data feeds to adopt
policies that promote fairness.
5. We should require increased transparency in the way that markets
operate. The SEC should demand that all trading centers report
trade executions in real time, and all routing practices should
be disclosed by those trading centers and brokers who touch
customer orders.
In summary, we believe that adopting these proposals will help to
inspire confidence in the investing public in the U.S. capital markets.
Thank you again for inviting me to testify today and I look forward to
your questions.
______
PREPARED STATEMENT OF KENNETH C. GRIFFIN
Founder and Chief Executive Officer, Citadel LLC
July 8, 2014
Chairman Johnson, Ranking Member Crapo, Members of the Committee, I
am Kenneth Griffin, Founder and CEO of Citadel LLC. I appreciate the
opportunity to testify here today and share our views regarding the
state of the U.S. equity markets.
Established in 1990, Citadel is a leading global financial
institution that provides asset management and capital markets
services.
Citadel manages in excess of $20 billion in investment capital on
behalf of institutional investors and high net worth families. As a
significant investor in the U.S. equity markets, Citadel has a strong
interest in the integrity, transparency, efficiency, and stability of
our markets. Our equity research teams follow over 1,800 public
companies, seeking to identify appropriate investment opportunities.
Our equity research process, combined with our ability to execute upon
our investment ideas in a cost-effective manner, enables us to deliver
returns to the pensions, endowments, sovereign wealth funds and other
institutions that entrust us with their investment dollars.
Citadel Securities is one of the leading market makers in the
United States, and is a market leader in the execution of orders on
behalf of retail investors. Citadel Securities makes markets in more
than 7,000 U.S.-listed securities and 18,000 OTC securities worldwide.
Since 2005, we have used our automated trading systems to deliver
greater reliability, innovation and service to retail investors. In
short, we empower retail investors by deploying sophisticated
technology with respect to market data, order routing, and execution
strategies in providing best execution.
Our capabilities allow us to deliver faster, more reliable and
lower-cost trades for millions of retail investors. This has made us a
trusted and valued resource to most of America's major retail brokerage
firms. Our continued investment in people, compliance, process and
technology earns us business on the merits, and I am proud to say that
our continued growth is evidence of the enormous commitment we have
made to support the interests of retail investors.
Citadel's experience as both an institutional investor and an
active liquidity provider in the U.S. equity markets gives us deep
insight into the strength, structure and resilience of our equity
markets. From that vantage point, I can state without hesitation that
the U.S. equity markets are the fairest, most transparent, resilient
and competitive markets anywhere in the world.
* * * * *
The U.S. equity markets play a fundamental role in our economy.
They facilitate capital formation by channeling savings into productive
enterprises, creating a win-win for American investors and businesses,
both small and large. The more efficiently our markets operate, the
greater the benefit to the investing public and to the enterprises that
rely on them to fund the growth of their businesses.
In recent months, some have questioned the fairness of U.S. equity
markets. They have raised serious questions about the changes that have
taken place in our markets. They have called into question the motives,
and in some cases even the integrity, of market participants,
exchanges, regulators and virtually everyone else who has introduced
the changes that have unleashed competition and revolutionized the way
our securities markets work.
It is my intent today to respond to this criticism, and to separate
fact from fiction.
Over the past two decades, a wave of innovation has swept through
the markets in response to new technologies and thoughtful regulation.
This has disrupted the ``old boys' network'' to the benefit of all
investors. While the basic function of the stock market--matching
buyers and sellers--remains the same, the mechanisms through which
buyers and sellers come together has been revolutionized. In the
supposed ``good old days,'' much of the trading in a given stock
happened on the trading floor of a single stock exchange in a single
specialist post under the control of a single specialist.
In recent years, regulatory changes combined with technological
innovation have disrupted the old order. Today's markets are incredibly
competitive, wherein a variety of competing trading venues have emerged
alongside the exchanges. Orders are now matched and executed by
computers and a new generation of analytically driven and
technologically sophisticated market participants has emerged as the
dominant liquidity providers, displacing the manual intermediaries that
once controlled the markets.
The unleashing of competition and surge in innovation has markedly
improved conditions for all investors, who benefit from dramatically
lower trading costs, improved market transparency and liquidity, and
increased competition by liquidity providers. As a result, bid-ask
spreads are substantially narrower, currently averaging less than 0.03
percent for S&P 500 stocks, while displayed market depth for the
average stock, measured as the value of the shares displayed on the bid
and offer, is nearly triple what it was a decade ago.
Fees and commissions are also much lower--retail investors can now
trade for under $10 (down from $25+) and institutional brokerage
commissions often are less than 2 cents per share (down from 6 cents),
and can be as low as a fraction of a penny per share. Retail investors
in particular have benefited--not only do they frequently get better
prices than those publicly quoted, but they often get their orders
filled at such prices for more size than is publicly displayed.
The disruptive innovation that has taken place within the equities
market has created winners and losers. While investors have clearly
benefited, most legacy market participants have lost out. They simply
cannot compete in today's hyper-competitive and incredibly efficient
marketplace. And so we should not be surprised that they publicly yearn
for the old days when they extracted disproportionate rents from
investors on the basis of anti-competitive business practices.
I applaud the regulatory efforts to ensure that U.S. equity markets
continue to best serve the interests of all investors. In this regard,
Citadel supports a data driven and comprehensive review of U.S. equity
market structure, and we believe the SEC is taking constructive steps
to gather and analyze relevant data and information, ensure the
market's operational stability, and protect market quality and
fairness.
The SEC has implemented several measures to obtain the data it
needs to evaluate market operations, quality, and performance. For
example, the SEC has adopted the Large Trader Rule and the Consolidated
Audit Trail framework, and has implemented the MIDAS system through its
new Office of Market Analytics so that it may efficiently gather key
data and analyze significant market events and trading activities. The
financial crisis and the May 2010 ``Flash Crash'' illustrated the need
for the SEC to be able to swiftly reconstruct and analyze market
events. Moreover, as the SEC considers various reform ideas and
assertions about problems with the current equity market structure, it
needs a rich set of data to analyze methodically. That will ensure that
the SEC has the best information available when making these critical
decisions.
With the balance of my testimony, I want to focus on a handful of
ideas and concepts that I believe will further strengthen investor
protections, further improve price transparency and market liquidity,
and promote market resiliency in times of crisis.
* * * * *
Enhancing Market Quality
Today's markets are more competitive and liquid, with lower overall
transaction costs, than ever before. To further improve market quality,
we must continue to take steps that encourage competition. Encouraging
competition leads to greater price discovery and market liquidity and
reduces both the cost of trading for investors and the cost of capital
for American businesses. As we foster greater competition, we must
continue to take steps to protect the interests of retail investors in
our equity markets.
I recommend the following proposals to enhance our market quality.
Take a Rational Approach to Tick Sizes
The SEC recently ordered the exchanges and FINRA to jointly develop
a pilot plan that would require certain stocks to trade in minimum
price increments larger than the current one penny trading increment
(the so-called minimum ``tick size''). We applaud the SEC for its
efforts to gather hard data on this topic before embarking on any
broader or longer term policy changes. We nonetheless remain concerned
that widening tick sizes will artificially widen spreads and thus drive
up trading costs for all investors without any tangible offsetting
benefit to market quality.
We believe that the SEC should instead focus on tick increment
reforms that will both promote liquidity on displayed markets and
reduce the cost of trading. Specifically, the SEC should establish a
half-penny tick increment for the highest trading volume stocks trading
under a specified dollar value. In many cases, the half penny shaved
off the one-cent increment will go directly into the pockets of
investors. And rather than having to go to dark pools to find mid-point
liquidity in such stocks, smaller tick sizes would allow this liquidity
to be displayed and readily accessed in the lit markets. This
modification would thus bring substantially more of the orders and
trades in these stocks to lit markets, and move them away from the dark
markets.
Reduce Access Fees to Reflect Declining Transaction Costs; Broaden Caps
on Access Fees
Under Regulation NMS, the charge to liquidity takers in today's
maker-taker system is called an ``access fee.'' The current NMS maximum
access fee of 30 cents per 100 shares is now significantly greater than
the cost of providing matching services by the exchanges and should be
reduced to reflect the current competitive reality. Exchanges are
permitted to share the access fees they charge with liquidity providers
in the form of exchange rebates. A meaningful reduction in the maximum
access fee would materially reduce exchange rebates.
In general, exchange rebates encourage exchanges and liquidity
providers to be more competitive. Exchange rebates also reward and
encourage displayed liquidity, which greatly benefits the price
discovery process. Banning exchange rebates would dampen competition
between exchanges and would result in less posted liquidity and could
result in wider quoted spreads. The SEC has wisely focused on
disclosure and other mechanisms to manage any potential conflicts of
interest that may arise as a result of these fee structures. We believe
a reduction in the minimum tick size for the most liquid low priced
securities combined with a reduction in the maximum permitted access
fee would serve the best interests of all market participants.
More importantly, we urge the SEC to close gaps by adopting an
access fee cap in important segments of the market that have no access
fee cap. First, we urge the SEC to expand the access fee cap to include
quotes that are not protected by Regulation NMS. Second, we urge the
SEC to implement a parallel (and proportionate) access fee cap for sub-
dollar stocks. Third, the SEC should move forward with its proposed
rulemaking to cap access fees in the options markets.
Reduce Regulatory Arbitrage Between ATSs and Exchanges
In recent years, increasing amounts of trading has occurred on
Alternative Trading Systems (``ATSs''). While public quotes on
exchanges are available to all investors, this is not necessarily the
case for liquidity present on ATSs. In fact, ATSs may refuse access to
certain market participants, make available order types that will not
interact with certain types of participants, give execution priority to
certain market participants, and/or charge different fees to different
types of participants.
ATSs (which include dark pools) should be subject to anti-
discrimination rules comparable to those that apply to securities
exchanges, and should be required to offer fair and impartial access to
market participants. In particular, ATSs should only be allowed to
determine execution priority based on the characteristics of an order
(e.g., price, size, time of arrival), and should not be allowed to
allocate executions based on the identity of the sender. For example,
broker preferencing is a practice that has the potential to return our
markets to the ``old boys' network'' of prior decades when who you were
and who you knew mattered more than the merits of your order.
Reducing the regulatory arbitrage between ATSs and exchanges will
foster greater competition between the venues, and reduce the
incentives to conduct business on the often discriminatory ATSs at the
expense of our public markets.
Preserve the Transparent and Regulated Practice of Payment for Order
Flow
We support the SEC's well-established policy of permitting payment
for order flow for a number of reasons. First, payment for order flow
is a transparent and regulated practice, whereby exchanges and market
makers pay a fee to broker-dealers that route orders to them. If a
broker-dealer receives payment for order flow, it must disclose this
arrangement under SEC regulation, so that its customers may decide
whether they want to continue to send their orders to the broker-dealer
in light of the payment for order flow arrangements. Second, payment
for order flow does not affect a broker-dealer's obligation to obtain
best execution for its retail customers. Third, and perhaps most
importantly, payment for order flow that is subject to a robust
disclosure framework is far better and creates more accountability than
opaque reciprocal business practices that would otherwise proliferate
and could not realistically be prohibited.
Enhance Retail Investors' Transparency into Brokers' Execution Quality
In an effort to ensure that investors are receiving the best
execution possible, we believe the SEC should require brokers to
publicly report consistent, standardized execution quality metrics in a
way that allows investors to easily measure performance. We can empower
retail investors with information about brokers' execution quality and
position them to make better decisions, while also enforcing an
important check on the brokerage community. Today, retail investors
don't have access to all the information they could or should have, and
can only see which destinations are utilized by their brokers, along
with very basic information about payment for order flow arrangements.
While retail investors may request more specific information regarding
their orders, they have no way to compare the quality of the executions
received by competing retail brokers.
We recommend that the SEC require all execution quality reports to
be comprehensive, understandable, accessible in a downloadable format,
and published for at least 3 years. Investors can then track the
quality of executions over time, and hold their brokers accountable.
Moreover, the disclosure of payment for order flow could be enhanced by
requiring that precise amounts of remuneration (hundredths of a cent)
be disclosed as opposed to the current practice of providing rounded
numbers in the reports (typically preceded by the phrase, ``less
than'').
Increase Protections for Retail Investors Trading Odd Lots
We recommend that the SEC amend applicable order protection rules
to reclassify an odd lot to be an order for value of less than $500.
Currently, any order for less than 100 shares is considered an odd lot
and does not receive the same protections as the best round lot quote
in the same stock. Because many stocks are trading at a high dollar
value, many investors are being unnecessarily deprived of the benefits
of protections received by round lot orders. For example, Google,
ticker symbol ``GOOG,'' ended the month of May trading at over $550 per
share. An investor placing a 50 share GOOG order is investing over
$27,500--yet that investor's limit order is not protected from being
traded through because it is considered an odd lot. As a result, quoted
spreads are wider than they should otherwise be since this liquidity is
not reflected in the protected quote. Given that odd lots accounted for
nearly 5 percent of trading volume in 2013, odd lot status needs to be
redefined and based on total order value, not share quantity.
* * * * *
Improving Market Resilience
Operational soundness and stability are fundamental to the
confidence that participants have in any market. Automation and
computerized trading have dramatically improved these conditions.
Previously, markets were notoriously opaque and errors and control
breakdowns were the norm. Participants in manual markets, including
Citadel, would routinely encounter workflow control issues, trade
breaks, and delays in receiving fills and trade confirmations. Although
some have chosen to reminisce fondly about the past, the reality was
much different.
In recent years, the SEC has taken important steps to further
strengthen the stability and operational functioning of our markets.
The Regulation SCI proposal, the adoption of Rule 15c3-5 on market
access, and the post-``Flash Crash'' reforms addressing liquidity gaps
through limit up/limit down and circuit breaker rules, along with more
predictable clearly erroneous rules and the abolition of stub quotes,
represent important progress.
Those reforms, among others, have served to enhance confidence in
our markets by minimizing the incidence of disruptive trading and
managing and mitigating the consequences of any systemic trading
malfunctions that do occur. Nonetheless, we recommend a number of
additional measures to fully achieve the goal of greater market
resilience.
Mandate and Harmonize Exchange-Level Kill Switches
The SEC should require mandatory exchange-level kill switches, and
ensure that exchanges have clear authority and responsibility to
immediately block and stop activity that appears erroneous and so
severe that it is likely to materially impact other members and the
market. The activity of a large number of market participants
intersects on exchanges and they are thus best positioned to
efficiently and consistently monitor activity across a very large
number of market participants.
To cite one example, while NYSE detected erroneous trading activity
by Knight Capital on August 1, 2012 within a few minutes, the erroneous
activity continued for 30 more minutes. If NYSE had a kill switch in
place, it could have halted Knight Capital's erroneous trading much
sooner, and prevented disastrous results.
While a number of exchanges have responded by implementing some
kill switches, the kill switches that have been implemented to date
suffer from certain weaknesses that have limited their effectiveness.
First, they only provide market participants with the optional
ability to set certain thresholds that may then trigger notifications,
disable order entry, or cancel open orders. We should not rely on
market participants alone to protect the market from their mistakes.
Exchanges should still be required to implement and administer their
own mandatory kill switches.
Second, kill switches add latency to the processing of orders. As a
result, firms that voluntarily use kill switches are disadvantaged
because their orders reach the exchange more slowly than other market
participants' orders. Kill switches offered by exchanges should be
implemented in a manner that introduces no additional latency and
promotes a level playing field.
Third, kill switches are designed differently at each exchange.
This lack of uniformity significantly reduces utility and efficacy
because it requires significant resources to properly configure and
maintain overlapping and inconsistent kill switch parameters at each
exchange.
Remove Exchange SRO Powers and Immunity
The special status of exchanges as SROs that have regulatory
authority over their broker-dealer members, combined with a history of
limited liability, has created a conflicted and weaker market structure
than is optimal for fair and efficient markets.
Exchanges face an irreconcilable conflict of interest in the
performance of their duties as SROs. This conflict of interest in the
dual role of regulator and competitor has led to inconsistencies in the
manner in which the exchanges regulate their members. On the one hand,
public exchanges are bound by their fiduciary duty to maximize
shareholder profits, while on the other hand, they are required to be
fair and impartial regulators of the broker-dealers with whom they
compete. Exchanges and broker-dealers have become direct competitors in
many aspects of their businesses. For example, acute competition exists
for order flow, order routing services, and the provision of
algorithmic trading services. Yet, to a significant extent, exchanges
are able to control the landscape on which they and broker-dealers
compete for business.
Further, as SROs, exchanges claim to be insulated from private
liability for damages they might cause, based upon both a judicially
created doctrine of ``absolute immunity'' and limitations on liability
codified by their own rules. Limiting this immunity would increase the
stakes for exchanges in connection with general culpability for
operational failures. Facing liability for operational failures would
give exchanges very strong financial incentives to invest heavily in
steps to prevent or minimize the impact of operational failures.
Apply Regulation SCI to All Alternative Trading Systems
All ATSs, most of which are dark, should be subject to proposed
Regulation SCI. Regulation SCI, as currently proposed, would impose
substantial requirements on how exchanges and the largest ATSs design,
develop, test, maintain, and monitor systems that are integral to
operational integrity. ATSs, which perform the same exact market
function as exchanges, should be subject to the same standards as
exchanges with respect to the issues covered by Regulation SCI.
Proposed Regulation SCI would only apply to the largest ATSs, and we
see no reason for this size limitation.
Balance Benefits and Costs of New Entrants to Check Fragmentation
Regulation NMS and the foundational regulations that preceded it,
along with technological advances, have helped unleash an enormous
degree of competition among market centers. In recent years, however,
the costs that each new market center imposes on the market in terms of
additional complexity and operational risk have started to outweigh the
marginal benefits of a new competing market center. The steps described
above will help restrike this balance by requiring that market centers
have sufficient resources and make sufficient investments in
operational excellence. We expect that over time, this will reduce
fragmentation by eliminating marginal market centers that rely on low
cost of market entry and operation, externalization of the costs of
catastrophic failure, and internalization of the profits of any
success.
* * * * *
To conclude, these are important steps that we should take to
further enhance market quality, improve market resilience and
strengthen investor protection. However, we must pursue this agenda
without sacrificing the extraordinary achievements we have made in
terms of market efficiency, lower costs, and increased fairness and
competitiveness. We must not jeopardize the preeminent global standing
of the U.S. equity markets.
Thank you for the opportunity to testify before this Committee
today.
I would be happy to answer your questions.
______
PREPARED STATEMENT OF KEVIN CRONIN
Global Head of Trading, Invesco Ltd.
July 8, 2014
Thank you, Chairman Johnson, Ranking Member Crapo and Members of
the Senate Committee on Banking, Housing and Urban Affairs for the
opportunity to speak here today. I am pleased to participate on behalf
of Invesco at this hearing examining U.S. equity market structure.
Invesco is a leading independent global asset management firm with
operations in over 20 countries and assets under management of
approximately $790 billion. Many of the investors served by Invesco are
individuals who are saving for their retirement and other personal
financial needs, including U.S. investors in defined benefit and
defined contribution plans, such as 401(k) plans, IRAs and similar
savings vehicles.
Through its investment advisor affiliates, Invesco manages money
for investors worldwide who seek professional participation in the
markets, both directly and through vehicles such as mutual funds and
ETFs. These are long-term investors who are saving for their
retirements, to purchase a home or send their kids to college. These
long-term investors are the cornerstone of our Nation's capital
formation process, and retaining their confidence is fundamental to
well-functioning U.S. securities markets, which are the envy of the
world. To ensure long-term investor confidence, it is incumbent upon
regulators and market participants to address issues raised by
developments in the structure and operation of the U.S. equity markets,
and we are grateful to this Committee for its attention to these
important issues today.
All who seek to maintain our U.S. equity markets as the most
respected in the world should have a strong interest in ensuring that
those markets are highly liquid, transparent, fair, stable and
efficient. Those qualities create a level playing field for all
investors, including ordinary American savers served by Invesco. In
order to foster investor confidence and preserve robust liquidity, the
regulatory structure governing our financial markets should promote,
and not impede, those qualities.
Today, due in large part to regulatory changes and developments in
technology in recent years, there is robust competition among exchanges
and alternative execution venues. These changes have spurred trading
innovation and enhanced investor access to markets. Market
participants, including Invesco, now have much greater choice and a
higher degree of control in how and where to execute our trades. These
changes have materially benefited investors in the form of lower
commissions, spreads and implicit transaction costs, which in turn have
enhanced the all-important liquidity of the equity markets.
Unfortunately, some of these regulatory, competitive and
technological changes have also brought unintended consequences, which
have included un-leveling the playing field to a degree where certain
sophisticated market participants can reap benefits at the expense of
ordinary savers. We also are concerned that the one-size-fits-all
approach of the current market structure fails to recognize the very
real differences between trading large-cap stocks versus trading mid-
cap and small-cap stocks. These developments challenge investor
confidence in the liquidity, transparency, fairness, stability and
efficiency of the markets. These unintended consequences include the
following:
Market Complexity and Fragmentation Have Negatively Impacted Investor
Confidence
Many investors, including Invesco, believe markets have become too
complex and fragmented, not because they need to be but rather because
we have allowed them to become so. This complexity has contributed to a
number of the technological mishaps over the past several years. These
mishaps shake investor confidence in markets. While we commend the
Securities and Exchange Commission (``SEC'') for the actions it has
taken to address many of the structural issues relating to these
events, it is important to recognize that today there are underlying
structural issues that can give sophisticated participants an unfair
advantage over ordinary investors.
For example, exchanges sell co-location services to market
participants that allow those participants to locate their servers in
the same facility as the exchange's order matching engines and offer
these participants direct data feeds from the exchange. These direct
data feeds are faster than the indirect data feeds that other
participants get from the Securities Information Processor. Because of
this speed differential, co-located participants with direct data feeds
can gain an unfair advantage over those participants that are not co-
located and do not receive direct data feeds, allowing the former to
react more quickly to trading information. In our opinion, there is
nothing more corrosive to investor confidence than allowing some market
participants to have an unfair advantage over others.
Today in the United States, there are 11 exchanges and over 40
alternative trading systems in which investors can trade equities. The
rules governing the exchanges are very different from those governing
the alternative trading systems (e.g., ``dark pools''), a difference
that can be very confusing to market participants. These different
rules also have facilitated an un-level playing field that unfairly
favors sophisticated participants over ordinary investors. Many of
these execution venues offer economic inducements to broker-dealers and
high-frequency traders to route their orders to them. A number of these
destinations offer high-frequency trading participants complex order
types (e.g., ``conditional orders'') that may enable them to detect the
trading interests of other participants and then use that information
to their advantage. In such a complex and fragmented environment,
determining which execution venue will lead to the best trading outcome
can be very difficult even for a firm like Invesco.
Conflicts of Interest Have Impacted Market Transparency and Fairness
The robust price discovery that historically has defined our
markets has been weakened as a result of the amount of trading activity
occurring away from exchanges. It is believed that as much as 35-40
percent of all trading activity in U.S. equities now takes place away
from the exchanges. Much of the movement away from the exchange markets
is a result of broker-dealer order routing practices including
``internalization'' and the proliferation of specialized alternative
trading venues, including ``dark pools.''
The order routing practices of some broker-dealers raise a number
of concerns for investors. For example, investors are not provided the
information from broker-dealers needed to determine if they are
receiving best execution within these dark pools. They are also given
only limited insight into how and where broker-dealers route their
orders. As a consequence, it is very difficult for investors to make
informed decisions about the quality of executions they have received.
Much of the problem can be traced to two inherent conflicts of
interest. The first is a broker-dealer's interest in maximizing
economic inducements by capturing liquidity rebates associated with the
so-called ``maker-taker'' pricing model and by receiving payment for
order flow from off-exchange market makers. The second is a broker-
dealer's interest in avoiding paying access fees to take liquidity from
other trading venues. Under the current regulatory structure, a broker
is incented to keep as many trades as possible within its own
internalized systems, including within its own dark pools. These
problems are not well-disclosed to clients, and yet they can drive
brokers' order routing decisions that may be at odds with their
clients' interest in obtaining best execution.
High-Frequency Trading and Market Liquidity
There has been much discussion about high-frequency trading and its
impact on trading markets. Today, there are a number of different types
of participants within the marketplace who could be referred to as
high-frequency traders. It is our view that high-frequency trading is
not bad in and of itself, but there are certain trading strategies
performed in connection with high-frequency trading that have the
effect of being manipulative or disruptive. These can include using an
information and speed advantage to trade ahead of other market
participants. These strategies have arisen as a result of enabling
technology, the fragmented structure of the markets and a lack of
uniform regulation and market practices among trading venues.
Changes to market structure have had a pronounced impact on the
role of traditional market-makers and the evolution of electronic
market-making. While there are today a number of market-makers and
high-frequency market-making strategies that make markets in a number
of securities, much of this appears to be focused on large-cap
securities. While it is true that these high-frequency market-making
strategies have increased trading volumes in many of these stocks, it
is less clear that they are creating real liquidity. Moreover, the area
of the market where market-makers have historically provided the most
valuable liquidity--mid-cap and small-cap stocks--have not benefited
from the evolution of market structure and the move to electronic
market-making.
To restore a level playing field in the markets--and, thereby,
restore investors' confidence in the fairness and transparency of the
markets--we believe it is time for regulators and market participants
to address these issues. Invesco recommends the following improvements:
1. Require broker-dealers to provide much greater disclosure about
their order routing activities, their dark pool operations,
order types used and all other data required for investors to
make accurate determinations of execution quality. If there is
greater disclosure about how and where clients' orders are
routed and other necessary data for investors to make accurate
best execution determinations, investors will be able to make
much better informed decisions about how their brokers are
performing and, consequently, which brokers they should choose
to use.
2. Ensure that the dissemination of market data is fair to all
market participants. This could be achieved in a number of
different ways, including by eliminating direct data feeds,
slowing down the direct data feeds or through greatly enhancing
the Securities Information Processor's infrastructure to allow
it to transmit market data to participants at substantially the
same speed as the direct data feeds. It is in the nature of
competition that some participants will be able to process
information much faster than others, but these participants
should not be given unequal access to allow them to front-run
other investors' orders.
3. Eliminate the maker-taker pricing model and substantially reduce
access fee caps. We believe eliminating the maker-taker pricing
model--and, more specifically, the liquidity rebates provided
therein--and substantially reducing market access fee caps,
would remove certain inherent conflicts faced by broker-
dealers. This would make it more likely that broker-dealer
activities will be performed in a manner and with an outcome
more consistent with their clients' best execution objectives
rather than their own pecuniary interests.
4. Harmonize the regulation of exchanges, alternative trading
systems and other trading venues. This will level the playing
field between ordinary investors and other participants and
ensure fairness, consistency and integrity to the trading
markets.
5. Require registration for all high-frequency trading participants
and the establishment of a uniform regulatory regime. The
activities and strategies employed by high-frequency traders
are sufficiently disparate, nontransparent and complex that a
reasonable first step in regulation would be to ensure that all
entities that engage in high-frequency trading be required to
register under a uniform regulatory regime that has the
resources and capabilities to detect and, where appropriate,
take action against any trading strategies that are deemed
manipulative or predatory.
6. Institute a comprehensive ``trade-at'' rule pilot program. The
trade-at rule would require any orders internalized by broker-
dealers to provide meaningful price improvement. If material
price improvement cannot be provided, then those orders would
be routed to more transparent markets. Such a rule would reduce
broker-dealer conflicts and may result in much more robust
price discovery for investors. We recommend that the SEC work
with exchanges, investors and other market participants to
structure this pilot program.
7. Market-making participants, exchanges, issuers and investors
should work with regulators to facilitate market-making
activities by creating sensible, transparent incentives and
obligations for making markets generally, but for mid-cap and
small-cap stocks in particular.
Invesco believes that these recommendations, if acted upon, will
result in less complicated and more robust, highly liquid, transparent,
fair, stable and efficient markets. They would address concerns of
ordinary savers that otherwise threaten confidence in the integrity of
the U.S. equity markets. We are highly encouraged by Chair White's
recent speech outlining a number of initiatives that the SEC is
considering to improve U.S. equity market structure. These initiatives
will address many of the issues we have raised historically and are
raising again here today. We also would like to commend the SEC for its
recent action to establish a thoughtful pilot program to assess tick
sizes for small company stocks.
Thank you again for your attention to these important issues here
today. I look forward to answering any questions you may have.
______
PREPARED STATEMENT OF JAMES J. ANGEL, Ph.D., CFA
Associate Professor, Georgetown University McDonough School of Business
July 8, 2014
My name is James J. Angel and I am an associate professor of
finance at the McDonough School of Business of Georgetown
University.\1\ I wish to thank the Committee for looking at these
important issues and for asking me to appear before you. I have been
asked to focus on the regulation, practices, and structure of the
United States stock markets. I will begin with regulation.
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\1\ My comments are strictly my own and do not necessarily
represent those of Georgetown University or anyone else. From 2000
through 2010 I served as an independent director on the board of
directors of the Direct Edge stock exchanges (EDGX and EDGA). I was a
Visiting Academic Fellow from 1999 to 2000 in residence at the NASD
(now FINRA), and have served as Chair of the Nasdaq Economic Advisory
Board. As an investor I practice what I preach in terms of portfolio
diversification and hold a well-diversified stock portfolio that
includes small investments in a large number of public companies,
including most financial services firms. I also provide expert
consulting services to Government agencies, law firms, exchanges,
financial services firms, and others.
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Regulation
If Congress gets regulation right, then the regulators will make
the right decisions on the details. Congress can then devote its scarce
time to other important matters. If our regulatory system worked
properly, Congress would not have to spend its time addressing minutiae
(albeit important minutiae) such as the tick size in our financial
markets.
Money attracts thieves just like garbage attracts flies, and that
is one of the reason why we need good cops to keep the bad guys out of
our financial markets. We all benefit from fair and orderly markets
that protect investors, supply capital to support economic growth,
provide useful risk management tools, and promote economic efficiency.
Unfortunately, the United States has an extremely fragmented
financial regulatory structure. There are literally hundreds of
different financial regulatory agencies at the State and Federal level.
As we learned in the financial crisis, many items can fall through the
cracks and the different regulatory agencies do not always play nicely
with each other, to say the least.
Congress attempted to address many regulatory issues in the Dodd-
Frank and JOBS Acts. However, these Acts did not really address the
structure of our regulatory system, which is badly in need of reform.
Here are just a few of the symptoms of dysfunction in our regulatory
system:
1. The JOBS Act could and should have been done by the SEC with its
pre-existing authority.
In 2012, Congress passed the JOBS Act with a broad bipartisan
consensus in order to make capital more freely available to growing
enterprises and thus create more jobs. Among other things, the JOBS Act
temporarily reduces regulatory burdens for newly public ``emerging
growth companies,'' reduces restrictions on private share offerings,
and provides a framework for crowdfunding.
All of these provisions could and should have been done by the SEC
using its pre-existing legislative authority. In particular, Section 36
of the Securities Exchange Act gives the SEC broad powers to exempt
particular entities or groups of entities from various rules. The SEC
should have recognized the problems in capital formation that led
Congress to adopt the JOBS Act and used its existing powers to do what
the JOBS Act mandated. Yet it did not. As an institution, it was unable
to recognize the problems facing our capital markets and craft
appropriate solutions. Worse yet, the SEC has missed, perhaps
intentionally, many of the mandated deadlines in the JOBS Act.
2. The implementation of the Volker Rule demonstrates the fragmentation
of our financial regulatory system.
As part of the 2010 Dodd-Frank legislation, the Congress passed the
so-called ``Volker Rule'' to prohibit ``proprietary trading'' by banks.
Alas, our regulatory system is so fragmented that no less than four (!)
agencies have had to engage in rulemaking to implement this
provision.\2\ The rulemaking sausage factory has come up with an
extremely complex and expensive rule. Similar evidence of fragmentation
arises in the various swap rules in which the CFTC has the bulk of the
responsibility and yet the SEC has to do rulemaking for the tiny slice
in its jurisdiction.
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\2\ See http://www.sec.gov/rules/proposed/2011/34-65545.pdf.
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3. Glacially slow responses by the SEC to apparent violations of
Federal securities laws hurt investor confidence.
The old saying ``Justice delayed is justice denied'' is just as
true now as it has always been. When investors perceive that little is
done to enforce our securities laws, they lose confidence in our
financial system. The lack of high-level prosecutions from the recent
financial crisis is but one example.
Even if our regulatory system is vigorously attempting to enforce
the laws, the long delays between the observation of the alleged
offense and any visible regulatory action create the impression that
the SEC is incapable of properly enforcing our securities laws. Here is
one example of which I have some personal knowledge:
In April of 2013, W2007 Grace Acquisition I, (``Grace'') a Goldman
Sachs controlled entity, filed an application with the SEC seeking an
exemption from its registration requirements under the Securities Act
of 1934.\3\ To make a very long story short, Grace was the successor
company to Equity Inns, a publicly traded firm. Goldman led a leveraged
buyout in 2008 that bought up the common shares of Equity Inns, but not
the NYSE-listed preferred shares. Most of these preferred shares were
held by retail investors, many of them senior citizens. Grace claimed
that it had less than 300 shareholders of record, which permitted it to
deregister its shares from the SEC and stop providing public financial
information.\4\ One of the shareholders, a Mr. Joseph Sullivan, created
a series of trusts in order to increase the measured number of
shareholders ``of record'' over the 300 threshold, which would require
Grace to once again file public financial statements with the SEC.\5\
Grace filed for an exemption, claiming that the Sullivan trusts should
be counted as only one shareholder of record.
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\3\ Disclosure: I own less than 100 shares of Goldman Sachs common
stock as well as less than 100 shares of the preferred stock of W2007
Grace Acquisition I. There are many more plot twists in this soap
opera. See the SEC comment file 81-939 at http://www.sec.gov/rules/
other/2013/34-69477-application.pdf. Even if the SEC and FINRA are
investigating allegations of various infractions, this should not stop
the SEC from ordering the firm to resume its filing of public financial
statements.
\4\ Title VI of the JOBS Act reiterated the 300 shareholder of
record threshold below which issuers could deregister from the SEC,
which suspends their filing requirements. Under SEC Rule 12(h)(3)(e),
if the number of shareholders ``of record'' of a deregistered issuer
increases above the 300 threshold as of the end of its fiscal year,
then the issuer has 120 days to resume filing.
\5\ For the purposes of counting the number of shareholders ``of
record'' to determine whether a company is required to file financial
statements with the SEC, current interpretations of SEC rules do not
count beneficial shareholders who hold shares in street name in
brokerage accounts. Grace has well over 1,000 beneficial shareholders.
It is quite odd that the SEC does not count retail shareholders who
hold shares in street name in brokerage accounts when it determines
whether a company has enough shareholders to merit required
registration with the SEC.
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It has been more than a year since this petition was filed, and the
SEC has not announced any decision in the matter. It is my
understanding that the SEC has not even bothered to contact Mr.
Sullivan to examine the nature of his trusts. For the SEC to take over
a year on this matter without even contacting the creator of the trusts
to learn more about their nature shows a shocking slowness or
sloppiness in its handling of the matter. However, my examination of
the shareholder of record list indicates that there are and have been
many more than the required 300 shareholders of record needed to
require a resumption of its registration requirements even without the
Sullivan trusts.\6\ Grace appears to be openly and flagrantly
delinquent in its SEC reporting obligations, to the detriment of its
preferred public shareholders. That the SEC has allowed this
delinquency to fester leads to the suspicion that Goldman is getting
the Bernie Madoff or John Mack treatment in this case. Even if the SEC
in its infinite wisdom rules otherwise, this proceeding should not have
been dragging on for over a year with no end in sight. This does not
bode well for public confidence.
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\6\ For more details, see one of my comment letters at http://
www.sec.gov/comments/81-939/81939-41.pdf.
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I would like to emphasize that the problems with our regulatory
structure are not the fault of the people who work there. Most of the
people who work in these agencies are hard working and intelligent
people who are honestly trying to do their jobs as best as they can.
The problem is the structure of the regulatory system, and this is
something that only Congress can fix. I will get to my suggested
solutions at the end.
Practices
Trading technology has changed dramatically in recent years, and
there has been much controversy over various practices used in the
financial markets. This section describes some of the controversial
practices in financial markets.
Not all users of high-speed computers are the same.
There has been much discussion lately of modern trading practices.
Often all uses of high-speed computers are lumped into one catch-all
phrase of ``high-frequency trading.'' ``High-frequency trading'' is a
misleading catchall term. Some ``HFT'' practices help the market, and
some hurt. This is why we need a regulatory system that is smart enough
to tell the difference between the good and bad uses of high speed
computers and that has the capacity to keep out the bad while not
harming the good.
Market making and ETF arbitrage benefit low-frequency retail investors.
Here is one example of a ``high frequency'' technique that is
beneficial to low frequency retail investors like me. Many retail
investors invest through exchange traded funds (``ETFs''), convenient
basket products that allow an investor to buy part of a large basket of
securities with a single trade. For example, an investor can buy a
basket of all 30 stocks in the Dow Jones Industrial Average by buying
the Dow Diamonds ETF. Retail investors can trade the ETF with the
confidence that its price will closely track the price of the stocks in
the index because arbitrageurs monitor the price of the ETF and the
price of the stocks that go into the ETF. When the price of the ETF
gets out of line with the price of the stocks in the basket,
arbitrageurs swoop in to buy the cheap side and sell the expensive side
in order to capture the difference. This pushes the cheap side up and
the expensive side down, and thus pushes prices back into the proper
alignment. Because this is such a simple strategy, it is easy to
duplicate and there are many competitors. When an arbitrage opportunity
arises, there is a race to take advantage of it. The first trader to
trade wins, and the rest lose, even if they lose by only a thousandth
of a second. Therefore, the traders invest in technology to speed up
their trading by buying the fastest computers they can and then putting
them as close to the stock exchange computers as they can get so that
their orders will get to the exchange even faster.
Traders use high speed computers to engage in a variety of other
trading strategies as well. These include market making, a strategy
similar to that of a car dealer who provides the service of convenience
by buying at a trade-in price and selling at the retail price. The car
dealer does not want to be a long-term owner of the car, but to sell it
as quickly as possible. Likewise, market makers do not want to be long-
term investors, but they provide the service of immediacy to investors
who want to buy or sell a stock quickly. By being willing to buy and
sell at all times, they make sure there is a buyer when long-term
investors want to sell and vice versa. Competition between market
makers helps to keep transactions costs low for the long-term
investors.
Other strategies are more controversial.
Traders have been looking for trends in stock prices since the
beginning of financial markets. Generations ago, ``tape watchers''
would gather in brokerage firms to watch the ticker tape and guess
where prices were going. Later, chartists and day traders would do the
same. These investors attempt to discern where prices are going by
learning from the information that large investors leak when they break
up large orders into many smaller trades. As the price and quantity of
every stock trade in the highly transparent U.S. market become public
knowledge immediately, every time one of these small pieces of a larger
order trade, they are leaving clues about their future trading.
Now, instead of standing in brokerage firms and reading a paper
ticker tape, some traders use computer programs to guess which way
prices are going. Some would call these predictive traders
``predatory'' traders as they seek to gain from the stock price
movements caused by larger traders. It is a myth, however, that such
traders ``see'' institutional orders before they hit the market. Such
traders merely guess at the direction of future stock price movements
based on the data that are available to anyone who wants to pay for it.
Here is an example known as ``latency arbitrage.'' Suppose that
there are two stock exchanges that are 25 miles apart. It takes about
one hundred microseconds (millionths of a second) for light, and thus
information, to travel from one exchange to the other by the fastest
route. Both exchanges are offering to sell 5,000 shares at $20.00 per
share. Suddenly someone buys all 5,000 shares available on the first
exchange, and now the only shares available for sale on the first
exchange are priced at $20.01. At this point it stands to reason that
if a sophisticated large trader has bought up all of the shares on the
first exchange, then prices are going up. Those 5,000 shares that are
offered on the second exchange might still be available, and whoever
buys them will make money as the price goes up. Indeed, the large
trader who bought up all the shares on the first exchange may well be
on his or her way to try to buy up the shares on the second exchange.
Now the race is on. Traders use the fastest computers and communication
links they can to rush to the other exchange and buy up the cheap
shares there before anyone else does. If the large trader is using a
slow communication line, the fast trader may well arrive at the second
exchange in time to scoop up the available shares at $20.00, leaving
none behind for the large trader whose order initiated the transaction.
These high speed traders use a variety of techniques to trade as
fast as possible. Not only do they buy the fastest computers they can,
they try to locate them as close as possible to the computers used by
the stock exchanges to process trades, a process known as co-location.
They subscribe to the fastest data feeds possible, the direct data
feeds offered by the exchanges, and transmit their orders using the
fastest data lines they can.\7\ There has been a considerable hue and
cry over the fact that some investors pay for faster data feeds than
other investors receive. The important fairness consideration is to
make sure that such high speed data feeds are available on
nondiscriminatory terms to all market participants.
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\7\ The direct feeds are faster than the consolidated data feed
that contains the data from all of the exchanges. The consolidated data
feed will always be slower because it takes time for the information to
travel from the exchange that created it to the point of consolidation
and to be consolidated into the data feed.
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As a low-speed low-frequency investor, I am not concerned that
some, if not most, market participants have faster computers and faster
data feeds than I do. My trading strategies, like those of most retail
investors, are not based on reacting instantaneously to news or other
information, but instead on longer-term buy and hold strategies. As I
am not racing to react faster than other participants, I do not care
that other high-speed investors are racing with each other.
Some uses of high speed technology are just plain bad.
I will not argue that all uses of high-speed computers are
necessarily good. Manipulators can use fast computers as well. One
manipulative strategy is known as order ignition. Here is an example. A
computer program (known as an algorithm, or ``algo'') searches for a
stock where the amount of buy orders seems unusually small and the
stock seems vulnerable as a result. Then the algo puts in a large short
sale order with the intent of pushing down the price in order to
trigger ``stop'' orders, orders to sell after a stock has dropped below
a specified price. The triggered selling of the stop orders causes the
stock to drop further, at which time the algo kicks in and buys the
stock back to cover the short at a profit. Such manipulative trading is
antithetical to a fair and orderly market.
Maker-taker pricing
The current pricing system used by most stock exchanges is usually
called ``maker-taker'' pricing. The exchanges charge a fee to market
orders because they ``take'' liquidity and pay a rebate to a limit
order that gets filled because it made liquidity. For example, suppose
a customer puts in a limit order to buy 100 shares of BAC at a price
not to exceed $15.00 per share. Later, another customer market order
comes in and is matched with that resting limit order. Under typical
exchange pricing schedules, the market order would pay the exchange 30
cents and 28 cents of that (93 percent!) is rebated to the resting
limit order.
I have long criticized maker taker pricing.\8\ It has created a
number of distortions in the market, and I have called for its
elimination or restriction. However, as I believe in evidence-based
rulemaking, it would be appropriate to conduct a scientifically
designed pilot experiment to examine the impact of reducing and
eliminating exchange access fees. I believe that eliminating or
reducing maker-taker pricing would greatly reduce the incentive for
investors to send orders to some so-called ``dark pools'', as one of
the advantages of such trading platforms is to avoid exchange fees.
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\8\ See my comment letters to the SEC at http://www.sec.gov/rules/
proposed/s71004/jjangel012505.pdf and http://www.sec.gov/rules/
proposed/s71004/jjangel051904.pdf, as well as my joint articles with
Larry Harris and Chester Spatt, Equity Pricing in the 21st Century and
Equity Pricing in the 21st Century: An Update.
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Broker order handling practices
The practices by which brokerage firms route customer orders are
also controversial. Brokerage firms have a duty of ``best execution''
in handling their customers' equity orders.\9\ The SEC currently
requires market centers to disclose execution quality statistics in
Rule 605 and for brokerage firms to disclose how they route orders in
Rule 606. However, these disclosures currently do little to inform
retail customers how well their orders are being filled. A better
solution would be for the brokerage firms themselves to disclose
execution quality directly to their customers.
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\9\ I concur with SEC Chair White's comments that brokers should
have a similar best execution requirement for retail fixed income
orders. http://www.sec.gov/News/Speech/Detail/Speech/
1370542122012#.U7o0A_ldWSo.
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Exchange order types
The proliferation of special order types at the stock exchanges has
also been controversial. Critics charge that these order types create
an unfair advantage as well as add complexity to the marketplace.
However, they are available to all investors.\10\ The real question is
whether they can cause the market to react in an unstable or otherwise
undesirable manner. So far I have seen no evidence that they do.
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\10\ However, many retail trading Web sites are simplified to the
point that they do not offer complex order types. Investors wanting to
use complicated order types would have to go to brokerage firms that
offer them.
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Tick size: Issuers should be allowed to choose their own tick size.
The tick represents the smallest allowable price differences in
stocks. Currently, the United States has a ``one tick fits all'' model
with a tick size of one penny for all stocks over $1.00. Thus, brokers
are allowed to accept orders at $10.00 and $10.01, but not $10.0001.
The tick represents the smallest amount of money an investor has to pay
to jump to the next level in the queue. A wider tick benefits patient
traders who place limit orders, as investors would have to pay more to
jump in front of them. However, a wider tick harms impatient traders
who cross the bid-ask spread and trade with market orders and thus pay
a higher transaction price. The optimal tick represents a tradeoff that
results in a balanced ecosystem of liquidity takers and demanders. The
optimal tick is not zero and not infinity, but somewhere in between.
And it is not the same for all stocks.
The SEC is currently planning a pilot study to examine the impact
of different tick sizes on smaller stocks. This is good as far as it
goes, as it will provide useful information with which to inform
rulemaking. However, the big issue is ``Who decides what the tick size
will be for various companies?'' I believe that each issuer should be
able to select their own tick size, as they have the proper incentive
to select a tick that provides optimal liquidity for their company.
Neither the exchanges nor the SEC have the similarly powerful incentive
to get it right.
The risks of technology: We are still vulnerable to major disruptions
like the Flash Crash.
Most of the time our markets work well. Except when they don't. The
Flash Crash of May 2010 is a case in point. I had warned the SEC in
writing five times in the year before the Flash Crash that our market
was vulnerable to such disruptions.\11\ Our market is still vulnerable.
Our market is a complex nonlinear network. It is in the nature of
financial markets that from time to time they are overwhelmed with
tsunamis of trading activity that can overwhelm the capacity of the
market network to produce fair and orderly prices. Complex networks
that are pushed beyond their capacities fail in weird and strange ways
that are difficult if not impossible to predict.
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\11\ These are listed in my December 8, 2010 testimony to the
Senate Committee on Senate Subcommittee on Securities, Insurance, and
Investment and the Senate Permanent Subcommittee on Investigations.
This testimony also contains a summary of the events of the Flash
Crash. http://www.banking.senate.gov/public/
index.cfm?FuseAction=Files.View&FileStore_id=
a4f49d29-fe78-4ed9-839-3a6c09917298.
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Subsequent to the Flash Crash, the U.S. equity markets instituted
several types of circuit breakers:
1) The ``Limit Up-Limit Down'' system causes a short trading halt in
individual stocks if the market price moves outside of a
predetermined price band.\12\
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\12\ See http://www.sec.gov/rules/sro/nms.shtml#4-631 for details.
2) The short sale circuit breaker restricts short selling at the bid
price for the rest of the day and the subsequent day if a stock
drops 10 percent below the previous day's price.\13\
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\13\ See http://www.sec.gov/rules/final/2010/34-61595.pdf for
details.
3) Market-wide circuit breakers halt the entire market for various
periods of time under various conditions.\14\
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\14\ See http://www.sec.gov/rules/sro/bats/2012/34-67090.pdf.
Indeed, note that the market-wide circuit breakers were done as rule
filings by 16 separate SROs. See SR-BATS-2011-038; SR-BYX-2011-025; SR-
BX-2011-068; SR-CBOE-2011-087; SR-C2-2011-024; SR-CHX-2011-30; SR-EDGA-
2011-31; SR-EDGX-2011-30; SR-FINRA-2011-054; SR-ISE-2011-61; SR-NASDAQ-
2011-131; SR-NSX-2011-11; SR-NYSE-2011-48; SR-NYSEAmex-2011-73; SR-
NYSEArca-2011-68; SR-Phlx-2011-129. This is another example of the
absurd fragmentation of our regulation among SROs.
These are mostly improvements as far as they go, but there is still
more work to be done.\15\ In particular, there is no evidence of any
coordination in these efforts across the equity, options, and futures
markets, despite the fact that the Flash Crash demonstrated the close
interrelationships between these markets and the ease with which a
disruption in one market can be transmitted to other markets. This is
another example of the dangers caused by the fragmentation of our
regulatory system.
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\15\ For more technical comments on circuit breakers, see my
comment letter at http://www.sec.gov/comments/sr-bats-2011-038/
bats2011038-2.pdf.
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The current system deals appropriately with disruptions to the
trading of individual stocks, although more refinement is needed for
handling small stocks with wide bid-ask spreads. However, the system is
totally untested in dealing with large market wide disruptions across
multiple asset classes. The rigidity of the rules could also hamper the
restart or lack thereof when the next tsunami hits the markets. And
there will always be another one coming. We just don't know when.
Structure
The United States has a competitive, ``open-architecture'' equity
market structure.
Many commenters use the pejorative term ``fragmented'' to describe
the current U.S. market structure. This word has a negative
connotation. Its synonyms include broken, shattered, splintered, and
disorganized. It is anything but these. Our markets are better than
they have ever been by traditional measures of transactions costs,
speed of execution, intraday volatility, transparency, and certainty of
settlement.
However, the high quality of the U.S. markets does not imply that
they can't get better. The fundamental trading problem has not been
solved. Our market structure allows new market entrants to ideas for
better trading systems to plug into our National Market System. This
competition improves the breed.
It should be noted that we have the market structure that Congress
rightly decreed in 1975. In 1975, Congress passed the so-called
National Market System amendments to our securities laws. In
particular, Congress added Section 11A (a)(1)(c) to the Securities
Exchange Act which called for a competitive market structure with
competition among exchanges, broker-dealers, and other than exchange
markets. And that is what we have today.
Some complain that we have ``too many'' exchanges or other places
to trade. Do we have too many supermarkets or gas stations to choose
from? Normally we depend upon competition to provide incentives for
efficiency and good customer service. The cost of trading is much lower
in the hyper competitive equity space than in the highly concentrated
futures industry.
A competitive market structure makes good economic sense.
The logic behind a competitive market structure is simple and
compelling. A monopoly exchange structure suffers from all of the
normal problems of a monopoly. Even a not-for-profit monopolist will
lack incentive to improve the product or to run the operation
efficiently. A for-profit monopolist will charge high prices to the
detriment of social welfare. In the olden days, the technology was such
that the NYSE was an almost natural monopoly. As the saying goes,
liquidity attracts liquidity, and the old NYSE had a huge network
advantage over everyone else because it had the liquidity that
investors sought.
In order to prevent monopoly there is a need for competition. And
the profit motive is a great motivator for competition. That gives us a
world of competing for-profit exchanges.
Fortunately, the computer revolution has changed the economics of
the equity exchange business. An equity exchange is no longer a natural
monopoly, but a hotly competitive enterprise. Low cost and high speed
communications have neutralized most of the network advantage of the
dominant exchanges, making it possible for entrants to enter the
business.
The United States is not alone in adopting this structure. Most
developed countries are moving toward market structures in which for-
profit entities compete with each other. The European approach
expressed in MIFID (Markets in Financial Instruments Directive) is an
example.
Some observers claim that the current market structure is a result
of Regulation NMS, which was passed by the SEC in 2005. However, NMS
merely codified and updated a number of rules. What was significant,
was that it extended trade-through protection to NASDAQ-listed stocks,
which did not have it before, and it provided trade-through protection
only to orders that were electronically accessible, which forced the
NYSE to more fully automate its systems.\16\
---------------------------------------------------------------------------
\16\ A trade-through occurs when one exchange trades at a price
even though another exchange was quoting a better price. I commented at
the time, and still believe, that a trade-through rule that prevents
trade throughs is unnecessary. The economic incentives pushing
brokerage firms to get the best price for their customer are so
overwhelming that they can and do go to the market with the best price.
A trade-through rule just adds significant complexity to the market
network with little improvement in market quality.
For the record, here is an oversimplified summary of NMS (CFR
---------------------------------------------------------------------------
Sec. Sec. 242.600 through 242.612):
Rule 601: All trades in NMS stocks must be reported to the
consolidated tape.
Rule 602: Each exchanges best bids and offers must be reported
so that the consolidated National Best Bid and Offer (NBBO) can
be calculated.
Rule 603. Brokers must display consolidated trade and quote
information to clients. They can't just give out the data from
only one exchange.
Rule 604. Dealers must display customer limit orders to the
market.
Rule 605. Market centers must report execution quality
statistics.
Rule 606. Brokerage firms must report each quarter how they
route customer orders and what kind of payment for order flow
they receive.
Rule 607. Brokers must disclose payment for order flow to
customers.
Rule 608. Exchanges work together to form NMS plans.
Rule 609. Securities Information Processors (SIPs) must
register on Form SIP.
Rule 610. The access fee (take part of maker-taker) is limited
to $.003 per share. Locked and crossed markets are prohibited.
Rule 611. Exchanges must have policies to prevent trade
throughs.
Rule 612. The tick size for all stocks over $1.00 is $.01.
Recommendations to Congress
1. Start the debate to fix regulation.
This will be a long and sometimes painful process that will take
many years. Even though pessimists will say that nothing will be passed
due to partisan gridlock, or that an SEC-CFTC merger is impossible
because the various committees do not want to give up their oversight
powers, we need to start the process now. Reform will not occur unless
the debate begins.
Congress should direct all of the Federal regulatory agencies and
self-regulatory organizations such as FINRA to conduct thorough studies
of the structure and effectiveness of regulation and make suggestions
for reforms that 1) simplify the currently complex and overlapping
regulatory system, 2) reduce unnecessary compliance costs, 3) provide
usable rights of appeal for high-handed regulatory action or inaction,
4) enhance consumer protection, and 5) enhance economic efficiency and
capital formation. Although these goals sometimes appear to conflict,
we need to start the process now.
Congress should also fund a study similar to the U.K. Foresight
project in which experts from around the world are invited to submit
studies on the relevant topics.
Of course, there should be lots of hearings as part of this debate.
However, this process should also closely examine experience around
the world. We did not invent financial regulation. We copied much of
the U.S. system from the U.K. many years ago. Congress should
explicitly study the experience of other countries around the world to
see what we should do here. In particular, there has been a lot of
fresh thinking in Europe as the Europeans struggle to harmonize their
regulation, and we can learn from their debates as well.
2. Consider functional-based regulation.
Currently, our regulatory system is a hodgepodge of institutional-
based regulators. However, financial services spill across these
institutional boundaries, leading to many overlaps and gaps. We should
seriously consider a functional-based system with regulatory bodies
based on function rather than institution. We would thus have a markets
regulator, a consumer protection regulator, a solvency regulator, a
guarantee fund, and so forth.
3. The role of SROs needs to be rethought.
This debate should include a thorough examination of the SRO model.
The current SRO model came about as part of a political compromise
during the creation of the SEC. The industry would regulate itself
through exchange-based SROs, and the SEC would regulate the SROs. This
moved part of the cost of regulation off the Federal budget, and
provided some industry input into the result. Since the NYSE was the
dominant exchange, it regulated exchange member firms and the NASD
regulated the rest. This worked well for many years. However, in a
world with competing trading platforms, there needs to be a market-wide
regulator. Although FINRA has become the de facto market wide
regulator, its role should be examined carefully.
4. Put the SEC and CFTC in the same buildings.
The SEC and CFTC in particular should integrate their operations.
Even if a full merger is not yet politically feasible, placing the
agencies in the same buildings with shared common facilities will
enhance cooperation between the agencies.
5. Move the locus of SEC/CFTC operations from DC to NY and Chicago.
Our regulatory agencies have problems attracting enough good people
with industry experience. These people are usually found in New York
and Chicago, and are often unwilling to uproot their families for the
kind of salaries the Government offers. By moving most operations to
our financial centers, the SEC will be able to hire people who know
where the bones are buried, and more closely and personally monitor the
industry.
6. Fully fund the SEC budget with close oversight of how the money is
spent.
We have been pennywise and pound foolish in how we fund the SEC. We
have gotten what we have paid for. The sum total of every dollar spent
on the SEC since its founding in 1934, even grossed up for inflation,
is less than investor losses from one Bernie Madoff. A properly
functioning agency will more than pay for itself with lower compliance
costs for law abiding citizens, faster and more efficient capital
raising, and fewer investor losses due to fraud. However, the SEC has a
history of misallocating resources in the past. Congress should specify
carefully where the money should be spent and follow up on the results.
7. Monitor the qualifications of the people in the regulatory agencies.
One longstanding problem with the SEC is that it has plenty of
lawyers but an insufficient number of people with other necessary
qualifications. Congress should demand regular updates from regulatory
agencies on the nature and qualifications of the staff. In particular,
every time a regulator testifies before you, I suggest asking the
following questions:
a) How many people are working on this issue?
b) How many of them have two or more years of industry experience?
c) How many of them have passed a FINRA exam such as Series 7?
d) How many of them have degrees in:
a) Economics or business?
b) Engineering or computer science?
e) How many of them have professional certifications such as CFA or
CPA?
8. Monitor the speed of execution, but watch out for games.
One of the major problems with the SEC is the slow speed with which
it operates. The slowness of its operations is a major impediment to
investor confidence. While accuracy is more important than speed, speed
is nonetheless important. The SEC's lawyer-dominated culture feels that
the glacial progress of judicial and legislative processes is
appropriate for regulation, when in fact it is wholly inadequate in the
modern world. The SEC needs to have a cultural change so that it
recognizes that delay is costly to the country.
Congress has repeatedly attempted to address this issue by
providing deadlines for the SEC to respond. The SEC repeatedly misses
these deadlines with seeming impunity, while misallocating resources to
other nonmandated areas. However, Congress needs to be very careful
that the SEC does not play VA-style games with the numbers.
Congress needs to demand statistics from regulatory agencies on the
length of time that an agency is taking on various areas. For example,
Congress should expect and pay attention to statistics on the status of
mandated rulemakings, length of investigations in process, SRO rule
filings, and no-action letter requests.
9. Create a Serious Fraud Office to prosecute criminal financial
offenses.
It was a great disappointment to me and others how few criminal
prosecutions occurred subsequent to the financial crisis.\17\
Currently, the SEC only has civil jurisdiction and must turn over
criminal cases to the Department of Justice. However, DOJ has many
other responsibilities, and it is understandable that terrorists and
gangsters will be their top priority. A separate agency focused only
with prosecuting financial fraud will be able to develop expertise in
complex financial fraud will leaving financial fraud FBI et al. get
distracted by going after terrorists and truly bad guys.
---------------------------------------------------------------------------
\17\ See http://www.justice.gov/oig/reports/2014/a1412.pdf.
---------------------------------------------------------------------------
10. Encourage agencies to provide more status information to tipsters.
The agencies should be encouraged to be more open with tipsters and
complainants about the status of investigations. I can attest from
personal experience that it is extremely frustrating to receive no
follow up after submitting a tip. A simple follow up message to the
effect of ``The case is still open'' or ``We plan no further action at
this time'' would help to increase investor confidence in the integrity
of the system by letting them know that something is being done with
their complaints.
11. Open an investor advocate offices in or attached to every State and
Congressional district.
As Members of Congress, you are well aware of the numerous
complaints that you get from frustrated citizens with regard to
financial matters. Often citizens are so confused by the overwhelming
alphabet soup of Federal and State agencies that they don't know where
to turn for help. A properly funded financial ombudsmen type office
attached to every Senator or Representatives office would provide
appropriate guidance to help citizens navigate the regulatory maze. The
office would also follow up on cases to make sure that they do not get
the Bernie Madoff and John Mack treatments. This will increase investor
confidence because investors will feel heard and have a sense that
their tips are getting a proper investigation.
12. Continue to build a culture of evidence-based rulemaking at Federal
regulatory agencies.
The forthcoming pilot experiment with regard to tick size is a
great step forward. It is sad that once again it took Congressional
action to prod the SEC to do something it could and should have done on
its own volition. The Congress should encourage a culture of evidence-
based rulemaking through carefully designed pilot experiments. I have
heard that there is some concern at the SEC that the agency may not
have legislative authority to conduct properly randomized scientific
pilot studies. Congress should clarify the relevant statutes to
indicate that the SEC does indeed have such authority.
13. Amend the APA to require agencies to look at how other countries
and other entities address similar issues.
Many agencies have an insular culture that does not naturally
explore how other entities deal with similar problems. This is a
mistake. We do not have to keep reinventing the wheel. The
Administrative Procedures Act should be amended to require each
rulemaking to explicitly address how other countries and other entities
have addressed similar issues. This is particular important given the
global nature of financial services, and the need to work with other
regulators. Explicitly examining how other regulatory entities address
a problem makes it more likely that we will adopt a similar approach,
leading to a more uniform global regulatory environment and thus
reducing compliance costs.
______
PREPARED STATEMENT OF TOM WITTMAN
Executive Vice President and Global Head of Equities
NASDAQ OMX Group, Inc.
July 8, 2014
Thank you Chairman Johnson and Ranking Member Crapo for the
opportunity to testify today on ``The Role of Regulation in Shaping
Equity Market Structure and Electronic Trading.''
Thanks to the efforts of SEC Chairman Mary Jo White, the debate as
to whether we change our equity market structure is over. The SEC has
launched an evaluation of what changes are needed and has taken a first
step by releasing the guidelines for the creation of special market
structures for a range of smaller stocks known as the Tick Size Pilot.
We support Chair White's efforts which also include the launch of a
series of efforts to evaluate more holistically the broader market
structure and to take action to ensure robust regulation of all
participants in the markets. These are all positive developments that
NASDAQ OMX absolutely endorses.
Now it is time for us to talk about solutions.
We agree with Chair White that our markets are not rigged, but, are
indeed the strongest capital markets in the world. And we at NASDAQ OMX
have been dedicated to ensuring fair access to all investors in our
marketplace and view fair access as a hallmark of our organization. Let
me be clear, NASDAQ OMX endeavors to ensure everyone has a fair and
equitable experience with us, and we fully support any effort to ensure
that there is fairness and transparency in the market. While we are
firm in our belief that the U.S.-licensed exchanges provide a fair and
highly efficient market platform, we agree with many others that the
markets are complex today. And, while that complexity can bring
benefits to participants, we agree that it also brings a need for
regular examination. When appropriate, we should move quickly to update
the market rules consistent with the Exchange Act principles of
fairness and transparency. As an exchange, we believe that the bedrock
principle for well-functioning and fair markets is the need for robust
price discovery--and transparent price discovery is at the center of
what exchanges do for our economy.
Special Role of Exchanges:
Companies like Comcast, Cisco, GoPro, Intel, AmGen, Celgene and
Mylan use capital they raise from listing on The NASDAQ Stock Market
(NASDAQ) to finance their missions of making cutting-edge products that
transform lives and industries. The public trading of these companies
allows Americans to invest in and participate in the American Dream,
and allows companies to understand the value of their company and raise
additional capital by issuing new shares. With financing provided by
the public markets, these companies create millions of jobs and bolster
the American and global economies. We see tangible evidence of this,
from Silicon Valley to the Northern Virginia high tech corridor and in
my home State of Pennsylvania.
An exchange listing is a valuable asset to a company's livelihood.
The iconic public companies that your constituents recognize, such as,
Apple, Microsoft, Google, eBay and Amazon, must provide broad and deep
transparency regarding their operations; they must satisfy exchanges'
listing standards; and they remain continuously subject to exchange
rules protecting investors against corporate fraud and abuse. Exchange
listed companies have an ongoing responsibility to maintain high
financial, operating, and governance standards, which are rigorously
enforced by the exchanges, to ensure investor confidence.
Equity exchanges in the United States are uniquely entrusted with
the important responsibility of being a catalyst for growth and wealth
creation. After the IPO, exchanges have a continuing role in fostering
price discovery and transparency. By allowing investors to come
together in an efficient and open manner, we enable them to discover
the price at which these public companies can be bought and sold
throughout each trading day. Exchanges, like NASDAQ, then disseminate
those prices for your constituents to see on television, online and in
newspapers. Exchange equity quotes create the reliable reference price
for all trading. Exchange quotes are a byproduct of the SEC-approved
rules and robust regulatory systems that equities exchanges must
develop and enforce to protect investors and to provide lit and orderly
markets. We fully disclose and seek SEC approval of all of the policies
and practices that we use to operate our markets.
Market Structure:
Now we turn to the details regarding the processes and mechanisms
within the U.S. market system used to create a transparent market.
First, with regard to order types, NASDAQ OMX supports the Chair's call
for a thorough review of existing order types, which highlights the
difference between exchanges and lighter regulated ATSs. Each venue
(exchange or broker owned) has its own systems and procedures and each
competes for orders from brokers and ultimately investors. Each venue
has its own order types and each is continually talking to market
participants to develop new order types that satisfy the needs of the
marketplace.''
Unlike less-regulated ATS trading venues, including dark pools,
when seeking to launch a new order type, NASDAQ was subject to a
rigorous process to define, design, evaluate, explain and obtain SEC
approval of order types. As an exchange we are required to expose
innovative ideas to the market through the notice and comment process.
We were subject to public scrutiny and examination of our ideas by our
competitors. This process often undermines the benefits of our
innovation, allowing our competitors, particularly those who are less
regulated, time to potentially mimic our ideas before we even had our
ideas approved. This is one of the costs of maintaining an SRO license.
For the sake of transparency and to help members understand our order
types, we have posted on our Web site a list and a plain-language
description of all of NASDAQ's order types.
Turning to the issue of dark pools, many of our concerns with
today's fragmented market structure are the direct result of layers of
iterative market structure decisions that have built up through the
years when SEC approval was based upon the technological and market
needs at the time these rules were proposed and approved. Many current
problems with our markets stem from well-intentioned regulations like
Regulation ATS and Regulation NMS, which sought to promote competition
and to resolve tensions between electronic and floor-based trading.
But, regulations cannot be adopted and forgotten; they must evolve as
conditions change. Regretfully, over time Regulation ATS and Regulation
NMS have led to a significant increase in dark trading, which denies
market participants a clear view of trading interest in a given stock--
preventing the full strength of supply and demand to determine price.
The latest dark trading data available to us from Rosenblatt for June
indicates that almost 40 percent of all trading in our markets was done
away from the lit exchanges.
While alternative trading venues certainly have an appropriate role
within a well-functioning market, we strongly believe that the current
trend toward dark trading as the market's default setting is an
unhealthy phenomenon. The United States is not alone in its challenges
with dark trading. Other countries are adapting their rules to address
the concern that dark trading reduces the fairness and transparency of
the markets. Specifically, Canada modified its market structure to
limit dark trading and to maximize price discovery and the EU has
included a regime for capping the level of dark trading in its recent
MIFID policy changes. It's time for the United States to update
Regulation NMS, and we can benefit from examining other countries'
efforts to determine a structure that could work within our own
markets.
On the topic of high frequency trading, NASDAQ supports Chair
White's call to have all high frequency trading firms register. While
we have not seen the details, we believe there are benefits in the SEC
assuming a broader role and to lay the groundwork for greater
transparency into all trading activity. Many in the public arena have
attacked high frequency trading as a business model. We encourage and
support a thorough analysis of the subject in order to reach a rational
conclusion. In our view, high-frequency firms that are registered
broker-dealers--whose primary function is as a regulated market-maker--
offer the valuable service of providing liquidity throughout the
trading day, which stabilizes pricing in the market and aids in price
discovery. However, what we know from experience is that our industry,
no matter the business model, will always attract individual players
who cross the line. They forget the true purpose of the markets, and
they find opportunities to exploit them. The role of NASDAQ, the other
licensed, regulated exchanges, FINRA (the Financial Industry Regulatory
Authority), and the SEC is to surveil the market and identify those
individual `bad actors.' We will continue to be vigilant in serving
that critical industry function.
Systems Resiliency:
Another area of focus in recent years has been the resiliency of
the systems that underpin the U.S. markets. At NASDAQ OMX we are
focused every day on how to improve our markets and make them more
resilient and robust. We recognize that past events across the markets,
including our own, may have harmed investors' confidence in the U.S.
markets. We are extremely focused on identifying and mitigating risks
in our systems and infrastructure, as well as in the interconnectivity
across the markets. Providing resilient and robust markets is critical
for efficient capital formation, investor confidence, and job creation.
We are confident we can provide that resiliency. In this area we are
engaged in many efforts to be a catalyst for positive change. For
example, we recently implemented so called ``Kill Switch'' to provide
another backstop against a computer incident going from a localized
issue to a market-wide problem.
The role of exchanges is more important than ever in today's
challenging environment. And yet, market complexity continues to create
new risks that we are constantly working with other market participants
and the SEC to address. Investor demand and the nature of regulatory
complexity have made U.S. markets lightning fast, fragmented and deeply
inter-connected. This complexity has added many more friction points
where mistakes can occur.
That's why NASDAQ OMX favors the adoption of Regulation SCI, which
the Chair highlighted in her recent public remarks. The U.S. market is
only as strong as its weakest link. To protect investors, all market
participants and trading venues--not just exchanges--must be subject to
rigorous standards of technology design, testing, and implementation.
While NASDAQ OMX favors the expansion of protections that Regulation
SCI will bring to some ATSs and brokers, in our view the obligation
should be expanded further to include all ATSs because every ATS poses
a systemic risk to a tightly linked market.
The SEC deserves credit for its leadership through recent,
challenging times. In the aftermath of the May 6th, Flash Crash, the
SEC and the exchanges worked quickly and cooperatively to devise new
protections to keep trading errors from spreading too rapidly or
inflicting unacceptable harm on the overall market. The exchanges
reformed their rules for breaking trades, instituted single stock
circuit breakers, updated market-wide circuit breakers, and implemented
the Limit Up/Limit Down mechanism. NASDAQ OMX has also, on its own,
developed tools to help broker-dealers manage their obligations under
the Market Access Rule.
At NASDAQ OMX we are passionate about and steadfast in the role we
play in capital formation and improving the performance of the
economies we serve. We think that the SRO model and U.S. market
structure have been effective in protecting investors over many
decades. But as technology and the inter-relation among all traded
asset classes evolve, so too must the regulatory environment in which
the markets operate. If it does, we will continue to protect investors,
transparently set prices for the stocks of our listed companies, and
support our economy through highly efficient capital formation and job
creation. All of our employees, including our CEO work hard to deliver
a dependable, fair and safe environment for investors and to fuel the
U.S. economy. We look forward to working with this Committee. Thank you
for your invitation to testify. I look forward to your questions.
______
PREPARED STATEMENT OF JOE RATTERMAN
Chief Executive Officer, BATS Global Markets, Inc.
July 8, 2014
Thank you and good morning. My name is Joe Ratterman, Chief
Executive Officer of BATS Global Markets, Inc. (``BATS''), and one of
the founding employees. I am pleased to be here and want to thank
Chairman Johnson, Ranking Member Crapo, and the entire Banking
Committee for inviting me to testify on matters related to the U.S.
equity market structure. This Committee has played a leading role in
the development of the securities laws over the past 80 years, and I
appreciate the attention to these timely and important issues related
to our capital markets.
BATS was a startup less than a decade ago, formed in 2005 in
response to a competitive void that emerged in the U.S. equity markets.
The NYSE and NASDAQ had acquired the first generation of efficient,
technology-oriented exchange competitors, namely Archipelago, Inet
(which reflected the merger of Instinet and Island), and Brut. In the
face of this exchange duopoly, BATS stepped into the competitive void,
launching as a small alternative trading system (``ATS'') from a north
Kansas City storefront in January 2006. In January of this year, we
merged with Direct Edge, an innovative exchange operator that was
similarly formed in 2005 to enhance competition among markets.
BATS remains headquartered in the Kansas City area, and maintains
offices in New York, New Jersey, and London. With approximately 300
employees globally, we compete vigorously every day in the United
States and Europe to earn our customers' business and trust. We have
leveraged technology to significantly reduce execution costs for all
investors and deliver innovative products and services to market
participants.
I agree with the sentiments recently expressed by SEC Chair Mary Jo
White, who said that our markets are ``not broken, let alone
rigged.''\1\ Academic and empirical evidence overwhelmingly
demonstrates that the automation of the market over the last decade or
more has resulted in significant enhancements in market quality for
long-term investors, whether retail or institutional. But like Chair
White and her fellow commissioners, I recognize that our markets are
not perfect; indeed, the search for perfection is a never-ending quest.
As exchanges, we are not only competing market centers, but also
regulators and, therefore, approach these issues with utmost
seriousness. Because of this, I am particularly grateful to be here
today and have the opportunity to share my views.
---------------------------------------------------------------------------
\1\ Mary Jo White, Chair, SEC, Enhancing our Equity Market
Structure (speech given at Sandler O'Neill & Partners, L.P. Global
Exchange and Brokerage Conference, New York, NY, June 5, 2014).
---------------------------------------------------------------------------
I. Background
In 1975, Congress amended the Exchange Act of 1934 (``Act'') to
adopt Section 11A, which was designed to facilitate the establishment
of a national market system to link together the multiple individual
markets that trade securities. Congress intended for the SEC to take
advantage of opportunities created by advancements in technology to
preserve and strengthen the securities markets. By leveraging
technology, our national market system is designed to achieve the
objectives of efficient, competitive, fair, and orderly markets that
are in the public interest and protect investors.
In response to this Congressional mandate, the SEC has adopted
various rules since 1975 to further the objectives of the national
market system, including the order handling rules in 1997, Regulation
ATS in 1998, decimalization in 2000, and Regulation NMS in 2005. Many
of the innovative structural characteristics of our market owe their
existence to Congress' 1975 amendments to the Act, and subsequent SEC
rulemaking in furtherance of those amendments.
Our national market system is premised on promoting fair
competition among individual markets, while at the same time assuring
that all of these markets are linked together in a unified system that
promotes interaction among the orders of buyers and sellers. The
national market system thereby incorporates two distinct types of
competition--competition among individual markets and competition among
individual orders--that together contribute to efficient markets.
Vigorous competition among markets promotes more efficient and
innovative trading services, while integrated competition among orders
promotes more efficient pricing of individual stocks for all types of
orders, large and small. Together, they produce markets that offer the
greatest benefits for investors and listed companies.
In adopting Regulation NMS, the SEC stated that its primary
challenge in facilitating the establishment of the national market
system has been to maintain the appropriate balance between fostering
competition between markets and fostering competition between orders;
mandates that at times come into conflict. The SEC further stated that
it attempted to avoid the extremes of: (1) isolated markets that trade
securities without regard to trading in other markets, and (2) a
totally centralized system that loses the benefits of vigorous
competition and innovation among individual markets. The SEC navigated
these extremes by allowing market competition, while at the same time
fostering order competition through the adoption of the order
protection rule, which prohibits markets from trading without regard to
the prices posted on other markets.
As a result, today we have an equity marketplace that is widely
considered to be the most liquid, transparent, efficient and
competitive financial market in the world. Costs for long-term
investors, both institutional and retail, in the U.S. equity
marketplace are among the lowest globally and these gains in market
quality have been noted by academics, institutional buy-side investors,
and agency brokers:
In April 2010, Vanguard noted that estimates of declining
trading costs over the previous 10 to 15 years ranged from a
reduction of 35 percent to more than 60 percent and stated that
Vanguard's own experience was in line with that range. Reduced
trading costs, as Vanguard noted, flow directly as a
``substantial benefit to investors in the form of higher
returns.''\2\
---------------------------------------------------------------------------
\2\ See Letter from George Sauter, Managing Director and Chief
Investment Officer, Vanguard Group, Inc., to Elizabeth M. Murphy,
Secretary, Securities and Exchange Commission, dated April 21, 2010.
In June 2013, three economists, including former SEC Chief
Economist Larry Harris, found a dramatic change in the spread
for NYSE-listed and Nasdaq-listed stocks over the preceding 12
years. In particular, between 2001 and 2013, the spread paid by
investors had decreased from more than 6 cents to below 2 cents
for NYSE-listed stocks and from above 5 cents to below 3 cents
for Nasdaq-listed stocks.\3\
---------------------------------------------------------------------------
\3\ See Angel, James J., Lawrence E. Harris and Chester S. Spatt,
``Equity Trading in the 21stCentury: An Update'' (June 21, 2013),
available at http://papers.ssrn.com/sol3/
papers.cfm?abstract_id=1584026.
In April 2014, Blackrock noted the same positive trends in
their assessment of market structure performance since 1998,
stating that bid-ask spreads have narrowed significantly and
that institutional trading costs have declined and are among
the lowest in the world.\4\
---------------------------------------------------------------------------
\4\ See BlackRock, ``U.S. Equity Market Structure: An Investor
Perspective'' (April 2014).
In June 2014, ITG's Global Cost Review Report further
confirmed the decline in institutional trading costs, noting
that from Q3 2009 to Q4 2013, implementation shortfall \5\
costs decreased from roughly 45 basis points to 40 basis
points. (This decline followed a drop from 63 basis points in
Q3 2003).\6\
---------------------------------------------------------------------------
\5\ ITS defines Implementation Shortfall cost as the difference, or
slippage, between the arrival price and the execution price for a
trade.
\6\ See ITG, ``Global Cost Review Q4/2013'' (June 6, 2014),
available at http://itg.com/marketing/
ITG_GlobalCostReview_Q42013_20140509.pdf; see also Speech by Chair Mary
Jo White: Enhancing Our Equity Market Structure. (June 5, 2014)
Further, our market is able to handle volume and message traffic
considered astronomical only a few decades ago, and the efficient
operation of this market throughout the recent financial crisis and
resulting volatility should serve as a reminder of the systemic risks
that have been reduced as a result.
Despite the overall high quality of our equity capital markets
today, we must remain focused on identifying areas in which market
quality and stability can be improved and regulators should consider
responsible, data-driven regulatory action where appropriate. In this
regard, we are encouraged by the SEC's plan for a continuous and
comprehensive review of the state of our market structure, and we
appreciate the Banking Committee's oversight. Such a review is timely
because the aforementioned changes, particularly those following from
the implementation of Regulation NMS in 2007, reflect a relatively
recent and dramatic evolution in the manner in which securities trade.
We should always strive to improve market quality, but should act
only when we can be sure to avoid disrupting or reversing the
substantial improvements in market quality we have experienced. While
it has been widely recognized that retail investors have benefited the
most from improvements in market quality over the last decade, I also
believe institutional investors have experienced measurable benefits in
the form of the above-referenced reductions in implementation shortfall
costs. That said, I recognize that institutional investors continue to
face challenges in executing large orders with a minimum of market
impact. To be sure, finding a ``natural'' investor or liquidity
provider willing to take the opposite side of a well-informed
institutional investor's order is a complex problem to solve regardless
of market structure.
Policymakers looking to reform our equity market structure must be
cognizant of the concern that enacting rules that tip the scales for or
against particular market constituents runs the very real risk of
negating benefits currently delivered by our equity markets. Therefore,
we advocate for responsible and carefully crafted changes supported by
reliable data and perhaps even tested through pilot programs of
sufficient duration to obtain data that adequately demonstrates the
impact of the change.
II. Speed of Today's Markets
There has been much commentary of late regarding the speed at which
our equity market operates, and the benefits and risks associated with
that speed. It is certainly true that today's fully automated equity
market is capable of processing order messages in timeframes that were
unthinkable a decade ago. These gains in speed (or reductions in
latency) have been made possible by advances in the computer hardware
and software that underpin the equity market structure, as well as
innovations by industry participants.
The increasing speed at which equity trading occurs is but another
dimension of how technology has improved the efficiency of our markets.
Whether trading as an investor or acting as a market maker, time equals
risk, and execution speed reduces that risk and the costs associated
with it. This risk mitigation benefits all investors in the form of a
lower risk premium, expressed as tighter spreads and lower overall
transaction costs. Importantly, these benefits are quantifiable; as
noted above, the evidence shows a market that has experienced declining
spreads for retail investors and declining implementation shortfall
costs for institutional investors.
Long-term investors are the primary beneficiaries of this risk
mitigation through the narrowing of spreads. Both institutional and
retail investors have access to tools that leverage the benefits of
these improvements in speed. For example, institutional investors can
and regularly do utilize trading algorithms programmed on brokers'
servers co-located within market centers. And, retail investors
accessing real-time market data can act on trading decisions from their
brokers' Web sites and receive an execution report within a matter of
seconds or even less, at a price at or better than the national best
bid and offer (``NBBO'') prevailing at the moment the trade was placed,
and with a commission rate of less than $10. This result is widely
taken for granted today, but it was not that long ago when retail
orders were processed much slower, with much less certainty of outcome,
and at commission rates considerably higher than those today.
It is not readily apparent why regulators should be particularly
concerned about the extent to which firms are willing to pay for tools
that help them achieve increased speed. It stands to reason that if the
marginal cost of gaining additional speed exceeds the marginal benefit,
firms will decide not to spend the money seeking that gain. As a
practical matter, it is worth noting that we are probably reaching that
point now.
That said, there are risks and concerns associated with the speed
of trading that warrant managing and addressing. Differentials in speed
associated with the dissemination of market data may create perceptions
of unfairness. Because of the flexibility of our national market system
for market data, it is in many ways the fairest in the world. With
side-by-side competition between a nationally consolidated feed and
direct feeds from multiple exchanges, market participants pay only for
the content and related infrastructure they actually need. Given that
quote and trade information serve multiple needs ranging from real-time
trading data to back-office reference information to news and
information, providing multiple products through multiple sources meets
the needs of market participants in a diverse, constructive, and
efficient fashion.
Nonetheless, there remain perceptions that differences in content
and speed of dissemination confer unwarranted advantages on select
market participants. And perceptions affect investor confidence about
the integrity of the markets, so I take them very seriously. While Rule
603 of Regulation NMS dictates that exchanges do not release market
data to private recipients before disseminating that data to the public
securities information processor (``SIP''), differences in content and
downstream technologies can still create a perception of unfairness.
To address this perception issue most effectively, exchanges should
continue to strive to make the dissemination of consolidated data
through the SIPs as fast as possible, and should consider including
aggregated depth-of-book data per exchange based on industry demands.
Perceptions of unfairness are also present with respect to the
market data exchanges use in their matching engines and routing
infrastructure to calculate the NBBO. Some have suggested that
exchanges using the SIP data to calculate the NBBO provide unfair
opportunities to sophisticated traders engaging in risk-free latency
arbitrage. Exchanges historically have used SIP data to determine the
NBBO with the changeover to direct feeds being a relatively recent
phenomenon. While that change yields an optimization in the speed with
which quotes can update, there are reasons why that optimization is not
as significant at an exchange as the difference in the speed between
the SIPs and direct feeds. Specifically, this is because exchanges
accept intermarket sweep orders (``ISOs''), which can display on an
exchange at a price from the SIP data that appears to lock another
exchange's quote. The ISO designation on an order tells the exchange
that the sender has either sent an order to execute against the locking
quote or that the sender has a faster view of the market and knows that
the locking quote no longer exists. Therefore, when SIP data is
augmented by ISOs, exchanges are able to update the quote in their
matching engines nearly as fast as direct feeds update.
III. Conflicts of Interest
Certain practices surrounding broker agency relationships, such as
payment for order flow and soft dollar arrangements, as well as
exchange fee structures create the potential for conflicts of interest;
however, I believe these potential conflicts of interest can be and
generally are managed by vigorous oversight within broker-dealers, and
can be supplemented through additional transparency as well as
oversight and enforcement by FINRA and the SEC. For example, I believe
institutional investors could benefit from additional transparency
about the ATSs to which their brokers route orders. I support the
voluntary initiatives of some ATSs to make public their Form ATS, and
additional steps could be considered to require ATSs to provide
customers with their rules of operation, which would include order
types, eligible participant and participant tiers, all forms of data
feed products, and order-routing logic and eligible routing venues.
With this information, institutional investors would be better
positioned to determine which trading venues best meet their trading
needs, and compare disparate broker product and service offerings.
Moreover, I support reviewing current SEC rules designed to provide
transparency into execution quality and broker order routing practices.
In particular, Rules 605 and 606 of Regulation NMS require execution
venues to periodically publish certain aggregate data about execution
quality and require brokers to publish periodic reports of the top 10
trading venues to which customer orders were routed for execution over
the period, including a discussion of any material relationships the
broker has with each venue. Publication of this data has helped better
inform investors about how their orders are handled.
Nonetheless, these rules were adopted nearly 15 years ago \7\ and
the market has evolved significantly enough to warrant re-examining
whether additional transparency could be provided that would benefit
investors. For example, advances in technology now permit significant
market events to occur in millisecond timeframes, and audit trails are
granular enough to capture that activity. However, the current
requirements of Rule 605 effectively allow a trading venue to measure
the quality of a particular execution by reference to any national best
bid or offer in effect within the 1-second period that such order was
executed. Given the frequency of quote updates in actively traded
securities within any single second, compliance with this requirement
may not in all cases provide adequate transparency into a particular
venue's true execution quality. In addition, the scope of Rule 605
could be extended to cover broker-dealers, and not just market centers.
Transparency could further be improved by amending Rule 606 to require
disclosure about the routing of institutional orders, as well as a
separate disclosure regarding the routing of marketable and
nonmarketable orders.
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\7\ Exchange Act Release No. 43590 (Nov. 17, 2000) (Rules 605 and
606 were originally adopted as Rules 11Ac1-5 and 11Ac1-6, respectively,
under the Exchange Act).
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Some have suggested that exchange fee structures may be the source
of unmanageable conflicts of interest associated with order routing
decisions. The dominant exchange pricing mechanism over the last decade
has been the so-called maker-taker model, which generally encourages
liquidity makers to take the risk of exposing an order in the
marketplace by paying them a small rebate, if and only when their order
is executed. Under Regulation NMS, exchange fees to access--or
``take''--liquidity are capped at 30 cents per 100 shares, which
effectively serves as a cap on the rebate that can be paid to liquidity
makers.
These rebates provide an effective incentive to encourage liquidity
makers to post tight bid-offer spreads, which benefit all investors. I
believe restricting incentives to provide liquidity could be counter-
productive. Whether it is banning the current maker-taker fee
structure, limiting payment for order flow generally, or other attempts
to alter the fundamental economics of trading, price controls are a
blunt instrument likely to cause disruptions and consequences that are
unforeseeable and potentially detrimental to all types of investors. I
am concerned that additional pricing restrictions could drive
significantly more volume to dark venues or order types, make the
compensation brokers receive for their liquidity far less transparent,
and widen the displayed bid-ask spread in a manner that effectively
taxes all investors. Efforts to avoid these potential consequences
could lead to a set of regulations so complex that the root cause of
future behaviors could never fully be known.
IV. Venue Complexity--How Many Is Too Many?
Competition and automation have combined to dramatically improve
the market's trading infrastructure. The low commissions, diversity of
products and ability to handle large order and trading volumes are a
direct result of these forces. Regulation ATS and Regulation NMS
provided a framework for this competition to thrive, and maintaining a
system whereby new entrants can prove their value to the market is
essential. At the same time, we need to reconsider where regulation may
artificially subsidize competition or encourage complexity that does
not address a market need.
In particular, all exchanges are given a significant competitive
advantage regardless of their size by virtue of the order protection
rule under Regulation NMS. While this was necessary in an era where
legacy exchanges routinely ignored their competitors, current practices
have reduced the need for regulatory protections of smaller venues.
Recent events provide evidence that market forces ultimately can
correct for venues that add only marginal value; the existing
concentration of exchanges among scale providers--including BATS--means
that in some cases the marginal operating cost for a ``new'' exchange
is near zero. The cost and complexity of connectivity to a small venue
for market participants, however, can be substantial.
Accordingly, Regulation NMS should be revised so that, until an
exchange achieves greater than a de minimis level of market share,
perhaps 1 percent, in any rolling 3-month period:
They should no longer be protected under the order
protection rule; and
They should not share in/receive any NMS plan market data
revenue.
The combination of these two provisions would: (a) potentially
reduce client costs in connecting to small exchanges, giving them the
flexibility to route around them should they so choose, while still
protecting displayed limit orders on all venues of meaningful size; and
(b) take away market data revenue that may be the basis for the
continued operation of marginal venues.
V. Order Type Complexity--Drivers and Solutions
While I am sensitive to concerns about the complexity of our
markets, the vast majority of market functionality exists because it
meets the needs of a diverse group of market participants.\8\
Functionality becomes counter-productive when it exists solely to
address arcane or trivial requirements, rather than addressing
important economic, operational or regulatory needs of market
participants. This is especially true when the level of complexity is
high in relation to the supposed benefits.
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\8\ See e.g., Gregg E. Berman, Associate Director, Division of
Trading and Markets, SEC, What Drives Complexity and Speed of our
Markets (speech given at the North American Trading Architecture
Summit, New York, NY, April 15, 2014).
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One such driver of excessive exchange complexity is rooted in an
often-overlooked provision of Regulation NMS--the ban on locked
markets. Price-sliding logic and other order types such as ISOs often
stem directly from this discrete prohibition. Given that existing
regulatory guidance already effectively prohibits locking a market for
the sole purpose of avoiding or reducing fees, revisiting regulatory
obligations in this regard could be a simple yet powerful way to
materially reduce the complexity of exchange operations.
VI. Systemic Complexity--Strengthening Critical Infrastructure
Technology has undoubtedly transformed our market for the better,
but it has also created new challenges and risks. Even in a market with
fewer exchanges and fewer order types, the risk of IT or operational
malfunctions will remain. Since 2010, the SEC and the industry have
worked constructively to improve coordination and systemic risk
management, from the implementation of Limit Up/Limit Down execution
price bands to the enactment of the Market Access Rule to the
harmonization of the standards for clearly erroneous trades. Taken
together, these initiatives represent significant progress with respect
to enhancing market stability.
This progress is measurable. According to the Financial Information
Forum, exchange system issues as measured by self-help declarations
have dropped more than 80 percent since 2007 and 2008, the first years
after Regulation NMS. In addition, the number of clearly erroneous
executions across the industry has dropped dramatically over the last
few years. For example, clearly erroneous events reported on the BATS
BZX Exchange in 2014 is on pace to be approximately 66 percent lower
than 2013 and 85 percent lower than the previous 5-year average.
Further mitigating operational risk requires continuous vigilance
and a flexible framework. More can and needs to be done with respect to
critical market infrastructure as a whole, and by the individual
institutions that actively participate in the markets. In particular, a
well vetted and properly scaled Regulation SCI should be finalized and
adopted with respect to exchanges, SIPs and clearance and settlement
facilities. While the SEC should work with these future Regulation SCI
entities to refine its requirements in a manner that will achieve the
best outcomes, completing this regulation should be prioritized. I am
encouraged by Chair White's recent comments on her desire to finalize
the proposal. This would strengthen market infrastructure truly deemed
to be ``critical'' around industry best practices and help better
manage the complexity that competition brings where it is needed.
VII. Conclusion
While our current equity market structure is certainly not perfect,
I believe that it is by far the fairest, most efficient and most liquid
market in the world. And because it is a complex ecosystem,
policymakers need to be mindful of the potential unintended
consequences of sudden, significant changes. I fully support the SEC
conducting a deliberate, data-driven study of the quality of our market
structure and advocate for reforms where that analysis supports the
likelihood for market quality improvement.
Thank you for the opportunity to appear before you today. I would
be happy to answer any of your questions.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
RESPONSE TO WRITTEN QUESTION OF SENATOR BROWN FROM JOE
RATTERMAN
Q.1. Since at least 2012, former high-frequency traders have
been expressing concerns about exotic order types that
technically comply with the SEC's regulations, but which allow
high-frequency traders to jump the queue and exploit price
advantages that come from latencies.
NYSE announced in May that it was eliminating 15 order
types. However, NYSE continues to allow high-frequency traders
to use some predatory order types, like ``Post No Preference
Blind,'' in which high-frequency traders' bids to remain
blocked from the market and then jump to the top of the queue.
Nasdaq has a similar order type called ``Post Only with
Automatic Re-Entry,'' DirectEdge has ``Hide Not Slide,'' and
BATS offers ``Only Post Only.''
When I asked Mr. Sprecher about these order types at the
hearing, he said:
[A]s you say, I'm uncomfortable with having all these order
types. I don't understand why we have them. And I've started
unilaterally eliminating them. The problem that we have is that
orders today are--decisions on where orders go are not made by
humans. They're made by computers that are so-called smart
order routers. And many of these order types exist to attract
the orders. And I'm trying to balance cleaning up my own
house--I live in a glass house, and I'm trying to clean it up
before I criticize others. At the same time. I can't make the
New York Stock Exchange go to zero. It would be bad for this
country for the New York Stock Exchange to no longer have
trading activity. So, it's why I've been outspoken. I hope that
other exchange leaders will follow my lead. I'd like to get us
all working together to eliminate these types.
I'd be happy if we can do it as a private sector initiative.
I'd be happy if the SEC ordered us to get rid of them. I'd be
happy if Congress took action. Any way we can reduce them, I'd
be happy . . .
I can't take the New York Stock Exchange to 1 percent, but I
appreciate your allowing me to talk about this publicly to you
all and to the camera and a microphone. Because I think that I
need to put pressure on all my colleagues to follow my lead.
My question is this: will you work with Mr. Sprecher to
eliminate predatory order types from your exchanges, including
the specific order types identified above?
A.1. My perspective is that an order type should satisfy one of
two primary objectives, and if it doesn't, then and only then
should it be eliminated from the market.
The first primary objective would be to allow a member to
maintain compliance with the current regulatory environment.
Rather than remove these order types, we should re-examine the
regulatory requirement that drove the development of the order
type to begin with.
The second primary objective of an order type would be to
allow a member to fully express their intentions for the
handling of their order in electronic form, so that the
exchange can make electronic decisions during the life of that
order that conform to the member's original intentions. Much of
the order type functionality that exists is simply electronic
``check boxes'' for how the exchange needs to manage the order
at each decision point during the order's lifetime.
Order types that don't meet one of these two criteria
should be considered for retirement, and that's how I have
historically thought about reducing the complexity from within
our own platform's software code base.
I don't believe that we have any order types that would be
considered predatory, but if we ever determined that an order
type on our system had been used in a predatory way, we would
first seek an enforcement action against the firm who employed
the predatory approach, and we would review whether the order
type inherently attracted predatory behavior, and if so, we
would take actions to eliminate the predatory nature of the
order type or even the order type itself.