[Congressional Record Volume 155, Number 115 (Tuesday, July 28, 2009)]
[Senate]
[Pages S8183-S8186]
From the Congressional Record Online through the Government Publishing Office [www.gpo.gov]




                          INVESTOR PROTECTION

  Mr. KAUFMAN. Madam President, all Americans hope that the ``green 
shoots'' we have been seeing recently--evidence of the economy turning 
around--won't wither. One thing that will help make our recovery strong 
and sustainable is the return of investor confidence. That is why 
making certain our financial markets operate fairly and openly is so 
important.
  Free and fair markets and democracy are America's two greatest 
pillars of strength. Our financial markets have long been the engine of 
American growth and the envy of the world. Efficient and free capital 
markets are essential to all of what makes America great: investment in 
private enterprise, the availability of capital to expand and grow our 
economy through innovation and new ideas, and the ability to save for 
retirement in hopes that investment will result in comfort for our 
later years. But we have seen what happens when you take the referees 
off the field, when we fail to have clear and fair rules for everyone. 
It is the job of our democratic government to set those rules and to 
keep the referees--our financial regulators--on the field.
  I rise today because we continue to see that our financial markets 
simply do not operate on a level playing field for all investors. That 
is a threat to the credibility of our financial markets and, as a 
result, to our country's economic well-being.
  We have an unfair playing field that leaves us with, in effect, two 
markets: one for powerful insiders and another for average investors; 
one market for huge volume, high-speed players who can take advantage 
of every loophole for profit, and another market for retail investors 
who must play by the rules and whose orders are filled without any 
special priority. This situation simply cannot continue. It is the 
national equivalent of ``separate and unequal.''

[[Page S8184]]

  I offer my colleagues three examples of this two-tier system which 
undermines the fairness and efficiency of our financial markets. First, 
today the biggest players on Wall Street are using their automated, 
high-speed trading programs to engage in short selling of stocks. 
Informed observers believe organized ``bear raids''--short selling 
combined with coordinated ``misinformation'' campaigns--contributed to 
the demise of Lehman Brothers and Bear Stearns, key elements in the 
collapse of our financial markets last year. With the repeal of the 
uptick rule in 2007 and no substantial substitute in its place, the 
threat of such damaging manipulation is still with us.
  Since March 3, I have spoken frequently about the urgent need for the 
SEC to restore the substance of the uptick rule. This rule required 
investors simply to pause and to wait for an uptick in price before 
continuing to short sell. Without such a rule in place, investors who 
own those stocks are more vulnerable to hedge fund bear raiders.
  So far, the SEC has initiated rulemaking and conducted on April 8 a 
roundtable discussion among key experts on some kind of price test that 
could substantially replace the uptick rule in today's high-speed, 
high-tech markets. While that process has begun, we have yet to see it 
bear fruit.
  Second, big market players can engage in naked short selling--selling 
stock for which they have no legal claim and for which they cannot 
deliver. Since my first speech on this subject in March, I have come to 
the floor several times and coauthored letters with my colleagues about 
the need for the SEC to end naked short selling. In that abusive 
practice, traders bet on shares losing value--shares they have not 
borrowed and in some cases never even intend to borrow--in time for 
settlement.
  Yesterday, the SEC made permanent a temporary rule they had enacted 
last fall and proposed some new transparency measures, and the 
Commission announced plans for a roundtable discussion on September 
30--2 months from now. The Commission will finally begin to discuss 
publicly the potential solutions that a bipartisan group of Senators 
and I have been urging: either a pre-borrow requirement or a 
centralized ``hard locate'' system. The Depository Trust and Clearing 
Corporation tells us it has the capacity and the willingness to 
implement that system but only if the SEC requires it through a rule.
  That is some progress, but we need more urgency at the SEC to 
implement tougher rules that will stop naked short selling through an 
enforceable system. This is imperative, because the current 
``reasonable belief'' standard is virtually unenforceable, even against 
those who engage in concerted action to manipulate prices downward.
  Yesterday's announcement by the SEC admits that the rule they made 
permanent yesterday has only reduced fails to deliver by 57 percent. 
That leaves a lot of room for improvement. Why not have an enforceable 
system such as that proposed last week by seven Senators of both 
parties that could end naked short selling once and for all? I am 
hopeful we will soon see movement on this.
  Third, we have the most recent revelation of so-called ``flash 
orders'' by high frequency traders. These allow exchange members who 
pay a fee to get a first look at share order flows before the general 
public. By viewing this buy and sell order information for milliseconds 
before it goes in the wider market, these investors gain an unfair 
advantage over the rest. Today I join Senator Schumer in urging the SEC 
to prohibit the use of these flash orders used in connection with 
optional display periods currently permitted by DirectEdge, Bats 
Exchange, and NASDAQ.
  As the New York Stock Exchange complained to the SEC on May 28, 
selling flash orders for free provides:

       Non-public order information to a select class of market 
     participants at the expense of a free and open market system.

  To use a baseball metaphor, flash orders allow some batters to pay to 
see the catcher's signals to the pitcher while the rest of us don't see 
them. We have to make an informed judgment with a normal amount of 
risk. Markets that permit a privileged few to have special access to 
information cannot maintain their credibility.
  I ask: Is this what is happening on Wall Street today? When millions 
of Americans have lost so much money in the stock market, do Wall 
Street actors continue to make record trading profits by exploiting 
loopholes using high-speed computers?
  William Donaldson, former chairman of the SEC and the New York Stock 
Exchange, has said:

       This is where all the money is getting made . . . If an 
     individual investor doesn't have the means to keep up, 
     they're at a huge disadvantage.

  As Senator Schumer wrote in his letter:

       If allowed to continue, these practices will undermine the 
     confidence of orderly investors and drive them away from our 
     capital markets.

  America simply cannot afford this loss of integrity of its financial 
markets.
  Amazingly, it is a loophole in current regulations that allows this 
unfair practice. This can and should be fixed immediately.
  Flash orders, the uptick rule, and naked short selling are not just a 
list of complaints. I believe they are interconnected. They are 
interconnected by an unsupported faith in the religion of self-
regulation and liquidity. That religion believes that no price is too 
high for deeper liquidity--maximizing the volume and frequency of a 
transaction--because it reveals the greatest amount of information 
about stock values. There is one more article of faith--that innovation 
by market players is always beneficial.
  When the financial markets were decimalized and the uptick rule 
repealed, the SEC and leading market institutions claimed that the 
technology would lead to deeper liquidity and market efficiencies 
benefiting all investors. High-speed trading, sophisticated algorithms, 
and high volume short selling all have grown exponentially in recent 
years.
  MIT, our Nation's greatest engineering school, sent 11 percent of its 
2008 graduates to work on Wall Street. All this, some say, has led to 
deeper liquidity.
  America was founded with a spirit of entrepreneurship and a 
celebration of economic innovation. There are so many things Wall 
Street does right, and historically Wall Street was built on a 
foundation of trust and credibility. But America was also born from the 
principle of equal opportunity. While we should keep encouraging the 
kind of commercial ingenuity that fuels the prosperity of financial 
markets, we must ensure that technology is not employed to advantage 
one small group over the rest. That is not what free market is about.

  Indeed, there is a place in our markets for high-speed arbitrage 
functions, because they can and have narrowed bid-ask spreads and 
lowered the cost of trading for all. High-speed arbitrage also helps 
price discovery and keeps the prices of similar assets traded in 
different markets more closely aligned.
  When it comes to flash orders, however, I think most investors, even 
those who trade regularly, are waking up very surprised to learn that 
these practices are even permitted, just as we were surprised last year 
to learn about the rampant extent of naked short selling. Many 
investors have been suspicious for years that insiders on Wall Street 
hold built-in advantages over average investors. Flash orders are a 
classic example of being taken aback not by what is illegal but by what 
is legally occurring directly under the nose of our financial 
regulators and leading market institutions.
  Since I began speaking out against naked short selling, I have heard 
from some of the biggest companies in America that are concerned about 
the effects of naked short selling. But they do not want to speak out 
because they fear that any hint of vulnerability they admit even 
privately to public officials will leak out and make them the target of 
these predatory raiders.
  I have also heard from investors around the country. They have 
complained that large broker-dealers are somehow permitted to trade 
ahead of most investors. These average and even sophisticated investors 
relate that in their experience they never seem to be able to execute 
trades at the best available published bid or asking price. They 
complain that large orders always seem to get a priority over their 
smaller orders. Until now, I never knew what to make of these claims.

[[Page S8185]]

  In the New York Times this past Friday, on investor blogs for weeks 
now, and in a comment letter filed by the New York Stock Exchange on 
May 28, commentators have begun to explain how flash orders work to, 
quite literally, ``pick the pockets'' of the average investor. In 
essence, these traders get a very quick look at all pending orders in 
advance and through technology can trade ahead of these orders.
  I ask unanimous consent that the Times article be printed in the 
Record.
  There being no objection, the material was ordered to be printed in 
the Record, as follows:

                [From the New York Times, July 24, 2009]

             Stock Traders Find Speed Pays, in Milliseconds

                          (By Charles Duhigg)

       It is the hot new thing on Wall Street, a way for a handful 
     of traders to master the stock market, peek at investors' 
     orders and, critics say, even subtly manipulate share prices.
       It is called high-frequency trading--and it is suddenly one 
     of the most talked-about and mysterious forces in the 
     markets.
       Powerful computers, some housed right next to the machines 
     that drive marketplaces like the New York Stock Exchange, 
     enable high-frequency traders to transmit millions of orders 
     at lightning speed and, their detractors contend, reap 
     billions at everyone else's expense.
       These systems are so fast they can outsmart or outrun other 
     investors, humans and computers alike. And after growing in 
     the shadows for years, they are generating lots of talk.
       Nearly everyone on Wall Street is wondering how hedge funds 
     and large banks like Goldman Sachs are making so much money 
     so soon after the financial system nearly collapsed. High-
     frequency trading is one answer.
       And when a former Goldman Sachs programmer was accused this 
     month of stealing secret computer codes--software that a 
     federal prosecutor said could ``manipulate markets in unfair 
     ways''--it only added to the mystery. Goldman acknowledges 
     that it profits from high-frequency trading, but disputes 
     that it has an unfair advantage.
       Yet high-frequency specialists clearly have an edge over 
     typical traders, let alone ordinary investors. The Securities 
     and Exchange Commission says it is examining certain aspects 
     of the strategy.
       ``This is where all the money is getting made,'' said 
     William H. Donaldson, former chairman and chief executive of 
     the New York Stock Exchange and today an adviser to a big 
     hedge fund. ``If an individual investor doesn't have the 
     means to keep up, they're at a huge disadvantage.''
       For most of Wall Street's history, stock trading was fairly 
     straightforward: buyers and sellers gathered on exchange 
     floors and dickered until they struck a deal. Then, in 1998, 
     the Securities and Exchange Commission authorized electronic 
     exchanges to compete with marketplaces like the New York 
     Stock Exchange. The intent was to open markets to anyone with 
     a desktop computer and a fresh idea.
       But as new marketplaces have emerged, PCs have been unable 
     to compete with Wall Street's computers. Powerful 
     algorithms--``algos,'' in industry parlance--execute millions 
     of orders a second and scan dozens of public and private 
     marketplaces simultaneously. They can spot trends before 
     other investors can blink, changing orders and strategies 
     within milliseconds.
       High-frequency traders often confound other investors by 
     issuing and then canceling orders almost simultaneously. 
     Loopholes in market rules give high-speed investors an early 
     glance at how others are trading. And their computers can 
     essentially bully slower investors into giving up profits--
     and then disappear before anyone even knows they were there.
       High-frequency traders also benefit from competition among 
     the various exchanges, which pay small fees that are often 
     collected by the biggest and most active traders--typically a 
     quarter of a cent per share to whoever arrives first. Those 
     small payments, spread over millions of shares, help high-
     speed investors profit simply by trading enormous numbers of 
     shares, even if they buy or sell at a modest loss.
       ``It's become a technological arms race, and what separates 
     winners and losers is how fast they can move,'' said Joseph 
     M. Mecane of NYSE Euronext, which operates the New York Stock 
     Exchange. ``Markets need liquidity, and high-frequency 
     traders provide opportunities for other investors to buy and 
     sell.''
       The rise of high-frequency trading helps explain why 
     activity on the nation's stock exchanges has exploded. 
     Average daily volume has soared by 164 percent since 2005, 
     according to data from NYSE. Although precise figures are 
     elusive, stock exchanges say that a handful of high-frequency 
     traders now account for a more than half of all trades. To 
     understand this high-speed world, consider what happened when 
     slow-moving traders went up against high-frequency robots 
     earlier this month, and ended up handing spoils to lightning-
     fast computers.
       It was July 15, and Intel, the computer chip giant, had 
     reporting robust earnings the night before. Some investors, 
     smelling opportunity, set out to buy shares in the 
     semiconductor company Broadcom. (Their activities were 
     described by an investor at a major Wall Street firm who 
     spoke on the condition of anonymity to protect his job.) The 
     slower traders faced a quandary: If they sought to buy a 
     large number of shares at once, they would tip their hand and 
     risk driving up Broadcom's price. So, as is often the case on 
     Wall Street, they divided their orders into dozens of small 
     batches, hoping to cover their tracks. One second after the 
     market opened, shares of Broadcom started changing hands at 
     $26.20.
       The slower traders began issuing buy orders. But rather 
     than being shown to all potential sellers at the same time, 
     some of those orders were most likely routed to a collection 
     of high-frequency traders for just 30 milliseconds--0.03 
     seconds--in what are known as flash orders. While markets are 
     supposed to ensure transparency by showing orders to everyone 
     simultaneously, a loophole in regulations allows marketplaces 
     like Nasdaq to show traders some orders ahead of everyone 
     else in exchange for a fee.
       In less than half a second, high-frequency traders gained a 
     valuable insight: the hunger for Broadcom was growing. Their 
     computers began buying up Broadcom shares and then reselling 
     them to the slower investors at higher prices. The overall 
     price of Broadcom began to rise.
       Soon, thousands of orders began flooding the markets as 
     high-frequency software went into high gear. Automatic 
     programs began issuing and canceling tiny orders within 
     milliseconds to determine how much the slower traders were 
     willing to pay. The high-frequency computers quickly 
     determined that some investors' upper limit was $26.40. The 
     price shot to $26.39, and high-frequency programs began 
     offering to sell hundreds of thousands of shares.
       The result is that the slower-moving investors paid $1.4 
     million for about 56,000 shares, or $7,800 more than if they 
     had been able to move as quickly as the high-frequency 
     traders.
       Multiply such trades across thousands of stocks a day, and 
     the profits are substantial. High-frequency traders generated 
     about $21 billion in profits last year, the Tabb Group, a 
     research firm, estimates.
       ``You want to encourage innovation, and you want to reward 
     companies that have invested in technology and ideas that 
     make the markets more efficient,'' said Andrew M. Brooks, 
     head of United States equity trading at T. Rowe Price, a 
     mutual fund and investment company that often competes with 
     and uses high-frequency techniques. ``But we're moving toward 
     a two-tiered marketplace of the high-frequency arbitrage 
     guys, and everyone else. People want to know they have a 
     legitimate shot at getting a fair deal. Otherwise, the 
     markets lose their integrity.''

  Mr. KAUFMAN. Madam President, in America where all are created equal, 
Wall Street technology has permitted the powerful to exploit loopholes 
that make some investors now more equal than others.
  The most basic principle of a free market system is that anyone can 
transact goods at prices based on a free and open market, not based on 
some kind of insider status. These flash order practices fly in the 
face of Regulation NMS, which the SEC issued to guarantee that trades 
are executed at the best price as soon as orders become available. With 
flash orders, there doesn't seem to be any guarantee of this anymore.
  I call again for the SEC to act quickly to protect investors in four 
critical areas. First, we need to implement a rule that provides the 
substantive protections removed when the uptick rule was rescinded in 
2007.
  Second, the SEC must end naked short selling. No one should be able 
to short a stock unless they have located specified shares of stock and 
obtained a contractual claim to borrow the stock in time for delivery. 
The SEC's announcement yesterday of plans for more discussion does not 
accomplish this. We need concrete action soon by the SEC.
  Third, the SEC must prohibit the use of flash orders. No one--no 
one--should be permitted to use information asymmetry that permits 
high-speed computer trading to have an advantage over average 
investors.
  Finally, the SEC should establish disclosure and transparency 
equality. The disclosure requirements that apply to pooled funds worth 
greater than $100 million should apply uniformly to all, including 
hedge funds, for both long and short positions, and the level of 
transparency for order flows should be the same for all.
  I truly believe our new SEC chairman is focused on these issues and 
she is making progress on a number of fronts. But it is the job of 
Congress to urge regulators to fix problems. SEC Chairman Schapiro 
inherited an SEC that had made many mistakes. I respect the fact that 
Chairman Schapiro is working hard every day to right a foundered ship. 
The other commissioners are joining her in that task.

[[Page S8186]]

  In closing, I implore the SEC once again to act urgently to fulfill 
its core mission: protecting investors. The reason protecting investors 
is so important is that by doing so, the SEC ensures the credibility of 
the financial markets. If the SEC refuses to restore a level playing 
field to rebuild investor confidence in our market, then we in Congress 
will have to step in and do it ourselves.
  Protecting investors is too important to the Nation, to the integrity 
of our financial markets, and to our economic recovery. I say again 
that legitimate capital markets and arbitrage functions have value, 
like legitimate short-selling has value. But exploiting an unequal 
playing field only skims our Nation's wealth. It doesn't create wealth 
or value, except for a privileged few. That harms the integrity of our 
financial markets and, by doing so, threatens the very foundation of 
our economic well-being.
  As Americans, we must have faith in our institutions, both the 
markets and government, and we must believe that if we work hard and 
play by the rules, all will be treated equally. That is what is at 
stake. Our financial industry and capital markets can be a powerful 
engine for the American economy. But the SEC and Congress must work 
together to restore investor quality, integrity, and credibility of our 
financial markets.
  Mr. President, I yield the floor.
  The PRESIDING OFFICER (Mr. Udall of Colorado). The Senator from Ohio 
is recognized.
  Mr. BROWN. Mr. President, I thank Senator Kaufman for his bold 
advocacy on behalf of consumers and investors and for a better 
financial system.
  Mr. KAUFMAN. I thank the Senator.

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