[Senate Hearing 114-238]
[From the U.S. Government Publishing Office]
S. Hrg. 114-238
REGULATORY REFORMS TO IMPROVE EQUITY MARKET STRUCTURE
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HEARING
before the
SUBCOMMITTEE ON
SECURITIES, INSURANCE, AND INVESTMENT
of the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED FOURTEENTH CONGRESS
SECOND SESSION
ON
EXAMINING RECENT EFFORTS BY THE SEC AND FINRA IN AIDING THE FUNCTIONING
AND STABILITY OF THE EQUITY MARKETS, AND IDENTIFYING KEY ISSUES UNDER
CONSIDERATION TO REDUCE MARKET COMPLEXITY, INCREASE OPERATIONAL
STABILITY, AND PROMOTE
EFFICIENCY, COMPETITION, AND CAPITAL FORMATION
__________
MARCH 3, 2016
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Available at: http://www.fdsys.gov/
______
U.S. GOVERNMENT PUBLISHING OFFICE
99-832 PDF WASHINGTON : 2016
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
RICHARD C. SHELBY, Alabama, Chairman
MIKE CRAPO, Idaho SHERROD BROWN, Ohio
BOB CORKER, Tennessee JACK REED, Rhode Island
DAVID VITTER, Louisiana CHARLES E. SCHUMER, New York
PATRICK J. TOOMEY, Pennsylvania ROBERT MENENDEZ, New Jersey
MARK KIRK, Illinois JON TESTER, Montana
DEAN HELLER, Nevada MARK R. WARNER, Virginia
TIM SCOTT, South Carolina JEFF MERKLEY, Oregon
BEN SASSE, Nebraska ELIZABETH WARREN, Massachusetts
TOM COTTON, Arkansas HEIDI HEITKAMP, North Dakota
MIKE ROUNDS, South Dakota JOE DONNELLY, Indiana
JERRY MORAN, Kansas
William D. Duhnke III, Staff Director and Counsel
Mark Powden, Democratic Staff Director
Dawn Ratliff, Chief Clerk
Troy Cornell, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
______
Subcommittee on Securities, Insurance, and Investment
MIKE CRAPO, Idaho, Chairman
MARK R. WARNER, Virginia, Ranking Democratic Member
BOB CORKER, Tennessee JACK REED, Rhode Island
DAVID VITTER, Louisiana CHARLES E. SCHUMER, New York
PATRICK J. TOOMEY, Pennsylvania ROBERT MENENDEZ, New Jersey
MARK KIRK, Illinois JON TESTER, Montana
TIM SCOTT, South Carolina ELIZABETH WARREN, Massachusetts
BEN SASSE, Nebraska JOE DONNELLY, Indiana
JERRY MORAN, Kansas
Gregg Richard, Subcommittee Staff Director
Milan Dalal, Democratic Subcommittee Staff Director
(ii)
C O N T E N T S
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THURSDAY, MARCH 3, 2016
Page
Opening statement of Chairman Crapo.............................. 1
Prepared statement........................................... 26
Opening statements, comments, or prepared statements of:
Senator Warner............................................... 2
WITNESSES
Stephen Luparello, Director, Division of Trading and Markets,
Securities and Exchange Commission............................. 4
Prepared statement........................................... 26
Richard G. Ketchum, Chairman and CEO, Financial Industry
Regulatory Authority........................................... 6
Prepared statement........................................... 37
Additional Material Supplied for the Record
Letter to Committee from Mary Jo White, Chair, Securities and
Exchange Commission............................................ 43
(iii)
REGULATORY REFORMS TO IMPROVE EQUITY MARKET STRUCTURE
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THURSDAY, MARCH 3, 2016
U.S. Senate,
Subcommittee on Securities,
Insurance, and Investment,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Subcommittee convened at 10 a.m., in room 538, Dirksen
Senate Office Building, Hon. Mike Crapo, Chairman of the
Subcommittee, presiding.
OPENING STATEMENT OF CHAIRMAN MIKE CRAPO
Chairman Crapo. The Committee will come to order.
This is a hearing of the Subcommittee on Securities,
Insurance, and Investment relating to market structure. I think
we will have a very good hearing today and I appreciate
everyone's attendance.
The landscape of stock markets and trading today is
substantially different than it was 20, 10, or even 5 years
ago. Regulations and technological innovation have moved stock
trading from the floors of exchanges to virtually all trading
now being conducted electronically on automated markets.
Technology and innovation has benefited investors by leading to
tighter spreads, lower costs, and more efficient markets.
However, the expansion of trading venues, speed, and
mandated interconnectedness of exchange and market participants
has raised questions regarding market complexity and
resiliency. For the past several years, the Securities and
Exchange Commission and the Financial Industry Regulatory
Authority have been working to better understand whether their
market structure rules have kept pace with the changes in
trading technology and practices.
In 2014, the Banking Committee held a hearing with a broad
mix of market participants to examine the role of regulation in
shaping today's markets as well as whether these markets are as
resilient and as stable as they should be. Several witnesses at
the hearing argued that Regulation NMS, a set of SEC market
structure rules that passed by a three-two vote over 10 years
ago, needed to be reexamined.
Later in the year, SEC Chair White provided an update to
her market structure agenda in a response to a letter Senator
Johnson and I sent and highlighted three fundamental policy
questions that the Commission would be focusing on.
First, the trade-through restrictions in Rule 611 of
Regulation NMS and whether they should be rescinded or
modified.
Second, the current regulatory model for exchanges and
other trading venues and whether it makes sense for today's
markets.
And, third, the maker-taker fee structure, including the
related issue of restrictions on locking and crossing
quotations in Rule 610 of Regulation NMS.
These are complicated issues and I appreciate the data-
driven approach by the SEC and FINRA and the extensive comments
from market participants, investors, and academics. It will be
helpful to understand from our witnesses what progress has been
made in identifying and prioritizing the key concerns with our
equity market structure and what options are being explored to
address them. After all, the 2010 Flash Crash is still fresh in
many of our minds and additional market events have raised
concerns about market integrity and resiliency.
In fact, the SEC's Equity Market Structure Advisory
Committee met to diagnose and discuss one of the latest market
disruptions, namely, what went wrong last August 24 when
dramatic price moves triggered more than 1,000 trading halts in
hundreds of stocks and exchange-traded funds.
Today, this Committee hopes to hear from our witnesses
about what lessons were learned from recent market disruptions
and what steps need to be taken to strengthen the operation of
the markets. The U.S. capital markets are vital to the growth
of our economy and we need to take the necessary steps to make
sure that the U.S. financial system and markets remain the
preferred destination for investors throughout the world.
I do look forward to the testimony of our witnesses, who I
will introduce in just a moment, but let me turn first to my
colleague, Senator Warner.
STATEMENT OF SENATOR MARK R. WARNER
Senator Warner. Well, thank you, Chairman Crapo, and thank
you for holding this hearing on this very important topic.
I was going to remark that, knowing how it is a little
complicated, I was happy to see that at least one of our
colleagues was here, but already our comments have driven him
out of the room, so----
[Laughter.]
Senator Warner.----but we are glad to see him----
Chairman Crapo. I am sure he is listening on his iPhone.
Senator Warner. Over the past few decades, we have seen
remarkable technological progress and innovation in our
security markets, coupled with substantial regulatory reform.
Some of these advances and reforms, including decimalization,
have brought considerable rewards for individual investors by
narrowing spreads and increasing liquidity. Most trades today
can happen within fractions of a second, providing good prices
and counterparties for those seeking to buy equities around the
world.
But, at the same time, we have seen increased volatility
and periodic dislocations. In recent years, as the Chairman
mentioned, we have seen a market-wide Flash Crash, a series of
mini-Flash Crashes in individual equities in Blue Chip stocks,
a Flash Freeze at NASDAQ in 2013, problems with high-profile
IPOs like Facebook and BATS, a glitch at the New York Stock
Exchange in July 2015 that halted trading for hours, an ETF
meltdown in 2015, and numerous allegations of and settlements
for misbehaviors by dark pool operators.
It is clear much work around market structure remains. So,
where do policymakers go from here? Let me make four quick
points.
First, in the era of microsecond trading, we need to
reevaluate the way our stock markets function. Chair White has
made the right call by asking the Commission to conduct a
holistic market structure review. We need data to be able to
rationally analyze the market so appropriate investor
protections can ultimately be implemented.
Second, I believe strongly we should explore additional
pilots. It has been nearly 2 years since Chair White announced
her holistic review. Some have argued against conducting pilots
in the interim as inconsistent with this review, but I do not
think this is necessarily the case. As long as pilots are
carefully crafted and done in a timely fashion, they can
produce valuable data.
Last week, I saw a stunning graphic from RBC Capital
Markets that charted 839 different fee schedules that are
composed of 3,729 separate fee variables. When one examines
these variables in detail, it appears that certain exchanges
are using their fee engineers to put together bespoke pricing
terms for one or a small handful of customers in order to
attract and retain order flow. Given this incredible
complexity, it is likely very difficult for market participants
to know whether they are getting best execution and the benefit
of a fair and orderly market.
To address this, there is a proposal pending before the SEC
that would, for a 6-month period, eliminate rebates or
comparable inducements for a random sample of 50 of the 100
most actively traded stocks. I strongly endorse this maker-
taker pilot to help detect conflicts of interest, promote price
transparency, and reduce inefficiencies.
Third, we should examine the role dark pools play in market
structure, particularly in light of recent settlements with the
SEC and the New York Attorney General. The original rationale
for alternative trading venues--executing block sales, large
block sales--appears to have diminished, with only an average
trading size of 187 shares at the five largest dark pools,
according to a recent FINRA study in 2014. I would love to hear
more on that subject. The SEC has made recent studies in both
enforcement and regulation of this space, recent strides, and I
hope it continues.
Fourth and finally, we must have the regulatory tools
necessary to conduct adequate market oversight. This means
establishing the Consolidated Audit Trail (CAT) so the SEC can
have real-time insight into the mechanics of the stock market.
It is beyond frustrating that nearly 6 years after the Flash
Crash we still have not built the CAT. Both of our witnesses
today have a critical role in its approval, so I look forward
to hearing their explanations on its timely completion.
Thank you, Mr. Chairman, and I look forward to our
witnesses' testimony.
Chairman Crapo. Thank you very much, Senator Warner.
I saw the same graphic you did, and it is remarkable to see
the kind of analysis that can show the complexity of the
markets that we are now dealing with.
And, again, I appreciate the work that both the SEC and
FINRA are doing. We want to both, I think, encourage that that
work proceed quickly and that we address these critical issues
and get the advice and counsel of those who regulate these
markets.
And, in that context, our witnesses for today's hearing on
Regulatory Reforms to Improve Market Structure are Mr. Stephen
Luparello, Director of the Division of Trading and Markets at
the U.S. Securities and Exchange Commission, and Mr. Richard
Ketchum, Chairman and CEO of Financial Industry Regulatory
Authority.
As many of you may know, Rick Ketchum has announced that he
is going to be retiring later this year, and I know that I will
miss you, Rick. All of us will. Thank you for your service and
for your dedication to improving our markets. We appreciate it
very much.
Mr. Ketchum. Thank you very much for those words.
Chairman Crapo. Gentlemen, I think you know the rules very
well. We have allocated 5 minutes to each of you, and we will
have you go in the order I introduced you. And at that point,
then, we will have an opportunity for some questions and
dialogue.
Mr. Luparello.
STATEMENT OF STEPHEN LUPARELLO, DIRECTOR, DIVISION OF TRADING
AND MARKETS, SECURITIES AND EXCHANGE COMMISSION
Mr. Luparello. Chairman Crapo, Ranking Member Warner,
Members of the Subcommittee, thank you for inviting me to
testify regarding equity market structure. I welcome this
opportunity to discuss a topic of such importance to investors,
public companies, our securities markets, and capital
formation.
Enhancing U.S. equity market structure continues to be a
primary focus of the SEC. It was a primary focus in 2015 and
will continue to be in 2016. My written testimony lays out the
full range of the SEC initiatives.
In 2015, for example, the SEC published a proposal to
enhance the operational transparency of alternative trading
systems, proposed amendments to a rule that would require
broker-dealers who engaged in proprietary trading in off-
exchange venues to become members of a national securities
association, and approved a pilot program to assess the effect
of tick sizes on market quality for smaller issuers.
Before I touch briefly on a few upcoming initiatives, I
want to give an overview of the Commission's program for equity
market structure to help illuminate how particular initiatives
fit into the program as a whole.
Today's equity markets, as you know, are dominated by
computer algorithms. These algorithms are capable of
generating, routing, and executing orders with enormous
sophistication, volume, and speed. They have enabled types of
market mechanisms and trading practices that were not possible
in the days of manual markets.
Our regulatory regime must keep pace with and adjust
appropriately in response to these market changes. But doing so
requires thorough study and an appreciation of the workings of
the full market. Market structure issues typically are complex
and highly interrelated. Even when a particular problem is
identified, efforts to develop a response must reflect the full
consideration of the risk of unintended consequence.
To meet this challenge, our ongoing equity market structure
review is based on three key elements. First, it is data
driven. A vital first step in dealing with market structure
questions is to marshal relevant data. Although data analysis
alone cannot dictate particular outcomes, it is extremely
valuable to help narrow the range of viable regulatory
responses.
Accordingly, the SEC has made a concerted effort in recent
years to strengthen its capabilities for data collection and
analysis. These efforts include capturing a wider range of data
sources, deploying more sophisticated technology tools and
analyzing data, and employing additional personnel with the
necessary quantitative skill sets.
Second, our review of equity market structure is open to a
wide range of views. Many market structure issues arise in the
context of proposed SEC rules, national market system plans,
and exchange rules. These procedural contexts provide an
extensive opportunity for public comment. But given the
complexity of market structure issues, the SEC has taken an
extra step of seeking out a wide range of views in contexts
other than specific proposals and adoptions. These have
included concept release, public roundtables, a request for
comment on particular topics, and the establishment of the
Equity Market Structure Advisory Committee.
Finally, our equity market structure review is
comprehensive in scope. Properly assessing market structure
issues requires full appreciation of the extent to which market
participants, the tools they employ, and the trading venues
they use are interrelated. Rarely, if ever, does a material
change in one aspect of market structure not have important
effects on other aspects of market structure.
Accordingly, the SEC does not address issues in isolation.
Rather, as outlined in my written testimony, the SEC has
advanced initiatives that encompass market stability, high
frequency trading, fragmentation, broker conflicts, and the
quality of markets for smaller companies. Focus on this wide
range of substantive issues is intended to help address
particular areas of concern while still providing an
opportunity to assess the extent to which these issues and
initiatives across different categories are interrelated.
I will finish by briefly mentioning four particular
initiatives that should see important developments in the
coming months. One, as mentioned already, is the Consolidated
Audit Trail, or CAT, which would represent a major step forward
in oversight of the equities markets. We have approved certain
exemptions and approved the CAT project manager, clearing the
way for the staff to be in a position soon to make a
recommendation to the Commission for publishing the CAT plan
for notice and comment.
Another noteworthy new rulemaking initiative involves
institutional order routing transparency, which would expand
investors' understanding of the brokers' routing decisions--of
their brokers' routing decisions--by mandating standardized
order routing disclosures. I anticipate that the staff will
make a recommendation on this initiative in 2016.
Another noteworthy new initiative is an anti-disruptive
trading rule. Staff is developing a recommendation that would
be narrowly tailored to address aggressive destabilizing
strategies in conditions where they have the most possible
impact to exacerbate price volatility.
And, finally, a fourth initiative is the potential for a
pilot program, as discussed, on maker-taker fee structures. A
subcommittee of the SEC's Equity Market Structure Advisory
Committee is assessing this issue and I anticipate that it will
have a recommendation ready to discuss by the full committee at
its next meeting in April.
Thank you for inviting me to testify to discuss these
issues and I look forward to answering your questions.
Chairman Crapo. Thank you very much, Mr. Luparello.
Mr. Ketchum.
STATEMENT OF RICHARD G. KETCHUM, CHAIRMAN AND CEO, FINANCIAL
INDUSTRY REGULATORY AUTHORITY
Mr. Ketchum. Chairman Crapo, Ranking Member Warner, and
Members of the Subcommittee, I also want to thank you for the
opportunity to testify today.
In recent years, there has been an increased debate about
the structure of capital markets. Once the domain of
regulators, market operators, and large sophisticated
investors, market structure is now a topic for much broader
public discourse. This discourse often, appropriately, includes
questions about whether or not the markets are fair and whether
they provide a level playing field for all investors.
Questions of market structure can be broad and complex and
it can be difficult to pinpoint what really needs to be
addressed. I believe there are three key aspects of the markets
that securities market participants and regulators should
always be working to strengthen: market fairness, market
transparency, and market liquidity.
Investors must have confidence that they can access
current, accurate market prices that reflect true investor
supply and demand. That means that market structure must foster
and promote accurate prices and low trading costs for retail
investors. Having been in this business for a long time, I have
seen many significant market structure changes that have
benefited investors, but some of these changes have also led to
a more complex and fragmented market.
FINRA has responsibility to oversee and regulate over-the-
counter trading of exchange listed and non-exchange listed
securities as well as trading in many fixed income instruments.
In addition, FINRA provides automated surveillance and other
regulatory services to U.S. equity and options exchanges,
conducting surveillance for approximately 99 percent of the
listed equity market and approximately 70 percent of the listed
options market.
As a result, while the markets have become increasingly
fragmented, we have been able to aggregate trading data across
the markets to conduct comprehensive cross-market surveillance.
This is important because we have found many instances where
market participants have consciously dispersed their trading
activity across multiple markets in an effort to avoid
detection.
In addition, FINRA's cross-market surveillance program
enables us to detect those market participants who are acting
in concert to engage in market manipulation schemes. Our
innovative program allows us to run dozens of surveillance
patterns and threat scenarios across the data we gather to look
for manipulation and front running as well as layering,
spoofing, algorithmic gaming, and other abusive conduct. This
sophisticated surveillance allows us to detect activities that
we were not able to see before. We are also starting to design
surveillance programs that will span equities and options
markets together to detect potential cross-product manipulative
conduct.
Transparency is another market feature of paramount
importance to investors, and FINRA recently proposed a series
of initiatives designed to increase the scope of trading
information we receive and provide more transparency into
trading activities to market participants and investors. In
general terms, these efforts include a call for alternative
trading systems to provide more in-depth order information for
regulatory surveillance, greater transparency of volume
executed away from stock exchanges, more granular audit trail
information, and tighter restrictions around allowable clock
drift to better ensure proper sequencing of events.
These FINRA initiatives align with broader market structure
changes implemented by the SEC and other market participants.
Since the May 2010 Flash Crash, the SEC, FINRA, and the U.S.
stock exchanges have implemented a variety of initiatives to
minimize the impact of extreme volatility. Among the changes,
regulators adjusted the market-wide trading pause, which gives
market participants an opportunity to assess their positions,
valuation models, and operation capabilities when extreme
periods of volatility occur. In addition, FINRA and the
exchanges implemented a limit up-limit down initiative which
addresses the type of sudden price movements that the market
experienced during the Flash Crash.
We had an excellent opportunity to evaluate the
effectiveness of these changes last August 24. The events of
that day illustrated both the value of having appropriate
controls in place and areas where those controls might be
enhanced, and I look forward to discussing this in greater
detail with the committee.
Many of these issues are being considered by the SEC's
Equity Market Structure Advisory Committee, of which I am a
member. Among other things, the committee is reviewing the
current regulatory model for exchanges and other trading venues
as well as the current state and impacts of Regulation NMS, and
in particular, the EMSAC is considering whether rules on
limiting trade throughs, capping access fees, and preventing
locked and crossed markets continue to serve their intended
purposes.
I appreciate the opportunity to testify today and would be
happy to answer any questions you may have. Thank you.
Chairman Crapo. Thank you very much. And, again, I
appreciate the effort that both of you and your organizations
have been involved in on this. And, to start with, I would note
that, as Senator Warner indicated, Chair White 2 \1/2\ years
ago now embarked on the holistic approach and we had been
looking at these issues even for a couple of years before that.
I am in the mode of wanting to find out how soon we will get to
go on some of the answers.
Each of you in your testimony have identified some specific
areas and proposals that you think are--I assume you think are
ready to move forward. So, what I would like to ask you to do,
both of you to do right now for the remainder of the time I
have in my questioning in this round is to pick maybe the top
two proposals or actions that you think need to be made, and I
am talking about in terms of what we can get to as quickly as
we can, or how quickly we can get to some proposals on the
table so we can start moving and then give me a little bit of a
timeframe idea of what you think that we are looking at in
terms of getting to these proposals. Mr. Luparello.
Mr. Luparello. So, it is a fortunate coincidence that I
think my top two are the ones that are next up in terms of us
getting proposals out, both of which I alluded to in my oral
statement, but specifically the Consolidated Audit Trail and
our institutional order routing disclosure rule, which in
shorthand, we call Institutional 606.
Chairman Crapo. And I heard you say ``soon'' on the
Consolidated Audit Trail and during 2016 on the other, so how
about--can you specify that a little bit?
Mr. Luparello. Well, you know, I generally get in trouble
when I put specific dates on things----
[Laughter.]
Mr. Luparello.----but I will at least reference that the
Chair recently said that it is her desire to have the
Consolidated Audit Trail approved and the plan processor
selected in 2016, and if you back out some of the hard dates
that go into that, that would require us to get the plan out
for notice and comment in the coming few weeks.
Institutional 606 is something we are working hard to get
out in somewhat a similar timeframe. One of the reasons why I
think it is both an important rule and an important rule to get
out soon is it works nicely in complement with our Reg ATS
proposal that we put out. Both of those rules stand on their
own as very good, important disclosure-based rulemakings. But,
in a way, they work even better together.
Chairman Crapo. All right. Thank you.
Mr. Ketchum.
Mr. Ketchum. Well, let me start and agree with Steve on
both of his pieces, without counting them as my two, but I will
just briefly----
[Laughter.]
Chairman Crapo. We will grant you that.
Mr. Ketchum. But, I will briefly mention on the
Consolidated Audit Trail, FINRA obviously does a substantial
percentage of the market surveillance tasks where audit trail
information is so critical and CAT is a huge step forward. The
ability to move from a two-step process of identifying the
firms that are executing and clearing trades where they may be
problematic to an ability to identify customers as opposed to
having to go out to firms to get that information dramatically
reduces false positives, dramatically improves our ability to
identify problematic activity, and I could not be more
supportive of the SEC's efforts there.
I would just note, it is a complex task, and I know,
Chairman Crapo, that you have always been interested in balance
and ensuring that this is done the right way, as well. I think
the SEC's exemptive order, which I compliment Steve on for
getting out yesterday, was a great example from what was
submitted by the exchanges and FINRA of the type of efforts to
both move CAT forward but also move it forward in a way that is
operationally the most efficient and effective, and I look
forward to the publication of the plan and moving it as quickly
as possible.
Two other things I will mention. It is the right time to
address and manage and look closely at the maker-taker issue. I
compliment the SEC for moving forward on a pilot, working with
the exchanges and FINRA, and I think there were a variety of
excellent reasons to set the maker-taker pricing and access fee
provisions where it was at the time the SEC did. The markets,
as both, Chairman Crapo, you and Ranking Member Warner
indicated, have changed dramatically since then. The arbitrage
issues around maker-taker pricing today raise real questions
from the standpoint of efficiency and investor confidence. It
is the right time to look at it.
And, the last piece is, we collectively, both the SEC, the
exchanges, and FINRA, all need to respond to the areas where
there is still more to be done showing up from the standpoint
of trading on August 24. Fundamentally, the markets and the
steps that were put in place worked and operated well to reduce
the type of volatility that we had seen earlier at the Flash
Crash. But, there are a range of issues, as I indicated in my
testimony, that deserve to be looked at closely, and I think
that also, from an investor confidence standpoint, is something
we ought to get to.
Chairman Crapo. Well, thank you very much, and you both
kept me right on time.
Senator Warner.
Senator Warner. I appreciate the Chairman's questions.
I am going to come at it maybe with a little more edge. I
think it is great, what you have--and I say this--I know you
guys are both trying to get us where we need to be, but, you
know, it is 6 years on the CAT, and I hope you will take back,
Steve, the notion to the Commission that at least this
Senator's patience is wearing very thin. I also wonder, on the
Consolidated Audit Trail, since the SEC does not have
jurisdiction over the futures markets, obviously, that is CFTC,
but as we saw with the Flash Crash, if you have something
happen on the futures side, it can also affect the equities
side.
So, I am going to get out at least two of my questions and
I am going to ask you to both answer quickly, because I have
got three or four more. How do we deal with that jurisdictional
issue, recognizing that you have committed that we are going to
get this project--the CAT finished in 2016, point number one.
Point number two, to where, Mr. Ketchum, you were at, I
think the maker-taker pilot is really, really important. I do
not know if--Senator Crapo and I both saw it. I do not know if
Senator Warren saw the RBC chart that showed--again, I just say
to say again--839 different fee models and over 3,700 different
kind of fee structures, a level of complexity that even for
Wall Street is over the top, that clearly is driving
commissions, fees, and rebates in a way that is not
transparent, that does not guarantee best markets, that under
the guise of bespoke products, I think, is creating a real
disservice, and my understanding, at least, in terms of a
maker-taker pilot, if you decide to move forward, this would
not require months and months of preparation. You could simply
pick an arbitrary 100 equities, put 50 in the control batch and
50 in the noncontrol batch and flick a switch and we could
start that pilot.
So, I would like you on the first round, briefly, because I
have got, again, a few others to whack at--to hit on--how hard
around the CAT without the jurisdiction on futures, and can we
be assured that we are going to move forward on maker-taker in
a timely manner, in either order.
Mr. Luparello. I will be happy to start. CAT could not be a
higher priority for us, and getting a recommendation to the
Commission----
Senator Warner. Six years is a long time.
Mr. Luparello. I--I appreciate that, and I have lived that
for--I have lived in that space for all of it, including some
time living with access to inadequate information. So, we--like
I said, it could not be a higher priority for the Commission,
for the Chair, and especially for me and my staff, and we
expect to have something very, very soon.
I think the issue of other products, it cannot be
overstated. There are some jurisdictional issues. I know the
CAT plan participants, and Rick is more close to this than I
am, have been identifying those potential expansions into other
products, because August 24 proved what I think we already
knew, which is that the futures markets and the cash markets
are inextricably linked, and if we do not have a good vision
into those, we are still--we are going to be seeing a much more
complete picture on a day in, day out basis, but during times
of extreme market stress, we are going to be missing an
important part of the picture if we do not have futures there.
I agree, I think maker-taker is a pilot that, unlike some
other pilots, where I think we are concerned that we are adding
even more complexity when you put a pilot into place, that
maker-taker is one that can be done very simply. We look
forward to the recommendation from the Equity Market Structure
Advisory Committee. I think it will be something we will be
able to act on very quickly.
Senator Warner. When?
Mr. Luparello. The subcommittee is supposed to make a
recommendation to the full committee at the next full committee
meeting, which is late April. And, so, that full committee will
then----
Senator Warner. Do you think there will be a
recommendation, either go or no go?
Mr. Luparello. I think the Subcommittee will be ready to
make a recommendation to the full committee. Given the
conversations that the full committee has had, I obviously
cannot commit the full committee. I would expect that they
would probably have some questions about the construction of a
pilot, but I think there is broad-based support, which is,
obviously, very important because it is a committee with a
number of different market participants and constituents, that
I think there will be broad-based support for a pilot.
Obviously, the details of how you construct the pilot are to be
determined.
Senator Warner. Rick.
Mr. Ketchum. As the operator of most of the market
surveillance activity going on in the markets today, nothing
could be more important to us than moving to CAT. We are
fortunate now that we can look across markets and across
products, but the Consolidated Audit Trail dramatically
enhances the effectiveness of our job.
You are right, Senator Warner, that there is no question
that including futures and, frankly, on the way, credit default
swaps would be a huge step forward with respect to the
Consolidated Audit Trail and efforts should be made to move
across jurisdictional lines. We have worked closely with the
MERC with respect to investigations for years and they have
been tremendously cooperative. But, the only way to effectively
identify or recreate markets is to have it all in one single
database, and your point is absolutely correct.
Senator Warner. Can you quickly address, since my time is
out and I want to come back next round on tick size and bond
market transparency, just very quickly on maker-taker.
Mr. Ketchum. Maker-taker, I absolutely support a broader
pilot. It is something that should be done from the standpoint
of data. There are a lot of interesting questions around it.
But, to me, sitting as just one member of the Equity Advisory
Committee of the Commission, I think this is absolutely the
right time to look and make changes to the maker-taker pricing.
Chairman Crapo. Thank you, Senator Warner.
And, Senator Warren. Senator Warren has to leave to another
Committee meeting, and so she is going to get a few extra
minutes on this one instead of waiting for the second round, if
that is all right with you, Mr. Warner.
Senator Warren. Thank you.
Senator Warner. Sure.
Senator Warren. Thank you very much Mr. Chairman. I really
appreciate your cooperation so I can cover two hearings, and
also appreciate your calling this hearing. This business about
market structure is just powerfully important. That makes this
hearing very important.
I want to focus on the self-regulatory aspect of this
market. FINRA is not a Government agency. It is instead an
independent nonprofit organization that is responsible for
regulating parts of the securities industry. So, I looked on
your Web site and the Web site for FINRA says that it is
dedicated to investor protection and works everyday to ensure
that every investor receives the basic protections they
deserve. I want to explore whether this industry self-
regulation really works.
This week, three economists from the University of
Chicago's Booth School of Business released a study that looked
at records on 1.2 million registered financial advisors and
brokers from 2000 to 2015, and they found that 1 in 13 had a
documented record of criminal, civil, or regulatory misconduct.
Amazingly, only about half of them had been fired by their
firms because of this misconduct, and of the half that were
fired, 44 percent got a job at another advisory firm within a
year.
Now, the study also finds that certain advisory firms hire
a huge number of advisors with a history of misconduct and
those firms tend to, quote, ``cater to unsophisticated
consumers, particularly the elderly and those with less
education.'' For example, a customer walking into an
Oppenheimer and Company retail location looking for financial
advice has a one in five chance that the advisor will have a
documented history of misconduct.
Mr. Ketchum, as the head of FINRA, what are you doing to
make sure that the elderly and people who can least afford bad
financial advice do not fall into the net of someone who has
already got a documented history of misconduct?
Mr. Ketchum. Senator Warren, I am glad you asked that
question. First, I read that study, as well, with great
interest, and I do find it dismaying that firms do hire in many
circumstances persons with those type of records. Those are
exactly the factors we look at from the standpoint of where we
focus our exams and where we focus our enforcement
investigations. It is exactly those type of factors which
result in us barring or suspending up to a thousand persons a
year, bringing action with respect to a wide range of firms and
more than a thousand actions a year. And we care very much
about the issues from the standpoint of recidivism and the
potential impact with respect to investors.
Senator Warren. Well, I appreciate, Mr. Ketchum, that you
care about this, but these are the data about what is going on
right now. I want to know what you plan to do about it. You
know, we have got FINRA-registered companies where 15 to 20
percent of the FINRA-registered advisors have a history of
misconduct. What is going on here?
Mr. Ketchum. Well, first up, and let us go back to the
definition of misconduct, which is, among other things, that
the firm settled an arbitration or a complaint for some amount
of money without admission one way or another with respect to
the investor.
Senator Warren. But----
Mr. Ketchum. These are absolutely incidents of exactly the
type of thing we look at from an exam standpoint----
Senator Warren. Well, I am glad you are looking at it----
Mr. Ketchum.----but we do actually have to find somebody--
--
Senator Warren.----but you are not taking them off the
street. And let us be----
Mr. Ketchum. We do when they violate the rule. Yes, we do.
We bar----
Senator Warren. Then how can it be so----
Mr. Ketchum. We bar hundreds of----
Senator Warren. How can there be so many? How can it be
that you could walk into an Oppenheimer and Company and have a
one in five chance of encountering someone who has prior--
recorded prior misconduct? And, let us keep in mind, this does
not--these are not trivial.
The other thing that the study found was that advisors who
have engaged in prior misconduct are five times more likely to
engage in future misconduct when compared with the average
advisor. So, we are talking about real risk here.
Mr. Ketchum. And that is exactly the risk we look at with
respect to our exams and enforcement investigations, and that
is why many of those people get barred every year.
Senator Warren. Well, all I can say, Mr. Ketchum, is you
obviously are not getting them out of the industry. They are
still there. They are there in big numbers. And they are
concentrated in places where they are most likely to encounter
unsophisticated consumers and I think that is a real problem
that we have got.
So, let me look at another aspect of the industry self-
regulation. Almost every advisory contract these days includes
a forced arbitration award, and that means that if investors
think they have been cheated, they cannot go to court, and if a
bunch of them get cheated by the same broker in the same
scheme, they cannot combine their claims into a class action.
They have to come to you, to FINRA, for arbitration.
Now, it turns out that investors do not win very often in
arbitration and that even if they do manage to win, they do not
get paid. A recent report from the Public Investors Arbitration
Bar Association found that over $60 million in arbitration
awards to investors in just 1 year, 2013, are still unpaid. And
just to put that in context, that means of the people who
finally made it all the way through the arbitration process and
managed to actually win against their broker or advisor, about
a quarter of them still have not gotten the money that they won
in the arbitration award.
Now, the same issue--main issue here seems to be that these
security firms do not have the money on hand to pay these
awards. They stay in business, but they do not have the money.
So, what is FINRA planning to do to ensure that these firms and
brokers actually have the money to pay an arbitration award
when they cheat people?
Mr. Ketchum. OK. Three sets of responses to your very valid
question.
First, with respect to any firm that continues to do
business in the securities industry, unless they leave and
become an investment advisor, we will bar them if they do not
pay their awards, plain and simple as that. No one can stay in
as a FINRA member and not pay their arbitration awards. And we
do that----
Senator Warren. So, you are telling me--I just want to make
sure I understand what that means. You are saying of the $60
million in arbitration awards from 2013, all of those people
are now barred? They are not part of FINRA anymore?
Mr. Ketchum. If I can get through my three answers----
Senator Warren. OK.
Mr. Ketchum.----I will try to address each part. If they
continue to have money, if they continue to do business as a
FINRA member and they do not pay their arbitration awards, we
will bar them.
Now, you are right, and one of the things that we have is
that firms become insolvent, leave FINRA, and in those
situations, we lose our jurisdiction from that standpoint and
investors--from the standpoint of barring them, they are
already gone--just as, by the way, they do if they are an
investment advisor bringing an action against the firm and that
firm goes insolvent with respect to enforcing a court decision,
they have to go to court to enforce it, and that is a big
problem from the standpoint of the number of people that are
not paid.
You raised exactly the right questions. The question as to
whether the capital requirements are at the right level are
fair questions. They are things we will look at at FINRA,
although I will note capital requirements are essentially
something that the SEC has taken responsibility for. Now, most
of the time, we want to get these people out of the industry if
they are doing bad things to investors.
But, whether there should be jumps before firms leave to
ensure that they have left capital to meet their arbitration
obligations that may come forward is something we are looking
at. Whether, one way or another, there should be a fund to try
to at least address this with respect to small investors that
are terribly harmed by that. I could not agree more that each
of those issues ought to be looked at.
Senator Warren. OK. So, what I am hearing you tell me, and
I just want to make sure I have this right, is that you believe
that there ought to be more regulation so there is money
available when people get cheated. And, second, you are telling
me that all of the people who were cheated in 2013 who got
arbitration awards who have not paid out, that all of those
dealers and brokers are now out of the business and out of your
jurisdiction. Is that right?
Mr. Ketchum. I am not--I am saying that those that have not
paid out will either be in a short period of time barred or are
already out.
Senator Warren. This is now 3 years.
Mr. Ketchum. Well, but with respect to those, they are
gone. Those are firms that have left FINRA.
Senator Warren. All of them from 2013 are gone.
Mr. Ketchum. Those--yes.
Senator Warren. OK.
Mr. Ketchum. Those are firms that have left FINRA and the
collection issues are exactly the same collection issues you
have when a firm goes insolvent with respect to court.
Senator Warren. Well, I just want----
Mr. Ketchum. But something should be done about it, and I
want to repeat what you just said. I do believe this is an
issue we want to be part of, we want to work with the SEC on,
and it is a real concern.
Senator Warren. Well, I just want to say on both of these,
I think something should be done about brokers and dealers who
put customers at risk. Brokers and dealers have arbitration
awards against them and cannot even pay when there is an award
against them. They are serious issues. They affect ordinary
investors. FINRA is supposed to be looking out for these folks,
not for the advisory firms, and I hope you will address these
issues quickly.
Thank you, Mr. Chairman. Thank you for your indulgence in
giving me the extra time.
Chairman Crapo. Thank you, Senator Warren.
Senator Donnelly.
Senator Donnelly. Thank you, Mr. Chairman.
I appreciate the efforts of the SEC and Chair White in
recent years to review and improve the structure of our equity
markets. They are significantly more complicated, and in recent
decades, we have moved from a single dominant stock exchange to
a marketplace now featuring 12 exchanges, 40 dark pools, and
hundreds of broker-dealers. Additionally, trading is electronic
and highly automated.
And, Mr. Ketchum, you spent 14 years with the SEC before
working for the exchanges and on Wall Street. Can you describe
the significant changes in market complexity you have witnessed
and the effect.
Mr. Ketchum. Well, I will try to, Senator Donnelly, and you
are right. The changes are dramatic. I think over a period of
years, with a combination of technological advances and the
SEC's focused effort to reduce barriers to entry and encourage
competition, the markets have changed dramatically. We have
moved from an environment where the New York Stock Exchange and
NASDAQ stock market accounted for virtually all trading that
occurred, where they operated with respect to either a single
specialist system or a constrained market-maker system from the
standpoint of providing liquidity to the environment that Mr.
Luparello described earlier in his statement where liquidity is
essentially provided through a range of algorithmic active
traders, some of whom have requirements and obligations built
into their exchange registrations and some of whom do not.
The markets are also dramatically fragmented across large
numbers of exchanges and automated trading systems, and that
has changed the environment and raised issues from the
standpoint of transparency, disclosure as to how orders are
handled, issues from the standpoint of best execution, and,
obviously, as has been discussed before, maker-taker pricing.
This is an area that continues to deserve great----
Senator Donnelly. Let me ask both of you, do you think the
regulators have the tools to keep pace with the technology
development and the efforts that are being put forward to try
to constantly move the ball? You know, we have seen time after
time some of these flash situations and others where the
regulators are on this effort and the ball has already moved to
this point.
Mr. Luparello. So, jurisdictionally, clearly, we have the
tools we need. From the ability to both gather and analyze
data, we have improved dramatically over the past few years,
but there is still some way to go. So, in all of these issues,
we always try to start first by analyzing the data we have
available. I think, as you can see with the work we have done
after the August 24 event, that is still a process that is a
little more burdensome, a little more cumbersome than we would
like. As we make progress on that, I think the ability to
analyze data in a more nimble way, use both the expertise and
the jurisdiction we have, and work with the
variety of market participants, will give us the ability to
react in a timely fashion to market events.
Mr. Ketchum. I will agree with Steve that between us, and
particularly the SEC has the regulatory tools necessary to
address this and also analyze the markets. I will stick on the
market surveillance side, where FINRA takes a primary
responsibility. We have dramatically better capabilities now
than we ever had before through our contracts across exchanges,
both stock and options, to look across markets and identify
manipulative activity that does not define the most active
traders, but with respect to those aberrant ones. But, we can
do better. A key tool is the Consolidated Audit Trail and I
look forward to----
Senator Donnelly. What concerns both of you the most about
the current structure of the equity markets? Where, when you
look, you go, here is a hole that somebody is about ready to
exploit, here is a problem that we are--you know, and it is a
hard question to answer. What are the problems you are missing
that almost you do not know you are missing at this point?
Mr. Luparello. Well, all right, the answer is what you do
not know. I think we are less--we are always attentive to the
issues of the robustness of the structure, but, again, I think
the pattern over the past few years has demonstrated that a
number of the steps that the Commission has asked for and the
markets have put into place have made the market broadly a more
robust place. I think you look at the events in July, where one
of the major markets was out for an extended period of time,
fortunately the middle of the day, neither the beginning nor
the end of the day, and the markets were able to trade pretty
efficiently without that one primary market being in the
marketplace.
I think in terms of what we worry about, we worry about
what everybody else worries about, which is cyber and those
kinds of issues and whether the rules we have put into place,
which are significant, are right, rightly tailored, and being
adhered to to ensure that we are doing everything we can from
that standpoint to make the market robust.
Senator Donnelly. Mr. Ketchum.
Mr. Ketchum. The market has dramatically improved from a
resiliency standpoint in addressing some of the excess
volatility issues when you look back to the Flash Crash, where
I think the markets, as a result of the changes, were truly
unsafe at any spade. We still need to step back, look at events
like August 24, and identify the additional steps needed to
address and ensure that those protections against unnecessary
volatility continue to be improved. And we still need to
enhance our audit trail to ensure we are identifying those
small numbers of serious manipulative activities and creative
activities in the most effective way possible.
Senator Donnelly. If I could ask just one more question,
and this is--you may consider this a little bit offbeat, but
when you look and you saw that there was a whole system set up
to try to race ahead of trades, to try to gather the
information and race ahead of trades that were being made to
make more money, and part of it was putting locations and
buildings right next door to buildings next door to buildings,
when you look, is there anybody in your organizations that look
for unusual activities, where you go, why are seven firms going
into this building right next to this building, for instance?
Do you look for things that, for want of a better way to put
it, seem to have no real reason other than something may be
going on?
Mr. Luparello. So, there is a very important question about
whether the race for speed reaches a point of diminishing
returns and whether we should do things in the market that
enable market participants of different speeds and different
capabilities to have as good an experience as possible.
I think in the context of co-location, that is, in fact, a
regulated function, that these are functions that the exchanges
provide to their members. They must provide them on equal terms
to all of their members. So, there is that aspect, at least,
issues around speed and latency are highly regulated. It is a
very important separate question about whether people are
taking those speed advantages and using them for improper
purposes. I think that is something that both we and FINRA--and
again, FINRA is the front-line regulator--spend a lot of time
both thinking about and looking at.
Mr. Ketchum. Certainly, our primary focus of our
surveillance is looking at the outcomes, the trading and
whether that trading is, in one way or another, taking
advantage of other investors. And, I think, there, we are far
more sophisticated in identifying patterns that suggest those
problems than we have ever been before.
Senator Donnelly. Thank you, Mr. Chairman.
Chairman Crapo. Thank you, Senator Donnelly.
We will have a second round of questions, and I will start
it out with you, Mr. Ketchum. In fact, this is an issue that I
think I am really sort of teeing up for Senator Warner here,
but I wanted to get my bite at it first.
FINRA and the Municipal Securities Rulemaking Board are
expected to finalize rules to increase the disclosure of broker
fees for retail trades and bonds. How will that work, and do
you expect retail investors to get better pricing?
Mr. Ketchum. Thank you for that question, Chairman Crapo,
and I think it shows--and both of you have demonstrated over
time through your recognition that while there are many
important issues to look at with respect to the equity market,
there are also significant issues with respect to the evolving
fixed income market.
Yes, when I look at the present environment with respect to
fixed income securities and look at the range of trade prices
that exist with respect to similar bonds, we see a pattern in
which firms, although they are not engaging in illegal activity
from the standpoint of the markets, they charge meaningfully
significant, as in multiple times of the amount of markup. That
is precisely the type of situation where additional disclosure
to investors that can--will, I think, encourage a more
efficient market.
We saw that happen with respect to TRACE when we began, and
on the municipal security side, where trade reporting began and
that resulted in more efficient pricing. I think this will, as
well. It is not a cure all. And, in addition, we need to look
very closely at the operational cost, which is what we will
certainly continue to follow as we file these proposals with
the SEC through that comment period.
Chairman Crapo. All right. Thank you very much.
I am going to let Senator Warner dig deeper into that one,
if he chooses to. I want to use the rest of my time in this
questioning period with you, Mr. Luparello. Well, actually,
this could be for both of you, too, so you will have to listen
in, Mr. Ketchum.
The SEC Equity Market Structure Advisory Committee has four
different subcommittees, and this kind of follows on my first
line of questioning. I am trying to pull out of you just where
we are on all of this and what we can expect to see and how
soon. But, those four subcommittees are subcommittees on Reg
NMS, on trading venue regulation, on retail customer issues,
and on market quality. And, I realize that is a pretty broad
swatch, but I am curious to hear from you just, basically, what
are the main options that we are seeing develop in these
subcommittees and what more decisions need to be made before we
get some proposals.
Mr. Luparello. So, the Equity Market Structure Advisory
Committee--and it is true that Rick is on at least two of those
subcommittees, so he has got a vantage point in terms of the
operations of the subcommittees that I do not have--the
committee itself has been in place for about a year or so. It
is relatively new. The creation of the subcommittees is even
newer than that. And, so, to a certain extent, how they are
going to define their jurisdiction, what they are going to
choose to focus on is something that they are still
considering.
We talked about asking one of--we directed one of--
requested that one of the subcommittees focus immediately on
constructing a maker-taker pilot. I think that is an important
first tangible deliverable that a subcommittee will deliver and
it is absolutely the right priority.
There are a number of other things in play. I think one of
the other ones we continue to think is a good area for a
subcommittee to focus on and to make recommendations to us
about is around issues of plan governance.
So, in some ways, the work of the committees is still
fairly
nascent and what they are going to choose to focus on is
something that they are trying to figure out at this point.
But, again, progress on an access fee pilot and progress on
advice around plan governance are two very important things,
and if they deliver those to the committee in the near term,
they will be really delivering some valuable benefit.
Chairman Crapo. Thank you.
Do you want to add something to that, Mr. Ketchum?
Mr. Ketchum. Well, as Mr. Luparello indicated correctly, I
am on two--lucky enough to be on two of those subcommittees,
one of which is focusing on best execution and customer order
routing information, the other of which is looking at venue
issues from the standpoint of the operation of plans and the
appropriate regulatory treatment of exchanges and automated
trading systems.
The great advantage of the subcommittees, the Commission
has set up these meetings so that we get input from a wide
variety of persons with regard to the committee as a whole. The
subcommittee allows us to also bring in a variety of experts
and have more open two-way conversation to discuss potential
actions, and that is what we are really trying to look through
there with respect to both of my subcommittees.
I expect that this will result in very concrete
recommendations for improvements with respect to the type of
information that is now provided with regard to executions by
both the market-making firms and the order routing firms, and
also responses with respect to the appropriate environment for
exchange and ATS regulation. So, I think the subcommittees help
with that.
My impression is the focus now is that the--I expect in
each of the areas that Steve discussed there will be concrete
recommendations coming out, Mr. Chairman.
Chairman Crapo. Well, thank you.
And, again with regard to both of you, quickly--I have got
2 minutes, basically, here--what issues in the fixed income
markets, do you think, need to have some heightened attention?
Mr. Luparello. I would start by complimenting Mr. Ketchum
on the work that FINRA has done in preparing to get a rule
filing to us as well as MSRB in the area of retail order
execution transparency. I think that is an enormous step
forward. It is a long time coming. For Rick and I, it is an
especially long time coming. So, we are looking forward to
that.
I think the other thing we are spending a lot of time on is
that there has been a real development, again, mostly in the
retail space, of the creation of transparency venues that
basically look like ATSs that are bringing pre-trade
transparency to the fixed income markets where it really has
not existed before.
I think one of the things we spend, like I said, a lot of
time thinking about is are there ways we can encourage and push
that forward without, as the regulator, perhaps interfering
with what would otherwise be positive natural developments. So,
we are in conversations with many of the platforms that provide
these liquidity venues and trying to figure out what we can do
to make sure that that development, which is a very positive
development for investors, continues to move forward.
Chairman Crapo. Thank you.
Mr. Ketchum.
Mr. Ketchum. I would completely agree with the two issues
Steve identified. I will mention one in a slightly different
area, and that is Treasury securities. The agencies
responsible, including Mr. Luparello with respect to the SEC,
put out, I think, an excellent study that demonstrated the lack
of transparency and also the dramatic changes with respect to
how Treasury securities are trading now versus just a few years
ago, and the time to move forward on that, and there has been a
request for comment coming out of the Treasury Department that
I thought was really very well done, time to move forward to
ensure first, at a minimum, that there is full regulatory
reporting of all transactions involved in the Treasury market
and looking closely at the question of greater transparency.
This is one of the most important markets of the world, but it
distinguishes itself from all other fixed income markets in the
United States from the lack of transparency.
Chairman Crapo. Well, thank you very much.
Senator Warner, the floor is yours.
Senator Warner. Well, thank you, Mr. Chairman, and really,
again, very much appreciate the fact that you have called this
hearing.
And, I just want to make an editorial comment before I get
to--I have got a whole series of additional questions and
buckets we have not even gotten into yet. But, I think it is
really important that you hear us that the public's faith in
the markets and the transparency and is it going to be treated
fairly, I think we are not out of the woods on that. I think
Senator Warren's comments about arbitration and the failure to
get paid, you know, that came up late February in the Wall
Street Journal, I think we do need action and we need prompt,
quick action from FINRA, Mr. Ketchum, so that there is, whether
it is a reserve fund or some action, but not an action that is
studied for years.
You know, on the Consolidated Audit Trail, it is
complicated. I understand that, appreciate that. But, it is 6
years, 6 years since the Flash Crash. You know, on the maker-
taker pilot, I have not done all the research, but just common
sense says if you have got 839 different fee schedules and over
3,700 different fee variables all trying to create bespoke
products that push fees and rebates to individual brokers, that
is not on the up and up. And, I appreciate the idea that the
subcommittee is going to recommend something in April, but we
really do need to know when the full committee is going to act
and when is this pilot going to take place.
Let me get out a couple more before I even start on my next
round. You know, the bond market transparency that Senator
Crapo raised, Senator Coburn and I raised this issue in
legislative form 2 years ago, and yet we still do not have a
full-fledged answer, and there are mark-ups and mark-downs and
selling bonds. I mean, the bond markets ought to be the most
transparent of our markets.
So, do either one of you want to respond on that, on the
generic, and I have got three or four more things on specific I
want to question you on. You might tell me that the
subcommittee is going to act in April and the full committee is
going to act by July or something.
Mr. Luparello. No, I think the subcommittee will make the
recommendation to the full committee in April. I expect to get
the full committee's reaction to that at their meeting in
April, and so----
Senator Warner. Do you think they will actually act?
Mr. Luparello. I--that is--that is our--I cannot speak for
the committee, since it is an independent committee, but I
would assume that a number of these--first of all----
Senator Warner. So, it is not unrealistic to think that we
might have a maker-taker pilot at least started or close to
started this summer?
Mr. Luparello. No. Unfortunately, a committee
recommendation is just a recommendation to the staff. Again, I
think you find that--that recommendation will find a very ready
audience with the staff, but the staff still needs to make a
recommendation to the Commission. Then the Commission would
need to put it out for notice and comment. So, a Commission-
mandated maker-taker pilot would take a few months after that.
Senator Warner. Mr. Ketchum, do you want to comment on----
Mr. Ketchum. Well, on that, I just----
Senator Warner.----either that or on market transparency?
Mr. Ketchum.----speak as one member of the committee and
recognize in the end this will be a Commission decision, as
Steve indicates. But, I certainly support a pilot. I look
forward to see exactly what the subcommittee recommends, but I
am pretty confident we will be supportive of it.
I just want to take a second on fixed income. You are
right. This is an area that has dramatically changed. It has
become more and more an area where retail investors are
participating both directly and indirectly through bond funds.
I think the steps we have proposed with respect to mark-up
disclosure and what I expect will come out of the MSRB is
critically important and there is nothing that is more
important to me than to see that go forward.
And, as far as the points you made, Senator Warner, on
arbitration, since I am retiring this year, I am not thinking
in multiple years. This is a year that is terribly important to
me as to what we do and this is something that is very
important to me to make progress on.
Senator Warner. Done this year, in terms of some level of
reserve or some ability for firms not to exit and leave people
holding the bag?
Mr. Ketchum. I need to have that conversation with my board
and there needs to be specific proposals, but yes, I hope so.
Senator Warner. Mr. Chairman, can I take a couple more?
One of the areas that, Mr. Chairman, you raised at an
earlier hearing and we both focused on terms of trying to
provide more liquidity for small stocks, or smaller traded
stocks, we talked about a tick size pilot. Again, agreement.
Again, hope and expectation that that tick size pilot was going
to take place this year. We saw it was supposed to take place
and move forward in May. That date slipped to October.
Arguably, some of the exchanges seem to have put forward
proposals that seem to be more focused on preserving their own
commercial interests than actually trying to provide a
legitimate experiment.
Are we going to hit October? I know there were three
proposals. Where does it stand?
Mr. Luparello. We are----
Senator Warner. How do we actually get this one on the
``done'' list?
Mr. Luparello. You have identified exactly the right issues
that have caused the delay, but we are going to get it done by
October. We have now filings in from----
Senator Warner. That is for the record, October, no further
delay?
Mr. Luparello. That is. That is from the standpoint of what
we can deliver. So, we now have--we now have filings in from
two of the markets that define some of the provisions, I think,
in a manner more consistent than we--more consistent than had
originally and more in line with what we were expecting. We
assume the other markets will find that to be consistent with
what their expectations of what a trade act component would
look like. We are ready to move forward on all of them. I think
we now have that level of consistency. We have the data
gathering part of the
rulemaking done, and so I think we are in very good shape to
move forward in a way perhaps we had not been in good shape up
until these past few weeks.
Senator Warner. But, it is a fair critique, not of you all,
but some of the exchanges, that their first round of proposals
were more about preserving their own commercial interest than
actually trying to figure out how we can bring more trading
frequency and liquidity to smaller cap stocks.
Mr. Luparello. I guess I would say that for certain
markets, the definition of trade, that is in the eye of the
beholder. There was certainly differences of opinion on how
that should be scoped.
Senator Warner. One of the things that we have, when I
think anyone questions, whether it is HFTs or other aspects of
the market, the ever more technologically driven market, I feel
at times that you get kind of a dismissive response of, well,
gosh, the god of liquidity trumps everything. So, that is the
answer to any question that any nonperson from the market gets.
You guys just do not understand because it is all about
liquidity.
Well, part of liquidity is, you know, the ability also for
market making, and yet we do not have any kind of standardized
definition of what a market-maker would end up looking like.
Does it make sense to think about standardizing a definition
around market maker? You know, should there be something that
says you have got to have 99.9 percent of the time the ability
to make a market? You do question some of these folks who say
they are market makers, but at the end of the day have a closed
out, completely closed-out position. It seems just--again, I am
not as sophisticated as some, but that seems inherently
contradictory of the notion that you are making a market if you
have closed out your position at the end of the day.
We all know since 1987 to the Flash Crash and others market
making is great when it is going up, but nobody wants to catch
the knife when it is falling. So, thoughts on the whole
question about some level of standardization around market
making.
Mr. Luparello. It is a very important issue and I think it
was part of Rick's response to Senator Donnelly in terms of the
dramatic changes in the market over the past couple of decades.
It is fair to say that the obligations of being a market maker
are considerably less than they used to be. The benefits of
being a market maker are also less. So, the idea of potentially
giving market makers some advantages that they do not have now
in exchange for certain obligations that they do not have now
is one that is a very important question and one that touches
on a variety of different areas in the overall analysis of
market structure.
I think it is something where, again, the expertise of the
committee is something we look to rely upon, but not
exclusively. But, it is a very complex question.
Mr. Ketchum. I agree with Steve. With respect to my first
SEC advisory committee, I was associated with the
recommendation that this be looked at. I do think that greater
definition of market-making obligations and market-making
incentives is something that should be focused on. I entirely
support the SEC looking at it.
Senator Warner. But, I hope we would actually move forward,
because I think, again, whether it is liquidity or market
making, there are lots of broad-based rationales given that,
when the stuff hits the fan, sometimes if they are not there,
then this value disappears.
Let me get even a little more out there. One of the tools
that SEC has, FINRA has, the FTC has, as the markets move more
and more into algorithmic computer-driven trading, we know you
all have the ability in certain instances to actually go in and
look at the underlying code. Now, understanding that many of
these firms believe that that underlying code is their
proprietary secret sauce, I understand that as somebody who
used to be in the tech world. But, I wonder, does it make sense
to actually tag some of those codes so that in an event of a
market meltdown or enormous turmoil, in kind of a post-action
report, you could have tagged that code to see which of these
secret sauces may have actually contributed to market
meltdowns? And is anybody thinking through that?
Mr. Luparello. Yes, but I need to point out that there are
a couple of assumptions that are in that that need to be
validated or acted upon, one of which is that active
proprietary traders are broker-dealers. I think that is
something where, while most of them are now, it is important
for the Commission to clarify that. It is something we are
working on. And also that the code that is embedded in some of
the algorithmic programs are, in fact, books and records of the
broker-dealer.
So, I think, as a general matter, like I said, most active
traders, most HFTs are broker-dealers. I think they generally
think of those things as books and records. When push comes to
shove, I would hope they continue to hold those positions.
Those are very important things for the Commission to clarify
and are on our list of things to do in the coming months.
But, absolutely, a better understanding of how algorithms
are developed, how they are deployed, what their purposes are,
and what order flow came from what algorithms is a very
important piece of information that we need to have when we
reconstruct markets, especially during volatile----
Senator Warner. Right, I understand the proprietary nature
and that needs to be protected, but the ability to go in after
the fact and see the results--Mr. Ketchum, do you want to----
Mr. Ketchum. I will just add two supplemental things from
that standpoint. I completely agree that both being better able
to identify problems with respect to an algorithm and in
particular to create greater accountability from the standpoint
of the supervisory obligations of the broker-dealer that is
essentially providing the route to execute those orders is
absolutely critical.
In the present environment where we are trying to do that,
recognizing that these are very clever folks who now send their
strategies when they are manipulative over multiple broker-
dealers, as I indicated before, to numerous markets, we are
starting to throw report cards back to the firms that are
executing when we see algorithms repeating again and again,
manipulative activity using multiple broker-dealers, so those
firms, even if they do not see the whole activity, can
recognize their accountability from a supervision standpoint
to, frankly, shut that algorithm off.
Separately, as we move to a Consolidated Audit Trail, I
know I am just--this is throwing a red flag at you----
Senator Warner. Adding fire----
Mr. Ketchum.----but as we move to a Consolidated Audit
Trail----
Senator Warner.----fuel to the fire here.
Mr. Ketchum.----we will then have exactly the ability to
pinpoint with greater granularity the specific algorithm
activities. And, I could not agree more that both the
accountability of supervision and getting to that point where
we can pinpoint the algorithm activity is really important.
Mr. Luparello. And, I guess the one thing I would add is
while we absolutely have access--need to have access to the
information to be able to understand the markets, we are not
insensitive to the issue of the secret sauce. The number of
times you would need to ask for code, the protections around
asking for information of that sensitive and proprietary a
nature is something that we would need to be very careful of.
Senator Warner. I would just say, and I do not want to
state the Chairman's position, but the Chairman and I want the
markets to work. We are generally supportive of, you know, some
of the advantages that have come out of the technological
developments over the last 20 years. But, we also know, and we
both went through kind of a litany in our opening statements of
all of the glitches and challenges that the markets have seen
even post-2008.
And, at least from this Senator, I would take as a real
deep concern that the things that we need to do to keep
investor trust, and not just nonsophisticated investors, all
the way up the food chain, and recognizing--I think one of you
mentioned--there is so much money to be made, we are always
going to be chasing wherever the markets and the advances move
forward.
But, when we look at the CAT taking 6 years, when we look
at transparency in the bond markets, talking about it now for
two-plus years, when we have been looking at questions like the
tick size pilot being continued to be pushed off, when we are--
I appreciate, Steve, your comments about maker-taker, but
trying to get to a point of, all right, when is it going to
actually happen, and this one, at least if I understand, at
least, you may have to write a--put out a Notice of Proposed
Rulemaking, but the ability to actually turn on--we are talking
about a 100-size pilot of which 50 would be in the control and
50 would be in the noncontrol--it is not that complicated, and
you cannot not look at the RBC data and not say something funky
is going on here. That is a technical term.
I would just encourage us that we act with as much speed as
possible, and I would appreciate your--let me add to what
Senator Crapo has said--appreciate your service. But, I can
think of no--nothing better in terms of part of your legacy
than to say, at least on this issue of arbitration, people who
rightfully have an ability to collect from malfeasance, that
simply being able to escape the marketplace or go out of
business where there needs to be some financial obligation,
that would be a great legacy coming out of your tenure.
Thank you, Mr. Chairman.
Chairman Crapo. Thank you, Senator. And, you and the others
have all helped us get into a number of very critical issues
here today.
I cannot help but say that, when you talked about the god
of liquidity in terms of being the answer to so many of the
questions, I wonder if the power behind the curtain is order
flow as opposed to liquidity in some of these contexts.
But, that being said, I want to really thank you, Senator
Warner, for really providing the exclamation point to the
reason this hearing was called, which is that we want to--you
know, we want to see things studied. We appreciate the
importance of getting the appropriate data. We want to get it
right.
But, there is an increasing level of frustration in terms
of getting around the board and back to go again and starting
to implement some of the needed reforms for our market
structure. I do not think there is any disagreement, if much at
all anywhere, about the fact that we need to have some movement
in terms of having our regulatory system keep up with our
market structure and with the dynamics that we are dealing
with.
So, I appreciate both of you, our witnesses, being here and
being willing to come up and be grilled in front of a
Committee. But even more than that, I appreciate the work you
are doing and your commitment that you have given us here today
to help us get some of these issues over the goal line and help
us start to move on some of these critical processes and
reforms.
Unless you have anything else, Senator Warner, we will
adjourn the hearing. Thank you.
[Whereupon, at 11:15 a.m., the hearing was adjourned.]
[Prepared statements and additional material supplied for
the record follow:]
PREPARED STATEMENT OF CHAIRMAN MIKE CRAPO
The landscape of stock markets and trading today is substantially
different than it was 20, 10, or even 5 years ago.
Regulations and technological innovation have moved stock trading
from the floors of exchanges to virtually all trading being conducted
electronically on automated markets. Technology and innovation has
benefited investors by leading to tighter spreads, lower costs, and
more efficient markets.
However, the expansion of trading venues, speed, and mandated
interconnectedness of exchange and market participants has raised
questions regarding market complexity and resiliency.
For the past several years the Securities Exchange Commission and
the Financial Industry Regulatory Authority have been working to better
understand whether their market structure rules have kept pace with
changes in trading technology and practices.
In 2014, the Banking Committee held a hearing with a broad mix of
market participants to 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.
Several witnesses at the hearing argued that Regulation NMS, a set
of SEC market structure rules that passed by a 3-2 vote over 10 years
ago, needed to be reexamined.
Later in the year, SEC Chair White provided an update to her market
structure agenda in a response to a letter Senator Johnson and I sent
and highlighted three fundamental policy questions the Commission would
be focusing on:
The trade-through restrictions in Rule 611 of Regulation NMS and
whether they should be rescinded or modified.
The current regulatory model for exchanges and other trading venues
and whether it makes sense for today's markets.
The maker-taker fee structure, including the related issue of
restrictions on locking and crossing quotations in Rule 610 of
Regulation NMS.
These are complicated issues and I appreciate the data driven
approach by the SEC and FINRA and the extensive comments from market
participants, investors, and academics.
It will be helpful to understand from our witnesses what progress
has been made in identifying and prioritizing the key concerns with our
equity market structure and what options are being explored to address
them.
After all, the 2010 Flash Crash is still fresh in many of our minds
and additional market events have raised concerns about market
integrity and resiliency.
In fact, the SEC's Equity Market Structure Advisory Committee met
to diagnose and discuss one of the latest market disruptions, namely
what went wrong last August 24 when dramatic price moves triggered more
than 1,000 trading halts in hundreds of stocks and exchange-traded
funds.
Today, this Committee hopes to hear from our witnesses about what
lessons were learned from recent market disruptions and what steps need
to be taken to strengthen the operation of the markets?
The U.S. capital markets are vital to the growth of our economy and
we need to take the necessary steps to make sure the U.S. financial
system and markets remain the preferred destination for investors
throughout the world.
______
PREPARED STATEMENT OF STEPHEN LUPARELLO
Director, Division of Trading and Markets
Securities and Exchange Commission
March 3, 2016
Chairman Crapo, Ranking Member Warner, and Members of the
Subcommittee:
Thank you for inviting me to testify on behalf of the U.S.
Securities and Exchange Commission (SEC or Commission) regarding equity
market structure. I welcome this opportunity to discuss with you a
topic of such importance to investors, public companies, our securities
markets, and capital formation.
The securities markets are ever-evolving and technology has been
the primary driver of the changes. The ongoing challenge for regulators
is to ensure that regulatory regimes are appropriately updated to
respond to evolving market mechanisms and trading practices.
Today, I will update you on the SEC's efforts for meeting this
challenge with respect to the U.S. equity markets. Enhancing equity
market structure continued to be a primary focus of SEC efforts in
2015, as it will be in 2016. Among other things, the SEC published a
proposal to enhance the operational transparency of alternative trading
systems (ATSs), proposed amendments to a rule that would require
broker-dealers engaging in proprietary trading at off-exchange venues
to become members of a national securities association, and approved a
pilot program to assess the effect of tick sizes on market quality for
smaller companies. We plan to continue to make important strides in
2016.
I. Overview of the SEC's Program for Equity Market Structure
Today's equity markets, as you know, are dominated by computer
algorithms. These algorithms are capable of generating, routing, and
executing orders with enormous sophistication, volume, and speed. They
have introduced types of market mechanisms and trading practices that
were not possible in the days of manual markets.
Our regulatory regime must keep pace with and adjust appropriately
in response to these market changes. But doing so requires thorough
study and an appreciation of the workings of the full market. Market
structure issues typically are complex and highly interrelated. Even
when a particular problem is identified, efforts to develop a response
must reflect a full consideration of the risk of unintended
consequences.
To meet this challenge, the SEC is engaging in an ongoing equity
market review that is based on three key elements--it is data-driven,
open to considering a wide range of views on all issues, and
comprehensive in scope.
Data-Driven Analyses
A vital first step in dealing with market structure questions is to
marshal relevant data. Although data analyses alone cannot dictate
particular outcomes, they are extremely valuable in helping to narrow
the range of differences in perspectives and of viable regulatory
responses. Accordingly, the SEC has made concerted efforts in recent
years to strengthen its capabilities for data collection and analysis.
These efforts include capturing a wider range of data sources,
deploying more sophisticated technology tools for analyzing data, and
employing additional personnel with the necessary quantitative skill
sets to use these tools.
The SEC is committed to bringing data analysis fully to bear on
equity market structure issues. Many of the results of these efforts
can be found on an SEC Web page that is devoted to helping inform the
public debate on equity market structure.\1\ The Web page includes a
series of research papers, underlying data highlights, and literature
reviews prepared by SEC staff that address issues such as the speed of
trading, trading in off-exchange venues, high frequency trading, market
fragmentation, and market quality for small capitalization companies.
Most recently, staff-prepared papers were added that address two
notable market events that occurred in 2015--the New York Stock
Exchange (NYSE) trading suspension on July 8th and the August 24th
market volatility--both of which are discussed further below.
---------------------------------------------------------------------------
\1\ See http://www.sec.gov/marketstructure/.
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Open to Wide Range of Views
Many market structure issues arise in the context of proposed SEC
rules, national market system (NMS) plans, and exchange rules. These
procedural contexts provide an opportunity for public comment. Given
the complexity of market structure issues, however, the SEC has taken
the extra step of seeking out a wide range of views in contexts other
than specific proposals and adoptions. These have included a concept
release,\2\ public roundtables,\3\ and a request for comment on
particular topics.\4\ The SEC also has approved over 40 exchange-level
active pilots, as well as two market structure-related pilots initiated
by the Commission and implemented in the form of NMS plans submitted by
the exchanges and FINRA.
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\2\ Concept Release on Equity Market Structure, Securities Exchange
Act Release No. 61358, 75 FR 3594 (January 21, 2010) (File No. S7-02-
10), available at http://www.sec.gov/rules/concept/2010/34-61358fr.pdf.
\3\ A roundtable on decimalization was held at the SEC on February
5, 2013, and a roundtable on market structure was held at the SEC on
June 2, 2010.
\4\ Request for Comment on Exchange-Traded Products, Securities
Exchange Act Release No. 75165, 80 FR 34729 (June 17, 2015), available
at https://www.gpo.gov/fdsys/pkg/FR-2015-06-17/pdf/2015-14890.pdf.
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To further provide an opportunity for a wide range of views and
inputs, the SEC established the Equity Market Structure Advisory
Committee (EMSAC), which held its first meetings in 2015. The 17
members of EMSAC bring an enormous range of expertise, experience, and
perspectives to their deliberations on equity market structure. EMSAC
brings in an even wider range of perspectives by inviting nonmembers to
make presentations on key issues at each EMSAC meeting. EMSAC also has
formed four subcommittees to affirmatively seek out additional
viewpoints and conduct detailed evaluations of market structure issues
for EMSAC's consideration. As discussed further below, EMSAC's public
proceedings already have shed a great deal of light on key market
structure issues,\5\ and I anticipate this will continue in 2016. To
date, the EMSAC has not provided the Commission with any
recommendations.
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\5\ See http://www.sec.gov/spotlight/equity-market-structure-
advisory-committee.shtml.
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Comprehensive in Scope
The U.S. equity market is a complex ecosystem in which different
types of market participants employ a range of tools and strategies to
trade on 12 registered exchanges, more than 40 ATSs, and more than 200
non-ATS broker-dealers. Properly assessing market structure issues
requires a full appreciation of the extent to which these market
participants, tools, and trading venues are interrelated. Rarely, if
ever, does a material change in one aspect of market structure not have
important effects in other aspects of market structure.
Accordingly, the SEC's equity market structure program does not
attempt to address issues in isolation, but rather is comprehensive in
scope. As laid out in Chair White's market structure remarks in June
2014,\6\ the SEC has advanced initiatives that address five broad
categories of issues: market stability, high frequency trading,
fragmentation, broker conflicts, and quality of markets for smaller
companies. Focus on these substantive issues is intended to help
address particular areas of concern, while still providing an
opportunity to assess the extent to which issues and initiatives across
different categories are interconnected.
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\6\ Chair White's June 5, 2014 speech, entitled ``Enhancing Our
Equity Market Structure,'' is available at https://www.sec.gov/News/
Speech/Detail/Speech/1370542004312.
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II. Equity Market Structure Developments and Initiatives
A. Market Events in 2015
There were two notable market structure events that occurred in
2015--the NYSE's suspension of trading on that exchange for more than 3
hours on July 8, 2015, and the unusual level of price volatility on
August 24, 2015. While the markets generally responded well, each event
brought to light certain issues and provided a useful opportunity for
focused empirical analysis by SEC staff.
NYSE Trading Suspension on July 8, 2015
On July 8, 2015, the NYSE, because of a systems issue, suspended
trading in all symbols on the exchange at 11:32 a.m. and reopened at
3:10 p.m.\7\ To help assess the effect of this suspension on trading,
on February 3, 2016, SEC staff in the Office of Analytics and Research
(OAR) within the Division of Trading and Markets published a Data
Highlight on the SEC's equity market structure Web site. The Data
Highlight examines trading volume, quoted spreads, and quoted depth
before, during, and after the suspension.\8\
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\7\ See www.nyse.com/market-status/history for a description of the
events leading up to the trading suspension at NYSE on July 8, 2015.
\8\ The data highlight is available at http://www.sec.gov/
marketstructure/research/highlight-2016-01.html.
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Total trading volume in NYSE-listed corporate stocks on July 8 was
well within the range of observed trading volume in the first 7 months
of 2015. While the NYSE's share of trading volume declined, other
market centers--especially other exchanges--experienced corresponding
large increases in trading volume in NYSE-listed stocks on July 8. The
Data Highlight observed, however, that NYSE-listed stocks experienced
substantial increases in spreads and substantial decreases in depths.
Not all NYSE-listed stocks were equally affected by the NYSE trading
suspension. Large cap NYSE-listed stocks experienced the biggest
declines in depth, while small cap NYSE-listed stocks experienced the
biggest increases in spreads.
The observations in the Data Highlight reflect the resilience of
the U.S. equity market structure to the sudden withdrawal of even a
large exchange, but also suggest that such a withdrawal is not without
effects on market quality. In this respect, the event demonstrates the
need for continued emphasis on systems reliance and integrity that has
been a focus of the SEC's efforts in recent years and is discussed
below.
In addition, although the NYSE was able to resume trading on July 8
prior to its closing auction, the potential that it would not be able
to do so highlighted the need to address a ``single point of failure''
in equity market structure at the close. This type of vulnerability has
been targeted by the critical market infrastructure initiative of the
SEC and self-regulatory organizations (SROs). The opening and closing
auctions on primary listing exchanges are integral aspects of a normal
trading day and continue to be dominated by the primary listing
markets. As discussed below, NASDAQ and NYSE are working to achieve
redundancy in these auctions.
Price Volatility on August 24, 2015
On Monday, August 24, 2015, the U.S. equity markets and equity-
related futures markets experienced unusual price volatility,
particularly during the period surrounding the 9:30 a.m. opening of
regular trading hours at the start of a new trading week. To help
assess the operation of the U.S. equity markets under stressed
conditions, SEC staff in OAR published a Research Note on the August 24
event on the SEC's equity market structure Web site.\9\ In recent
years, the SEC and SROs have implemented several regulatory initiatives
to address severe short-term price volatility.\10\ The events of August
24 provided a useful opportunity to evaluate the practical operation of
these initiatives under stressed market conditions. The Research Note
provides empirical data and other information to help assess trading on
August 24, including several issues that have been debated among market
participants and observers. These issues include the opening process at
primary listing exchanges, the triggering of trading pauses under the
National Market System Plan to Address Extraordinary Market Volatility
(commonly known as the ``Limit Up-Limit Down,'' or ``LULD Plan''), and
the effects of market volatility on trading in exchange-traded products
(ETPs).
---------------------------------------------------------------------------
\9\ The Research Note is available at https://www.sec.gov/
marketstructure/research/equity_market_volatility.pdf.
\10\ Such initiatives include the revision of market-wide circuit
breakers that apply across the securities and futures markets and the
National Market System Plan to Address Extraordinary Market Volatility
(commonly known as the Limit Up-Limit Down, or LULD, Plan).
---------------------------------------------------------------------------
The empirical data in the Research Note suggests that, in contrast
to the Flash Crash on May 6, 2010,\11\ broad market prices did not
``flash crash''--defined as a sudden and extreme price decline that is
unexplained by the arrival of new information and is soon reversed. On
August 24, broad market prices already had declined by 5 percent in
pre-9:30 trading. At 9:30, the equity markets opened for regular
trading hours at broad market price levels that were consistent with
the pre-9:30 trading. The broad market then absorbed a surge in price-
insensitive selling (with volume as much as 4 to 8 times higher than
normal in many securities) with a relatively small price decline of 2
percent and soon recovered. Also, unlike the 2010 Flash Crash, equity
market infrastructure and trading systems held up without serious
incident to the high trading volume and message traffic of August 24.
---------------------------------------------------------------------------
\11\ The report of the staffs of the CFTC and SEC on the May 6,
2010, Flash Crash is available at https://www.sec.gov/news/studies/
2010/marketevents-report.pdf.
---------------------------------------------------------------------------
However, the empirical data in the Research Note also suggests
certain issues that arose on August 24 that generally fall within three
broad categories and require attention.
First, in the opening minutes of trading on August 24, a
significant minority of ETPs experienced what could be described as a
breakdown in arbitrage--specifically, they traded at substantial
discounts to the underlying indexes they were designed to track.
Second, many of these ETPs that experienced high volatility
triggered trading pauses under the LULD Plan. These trading pauses
helped prevent the irrational prices that occurred during the 2010
Flash Crash (such as one penny prices). The ETPs, however, did not
resume trading in an orderly fashion, but traded erratically in ways
that triggered additional LULD pauses. More than 80 percent of LULD
pauses on August 24 occurred in ETPs, and most of these were repeat
pauses in the same symbols and occurred when prices were recovering
upward. Notably, although a significant minority of ETPs experienced
severe volatility and multiple LULD pauses on August 24, a majority of
ETPs experienced levels of volatility consistent with broad market
prices, and 80 percent of ETPs did not experience a single LULD pause.
The third category of issues on August 24 related to corporate
stocks. Unlike for the market broadly, prices for a relatively small
number of individual corporate stocks experienced flash crashes--
extreme price declines followed by quick recoveries. These included six
corporate stocks with very large capitalizations. In addition, 4.7
percent of the more than 4,000 corporate stocks analyzed in the
Research Note declined by 20 percent or more from the previous Friday's
close price, while 19.2 percent of the more than 1,400 ETPs analyzed in
the Research Note declined by 20 percent or more.
The unusual volatility on August 24 warrants continued close
evaluation to consider whether regulatory responses may be appropriate.
As noted below, the SRO participants in the LULD Plan are considering
potential modifications, and
individual exchanges also are assessing their opening and reopening
processes. And prior to August 24, the Commission broadly requested
comment on ETPs, including the extent to which arbitrage mechanisms are
effective in aligning ETP prices with their underlying indexes.\12\
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\12\ Request for Comment on Exchange-Traded Products, Securities
Exchange Act Release No. 75165, 80 FR 34729, 34740-34741 (June 17,
2015), available at https://www.gpo.gov/fdsys/pkg/FR-2015-06-17/pdf/
2015-14890.pdf. The Comment period closed in August 2015, and the SEC
has received 40 comment letters, which are available at https://
www.sec.gov/comments/s7-11-15/s71115.shtml.
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SEC staff continues to examine a broad spectrum of issues related
to trading on August 24. These include, among other things:
(1) factors that may have been associated with volatility in ETPs
and other securities, including the nature of selling pressure,
sources of liquidity provision, and, for ETPs, create and
redemption activity;
(2) the effect of Regulation SHO short-sale restrictions;
(3) the opening process on primary listing exchanges, including the
nature of trading prior to and immediately after the opening
auction on the primary listing exchange;
(4) the reopening process following LULD pauses, including the
nature of participants in the reopening auctions on primary
listing exchanges and the rules and practices employed by
exchanges in connection with reopenings;
(5) the operation of the LULD Plan, particularly as it applies in
the period following the opening of regular trading hours and
to reopenings following LULD pauses; and
(6) the operation of market-wide circuit breakers, particularly as
they apply in the period following the opening of regular
trading hours.
B. Regulatory Initiatives
The Commission advanced a series of key regulatory initiatives
relating to equity market structure in 2015, and more are on the SEC's
agenda for 2016.
1. Preventing Market Instability
One of the most serious concerns about highly electronic markets is
the risk of instability and disruption. Sophisticated technology tools
can enhance efficiency, but they also can facilitate the rapid onset of
a trading disruption. These disruptions can arise when systems that
drive algorithmic trading fail or malfunction, and also when high-speed
trading leads to sudden gaps between liquidity demand and supply that
can cause extreme price volatility. Addressing the risk of instability
and disruption from these two sources has been a high priority of the
SEC in recent years and will continue to be a focus in 2016.
Regulation Systems Compliance and Integrity (SCI)
The Commission adopted Regulation SCI in November 2014 to
strengthen the technology infrastructure of the U.S. securities
markets. Regulation SCI imposes requirements on key market participants
intended to reduce the occurrence of systems issues, improve resiliency
when systems problems do occur, and enhance the Commission's oversight
and enforcement. Subject to a few exceptions, SCI entities were
required to start complying with the requirements of Regulation SCI on
November 3, 2015. The Technology Controls Program in the SEC's Office
of Compliance Inspections and Examinations is now examining SCI
entities for compliance with Regulation SCI.
A CyberWatch team has also been established that is responsible for
triaging all system events reported to the SEC under Regulation SCI.
This team currently monitors all the filings required by Regulation SCI
that are submitted by SCI entities to the SEC. When a major SCI event
is reported, they maintain constant communication with the SCI entity
until the event is deemed resolved. Since Regulation SCI went live on
November 3, 2015, CyberWatch has received 326 filing submissions,
including Non-De Minimis Event Notifications & Filings, Quarterly De
Minimis and System Change Reports, and Annual Review Reports.
The Commission staff, in response to Chair White's directive, is
preparing recommendations for the Commission's consideration as to
whether an SCI-like framework should be developed for other key market
participants, such as certain broker-dealers and transfer agents, whose
operations can have a significant market impact if they are
disrupted.\13\
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\13\ Chair White's November 19, 2014, statement is available at
https://www.sec.gov/News/PublicStmt/Detail/PublicStmt/1370543489640.
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Critical Market Infrastructure
Since 2013, SEC staff has been working with the SROs, including
clearing agencies, on a range of market structure and infrastructure
initiatives. One of these initiatives involved improving the resiliency
of systems that constitute potential single points of failure,
including the securities information processors for consolidated market
data feeds (SIPs). In June 2014, the SIPs implemented enhancements to
their disaster recovery sites and systems to establish a ``hot/warm''
backup process to provide for a 10-minute fail over from the primary to
the backup sites. In addition, the equity exchanges have amended their
clearly erroneous rules and the options exchanges have amended and
harmonized their obvious error rules to provide greater clarity to
market participants regarding trade breaks. The equity and options
exchanges also have been enhancing their risk mitigation mechanisms.
Most recently, the NYSE and NASDAQ have progressed on an initiative to
serve as each other's backups if they are unable to fail over to their
backup sites in time to run their respective closing auctions. These
efforts compliment the new requirements of Regulation SCI, which are
applicable to critical market infrastructure.
LULD Plan
Initially approved on a pilot basis in 2012,\14\ the LULD Plan
establishes a market-wide mechanism that is intended to moderate
extraordinary price volatility in individual securities and reduce the
incidence of erroneous trades. In particular, the LULD Plan requires
trading centers to have policies and procedures reasonably designed to
prevent trades from occurring outside specified price bands. If the
national best offer (bid) reaches the lower (upper) price band, a limit
state is initiated. If such national best bid or offer does not recover
to inside the price bands within 15 seconds, a 5-minute trading pause
is triggered to accommodate more fundamental price moves (as opposed to
erroneous trades or momentary gaps in liquidity). The LULD mechanism is
intended to reduce the negative impacts of sudden, unanticipated price
movements in securities, thereby protecting investors and promoting a
fair and orderly market. In particular, the LULD Plan is designed to
address the type of extreme short-term price volatility that occurred
during the 2010 Flash Crash.
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\14\ See Securities Exchange Act Release No. 67091, 77 FR 33498
(June 6, 2012) (File No. 4-631), available at https://www.sec.gov/
rules/sro/nms/2012/34-67091.pdf.
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The LULD Plan continues to operate on a pilot basis. Consistent
with the SEC's data-driven approach to market structure issues, the
SROs were required to provide an assessment of the LULD Plan. The SROs
engaged a third-party consultant to provide an empirical assessment of
the Plan's operation, which was submitted to the SEC in May 2015.\15\
The consultant found that the LULD Plan generally had succeeded in
preventing erroneous trades in large cap stocks during regular trading
hours, and that the vast majority of limit states resolved themselves
without triggering a trading pause. The consultant observed, however,
that many LULD limit states and trading pauses occurred in small, low
volume stocks, and that most were unnecessary and related more to
difficulty in determining the opening reference price when the opening
auction on the primary listing exchange did not produce a trade rather
than to excess volatility.
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\15\ See Angel, James J., ``Limit Up-Limit Down: National Market
System Plan Assessment To Address Extraordinary Market Volatility''
(May 28, 2015), available at http://www.sec.gov/comments/4-631/4631-
39.pdf.
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The Commission recently published the SROs' proposal to extend the
LULD Plan for another year until April 2017.\16\ As noted by the SROs,
extension of the pilot period will enable the SROs and the Commission
to further evaluate the LULD Plan's operation. The SROs also have
proposed to amend the LULD Plan to modify the identification of the
first reference price of the day for those securities that do not have
an opening auction trade. The first reference price for these
securities would be the closing price of the security on the primary
listing exchange on the previous trading day, or if no such closing
price exists, the last sale on the primary listing exchange reported by
the SIP. The Commission will consider whether to approve or disapprove
the proposed amendment to the LULD Plan after the notice and comment
process.
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\16\ See 81 FR 10315 (Feb. 29, 2016). The comment period for the
proposal ends on March 21, 2016.
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The SROs are continuing to evaluate additional issues regarding the
operation of the LULD Plan, including those that may have been revealed
by the events of August 24, 2015. On August 24, for example, trading
centers resumed trading following a LULD pause but before new price
bands were disseminated by the SIP. Many of these trades were executed
at prices outside the new price bands. I
understand that the SROs are working quickly to enhance their
procedures to ensure they do not resume trading following a LULD pause
without an effective price band in place, either by waiting for the
message from the SIP or by temporarily calculating the new price bands
internally. Given the potential for this problem to undermine the
effectiveness of the LULD Plan when securities reopen following a
trading pause, I have asked that each SRO enhance its procedures as
soon as possible, but no later than April 1, 2016.\17\
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\17\ See Letter from Stephen Luparello, Director, Division of
Trading and Markets, SEC, to Mr. Paul Roland, Chairman of the LULD Plan
Operating Committee, dated February 10, 2016 (Re: Limit Up-Limit Down
Plan to Address Extraordinary Market Volatility).
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I also understand that the SROs intend to propose a LULD Plan
amendment to refine the operation of the LULD mechanism to eliminate
the need for clearly erroneous execution rules, except in very limited
objective circumstances. I expect that such an amendment will be filed
for Commission consideration during the course of the next pilot
period, should the Commission approve the proposed extension.
Finally, I understand that there are a number of other issues that
the SROs are analyzing with a view toward possible further amendments
to the LULD Plan, including: (i) a review of ETPs to determine whether
adjustments should be made to the Plan to account for the particular
trading characteristics of ETPs; (ii) the impact of double-wide price
bands during the opening period, (iii) the advisability of coordinated
reopening procedures; and (iv) potential enhancements to the
categorization of securities into different tiers.
Shortening the Settlement Cycle
Currently, most securities transactions in equity and debt settle 3
days after the trade has been executed, which is referred to as ``trade
date plus three'' (T+3). Last spring, the Industry Steering Committee
(ISC),\18\ established by the Depository Trust Clearing Corporation and
co-chaired by Securities Industry and Financial Markets Association
(SIFMA) and the Investment Company Institute (ICI), published a white
paper that addresses certain procedural steps it believes are necessary
to achieve the move to T+2.\19\ The white paper also includes an
implementation timeline that targets the transition to T+2 by the end
of the third quarter of 2017.
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\18\ The ISC oversees the Industry Working Group and Sub-Working
Groups. All these groups are responsible for assessing the scope,
requirements, and changes needed to facilitate the implementation of
T+2.
\19\ PricewaterhouseCoopers LLP, Shortening the Settlement Cycle:
The Move to T+2 (2015), available at http://www.ust2.com/pdfs/ssc.pdf.
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Chair White and the Commissioners have expressed their support for
the industry T+2 initiative,\20\ and Chair White has asked the staff to
develop a proposal to amend Rule 15c6-1. The staff is currently working
on a proposal for the Commission's consideration, and is actively
engaged in discussions with the ISC regarding industry planning and
preparation for the prospective migration to T+2.
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\20\ Letter from the Hon. Mary Jo White, Chair, U.S. Securities and
Exchange Commission to the ICI and SIFMA (September 16, 2015),
available at: http://src.bna.com/i7; Statement Regarding Proposals to
Shorten the Trade Settlement Cycle, Commissioner Michael S. Piwowar and
Commissioner Kara M. Stein (June 29, 2015), available at https://
www.sec.gov/news/statement/statement-on-proposals-to-shorten-the-trade-
settlement-cycle.html.
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Transfer Agent Regulation
On December 22, 2015, the Commission issued an advanced notice of
proposed rulemaking concerning a range of potential new requirements
for transfer agents.\21\ This marked the first significant action by
the Commission in this area in over 40 years.\22\ The staff will
consider comments received as it develops further recommendations to
the Commission for transfer agent reform.
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\21\ See Transfer Agent Regulations, Securities Exchange Act
Release No. 34-76743 (Dec. 22, 2015), available at http://www.sec.gov/
rules/proposed/2015/34-76474.pdf.
\22\ See Chair Mary Jo White, U.S. Securities and Exchange
Commission, Beyond Disclosure at the SEC in 2016 (Feb. 19, 2016),
available at http://www.sec.gov/news/speech/white-speech-beyond-
disclosure-at-the-sec-in-2016-021916.html; see also Commissioners
Michael Piwowar and Kara Stein Statement of Support for the Need to
Modernize the Commission's Transfer Agent Rules (June 11, 2015),
available at http://www.sec.gov/news/statement/statement-of-support-
modernize-sec-transfer-agent-rules.html.
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2. Addressing High Frequency Trading
As algorithmic trading has increasingly dominated equity market
volume, concerns have been raised about the speed and fairness of the
equity markets. Algorithmic trading encompasses the high frequency
trading strategies employed by proprietary trading firms, as well as
much of the trading by brokers acting on behalf of institutional
investors. Algorithmic traders use a variety of low-latency tools.
These include co-located services in the data facilities of trading
venues and direct data feeds from these venues rather than consolidated
data feeds, which are on average less than 1 millisecond slower than
the direct data feeds due to the time needed for consolidation of data
at the SIPs. While rolling back the technology clock is neither
feasible nor appropriate, the SEC must assess the extent to which
specific elements of an algorithmic trading environment may not
optimally serve the interests of investors, as well the effectiveness
of its regulatory oversight of high-speed and high-volume trading.
Additional Timestamps for Consolidated Data Feeds and Data Feed Usage
In response to Chair White's request to enhance the ability of
market participants to monitor market data latencies, the SROs added
additional timestamps to the consolidated data feeds in 2015 that
reflect, for each order or execution processed by an exchange, the
event processing timestamp included on the exchanges' direct data
feeds. The exchanges also enhanced their procedures for clock
synchronization. With a common event time reflected in both the
consolidated and direct data feeds, market participants can now more
readily assess the absolute and relative latencies of each, and
determine which data feed best meets their trading or other business
needs. In 2014, the exchanges, again in response to a request from
Chair White, disclosed in their rules how they use the consolidated and
direct market data feeds in their operations, thereby enhancing the
opportunity for public understanding of today's equity markets.
Membership Requirements for Dealers Trading in Off-Exchange Venues
In March 2015, the SEC proposed amendments to Exchange Act Rule
15b9-1 that would require broker-dealers engaging in proprietary
trading at off-exchange venues to become members of a national
securities association.\23\ SEC staff is reviewing comments on the
proposal and is working to prepare a recommendation for the Commission
to consider in 2016.
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\23\ Exemption for Certain Exchange Members, Securities Exchange
Act Release No. 74581, 80 FR 18036 (April 2, 2015), available at
https://www.gpo.gov/fdsys/pkg/FR-2015-04-02/pdf/2015-07293.pdf. The
Commission has received 21 comment letters on the proposal, available
at https://www.sec.gov/comments/s7-05-15/s70515.shtml.
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Enhanced SEC Recordkeeping Requirements for Trading Algorithms
SEC staff is developing a rulemaking recommendation for the
Commission to consider that would strengthen recordkeeping requirements
for algorithmic trading. Such requirements may encompass key elements
of the algorithm itself, as well as a record of the orders generated by
the algorithm. Such records would provide greater transparency for
regulators into algorithmic trading.
Status of Unregistered Broker-Dealers
SEC staff is developing a recommendation for the Commission to
consider in 2016 that would clarify the status of active proprietary
traders that are not registered as broker-dealers and subject certain
of them to the SEC and SRO regulatory regime for broker-dealers.
Anti-Disruptive Trading Rule
SEC staff is developing a recommendation for the Commission to
consider that would address the use of aggressive, destabilizing
trading strategies in conditions when they could most seriously
exacerbate price volatility. Such a rule will need to be carefully
tailored to apply to active proprietary traders in short time periods
when liquidity is most vulnerable and the risk of price disruption
caused by aggressive short-term trading strategies is highest.
EMSAC Discussions
EMSAC has formed a Market Quality subcommittee that will consider
the impact of technology on the efficiency of the markets and systemic
risks. Among other things, the subcommittee will consider market-maker
obligations and high frequency trading strategies that may exacerbate
volatility. Any advice or recommendations of the subcommittee (and
other subcommittees mentioned below) would be presented to the full
advisory committee for its consideration.
3. Consolidated Audit Trail
In July 2012, the SEC adopted Rule 613 under Regulation NMS
requiring the SROs to submit an NMS plan to create, implement, and
maintain a Consolidated Audit Trail (CAT). The CAT would capture
customer and order event information for orders in NMS securities,
across all markets, from the time of order inception through routing,
cancellation, modification, or execution. CAT would represent a
significant step forward in regulatory capabilities for oversight of
the equity markets. In 2015, the SEC and SROs continued to make
substantial progress toward a CAT.
First, the SROs filed amendments to the CAT plan in 2015 that
contained additional information than the original plan necessary to
the consideration of an operational plan. On February 27, 2015, the
SRO's filed an Amended and Restated CAT NMS Plan.\24\ On December 24,
2015, and February 9, 2016, the SROs filed an amendment to the Amended
and Restated CAT NMS Plan.\25\
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\24\ See Letter from the SROs, to Brent J. Fields, Secretary,
Commission, dated February 27, 2015.
\25\ See Letters from the SROs to Brent J. Fields, Secretary,
Commission, dated December 23, 2015, and February 8, 2016.
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Second, the SEC approved an amendment to the CAT plan processor
selection plan in June 2015 allowing the SROs to move forward with
selecting the plan processor, which would build and operate the CAT.
The CAT plan processor selection plan, which is separate and distinct
from the CAT plan, governs the SROs' governance and selection of the
CAT processor. The SEC also approved an amendment providing for recusal
of plan participants in circumstances that might present conflicts of
interest. In accordance with these amendments, the SROs narrowed the
bids for CAT plan processor from six bidders to a shortlist of three
bidders in November 2015.
Third, in anticipation of the SROs' completion of the CAT plan, we
appointed a CAT project manager in November 2015. This person will be
the technological point person for the development and usage of the CAT
at the SEC, as well as the SEC's liaison with the SROs and the CAT plan
processor. The CAT manager will maintain an open line of communication
with the SROs and market participants.
Fourth, on March 1, 2016, the Commission approved exemption
requests submitted by the SROs to provide the SROs the flexibility to
include, in the CAT plan for notice and comment, alternative approaches
to those described in Rule 613.\26\
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\26\ See Order Granting Exemptions from Certain Provisions of Rule
613 Pursuant to Section 36(a)(1) of the Securities Exchange Act of
1934, Securities Exchange Act Release No. 34-77265 (March 1, 2016).
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Fifth, SEC staff is reviewing the Amended and Restated CAT NMS Plan
to provide a recommendation to the Commission regarding publication of
the plan for notice and comment. Although I cannot provide exact
timing, I hope the staff will be in a position to submit a
recommendation to the Commission soon to publish the CAT plan for
public notice and comment.
If the Commission approves publication of the plan, there would
likely be a 60-day comment period during which interested parties may
submit comments to the Commission on the plan as noticed. SEC staff
will consider comments received and evaluate what recommendations to
make to the Commission, including potential modifications to the plan.
Upon Commission approval of a CAT plan, Rule 613 provides that a plan
processor shall be selected within 2 months of the effective date of
the plan. SROs begin reporting data within 1 year of effectiveness; SRO
members, except those that qualify as small broker-dealers, begin
reporting data within 2 years of effectiveness; and SRO members that
qualify as small broker-dealers begin reporting with 3 years of
effectiveness.
4. Enhancing Market Transparency and Examining Trading Venue
Regulation
As noted earlier, equity trading volume now is divided among 12
exchanges, more than 40 ATSs, and more than 200 non-ATS broker-dealers.
The competition for order flow among these venues benefits investors by
encouraging services that meet particular trading needs and by keeping
trading fees low. As noted above in connection with the NYSE suspension
of trading on July 8, multiple trading venues also can help avoid
disruptions if one venue, even a major exchange, experiences a systems
problem. Fragmented markets, however, also can raise questions
regarding the rules that govern their operations and intermarket
trading, including the extent to which their operations are transparent
to investors and whether the rules establish a fair and level playing
field for competition.
Proposal To Enhance ATS Operational Transparency
In November 2015,\27\ the SEC proposed to amend Regulation ATS to
require ATSs that facilitate transactions in NMS stocks to make public
disclosures on Form ATS-N about: (1) the activities of the broker-
dealer that operates the ATS, and its
affiliates, that relate to the ATS; and (2) the manner in which the ATS
operates, including disclosures about types of subscribers, order
types, execution procedures, and use of market data. These proposed
rules are designed to provide greater transparency around the
operations of ATSs so market participants can better evaluate ATSs as
potential trading venues and make more informed routing decisions.
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\27\ Regulation of NMS Stock Alternative Trading Systems,
Securities Exchange Act Release No. 76474, 80 FR 80998 (December 28,
2015), available at https://www.gpo.gov/fdsys/pkg/FR-2015-12-28/pdf/
2015-29890.pdf. The comment period closed on February 26, 2016, and
comments are available at http://www.sec.gov/comments/s7-23-15/
s72315.shtml.
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The Commission also proposed rules to provide a process for the
Commission to determine whether an ATS qualifies for the exemption
under which it operates and declare an NMS Stock ATS's initial Form
ATS-N either effective or, after notice and opportunity for hearing,
ineffective. The proposal includes a process for an ATS to file, and
the Commission to review, amendments to Form ATS-N. The Commission also
proposed rules to provide a process for the Commission to suspend,
limit, or revoke the exemption after providing notice and opportunity
for hearing. Finally, the Commission proposed that all ATSs' safeguards
and procedures to protect subscribers' confidential trading information
be written. These proposed rules are designed to facilitate the
Commission's oversight of ATSs and thus, better protect investors.
The comment period on the ATS proposal closed on February 26, 2016.
SEC staff is reviewing comments on the proposal and preparing a
recommendation for the Commission to consider in 2016.
SEC Staff Papers and EMSAC Discussions regarding Rule 611 of Regulation
NMS and Trading Venue Regulation
In April 2015, SEC staff prepared a briefing paper on Rule 611 of
Regulation NMS, which restricts the execution of trades at prices that
are inferior to quoted prices.\28\ The paper first notes Rule 611's
place in the U.S. regulatory regime for equity market structure and
then summarizes the Rule's requirements and the SEC's objectives for
the Rule when adopted. It then addresses changes in equity market
structure that have occurred since Rule 611 was adopted in 2005,
supported by a series of data tables. The tables provide data on
changes in the market shares of trading venues, visible and dark
fragmentation, trading volume, average trade size, and trade-through
rates.
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\28\ The paper is available at https://www.sec.gov/spotlight/emsac/
memo-rule-611-regulation-nms.pdf.
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EMSAC considered issues raised by the Rule 611 paper at a meeting
in May 2015. It also has formed a Regulation NMS Subcommittee that will
consider, among other things, the impact of Regulation NMS, including
Rule 611, and whether it should be modified to reflect changes in
trading technology and practices, and competition.
In October 2015, SEC staff prepared a briefing paper on the current
regulatory model for trading venues and for market data
dissemination.\29\ It contrasted the regulatory model applicable to
national securities exchanges, which are SROs, with that applicable to
ATSs, which are registered as broker-dealers. The paper also was
intended to facilitate a discussion of the SROs' role in the
collection, processing, and dissemination of market data and the
treatment of associated fees.
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\29\ The paper is available at http://www.sec.gov/spotlight/emsac/
memo-regulatory-model-for-trading-venues.pdf.
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EMSAC considered issues raised in the trading venue papers at a
meeting in October 2015. It also created a Trading Venues Regulation
subcommittee to consider the current regulatory model for trading
venues and whether it is optimally serving all market participants and
the market as a whole.
5. Mitigating Broker Conflicts
Another area of focus in equity market structure is broker
conflicts and how they are exacerbated or mitigated by the availability
of many different trading venues. These venues offer a plethora of
order types and other trading services, as well as various fees and
payments related to these services. Most investors rely on their
brokers to navigate market complexities of fragmented markets on their
behalf, but monitoring execution quality can be difficult for even
sophisticated investors.
Institutional Order Routing Transparency
SEC staff is developing a recommendation for the Commission to
consider in 2016 that would expand investors' understanding of their
brokers' routing decisions. Among other things, the staff's
recommendation would enhance the information provided to institutional
customers through standardized order routing disclosures. Requiring
standardized disclosures, in combination with the recently proposed
enhanced ATS operational transparency rulemaking, would be intended to
provide sufficient baseline information to institutional investors to
bolster their ability to: (1) assess the potential for harmful
information leakage concerning their orders; (2) assess the conflicts
of interest their broker-dealers may face in handling their orders; (3)
assess the performance of a broker-dealer in handling their orders and
achieving best execution; and (4) compare the services of their routing
broker-dealers.
Exchange Order Type Transparency
As another means of increasing transparency in the markets, Chair
White asked the exchanges in 2014 to conduct a comprehensive review of
their order types and how they operate in practice.
The exchanges also were asked to consider appropriate rule changes
to help clarify the nature of their order types and how they interact
with each other (including a clear description of all material aspects
of the operation of their order types). As a result, all of the
exchanges reviewed their order types and related rules, and submitted
proposed rule changes that provide substantial additional detail on
their operation.
SEC Staff Papers and EMSAC Discussions regarding Maker-Taker Fee
Structure and Customer Issues
In October 2015, SEC staff prepared a briefing paper on the maker-
taker fee structure offered by many exchanges.\30\ The purpose of the
paper was to facilitate an objective assessment of maker-taker fees in
the U.S. equity markets by outlining the development of the maker-taker
fee model, summarizing the current public debate about its impact on
equity market structure, and presenting both the asserted advantages
and disadvantages of maker-taker fee structures. EMSAC also discussed
maker-taker fee issues at multiple meetings in 2015, and its Regulation
NMS subcommittee will consider approaches to a potential access fee
pilot.
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\30\ The paper is available at https://www.sec.gov/spotlight/emsac/
memo-maker-taker-fees-on-equities-exchanges.pdf.
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In January 2016, SEC staff prepared a briefing paper that was
intended to facilitate consideration of certain issues affecting
customers--particularly retail customers--in the current equity market
structure, namely: (1) the risks of using certain order types; (2) the
potential conflicts presented by payment-for-order-flow arrangements;
and (3) the development of more meaningful execution quality
reports.\31\ EMSAC discussed these customer issues at its February 2016
meeting and also has created a Customer Issues subcommittee to consider
initiatives to protect investor interests and promote investor
confidence.
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\31\ The paper is available at http://www.sec.gov/spotlight/equity-
market-structure/issues-affecting-customers-emsac-012616.pdf.
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6. Building Quality Markets for Smaller Companies
Smaller public companies face market structure challenges that are
not the same as those of larger companies. These include the need for a
sufficiently liquid market that provides their investors with a
reasonably efficient means to establish and liquidate positions. A
single market structure may not fit all companies, and the SEC has
sought to focus concretely on how to enhance the equity market
structure for smaller companies.
Tick Size Pilot
One initiative designed to address concerns about improving
liquidity in the secondary market for smaller companies is the
development of a pilot program that would allow smaller companies to
trade at wider tick sizes. In June 2014, the SEC directed the equity
exchanges and FINRA to act jointly in developing and filing a national
market system plan to implement a tick pilot program. The Commission
noted particularly that a pilot program could facilitate studies of the
effect of tick size on liquidity, execution quality for investors,
volatility, market-maker profitability, competition, transparency, and
institutional ownership in the stocks of small-capitalization
companies.
In May 2015, the Commission approved a plan filed by the equity
exchanges and FINRA (Participants) to implement a tick size pilot
program (Tick Size Pilot).\32\ In November 2015, the Commission issued
an exemption to the Participants from implementing the Plan until
October 3, 2016.\33\
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\32\ Securities Exchange Act Release No. 74892, 80 FR 27513 (May
13, 2015), available at http://www.sec.gov/rules/sro/nms/2015/34-
74892.pdf.
\33\ Securities Exchange Act Release No. 76382, 80 FR 70284
(November 13, 2015), available at http://www.sec.gov/rules/exorders/
2015/34-76382.pdf. The Tick Size Pilot was scheduled to begin in May
2016. However, in order to give the SROs and their members sufficient
time to implement the Tick Size Pilot, the Commission issued the
exemption to the Participants.
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The Tick Size Pilot will have a 2-year duration (Pilot Period), and
will include exchange-listed common stocks that have the following
characteristics: (1) a market capitalization of less than $3 billion;
(2) a closing price of at least $2 per share on the last day of the
measurement period (and a closing price of not less than $1.50 per
share during the measurement period); (3) a consolidated average daily
volume of one million shares or less; and (4) a volume-weighted average
price of at least $2 per share (Pilot Securities).
Pursuant to the Tick Size Pilot, Participants will collect data
reflecting a variety of market quality metrics with respect to the
Pilot Securities and transmit such data to the Commission. The
collected data will be publicly available in an aggregated form. In
addition, the Participants are required to conduct, and provide the
Commission with, a publicly available impact assessment. The
Participants are scheduled to begin collecting Tick Size Pilot data in
April 2016, which is 6 months prior to the start of the Pilot Period.
The Participants have submitted to the Commission proposed rule
changes to implement the quoting and trading requirements and the data
collection requirements.\34\ The Commission has approved the proposed
rules to implement the data collection requirements that have been
submitted, as well as one of the proposals to implement the quoting and
trading proposals that have been submitted.\35\
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\34\ See, e.g., Securities Exchange Act Release No. 76552 (December
3, 2015) (File No. SR-BATS-2015-108), available at http://www.sec.gov/
rules/sro/bats/2015/34-76552.pdf; Securities Exchange Act Release No.
76229 (October 22, 2015) (File No. SR-NYSE-2015-46), available at
http://www.sec.gov/rules/sro/nyse/2015/34-76229.pdf.
\35\ Securities Exchange Act Release No. 77105 (February 10,
2016)(order approving BATS' rules to implement the data collection
requirements of the Tick Size Pilot), available at http://www.sec.gov/
rules/sro/bats/2016/34-77105.pdf; Securities Exchange Act Release No.
77164 (February 17, 2016) (order approving FINRA's rules to implement
the data collection requirements of the Tick Size Pilot), available at
http://www.sec.gov/rules/sro/finra/2016/34-77164.pdf; Securities
Exchange Act Release No. 77218 (February 23, 2016) (order approving
FINRA's rules to implement the quoting and trading requirements of the
Tick Size Pilot), available at http://www.sec.gov/rules/sro/finra/2016/
34-77218.pdf.
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Venture Exchanges
On March 4, 2015, the SEC's Advisory Committee on Small and
Emerging Companies held a meeting at which it considered venture
exchanges and other means to increase secondary market liquidity for
investors in smaller companies. Previously in 2013, this Advisory
Committee had recommended the development of a separate U.S. equity
market that would facilitate trading in the securities of small and
emerging companies.
On March 10, 2015, the Commission submitted testimony to this
Subcommittee for its hearing on venture exchanges and small
capitalization companies.\36\ The Commission stated that it was
considering innovative approaches that appropriately balance the needs
of smaller companies for efficient secondary markets and the interests
of investors in smaller companies. It noted that venture exchanges
potentially could achieve such a balance by providing investors a
transparent and well-regulated environment for trading the stocks of
smaller companies that offers both enhanced liquidity and strong
investor protections. The Commission observed that it had previously
approved a proposal for a venture exchange, but the exchange had never
been launched. It emphasized, however, that, as it did with the BX
Venture Market, it would carefully consider any efforts of exchanges
that were particularly designed to meet the needs of smaller companies
and their investors.
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\36\ A copy of that testimony is available at http://www.sec.gov/
news/testimony/testimony-venture-exchanges.html.
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The Commission continues to be receptive to efforts that would
appropriately balance the needs of smaller companies and the interests
of their investors.
III. Conclusion
Thank you again for inviting me to discuss the SEC's efforts to
strengthen the U.S. equity market structure. As is evident from the
many initiatives noted above, the SEC's program for optimizing equity
market structure is actively moving forward. I look forward to
answering your questions.
______
PREPARED STATEMENT OF RICHARD G. KETCHUM
Chairman and CEO, Financial Industry Regulatory Authority
March 3, 2016
Chairman Crapo, Ranking Member Warner and Members of the
Subcommittee:
On behalf of the Financial Industry Regulatory Authority, or FINRA,
I would like to thank you for the opportunity to testify today about
current issues and potential regulatory changes that could improve
equity market structure.
In recent years, there has been increased debate about the
structure of capital markets. Once the domain of regulators, market
operators and large, sophisticated investors, market structure is now a
topic for much broader public discourse. This discourse often includes
questions about whether or not the markets are fair and whether they
provide a level playing field for all investors.
Partly this concern is a reaction to volatility. For example, last
August the Dow Jones Industrial Average plummeted more than 1,000
points within the first 10 minutes of trading, with message traffic
nearly doubling. And the Chicago Board Options Exchange Volatility
Index--the U.S. market's so-called ``fear gauge''--surged 45 percent to
its highest level in nearly 4 years. While the gauge has cooled since
then, it remains elevated, recently hovering around 22, which is nearly
double last year's low mark of just under 12.
While I can't fully diagnose what may at times be ailing the equity
markets, this tumult exemplifies the importance of the structure of
markets for financial instruments. All of us here know today that
questions of market structure can be broad and complex, and it can be
difficult to home in on what really needs to be addressed. I believe
there are three key aspects of the markets that securities market
participants and regulators should always be working to strengthen:
market fairness, market transparency and market liquidity.
SEC Chair Mary Jo White has set out a road map for potential future
changes in the equity and fixed income markets, which specifically
includes an important, ongoing role for FINRA and other SROs. A number
of changes have already been made or are in progress; many remain under
discussion and analysis. As all such changes are contemplated, it is
important to consider how proposals might enhance market fairness,
transparency and liquidity.
FINRA
Before I address specific market structure issues and initiatives,
I'd like to provide a brief overview of FINRA and its regulatory
programs. FINRA provides the first line of oversight for broker-dealers
and the U.S. securities markets, and through its comprehensive
regulatory programs, regulates the firms and brokers that sell
securities in the United States. FINRA oversees nearly 4,000 brokerage
firms and over 600,000 registered brokers. FINRA touches virtually
every aspect of the broker-dealer business--from registering
individuals to examining securities firms; writing rules and enforcing
those rules and the Federal securities laws; informing and educating
the investing public; providing trade reporting and other industry
utilities; and administering the largest dispute resolution forum for
investors, brokerage firms and individual brokers.
We also work behind the scenes to detect and fight fraud. In
addition to our own enforcement efforts, each year we refer hundreds of
fraud and insider trading cases to the Securities and Exchange
Commission (SEC) and other agencies. FINRA regularly shares information
with other regulators, leading to important actions that can prevent
further harm to investors.
More than 10 years ago, FINRA established the FINRA Investor
Education Foundation to support innovative research and educational
projects aimed at improving the financial capability of all Americans.
Together with the Foundation, FINRA is committed to providing investors
with information and tools they need to better understand the markets
and basic principles of investing--and to help them protect themselves.
In addition, FINRA operates and regulates OTC market transparency
facilities that provide the public and professionals with timely quote
and trade information of publicly traded equity and debt securities.
They are the primary source for regulatory data on these transactions,
and provide FINRA-registered firms with tools to comply with reporting
obligations in secondary-market activity in fixed income and equity
securities. In this role, we are continually evaluating and identifying
areas where enhanced transparency can benefit investors and the
markets.
Finally, and of particular relevance to today's hearing, FINRA,
directly and through our regulatory service agreements with exchanges,
monitors approximately 99 percent of all trading in U.S. listed
equities markets and 70 percent of the options markets. In fact,
FINRA's market surveillance systems process approximately 42 billion
market events each day to closely monitor trading activity in equity,
options and fixed income markets in the United States.
Evolution of Market Structure
Any sound evaluation of equity market structure should begin with
an understanding of where things stand now, and how we got here. In the
past 20 or so years, the equity markets have changed in many
fundamental ways. Perhaps the most significant development has been the
shift from human-intermediated markets to electronic intermediation.
While some observers have noted that high frequency trading (HFT)
activity may be declining since its peak around 2009, it is
nevertheless clear from various estimates that automated trading has
become the predominant force in equities markets. We have seen many of
the traditional floor-based brokers and market-maker specialists of
previous years replaced by firms commonly characterized as HFT.
Market structure arrived at its current state because of several
interrelated factors. Technological advancements have most obviously
allowed for the rise of highly automated, low-latency trading systems
capable of digitally ingesting orders, trades and news and making
advanced trading decisions. Many also point to the impact of regulatory
action, including Regulation ATS, decimalization, and Regulation NMS,
all of which have the underlying goals of promoting competition,
lowering trading costs, and enhancing best execution.
However, as SEC staff has observed recently in a number of
detailed, thoughtful papers, there are no easy explanations. For
example, while Regulation NMS is commonly cited as a cause of market
fragmentation and the proliferation of HFT, even prior to Regulation
NMS, Nasdaq had undergone a major transformation from a traditional
dealer model to a new, electronic market structure. Similarly, some
believe HFT owes its existence to the increase in the number of trading
venues, yet HFT is also a significant force in the E-Mini futures
contract, which trades in a highly centralized market.
The fact that market structure developments cannot always be easily
explained does not prevent regulatory improvement. It simply
underscores the need for careful data analysis. For example, the SEC's
MIDAS project has been providing greatly enhanced insight into the
functioning of markets and has helped provide a foundation for market
structure refinements. Similarly, FINRA, through it Order Audit Trail
System called OATS, collects and processes billions of order-related
events each day that also helps shed light on some of the fundamental
market structure policy questions.
There is undoubtedly more work to be done. The rise of automation
has delivered many benefits to investors, who are now able to trade
much more quickly and cheaply than ever before. But there are potential
inefficiencies in today's market structure that we must continually
evaluate to make sure markets are fair, transparent and liquid.
Market Fairness
Investors must have confidence that they can access current,
accurate, bona fide market prices that reflect true investor supply and
demand. That means that the market structure established, including the
regulatory framework supporting it, must foster and promote accurate
prices and low trading costs for retail investors. Having been in this
business for a long time, I've been part of many significant regulatory
changes that have benefited investors. However, competition and
regulatory changes have also led to a more complex, fragmented market.
In today's increasingly fragmented market, bad actors can consciously
disperse their trading activity across markets, asset classes and
broker-dealers in an attempt to hide their footprints and avoid
detection. It is part of our job at FINRA to monitor what's happening
in the market and ensure that the markets operate fairly.
FINRA has responsibility to oversee and regulate over-the-counter
(OTC) trading of exchange-listed and non-exchange-listed securities, as
well as trading in corporate and municipal debt instruments and other
fixed income instruments. FINRA also conducts examinations of market
making and trading firms to assess compliance with FINRA trading rules
and the Federal securities laws. In addition, FINRA provides automated
surveillance and other regulatory services to U.S. equity and options
exchanges. FINRA has regulatory service agreements (``RSAs'') in place
with 10 of the 12 U.S. equity exchanges and all U.S. options exchanges.
By virtue of these agreements, FINRA conducts market surveillance for
approximately 99 percent of the listed equity market and approximately
70 percent of the listed options market. As a result, while the markets
have become increasingly fragmented, through our contracts with
exchange clients, FINRA has been able to aggregate trading data across
the markets to conduct comprehensive, cross market surveillance. This
is important because FINRA has found many instances where market
participants have consciously dispersed their trading activity across
multiple markets in an effort to avoid detection. In addition, FINRA's
cross market surveillance enables us to detect those market
participants who are acting in concert to engage in market manipulation
schemes. We have found that such activity accounts for a significant
percentage of our cross market surveillance alerts.
We developed an innovative cross-market surveillance program that
allows us to run dozens of surveillance patterns and threat scenarios
across the data we gather to look for manipulation and frontrunning, as
well as layering, spoofing, algorithmic gaming, and other abusive
conduct. This sophisticated surveillance allows us to detect activities
that we were not able to see before. For example, 51 percent of our
cross-market alerts identify potential manipulative activity by two or
more market participants acting in concert. And 57 percent of our
cross-market alerts identify potential manipulation by a market
participant on multiple markets. FINRA also is starting to design
surveillance programs that will span equities and options markets
together to detect potential cross-product manipulative conduct.
In addition to SEC and FINRA oversight, firms themselves have a
fundamental obligation to supervise their own trading activity to
ensure that the activity does not violate any applicable SEC or FINRA
rules. A number of existing SEC and FINRA rules specifically govern
firms' trading activities including the SEC's Market Access Rule, which
requires firms with market access to have a system of effective risk
management controls and supervisory procedures. Although a reasonable
supervision and control program may not foresee every potential failure
or prevent every undesirable consequence, it is an additional
protective measure in today's regulatory structure that promotes and
supports market fairness.
And as you know, in July 2012, the SEC adopted Exchange Act Rule
613 requiring 19 SROs--FINRA and the 18 national securities exchanges--
to work together to jointly file a NMS plan to govern the creation,
implementation, and maintenance of a Consolidated Audit Trail, or CAT,
which will collect information on virtually every order and trade in
equity securities and options in the United States. The CAT will be the
world's largest repository of securities data, processing approximately
58 billion records on a daily basis.
FINRA strongly supports the SEC's action to require the development
of the CAT, an important initiative that will even further enhance
regulators' ability to conduct surveillance of trading activity across
multiple markets and perform market reconstruction and analysis.
Comprehensive intermarket surveillance is essential to ensuring the
overall integrity of the U.S. securities markets and maintaining the
confidence of investors in those markets.
Market Transparency
Transparency is of paramount importance to the equity markets. The
SEC said recently, and I agree, that transparency is a primary tool by
which investors protect their own interests. To this end, the FINRA
Board of Governors formed a Working Group to assess FINRA's rules and
regulatory programs related to HFT, which resulted in a series of
initiatives designed to increase the scope of trading information FINRA
receives and provide more transparency into trading activities to
market participants and investors.
In general terms, these efforts include a call for alternative
trading systems (ATSs) to provide more in-depth order information for
regulatory surveillance, greater transparency of volume executed away
from stock exchanges, more granular audit trail information and tighter
restrictions around allowable clock drift to better ensure proper
sequencing of events.
These initiatives build on an earlier initiative from 2014, when
FINRA began publishing on its Web site weekly volume information
regarding transactions in equity securities executed within ATSs. Since
that time, FINRA has been considering additional data that may be
useful to market participants and investors and is expanding this
initiative to provide more insight into larger-sized, or ``block,''
trades. Later this year, FINRA will begin publishing monthly aggregate
ATS block trading statistics, which will provide interested parties
with more detailed information on ATS trading activities, thus further
enhancing transparency in the over-the-counter market. In addition,
FINRA will be further expanding its transparency initiative by
publishing the remaining equity volume executed over-the-counter by
FINRA member firms, including the trading activity of non-ATS
electronic trading systems and internalized trades. The ATS and non-ATS
volume data on FINRA's Web site will be free of charge to all users.
Data from FINRA's ATS transparency initiative helped inform the
SEC's recent proposal to significantly revise the disclosure regime for
NMS Stock ATSs. The SEC's proposal would, among other things, require
greater public disclosure concerning the operation of business dealings
of NMS Stock ATSs and would provide for enhanced oversight of these
ATSs' filings. As it stated in its recent comment letter on the
proposal, FINRA fully supports the proposal's objective of enhancing
market transparency.
Market Liquidity and Volatility
Since the May 2010 Flash Crash, the SEC, FINRA and U.S. stock
exchanges have implemented a variety of initiatives to minimize the
impact of extreme volatility, the causes of which can vary from market
forces to technological malfunctions. These initiatives have created a
multi-faceted safety net for the markets and are designed to promote
investor confidence. Among the changes, regulators adjusted the market-
wide trading pause, which gives market participants an opportunity to
assess their positions, valuation models and operational capabilities
when extreme periods of volatility occur.
On top of that, FINRA and the exchanges implemented a limit up/
limit down initiative, which addresses the type of sudden price
movements that the market experienced during the Flash Crash. Under the
plan, a limit up and limit down mechanism prevents trades in NMS stocks
from occurring at prices outside of certain ranges. And if the changes
in price are more significant and prolonged, the limit up/limit down
plan would trigger a trading pause in that security.
We had an excellent opportunity to evaluate the effectiveness of
these changes last August 24th, when the Dow plummeted more than 1,000
points within the first 10 minutes of trading. The events of that day
illustrated not a market out of control, but the value of having
appropriate controls in place. Were it not for the limit up/limit down
procedures, the market fluctuations last August would have been more
dramatic. There were over 1,200 trading pauses that day, with over
1,000 occurring in exchange-traded products (ETPs), many which were
repeats in the same ETP.
Clearly, the August events showed these processes are serving a
crucial function, but also showed that additional refinements are
necessary. One of the issues that day was the big gaps between the
value of underlying indexes and the exchange-traded funds (ETFs) that
track them. ETFs combine aspects of mutual funds and conventional
stocks. They operate like a mutual fund by offering an investor an
interest in a professionally managed, diversified portfolio of
investments. Unlike mutual funds, however, ETF shares trade like stocks
on exchanges and can be bought or sold throughout the trading day at
fluctuating prices, whereas mutual funds are priced just once at the
end of the trading day. On August 24th, unusual trading affected many
of the major ETFs as well as many less liquid ones. While trading
volume surged, public display of trading interest--or liquidity--
dropped. And we saw pricing volatility in ETFs because of the conflicts
between halts on the underlying stocks within the indices and the
pricing of the index.
The volatility and the issues we saw with ETFs offers up a great
opportunity for regulators to take another look at the effectiveness of
the initiatives put in place after the 2010 Flash Crash, as well as our
market structure generally. Among the issues ripe for review are the
opening processes on primary listing exchanges; the operation of the
limit up/limit down at the opening of trading, at re-openings after a
trading pause and where the price is rebounding; the use of single
market prices rather than consolidated prices for index calculations at
times when the primary market opens outside its normal process; the use
of stop orders, which become market orders when triggered and can
execute at a price substantially worse than anticipated by the
investor, particularly in volatile markets; and whether market-maker
quoting obligations are stringent enough to promote market stability.
Liquidity in the U.S. markets has thrived because of confidence in
the markets. Investors need to be sure that markets will operate
predictably. And it's important for us as regulators to implement
programs that minimize the impact of market volatility and to limit
market disruption while also promoting an efficient price discovery
that encourages the provision of liquidity.
Work of the SEC's Equity Market Structure Advisory Committee
As noted in the Subcommittee's invitation to testify, the questions
enumerated above as well as a number of other market structure issues
are also being considered by the SEC's Equity Market Structure Advisory
Committee (EMSAC), of which I am a member. In addition, given the
number and broad ranging issues to address, the EMSAC created four
subcommittees to focus on specific equity market structure areas:
Regulation NMS, Trading Venues Regulation, Customer Issues and Market
Quality. These subcommittees have met several times between full EMSAC
meetings. Both the SEC staff and EMSAC members have dedicated
significant time and effort with good progress being made, and I look
forward to seeing where the process takes us.
EMSAC discussions have ranged from more broad, thematic topics such
as increased coordination between the equities and futures markets to
more specific regulatory and market-based improvements, like retail
investors' use of certain order types. For example, discussions have
included efforts to update the SEC's rules on the public disclosure of
execution-quality statistics and order-routing practices. These rules
brought much needed transparency to the markets when they first were
adopted, but market structure has been largely transformed since then
and they are in need of updating to better reflect the current market
structure.
In addition, the committee is reviewing the current regulatory
model for exchanges and other trading venues, as well as the current
state and impacts of Regulation NMS. In particular, the EMSAC and its
subcommittees are considering whether the Regulation NMS rules on
limiting trade throughs, capping access fees, and preventing locked or
crossed markets continue to serve their intended purpose. These rules
were generally intended to bolster investor protection when they were
adopted, but some market observers have questioned whether they might
also have contributed to market fragmentation and rebate arbitrage.
The EMSAC also is actively considering many of the questions about
market volatility highlighted above, including the operation of limit
up/limit down and whether firms could better educate their customers
about the risks of market and stop orders. This issue is one example of
a place where FINRA believes it can work in parallel to complement
EMSAC efforts. Guided by the recent EMSAC discussion, and based on
FINRA's own regulatory analysis, FINRA is currently considering
providing additional guidance to firms to underscore the importance of
investor education in this area. The EMSAC has heard a variety of views
on these important market structure questions, which is why, as I noted
above, I believe it is critical to use data as the guide forward as we
evaluate how any potential changes may impact market fairness,
transparency and liquidity. I look forward to continuing to offer my
and FINRA's experience and expertise as the EMSAC moves forward with
its work.
Small Company Issues
Issues related to small company issues deserve careful
consideration as well. FINRA has been involved in several projects
focused on this segment of the market.
Tick Size Pilot Program
On May 6, 2015, the SEC approved an NMS Plan submitted by the SRO
Participants to implement a Tick Size Pilot Program. The Order approved
the NMS Plan for a 2-year period, which is to commence on October 3,
2016. The Plan is designed to allow the Commission, market
participants, and the public to assess the impact of increment
conventions (commonly referred to as tick sizes) on the liquidity and
trading of the common stock of small-capitalization companies. The Tick
Size Pilot is a data-driven test and will evaluate whether or not
widening the tick size for securities of smaller capitalization
companies would impact trading, liquidity and market quality of those
securities. The pilot will consist of a control group and three test
groups, with each test group having approximately 400 securities. Each
SRO Participant, including FINRA, is required to comply, and to enforce
compliance by its member organizations, as applicable, with the
provisions of the Plan. The SROs have filed rule changes in furtherance
of the Pilot and have been working closely with the industry on
implementation issues, including the data reporting requirements
necessary to allow for effective data and impact analysis of the
different test groups.
JOBS Act Implementation
In order to fulfill our mandate under the JOBS Act crowdfunding
provisions, we filed proposed rules and forms with the SEC for SEC-
registered funding portals that become FINRA members. FINRA streamlined
the rules to reflect the limited scope of activity that Congress
permitted to funding portals while also maintaining investor
protection. The SEC approved FINRA's Funding Portal Rules, which became
effective on January 29, 2016. FINRA's systems were ready as of that
date to begin receiving applications from prospective funding portals.
FINRA's regulatory program is fully prepared for the May 16, 2016,
effective date of the SEC's Regulation Crowdfunding.
Conclusion
FINRA appreciates this opportunity to discuss these important
market structure issues and its programs with the subcommittee. We
remain committed to working closely with the SEC, other regulators,
this subcommittee and the full committee as we continue to work toward
our dual mission of protecting investors and safeguarding market
integrity.
Additional Material Supplied for the Record
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