[Senate Hearing 111-434]
[From the U.S. Government Publishing Office]
S. Hrg. 111-434
DARK POOLS, FLASH ORDERS, HIGH-FREQUENCY TRADING, AND OTHER MARKET
STRUCTURE ISSUES
=======================================================================
HEARING
before the
SUBCOMMITTEE ON
SECURITIES, INSURANCE, AND INVESTMENT
of the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED ELEVENTH CONGRESS
FIRST SESSION
ON
EXAMINING THE DARK POOLS, FLASH ORDERS, HIGH-FREQUENCY TRADING, AND
OTHER MARKET STRUCTURE ISSUES
__________
OCTOBER 28, 2009
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
Available at: http: //www.access.gpo.gov /congress /senate/
senate05sh.html
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56-562 PDF WASHINGTON : 2010
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
CHRISTOPHER J. DODD, Connecticut, Chairman
TIM JOHNSON, South Dakota RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York JIM BUNNING, Kentucky
EVAN BAYH, Indiana MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii JIM DeMINT, South Carolina
SHERROD BROWN, Ohio DAVID VITTER, Louisiana
JON TESTER, Montana MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin KAY BAILEY HUTCHISON, Texas
MARK R. WARNER, Virginia JUDD GREGG, New Hampshire
JEFF MERKLEY, Oregon
MICHAEL F. BENNET, Colorado
Edward Silverman, Staff Director
William D. Duhnke, Republican Staff Director
Dawn Ratliff, Chief Clerk
Devin Hartley, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
______
Subcommittee on Securities, Insurance, and Investment
JACK REED, Rhode Island, Chairman
JIM BUNNING, Kentucky, Ranking Republican Member
TIM JOHNSON, South Dakota JUDD GREGG, New Hampshire
CHARLES E. SCHUMER, New York ROBERT F. BENNETT, Utah
EVAN BAYH, Indiana MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii DAVID VITTER, Louisiana
SHERROD BROWN, Ohio MIKE JOHANNS, Nebraska
MARK R. WARNER, Virginia
MICHAEL F. BENNET, Colorado
CHRISTOPHER J. DODD, Connecticut
Kara M. Stein, Subcommittee Staff Director
William Henderson, Republican Subcommittee Staff Director
Randy Fasnacht, GAO Detailee
(ii)
C O N T E N T S
----------
WEDNESDAY, OCTOBER 28, 2009
Page
Opening statement of Chairman Reed............................... 1
Prepared statement........................................... 44
Opening statements, comments, or prepared statements of:
Senator Bunning.............................................. 2
Prepared statement....................................... 44
WITNESSES
Edward E. Kaufman, Senator from the State of Delaware............ 3
Prepared statement........................................... 45
James Brigagliano, Coacting Director, Division of Trading and
Markets, Securities and Exchange Commission.................... 7
Prepared statement........................................... 57
Responses to written questions of:
Senator Menendez......................................... 90
Senator Vitter........................................... 91
Frank Hatheway, Senior Vice President and Chief Economist, NASDAQ
OMX............................................................ 8
Prepared statement........................................... 61
William O'Brien, Chief Executive Officer, Direct Edge............ 10
Prepared statement........................................... 63
Christopher Nagy, Managing Director of Order Routing Sales and
Strategy, TD Ameritrade........................................ 13
Prepared statement........................................... 65
Daniel Mathisson, Managing Director and Head of Advanced
Execution Services, Credit Suisse.............................. 14
Prepared statement........................................... 67
Robert C. Gasser, President and Chief Executive Officer,
Investment Technology Group.................................... 16
Prepared statement........................................... 71
Peter Driscoll, Chairman, Security Traders Association........... 18
Prepared statement........................................... 84
Responses to written questions of:
Senator Bunning.......................................... 93
Adam C. Sussman, Director of Research, TABB Group................ 20
Prepared statement........................................... 88
Additional Material Supplied for the Record
Statement submitted by Larry Leibowitz, Group Executive Vice
President and Head of U.S. Execution and Global Technology for
NYSE Euronext.................................................. 94
Statement submitted by Thomas M. Joyce, Chairman and Chief
Executive Officer, Knight Capital Group, Inc................... 100
Statement submitted by the Investment Company Institute.......... 107
(iii)
DARK POOLS, FLASH ORDERS, HIGH-FREQUENCY TRADING, AND OTHER MARKET
STRUCTURE ISSUES
----------
WEDNESDAY, OCTOBER 28, 2009
U.S. Senate,
Subcommittee on Securities, Insurance, and Investment,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Subcommittee met at 9:32 a.m., in room SD-538, Dirksen
Senate Office Building, Senator Jack Reed (Chairman of the
Subcommittee) presiding.
OPENING STATEMENT OF CHAIRMAN JACK REED
Chairman Reed. Let me call the hearing to order, and I want
to begin by welcoming my friend and colleague, Senator Ted
Kaufman. Ted has spent a considerable amount of time examining
some of these cutting-edge issues facing increasingly high-tech
capital markets. And I also want to welcome the witnesses who
will join us for the second panel.
As many families struggle to regain their footing, stay in
their homes, and keep their jobs in the wake of a severe
recession caused by reckless profit seeking on Wall Street, it
is appropriate and timely to meet today to ask questions about
the role of technology in our financial markets. Today's
hearing is a check-up on our equity markets amid concerns that
technological developments in recent years may be
disadvantaging certain investors.
Electronic trading has evolved dramatically over the last
decade, and it is important that regulators keep up. For
example, trading technology today is measured not in seconds or
even milliseconds, but it in microseconds, or one-millionth of
a second. So even a sneak peek of a fraction of a second using
what is called a ``flash order'' may give some market
participants a significant advantage.
Our hearing will take a closer look at such flash orders,
along with other market structure issues such as dark pools,
which are private trading systems that do not display quotes
publicly; and high-frequency trading, a lightning-fast
computer-based trading technique.
According to the SEC, the overall proportion of displayed
market segments, those that display quotations to the public,
has remained steady over time at approximately 75 percent of
the market. However, undisplayed liquidity has shifted from
taking place on the floor of the exchanges or between
investment banks to what are currently known as ``dark pools,''
with the number of such pools increasing from approximately 10
in 2002 to approximately 29 in 2009. Dark pools today account
for about 7.2 percent of the total share of stock volume.
Dark pools and other undisplayed forms of liquidity have
been considered useful to investors moving large numbers of
shares since it allows them to trade large blocks of shares of
stock without giving others information to buy or sell ahead of
time.
However, some critics of dark pools argue that this has
created a two-tiered market in which only some investors in
dark pools, but not the general public, have information about
the best available prices. The SEC has recently proposed
changes in this area to bring greater transparency to these
pools.
Flash orders and high-frequency trading have also raised
concerns. Flash orders, which enable investors who are not
publicly displaying quotes to see orders before other
investors, have raised questions about fairness in the markets,
and the SEC has recently proposed to ban them. High-frequency
trading, a much more common technique used extensively
throughout the markets, is the buying and selling of stock at
extremely fast speeds with the help of powerful computers. This
activity has raised concerns that some market participants are
able to game the system using repeated and lightning-fast
orders to quickly identify other traders' positions and take
advantage of that information, potentially disadvantaging
retail investors.
Other investors argue that the practice has significantly
increased liquidity in the markets, improved price discovery,
and reduced spreads, and that high-frequency trading is being
used by all types of investors.
Today's hearing will help to answer some important
questions about these issues. Have recent developments helped
or hurt the average investor? How have these developments
impacted the average household's ability to save for college
and retirement? What risks must we be vigilant about in how we
structure and operate our markets going forward?
I have asked today's witnesses to discuss the potential
benefits and drawbacks of dark pools and other undisplayed
quotes now used and historically used in our markets. I have
also asked them to talk about flash orders and high-frequency
trading.
Finally, as the SEC has recently taken steps to ban flash
orders and increase transparency in dark pools, we will hear
perspectives on the SEC's actions and ask our panelists what
additional legislative or regulatory changes, if any, are
needed to protect retail investors and ensure fair markets.
And now let me recognize the Ranking Member, Senator
Bunning.
STATEMENT OF SENATOR JIM BUNNING
Senator Bunning. Thank you, Mr. Chairman. I think this will
be an educational hearing about several complex topics that
have been in the news lately.
A lot of things have changed in the security market since I
sat at a trading desk. Just about all trades take place over
computers now. Trading used to be done over the phone or in
person. There are many more stocks and other securities traded
now, just as there are many more investors.
But even though the technology and the amount of money
changing hands has changed, a lot is still the same. Investors
are still looking for the best price, and traders are still
using every tool they can to get an edge. And there is always
someone trying to make a quick buck off the unsophisticated or
uninformed or even through manipulation and fraud.
Historically, the way we have tried to make our markets
safer and fairer is by increasing transparency and access, and
I think that it has worked. But in order for those principles
to continue to work, the SEC must stay on top of the changing
markets and update its rules as necessary. I am glad to see the
Commission is reviewing its market structure rules, and I hope
it does not limit those reviews to just topics that have been
covered in the news.
I also hope the Commission will let this Committee know if
there are any gaps in its authority that we need to fill so any
market structure can be properly addressed.
Thank you, Mr. Chairman. I am looking forward to hearing
from our witnesses.
Chairman Reed. Thank you very much, Senator Bunning.
Senator Johanns.
Senator Johanns. I am going to pass on an opening
statement.
Chairman Reed. Senator Corker.
Senator Corker. I do not make opening statements. I would
like the Senator to realize that Republicans are here to listen
to him and Democrats are not, whatever that means.
[Laughter.]
Chairman Reed. We have heard a lot from him.
Senator Gregg.
Senator Gregg. [Inaudible.]
[Laughter.]
Chairman Reed. And now it is my privilege to introduce
Senator Kaufman. Senator Kaufman is recognized as the chief of
staff for Senator Joe Biden for 19 years, but he has also been
teaching at Duke University, courses in Congress for 18 years,
and he has been a member of the board of Broadcasting Board of
Governors for 13 years, and he has trained as an engineer at
the University of Pennsylvania and has an MBA from the Wharton
School. And before he started working for the Vice President,
he worked for DuPont, which I think brought him to Delaware, or
kept him in Delaware. So I am very happy to have him here this
morning.
Senator Kaufman.
STATEMENT OF EDWARD E. KAUFMAN, SENATOR FROM THE STATE OF
DELAWARE
Senator Kaufman. Thank you. Thank you, Chairman Reed and
Senator Bunning, and I want to thank my Republican friends for
showing up for my presentation.
I want to thank you. This is a very important hearing, and
I think both your opening statements from my standpoint were
excellent in terms of pointing out some of the things that we
have to deal with. And I hardly think there are many things
that we have to deal with at a time when we are dealing with so
many important things that are really much more important than
what is going to happen in this Committee.
I want to keep my remarks brief, but I have a longer
statement I would like to submit for the record.
Chairman Reed. Without objection, all statements will be
made part of the record.
Senator Kaufman. Mr. Chairman, our stock markets have
evolved rapidly over the past few years, as Ranking Member
Bunning said, in ways that raise important questions for this
hearing to explore. Technological developments have far
outpaced--far outpaced--regulatory oversight, and traders who
buy and sell stocks in milliseconds--capitalizing everywhere on
very small price differential in a highly fragmented
marketplace--now predominate over value investors. Liquidity as
an end seems to have trumped the need for transparency and
fairness. We risk creating a two-tiered market that is opaque,
highly fragmented, and unfair to long-term investors.
I am very concerned that only timely and effective
examination, such as what this Committee is going through,
which leads to clear and enforceable rules can maintain the
integrity of U.S. capital markets, which we all know is an
essential component of our Nation's success.
It was the repeal of the uptick rule by the SEC in 2007
which first brought my attention to this issue. When I was at
Wharton getting my MBA in the mid-1960s, the uptick rule was
considered a cornerstone of market regulation. As many on the
Subcommittee have noted, the uptick rule's repeal made it
easier for bear traders, bear raider traders--no longer
constrained to wait for an uptick in price between each short
sale--to help bring down--this activity, I am convinced, helped
to bring down Lehman Brothers and Bear Stearns in their final
days.
In April, Senators Isakson, Tester, Specter, Chambliss, and
I introduced a bill prodding the SEC to reinstate the rule. As
the months have gone by, I have asked myself: Why is it so
difficult for the SEC to mandate some version of the uptick
rule and impose ``hard locate'' requirements to stop naked
short selling? That is not what this hearing is about today,
but that is what got me interested. Why has it taken them so
long to do it? And that is how I got interested in the issues
that you are going to deal with today. It became clear to me
that none of the high-frequency traders who now dominate the
market, almost 70 percent of the market, want to reprogram
their computer algorithms to wait for an uptick in price or to
obtain a ``hard locate'' of available underlying shares. That
means basically selling something they do not have, have not
borrowed, and do not own. Something that is kind of basic to
our markets, you have to own what you are selling.
I began to hear from many on Wall Street and other experts
concerned about a host of questionable practices, all connected
to the decimalization and digitalization of the market and the
resulting surge in electronic trading activity. I am not
opposed to electronic trading, but I think we need to take a
hard look at what is going on here. It became clear to me that
the SEC staff was considering issues piecemeal--like the rise
of flash orders, which was in your statements--without taking a
holistic view of the market's overall structure, applying rules
from a floor-based trading era--and Senator Bunning was on the
trading floor--to the current electronic trading venues in ways
that are clearly questionable.
The facts speak for themselves. We have gone from an era
dominated by a duopoly of the New York Stock Exchange and
NASDAQ to a highly fragmented market of more than 60 trading
centers. Dark pools, which allow confidential trading away from
the public eye, have flourished, growing from 1.5 percent to 12
percent of market trades in under 5 years.
Competition for orders is intense and increasingly
problematic. Flash orders, liquidity rebates, direct access
granted to hedge funds by the exchanges, dark pools,
indications of interest, and payment for order flow are each a
consequence of these 60 centers all competing for market share.
Moreover, in just a few short years, high-frequency
trading--which feeds everywhere on small price differences in
many fragmented trading venues--has skyrocketed from 30 percent
to 70 percent of daily volume. Indeed, the chief executive of
one of the country's biggest block traders in dark pools was
quoted last week as saying that the amount of money devoted to
high-frequency trading could, and I quote, ``quintuple between
this year and next.''
So I am pleased that the Securities and Exchange Commission
has begun to address flash orders and dark pools.
Let me quickly lay out three reasons why this hearing is so
important:
First, we must avoid systemic risk to the markets. Our
recent history teaches us that when markets develop too
rapidly, when they are not transparent, effectively regulated,
or fair, a breakdown can trigger disaster.
Second, while rapid advances in technology can produce
impressive results, they are combined with market fragmentation
in ways that are moving us from an investor's market to a
trader's market.
Third, we must ensure that retail investors are not
relegated to second-tier status. Let me repeat that. Third, we
must ensure that retail investors are not relegated to second-
tier status. The markets should work best for those who want to
buy and hold in hopes of a golden retirement, not just for
high-frequency traders who want to buy and sell in
milliseconds.
As SEC Chair Schapiro acknowledged just yesterday, and I
quote, ``I believe we need a deeper understanding of the
strategies and activities of high-frequency markets and traders
and the potential impact on our markets and investors of so
many transactions occurring so quickly.''
Technology should not dictate our regulatory destiny;
rather, our regulatory policy should provide the framework and
guidelines under which technology operates. As values,
transparency and fairness must always trump liquidity. Our
foremost policy goal must be to restore the markets to their
highest and best purposes. Serving the interests of long-term
investors, establishing prices that allocate resources to their
most productive uses, and enabling companies--large and small--
to raise capital to innovate, create jobs, and grow.
Thank you, Mr. Chairman.
Chairman Reed. Thank you, Senator Kaufman.
Do my colleagues have any questions?
Senator Corker. Out of courtesy, I will not ask any, but
thank you so much for the testimony.
[Laughter.]
Senator Kaufman. Thank you.
Chairman Reed. Senator Corker always says the right thing.
He is just impeccable. Thank you, Senator Kaufman, for your
testimony.
Senator Kaufman. Thank you.
Chairman Reed. I would call up the second panel.
[Pause.]
Chairman Reed. We appreciate your interest in this topic,
and we thank you for being here today. All of your statements
will be made part of the record, so there is no need to simply
read the statement. And I ask you to keep your remarks to 5
minutes so that we can get to questioning pretty quickly. That
is 40 minutes this way, as Senator Bunning points out. Let me
introduce the panelists and then ask them to begin their
testimony.
Our first witness is Mr. James Brigagliano, Coacting
Director of the Division of Trading and Markets at the
Securities and Exchange Commission. In that capacity, he shares
responsibility for the regulation and oversight of securities
firms, clearing organizations, and the United States securities
markets. Prior to joining the Division of Trading and Markets,
Mr. Brigagliano was an assistant general counsel for litigation
in the Commission's Office of the General Counsel and began his
career in private practice in New York. Thank you.
Our next witness is Dr. Frank Hatheway, and he is the
Senior Vice President and Chief Economist at NASDAQ OMX, where
he is responsible for a variety of initiatives related to the
company's global markets and market structure. Prior to joining
NASDAQ OMX, Dr. Hatheway was a finance professor at Penn State
University, and he has served as an economic fellow and senior
research scholar with the U.S. Securities and Exchange
Commission. Thank you.
Mr. William O'Brien is the Chief Executive Officer of
Direct Edge, a large U.S. stock market that currently operates
as an electronic communications network, a type of alternative
trading facility. Prior to joining Direct Edge, Mr. O'Brien
held senior management positions at the NASDAQ stock market and
Brut ECN.
Our next witness is Mr. Christopher Nagy. He is the
Managing Director of Order Routing Sales and Strategy at TD
Ameritrade. As such, he is responsible for developing and
implementing best execution and order routing strategy for the
company. With more than 20 years in the securities industry, he
has also worked with NASDAQ Quality of Markets Committee, QMC,
the Securities Trade Association Trading Issues Committee, the
Options Industry Council Roundtable, among others. Thank you,
Mr. Nagy.
Mr. Dan Mathisson is a Managing Director and Head of
Advanced Execution Services at the Investment Banking Division
of Credit Suisse. Mr. Mathisson joined Credit Suisse in 2000 as
a Director of Index Arbitrage. Prior to that, he was the head
of Equity Trading at D.E. Shaw, a quantitative hedge fund based
in New York.
Mr. Bob Gasser is the Chief Executive Officer and President
of the Investment Technology Group. Mr. Gasser was previously
CEO at NYFIX, Inc., a global electronic trading execution firm.
Before NYFIX, Mr. Gasser was head of U.S. Equity Trading at
JPMorgan. Concurrently, Mr. Gasser served on the Board of
Directors of Archipelago Exchange as well as on the NASDAQ
Quality of Markets Committee and the New York Stock Exchange
Upstairs Traders Advisory Committee.
Mr. Peter Driscoll is the Chairman of the Security Traders
Association as well as the Chair of the Executive Committee and
Cochair of its Washington Committee. He is also a member of the
NASDAQ Institutional Advisory Council. Mr. Driscoll is also a
Vice President and Senior Equity Trader at the Northern Trust
Company in Chicago, Illinois, which he joined in 2000. Prior to
joining Northern Trust, he worked on the floor of the Chicago
Stock Exchange from 1975 to 2000, the last 10 years of which he
served as the President of Driscoll Trading Group, an
institutional floor brokerage firm.
Our final witness is Mr. Adam Sussman, the Director of
Research at TABB Group. Mr. Sussman joined the firm in 2004 as
a senior analyst, serving as the senior product manager
responsible for order management systems, routing, and next-
generation trading tools focused on the equities and options
markets at Ameritrade, a brokerage industry subsidiary of
Ameritrade Holding Corporation.
Thank you, gentlemen, and now, Mr. Brigagliano, please
begin.
STATEMENT OF JAMES BRIGAGLIANO, COACTING DIRECTOR, DIVISION OF
TRADING AND MARKETS, SECURITIES AND EXCHANGE COMMISSION
Mr. Brigagliano. Thank you, Chairman Reed, Ranking Member
Bunning, and Members of the Subcommittee, for giving me the
opportunity to speak to you today about the U.S. equity markets
on behalf of the Securities and Exchange Commission.
The Commission currently is taking a broad and critical
looking at market structure practices in light of the rapid
developments in trading technology and strategies. In
September, the Commission proposed to prohibit the practice of
flashing marketable orders. In general, flash orders are
communicated to certain market participants and either executed
immediately or withdrawn immediately after communication. Flash
orders are exempt from the Exchange Act's quoting requirements
as the result of an exemption formulated when most trading took
place on the floors of the exchanges.
The Commission is concerned that the exception for flash
orders from Exchange Act quoting requirements is no longer
necessary or appropriate in today's highly automated trading
environment.
The flashing of order information could lead to a two-
tiered market in which the public does not have access, through
the consolidated quotation data streams, to information about
the best available prices for U.S.-listed securities that is
available to some market participants through proprietary data
feeds.
Last week, the Commission made additional proposals related
to dark pools. The first proposal would require actionable
indications of interest to be subject to the same disclosure
rules that apply to quotations. The second proposal would lower
the automated trading system, or ATS, trading volume threshold
for displaying best-priced orders in the consolidated quote
stream. Taken together, these changes would help make the
information conveyed by actionable IOIs, by dark pools and
others, available to the public instead of just to a select
group. At the same time, both proposals would exclude from
their requirements certain narrowly targeted IOIs related to
large orders.
The Commission also proposed to create a similar level of
post-trade transparency for ATSs, including dark pools, as
exist for registered exchanges. Specifically, the proposal
would require real-time disclosure of the identity of dark
pools and other ATSs on the public reports of their executed
trades.
But these steps are just the beginning. Over the coming
months, I anticipate that the Commission will consider
additional issues relating to dark liquidity more broadly,
perhaps by issuing a concept release.
Another practice that is being examined by Commission staff
is high-frequency trading. While the term lacks a clear
definition, it generally involves a trading strategy where
there are a large number of orders and also a large number of
cancellations--often in subseconds--and moving into and out of
positions many times in a single day.
High-frequency trading plays a significant role in today's
markets by providing a large percentage of the displayed
liquidity that is available on the registered securities
exchanges and other public markets. Many are concerned,
however, that high-frequency trading can be harmful, depending
on the trading strategies used, both to the quality of markets
and the interests of long-term investors.
We are also exploring ways to assure that the Commission
has better baseline information about high-frequency traders
and their trading activity. This would help to enhance the
Commission's ability to identify large and high-frequency
traders and their affiliates.
Another market structure issue that the Commission staff is
exploring is sponsored access--also known as ``direct market
access'' or ``DMA''--where the broker-dealer members of an
exchange allow nonmembers--in many cases, high-frequency
traders--to trade on that exchange under their name. Sponsored
access raises concerns about whether sponsoring broker-dealers
impose appropriate and effective controls on sponsored access
to fully protect themselves and the markets from financial risk
and to assure compliance with all regulatory requirements. In
evaluating these market structure issues, the Commission is
focused on the protection of investors, maintaining fair,
orderly, and efficient markets, and facilitating capital
formation.
Thank you for giving me the opportunity to speak to you
today. I am happy to answer any questions you may have.
Chairman Reed. Thank you very much.
Dr. Hatheway.
STATEMENT OF FRANK HATHEWAY, SENIOR VICE PRESIDENT AND CHIEF
ECONOMIST, NASDAQ OMX
Dr. Hatheway. Good morning, Chairman Reed, Ranking Member
Bunning, and Members of the Subcommittee. Thank you for the
opportunity to offer my perspectives on recent developments in
U.S. equities markets. I speak as an economist who has studied
equities markets for several decades from multiple vantage
points--as an options trader on the floor of the Philadelphia
Stock Exchange, as a professor at Penn State, as an Economic
Fellow at the SEC, and, currently, as NASDAQ's Chief Economist.
The topics before us--dark pools, high-frequency trading,
flash orders--represent transformations of the market from an
environment where the predecessors of these practices were
carried out between people rather than in their current
computerized guise. The fundamental economics of these
practices are not new. Similarly, the debate over the
appropriateness of the latest technology is only new in the
sense that the specific technology and the speed at which it
operates is new, not the issue of replacing slow with fast or
old with new.
As an economist, my remarks are going to focus on what
makes a good market, focus on the market as a whole, not on an
order-by-order basis or broker-by-broker basis. And because
these innovations in the market have historical precedence, we
can look at historical criteria for a good market.
A good market is one that maximizes price discovery. That
means you bring supply and demand together at a single point.
That is what we do as an exchange. We produce information about
the price. And markets do this at their best when they are
open, when they are transparent and offer everyone a level
playing field.
The components that tend to make up a good market are a
market that encourages innovation and competition--competition
between exchanges and nonexchanges using the best technology
available to execute trades at the right price, quickly,
cheaply. Automation of trading for clients and market makers
has made this process much more efficient than it was in 1984
when I started. Fair and equal access is also important. The
markets should reflect everyone's supply and demand.
In 1997, order handling rules ended a two-tier market that
existed on NASDAQ and greatly democratized the markets,
ultimately taking control of price setting away from market
makers and specialists and giving it to everyone who is
interested in participating in the market.
Sound regulation is a final critical component. Markets
will be rational when trading rules are clear and fair,
rigorously enforced, with strong surveillance and compliance.
And in my opinion, the best way to do this, to establish an
effective market, is to emphasize public orders over private,
investors over professionals, a market structure that sets the
best possible benchmark by which everyone will trade, a market
that facilitates price discovery.
There are negatives to dark pools, and by dark pools, I
will use the same definition as Chairman Reed did in his
opening statement, that this is a market that does not offer
information about its quotes. There are going to probably be
different definitions of that today. In economic terms, there
is no pretrade transparency into the market. These markets have
the potential to isolate limit orders and potentially widen
spreads and hurt market quality. As SEC Commissioner Walter
wisely said, ``Every share that gets executed in the dark does
not contribute fully to price discovery. The question becomes
how many dark shares are too many and do I think there is a
problem today.''
Dark trading has increased in the U.S. over the last year
and a half, 2 years, potentially 5 to 10 percentage points
across the board. We began looking at this by looking at three
NASDAQ-listed Dow stocks: Microsoft, Intel, Cisco. They
experienced a steady increase in dark trading and a steady
deterioration in their quoted spread, in the benchmark that
people use to monitor prices.
Turning from anecdotes, we looked broadly at all the stocks
that trade on the NYSE and on NASDAQ. Controlling for factors
of influence and spread, we came to a similar conclusion: that
as dark trading approaches 35 or 40 percent of volume for
active stocks, the deterioration in spread quality becomes
increasingly material, on the order of fractions of a cent--
three-tenths of a cent to half a cent--but given the narrowness
of spreads in today's efficient markets, that is a 10- to 15-
percent increase in the width of the benchmark.
Collectively, darkness is harming the market. Individually,
dark pools have value. Negotiation is critical for large block
orders and always has been. Broker-dealers do this with skill,
with capital, and with technology, and need to continue to do
so. But these orders need a robust public quote to serve as a
benchmark. We support the SEC proposals to reposition dark
pools to require public display of actionable IOIs when volume
crosses a certain threshold and also to exempt blocks. The SEC
proposal prioritizes the public market, transparency,
competition, and fair access.
Turning to other topics, we support banning flash orders.
We also believe that dark pools and flash orders are wrongly
confused with high-frequency trading and algorithmic trading.
High-frequency trading and algorithmic trading is automation.
It improves efficiency and improves price discovery. It brings
competition, fair and equal access to the market, and we do not
want to step away from those goals. The market should be open,
transparent, competitive, and well regulated. That is what
serves investors. Technology employed today means speed and
efficiency. We should keep it.
Thank you very much, and I look forward to your questions.
Chairman Reed. Thank you very much, Doctor.
Mr. O'Brien, please.
STATEMENT OF WILLIAM O'BRIEN, CHIEF EXECUTIVE OFFICER, DIRECT
EDGE
Mr. O'Brien. Chairman Reed, Ranking Member Bunning, Members
of the Subcommittee, I would like to thank you for the
opportunity to testify today on behalf of Direct Edge, the
Nation's third largest stock market.
Over the past 2 years, our share of U.S. stock trading has
risen from under 1 percent to approximately 12 percent because
we have innovated in response to a changing market structure to
deliver better solutions for our customers and their customers,
the Nation's investors. Certain of these changes have triggered
a debate over the past several months regarding the structural
integrity of our markets, which is now at a critical juncture.
In this regard, the work of the Subcommittee to hold this
hearing is both very timely and very valuable.
I believe that through careful examination, appropriate
regulatory protections can be preserved without taking steps
that would ultimately undermine investor confidence by
restricting innovation, competition, or efficiency. I like to
structure that belief by offering some guiding principles
toward any shape market structure reform should take so we can
deal with what really matters, improving our Nation's stock
market for the benefit of investors.
First, current market structure is fundamentally fair and
sound. By every quantitative and qualitative measure, the U.S.
cash equities market serves as a model for the entire world,
performing as well as it ever has in terms of liquidity,
implicit and explicit transaction costs, and transparency.
During the worst financial crisis of our lifetimes, the U.S.
equity market operated efficiently, while markets for certain
other financial instruments, such as auction-rate securities,
mortgage-backed securities, virtually ceased to operate. Recent
developments have not materially eroded the efficiency of our
marketplace.
While the evolution of technology, functionality, and the
economics of trading require everyone to adapt, that alone
should not be the root reason for market structure reform.
Trends and changes always require a continual analysis of how
regulation needs to respond, but this should not be confused
with a broader need to re-architect our market due to any
fundamental flaw or unfairness.
Second, high-frequency trading and technology are valuable
components of current modern market structure. The innovation
and efficiency that technology has brought to stock trading
inures to the benefit of every American investor. When
decimalization, trading in pennies, came to the markets in
April 2001, there was a near total evaporation of traditional
capital commitment, with market makers far less willing to
provide competitive bids and offers as spreads narrowed. Firms
willing and able to adapt to this reality, along with new
competitors, rose in their place with business models
predicated on extremely efficient use of technology to
facilitate our markets.
The benefits of high-tech trading continue to this day in
several forms, including more efficient price discovery, lower
investor costs, and greater competition, which benefit all
investors. All brokers have, in some form, adapted high-
frequency technology, to the point that retail investors can
have their orders executed in under a second via the Internet
from anywhere on the planet.
As with the technological transformation of any market,
issues have emerged which warrant close examination and likely
new regulation. High-frequency trading strategies are now
pursued by unregulated entities who have been given broker-like
access to exchanges without adequate controls of the compliance
or systemic risks, often called naked access. Exchange products
that offer a direct presence at exchange data and trading
facilities, called colocation, need to be regulated in a manner
as transparent as all other fees. But any evaluation of these
issues should start from a productive vantage point that, when
well regulated, high-frequency trading and technology are
generally healthy and positive.
Second, exchanges aren't always the best place to execute a
trade. The over-the-counter and the exchange markets have
operated side-by-side for over 30 years to the great benefit of
retail and institutional investors. There are many legitimate
economic, execution quality, and policy reasons why investors
and their agents seek an off-exchange execution through a dark
pool, a market maker, or other means. Exchanges do play a
critical role in providing pretrade transparency and price
discovery and that benefits those who tradeoff-exchange. If the
level of that activity were to drop precipitously below
historical norms, a greater examination probably would be
necessary, but we are simply not near that point.
To keep exchanges relevant as central hubs of trading
interest, however, we need to pursue regulation that doesn't
drive the exchange markets and nonexchange markets further
apart. Direct Edge pioneered the use of flash order technology
precisely to bring retail and other investors access to dark
pools that they previously had never had access to. This is
what any good exchange does, bringing as many buyers and
sellers together in a way that makes sense for all concerned.
True inequities can and should be eliminated, and we
applaud the thoughtful approach the Securities and Exchange
Commission has taken on this topic to date. But undue focus on
optional esoteric order types at the expense of ignoring the
broader trends that motivate customers to use these tactics, at
a minimum, provide only false comfort to investors and
potentially leave them more at risk than ever before.
Fourth, brokers are those best equipped to decide how to
execute customer orders. Every order type offers a range of
explicit-implicit costs and other features. Brokers are best
suited to decide how to use the tools that exchanges provide in
executing their orders. Delegation of this responsibility by an
investor to their broker is a cornerstone of our capital
markets. While each broker brings their own perspective and
execution strategy to the table, investors are free to choose
among scores of reputable brokers with data that is better than
ever before.
Fifth, equal access prevents two-tiered markets. The
broader range of technologies and products that brokers have at
their disposal is greater than ever. Every broker does not do
everything the same way, at the same speed, or with the same
resources. Brokers choose which exchanges to be members of and
which products of those exchanges to use. Investors participate
by choosing their broker and choosing the level of self-
direction they engage in. When a broker elects to use a certain
functionality, it does not imply that those who do not are
somehow unfairly disadvantaged. Markets do need to be
fundamentally fair, but that is not achieved on the basis of
attempting to mandate that everyone has substandard but equal
capabilities.
Sixth, in debating the need for reform, a data-driven
approach is optimal. The National Market System Amendments of
1975, the Order Handling Rules, and Reg NMS were all successful
because of their comprehensive approach. When considering
market structure reform, a big picture approach that values
objective data over subjective intuition or allegation is
highly preferable. To do otherwise could alter a market
structure that is generally performing well without adequate
basis for believing that improvements will make it even better.
Our stock market is the model for the entire world because
we anticipate and implement change better than anyone, and
adapting regulation is a key element of that. If we can address
these outstanding issues in a constructive fashion, we will
have provided a strong structural foundation for our Nation's
economic recovery to be realized upon.
Thank you for the opportunity, and again, I look forward to
your questions.
Chairman Reed. Thank you very much.
Mr. Nagy.
STATEMENT OF CHRISTOPHER NAGY, MANAGING DIRECTOR OF ORDER
ROUTING SALES AND STRATEGY, TD AMERITRADE
Mr. Nagy. Chairman Reed, Ranking Member Bunning, and
Members of the Subcommittee, thank you for allowing me the
opportunity to testify on equity market structure.
I am Chris Nagy, Managing Director of Routing Strategy with
TD Ameritrade. TD Ameritrade, based in Omaha, Nebraska, was
founded in 1975 and was one of the first firms to offer
negotiated commissions to individual investors. Over the course
of the next three decades, TD Ameritrade pioneered
technological changes, such as touchtone telephone trading and
Internet investing, to make access by individual investors more
accessible, affordable and transparent. TD Ameritrade has long
advocated for market structures that create transparency,
promote competition, and reduce trading costs for individual
investors.
As technology rapidly advances, it is ever more important
that the SEC complete a comprehensive review of the national
market system to ensure individual investors are not adversely
impacted. At the same time, regulation has the potential to
result in unintended consequences, making it critically
important that rulemaking be based on empirical data and
reasoned analysis.
Our Nation's stock markets have evolved dramatically over
the course of the last decade. In 2001, the average individual
investor transaction took upwards of 18 seconds to receive an
execution, while today that same transaction is done in less
than 1 second. These changes have been driven primarily by
technological innovation, but also in response to carefully
crafted regulations.
In addition, the move to decimalization early in the decade
reduced spreads by up to five-and-a-quarter cents, whose
benefits went largely into the pocketbooks of individual
investors.
In fact, today, the individual investor enjoys superior
pricing, lightening fast trade execution, fulfillment, and
ample liquidity in the markets. At no other point in the
history of the markets has the individual investor been closer
in terms of pricing to that of the institutional trader.
Variations of dark pools have been in our markets for
decades, taking on various forms from a broker taking an order
over the phone to a floor broker acting as agent. When
Regulation NMS was enacted in 2005, exemptions to the display
rule were granted, spawning the creation of the modern day
electronic dark pool. This market dynamic has given rise to
well over 40 alternative trading systems, transacting by some
estimates upwards of 35 percent of all stock market orders each
day.
Retail clients have little ability to react or interact
with these pools of liquidity. The irony is that dark orders
receive their pricing from the transparent exchanges where the
retail clients are. In many ways, dark pools are an excellent
example of a two-tiered market that gives institutional traders
a way to use retail order flow to their own benefit.
While the benefits of dark pools to reduce overall market
impact are there, serious questions need to be asked if we have
reached the tipping point. Conversely, innovative strategies
that promote efficiency and reduce investor costs in the
markets are critical if we are going to continue to level the
playing field for individual investors.
There has been much fanfare that flash trading is harmful
to retail investors. However, little data is offered to back
these claims. Defenders of flash argue that it allows users to
lower transaction costs and obtain better prices in the both
equity and options marketplaces. Although TD Ameritrade can
find no evidence that flash trading harms individual investors,
our firm believes that flash is a symptom of our current market
structure, and in many ways the perception that it is unfair
and predatory became the reality.
As we embark on an overhaul of our Nation's markets, it is
imperative that we continue to provide a low-cost, competitive
infrastructure that ensures individual investors have low
barriers to entry, which in turn promote investor confidence.
We must, however, ask if we have reached the tipping point with
an excess of alternative trading systems.
Interestingly, we can draw insight from a very different
yet similar circumstance. During the Great Depression, there
was an overabundance of taxi drivers, which reduced driver
earnings and congested city streets. To address the issue and
restore proper balance, the Medallion system was created,
placing a moratorium on the issuance of taxicab licenses. This
system created the proper balance of taxis while not crowding
the city streets.
In today's markets, as we emerge from the recent market
downturn, one must question if we have too many taxis
fragmenting our streets of liquidity. We should seek a solution
to provide competition in our markets without an over-surplus
of trading systems.
I appreciate the opportunity to appear before the
Subcommittee, not only on behalf of TD Ameritrade, but more
importantly, on behalf of our clients' individual investors.
Thank you.
Chairman Reed. Thank you very much.
Mr. Mathisson, please.
STATEMENT OF DANIEL MATHISSON, MANAGING DIRECTOR AND HEAD OF
ADVANCED EXECUTION SERVICES, CREDIT SUISSE
Mr. Mathisson. Good morning and thank you, Chairman Reed,
Ranking Member Bunning, and Members of the Subcommittee for
giving me the opportunity to share my views on the best
structure for our Nation's stock market.
My name is Dan Mathisson. I am the Managing Director at
Credit Suisse. The U.S. subsidiary of Credit Suisse, which is
formerly known as First Boston, has been operating continuously
in the United States since 1932. I run a unit called Advanced
Execution Services, which is a team of approximately 200
financial and technology professionals headquartered in New
York. We execute trades electronically on behalf of mutual
funds, pension funds, hedge funds, and other broker-dealers.
Credit Suisse trades approximately 1.2 billion shares a day, or
about one out of seven shares traded in the U.S. this year. We
also own and operate the largest dark pool by volume, which is
called Crossfinder.
On the topic of dark pools, we believe that despite their
unfortunate name, dark pools are beneficial to long-term
investors and occupy an important niche within our market
structure. We believe investors have a right to remain silent
and that dark pools merely automate a trading methodology that
has always existed.
We believe that much of the debate over dark pools has not
been properly focused. Long-term investors typically make
decisions based on corporate fundamentals, while short-term
traders typically make decisions based on interday trading
information, such as displayed orders. Those who would compel
dark pools to display their bids and offers in real time or to
reveal ATS identities in real time are helping precisely the
wrong side. Who would benefit from additional quantitative
information hitting the tape in real time, fundamental long-
term investors or short-term information-based traders?
Given the fears that already exist that high-frequency
traders are somehow taking advantage of the existing electronic
information, isn't it ironic that we are considering mandating
a slew of new very sensitive trade data to be delivered to them
in real time?
Now, some have questioned whether dark pools damage price
discovery in the markets. Despite popular belief, dark pools
must report all their trades immediately to the consolidated
tape. They are a valuable source of last trade data. In
addition, it should be noted that dark pools only make up
approximately 7 percent of U.S. stock volume. Dark pools will
likely always remain a niche trading product and will not lead
to the end of publicly displayed bids and offers.
But there is a problem with dark pools and that is
regarding equal access to them. Under Regulation ATS, dark pool
operators are allowed to decide who can participate in their
pool. Broker-dealers are sometimes denied access to each
other's dark pool for competitive or capricious reasons,
meaning that investors cannot be guaranteed access to the
entire marketplace currently.
We believe that markets work best when they are open to
all, and therefore, we propose that the fair access provision
of Reg ATS be changed to force all dark pools to be open to all
broker-dealers, and through those broker-dealers to the entire
investing public.
On the topic of high-frequency trading, there is no clear
definition of the term, making it very difficult to analyze its
effects or estimate what percent of the market it is, resulting
in what appear to be wide overestimates of what percent of the
market high-frequency trading makes up. We believe the focus at
this point in the debate should be on creating a clear
definition so that analysts and academics can perform rigorous
studies and we can separate the facts from the conspiracy
theories.
Regarding the issue of whether high-frequency firms have an
unfair advantage over others, we believe that disparities that
result from differentiated levels of investment and technology
are natural and occur in any industry. It is only unfair if the
opportunity to build similar technology doesn't exist for some.
We have seen no evidence of anyone being denied the opportunity
to build a high-frequency trading system as of yet.
In summary, we believe that the key to a strong and
resilient stock market is a healthy competition for order flow
among multiple venues, both dark and light, along with mandated
fair access to each of them. We believe that if all broker-
dealers have fair access to all venues, then all investors,
whether institutional or retail, would have an equal
opportunity to get the best price.
Thank you again for inviting me to participate in today's
hearing and I very much look forward to your questions.
Chairman Reed. Thank you.
Mr. Gasser, please.
STATEMENT OF ROBERT C. GASSER, PRESIDENT AND CHIEF EXECUTIVE
OFFICER, INVESTMENT TECHNOLOGY GROUP
Mr. Gasser. Chairman Reed, Ranking Member Bunning, and
Members of the Subcommittee, thank you for the opportunity to
testify this morning on current issues affecting U.S. market
structure. My name is Bob Gasser. I am the CEO of Investment
Technology Group. As a fully transparent and neutral player in
the industry, I would like to offer ITG's unbiased, fact-based
perspective on these issues to help you better understand the
current trading landscape.
ITG is a New York Stock Exchange listed company with 18
offices across 10 countries employing nearly 1,300 people
worldwide, and nearly 900 here in the U.S. As a specialized
agency brokerage firm, ITG provides technology to a broad
collection of the globe's largest asset managers and hedge
funds, allowing them to independently source liquidity on
behalf of their clients. Throughout our 22-year history, we
have run our business in the best traditions of U.S. innovation
and market leadership.
In 1987, POSIT was launched as one of the first dark
electronic matching systems. Since then, ITG's POSIT crossing
system has harmoniously existed within U.S. market structure,
including the Reg ATS and Reg NMS frameworks in more recent
years. We firmly believe that institutions need a place to
confidentially interact with each other to find natural block
liquidity. Nondisplayed pools of liquidity, such as POSIT,
provide a valuable solution for the buy side to comply with
their obligations as fiduciary to offer their clients the best
possible execution. Our analysis of millions of institutional
trades post the advent of Reg NMS confirms that POSIT reduces
market impact of block trades and enhances execution quality.
In my testimony today, I will begin by addressing the role
of dark pools and other undisplayed quotes historically in our
markets. I will outline the advantages nondisplayed pools of
liquidity provide for the marketplace. Finally, I will provide
our views on several topics that seem destined for further
regulatory scrutiny, sponsored access and exchange colocation.
Contrary to the pejorative name, dark pools have played a
positive role in the transformation of the U.S. equity markets
over the past decade. As SEC Commissioner Kathy Casey herself
points out, there is nothing sinister about dark pools. They
exist for legitimate economic reasons. Institutional investors
seeking to make large trades have always wanted to avoid
revealing the total size of their order. This, in turn,
benefits the millions of individual investors who invest in
mutual funds and pension plans. Without a facility like POSIT,
institutions with a natural interest in trading with one
another would be subject to unnecessary frictional cost.
We wholeheartedly embrace and support the broad concepts
the SEC highlighted during its open meeting last Wednesday. The
staff of the SEC's Division of Trading and Markets exercised a
tremendous amount of care and diligence in their examination of
current U.S. market structure. We interpret the SEC's recent
pronouncements as establishing a bright line between truly dark
pools and lit pools, with an exception for block liquidity. We
welcome the clarity. As a truly dark pool, POSIT will continue
to provide large executions and price improvement to its
customers.
Academic research demonstrates that market fragmentation,
including the proliferation of dark pools and other off-
exchange trading venues, does not harm market quality. We
support efforts to increase post-trade transparency so long as
the rules are applied consistently across the competitive
landscape. In fact, we believe that the data arising from such
transparency will better enable market participants to measure
the quality of the executions that they receive from the
various trading venues, thus enabling them to make better
routing decisions in the future.
We do have concerns about sponsored access and the risk it
potentially creates for market participants. Sponsored access
generally refers to the practice of a broker-dealer member of
an exchange providing other market participants, possibly
nonregulated entities, with access to that market center
without having the sponsored participants order flow flow
through the member systems prior to reaching the market center.
One of the concerns associated with sponsored access is that
the service can be provided without rigorous compliance
oversight and/or appropriate financial controls. We believe
that the issue of sponsored access firms deploying high-
frequency strategies on behalf of nonregulated entities
deserves regulatory scrutiny.
On the topic of exchange colocation, U.S. exchanges have
logically become mission critical technology providers to the
brokerage industry. They now host brokerage firms within
exchange-owned and operated data centers and provide access to
the circulatory and respiratory system of today's national
market system, market data and the matching of executed trades.
It is our hope that the SEC will provide similar clarity on
the issue of colocation within exchange data centers in a
future concept release. No firm should enjoy an advantage over
another firm based on physical proximity to exchange
technology. Principles of fair access and transparency must be
applied equally to this issue.
While we support the SEC's recent proposals, we are wary of
the dangers of unintended adverse consequences for market
structure. We note that Reg ATS and Reg NMS did produce the
competition that they were intended to foster without
compromising investor protection. The increased competition
evidenced by the existence of approximately 40 execution venues
in the U.S. market has reduced transaction costs and increased
execution speeds without degrading the transactional or
informational efficiency of the U.S. equity markets. To the
contrary, U.S. market systems withstood the demands of
unprecedented volatility and transaction volumes through the
financial turmoil of last fall with remarkable stability and
resiliency.
The confidence that global investors have in the efficiency
of the U.S. national market system is well placed. This
confidence is essential to U.S. leadership in the formation of
capital. All of our collective efforts toward structural reform
must focus on the preservation of this confidence.
Thank you, Mr. Chairman, and we look forward to your
questions.
Chairman Reed. Thank you very much, Mr. Gasser.
Mr. Driscoll, please.
STATEMENT OF PETER DRISCOLL, CHAIRMAN, SECURITY TRADERS
ASSOCIATION
Mr. Driscoll. Chairman Reed, Ranking Member Bunning,
Members of the Subcommittee and staff, thank you for the
opportunity to testify at this important hearing on behalf of
the Security Traders Association. I am Peter Driscoll, the
Senior Equity Trader at the Northern Trust and Chairman of the
Security Traders Association. I am here today representing the
STA, where we provide a forum for our traders to share their
unique perspective on issues facing the securities markets.
Today's individual investor trades in markets that are
characterized by narrow bid-ask spreads, low commissions, and
immediate execution of trades. It is, however, important to
realize that the majority of savings and investments are
institutionalized, invested through savings plans at work,
401(k) plans, and the like. Institutional investors also value
low commissions, tight spreads, and competition. The size of
these aggregated orders also requires us to identify deep pools
of liquidity where we can secure the best possible execution of
larger orders.
The U.S. equity markets functioned extremely well during
our recent economic crisis. The markets remained open. Security
prices accurately reflected the equilibrium between buyers and
sellers at the moment of execution.
The SEC recently held a meeting where it voted to issue
rules intended to strengthen the regulation of dark pools.
These rules were issued in the regular notice and comment
rulemaking process, affording all market participants the
opportunity to comment on the rules. The STA feels that the
process is the best way to uncover the unintended consequences
the proposed rules may have prior to it causing any market
disruptions.
Undisclosed liquidity has been part of the market since
their inception. In fact, many believe the New York Stock
Exchange was the largest dark pool. Floor brokers working large
orders traditionally posted only a small percentage of those
orders in the publicly displayed quotes. The advent of
decimalization and electronic trading required participants to
find alternative ways to execute their orders. Reg ATS made it
easier for investors' orders to execute without the
participation of a dealer. At the same time, it allowed
restricted access to some trading venues and decreased the
transactional data available to investors. As such, the STA
believes it is appropriate for the Commission to evaluate dark
pool access and transparency standards.
Many believe alternative liquidity pools provide efficiency
by lowering execution costs and providing competitive choices
in the execution process. Some believe trading in dark pools
degredates the price discovery process. We do not feel dark
volumes trending around 10 to 15 percent of overall volume are
anywhere near that degradation point. As with most things in
life, moderation is a key.
An efficient market structure can include alternative
liquidity pools and public quoting venues coexisting. The STA
does not believe limiting dark pools to de minimis percentages
of volume is the appropriate answer. Should the SEC determine
that too much volume is trading in these dark pools, the
standards that ATSs must adhere to should be updated and
competitive pressure should be allowed to solve the problem.
Increasing access and transparency is the answer.
Once a dark pool decides to broadcast information beyond
their own members, that information should be publicly
distributed. This transparency must be increased without
jeopardizing the pool participants' anonymity. The STA has long
held that similar products should be regulated by consistent
rules. The regulatory gap between ATS regulation and exchange
regulation should be rationalized. Balancing regulations will
allow all venues to compete more robustly.
Our 2008 report raised concerns about businesses being
built solely to capture rebates from maker/taker models and
market data plans. We remain concerned about the distortive
effects these businesses could have on issues by issuing quotes
and trades without investment intent. STA suggested the SEC
adjust the market data revenue allocation formulas to only
reward quality and tradable quotes. This remains good advice.
Sponsored access must include appropriate trade risk
management controls. Allowing naked access to markets in
today's interconnected market is undesirable from both an
industry and regulatory perspective. There is nothing unfair in
colocation as long as the access is provided to all who desire
it at a reasonable cost. Last week, two trading venues
voluntarily accepted Commission oversight of their colocation
plans, and we feel that this was a great step forward in the
regulation of these plans.
The SEC needs the resources to upgrade their technology and
hire more people to surveil today's markets. Trying to monitor
35,000 registered entities with 3,000-some-odd staff members
seems a daunting task.
We underscore the importance that changes to the current
regulatory framework need to be done in a deliberate and
carefully considered manner. If rules are adopted, pilot
programs should be used whenever possible to insure against the
possibility of market disruptions. We also emphasize the need
for the SEC and Congress to avoid picking winners and losers
and to allow competition and innovation to drive the market
changes when possible. Thank you.
Chairman Reed. Thank you, Mr. Driscoll.
Mr. Sussman, please.
STATEMENT OF ADAM C. SUSSMAN, DIRECTOR OF RESEARCH, TABB GROUP
Mr. Sussman. Chairman Reed, Ranking Member Bunning,
Subcommittee Members, thank you for holding these hearings.
Although I believe that U.S. equity markets are the standard
for market efficiency and investor protection, as my wife likes
to remind me, there is always room for improvement, and I am
glad to be a part of that process.
When I began in this industry in 1998, I worked for a young
retail online brokerage outfit. I was in charge of routing
their orders, designing the logic for their orders, and not
only would execution take minutes, but also there was a great
deal of uncertainty as to the status of the order. Clients
would call up asking what is going on with that order and we
couldn't even tell them what was going on because of the lack
of transparency in the markets.
When I left in 2004, execution times were reduced to
seconds and order status was no longer an issue. This is the
result of a great deal of regulatory and technological process
that we have made since then.
Now, as Director of Research at TABB Group, a financial
markets research and consulting firm, we are an organization
that is dedicated to helping folks understand this changing
trading landscape. Our clients and contacts span the entire
investment community, including pension plans, retail brokers,
mutual funds, hedge funds, high-frequency traders, exchanges,
brokers, and dark pools.
Some of the research I am going to talk about today is
based on detailed conversations with head traders at
traditional asset management companies that represent 41
percent of our Nation's institutional U.S. equity assets.
Now, these folks are the ones that are tasked with the
responsibility of overseeing the safe handling of our orders,
the orders that reside that come from pension funds, from
mutual funds, from 529 plans, and our hard-earned savings, and
they have a fiduciary obligation to balance the tradeoff
between price and time. As some of my copanelists mentioned,
this isn't just about price formation. This is about the proper
handling of orders, and in some cases, you have an order that
you need to get executed right away.
If you need to get that order executed right away, you are
going to broadcast that to as many folks as possible in order
to attract willing counterparties. However, if the order is
sensitive to price, you need to keep that order tighter to
your--you need to play those cards a little bit tighter. Any
information that leaks out about that order could cause the
price of the stock to move against you and thus harm your
investors.
So they have always had to make these choices, and it is
never as clear as just shouting from the hilltops or making
barely a whisper. There are a lot of degrees in between. And so
for price sensitive orders, they have always used dark
liquidity.
Now, in the past, that dark liquidity may have been calling
up a floor broker at the New York Stock Exchange where they
would discuss the parameters of these orders--size, price, how
urgently does it need to get done--and then that floor broker,
on behalf of that trader, would go out to the floor and seek
that liquidity out. Nowadays, those same instructions are
encoded in electronic messages and sent to the various
marketplaces that are available, but the intention is the same.
The challenge is that there was a value in that floor
broker. The relationship between the trader and the floor
broker was based on trust. It was based on a kinship that was
built up over time. In an electronic world, how do we build
that trust and confidence up?
At TABB Group, we believe that is with more disclosure,
more openness about the trading practices. That is why we
believe that dark pools should be more public about their types
of participants they have in their pools, the mechanisms they
use to execute plan orders.
Now, a lot of progress has been made on this front. In a
recent study that we conducted with those traders I mentioned
earlier, 71 percent now say that they are comfortable with the
practices that take place in these dark pools. That is up from
53 percent in 2008. So clearly, the dark pools on a voluntary
basis have been out there trying to educate the clients.
However, we do think that there needs to be more work done
here. We believe that that information should be public. We
believe it should use standardized terms so we can easily
compare the practices across these dark pools and that
regulators have a better chance of ensuring that these
disclosures actually match the actions that take place within
these dark pools.
However, I want to distinguish between this type of
disclosure about practices and the real-time identifiable
reporting of trading volume that was recently proposed by the
SEC. We believe that any real time identifiable reporting of
dark pools would hinder the institutional traders' fiduciary
obligation to protect the orders that come from a large portion
of our investor public.
Just quickly, I want to touch on high-frequency trading,
because we really believe that these are just today's
intermediaries. We used to call them market makers and
specialists, but because of the automated high-speed nature of
today's markets, anyone that wants to be an intermediary has to
execute in a high-speed fashion. And so when an institutional
trader wants to get an order done, they are likely to be
interacting with a high-frequency trader. Now, we do think it
is incumbent on high-frequency traders, which often shroud
themselves in secrecy, to be more forthcoming about their
activities and be more involved in trying to improve our market
structure.
I could talk on these issues for many more minutes, but I
have already overrun, so I will just wait for your questions.
Thank you very much.
Chairman Reed. Thank you, Mr. Sussman. Thank you all,
gentlemen, for testimony that was very thoughtful and also very
helpful to us. As some have indicated on the panel, we are just
beginning deliberations as technology becomes more evident and
the impact of the market is more evident.
We will do 7-minute rounds. I anticipate a second round,
but I want to get somewhat quickly to my colleagues.
Let me start with Mr. Sussman and ask the panel one
question, and we will let the SEC conclude. What are the
several--one, two, three big challenges that this new
technology poses to regulators? As you indicated, several
individuals indicated, this practice has been going on as long
as there have been markets trading without publicizing the
price. But what are the dangers, the three biggest challenges?
The SEC has to maintain fair and orderly markets. What are the
three issues that might affect that? Mr. Sussman, and then
right down the line.
Mr. Sussman. Yes, thank you. That is a great question.
For the institutional trader, it is knowing what is going
on with their order. In today's electronic markets, there are
so many different types of software that they use in order to
execute their orders, it is difficult for them to keep up with
what is actually happening with their orders. They need to use
these tools in order to efficiently interact with the
marketplace, you know, in order to efficiently distribute their
orders trading against other institutional investors, trading
against high-frequency traders.
But the issue is how much do they really understand about
the algorithms and the dark pools that they are handling. You
know, sometimes they feel overburdened by the amount of
information that they have to keep track of in order to execute
these orders.
But I do not think that they would, you know, ask for
anything else. I mean, this is a challenge that they accept
wholeheartedly as a part of their job, and they would rather
have the responsibility of understanding these pieces, you
know, rather than some regulatory framework force them to act
one way or another. You know, freedom is obviously a
responsibility as well as a right, and they accept that
challenge.
Chairman Reed. Thank you.
Mr. Driscoll, please.
Mr. Driscoll. Following on what Mr. Sussman said, at the
Security Traders Association several years ago, we were
concerned about the lack of knowledge on how institutional
orders were being routed through these dark pools, and we set
about a survey of the dark pools to try to discover how orders
were routed, why they were routed, and where they were finally
executed.
We ran into quite a bit of trouble getting those answers.
It seems that there was a lot of confidentiality clauses that
prevented pools from talking about where their orders were
executed. A lot of legalistic roadblocks. We again early this
year attempted to map liquidity and ran into similar
roadblocks.
So I would strongly emphasize that we are the ones sending
the orders to these dark pools, and it is our right to know how
these orders are executed and handled, and we have to have that
transparency so that we can provide best execution for our
clients. Transparency in the order routing process is extremely
important.
I would think that another one of our big concerns is the
process in which rules are promulgated. We feel very strongly
that regular notice and comment rulemaking is the right
procedure, and I would also say that the SEC is doing a
fantastic job trying to promote the transparency and fairness
in markets.
Chairman Reed. Mr. Gasser, please.
Mr. Gasser. Thank you, Mr. Chairman. I think there are a
couple of challenges here that I think are interesting ones
and, from the perspective of a fact-based approach, I think
provide more complexity to the question set up and asked of the
panel.
One is the issue of surveillability. With 40 liquidity
pools by most estimates now in operation in the U.S., how do
you bring that all back together? And I think that the proposal
that the Commission has put in place and the concept release
around the disclosure of transactions I think is--as I said in
my testimony, I think it is an important step in that
direction. So surveillance I think is a big challenge, and
clearly the Commission is taking some proactive steps, I think,
to improve that.
There has been, obviously, a lot of discussion here about
high-frequency trading. The question there is high-frequency
traders are important providers of liquidity to the market
today. One panelist had made the analogy to the days of the
specialists and the market maker. These guys have replaced
those folks, we would say in a much more transparent way,
actually, than existed in the past. But the question becomes:
What is a reasonable liquidity provision versus sometimes
manipulation of prices and markets?
Clearly, the high-frequency traders that are regulated,
there is obviously a tremendous amount of transparency
available to the regulators in terms of their practices, and so
we think that there is a significant amount of attention,
deservedly, on that particular issue.
To the point of a two-tiered market, I think one of the
issues of complexity that has arisen here is--and when I say
two-tiered market, I am not talking about institutional versus
retail. What I am referring to is the notion of folks that have
information and folks that do not have information. And this
notion of creating a virtual marketplace of dark pools that
selectively IOI to each other, indicate out to each other, I
think is also deserving of quite a bit of scrutiny going
forward. And as Pete alluded to, it is sometimes very difficult
to get to the bottom of exactly what is going on out there in
terms of this virtual linkage.
One great benefit of the current environment that we are
operating in--and it is great that you bring more light to this
topic--is that institutions are more sensitive to the issues we
are discussing today than they ever have been. So the best
practices now have been elevated amongst institutions in which
they are sending out questionnaires, asking very, very granular
questions about the practices that we as broker-dealers deploy
on their behalf. And so sunshine is the best disinfectant here,
and so I think, you know, the free market certainly is at work.
Chairman Reed. Thank you very much. I want to yield to
Senator Bunning so he has a chance. We will do a second round.
I will pick up with Mr. Mathisson and ask the same question and
give you more opportunity to think through it. Senator Bunning.
Senator Bunning. Thank you. I want to start with the SEC.
First of all, the question I pose to you is not one of--it
actually is not a question. It just is a feeling that the
American people have. It seems to me that the SEC has all the
power to address the market structure issues that we are
talking about today. Or does the SEC feel that Congress needs
to give them more authority?
Mr. Brigagliano. Thank you, Ranking Member Bunning. We have
indeed considerable authority to address most of the market
structure issues we have talked about today, and I should point
out that the legislative initiatives currently in Congress with
respect to bringing over-the-counter derivatives into the
regulatory tent and with respect to the regulation of hedge
funds are important adjuncts to our authority.
With more specificity on the trading structure, we
currently have a large-trader authority, and we are working on
possible proposals to better identify large traders so that we
can see who is trading, who the principals are, who their
affiliates are, get better information for time, get a better
audit trail. But it may be that enhanced authority to require
registration of some of these traders would be helpful as well.
Senator Bunning. OK. What steps are you taking to ensure
fair access for everybody to dark pools?
Mr. Brigagliano. Senator Bunning, with respect to dark
pools, as you know, we thought that addressing the two-tiered
market and the access to the best price information of orders
was step one.
Senator Bunning. But why should somebody be excluded? That
is my basic question. In other words, there are dark pools that
certain people get in and certain people do not. Why should
somebody be excluded?
Mr. Brigagliano. Senator Bunning, that is an excellent
question. One reason could be, for example, if a dark pool
caters to large-size traders, to mutual funds and pension
funds, it may well want to monitor the more predatory traders,
if you will. People who are going to try to front-run those
larger orders do not get in.
At the same time, when the Commission issues its concept
release in looking at dark pools more broadly and ATSs, I would
expect it to include a discussion, a broader discussion, as you
suggest, of fair access.
Senator Bunning. OK. This is for everybody, but I am going
to start with Mr. Driscoll and Mr. Nagy. Quickly, do you think
identifying a trade on the tape as coming from a specific dark
pool would affect prices in that stock?
Mr. Driscoll. I do not think it would affect prices in that
stock. I do think that it would affect the institutional
traders' order routing decisions. It would give them more
information as to where the stock was actually trading and help
us----
Senator Bunning. Well, if I am Fidelity and I have 100,000
shares, obviously I am not going to sell 100,000 shares. I am
going to give it to a broker and say, ``Break it down. Do 300,
300, 500, 800.'' And, obviously they have enough wherewithal to
do that. They are not going to trade 100,000 shares, and they
are not going to show 100,000 shares.
Mr. Driscoll. In the old days, that would be true. In
today's market, I have the technology on my desk to break that
order down and route it----
Senator Bunning. That is exactly right.
Mr. Driscoll. And you are right. Unless the portfolio
manager has made the investment decision to execute that order
at one time----
Senator Bunning. In other words, to show it.
Mr. Driscoll. Well, we probably would not show it in that
case, anyway. We would probably go and get a capital commitment
from one of our broker-dealers.
Senator Bunning. Well, but, see, in my opinion, I think all
trades should be put on the tape.
Mr. Driscoll. Absolutely. We concur wholeheartedly with----
Senator Bunning. As soon as the trade is made, it should be
put on the tape so everyone can see it.
Mr. Driscoll. In today's marketplace, the trades do hit the
tape right away. It is just a matter of----
Senator Bunning. I do not think we should identify the
person that is making the trade.
Mr. Driscoll. We would respectfully request that that
information be made available on a delayed basis so that our
information could not be used by somebody who would like to
take advantage of it.
Senator Bunning. Mr. Nagy.
Mr. Nagy. Ranking Member Bunning, thank you. It is
interesting because the little guy, the retail client, is
literally forced to have their trade printed to the tape
immediately upon that transaction occurring.
Senator Bunning. But that is not--a hundred, five hundred
shares, a thousand shares is not going to affect the market.
Mr. Nagy. That is true. Conversely, large institutional
trades are not required--especially in the dark pool, it is not
required to be printed right away. The benefit to that is
that----
Senator Bunning. Well, I disagree with that, so, you know,
I am--I think they should be.
Mr. Nagy. What I am saying is that I do believe that dark
pool trades, institutional trades, should be printed to the
tape.
Senator Bunning. The time the trade is made should be on
the tape.
Mr. Nagy. For the benefit of transparency in the
marketplace----
Senator Bunning. Yes.
Mr. Nagy. Yes, I think that is absolutely important and
paramount to ensure that we do not precipitate a two-tiered
market structure in our system.
Senator Bunning. OK. I agree.
Mr. Mathisson. Just to throw in a factual correction, dark
pools do have to print the trades immediately to the tape in
the current structure.
Senator Bunning. That is what I thought. But you do not
identify either side.
Mr. Mathisson. No. That is correct. That is not identified.
It is anonymous as to who traded it or which company or dark
pool put it up.
Senator Bunning. OK. I only have one more question left. I
have got lots of questions, but I only have time for one. One
thing I did not see mentioned in any of your testimony is
liquidity rebates or so-called ``maker-taker'' pricing designed
to draw order flow. Is the Commission going to look at these
practices, especially in regards to high-frequency traders that
make a big part of their business collecting these fees that
are ultimately paid by investors through higher costs?
Mr. Brigagliano. Senator, Ranking Member Bunning, I note
that when the Commission adopted Reg. NMS, it effectively
capped those maker-taker rebates at three mils. At that time,
there was significant comment suggesting that the maker-taker
model did encourage display in liquidity, which could be
salutary. Nonetheless, as the Commission looks further at high-
frequency trading in its concept release, it would make sense
to look at the impact of particular market pricing models on
trading behavior.
Senator Bunning. Thank you very much.
Thank you, Mr. Chairman.
Chairman Reed. Thank you, Senator Bunning.
Senator Corker.
Senator Corker. Mr. Chairman, thank you, and I thank each
of you for your testimony.
I am trying to develop some kind of consensus with all of
you who are testifying, and, again, thank you for being here
with the vast amount of knowledge you have. I do not hear
anybody--the notion of high-frequency trading, nobody here
really has an issue with that, right? I mean, it is the way the
market is made today; it is done electronically. Does anybody
have a problem with high-frequency trading? I just want to sort
of move that one off the table. I have not heard any complaints
about the issue of high-frequency trading.
Mr. Driscoll. Senator, I would like clear up a notion that
was addressed earlier. At our conference, our annual
conference, Seth Merrin did say that high-frequency trading
could quintuple over the next decade. But he also followed that
up by saying that he had no facts to back that up and he should
not be quoted on it. I think a lot of times----
Senator Corker. But he is quoted again.
Mr. Driscoll. Yes. I think a lot of times, you know,
numbers are tossed out there without any substance or empirical
evidence of them, and that makes us concerned.
I would also say that as far as high-frequency trading
goes, it is my job to stop the people that are trying to take
advantage of my orders. When I have an order working and I see
it is starting to move up because high-frequency traders have
sniffed it out, I will remove that order from the marketplace
and wait until it reverts to where I want to buy the stock or
sell the stock. So it is part of the job of the institutional
trader to trade against these people.
Senator Corker. But there is no problem that--there is no
essential problem with the fact that high-frequency trading
exists to create price discovery and----
Mr. Nagy. Senator, just to note on that, I would say that
one issue we would have in terms of high-frequency trading
would be more of one with capacity utilization. What is
commonplace with high-frequency trading is that there is
typically a very large number of orders that are submitted to
anyone particular entity. At the same time, there is equally a
very large number of cancellations that are submitted. What
that leads to is very low fulfillment rates. That effectively
creates many, many quote changes out there that may or may not
be necessary and unnecessary in the marketplace. For example, a
high-frequency trader puts a price out there, then immediately
removes that price; puts a price out, immediately removes that
price. The infrastructure that is built upon distributing those
quotes, of course, is taxed in that regard, so the question is:
How are those fees distributed in terms of the market data
costs and getting that to the retail investor? And how does
that impact market data? And I do not think today that those
costs are fairly disseminated amongst the marketplace.
Senator Corker. Any response to that, SEC?
Mr. Brigagliano. Yes, Senator Corker. As with other
strategies and technologies, high-frequency trading may well
have both benefits and raise concerns, and we have heard the
benefit about increasing liquidity. But concerns that we will
look hard at as we develop further audit trails and get into a
deeper dive in our concept release, for example, would be if a
trader is taking positions and then generating momentum through
high-frequency trading that would benefit those positions. That
could be manipulation, which would concern us. If there was
momentum trading designed--or that actually exacerbated intra-
day volatility, that might concern us because it could cause
investors to get a worse price. And the other item I mentioned
was if there were liquidity detection strategies that enabled
high-frequency traders to front-run pension funds and mutual
funds, that would also concern us.
Now, those are the things that we will look for as we do a
deeper dive, Senator.
Senator Corker. OK.
Mr. Driscoll. I think that it is important to mention also
that what high-frequency traders do do is they keep the fees
down for all the other investors. But the exchange fees are
distributed across a number of trades, and as those trades go
up, the fees become less for the other investors in the
marketplace.
Senator Corker. It seems to me that, aside from some of the
things that can happen with any system that need to be
regulated, high-frequency trading has made the cost of a
transaction far less for the investing public. And so, you
know, we hear it and it sounds like it is a bad thing. It looks
to me like, generally speaking, there are lots of attributes
that these market makers are bringing to the system.
It seems to me the other debate on--you know, let us move
to dark pools for just 1 second. It seems to me that if I am
hearing correctly, one base debate is whether a dark pool
should disclose after the transaction occurs or when actually
an order is made. Is that correct? Is that what I am hearing?
Mr. Driscoll. I think it is important to understand that
those trades are reported to the tape immediately. It is just--
--
Senator Corker. After the trade.
Mr. Driscoll. After the trade, but there is not any
attribution to who actually traded it. The transparency we are
talking about is attributing the trade to a specific dark pool.
Senator Corker. And I guess I am having difficulty
understanding if that is the case, the problem with--I mean, it
seems to me very much like what existed on the New York Stock
Exchange where you would call a specialist, they would make a
trade for you. So they would not move the market too quickly,
they would break it up. They would do it, and it seems like to
me that is exactly what these dark pools are doing, except
doing it electronically. Am I missing something?
Mr. Sussman. No. I think that is a correct
characterization, and the reason why, you know, we would oppose
the SEC's proposal as currently stated or as I interpret it is
that attributing it to the dark pool would then give the entire
market the sense that, hey, in this particular dark pool where
we know there are only certain market participants, there is
activity----
Senator Corker. Smart participants.
Mr. Sussman. Yes. There is activity going on, and they
would be able to use that information to trade ahead of the
institutional traders that are in that dark pool. So that is
the concern that we have.
Senator Corker. Respond, SEC.
Mr. Brigagliano. Yes, well, Senator, the Commission's post-
trade transparency initiative requires not that the individuals
trading be identified, but that the dark trading venue be
identified as an exchange would be identified. And where there
were concerns about disclosing information that could hurt an
institutional order, a large size order, the Commission did
propose an exception. But, preliminarily, the Commission saw no
reason not to display the smaller orders that other markets
must display.
Dr. Hatheway. And an issue from my perspective is on the
pretrade transparency, retail investor orders, at least the
best one in possession of a broker, have to be displayed to the
public so everyone is aware of those. Those orders become the
benchmark under which the dark pools trade.
Dark pools individually provide a number of the benefits
that have been mentioned here. Collectively, as the amount of
dark pool volume increases, you lose the transparency into
where people are willing to buy and sell. And I think the
pretrade dimension of what the SEC has on the table is
something that we should consider and adopt.
Senator Corker. I know my time is up, but it would seem to
me then that an institutional buyer would in that case, in your
case, be better off going back to the one person making the
trade. But it really seems like you would be setting things
back hugely solely to benefit an electronic exchange like you
have.
Mr. Gasser. Based on the data we collect, Senator, the
institutional buyer and seller will always be best served by
finding a natural institution on the other side. So in the
example of a Fidelity 100,000-share print, rather than split
that up into 300 shares and disseminate--into 300-share lots
and disseminate it over 40 execution venues, if they can find
Vanguard on the other side, within the framework of the exist
bid-offer spread, that is a frictionless trade, right? So----
Senator Corker. Let me say this. I am going to stay here
and ask more questions. We can talk more about it. My time is
up.
Senator Bunning. Let me enter in there, because the best
price is not going to exist.
Mr. O'Brien. I think it is about striking a healthy balance
between the price discovery that exchanges provide----
Senator Bunning. If I am going to try to trade 100,000
shares of IBM, and I am going to put it on somebody's trading
block or some institution has a trading block, I will not get
the best price for that 100,000 shares if I am the seller
unless I break it down and do it in many, many smaller trades.
Mr. Gasser. That is correct, Senator, unless there is an
equilibrium price of----
Senator Bunning. Well, how often----
Mr. Gasser. In our system, that happens every day. We
trades tens of millions of shares between institutions in a
dark manner.
Senator Bunning. Well, we will bring the institutions in
and ask them.
Mr. Gasser. What is that?
Senator Bunning. I said we will bring the institutions and
ask them.
Mr. Gasser. Absolutely. And I think what you would find is
that they are very supportive of that mechanism.
Chairman Reed. Thank you.
Senator Schumer. Thank you. And I think Senator Bunning's
questions were on the money. And if the market is so
fragmented, you never know that best price. That is the problem
here. That is the fundamental problem that we are trying to
create. But let me just say a few words and then ask some
questions.
I want to thank Senator Kaufman and, of course, you, Mr.
Chairman, and all the witnesses. Sorry I could not be here
during your testimony. I have looked at it.
As you know, I have taken an active interest in many of the
issues being discussed at today's hearing because I believe
America's capital markets have been and should continue to be
the leading markets in the world. For decades, why have they
been the leading capital markets? They are the most efficient,
the most transparent, the most fair, greatest integrity, and
they have been the envy of the world. When other countries are
setting up their capital markets, they look to us. And people
think they are getting a fair deal here, that things are less
likely to be manipulated here than anywhere else. We cannot
lose that.
An important part of that success is due to regulation that
has historically ensured that the little guy, while he might
not have as much money or these days the most advanced computer
systems, can be sure when he puts in an order, the price he
gets is fundamentally fair. That is what we are worried about
here.
And as I stated in my letter to the SEC last week, the
proliferation of alternative trading venues has significantly
altered the trading landscape. Many of these changes have been
largely for the better.
The competition provided by alternative trading systems
brought significant benefits to retail investors, and that has
been discussed by many of our witnesses. But these benefits
have come at a cost because our capital markets have become
increasingly fragmented, and market surveillance has not kept
pace, making it increasingly difficult, especially in light of
the technological developments that facilitate large volumes
trading at high speeds, to conduct adequate market surveillance
across the markets. I am concerned that this will erode the
confidence in the fundamental fairness of our markets.
And so I agree with Senator Corker. High-speed trading,
nothing wrong with it. It is good. To stop it would be Luddite.
But it can produce certain problems in the market in terms of
equality, that the little guy and the big guy have the same
shake. And that is what we have to guard against.
So the way to do this is not to abolish high-speed trading.
That would make no sense. The way to do it is to acknowledge it
is here and it has benefits, but we have to guard against the
liabilities that it brings.
So I propose to the SEC that market surveillance should be
consolidated across all trading venues to eliminate the
information gaps and coordination problems that make
surveillance across all the markets virtually impossible today.
It would deal with the problem that Senator Bunning correctly
brought up.
So my first question is to Mr.--I think you were wise to
call him ``Mr. SEC.'' Mr. Brigagliano--see? OK? As I noted in
my letter to Chairman Schapiro last week, I am concerned that
our fragmented market system of surveillance makes it nearly
impossible to monitor market manipulation, monitor trading
ahead of customer orders, and other abuses at the same time
that the fragmentation of our markets and technological
advances make such abuses easier to carry out.
Now, I understand that the SEC is looking at options to
increase the information available to regulators, but would the
SEC consider requiring fully consolidated market surveillance
across all markets?
Mr. Brigagliano. Senator Schumer, that has to be an
important element of enhancing our ability to surveil because
while there is an Intermarket Surveillance Group, while markets
share technologies, while they share information, without some
central focus something could be missed.
Senator Schumer. Right.
Mr. Brigagliano. So as we move forward in trying to develop
a better audit trail and better surveillance, you know, that
concept has to be part of it.
Senator Schumer. Good. I am glad to hear that. So you are
moving in that direction, right?
Mr. Brigagliano. Chairman Schapiro has an inter-division
task force working hard on those issues.
Senator Schumer. But you agree basically with the thrust,
the SEC agrees with the thrust of my remarks.
Mr. Gasser. Senator, may I----
Senator Schumer. Wait, wait. Let him answer first. He has
got the power.
Mr. Brigagliano. Senator, we are absolutely moving to
consider that. We think there is benefit to centralized
surveillance.
Senator Schumer. Great. Good. OK. My next question is for
Dr. Hatheway. You say in your written testimony that, ``Rapid
detection and enforcement through real-time and post-trade
surveillance are critical to fair and orderly markets.'' Would
NASDAQ endorse consolidated market surveillance? And if you can
answer yes or no, that would be just fine.
Dr. Hatheway. I will work the yes or no in there, Senator.
Thank you. We engage in multiple industrywide initiatives for
cooperative surveillance, including the Intermarket
Surveillance Group and the Options Regulatory Surveillance
Authority plan, the joint activity you mentioned a moment ago
to surveil for insider trading. We look forward to gaining
experience from these joint plans and the options initiative,
and we are moving ahead on consolidated regulation----
Senator Schumer. I did not quite----
Dr. Hatheway. So, yes.
Senator Schumer. Yes. Good. Thank you.
Mr. Nagy, what about you? From an investor's perspective--
did I pronounce your name right, sir? I am sorry.
Mr. Nagy. Close.
Senator Schumer. Mr. Nagy, from an investor perspective, do
you think consolidated surveillance would benefit your
customers and improve confidence in the integrity of our
markets?
Mr. Nagy. Senator Schumer, I think [inaudible].
Senator Schumer. Great. OK. Now, Mr. O'Brien of Direct
Edge, one of the concerns I have raised about flash orders,
that it might allow someone receiving a flashed order to detect
a pattern and trade ahead of those orders on other markets.
What is Direct Edge doing to make sure this doesn't happen?
Isn't it true that you can only monitor what is happening on
your own trading platform? You can answer those, and then
finally, we didn't agree on flash orders, but do you agree,
then, with my proposal for consolidated market surveillance
across all markets? You can answer all three questions.
Mr. O'Brien. I will answer that question first, which is
yes, because there is only so much one market center or
exchange can do in surveilling marketwide trading activities--
--
Senator Schumer. This is great.
Mr. O'Brien. ----for the patterns and the practices.
Senator Schumer. Good.
Mr. O'Brien. I think any order type that--whether it is a
flash, using flash order technology, or a limit order,
basically exposes information to other people and other people
may take action in response to that. That is the nature of
markets. Everyone wants to keep their cards to themselves, but
ultimately, you have to show information to other people in
order to get a trade executed.
What we have tried to do to ameliorate those concerns
within our own market is, one, make those order types optional.
Make people choose to see them so that they see that the
advantages of using them outweigh those risks.
Number two, the technical implementations we have done have
allowed us to look at the activity of the individual receiving
that information and trading on them within our market.
But third, and to go back to your, I think, underlying
thrust of your questioning, we have tried to and would support
better marketwide surveillance.
Senator Schumer. Good. Does anyone disagree with that, of
the other--Mr. Gasser, Mr. Driscoll, and Mr. Sussman?
Mr. Driscoll. I would be concerned that if we went to a
consolidated regulation regime, we would lose the nuances of
the markets. You know, the NASDAQ marketplace is quite
different than the New York Stock Exchange. So I would think
that we would want to go on to harmonize regulation more than
consolidate regulation so that we could keep those nuances that
add value in those marketplaces for us.
Senator Schumer. Why don't you--I don't quite understand.
You can still have nuances in the market and have a
consolidated market surveillance.
Mr. Driscoll. The regulators at the NASDAQ understand their
marketplace to a much better degree than somebody from the New
York Stock Exchange Regulation Department, is my point. So we
would want to make sure that those people had the ability to
continue working.
Senator Schumer. My time is up. Mr. Chairman, Mr. Gasser
wanted to----
Mr. Gasser. Yes. Senator Schumer, in my response to the
Chairman's question about the challenges that face the
marketplace, surveillability was the number one issue, so we
would be very supportive of consolidated surveillance.
Senator Schumer. Thank you, Mr. Chairman.
Chairman Reed. Thank you very much, Senator Schumer.
Senator Schumer. Thank you for those excellent answers.
[Laughter.]
Chairman Reed. I posed a question to roughly half the panel
about the challenges that we face, stepping back a bit, with
this new technology, given that many of these practices on a
person-to-person basis existed for years. So you have had time
to think about it, and if you could be as succinct as possible,
starting with Mr. Mathisson.
Mr. Mathisson. All right. Well, thank you. So you would ask
for the three issues that the regulators should be looking at
and the first one we believe they should be looking at is fair
access for dark pools, which we have already spoken about
today, but we believe that there is a significant problem, not
so much--the SEC raised the issue that dark pools might want to
shut out a type of investor because, as Mr. Brigagliano put it,
they might want to only trade with institutional investors and
keep out what he called predatory investors.
We believe that could be accomplished with objective
standards. We think that they could shut out people based on
order size, based on time people are willing to leave the
orders in the system. They could shut out people based on
disciplinary action history, to try to get out the guys who are
perceived to be sleazy. But we think it can be done in an
objective way, where you can set objective standards and say
anyone who doesn't meet this--anyone who meets this criteria is
allowed in. Anyone who does not is out. We don't think it
should be capricious in that they should be able to shut out
individual brokers that they perceive to be competitors.
The second issue would be the issue of what is called naked
access, which is when certain broker-dealers allow traders to
go straight to the market centers through their own technology
and give up the broker's name. It is referred to as naked
access. It means that there are no risk checks and it is not
passing through the broker's system. We believe that that does
raise issues of systemic risk.
And the third issue would be around proper transparency and
surveillance, as was just being discussed. We believe that
there should be real-time transparency to the regulators. There
should be real-time disclosure of a whole lot of things to the
regulators, but not to the trading public because there are
situations--information in the trading markets is not always a
good thing and transparency is not always a good thing in real
time in the trading markets because it does potentially allow
traders to get ahead of longer-term investors. So while we
believe there should be real-time disclosure of quite a few
things to the regulators, things to the overall market can wait
until the end of the day, end of the week, or end of the month.
Chairman Reed. Thank you very much.
Mr. Nagy, please.
Mr. Nagy. Thank you, Chairman. The first issue, I would
say, would be that of unintended consequences. In respect to
that, the SEC, particularly the Division of Trading and
Markets, has been very effective at creating a market structure
that serves the retail investor. Moreover, we think the SEC is
uniquely qualified to really have a deep understanding of micro
market structure that we are talking about here today and to be
able to see what some of those unintended consequences are
through the public rulemaking process that they currently have
today.
The second issue is really of investor integrity in our
markets. With that being said, the Senate oversight
responsibilities that you are conducting today, particularly of
the SEC, are paramount to ensure that our markets continue to
be fair for the individual investor. While today the markets do
function in a very competitive and robust fashion, we need to
ensure that the average Joe continues to get a fair shake in
the marketplace.
Finally, one of the issues which has benefited the markets
greatly over the years has been one of transparency. We need to
continue to promote transparency, as transparency is really the
key to driving long-term investment from the individual
investor in our marketplace.
Chairman Reed. Thank you very much.
Mr. O'Brien.
Mr. O'Brien. I think the first thing that is not often
talked about in this debate is just greater investor education.
I think we are all realizing, now more than ever, that we are
stewards of investor confidence and the average American has a
woefully antiquated understanding of how stocks are traded in
this day and age. And so there are a variety of steps that I
think need to be taken, and it is hard when the pace of change
is so rapid in order to do that. Rational disclosures, greater
education across the board. That allows investors, one, not to
wake up one day and realize that they feel like their stock
market is spinning out of control, and they can make informed
choices about how to get their orders executed.
I think the second, and I won't reiterate on this, but just
echoing Senator Schumer's concerns, regulators who are
accountable need the tools, talent, tenacity, and information
to be able to do their job in rapidly changing market
conditions. And I think maybe the biggest challenge is just
managing the--both important equally, but at times conflicting
objectives of promoting efficiency and competition.
We had a system 10 years ago that was very centralized and
in some ways very efficient, but it had its own problems--DOJ
investigations, specialists leaving the floor in handcuffs,
exchange executives having tens of millions of dollars of
compensation. We don't have those problems anymore, or
challenges, but we have new challenges and the line in this day
and age, especially with technology, between a trader and a
broker and a market and an exchange are increasingly blurred.
And so how to manage that competition in a way that, over time,
is producing a continually efficient market that investors have
confidence in.
Chairman Reed. Thank you very much, Mr. O'Brien.
Doctor.
Dr. Hatheway. Thank you very much, Mr. Chairman. The topics
we have been talking about today--high-frequency trading, dark
pools, flash orders--either originated with or were popularized
by ATSs. I think one thing that is missing in the current
regulatory structure is a thorough scrutiny by the SEC of the
business model of new ATSs when they are launched and SEC
review of new policies that ATSs intend to put in place as part
of their business. This is not rulemaking at the level the
exchanges are subject to. Instead, this is simply review by
another set of eyes as to what the potential market impacts may
be from innovative and competitive ideas should they become
widely adopted in the industry, as was the case with flash
orders.
The second point on disclosure of actionable IOIs, if that
should be adopted in rulemaking, the SEC needs to remain
vigilant as to whether that is sufficient to incur good
pretrade transparency. Some of us on this panel will remember a
time when you wanted to get a price in a stock, you had to make
three phone calls. You don't want an environment where you need
to ping three dark pools to find out what the price is, because
in a computerized environment, an outbound message or an
inbound message both can be done very, very quickly.
Finally, as Dan Mathisson said, sponsored access is
something that needs thorough scrutiny. NASDAQ has a rule
filing requiring pretrade risk management for the users of
sponsored access. We would encourage that to become standard
and other exchanges to file similar rules. Thank you.
Chairman Reed. Thank you very much.
Now, Mr. Brigagliano, you have the floor to summarize.
Mr. Brigagliano. Thank you, Chairman Reed. Advances in the
technologies and strategies in the market have resulted often
in lower trading costs and better prices for investors, and
they drive our economy and that is well and good.
At the same time, our job as regulators is to make sure
that the core principles of the Exchange Act--best execution,
fairness, nonmanipulated markets--are maintained. So as we look
at high-frequency trading, direct market access, dark pools,
colocation, flash orders, to pick up on Senator Schumer's
point, it is not a question necessarily of saying one is good
or bad, but it is addressing through rulemaking, auditing, and
surveillance any threats to those core principles that could
arise as the markets innovate and develop.
Chairman Reed. Thank you very much.
One other point I think you would agree to is that the
issue of adequate resources, what has impressed me is that I
would suspect these gentlemen have sort of much more
sophisticated software, hardware, every kind of ware, and sort
of more Ph.D.s and et cetera than the SEC. There is a real
issue here, a basic issue of just keeping up with the
technology, by having the technology and the expertise. Is that
an issue that you are working on at the SEC and ready to ask or
tell us what you need?
Mr. Brigagliano. Yes, Chairman Reed. Particularly as we
refine what we believe is necessary to make sure we adequately
can monitor and analyze trading with the new technologies, we
likely will need advanced in technology and additional
individuals with the skill sets to make that technology most
efficient for us.
Chairman Reed. Thank you very much.
I have one additional question, so I will recognize Senator
Bunning, Senator Corker, and then I will ask the question. If
you want to stay and ask other questions----
Senator Bunning. I will try to get mine in all this time,
since I have got 5 minutes.
First of all, you all seem very happy about the way things
are, or reasonably happy, but we have had some unbelievable
messes. I mean, a $50 billion mess is a pretty big mess. Now,
we somehow in regulations were not able to discover Bernie and
his Ponzi scheme that he was doing, and he wasn't even doing
it. It was all a hoax on the people. So somehow, the SEC has
got to be able to have the power to regulate those kind of
people that are dealing in securities or nonsecurities and just
plain fraud. I just hope that you have the tools to do that
with. Are you going to not answer, or are you going to answer
me?
Mr. Brigagliano. Ranking Member Bunning, I would be happy
to answer. I wanted to make sure that your question was
completed.
Senator Bunning. Oh, OK.
Mr. Brigagliano. We have identified the additional
enhancements we think we need in terms of better audit trail,
more information about large traders----
Senator Bunning. Quicker information?
Mr. Brigagliano. Quicker information and also who is really
behind the trade. Quicker access, really, is the way, you are
right, to find out who the principals are, who their affiliates
are, to sort that out more quickly when we need to find out,
and we are working on developing that capacity. And then, of
course, the additional technology to analyze this huge volume
of high-speed trading.
Senator Bunning. Mr. Driscoll, in your statement, you
suggested that regulatory gaps between exchanges and
alternative trading systems should be addressed. Do you have a
specific suggestion about what should be done?
Mr. Driscoll. As these dark pools that are incubated under
Reg ATS mature, we think that they should pick up one of the
responsibilities that the exchanges have. Whether that entails
sharing some of the regulatory burden, the costs, or starting
to manage the----
Senator Bunning. You are all making enough money to share
the burden.
Mr. Driscoll. ----or sharing the--starting to regulate some
of the members that are coming into their pools. We think that
the way to really weed out the ones that aren't providing more
value than the lit venues is to bring that regulation up and
let them share some of the burdens, making the playing field
more level for the exchanges and the ATSs.
Mr. O'Brien. Ranking Member Bunning, I would just add to
that. There is an example of how that is working. So Direct
Edge operates as a form of an ATS today, and we embraced that
regulation when we were very small. We have now become a
material part of the market and we are voluntarily in the
process of applying to the SEC to register our markets as
exchanges. We are actually, given our growth, seeking greater
regulation and responsibility overall.
Mr. Driscoll. I think----
Senator Bunning. Congratulations.
Mr. Driscoll. I think that that is exactly our point, is
that we want to develop deeper and better players in the
marketplace. So the incubation brings these more mature players
and they come in and pick up some of the responsibilities that
other markets are taking right now.
Senator Bunning. Mr. Nagy, you seem to be concerned about
the impact of dark pools and high-frequency trading practices
on retail investors, especially on the accuracy of displayed
prices. What do you think needs to be done to level the playing
field for retail investors while keeping the benefits for
institutional investors who are likely also representing the
same retail investors through retail funds?
Mr. Nagy. Sir, the concerns I put forth in my discussions
today represent our concern in terms of to what degree do you
reach a tipping point in terms of reducing the transparency in
the public marketplace for the benefit of dark trading. Today's
retail client, when they decide to purchase or sell a security,
the only real way they can be enabled to do that is by
ascertaining a quotation which is only available in the public
marketplace to decide what they are going to buy or sell.
As we see growth proliferation within dark pools, and I
don't focus so much on volume percentages per se. I would
rather focus on sheer numbers. It is estimated that there are
over 40 dark pools today. At any one point in time, that could
increase really exponentially because the process, the
Regulation ATS process is a fairly simplistic process.
Senator Bunning. I think that the information we have
gotten is different from the information you just quoted.
Mr. Nagy. How so, sir?
Senator Bunning. There are 29 dark pools that represent 7.2
percent of the market.
Mr. Nagy. Yes, that is--I have heard a lot of different
numbers, actually.
Senator Bunning. Well----
Mr. Nagy. We did a study last year where we found 42
different dark pools in the marketplace.
The real question, though, is to what degree does
proliferation of dark pools provide real benefit, and one of
the concerns or potential unintended consequences of some of
the dark pool regulation that the SEC is proposing by reducing
the display percentage to 0.25 percent is do you then
exponentially simply increase the number of dark pools in the
marketplace and further fragment the market, and we don't see
that being comprehensively addressed. Therefore, we believe
that there should be some sort of rigorous standards to ensure
that the process itself is robust, that process----
Senator Bunning. You are eating up all my time, so thank
you.
Mr. Nagy. Sorry, Senator.
Senator Bunning. This is a toss-up. Are there any practices
or market developments that we have not talked about today that
benefit select firms or groups over individual investors that
you think need to be addressed? That is a toss-up for anybody.
Don't all of you----
Mr. Sussman. If I could take the conversation away from the
U.S. equity markets, I think that the retail investor does not
have access to all of the products and instruments that
institutional investors do have access to.
Senator Bunning. Do they want them?
Mr. Sussman. Well, we should ask them.
Senator Bunning. Are they sophisticated enough to deal with
them?
Mr. Sussman. I think so, yes. I mean, I think that if you
are willing to--if you have an understanding of the market--I
mean, there are suitability requirements that brokers have----
Senator Bunning. When I was in the business, we said if you
want to do options and other things like that, go to the track.
You have got a better shot.
Mr. Sussman. Well, I mean, I think that if we are going to
allow our pension funds and mutual funds to trade in these
instruments and investors the same, why not give folks an equal
opportunity to trade those instruments themselves, as well. In
fact, when an individual investor takes on that responsibility,
they can be sure of how their money is invested, right? When
you put your money into a pooled fund, you actually are losing
that connection with your investments, and I think that is part
of the problem that we have today, is that people are so far
removed from the investment practices that go on that when
something like Bernie Madoff happens and everyone is surprised,
it is no surprise that when you start to disassociate----
Senator Bunning. Greed is no surprise. There is enough
going around.
Mr. Sussman. Right.
Senator Bunning. So when someone specifically bilks $50
billion out of the market, it doesn't surprise anybody who sits
up here. It may surprise some of you who are in the business,
but I doubt it.
So my question was is there something that we are missing--
--
Mr. O'Brien. Ranking Member Bunning, I will make a point,
and it has to do with market data. There has been a lot of
focus on flash as potentially giving select market participants
a millisecond advantage. I disagree with that for some reasons,
but the broader point and something that is very well known on
the street is that the consolidated quote, the national best
bid, best offer, is very slow and totally noncomprehensive
related to the proprietary data feeds that some exchanges are
selling to high-frequency traders and other customers and
earning----
Senator Bunning. Well, maybe that is a very key point that
the SEC should be looking at.
Mr. O'Brien. Yes, and our market data infrastructure on a
national basis hasn't been upgraded to reflect that reality.
Senator Bunning. Thank you.
Mr. Driscoll. Senator, if I may, just one further point on
that. I was concerned, too, about the slowness of the SIP quote
and was discussing it last week with the representative of a
major exchange who informed me that while that was a problem in
the past, the SIP quote is now up to three milliseconds behind
the direct data feeds from the exchanges. I don't know for a
long-term investor if that is a significant amount, but they
have made good strides in bringing that up to speed.
Senator Bunning. Thank you.
Chairman Reed. Senator Corker.
Senator Corker. Mr. Chairman, thank you, and we have so
many great witnesses today, I apologize for not being able to
talk with each one of you. You all have been great witnesses.
But I want to get back to the dark pool issue just to sort
of take one topic at a time, at least for me. Mr. Nagy, it
seems to me that the dark pools are an outgrowth of electronic
exchanges where people are trying to sell large bulks of shares
in a way that used to be done by individuals. So if we are
going to be almost all electronic exchanges, even the New York
Stock Exchange--I am just wondering whether that is not the
world they should have been in years ago--what is another
mechanism for large institutional traders of large blocks of
stock, what is a fairer way for them to be able to make those
types of trades without moving the market substantially and
really harming the very people they are investing for? What is
a better mechanism than a dark pool?
Mr. Nagy. So, Senator, you bring up a very, very good
point, and to clear my points, although I have concerns of
where dark pools are going, the proliferation or the birth of
dark pools, particularly after Rule 301 Reg ATS, has been very
beneficial in turning that volume and bringing that volume into
much more of an electronic format. If you do away with all dark
pools, then do you simply drive that business in back, and I
believe you stated this earlier, into its previous form, which
was a sales trader sitting up at a shop taking paper order
tickets down on the floor.
So I want to make sure that you understand that dark pools
do have a place to minimize transparent market impact in
today's marketplace. However, we must be cognizant and careful
of the proliferation of them.
As we approach, as Ranking Member Bunning said, we have
29--I have counted more than that--to what degree and what
measures do we put in place so that we don't have hundreds out
there, or perhaps even thousands----
Senator Corker. So your point is not that they are bad----
Mr. Nagy. Correct.
Senator Corker. ----it is just that too many of them might
be bad.
Mr. Nagy. That is correct.
Senator Corker. And you are talking about numbers, not
percentages of the market, is that correct?
Mr. Nagy. Yes, sir.
Senator Corker. OK. So, Mr. Mathisson, you made the point,
I think, that you shouldn't be able to exclude people, that
everybody ought to have access to a dark pool. But it seems to
me that if you do that, you kind of do away with the whole
purpose of the dark pool in the first place, don't you?
Mr. Mathisson. Well, the purpose of the dark pool is to be
able to buy or sell without displaying bids and offers to the
marketplace. It is not to avoid trading with any particular
type of party. So, no, I don't think--I think the purpose of a
dark pool is to replicate what in the old days was equivalent
to a broker putting the order in his pocket and looking for the
other side without actually displaying to the world that there
is a new buyer or a new seller in the marketplace.
Senator Corker. Mr. O'Brien, do you agree with that?
Mr. O'Brien. I think it is a combination. I mean, I think
the focus is how to allow dark pools to each have their own
kind of independent value proposition, but keep everyone
connected as reasonably possible, right. So that is really the
one reason why we use flash technology, in that while each dark
pool wasn't necessarily letting everybody in, we created a
network of 25 or so dark pools that people could access using
flash technology and get an execution on our exchange at the
same time. So it is about bringing everyone together in a way
that works for everybody, both over the short term and the long
term, and I think we can preserve that.
Senator Corker. Yes, sir?
Mr. Gasser. Senator Corker, I would respectfully disagree
with Dan. You know, just from ITG's and POSIT's perspective,
the vast majority of our executed volume in our dark pool was
institutional and we are very selective about the constituents
from the perspective of there are a lot of broker-dealers and
competitors that have competing business models, right, and
some of them have principal trading objectives. They are
operating as a fiduciary for another client, right, in some
cases. So our focus is singularly on the client, singularly on
the quality of execution, and it is not necessary about just
building market share and building executed volume. So I think
we need to maintain some sense of independence.
Taken to its logical extent is the upstairs market would,
in effect--I mean, taking it to that extreme, the upstairs
market would disappear. If I give Goldman Sachs access to
POSIT, why shouldn't I have access to their HOOT [phonetic] and
the communications that are going on between their sales
traders and block traders? So there is a level of transparency
here that I think could be counterproductive to the quality of
execution.
Mr. Driscoll. I would agree with that. You know, as an
institutional trade, I do not want my orders going into fuel
somebody's proprietary trading engine. I want to protect my
orders, and the way to do that is for me to know who is in
those pools and be able to trade with the people that I want to
trade with.
Senator Corker. And just for what it is worth, it seems to
me that is the most sensible place, and I realize there ought
to be a lot of disclosure, and I understand that is what most
people are pursuing. Some people want it before the transaction
occurs. Some people want it after. Again, it seems to me that
after makes more sense because the whole purpose is to keep
that order in your pocket until you know that you have been
able to transact it without moving the market. So, anyway, it
seems like a natural outgrowth of where our country and where
the world markets have gone.
But back to NASDAQ, Dr. Hatheway, moving on now to flash
trades, you all used to do that, and you stopped doing that.
And you all have been on the leading edge of--you know, maybe
you are the one that created all this mess in the first place
because of your great electronic exchange and people have
mimicked that. And I thank you for that, and I enjoyed visiting
your facilities.
But you all did have flash trading, and you stopped, and I
wonder if you might educate us as to why.
Dr. Hatheway. Certainly, Senator. Thank you for the
question. Flash trading was a feature of the market that
existed in the hands of our competitors. We undertook a
detailed analysis of flash trading, its impact that we saw on
the market. We also entered into discussions with the SEC.
Before we launched it, we had reservations about what it would
do to market quality. When we launched it and when the SEC
decided they would undertake rulemaking in this area, we
withdrew it. It never became a particularly material part of
our business. It was, as I said a few moments ago, a feature
that originated in other parts of the market, perhaps without
sufficient review when it first arose, and it became something
that was a missing part of our product suite. We were happy to
do without it and happy to see it eliminated from all the
markets.
Senator Corker. May I ask one more question?
Chairman Reed. Go ahead, Senator.
Senator Corker. Again, I thank each of you. The issue of
colocation, do you mind, since you all--obviously, I am sure
people want to collocate near NASDAQ. From your perspective,
what are the things that those who want to make sure that
markets act in transparent and fair ways, what are the main
issues that we ought to be concerned about as it relates to
colocation?
Dr. Hatheway. With colocation you cannot stop people from
striving for proximity, to be close to the exchange. We think
colocation----
Senator Corker. That has been while Wall Street existed in
the first place, right?
Dr. Hatheway. Wall Street existed, Threadneedle Street,
pick your street. They are all the same way. We think by
bringing the proximity within the exchange into a regulatory
environment where you have fair and nondiscriminatory access,
it provides benefits to the industry and to the investing
public. Small firms can gain access to the market, startups,
firms that are not particularly close to the city of New York.
So it brings competition.
The key thing for the Commission and for us is to be sure
that we have sufficient access so people who want to collocate
with us can, that it is provided fairly, and that the benefits
of colocation are nondiscriminatory between those who want it
and have it.
Senator Corker. But colocation, are there any real issues
right now that exist with colocation?
Dr. Hatheway. There are no issues that I am aware of. The
firms that are in our data center tend to be happy with what
they have, the resources that we make available to them. There
is a space available if more people want to come into the data
center. I cannot speak for other market centers that offer
colocation.
Senator Corker. And the benefit, just for novices like
myself, of actually being in your data center to someone who is
operating a dark pool or whatever, that benefit to them is?
Dr. Hatheway. The benefit to them is reaction time to
changes in the market. It is obviously----
Senator Corker. So it is the length of time that data takes
to get from point A to point B and, therefore, being adjacent
to it, it is literally that transmission that benefits that
collocator. Is that correct?
Dr. Hatheway. That is the perception among the collocators.
As an economist, I think if they were across the street, it
would not make an appreciable difference. But I am not a
technologist. But the technologists tell me that the speed of
light does not make a difference. You get the signal. Then the
time advantage becomes how fast you can process that
information.
As an old floor trader, yes, that is what mattered more,
not how quickly you could hear, how far across the pit you
were, but how quickly you could think.
Senator Corker. I could go on and on. Mr. Chairman, I thank
you. I do want to say, Mr. Sussman, I did not ask you any
questions, but I thought your presentation was outstanding and
very easy to understand. I think all of you have helped us
tremendously, and I thank you for having this hearing, Mr.
Chairman.
Chairman Reed. Thank you, Senator Corker.
I have got one final question, and that is, we have talked
about high-frequency trading, and I think it has been
characterized in many different ways. But I was somewhat
startled a few months ago when I read an article reporting on
the arrest of an employee of Goldman Sachs who had allegedly
stolen code for their high-frequency trading programs, and the
Federal attorney who was before the judge arguing for a very
high bail or no bail at all said that he was informed that with
this software, there is a danger that somebody knew how to use
the program and used it to manipulate markets in unfair ways.
So, you know, I think it is important now with this technique,
is there a way to use it? I mean, I think the presumption
underlying all your questions, is this being used in a
scrupulous way, just like our presumption was in many cases
that, you know, fellows like Bernie Madoff, et cetera, were
living up to their obligations, et cetera. But we have to be
prepared for a world in which one, two, or three people are not
scrupulous about their responsibilities. Mr. Gasser.
Mr. Gasser. Yes, Chairman Reed. We talked about
surveillability earlier on and the level of sophistication that
is needed to understand, you know, what is a liquidity
provision on the part of a high-frequency trader--in other
words, providing liquidity to the market--and what is potential
manipulation. We deploy, as I know other firms do, a tremendous
amount of technology to recognize patterns in the marketplace,
such that when we do enter the lit market, we understand
exactly how our orders are being interacted with.
And, you know, from our own experience, I can tell you that
there are some frictional trades going on out there that
clearly look as if they are testing the boundaries of liquidity
provision versus market manipulation. And so I think that the
technology we alluded to earlier--the software, the hardware,
the intellectual capital needed to do that--I think for most
firms that are operating in the U.S. marketplace today that
have a significant institutional share, it is a requirement in
terms of doing business. And certainly I think the SEC would
benefit greatly from having the same capabilities, but there is
clearly an issue at the extreme end. And I am sure it applies
to nonregulated enterprises, folks that do not have a
transparent regulatory environment to operate under. But that
is our----
Chairman Reed. Let me follow up with a basic question,
which I probably should have asked initially. These high-
frequency trading platforms can be located anywhere in the
world. Is that correct?
Mr. Gasser. Absolutely.
Chairman Reed. So you could have someplace beyond the reach
of regulators----
Mr. Gasser. Right, and that is why sponsored access is an
issue that is closely linked to this in terms of who are these
folks, are they regulated, nonregulated, are they entering
marketplaces without the proper compliance checks, the proper
financial checks. Even from a completely innocent perspective,
do folks have the ability to fat finger and move markets
arbitrarily, you know, completely unintentionally?
I think the high-frequency trading issue certainly is
deserving of focus, as is sponsored access. Those are highly
correlated.
Chairman Reed. Let me follow up. I know some other might
have comments, but I will follow up with one more question, Mr.
Gasser. That is, what happens when you suspect that the
envelope has been pierced and that someone--you just simply
protect your own trade or----
Mr. Gasser. Well, I think we are given quite a bit of
discretion on the part of our institutional clients to
participate and withdraw from the market as we see fit. So if
we are in what we describe as ``not held'' in that situation,
in other words, the sense of urgency that the institution has
is reasonable relative to what is going on in the market and we
have the ability or the authority or the discretion to pull out
of the market, we will, and we will return----
Chairman Reed. But there is no requirement, informal or
formal, to report your suspicions to the SEC----
Mr. Gasser. You know, it is a hard thing from the
perspective to determine, you know, exactly whether or not that
is just, you know, a circumstantial issue or something that is
clearly being--you know, one person. And it gets to that whole
issue of surveillability and transparency.
Mr. Sussman. Just a quick comment. I think this issue of
determining liquidity provisioning versus market manipulation,
you know, the issue with, well, there are 29 dark pools or
there are 42 dark pools, I think that is all symptomatic of the
fact that there is just a lack of standardized terminology
across the industry, and that the industry needs to come
together and say, you know, here is how we are going to define
what a dark pool is, here is what we are going to define as
appropriate liquidity provisioning versus market manipulation.
I mean, we cannot get much further in the process, we cannot
have the regulators expect to monitor how many dark pools there
are or if there is market manipulation going on unless everyone
agrees about the terminology. And I just think that that has
fallen behind the progress that we have made on other fronts.
Chairman Reed. Very good. Mr. Driscoll.
Mr. Driscoll. Just three follow-ups. On the fat thumb type
of an error, I think the exchanges with their harmonized
``clearly erroneous'' rules have taken a big step in preventing
a lot of the risk that goes along with that.
As far as people trying to take advantage of my orders, I
can see--I do not need technology to show me that. I can see it
and react as I need to, and that is my job. That is what we are
sitting on those desks to do.
Chairman Reed. But, there is no formal or informal
obligation to say, ``I have suspicions,'' to anyone so that
this--you self-correct.
Mr. Driscoll. I would not be able to get off the phone with
the SEC. I am an institutional trader. My job is to be
suspicious of the counter side of my trades.
Chairman Reed. Well, OK. Anyone else? I do want Mr.
Brigagliano to comment on behalf of the SEC.
Mr. Brigagliano. If I could get the microphone on, I will,
Chairman Reed. I think that this line of discussion has
highlighted two issues. One is the sponsored access issue,
which Ranking Member Bunning asked what is of most concern, and
there seems to be a pretty clear consensus that that should be
front burner, and it is at the SEC.
The other issue that really you have raised is cyber
security, and the Commission has technology people who work
with the markets to make sure that there is cyber security. But
we do hear about hacking incidents, sometimes from abroad, into
financial institutions, and that is certainly a problem that
the country needs to pay more attention to, and we are, and
that is another ground where we may need to put more resources.
Chairman Reed. Well, thank you very much. There may be
additional questions by my colleagues, those that attended and
those that may not have attended, and we would ask you to
respond to them as quickly as possible.
We will keep the record open until this Friday if there are
additional comments that you want to make or statements that
anyone would like to make.
Thank you very much. This has been a very informative
hearing on a topic that is important and is just beginning to
be recognized here. It has been recognized, I think, in the
regulatory community and the technology community and the
trading community, but we are beginning to recognize it, so
thank you for helping us understand this issue. The hearing is
adjourned.
[Whereupon, at 11:52 a.m., the hearing was adjourned.]
[Prepared statements, responses to written questions, and
additional material supplied for the record follow:]
PREPARED STATEMENT OF CHAIRMAN JACK REED
I want to start by welcoming my friend and colleague Senator Ted
Kaufman, who has spent considerable time examining some of the cutting
edge issues facing our increasingly high-tech capital markets. I also
want to welcome the witnesses joining us on our second panel this
morning.
As many families struggle to regain their footing, stay in their
homes, and keep their jobs in the wake of a severe recession caused by
reckless profit seeking on Wall Street, it is appropriate and timely to
meet today to ask questions about the role of technology and our
financial markets.
Today's hearing is a check-up on our equity markets, amid concerns
that technological developments in recent years may be disadvantaging
certain investors. Electronic trading has evolved dramatically over the
last decade, and it is important that regulators keep up. For example,
trading technology today is measured not in seconds or even
milliseconds, but in microseconds, or one-millionth of a second. So
even a sneak peek of a fraction of a second using what is called a
flash order may give some market participants a significant advantage.
Our hearing will take a closer look at such ``flash orders,'' along
with other market structure issues such as ``dark pools,'' which are
private trading systems that do not display quotes publicly, and ``high
frequency trading,'' a lightning-fast computer-based trading technique.
According to the SEC, the overall proportion of displayed market
segments--those that display quotations to the public--has remained
steady over time at approximately 75 percent of the market. However,
undisplayed liquidity has shifted from taking place on the floor of the
exchanges or between investment banks, to what are currently known as
dark pools, with the number of such pools increasing from approximately
10 in 2002 to approximately 29 in 2009. Dark pools today account for
about 7.2 percent of the total share of stock volume.
Dark pools and other undisplayed forms of liquidity have been
considered useful to investors moving large numbers of shares, since it
allows them to trade large blocks of shares of stock without giving
others information to buy or sell ahead of them. However, some critics
of dark pools argue that this has created a two-tiered market, in which
only some investors in dark pools but not the general public have
information about the best available prices. The SEC has recently
proposed changes in this area to bring greater transparency to these
pools.
Flash orders and high-frequency trading have also raised concerns.
Flash orders, which enable investors who have not publicly displayed
quotes to see orders before other investors, have raised concerns about
fairness in the markets, and the SEC has recently proposed to ban them.
High-frequency trading, a much more common technique used
extensively throughout the markets, is the buying and selling of stocks
at extremely fast speeds with the help of powerful computers. This
activity has raised concerns that some market participants are able to
``game'' the system, using repeated and lightning-fast orders to
quickly identify other traders' positions and take advantage of that
information, potentially disadvantaging retail investors. Other
investors argue that the practice has significantly increased liquidity
in the markets, improved price discovery, and reduced spreads, and that
high-frequency trading is being used by all types of investors.
Today's hearing will help to answer some important questions about
these issues. Have recent developments helped or hurt the average
investor? How have these developments impacted the average household's
ability to save for college and retirement? What risks we must be
vigilant about in how we structure and operate our markets going
forward?
I have asked today's witnesses to discuss the potential benefits
and drawbacks of ``dark pools'' and other undisplayed quotes now and
historically in our markets. I have also asked them how flash orders
and high-frequency trading have impacted the markets, and whether tools
like this may disadvantage certain investors, especially retail
investors.
Finally, as the SEC has recently taken steps to ban flash orders
and increase transparency in dark pools, we will hear perspectives on
the SEC's actions, and ask our panelists what additional legislative or
regulatory changes, if any, are needed to protect retail investors and
ensure fair markets.
______
PREPARED STATEMENT OF SENATOR JIM BUNNING
Thank you, Mr. Chairman.
I think this will be an educational hearing about several complex
topics that have been in the news lately.
A lot of things have changed in the securities markets since I sat
at a trading desk. While just about all trades take place over a
computer now, trading used to be done over the phone or in person.
There are many more stocks and other securities traded now, just as
there are many more investors.
But even though the technology and the amount of money changing
hands has changed, a lot is still the same. Investors are still looking
for the best price and traders are still using every tool they can to
get an edge. And there is always someone trying to make a quick buck
off the unsophisticated and uninformed, or even through manipulation
and fraud.
Historically, the way we have tried to make our markets safer and
fairer is by increasing transparency and access, and I think that has
worked. But in order for those principles to continue to work, the SEC
must stay on top of the changing markets and update its rules as
necessary. I am glad to see the Commission is reviewing its market
structure rules, and I hope it does not limit those reviews to just the
topics that have been covered in the news. I also hope the Commission
will let this Committee know if there are any gaps in its authority
that we need to fill so any market structure issues can be properly
addressed.
Thank you, Mr. Chairman. I look forward to hearing from our
witnesses.
______
PREPARED STATEMENT OF SENATOR EDWARD E. KAUFMAN
It's a privilege for me to testify at today's hearing, and I
commend Chairman Reed and Ranking Member Bunning for convening it.
Mr. Chairman, our stock markets have evolved rapidly in the past
few years in ways that raise important questions for this hearing to
explore.
Technological developments have far outpaced regulatory oversight;
and traders who buy and sell stocks in milliseconds--capitalizing
everywhere on minute price differentials in a highly fragmented
marketplace--now predominate over value investors. Liquidity as an end
seems to have trumped the need for transparency and fairness. We risk
creating a two-tiered market structure that is opaque, highly
fragmented and unfair to long-term investors.
I am very concerned about the integrity of the U.S. capital
markets, which are an essential component to the success of our Nation.
It was the repeal of the uptick rule by the SEC in 2007 which first
caught my attention. When I was at Wharton getting my MBA in the mid-
1960s, the uptick rule was considered a cornerstone of effective
financial regulation. As many on this Subcommittee have noted, the
uptick rule's repeal made it easier for bear raiders--no longer
constrained to wait for an uptick in price between each short sale--to
help bring down Lehman Brothers and Bear Stearns in their final days.
In April, Senators Isakson, Tester, Specter, Chambliss and I
introduced a bill prodding the SEC to reinstate the rule. As the months
have gone by, I have asked myself--why is it so difficult for the SEC
to mandate some version of the uptick rule and impose ``hard locate''
requirements to stop naked short selling? Then it became clear: None of
the high-frequency traders--who dominate the market--want to reprogram
their computer algorithms to wait for an uptick in price or to obtain a
``hard locate'' of available underlying shares.
I began to hear from many on Wall Street and other experts
concerned about a host of questionable practices--all connected to the
decimalization and digitalization of the market and the resulting surge
in electronic trading activity. It became clear that the SEC staff was
considering issues piecemeal--like the rise of flash orders--without
taking a holistic view of the market's overall structure, applying
rules from a floor-based trading era to our current electronic trading
venues.
I wrote SEC Chairman Schapiro on August 21 calling for a
comprehensive ``ground up'' review of the equity markets (my letter and
the Chairman's September 10 response are attached):
Actions by the SEC over recent decades have, perhaps
unintentionally, encouraged the development of markets which
seem to favor the most technologically sophisticated traders.
The current market structure appears to be the natural
consequence of regulations designed to increase efficiency and
thereby provide the greatest benefits to the highest volume
traders. I believe the SEC's rules have effectively placed
``increased liquidity'' as a value above fair execution of
trades for all investors.
Markets have become so fragmented--and the rise of high-
frequency trading that can execute trades in milliseconds has
been so rapid--that the SEC should review and quantify the
costs and benefits of these market structure developments to
all investors.
The facts speak for themselves. We've gone from an era dominated by
a duopoly of the New York Stock Exchange and NASDAQ to a highly
fragmented market of more than 60 trading centers. Dark pools, which
allow confidential trading away from the public eye, have flourished,
growing from 1.5 percent to 12 percent of market trades in under 5
years.
Competition for liquidity is intense--and increasingly problematic.
Flash orders, liquidity rebates, direct access granted to hedge funds
by the exchanges, dark pools, indications of interest, and payment for
order flow are each a consequence of these 60 centers all competing for
liquidity.
Moreover, in just a few short years, high frequency trading--which
feeds everywhere on miniscule price differences between and among the
many fragmented trading venues--has skyrocketed from 30 percent to 70
percent of the daily volume. Indeed, the chief executive of one of the
country's biggest block traders in dark pools was quoted last week as
saying that the amount of money devoted to high frequency trading could
quintuple ``between this year and next.''
So I'm pleased that the Commission has begun to address flash
orders and dark pools.
Let me quickly layout three reasons why this hearing is so
important:
First, we must avoid systemic risk to the markets. Our recent
history teaches us that when markets develop too rapidly, when they are
not transparent, effectively regulated or fair--a breakdown can trigger
a disaster.
Second, rapid advances in technology, which can produce impressive
results, combined with market fragmentation are moving us from an
investor's market to a trader's market. This can have significant
consequences. Last week, I met with the author of a soon-to-be released
Grant Thornton study that found that market structure changes since the
1990s have severely undermined the ability of small companies to raise
capital and issue IPOs.
Third, we must ensure that retail investors are not relegated to
second-tier status. When the average investor believes he or she is
paying a higher price for 100 shares of IBM, even if only marginally,
the integrity of our markets is significantly tarnished. The markets
should work best for those who want to buy and hold in hopes of a
golden retirement, not just for high frequency traders who want to buy
and sell in fractions of a second.
As Chairman Schapiro acknowledged just yesterday, ``I believe we
need a deeper understanding of the strategies and activities of high
frequency traders and the potential impact on our markets and investors
of so many transactions occurring so quickly.''
Many on Wall Street assure us we have nothing to worry about: that
high-speed technology has only led to positive changes: greater
liquidity, narrowed spreads and lower costs. Rules ensuring ``best
execution,'' they say, will always protect the investor. Don't take
those claims on face value.
Many of these ``liquidity providers'' are not regulated
market makers. Furthermore, liquidity mainly follows high-
volume stocks because that's where the profit is; in low volume
stocks, spreads remain wide.
Our regulators and broker-dealers are using antiquated
benchmarks and measurements to ensure fair trades. By the time
the consolidated best bid and offer data has been aggregated
from the many different market centers and then disseminated,
the time lag is large enough for an entire industry of high
frequency traders to book millions of dollars in profits.
Payment for order flow is an inherent conflict of interest.
Because it encourages broker dealers to send retail order flow
to the highest bidder and not to the trading center that is
necessarily best for the buyer or seller, payment for retail
order flow is a highly dubious practice.
Growing trading volumes in dark pools is undermining public
price discovery. While certain dark pools serve a useful
function--permitting large blocks of stock to change hands
without creating temporary price drops or gains--their
proliferation is undermining public prices.
High-frequency gaming strategies may be forcing retail
investors to pay higher prices, although the lack of
transparency and effective regulatory surveillance prevents us
from knowing the extent to which this might be happening. But
it is telling when sophisticated clients are reportedly
demanding that their major broker-dealers ``not hand over their
orders on a silver platter''--and when seminars for
institutional fund managers are conducted openly on how to
avoid being ``gamed'' in dark pools.
Technology should not dictate our regulatory destiny; rather our
regulatory policy should provide the framework and the guidelines under
which technology operates. Our foremost policy goal should be to
restore the markets to their highest and best purposes: serving the
interests of long-term investors, establishing prices that allocate
resources to their most productive uses, and enabling companies--large
and small--to raise capital to innovate, create jobs and grow.
The SEC's ground-up review of these issues should leave nothing
out, reviving old ideas and examining new ones: should markets be
centralized or decentralized; should we separate the markets based on
investor types; what should be the role of market makers; what role
might there be for real time risk management?
At a minimum, a few straightforward propositions should guide us to
a regulatory framework that permits vigorous competition while
substantially reducing the possibility of a two-tiered trading network,
one where long-term investors are vulnerable to powerful trading
companies that exist not to value or invest in the underlying
companies, but to feed everywhere on small but statistically
significant price differentials. As values, transparency and fairness
should trump liquidity.
First, we should reconsider the criteria for becoming an exchange
or market center. The market's unhealthy fragmentation, and the high-
speed trading strategies which thrive on its fractured state, are
growing far too rapidly to ensure that there are not unintended
negative consequences for the investing public.
Second, we should consider rule changes that ensure the best prices
are publicly available, not hidden from view in private trades. The
strength of a free market is based on this public display. We should
reduce ``internalization'' by broker-dealers, by insisting on
meaningful price improvement in comparison to the public quotes or by
granting the public quotes the right to trade first. And we should
reduce trading in dark pools by reducing the permissible threshold for
dark pool trading and by defining indications of interest, and other
quote-like trading signals, as quotes.
Third, we should root out conflicts of interest by ending payments
from market centers that encourage orders to flow their way. The search
for best execution by broker-dealers should not be subject to
temptation from the highest bidders. Liquidity rebates and direct
access to the exchanges by hedge funds, which are still unregulated
entities, also deserve careful review.
Fourth, regulators should measure execution fairness in
milliseconds for stock trades of all kinds, as only then can the
credibility of the markets be assured. The audit trails and records of
order execution in fragmented venues must be synchronized to the
millisecond and made readily available in statistically understandable
formats to regulators and the public. This obligation must be placed on
broker-dealers as well as market centers. Currently, while high
frequency traders bank profits in milliseconds, the first column for
time on the Rule 605 form, used by regulators to measure execution
quality, reads ``0-9 seconds.''
Fifth, regulators must develop more sophisticated statistical tests
to gain a granular view of gaming strategies, such as following high
frequency trading volume patterns. Only then can regulators separate
high frequency strategies that add value to the marketplace from those
that inexcusably take value away.
As a Nation, our credit and equity markets should be a crown jewel.
Only a year ago, we suffered a credit market debacle that led to
devastating consequences for millions of Americans. While we must
redress those problems, we must also urgently examine opaque and
complex financial practices in other markets, including equities,
before new problems arise. It is essential to ensure the integrity of
U.S. capital markets.
PREPARED STATEMENT OF JAMES BRIGAGLIANO
Coacting Director, Division of Trading and Markets, Securities and
Exchange Commission
October 28, 2009
Thank you Chairman Reed and Members of the Subcommittee for giving
me the opportunity to speak to you today about the U.S. equity markets
on behalf of the Securities and Exchange Commission (``SEC'' or
``Commission'').
The U.S. equity markets have undergone a transformation in recent
years due in large part to technological innovations that have changed
the way that markets operate. As markets evolve, the Commission must
continually seek to preserve the essential role of the public markets
in promoting efficient price discovery, fair competition, and investor
protection and confidence.
For this reason, the Commission is undertaking a broad review of
equity market structure to assess its performance in recent years and
determine whether market structure rules have kept pace with, among
other things, changes in trading technology and practices. This review
will address the advantages and disadvantages of matters including high
frequency trading, sponsored access, and dark forms of liquidity. In
fact, the Commission has already proposed rules related to banning
flash orders and three issues designed to shed greater light on dark
pools. Before I discuss these efforts in greater detail, however, let
me provide some important background.
Background: Operation of U.S. Equity Markets
The United States has a highly competitive market with a large
number of participants, including exchanges, electronic communications
networks or ``ECNs,'' alternative trading systems or ``ATSs,'' over-
the-counter (OTC) market makers, and proprietary trading firms.
Currently, ten registered exchanges trade equity securities. An
exchange brings together the orders of multiple buyers and sellers and
is required to provide the best bid and offer prices for each stock
that it trades, as well as last-sale information for each trade that
takes place on that exchange. This information is collected and made
public through consolidated systems that are approved and overseen by
the SEC. Any investor in the United States can see the best quotation
and the last-sale price of any listed stock, in real time. This
transparency is a key element of the national market system mandated by
Congress.
Under that system, the SEC seeks to promote competition among
trading venues, since this can lead to benefits for institutional and
retail investors, including lower transaction costs, improved liquidity
and execution, enhanced price discovery, and more choices for
investors. The SEC also seeks to ensure there is proper coordination
among all trading centers, and is mindful of any potentially harmful
effects of having orders placed in different markets rather than a
single, central market.
Competition among markets has increased dramatically, especially in
recent years. Thirty-four years ago, when Congress charged the SEC with
creating an integrated national market system, the New York Stock
Exchange (NYSE) accounted for the vast majority of trading volume in
listed stocks and NASDAQ was becoming a major market for OTC stocks.
NYSE and NASDAQ still play a significant role, but other markets,
including ECNs and ATSs that didn't exist a decade ago, are now major
participants in the national market system.
As a preliminary matter, let me describe ATSs and their origin,
since certain types of ATSs figure prominently in market structure
issues that I will discuss in a moment. ATSs are broker-dealers that
match the orders of multiple buyers and sellers according to
established, nondiscretionary methods. Although these types of systems
have existed since the late 1960s, they began to proliferate in the mid
1990s in response to technological developments that made it easier for
broker-dealers to match buy and sell orders. In 1998, the SEC created a
new regulatory framework, called Regulation ATS, which sought to reduce
barriers to entry for these systems and promote competition and
innovation, while appropriately regulating the exchange functions that
they performed.
Currently, there are 73 active, registered ATSs, and they trade all
types of securities. Four of these ATSs have chosen to publicly display
their best orders in the consolidated quote stream as exchanges do and
to allow their quotes to be accessed (at least indirectly) by any
investor. This subgroup of ATSs is known as ECNs. Over the last 15
years, ECNs have driven many beneficial changes in the equity
marketplace, such as faster trading technologies, new pricing
strategies, and robust intermarket linkages. Some ECNs have merged with
registered exchanges or have registered as exchanges themselves. For
example, BATS, the newest registered exchange, was until recently an
ECN. Direct Edge, which is currently an ECN, is applying to become a
registered exchange. Not only have ECNs, as well as other ATSs,
acquired significant market share, the competition they have brought to
the markets has caused incumbent exchanges to adapt and compete to
provide better services to investors.
Another type of ATS is the so-called ``dark pool.'' An ATS that
operates as a dark pool does not provide quotes into the public quote
stream. The number of active dark pools transacting in stocks that
trade on major U.S. stock markets has increased from approximately 10
in 2002 to approximately 30 in 2009. For the second quarter of 2009,
the combined trading volume of dark pools was approximately 7.2 percent
of the total share volume in these stocks, with no individual dark pool
executing more than 1.3 percent. Like ECNs, dark pools operating under
Regulation ATS must register as broker-dealers and become members of
FINRA. The Commission has recently been reviewing the regulatory
structure applicable to dark pools.
Although the phrase ``dark pool'' is new, the concept is old. Dark
liquidity--meaning orders and latent demand that are not publicly
displayed--has been present in some form within the equity markets for
many years. Traders are loath to display the full extent of their
trading interest. Imagine a large pension fund that wants to sell a
million shares of a particular stock. If it displayed such an order,
the price of the stock would likely drop sharply before the pension
fund could sell its shares. So the pension fund, assuming it could
execute its trade at all, would be forced to sell at a worse price than
it might have if information about its order had remained confidential.
In the not-so-distant past, the pension fund might have placed the
order, or some part of it, with a broker-dealer, which would attempt to
find contraside interest (whether on the floor of an exchange or by
calling around to other traders), preferably without giving up enough
information to move the market against its client. Information leakage
about a larger order was a serious problem, and the ``market impact''
of large orders would impose a major cost on investors.
Historically, many dark pools developed as computerized ways of
searching for contraside trading interest while preserving
confidentiality. While early dark pools were designed to cross large
orders, and such pools still exist today, most of the newer dark pools
are designed to trade smaller-sized orders. In some cases, these small
orders are derived from large ``parent'' orders that have been chopped
up into smaller pieces. In addition, some small orders represent orders
that the broker-dealer operating the ATS is attempting to cross
internally, rather than lose the execution to another market.
Looking at overall U.S. equity market structure, competition among
different markets appears to have yielded significant benefits to
investors, both retail and institutional: lower commissions, tighter
spreads, faster execution speeds, and greater systems capacity. And
from a systemic risk standpoint, having a network of interlinked
markets is preferable to having a single point of failure. When trading
is disrupted in one market, which happens occasionally, volume quickly
migrates to other markets.
Our equity markets have faced serious tests since the onset of the
financial crisis, and generally the markets have performed well.
Despite record volumes and volatility, particularly in the fall of
2008, the markets for U.S.-listed securities have remained open and
continued to operate in a fair and orderly manner and to perform their
vital price discovery function. Buyers and sellers could see current
prices and expect to execute their trades promptly at the prices they
saw on their screens.
But markets continually evolve, and among the questions that have
been raised about recent changes in the market are questions about
whether certain current market practices might create a two-tiered
market. The Commission's job is to make sure that the core principles
of the Exchange Act--fairness, efficiency, and best execution--are
maintained as the markets, and the environment in which they operate,
change. So the challenge for regulators is to monitor these changes and
update regulation when needed. The Commission currently is taking a
broad and critical look at market structure practices in light of the
rapid development in trading technology and strategies. I will address
some steps the Commission has taken recently, and some that I
anticipate it may take in the near future.
Commission Action on Market Structure Reforms
Flash Orders
In September, the SEC proposed to prohibit the practice of flashing
marketable orders. In general, flash orders are communicated to certain
market participants and either executed immediately or withdrawn
immediately after communication. Flash orders are exempt from the
Exchange Act's quoting requirements as the result of an exemption
formulated when most trading took place on the floors of the exchanges.
The exception was originally intended to facilitate manual trading in
the crowd on exchange floors by excluding quotations that were then
considered ``ephemeral'' and impractical to include in the consolidated
quotation data.
The Commission is concerned that the exception for flash orders,
whether manual or automated, from Exchange Act quoting requirements is
no longer necessary or appropriate in today's highly automated trading
environment. The consolidated quotation stream is designed to provide
investors with a source of information for the best prices in a listed
security, rather than forcing investors to obtain such information by
subscribing to all of the data feeds of the many exchanges and ATSs
that trade listed securities. The flashing of order information could
lead to a two-tiered market in which the public does not have access,
through the consolidated quotation data streams, to information about
the best available prices for U.S.-listed securities that is available
to some market participants through proprietary data feeds.
In addition, the recipients of the flashed order can trade at the
same price as the displayed quote without publicly quoting themselves.
At the same time, the investor who is publicly quoting may miss out on
the opportunity to receive an execution. The recipients of the flashed
order also may obtain an informational advantage by seeing and being
able to react to orders in the market before others can. As a result,
flash orders could lead to a two-tiered market where the public does
not have equal access to information about the best available prices
for listed securities.
Flash orders also offer potential benefits to certain types of
market participants. For example, for those seeking liquidity, the
flash mechanism may attract additional liquidity from market
participants who are not otherwise willing to display their trading
interest publicly, and could help lower the transaction costs of those
responding to flash orders. Flash orders may be executed through the
flash process for lower fees than those charged by many markets for
accessing displayed quotations.
Taking these factors into consideration, the Commission recently
proposed to ban flash orders, noting that while flash orders may
potentially be providing benefits to certain traders, it may no longer
serve the interests of long-term investors or the markets as a whole.
The Commission has stated, both in adopting Regulation NMS and in
proposing to ban flash orders, that the interests of long-term
investors should be upheld as against those of professional short-term
traders, when those interests are in conflict. The comment period on
the proposal to ban flash orders remains open until November 23, and
the staff and the Commission look forward to carefully analyzing the
comments received.
Dark Pools
Last week, the SEC made additional proposals related to market
structure. These proposals relate to three issues relevant to dark
pools and so-called actionable ``indications of interest'' or ``IOIs.''
IOIs, like flash orders, potentially create two-tiered markets in which
selected participants are made aware of prices that are available in
the market but that other investors don't know about. IOIs are used by
some market makers and dark pools to alert certain other market
participants about available trading opportunities. Some of these IOIs
are actionable IOIs: they contain enough information for a recipient to
act on them in the same way it would act on quotes.
Therefore, the Commission has put forth three proposals in this
area. The first proposal would require actionable IOIs to be treated
like quotations and be subject to the same disclosure rules that apply
to quotations. The second proposal would lower the ATS trading volume
threshold for displaying best-priced orders in the consolidated quote
stream. Currently, an ATS, if it displays orders to more than one
person, must display its best-priced orders to the public when its
trading volume for a stock is 5 percent or more. This proposal would
lower that percentage to 0.25 percent, meaning that dark pools that use
actionable IOIs and exceed the volume percentage threshold would be
required to publicly display those actionable IOIs as quotes. Taken
together these changes would help make the information conveyed by
actionable IOIs available to the public instead of just to a select
group.
At the same time, both proposals would exclude from their
requirements certain narrowly targeted IOIs related to large orders.
These size discovery mechanisms currently are offered by dark pools
that specialize in large trades. In particular, the proposal would
exclude IOIs for $200,000 or more that are communicated only to those
who are reasonably believed to represent current contra-side trading
interest of equally large size. The ability to have a method for
connecting investors desiring to trade shares in large blocks could
enable those investors to trade efficiently in sizes much larger than
the average size of trades in the public markets.
As you know, Chairman Schapiro has expressed concern about
transparency in dark pools generally. I mentioned earlier that all
trades, even those in dark pools, have to be reported to the
consolidated tape in real time. However, under the current system,
investors can see only that a trade occurred somewhere off an exchange.
They don't know which ATS executed the trade, or even whether it was
executed in a dark pool at all.
Therefore, the Commission also proposed to create a similar level
of post-trade transparency for ATSs, including dark pools, as for
registered exchanges. Specifically, the proposal would amend existing
rules to require real-time disclosure of the identity of dark pools and
other ATSs on the public reports of their executed trades. As with the
Commission's IOI proposal, this proposal also would exclude the
identification of the ATS for large trades of $200,000 or more, to
prevent potential detrimental information leakage that could interfere
with the ability of institutions to efficiently trade large blocks of
stock. \1\ In considering post-trade transparency, some have suggested
that such transparency may compromise proprietary trading strategies
and allow the market to ascertain the trading interest of investors,
while others have suggested that post-trade transparency disclosures do
not raise such concerns.
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\1\ The proposals discussed above do not attempt to address all of
the issues regarding dark liquidity.
---------------------------------------------------------------------------
Looking Forward
But these steps are just the beginning. As Chairman Schapiro has
indicated, now is an appropriate time to take a broad look at the whole
of U.S. equities market structure. Over the coming months, I anticipate
that the SEC will consider additional issues relating to dark liquidity
more broadly, perhaps by issuing a concept release.
Dark liquidity is offered not just by dark pools, but by large
dealer firms that internalize customer orders, ECNs, ATSs, and
registered exchanges, which have a variety of dark order types. As part
of the Chairman's directive to take a broad look at market structure
issues, the staff plans to examine whether the degree or nature of
trading with dark liquidity has changed in recent years and, if so,
whether it is having detrimental effects on the quality of the markets,
such as efficient price discovery.
Another practice that is being examined by the Commission staff is
high frequency trading. While the term lacks a clear definition, which
partially explains the confusion on the subject, it generally involves
a trading strategy where there are a large number of orders and also a
large number of cancellations (often in subseconds), and moving into
and out of positions, often many times in a single day.
High frequency trading plays a significant role in today's markets
by providing a large percentage of the displayed liquidity that is
available on the registered securities exchanges and other public
markets. Many are concerned, however, that high frequency trading can
be harmful, depending on the trading strategies used, both to the
quality of the markets and the interests of long-term investors.
The Commission recognizes that concerns have been raised that high
frequency traders have the ability to access markets more quickly
through high-speed trading algorithms and colocation arrangements. This
ability may allow them to submit or cancel their orders faster than
long-term investors, which may result in less favorable trading
conditions for these investors. This quicker access could, for example,
enable high frequency traders to successfully implement ``momentum''
strategies designed to prompt sharp price movements and then profit
from the resulting short-term volatility. In combination with a
``liquidity detection'' strategy that seeks solely to ascertain whether
there is a large buyer or seller in the market (such as an
institutional investor), a high frequency trader may be able to profit
from trading ahead of the large order.
High frequency trading, however, can also play a constructive role.
Some have argued that high frequency traders played a role in
continuing to provide liquidity during the recent market turmoil. High
frequency trading may also help to reduce market spreads. I expect that
the Commission would seek the public's views on the potential benefits
and drawbacks associated with high frequency trading, perhaps by
issuing a concept release to explore these issues in greater detail.
Commission staff is also exploring ways for the Commission to use
its statutory authority to assure that the Commission has better
baseline information about high-frequency traders and their trading
activity. This would help to enhance the Commission's ability to
identify large and high-frequency traders and their affiliates.
Another market structure issue that the Commission staff is
exploring is sponsored access--also known as ``direct market access''
or ``DMA''--where broker-dealer members of an exchange allow
nonmembers--in many cases, high frequency traders--to trade on that
exchange under their name. As electronic trading has become the norm,
this type of access to exchange execution systems has increased
significantly. In some cases, broker-dealers offer sponsored access to
customers without requiring the orders to pass through the broker-
dealers' systems. The appeal of the arrangement is that it helps
preserve anonymity and enables the fastest possible trading. There are,
however, a variety of risks involved when trading firms have unfiltered
access to the markets. These risks can affect many of the participants
in a market structure, including the trader's broker, the exchanges,
and the clearing entities. Sponsored access could raise concerns about
whether sponsoring broker-dealers impose appropriate and effective
controls on sponsored access to fully protect themselves and the
markets as a whole from financial risk, and to assure compliance with
all regulatory requirements. The Commission staff is looking at these
issues.
In evaluating these market structure issues, the SEC is focused on
the protection of investors, maintaining fair, orderly, and efficient
markets, and facilitating capital formation.
Thank you for giving me the opportunity to speak to you today on
behalf of the Securities and Exchange Commission. I welcome any
questions you may have.
______
PREPARED STATEMENT OF FRANK HATHEWAY
Senior Vice President and Chief Economist, NASDAQ OMX
October 28, 2009
Good morning Chairman Reed and Ranking Member Bunning. Thank you
for the opportunity to offer my perspective on recent developments in
U.S. equities markets. I speak as an economist who has studied equities
markets for several decades from multiple vantage points--as an options
trader on the floor of the Philadelphia Stock Exchange, as a Professor
of Economics at Penn State, as an Economic Fellow at the SEC, and,
currently, as NASDAQ's Chief Economist.
Based on my experience, while equities markets are in a period of
rapid transformation, it is important to view developments such as
flash orders, dark pools, and high frequency trading through a long
lens. These phenomena are, generally speaking, iterations of constant
market behavior adapting to new technology. The unmatched strength of
U.S. markets is the continual ability of Congress, the SEC, and self-
regulatory organizations to adapt to these iterations and protect
investors during periods of change as well as stability.
Markets have always harnessed the power of speed and communication
to drive trading efficiency--from telegraph, to telephone to fiber
optics. Transparency and price discovery are continually evolving
products of technology and market conditions. They reflect ever-present
tension between average investors' needs for meaningful public
reference prices and institutions' desires to execute block orders
while minimizing market impact.
This history reveals the following sound principles with which to
assess the latest market developments.
First, maximize efficient price discovery. Markets are most
efficient at promoting price discovery when the participants in the
markets are numerous and diverse, with divergent objectives from their
investments and divergent views on value. Discovering the true value of
securities requires maximizing transparency, display, and order
interaction.
Second, encourage innovation and competition. Secondary markets
function most efficiently when exchanges and nonexchanges compete to
develop the most advanced trading technology to execute trades quickly,
at the right price, and at a lower cost. Electronic markets and
electronic traders, who built their business and technology to compete
in this modern world, provide critical liquidity during good and bad
markets.
Third, guarantee fair and equal access. The definition of
``market'' assumes fair and equal access to all market participants.
Any step away from this principle and towards selective disclosure and
access will tend to create a two-tiered market where sophisticated
investors have unfair advantages over average investors. Selective
disclosure and access also creates distortions to the market, with
unknowable and unintended consequences.
Fourth, prioritize sound regulation. Markets and market
participants are more likely to behave in an economically rational
manner when trading rules are clear, fair, and rigorously enforced.
Rapid detection and enforcement through real-time and post-trade
surveillance are critical to fair and orderly markets.
Only by prioritizing public markets over private and average
investors over professionals can we simultaneously achieve all four of
these important goals: efficient price discovery, innovation and
competition, fair and equal access, and sound regulation. Consequently,
orders should first attempt to execute in the public market before
turning to the nonpublic markets. Without efficient price discovery,
competition, access, and sound regulation in the public markets, there
will be no accurate price for nonpublic market to reference.
Viewed through this lens, dark pools--meaning any market that does
not offer pretrade price transparency--are potentially problematic on
several grounds. They undermine public price discovery by shifting
liquidity away from the lit markets, isolating displayed limit orders,
widening public spreads, and decreasing execution quality. SEC
Commissioner Elisse Walter wisely said recently: every share that gets
executed in the dark does not contribute fully to price discovery. The
question becomes how many dark shares are too many?
Based on comparisons between stocks with otherwise similar
characteristics, execution quality begins to deteriorate when stocks
experience dark trading in excess of 40 percent of total volume. At
that point, the spread of the public reference price widens and
execution quality deteriorates. This conclusion is based on studying
snapshots of empirical data for the top 3,000 U.S. stocks by trading
volume that individually trade in excess of $500,000 average daily
dollar volume and 50,000 average daily shares.
This is not to say that dark pools don't have valued uses that are
consistent with core market principles. The transparent markets have,
since the beginning of markets, had difficulty in servicing the
requirements of large ``block orders'' without market impact. Broker
dealers have traditionally performed this necessary function, through
the use of capital, trading acumen, and the transparent market. The
broker dealer-operated block execution services are needed and must
continue. Broker dealers have advanced their services through creative
and innovative uses of technology.
NASDAQ supports the SEC's proposals, announced last week, to
reposition dark pools. The SEC proposed to require full public display
of ``actionable indications of interest'' or IOIs when dark pools
execute greater than 0.25 percent of aggregate share volume. Many Dark
Pools use IOIs to show trading interest to a select group of members
without displaying that trading interest with the broader public. The
SEC created an exception from the display requirement for block orders
of $200,000 or more in value. The SEC proposals prioritize public
markets, increase transparency, and encourage fair and equal access
while still respecting the need for traders to execute block trades
with minimal market impact.
One question I have as an economist is whether limits on using
actionable indications of interest would be a binding constraint on
dark pools. Even in the absence of actionable indications of interest,
some market participants may employ ``pinging'' strategies to probe for
and discover liquidity that is not advertised by outbound messages. In
other words, is it systemically beneficial for dark pools to choose to
remain completely dark no matter how large they grow?
Turning away from dark pools, NASDAQ also supports the SEC's
proposals to ban the use of flash orders. Flash orders originated from
and remain an accepted practice of floor exchanges, with the
effectiveness of the ``flash'' limited by the distance a human voice
could travel. As technology was added to floor trading operations,
automation of these flash capabilities occurred through systems such as
Block Talk on the NYSE. Later, fully electronic versions of this floor
flash capability were introduced by the CBSX and Direct Edge.
After full consultation with the SEC, NASDAQ OMX was one of the
last to offer flash orders. Most importantly, consistent with our core
principle of fair and equal access, NASDAQ created a flash order type
that was available to all investors rather than a select group of
members. NASDAQ was then the first exchange voluntarily to cease
offering the ``flash'' dark order type when Chairman Schapiro announced
a comprehensive review of the use of flash orders. NASDAQ will submit a
comment letter supporting the SEC's proposal to ban flash orders.
Recent commentary on flash orders and dark pools has wrongly
conflated these market structure concerns with questions on the
validity of market participants who engage in high-volume algorithmic
trading. Price discovery is most efficient when the participants in the
markets are numerous and diverse, with divergent objectives from their
investments and divergent views on value. This philosophical view of
proper markets is codified in our rules that mandate fair and equal
access to all market participants.
Any step away from this principle will create distortions to the
market, with unknowable and unintended consequences. Electronic markets
and electronic trading is the foundation of modern markets. The
activities of electronic market makers, who built their business and
technology to compete in this modern world, provide critical liquidity
during good markets and bad markets. These activities benefit all
investors.
Speed in the execution of transactions is another way in which
markets and market participants compete, and competition is the
lifeblood of efficient markets. In turn, open, transparent markets
facilitate competition. So long as information is available on an equal
basis to all market participants, the increased speed at which
transactions are executed provides tremendous benefits to investors by
enhancing liquidity and reducing transaction costs.
As we reflect on the current state of the U.S. equities markets we
see that investors had and continue to have faith that public markets
are discovering, displaying, and making accessible the best price for
each and all securities at all times. The steady, reliable performance
of equities markets during this time is a result of a constant
evolution of, and improvement of our markets.
______
PREPARED STATEMENT OF WILLIAM O'BRIEN
Chief Executive Officer, Direct Edge
October 28, 2009
Chairman Reed, Ranking Member Bunning, and Members of the
Subcommittee, I would like to thank you for the opportunity to testify
today on behalf of Direct Edge, the operator of the third-largest stock
market in the Nation. Over the past 2 years Direct Edge's market share
of U.S. stock trading has risen to approximately 12 percent, up from
only 1 percent in early 2007, because we have innovated in response to
changing market structure to provide new solutions for brokers and
their customers. Certain of these changes have triggered a debate over
the past several months regarding the structural integrity of our
equities markets, which is now at a critical juncture. Individual
investors are in need of greater clarity and education as to how our
stock market operates, and how to improve it. In this regard, the work
of the Subcommittee in conducting this hearing is timely and valuable.
Direct Edge believes that current market structure issues should be
framed so that investors understand how the evolution of stock trading
benefits them, and that through careful examination, appropriate
regulatory protections can be preserved without taking steps that would
ultimately undermine investor confidence by restricting innovation,
competition, and efficiency. To this end, Direct Edge offers guiding
principles for any market structure reforms, in order to focus the
current dialogue on what really matters--improving our stock market for
the benefit of the Nation's investors.
1. Current market structure is fundamentally fair and sound
By every quantitative and qualitative measure, the U.S. cash
equities market serves as a model for the world, performing as well as
it ever has in terms of its liquidity, implicit and explicit
transaction costs, and transparency. During the worst financial crisis
of our lifetime, the U.S. equity market was continually liquid and
efficient, while price discovery for certain other financial
instruments, such as auction-rate and mortgage-backed securities, was
virtually nonexistent. Recent developments have not materially eroded
the efficiency of our marketplace.
While the evolution of the technology, functionality, and economics
of trading require everyone to adapt, that should not be the root
reason for market structure reform. Though trends and changes always
require a continual analysis of how regulation needs to respond, this
should not be confused with a broader need to re-architect our market
due to any underlying fundamental flaw or unfairness.
2. High-frequency trading and technology are valuable components of
modern market structure
The innovation and efficiency that technology has brought to stock
trading inures to the benefit of every American investor. When
decimalization came to the equities markets in April 2001, there was a
near-total evaporation of traditional capital commitment, with market
makers far less willing to provide competitive bids and offers as
spreads narrowed. Firms willing and able to adapt to this new reality,
along with new competitors, rose in their place with business models
predicated on extremely efficient use of technology to facilitate our
markets. Without these trading firms continuously providing liquidity,
the market transition to pennies would have been much more turbulent
and expensive for investors. The benefits of high-tech trading continue
to this day in several forms, including more efficient price discovery,
lower investor costs, and greater competition, which benefits all
investors. All brokers have in some form deployed high-frequency
technology, to the point that retail investors can have their orders
executed in under a second via the Internet from anywhere on the
planet.
As with the technological transformation of any market, issues have
emerged that warrant close examination and likely new regulation. High-
frequency trading strategies are now pursued by unregulated entities
who have been given broker-like access to exchanges without adequate
control of the compliance or systemic risks, often called ``naked
access''. Exchange products that offer brokers a direct presence at
exchange data and trading facilities--often called ``colocation''--need
to be regulated in the same manner as transaction and other exchange
fees so that all investors have confidence that equal access and
opportunity are being provided. Any evaluation of these issues and
potential remedies should start, however, from a productive vantage
point that when well-regulated, high-frequency trading and technology
are generally healthy and positive.
3. Exchanges are not always the best place to execute a trade
Even though Direct Edge currently operates one exchange facility
and has applied to operate two new exchanges, we do not believe that
our market structure would be well served by requiring all orders to be
placed on exchange facilities. The equity exchange and over-the-counter
markets have existed symbiotically side-by-side for over 30 years, to
the great benefit of retail and institutional investors. There are many
legitimate economic, execution quality, and policy reasons why
investors and their agents seek an off-exchange execution, whether in a
dark pool, through an institutional or wholesale market maker, or other
means.
Exchanges do, however, play a critical role in providing pretrade
transparency and price discovery, which benefits those who trade off-
exchange. The recent Securities and Exchange Commission proposal to
increase the post-trade transparency of dark pool activity is an
appropriate first step in monitoring the balance between on and off
exchange trading and providing insight to the investing public. If the
level of overall market share among exchanges were to fall
precipitously below historical norms, it would be appropriate to
examine what further steps would be needed to maintain the role
exchange liquidity and price discovery plays in our market. But with
on-exchange liquidity consistently above 70 percent in recent times, we
are simply not near such a point.
To preserve the place of exchanges as central hubs of trading
interest, regulation that drives the displayed exchange markets and
nondisplayed off-exchange markets further apart must be avoided. Direct
Edge pioneered the use of flash order technology in the equities
markets precisely to give retail and other investors' access to dark
pool and other off-exchange liquidity they previously never had access
to, and our data shows investors receive better prices on their trades
as a result. This is what any good exchange does--bring buyers and
sellers together in a way that makes sense for all concerned. True
inequities should be examined and eliminated, and the thoughtful
approach the Securities and Exchange Commission has taken to date
should be commended. But undue focus on optional, esoteric order types,
at the expense of ignoring the broader trends that motivate customers
to use these tactics, at a minimum would provide only false comfort to
investors, and potentially leave them more at risk than ever before.
4. Brokers are best equipped to choose how to execute their customer
orders
Every order type offered by an exchange or other market center
provides some combination of immediacy, explicit fees, implicit costs,
opportunity for price and/or size improvement and market impact.
Investors that value an immediate execution above all else use market
orders, taking the price the market gives them and foregoing a chance
to do better. Those who seek price improvement use limit orders,
knowing full well they may wind up not trading at all. There are
countless other examples of how order flow should be managed in light
of investor objectives and preferences.
Brokers are best suited to decide when and how to use the tools
exchanges provide in executing customer orders. Delegation of the
responsibility to manage these aspects of execution quality by an
investor to a broker is, for all but the more sophisticated or self-
directed investor, a critical concept in how markets operate. The vast
majority of brokers fulfill their fiduciary obligations with integrity
and extreme efficiency. While each broker brings their own perspective
and execution strategy to the table, investors are free to choose among
scores of reputable, experienced brokers using a range of criteria and
information as the basis for deciding who to employ.
5. Equal access prevents ``two-tier markets''
The broad array of market technologies and products that brokers
have at their disposal is greater than ever. This empowers brokers to
customize their order-execution approach to the needs of their business
and customers. Every broker does not do everything the same way, at the
same speed, or with the same resources. Brokers choose which exchanges
to become members of, and then choose to use the products or services
offered by the exchange at their discretion. Investors participate by
choosing their broker and level of self-direction they engage in. This
is part of the fabric of competition, rather than a flaw in market-
based capitalism.
When a broker or investor elects not to utilize certain
functionality, technology, or strategies, it does not imply that those
who do are somehow unfairly advantaged. Markets need to be
fundamentally fair, but that is not achieved on the basis of attempting
to mandate that everyone has ``substandard but equal'' capabilities.
With equivalent access to exchanges for brokers and transparent
competition for customer business among brokers, all market
participants benefit from both fairness and differentiation.
6. In debating the need for market structure reform, a broad, data-
driven approach is optimal
Market structure reform that takes the entire context of recent
trends into account generally produces better results than issue-by-
issue reforms. The National Market System encouraged by the Securities
Act Amendments of 1975, the Order Handling Rules of 1996, and even
Regulation NMS are all viewed as having successfully advanced the
liquidity, transparency, and efficiency of our markets. Their strengths
lie in the comprehensive nature of the approach taken. Emergency
actions can be counterproductive because they tend to ignore root
causes and the likely unintended consequences. When considering market
structure reform, Direct Edge strongly believes in a ``big picture''
approach. We also highly value objective data over subjective intuition
or conjecture. To do otherwise could alter a market structure that is
generally performing well without an adequate basis for believing
improvements will result.
Conclusion
Our stock market is the model for the entire world because we
anticipate and implement change better than anyone, and adapting
regulation is a key element of this. If we can address outstanding
issues in a constructive fashion, focusing on how to improve regulation
while promoting what currently works well, we will have provided a
strong structural foundation upon which our Nation's economic recovery
can be realized. Once again, I'd like to thank the Subcommittee for the
opportunity to testify and I look forward to answering your questions.
______
PREPARED STATEMENT OF CHRISTOPHER NAGY
Managing Director of Order Routing Strategy, TD Ameritrade
October 28, 2009
Chairman Reed, Ranking Member Bunning, and Members of the
Subcommittee, thank you for the opportunity to testify on equity market
structure issues. I am Chris Nagy, Managing Director of Order Routing
Strategy for TD Ameritrade. \1\
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\1\ TD Ameritrade is a wholly owned broker-dealer subsidiary of TD
Ameritrade Holding Corporation (TD Ameritrade Holding). TD Ameritrade
Holding has a 33-year history of providing financial services to self-
directed investors. TD Ameritrade Holding's wholly owned broker-dealer
subsidiary, TD Ameritrade serves an investor base comprised of over 5.2
million funded client accounts comprised from every State in the union
with approximately $289 billion in assets (as of August 2009). TD
Ameritrade continues to focus on serving individual investors,
providing low-cost services, ranging from completely self-directed
investors to those served by registered independent advisors. During
August 2009, TD Ameritrade handled an average of 431,000 investor
trades per day, representing an average of 478 million shares per day.
We do not directly execute client orders, but rather act as agent in
routing orders to the marketplace. We use our position in the
marketplace to drive the markets to compete on price and cost. As a
result of our efforts, during June-September 2009, we were able to
obtain price improvement for 66 percent of our client share orders and
saved our clients $12.5 million by getting them better than the then
best price when they entered their order.
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TD Ameritrade, based in Omaha, Nebraska, was founded in 1975 and
was one of the first firms to offer negotiated commissions to
individual investors following the passage of the Securities Act
Amendments of 1975. Over the course of the next three decades, TD
Ameritrade pioneered technological changes such as touch-tone telephone
trading and Internet investing to make market access by individual
investors more accessible, affordable and transparent.
TD Ameritrade has long advocated for market structures that create
transparency, promote competition, and reduce trading costs for
individual investors. As technology rapidly advances, it is ever more
important that the SEC complete a comprehensive review of the National
Market System to ensure individual investors are not adversely
impacted. At the same time, regulation has the potential to result in
unintended consequences, making it critically important that rulemaking
be based on empirical data and reasoned analysis.
Our Nation's stock markets have evolved dramatically in the last
decade. In 2001, the average individual investor transaction took
upwards of eighteen (18) seconds to receive an execution while today
that same transaction is done in less than one (1) second. These
changes primarily have been driven by technological innovation, but
also in response to carefully crafted regulations. In fact, today the
individual investor enjoys superior pricing, lightning-fast trade
fulfillment, and ample liquidity. At no other point in the history of
the markets has the individual investor been closer in terms of pricing
with the institutional trader.
Gone are the days of slow human traded manual markets. The decline
in manual trading was not only due to technology, but also Regulation
NMS, which was designed to encourage fast quotes and limit order
display, with the goal of ensuring investors obtain the best prices
available in the markets. We also have witnessed a proliferation of
market center competition for order flow, a result of technological
innovation and Regulation ATS which lowered the barriers to entry. In
addition, the move to decimalization early in this decade reduced
spreads by up to 5\1/4\ cents whose benefits went largely into the
pocketbooks of individual investors.
It is natural in a highly competitive environment, particularly
when combined with rapid technological innovation, for market evolution
to occur. The facilitation of a National Market System, as called for
in the Securities Acts Amendments of 1975, has provided a framework for
this market evolution. As such, regulation has always been an integral
part of the development of the National Market System, with the SEC
refining rules such as requiring quote displays and ensuring that
trades are rarely executed at inferior prices.
Dark Pools
Variations of Dark Pools have been in our markets for decades
taking on various forms from a broker taking an order from an
institution over the phone to a floor broker acting as agent on an
order received via teletype. When Regulation NMS was enacted in 2005,
exemptions to the display rule were granted spawning the creation of
the modern day electronic Dark Pool. Because of decimalization, the
declining size of the quotes, and the need to minimize market impact,
institutional traders began seeking block trading alternatives or
algorithmic trading. This market dynamic has given rise to well over
forty Alternative Trading Systems transacting, by some estimates, 35
percent of all stock market orders each day. Retail clients have little
ability to interact with these growing pools of liquidity. The irony is
that dark orders receive their pricing from the transparent exchanges
where retail client trades are executed. In many ways, Dark Pools are
an excellent example of a two-tiered market that gives institutional
traders a way to use retail order flow to their own benefit. Certainly
no one intended for these exemptions to lead to such a stark, two-
tiered system of trading. While there is benefit to Dark Pools reduce
overall market impact, serious questions need to be asked if we have
reached the tipping point.
Flash Orders, High Frequency Trading and Market Access
Innovative strategies that promote efficiency and reduce investor
costs in the markets are critical if we are going to continue to level
the playing field for individual investors. There has been much fanfare
that flash trading is harmful to retail investors, however little data
is offered to back these claims. Defenders of Flash argue that it
allows users to lower transaction costs and obtain better prices in
both the equity and option markets. Interestingly, it is estimated that
Flash trading accounts for less than 2 percent of all market activity.
Although TD Ameritrade can find no evidence that flash trading harms
individual investors, our firm believes that Flash is a symptom of our
current two-tiered market structure and that in many ways the
perception that it is unfair and predatory became the reality. We fully
support the SEC's goal of ensuring that Flash is not used to further
two-tiered access and we support a comprehensive solution in this area.
High Frequency Trading on the other hand is estimated to be as high
as 75 percent of all daily trading volume on our stock exchanges. The
benefits cited are that High Frequency Trading provides additional
liquidity to the markets. While perhaps true, the issue of High
Frequency Trading is not of liquidity but rather one of capacity
utilization. While High Frequency traders send millions of orders to
exchanges they also send an equal number of cancellations leading to
low fulfillment rates. Some stocks can see more than seventy (70) quote
changes in a single second because of this activity. The sheer volume
creates technological issues for the dissemination of market data to
individual investors as they receive such data in their homes perhaps
thousands of miles away from the originating source. Meanwhile, High
Frequency Traders subscribe to specialized data feeds and situate their
technology on the exchanges' property, otherwise known as colocation.
While colocation improves speed of execution for all parties including
individual investors, oversight on how this process is administered is
nonexistent. Moreover, some exchange members provide High Frequency
Traders with direct access to the markets. These arrangements create
systemic risk by allowing High Frequency Traders to act as de facto
specialists without the capital obligations and at little cost while
the rest of the market picks up their tab.
Conclusion
As we embark on an overhaul of our Nation's markets it is
imperative that we continue to provide a low cost, competitive
infrastructure that ensures individual investors have low barriers of
entry, which, in turn, promote investor confidence and long-term
investment into our Nation's markets. We must, however, ask if we have
reached the tipping point with an excess of Alternative Trading
Systems. Interestingly we can draw insight from a very different yet
similar circumstance. During the Great Depression there was an
overabundance of taxi drivers, which reduced driver earnings and
congested city streets. To address the issue and restore a proper
balance, the Medallion system was created placing a moratorium on the
issuance of taxicab licenses. This system created the proper balance of
taxis while not crowding city streets. In today's markets as we emerge
from the recent market downturn, one must question if we have ``too
many taxis'' fragmenting the streets of liquidity. We should seek a
solution to provide competition in our markets without an over surplus
of trading systems.
I appreciate the opportunity to appear before the Committee not
only on behalf of TD Ameritrade but more importantly on behalf of our
clients, individual investors.
______
PREPARED STATEMENT OF DANIEL MATHISSON
Managing Director and Head of Advanced Execution Services, Credit
Suisse
October 28, 2009
Introduction
Good morning, and thank you for giving me the opportunity to share
my views on the best structure for our Nation's stock markets. My name
is Dan Mathisson, and I am a Managing Director and the Head of Advanced
Execution Services for Credit Suisse. \1\
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\1\ Credit Suisse provides its clients with private banking,
investment banking and asset management services worldwide. Credit
Suisse offers advisory services, comprehensive solutions and innovative
products to companies, institutional clients and high-net-worth private
clients globally, as well as retail clients in Switzerland. Credit
Suisse is active in over 50 countries and employs approximately 47,400
people. Credit Suisse is comprised of a number of legal entities around
the world and is headquartered in Zurich. The registered shares (CSGN)
of Credit Suisse's parent company, Credit Suisse Group AG, are listed
in Switzerland and, in the form of American Depositary Shares (CS), in
New York. Further information about Credit Suisse can be found at
www.credit-suisse.com.
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The U.S. broker-dealer subsidiary of Credit Suisse Group has been
operating continuously in the United States since 1932, when the First
Boston Corporation was founded. Today, Credit Suisse is the market
share leader in electronic trading, \2\ and Credit Suisse owns and
operates Crossfinder, the largest Alternative Trading System (ATS) by
volume. \3\
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\2\ Greenwich Survey, May 2009, Tabb Report, October 2009.
\3\ Rosenblatt Survey, September 2009, Tabb Survey, September
2009.
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Advanced Execution Services (AES) is a team of approximately 200
financial and technology professionals based in New York that executes
trades electronically on behalf of mutual funds, pension funds, hedge
funds, and other broker-dealers. AES currently connects with 31 U.S.
trading venues, and we help clients solve the problem of fragmentation
by electronically linking many market centers into one order. The AES
group does not engage in proprietary or risk trading. 100 percent of
our revenue comes from institutional client commissions, and therefore
our success depends on our ability to minimize our client's transaction
costs while providing safe and reliable trading systems.
I have been managing the AES group at Credit Suisse since founding
it in 2001. Prior to that, I traded stocks for 8 years for a New York
investment firm called DE Shaw & Co. In addition to my role at Credit
Suisse, I am presently on the Board of Directors for the BATS Exchange
based in Kansas City, and I am a regular columnist for Traders
Magazine, where I write about market structure issues. I appreciate the
chance to appear here today representing Credit Suisse.
Summary
Credit Suisse supports fair markets for all investors, and fair
access to all market venues. We believe that several of the recent
changes in the trading and markets area proposed by the Securities
Exchange Commission (SEC) are positive developments. For example, Rule
204, which we supported and which has already been implemented, has
dramatically reduced ``naked'' short-selling. The proposed ban on flash
orders is another positive step, and we support this change as well.
On the topic of dark pools, we believe that they merely automate a
process that has always existed, and that they are beneficial to the
U.S. market structure. However, we believe there is a problem with
today's market structure, due to a lack of fair access to dark pools
for all investors. Under Regulation ATS, dark pool operators are
allowed to decide who can participate in their pool, and broker-dealers
are often denied access to each other's pool for competitive or
capricious reasons. We believe that markets work best when open to all,
and therefore we propose that the Fair Access provision of Regulation
ATS be changed to force all dark pools to be open to all broker-
dealers, and through those broker-dealers, to the investing public.
While we acknowledge the need for fair access reform, we believe
that much of the debate over dark pools is misguided and is fueled by a
desire by exchanges to avoid healthy competition. We believe investors
have a right to remain silent, and that dark pools and dark order types
fill a critical need. Those who would compel dark pools to display bids
and offers have the issue exactly backwards: we believe dark pools and
dark order types help long-term investors, by giving them an avenue to
trade without revealing sensitive trading intentions to short-term
traders. We do not think that forcing investors to play poker with
their cards face-up would solve any problems, though it would
potentially create many new ones.
We believe that the ``price discovery'' argument is a red herring.
Despite popular belief, dark pools must report all their trades
immediately to the consolidated tape, and dark pools have always been,
and will remain, a niche product that will not lead to the end of
publicly displayed bids and offers.
In summary, we believe that the key to a strong and resilient stock
market is a healthy competition for order flow among multiple venues,
whether dark or light, along with mandated fair access to each of them.
The Role of Dark Pools
Selling 200 shares of ABC without moving the price is easy. Selling
2,000,000 shares is difficult--if word leaks out that a large pension
fund or other big investor is selling millions of shares, institutional
buyers of ABC will pull back, anticipating a price decrease, and other
sellers will be more aggressive, driving the price down. The result of
this information leak is that the stock would likely drop quickly,
potentially costing the pension fund a lot of money.
To avoid this scenario, institutional traders, and the brokers who
trade on their behalf, expend a great deal of effort figuring out ways
to buy and sell large amounts of stock that avoid signaling that a
large investor is buying or selling. This has always been the case. To
accomplish it, traders use a variety of trading techniques to reduce
trading signals. There are four main types of signals that can reveal a
trader's intentions to others: traditional phone calls, electronic
messages like ``IOIs'' (Indications of Interest), reading patterns
within the ``tape,'' or displaying bids and offers on exchanges.
Of the four types of signals, displayed bids and offers are the
most obvious signals, and therefore the most dangerous for investors--
by design, displayed bids and offers are immediately shown to every
trader in the marketplace. Therefore, the decision to display a bid or
an offer is not made lightly by an institutional trader.
Before computerized ``dark pools'' existed, traders often chose to
keep their bids and offers undisplayed, to avoid sending a signal of
their trading intentions to the marketplace. This was accomplished by
giving a ``not-held'' order to the floor brokers on the exchange who
would then keep sensitive orders ``in their pocket.'' The broker would
literally drop the order ticket in his pocket, without displaying it to
the world, while keeping his eyes and ears open for the other side of
the trade. This process also occurred at the specialist post on the
exchanges, and in the ``upstairs'' market, where brokers would hold
client orders while looking for the other side.
A ``dark pool'' merely automates this age-old process. Traders drop
orders into the computer's ``pocket.'' The computer, just like the
floor broker of old, does not tell anyone about the order in its pool.
If the other side of the trade happens to also drop into the pool, the
computer matches the two orders, and a trade occurs.
Computerized dark pools have been around since 1987. Today, they
are an enmeshed part of the trading ecosystem, and they exist because
they fill a need: the need for an institutional investor to be able to
trade without telling the entire world that a new buyer or seller has
entered the marketplace. Since decimalization, the number of shares
required to be considered potentially ``market-moving'' has decreased,
as the average trade size dropped from over 1400 shares in 1999, to
under 300 in 2009. In a decimalized environment of constant small
trades, even small orders can benefit from dark pools.
Questions have been raised about whether dark pools contribute to
``price discovery.'' Dark pools must report all trades to the
consolidated tape immediately, and their prints are a valuable source
of ``last trade'' data. When buying a house, buyers determine the
appropriate price based on the prices at which similar houses actually
sold in the neighborhood. Asking prices are interesting, but actual
home sales are far more important. To assert that ``last trade'' data
from dark pools does not contribute to price discovery is disingenuous.
The next question that is raised by dark pool opponents is: what if
all bids and offers went dark? Would there no longer be a quote?
Current estimates are that dark pools make up 8.6 percent of
consolidated U.S. equity volume, \4\ which we believe is in line with
historical amounts from when the dark market was ``upstairs'' or run in
the pockets of floor brokers. Dark pools fill a particular niche in the
trading ecosystem, and they are here to stay, but we think scenarios of
them taking over entirely are far-fetched and do not need to be
addressed further.
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\4\ Rosenblatt Securities, ``Market Structure Analysis and Trading
Strategy'', September 30, 2009.
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Exchanges, which are for-profit entities, are natural competitors
to dark pools. Every share matched silently on a dark pool is by
definition a share that the exchanges have lost to rigorous
competition. Therefore, the exchanges are understandably advocating for
their interests by cloaking their arguments around rhetoric such as
``price discovery'' and ``transparency.'' They are also trying to
harness the current debate around high-frequency trading to try to
somehow link it to dark pools in an attempt to increase the regulatory
costs for dark pool operators.
But the argument that dark pools are somehow part of the high-
frequency trading debate simply does not make sense. High-frequency
traders make their money by digesting publicly available order
information faster than others; dark pools hide order information from
everyone. Moving orders out of dark pools and onto exchanges would
enable high-frequency traders to use new streams of information that
are today kept quiet. This would not help retail investors, long-term
investors, or the capital markets.
Recommended Regulatory Changes To Ensure Fair Markets
Credit Suisse believes that several of the recent changes in the
trading and markets area proposed by the SEC are positive developments
and will help to ensure fair markets. However, one critical need has
not yet been addressed--fair access to all market venues. While we
believe that dark pools play a critical role in the marketplace,
institutions searching for liquidity across dark pools do face a
fragmentation problem.
Currently, Regulation ATS allows dark pool operators to decide
which broker-dealers can participate in their pool. There is a ``fair
access'' requirement, but it is not effective. The current rule
requires that ATS's only have to open their system to all users in any
individual stocks where they have exceeded 5 percent of the volume for
4 of the past 6 months. On top of that very high bar, there is a long
list of exemptions, including exempting any ATS that systematically
prices at the midpoint of the bid and ask.
Last week, the SEC proposed lowering the threshold for quoting by
ATS's when they send out so-called ``IOI's'' (which are electronic
messages that reveal trading information). The SEC specifically decided
to split the quoting threshold from the fair access threshold. Credit
Suisse believes that the SEC needs to focus on the issue of ensuring
that all broker-dealers have the ability to access all ATS's, enabling
all broker-dealers to send dark orders to all dark pools. We propose
the 5 percent threshold on the Fair Access provision be removed, and
that all investors receive an equal opportunity to swim in all dark
pools. Regulation NMS effectively connected the Nation's exchanges. A
simple change in the fair access provision of Regulation ATS could do
the same for dark pools.
The Role of Flash Orders and High-Frequency Trading
``Flash'' refers to orders that exchanges post for a fraction of a
second to subscribers of their data feed before forwarding them to
another exchange. Flash orders were created in 1978, when an exemption
was included as part of what is now Rule 602 of Regulation NMS. Credit
Suisse supports the proposed ban on flash orders.
But while we support the proposed ban, it is worth noting that we
do not support it for the reasons flash orders have been opposed in the
media. Opponents of flash orders have repeatedly stated an incorrect
argument: that flashes represent nonpublic information only available
to a group of privileged insiders. This is not correct--anyone can
subscribe to the exchange data feeds and anyone has the opportunity to
read flash quotes. Several of the major exchanges provide their data to
the public for free, while others charge a nominal monthly fee that
must be approved by the SEC. It is important to the debate to
acknowledge that flash orders are in fact publicly available
information, and that orders ``flashed'' are done so at the request of
the ``flashing'' client.
The reason that we do support the proposed ban is that flash orders
are allowed to virtually lock the market for a fraction of a second.
``Locking'' a market means that the highest bid is the same as the
lowest offer. Regulation NMS expressly banned locked markets, mandating
that a bid and offer at the same price must trade. Flash orders
therefore violate the spirit of Regulation NMS and weaken the concept
of a national market system.
High-frequency trading is linked in the debate to flash orders, but
unlike flash orders, it is an undefined term. High-frequency trading is
conceptualized as very short-term computerized trading, in which
traders go in and out of stocks at high speeds. But how fast to qualify
as a ``high-frequency trader'' is unclear--is a trader who goes in and
out of a position once every 5 minutes a high-frequency trader? How
about once an hour? Once a day? Most in the industry seem to use
Justice Potter Stewart's ``I know it when I see it'' obscenity
definition, but the result is that estimates of high-frequency trading
range from 10 percent up to 60 percent of the volume. Credit Suisse
believes the lower bound seems to be closer to the truth, but the lack
of a formal definition makes it impossible to estimate what percentage
of the marketplace they make up, or to perform any rigorous
quantitative analysis to evaluate their effects.
We believe the focus at this point in the debate should be on
creating a clear and specific definition of high-frequency trading, so
that analysts and academics can perform rigorous studies, and we can
separate the facts from the conspiracy theories. Only after rigorous
study of the nature and impact of high frequency trading should any
remedies be prescribed.
Equal Access and the Advantages of Technology
There is a big philosophical debate behind many of these questions:
what does ``an unfair trading advantage'' actually mean? Is it unfair
if a trader has any advantage at all, or just unfair if they have an
advantage that can't be replicated by others?
A staple of the argument against high-frequency trading is that
these traders have an informational advantage, since most people don't
have the technology to read and respond to market data in a split-
second time frame. This raises the question of why we would single out
technological advantages without also looking at other types of
advantages--no one has been suggesting that it is unfair to spend more
money on fundamental research, for example, or to hire smarter or
faster-thinking traders.
The question should not be: do people who have invested in
technology and figured out how to build smarter or faster computers
have an advantage? Of course they do, as they would in any industry or
undertaking. The question should be: do they have unfair access that
others can't replicate?
Here, we believe the answer is clearly no. High-frequency traders
base their investment decisions on publicly available market data. They
buy computer hardware the same way everyone else does. And they compete
for computer programming talent in the same job market as every other
company in America. In short, there are no unfair barriers to entry:
any entrepreneur can buy machines, hire programmers, subscribe to the
public data feeds and attempt to become a successful high-frequency
trader.
The only example that is used to demonstrate their ``unfair''
advantage is around the issue of colocation. ``Colocation'' refers to
the practice of setting up your trading computers in the same physical
building as the exchange's computers, to get a time advantage over your
competitors. Like ``dark pools'' being the 21st century version of
floor brokers putting order tickets in their pocket, colocation is the
21st century version of traders trying to get office space close to the
exchange. In the days before the telephone, brokers would send
``runners'' down the block to deliver orders. The closer a broker's
office was to the exchange, the faster they could execute orders, which
was a major selling point for brokers that were clustered near the
exchanges.
Today, firms do the computerized version of the same game of trying
to stay physically close to the exchanges. Credit Suisse has hundreds
of computers located in a data center operated by a third party, where
several exchanges and many other brokers and trading firms cluster
their machines. As in days of old, physical proximity to the exchanges
and speed of execution remains a major selling point. And the general
public can get access to the benefits of sophisticated technology and
colocated machines by selecting a technology-savvy broker-dealer to
transact on their behalf.
If data center owners discriminate against giving leases to certain
brokers or traders, it would be unfair, just as it would've been unfair
in the old days for landlords near the exchange to refuse to lease to a
particular ethnic group. But there is no evidence of unfairness in the
market for data center leases, and it was reported last week that
NASDAQ voluntarily agreed to have access to their data center regulated
by the SEC going forward. \5\
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\5\ Traders Magazine, October 22, 2009, ``SEC to Regulate NASDAQ's
Colocation Business'', by Peter Chapman.
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Therefore, while fair access is critically important, Credit Suisse
does not believe there is currently any unfairness of colocation
access. More generally, we oppose regulatory changes based on
disparities that result from some firms investing in technology while
other firms choose not to.
Conclusion
Credit Suisse believes that the main principles governing market
structure decisions should be the principles of fair access and
information protection. Fair access does not mean equality of results
or forced equality of technological capabilities--it means an equal
opportunity to participate in trading destinations, whether displayed
or dark, and an equal opportunity to invest in technology and processes
that allow investors to perform their best.
Fair access, when combined with the existence of multiple venues,
both dark and light, and protected by Regulation NMS and a robust Best
Execution standard, add up to a marketplace where all buyers and
sellers have an equal opportunity to achieve the best price. And it
adds up to a competitive marketplace where exchanges and dark pools
compete over technology and techniques to the benefit of all investors.
Information protection means that investors have a right to ask
their brokers to keep their orders ``in the pocket.'' It means
acknowledging that investors have the right to remain silent, and that
they deserve access to dark pools and dark order types that fill this
critical need.
In summary, we believe that:
1. Fair Access to all exchanges and dark pools is the solution to
solving problems of inequality in the markets. The ``Fair
Access'' provision of Regulation ATS should be overhauled to
allow all investors to participate in all dark pools. Access to
ATS quotes is not enough.
2. Attempting to steer orders from dark pools to displayed exchanges
is misguided and would benefit short-term information-based
traders, at the expense of big long-term investors.
3. High-frequency trading is a term that needs to be officially
defined by the SEC before it can be properly analyzed or
evaluated, and careful analysis is needed before prescribing
remedies for problems that may not exist.
4. Disparities that result from differentiated levels of investment
in technology are natural. It is only unfair if the opportunity
to invest and build similar technology does not exist.
Thank you for the opportunity to appear today and I will be happy
to answer any questions that you may have.
______
PREPARED STATEMENT OF ROBERT C. GASSER
President and Chief Executve Officer, Investment Technology Group
October 28, 2009
Introduction
Chairman Reed, Ranking Member Bunning, and Members of the
Subcommittee, thank you for the opportunity to testify this morning on
current issues affecting U.S. market structure. As a fully transparent
and neutral player in the industry, I would like to offer ITG's
unbiased, fact-based perspective on these issues to help you better
understand the current trading landscape.
ITG is a NYSE listed Company with 18 offices across 10 countries
employing nearly 1,300 people worldwide. As a specialized agency
brokerage firm, ITG provides technology to a broad collection of the
globe's largest asset managers and hedge funds, allowing them to
independently source liquidity on behalf of their clients. Throughout
our 22-year history, we have grown our business in the best traditions
of U.S. innovation and market leadership.
In 1987, POSIT was launched as one of the first ``dark'' electronic
matching systems. Since then, ITG's POSIT crossing system has
harmoniously existed within U.S. market structure, including the
Regulation ATS and Regulation NMS frameworks in more recent years. We
firmly believe that institutions need a place to confidentially
interact with each other to find natural block liquidity. Nondisplayed
pools of liquidity such as POSIT provide a valuable solution for the
buyside to comply with their obligations as fiduciary to offer their
clients the best possible execution. Our analysis of millions of
institutional trades post the advent of Regulation NMS confirms that
POSIT reduces market impact of block trades and enhances execution
quality.
In my testimony today, I will begin by addressing the role of
``dark pools'' and other undisplayed quotes historically in our
markets. I will outline the advantages nondisplayed pools of liquidity
provide for the marketplace, along with the concerns that exist today
about the activities within such pools and their effect on the broader
markets. I will then describe the effects of high-frequency trading on
the markets, and discuss the advantages and disadvantages that have
been cited for such techniques. Finally, I will provide our views on
several topics that seem destined for further regulatory scrutiny:
sponsored access and exchange colocation.
Dark Pools
Contrary to their pejorative name, dark pools have played a
positive role in the transformation of the U.S. equity markets over the
past decade. As SEC Commissioner Kathy Casey herself points out, there
is nothing sinister about dark pools; they exist for legitimate
economic reasons. Institutional investors seeking to make large trades
have always wanted to avoid revealing the total size of their order.
This, in turn, benefits the millions of individual investors who invest
in mutual funds and pension plans. Without a facility like POSIT,
institutions with a natural interest in trading with one another would
be subject to unnecessary frictional costs.
We whole-heartedly embrace and support the broad concepts the SEC
highlighted during its open meeting last Wednesday. The staff of the
SEC's Division of Trading and Markets exercised a tremendous amount of
care and diligence in their examination of current U.S. market
structure. We interpret the SEC's recent pronouncements as establishing
a bright line between truly dark pools and lit pools with an exception
for block liquidity. We welcome the clarity. As a truly dark pool,
POSIT will continue to provide large executions and price improvement
to its customers.
Academic research demonstrates that market fragmentation (including
the proliferation of dark pools and other off-exchange trading venues)
does not harm market quality. We support efforts to increase post-trade
transparency, so long as the rules are applied consistently across the
competitive landscape. In fact, we believe that the data arising from
such transparency will better enable market participants to measure the
quality of the executions that they receive from the various trading
venues, thus enabling them to make better routing decisions in the
future.
Indication of Interest
Indications of interest, commonly known as IOI's, have become a
commonly accepted method by which brokers and their clients communicate
trading interest to one another efficiently. In the past couple of
years, IOI's have empowered what we consider to be a potentially
harmful mutation in market structure by which various ATSs can in
effect create an ``inside'' market by sharing actionable IOI's
selectively while still operating with no requirement to display that
message. This practice has the potential to create a two-tiered market
of participants with and without access to information. The SEC has
deservedly focused on this issue and is recommending appropriate action
to eliminate the grey area between lit and dark marketplaces.
High Frequency Trading
As a pure agent and independent observer of high-frequency trading,
ITG does not have a stake in the use of this practice. However, we are
committed to looking out for the best interests of our clients and the
future of U.S. market structure. We hold the view that high-frequency
trading plays an important role in the marketplace. Specifically, high-
frequency firms take risk, commit capital, and provide liquidity in all
market conditions.
In today's highly evolved market, these high-frequency firms are
both large customers of exchanges/ECNs as well as some of their
strongest competitors. Accordingly, these firms are able to provide
cost saving opportunities for broker dealers that are ultimately passed
on to retail and institutional investors. Many of the high-frequency
firms are broker-dealers and, as such, are subject to the oversight of
the SEC and FINRA. Furthermore, many serve both institutional and
retail clients and are critically assessed on the quality of their
execution. Hence, these firms do not fly under the regulatory radar.
Sponsored Access
However, we do have concerns about ``sponsored access'' and the
risks it potentially creates for market participants. Sponsored access
generally refers to the practice of a broker-dealer member of an
exchange providing other market participants (possibly nonregulated
entities) with access to that market center without having the
sponsored participant's orders flow through the member's systems prior
to reaching the market center. One of the concerns associated with
sponsored access is that the service can be provided without rigorous
compliance oversight and/or appropriate financial controls. We believe
that the issue of sponsored access firms deploying high-frequency
strategies on behalf of nonregulated entities deserves regulatory
scrutiny.
It is important to realize that the issues of high frequency
trading and sponsored access are not black and white. Clearly, outsized
returns generated by questionable trading practices must be
scrutinized. However, retail and institutional clients benefit greatly
today from the liquidity provided by high frequency firms, which
generate reasonable returns in relation to the risk they assume. To
impair that through broad-brush regulatory intervention without a
targeted focus on abusive practices and the potential risks of
sponsored access could possibly harm the continuity and quality of U.S.
equity markets.
Equal Access to the Markets and Exchange Colocation
U.S. exchanges have logically become mission critical technology
providers to the brokerage industry. They now ``host'' brokerage firms
within exchange owned and operated data centers and provide access to
the circulatory and respiratory system of today's national market
system: market data and the matching of executed trades. It is our hope
that the SEC will provide similar clarity on the issue of colocation
within exchange data centers in a future concept release. No firm
should enjoy an advantage over another firm based on physical proximity
to exchange technology. Principles of fair access and transparency must
be applied equally to this issue.
Conclusion
While we support the SEC's recent proposals, we are wary of the
dangers of unintended adverse consequences for market structure. We
note that Regulations ATS and NMS did produce the competition and
innovation that they were intended to foster without compromising
investor protection. The increased competition evidenced by the
existence of approximately 40 execution venues in the U.S. market has
reduced transactions costs and increased executions speeds without
degrading the transactional or informational efficiency of the U.S.
equity markets. To the contrary, U.S. market systems withstood the
demands of unprecedented volatility and transaction volumes through the
financial turmoil of last fall with remarkable stability and
resiliency. The confidence that global investors have in the efficiency
of the U.S. National Market System is well placed. This confidence is
essential to U.S. leadership in the formation of capital. All of our
collective efforts toward structural reform must focus on the
preservation of this confidence.
Exhibit A
Biography of Robert Gasser, CEO and President of Investment
Technology Group--Bob Gasser is Chief Executive Officer and President
of Investment Technology Group. Mr. Gasser was previously CEO at NYFIX,
Inc., a global electronic trade execution firm. Before NYFIX, Mr.
Gasser was Head of U.S. Equity Trading at JPMorgan. Concurrently, Mr.
Gasser served on the Board of Directors of Archipelago Exchange as well
as on the NASDAQ Quality of Markets Committee and the NYSE Upstairs
Traders Advisory Committee. Mr. Gasser holds a Bachelor of Science
degree from Georgetown University, School of Foreign Service.
Exhibit B
Culs de Sacs and Highways
PREPARED STATEMENT OF PETER DRISCOLL
Chairman, Security Traders Association
October 28, 2009
Chairman Reed, Ranking Member Bunning, and Members of the
Subcommittee, thank you for the opportunity to testify at this
important hearing on behalf of the Security Traders Association.
I am Peter J. Driscoll, a Vice President and Senior Equity Trader
at the Northern Trust Company, Inc., in Chicago, Illinois, and the
Chairman of the Security Traders Association (STA). I am here today
representing the STA, a professional trade group that provides a forum
for our traders, representing institutions, broker-dealers, ECNs,
exchanges, market makers, and floor brokers to share their unique
perspective on issues facing the securities markets. Our members work
together to promote investor protection and efficient, liquid markets.
The financial services industry robustly competes for order flows
today. Individual investors trade in markets that are characterized by
narrow bid ask spreads, historically low commissions, immediate
electronic execution of trades, and research provided without charge.
It is important, however, to realize that the vast majority of
savings and investments are institutionalized, invested through savings
plans at work, 401(k)s, pension plans, or mutual funds. Professional
money management and diversification is critical for most investors who
have neither the time and training or the resources to manage their own
money. The institutions that work to identify investments for these
funds are in reality representing the individual investors and working
on their behalf. The aggregation of the interests of retail and
institutional investors brings its own challenges. Like retail
investors, institutional investors also value low commissions, tight
bid ask spreads and competition for their order flow. The size of these
aggregated orders also focuses their efforts on identifying pools of
liquidity, be they exchanges or other trading venues that provide deep
liquid markets where they can secure the best possible execution of
these large orders on behalf of their shareholders.
The U.S. equity markets functioned extremely well during our recent
economic crisis. The markets remained open, collectively trading
billions of shares daily and priced equity securities efficiently
according to the economic laws of supply and demand despite the
dramatic financial news that was impacting the Nation. Throughout the
declining markets, security prices were accurate and represented the
equilibrium between buyers and sellers at the moment of execution. As
most are aware there are times when there were more sellers than buyers
and prices decline significantly. Though painful, this is a natural
operation of the markets and our equity markets functioned exactly how
they were designed to function. Because of this, our markets have been
referred to as a national jewel and the envy of the world and they
lived up to that billing every single day during the economic upheaval.
We commend the Subcommittee for taking a proactive approach to
being an informed overseer of the markets. Your scrutiny is welcome and
this debate is a healthy one. Open forums such as this are an important
part of the regulatory process. Unfortunately, the topics before us
today are technically complex and not well understood outside the
industry itself. Additionally, the industry's flair for the dramatic
has given these rather mundane mechanisms names like dark pools that
carry a negative connotation. The market practices that we are
examining today are not new; they have merely been transformed to be
effective in the ever evolving electronic market structure. At the
Security Traders Association, we characterize this evolution as natural
growing pains that require industry debate to determine if regulatory
attention is needed. It is my pleasure to be here on behalf of the STA,
to be part of the informed debate by industry participants who
understand trading processes and the potential ramifications any
proposed regulations may have on our markets.
The Securities and Exchange Commission (SEC or Commission)
announced that they will issue a concept release concentrating on the
topics that we are addressing here today. The Commission also held an
open meeting where they voted unanimously to issue proposals intended
to strengthen regulation of dark pools of liquidity. These proposed
rules were issued in the regular notice and comment rulemaking process
affording all market participants the opportunity to comment on the
rules and discuss their concerns about their effect on the markets. The
STA feels that this process is the best way to uncover any unintended
consequences that a proposed rule may have prior to it causing any
serious disruption to the market.
Targeted regulation that ensures technology is used appropriately
and that all participants have equal access to market data and trade
execution is a mandate of the regulators. Identifying manipulation is
the appropriate priority of regulators. The Congressional Oversight
panel in their January Special Report on Regulatory Reform said:
The essential debate . . . [is a debate] between wise
regulation and counterproductive regulation. ``Wise regulation
helps make markets more competitive and transparent, empowers
consumers with effective disclosure to make rational decisions,
effectively polices markets for force and fraud, and reduces
systemic risk. Counterproductive regulation hampers competitive
markets, creates moral hazard, stifles innovation, and
diminishes the role of personal responsibility in our economy.
It is also procyclical, passes on greater costs than benefits
to consumers, and needlessly restricts personal freedom.''
We believe that there is room for wise regulation targeted to the
areas currently under review.
Dark or undisclosed liquidity has been part of the markets since
their inception. In fact, many believe that the New York Stock Exchange
was one of the largest dark pools in the markets. Floor brokers working
large orders traditionally posted only small portions of the order in
publicly displayed quotes. Dark liquidity is nothing new, though its
use has grown.
Like dark liquidity, market making has always played a role in the
equity markets. The participation of market makers has historically
helped promote efficient pricing as they make orderly two-sided
markets, stepping in to buy or sell a security when other market
participants were unwilling to do so.
Concerns have arisen about how these two functions fit in the new
electronic markets. Dark pools and electronic market making have
largely replaced the old manual processes and have increased in
popularity for several reasons. Decimalization of the markets in 2000
reduced the risk/reward scenario for market makers by reducing the
potential spread capture, the traditional means for market maker
remuneration, from 6.25 cents to a penny. They retained all of their
obligations to the market, including providing continuous two sided
markets and being the liquidity of last resort, but the rewards for
these obligations were cut dramatically. Traditional market making
became unprofitable and most market making firms reduced their market
making activity or bowed out of the business altogether. For the
institutions, decimalization meant smaller trade increments and
institutions had to change the way they worked orders in the market.
Anonymity is essential to prevent market players from capitalizing on
the information about their large institutional orders.
Alternative Trading Systems
Private trading facilities began to attract institutional order
flow and prosper because they provided the anonymity institutional
traders desired and reduced the likelihood of information leakage.
These new trading venues provided the institutions with a means of
executing their orders without impacting the price of the stock
significantly in this penny pricing environment. Private trading
facilities would match orders within their systems using the current
public quote to price the matches while depriving other market
participants the opportunity to step ahead of their orders.
These private trading facilities are subject to Regulation
Alternative Trading System (ATS), promulgated by the SEC to foster
competition among exchanges and other liquidity pools. The rule has
been tremendously successful in incubating new technology and fostering
technological competition for the exchanges. Regulation ATS provides a
registration and regulation regime for upstart businesses to enter the
markets and compete with minimal regulatory hurdles.
While Regulation ATS has gone further than any other regulation in
fulfilling a Congressional goal of the Securities Act Amendments of
1975 by making it practical for ``investor's orders to be executed
without the participation of a dealer,'' restricting access to certain
dark pools and limiting reporting of quotes and transactional data
appears to run contrary to another Congressional goal of those
amendments. Namely, that ``linking of all markets for qualified
securities . . . will foster efficiency, enhance competition, increase
information available to brokers, dealers and investors . . . and
contribute to best execution of such orders.'' As such, the STA
believes that it is appropriate for the Commission to evaluate dark
pool access and transparency standards.
Trading and the pursuit of ``best execution'' involves strategy and
the use of dark liquidity is one tactic in that strategy. Working an
order in the dark allows the buy side trader to keep control of the
order, keep the trading strategy confidential and limit the number of
shares exposed to the price discovery process at one time. Limiting the
size of the order exposed to the price discovery process allows the
trader to avoid overwhelming the supply/demand equilibrium and thus
achieve better priced executions. A great majority of market
professionals believe that dark pools, or alternative liquidity pools
as the STA generally refers to them, increase efficiency by lowering
execution costs and providing competitive choices in the execution
process.
Some market participants believe that trading in dark pools
degradates the price discovery process, the results of which
alternative liquidity providers use to price orders. Traditionally, the
large institutional orders have not been the driver of the price
discovery process. It has been the small orders, fragments of the
larger orders that interact to find the equilibrium price. While we
understand the price discovery concerns and believe that at some point
degradation may occur, we do not feel that with dark volumes trending
around 10-15 percent of overall volume we are anywhere near that
degradation point. As with most things in life moderation is a key. An
efficient market structure can include alternative liquidity pools and
public quoting venues coexisting. As long as we keep the appropriate
level of order flow pumping through the price discovery process we
should not see negative effects from this coexistence. In fact, recent
statistics indicate that the overall level of alternative liquidity use
has plateaued and individual pool gains now come at the expense of
other alternative liquidity pools. In our 2008 Special Report we
suggest that the Commission ``should closely monitor the aggregate and
individual volumes of alternative liquidity pools in order to ensure
adequate price discovery.'' We stand by that recommendation today.
It has been suggested that trading in alternative liquidity venues
disadvantages the ordinary retail investor. This is simply not factual.
As we mentioned earlier the ``average investor'' invests through
organized investment plans. These institutions use alternative
liquidity providers to increase the efficiency with which portfolio
decisions are implemented and reduce the costs associated with that
implementation. If you consider the average retail investor who has a
discount brokerage account and executes trades daily we would continue
to point out that alternative pools of liquidity provide benefits to
those participants. Prior to the advent of electronic trading and
alternative liquidity pools small investors were concerned about trade
certainty. Orders took several minutes to execute and the investor was
at risk during those minutes. Electronic markets provide instantaneous
executions, dark pools have provided the retail investor with the
opportunity for price improvement as their orders flow through these
alternative pools and the participation of high frequency traders
assures that the size desired by the investor will be present when an
execution consummates.
Assuring fair access to these alternative pools of liquidity and
increasing their transparency are important goals. As individual dark
pools gain market share and their volumes grow it will be important to
allow other market participants to not only see the order flow through
the quotes required once threshold levels have been achieved but also
interact with that order flow. The STA does not believe that limiting
the successful dark pools to de minimis percentages of volume is the
appropriate answer. Regulation NMS was promulgated to promote the
public display of limit orders, it drove more trading to dark venues.
Trimming the quoting and access thresholds to unrealistically low
levels could result in an explosion of new ATSs and further fragment
the market. Once a pool sponsor has developed the logic for the dark
pools matching engine, it may easily replicate it under a separate ATS
filing. Structural speed bumps will not force the dark pool operators
to push order flow to lit venues. There needs to be an incentive for
order senders to prefer the lit venues over the alternative venues.
Should the SEC through empirical evidence determine that too much
volume is trading in dark pools or that there are too many dark pools,
the standards that ATSs must adhere to should be upgraded and
competitive pressures should be allowed to solve the problem.
Increasing access and transparency is the answer, not arbitrarily
limiting the amount of business that can be done by one alternate
liquidity provider.
Dark pools should not be allowed to selectively share trading
information. Once a pool decides to share information beyond what they
provide to their members that information should be publicly
distributed. This transparency must be increased without jeopardizing
the pool participant's anonymity. Our members believe that a consistent
reporting regime must be developed so that participants can make
informed routing decisions. We further believe that pool operators must
provide participants with detailed information about how their routing
decisions are made and where the orders entrusted to them are executed.
The STA also believes that post-trade transparency must be upgraded in
such a way to allow other market participants to see which pools are
attracting flows in which issues while preserving the anonymity of pool
participants.
The STA has long held that similar products should be regulated by
consistent rules. We understand that exchanges receive some benefits
that ATSs do not. We are also aware that ATSs benefit from the
displayed quotes produced by the exchanges. We do not believe that the
offsetting of these benefits is disproportional enough to support the
degree of regulatory bias favoring one market structure over the other.
ATSs have changed the trading landscape. We believe that while it is
always important to incent competitive behavior, the regulatory gap
between ATS regulation and exchange regulation should be rationalized.
Balancing the regulations will allow all venues to compete more
robustly.
High Frequency Trading
The term ``high frequency trading'' is used to reference many
different business models. For example, statistical arbitrage firms
search for price disparities in the relationship between securities.
They purchase the theoretically cheaper security and sell the more
expensive one hoping to profit when prices regress to the mean. This
type of arbitrage helps make markets more efficient and dampens
volatility. Other high frequency traders hold themselves out as the new
market makers. Market makers, as mentioned before, have traditionally
had significant obligations to the markets and generally position risk
for longer than milliseconds. Some question if market making is needed
in the high volume millisecond trading environment that exists for
primary tier stocks. We believe that there is a need for market making
in secondary and tertiary issues, but not necessarily the primary tier
stocks where data suggests most high frequency traders concentrate
their activity. As competition enters the high frequency market making
arena we would expect that trading profits would constrict forcing
these market makers to begin making markets in lower tier stocks. Our
members believe that high frequency traders provide liquidity and that
their trading volumes help keep exchange fees low.
In the Special Report, ``The STA's Perspective on U.S. Market
Structure'' that the STA issued in May of 2008 we expressed concerns
about businesses being built solely to capture rebates from maker/taker
models and market data plans. We remain concerned about the distortive
effects these businesses could have on issues by generating quotes and
trades without investment intent contributing to the flickering quote
problem. STA suggested that the SEC adjust market data revenue
allocation formulas to only reward ``quality and tradable quotes and to
discourage quotes that serve only commercial interests . . . .'' We
believe this remains good advice and look forward to working with the
Commission to bring it about.
Sponsored Access
Sponsored access, the ability of an exchange member to provide
access to a customer, must include appropriate trade risk management
controls. Allowing ``naked'' sponsored access in today's interconnected
markets is undesirable from both the industry and regulatory
perspectives. One minor mistake in order entry could become a major
problem across many different trading venues if trades are allowed to
bypass risk management tools. Problems of this nature would put at risk
many market participants and not just the participant who created the
problem.
Colocation
Colocation is arrangement where a market participant can locate
their server in the same location that houses the trading venue's
matching engine. There is nothing inherently unfair in colocation as
long as access is provided to all who desire it at a reasonable cost.
Last week two major trading venues voluntarily accepted Commission
oversight of their colocation plans. We feel that this is an extremely
positive advancement in the regulation of colocation and that the
Commission should monitor changes in these plans to ensure a level
playing field.
Regulatory Resources
To adequately monitor and regulate the many issues we have
discussed, we believe that the SEC needs the resources to upgrade their
technology and hire more people to survail today's highly complex
markets. Trying to monitor 35,000 registered entities with only 3,000
plus or minus staff members seems a daunting task. The already
knowledgeable staff could also be bolstered through the addition of
staff who are seasoned market professionals.
Conclusion
The Security Traders Association looks forward to working with
market participants, governmental and self regulators, and the Congress
on these technical market issues that have grown to be of national
economic importance. We underscore the importance that any changes to
the current regulatory framework need to be done in a deliberate and
carefully considered manner, and if rules are adopted, to use pilot
programs whenever possible to ensure against the possibility of market
disruptions. We also emphasize the need for the SEC and the Congress to
avoid ``picking winners and losers'' and to allow competition and
innovation to drive market changes whenever possible. Regulation should
not protect inefficiencies that must ultimately be paid for by
investors.
That concludes my remarks on behalf of the Security Traders
Association. I thank you for the opportunity to participate in this
important hearing today.
Attachment: The Security Traders Association
What We Are
Founded 75 years ago, the STA is an association of some 5,200
individual professional traders of equities and options, represented in
and by 26 affiliates across North America. Our members represent all
segments of the industry--the buy side, the sell side, exchanges, ECNs,
and ATSs. They trade on behalf of investors of all types: individual,
institutional, and professional.
Over the years, STA has contributed significantly and expertly to
the legislative and regulatory discussion around market structure
issues. Because our membership is drawn from all segments of the
industry, the consensus views we develop, through our committee
process, often render the best ``prevetted'' market structure solutions
for investors, issuers, the industry, and our members. Our Committees
provide a voice for: the sell side (Trading Issues Committee); the buy
side (Institutional Committee); options traders (Options Committee);
and compliance officers (Compliance Committee). Positions are
recommended and voted on, and are then reviewed and approved by our
Board of Governors.
We have issued eight position letters in 2009. In addition, we have
produced two important White Papers: ``Fulfilling the Promise of the
National Market System--STA's Perspective on U.S. Market Structure''
(2003); and ``The STA Special Report--U.S. Market Structure 2008''
(2008).
What We Believe
The U.S. equity markets have demonstrated the ``modernization and
strengthening'' intended with the SEC's implementation of Regulation
NMS in 2007. The National Market System is always an evolving ``work in
progress.'' As in the past, the current market structure issues are a
result of explosive growth due primarily through technological and
regulatory changes. Examination of today's issues is not only
important, but also is appropriate and healthy.
We believe that a balance of competition and regulation yields
superior results for all investors, issuers, markets, and the industry.
We support the SEC as the appropriate regulator for our markets. In
such a highly technical environment, the SEC has the understanding and
procedures in place allowing for efficient regulation, consistent with
goals mandated in the Securities Act Amendments of 1975. We encourage a
pragmatic approach to ensure appropriate outcomes, based on empirical
evidence and domain expertise.
Given the role of the SEC, we strongly support the maintenance of
the Concept Release and notice and comment process as a critical
component of effective rule making by allowing all interested parties
to submit their views. This process allows a broad review by the SEC
prior to issuance of a final rule. Escaping the ``unintended'' is a
major benefit.
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PREPARED STATEMENT OF ADAM C. SUSSMAN
Director of Research, TABB Group
October 28, 2009
Dear Chairman and Committee Members, first, thank you for holding
this hearing. The U.S. equity markets have long been a pinnacle of
market efficiency and investor protection and critical to economy.
However, to maintain our leadership we ought to examine our system in
order to make sure it supports a wide range of investors.
During my career, the markets have undergone unprecedented
regulatory and technological change. I entered the industry in 1998,
designing retail order routing logic. In those days, executions would
take minutes. When I left Ameritrade in 2004, executions were measured
in seconds, and today they are measured in milliseconds.
Now, as Director of Research at TABB Group, a financial markets
research and consulting firm, I am part of an organization dedicated to
helping market professionals understand the trading landscape. Our
clients span the professional investment community from pension plans,
mutual funds, hedge funds, high frequency firms, and brokers, to
Exchanges and ATSs. Our studies put us in constant dialogue with head
traders of our Nation's top money management firms. Indeed, a
forthcoming piece of research, based on conversations with head traders
at firms that manage 41 percent of U.S. institutional assets, is on the
topic we are here to discuss.
For institutional money managers, trading is a balance between
price and time. If order information is not handled carefully execution
quality can deteriorate, which would harm pensioners, retirees, and
investors. Time-sensitive orders tend to be widely disseminated in
order to increase the speed of execution, while price-sensitive orders
stay dark to minimize impact on the stock. The tradeoff between dark
and lit is never black and white as instructions differ, liquidity
patterns are not consistent, and market conditions change.
While dark pools are new, underlying trading principles have not
changed since the Buttonwood tree. Large orders influence the market
and will never be fully unveiled. As trading has evolved to rely on
automated tools to facilitate decision making and execution, we need to
ask, ``What tools should investors have to control the dissemination of
trading information?'' In the past, traders gave large price-sensitive
orders to NYSE Floor Brokers. Now traders have the ability to codify
the execution decision and more closely manage how that order interacts
with the market. The complex mechanisms of today's market reflect the
competition to provide traders with state-of-the art tools.
TABB Group's concern about dark pools is ensuring that traders who
utilize these pools adequately understand their execution process. We
have seen much progress on this front. This year, 71 percent of traders
we interviewed were comfortable with dark pool practices, up from 53
percent in 2008. The increased voluntary disclosure by dark pools is a
positive step. TABB Group believes that there should be even greater
dark pool order handling disclosure so traders can be sure their
intentions are properly fulfilled. While we believe in disclosure, we
do not necessarily believe in pretrade or real-time post-trade dark
pool transparency, especially for small or midcap stocks. The
dissemination of this information in real time can harm execution and
force liquidity into other more manual dark forms. In this situation,
end of day disclosure is more desirable.
Opposite dark liquidity is high frequency trading (HFT). Markets
require intermediaries to provide liquidity. In the past they were
called specialists or market makers, while today we call them high
frequency traders. Little has changed in providing liquidity except
speed. HFT is merely an outgrowth of the regulatory and technological
progress reflecting the cost of immediate liquidity. Among the
institutional investors we spoke with 83 percent feel HFT has either a
positive or neutral impact. Those that believe HFT has a positive
influence on the markets cited the added liquidity and tighter spreads
as key benefits. Those that are neutral believe the responsibility of
execution quality rests on their shoulders. The 17 percent that believe
HFT has a negative influence on the market feel as if HFT profits
represent an unnecessary liquidity tax on their investors.
Finally, it is important to make the important distinction between
flash orders and high frequency. Flash orders at their height
represented only 3 percent of overall share volume. With BATS and
NASDAQ discontinuing the process, flash represents a small and
decreasing fraction of overall equity market volume. Flash orders are
another tool used to balance price and time--trading off information
for a better price or more volume. Flash has existed for years on the
NYSE Floor and on the market maker's desk, albeit manually. For flash
trading, TABB Group believes disclosure is paramount and the ability to
opt-out a must.
Trading is both an art and a science. To effectively balance the
price/time tradeoff, traders need a variety of tools. When we want to
tread lightly, we trade in the dark. When immediacy is virtue, we take
liquidity from wherever we can. As our markets evolve, so must our
tools. No one idea trumps all others and a single market does not serve
all. It is this competition among and within these different investment
philosophies, trading strategies, and market structures that creates a
more efficient marketplace for all market participants.
With that, I would like to thank this Committee for its time.
RESPONSES TO WRITTEN QUESTIONS OF SENATOR MENENDEZ FROM JAMES
BRIGAGLIANO
Q.1. Does integrating dark liquidity with displayed markets
improve execution quality for retail investors?
A.1. In general, vigorous competition among trading centers to
attract and execute retail investor orders is likely to improve
the execution quality of those orders. In the current U.S.
equity market structure, most marketable orders of retail
investors (either market orders or limit orders with prices
that make them immediately executable at the current best-
priced quotations) are routed to OTC market makers--a type of
dark liquidity. OTC market makers generally execute small
marketable orders of retail investors at the best displayed
prices or better. The nonmarketable orders of retail investors
typically are routed to displayed markets (such as exchanges
and electronic communications networks (ECNs)) that will
display the orders in the consolidated quotation data that is
widely distributed to the public.
Some displayed markets have attempted to integrate
displayed and undisplayed liquidity by using ``flash'' orders.
Flash orders are marketable orders that a displayed trading
center cannot execute immediately at the best displayed prices.
Rather than routing them to execute against the best displayed
prices, the trading center ``flashes'' the orders for a short
period (usually less than a second) to its market participants
in an effort to attract dark liquidity to execute the order. As
discussed in the recent Commission proposal to eliminate a rule
exception for flash orders (Securities Exchange Act Release No.
60684, 74 FR 48632 (Sept. 23, 2009)), while flash orders may
offer certain benefits, such as reduced trading fees, they
could disadvantage investors if their orders do not receive an
execution in the flash process and market prices move away from
the orders. In addition, use of flash order could create two-
tiered access to information about market liquidity as well as
discourage others to display their best quotes thereby
potentially widening spreads for all investors. The comment
period for the flash order proposal recently ended. The
Commission is reviewing the comments and will determine whether
and how to proceed with the proposal.
Q.2. What is the danger that SEC proposed rules will force dark
pools to interact less with the displayed market?
A.2. If the Commission were to adopt its flash order proposal
discussed above, flash orders could not be used by displayed
markets to access dark liquidity. This proposal would not,
however, prohibit displayed markets from routing orders to dark
pools. The use of dark liquidity in all its forms is an issue
that the Commission may consider as part of a concept release
or similar document.
The Commission has also published a proposal to address the
use of actionable indications-of-interest, or ``IOIs,'' by dark
pools (Securities Exchange Act Release No. 60997, 74 FR 61208
(Nov. 23, 2009)). These actionable IOIs sometimes are sent to
displayed markets in an attempt to attract order flow.
Actionable IOIs are not, however, included in the consolidated
quotation data that is widely distributed to the public. As
discussed in the Commission's proposal, the use of actionable
IOIs potentially can create private markets and two-tiered
access to information about the best displayed prices. The
comment period for the Commission's proposal ends on February
22, 2010. At that time, the Commission will consider the
comments and determine whether and how to proceed with the
proposal.
Q.3. Many concerns have been raised respecting fragmentation of
the markets, what are the positives?
A.3. Fragmentation can occur when many different trading
centers compete to attract order flow, and order flow is
dispersed widely among those trading centers. Vigorous
competition among trading centers for order flow can have many
benefits. These include the tailoring of trading services to
meet the needs of different types of market participants,
innovation in the design of trading services, and pressure to
keep trading fees low.
Section 11A of the Exchange Act directs the Commission to
facilitate the establishment of a national market system that
achieves fair competition among trading centers, but also other
objectives, such as efficiency, best execution of investor
orders, and the offsetting of investor orders. Fragmentation
can interfere with these other objectives. Linkages among
trading centers are the primary means to balance the goals of
competition among trading centers with the other national
market system objectives. Whether the linkages in the current
equity market structure are sufficient to achieve the benefits
of competition among trading centers while minimize the
potential harms of fragmentation is an issue that is part of
the Commission's ongoing review of market structure.
Q.4. Retail investors have different needs from firms who
engage in short term trading, how do we incorporate these
different needs in a manner that maximizes benefits for all?
A.4. The Commission repeatedly has emphasized the importance of
long-term investors, including retail investors, when
addressing market structure issues. The interests of long-term
investors and short-term professional traders often coincide,
but when they do not, the Commission has stated that its clear
responsibility is to uphold the interests of long-term
investors.
A good market structure should create a framework in which
competitive forces work for the benefit of long-term investors.
As noted above, for example, retail investors benefit when
there is strong competition among trading centers to attract
and execute their orders. The marketable orders of retail
investors generally are executed at prices that reference the
best displayed prices. When short-term traders compete to
provide liquidity at the best prices, this competition can
narrow quoted spreads and thereby directly benefit retail
investors by improving the prices at which their orders are
executed.
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RESPONSES TO WRITTEN QUESTIONS OF SENATOR VITTER
FROM JAMES BRIGAGLIANO
Q.1. At an open meeting on October 21, 2009, the Securities and
Exchange Commission (the ``Commission'' or ``SEC'') voted to
publish for public comment three proposals that would
significantly tighten the Commission's regulation of so-called
``dark pools.'' Given that and your participation in today's
hearing clearly the issue is very much on your radar screen.
Can you please lay out a little more clearly the pros and cons
of dark pools and flash orders? How do you weigh the liquidity
and pricing function that they provide institutional investors
with a need to ensure all market participants have equal access
to information and pricing?
A.1. The potential cons of dark pool orders (particularly the
actionable indications of interest, or ``IOIs'', that are the
focus of the dark pool proposals) and flash orders are: (1)
they may create a two-tiered market in which the public does
not have access, through the consolidated market data that is
widely available to the public, to information about the best
available prices for listed securities; (2) they may discourage
the public display of trading interest and harm quote
competition among markets, which could lead to wider spreads
and higher transaction costs for investors; (3) they may divert
a significant amount of valuable order flow from the markets
that publicly display the best prices and thereby detract the
quality of public price discovery in listed securities (such as
reduced depth or increased volatility); (4) if not used
appropriately, they can cause information leakage about the
dark pool or flash order that can harm the interests of the
submitter of the order; and (5) the flashing of orders at
marketable prices may undermine the purposes of the rules which
protect previously displayed quotations from being locked by
equal-priced contra-side quotations.
The potential pros of dark pool orders and flash orders
are: (1) the dark pool or flash mechanism may attract
additional liquidity from market participants who are not
willing to display their trading interest publicly and thereby
improve execution quality for the dark pool or flashed order
than if it were routed elsewhere; (2) a reduced or no fee for
executing the dark pool order or flashed order than the fee
that would have been charged (known an access fee or ``take''
fee) if the order were routed elsewhere; and (3) an ability for
institutional investors or brokers representing the interests
of institutional investors to trade without revealing their
large trading interest to the public and thereby to lower the
transaction costs of institutional investors.
A vital step in weighing the pros and cons of dark pool
orders and flash orders, including the liquidity and pricing
function and equal access to information and pricing, is
publishing the proposals and receiving the benefit of public
comment on the issues. The comment period on the flash order
proposal ended on November 23, 2009. The comment period on the
dark pool proposals ends February 22, 2010. The Commission
likely will want to assess the potentially serious drawbacks
associated with dark pool orders and flash orders, including
the danger of creating a two-tiered market, when considering
any benefits for long-term investors, such as quality of
execution, that may be provided. The Commission also likely
will want to consider whether such benefits are otherwise
obtainable.
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RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
FROM PETER DRISCOLL
Q.1. Mr. Driscoll, you suggested in your written statement that
market makers, especially high frequency traders claiming to be
market makers, aren't really making markets where it is needed
and are concentrating on the highest volume stocks. What should
the SEC or market participants do to fix this?
A.1. Market makers have always been (and continue to be) a
critical part of the U.S. capital markets. Day in and day out,
they provide billions of dollars of much needed liquidity to
the market, which enhances price discovery, transparency and
execution quality. Most traditional market makers provide
continuous two-sided markets and a wide spectrum of specialty
services in thousands of issues. Without these services,
capital markets would have dramatically wider bid-ask spreads,
volatility would increase and execution quality would quickly
deteriorate, especially in secondary and tertiary issues where
the lack of liquidity has traditionally been a problem.
Market makers have adapted technologies to make their
market-making operations more efficient. These technologies
help manage risks, execute orders quickly and enable the market
maker to remain competitive in the new electronic trading
structure. This investment in high-speed technology benefits
the market maker, their clients and the markets in general--a
case where competition and innovation directly benefit
investors.
It is essential to our members that we and the regulators
continue to evaluate and assess the benefits of competition
from new market making entrants to ensure that the benefits to
the investor are both quantifiable and tangible.
Additional Material Supplied for the Record
PREPARED STATEMENT OF LARRY LEIBOWITZ
Group Executive Vice President and Head of U.S. Execution and Global
Technology for NYSE Euronext
Introduction
Chairman Reed, Ranking Member Bunning, and Members of the
Subcommittee, my name is Larry Leibowitz, and I am Group Executive Vice
President and Head of U.S. Execution and Global Technology for NYSE
Euronext. I greatly appreciate the opportunity to share with the
Committee our written testimony on the subject of today's hearing. We
are grateful for the Committee's leadership in addressing the market
structures issues that are the focus of so much debate in today's
evolving marketplace.
This is a timely subject worth examining for several reasons. SEC
Chairman Schapiro has announced that the Commission is undertaking a
broad review of market structure issues; and, in fact, has already made
several proposals, all steps in the right direction. These issues are
important in the context of both the financial regulatory reforms the
Committee is considering and the advances in market practices and
technology that have become the focus of the public, regulators,
legislators, market participants, analysts, and commentators.
NYSE Euronext is a leading global operator of financial markets and
provider of innovative trading technologies. The company operates cash
equities exchanges in five countries and derivatives exchanges in
Europe and the United States, on which investors trade equities,
futures, options, and fixed-income and exchange-traded products. With
more than 8,000 listed issues, NYSE Euronext's equities markets--the
New York Stock Exchange, NYSE Euronext, NYSE Amex, NYSE Alternext, and
NYSE Arca--represent nearly 40 percent of the world's equities trading,
the most liquidity of any global exchange group. NYSE Euronext also
operates NYSE Liffe, the leading European derivatives business, and
NYSE Liffe U.S., a new U.S. futures exchange. We also provide
technology to more than a dozen cash and derivatives exchanges
throughout the world. The company also offers comprehensive commercial
technology, connectivity and market data products and services through
NYSE Technologies.
Regulation is an integral and important part of the NYSE Euronext
business structure. It is our belief that smart regulation--when
properly administered--adds value to the marketplace overall, as well
as to our business model. The current attention by this Committee, the
SEC, and policymakers and commentators to the questions of how to
update market structure regulation to address today's marketplace is
timely and of utmost significance to our own business as well as the
marketplace as a whole.
Specifically, today I would like to address:
the evolution of the equity markets since the adoption of
Regulations ATS and NMS in 1998 and 2005, respectively;
the SEC's dark pool proposals;
the SEC's proposal to eliminate ``flash'' orders;
high frequency trading;
colocation; and
direct market access.
In each case, I would like to identify what we view as the
principal issues and ideal solutions.
Evolution of the Equity Markets
In 1998, the SEC adopted Regulation ATS and Rule 3b-16, which
allowed new electronic trading markets to operate as exempt
``alternative trading systems'' instead of complying with the extensive
regulatory requirements borne by registered exchanges. Although
electronic trading systems were exchanges in all but name, prior to
Regulation ATS they were regulated not as exchanges but solely as
broker-dealers, with some additional reporting requirements. The SEC's
purpose in adopting Regulation ATS was to encourage ``innovative new
markets'' while providing ``an opportunity for registered exchanges to
better compete with alternative trading systems,'' by reducing the
regulatory disparities that existed at the time between regulated
exchanges and automated trading centers, \1\ Regulation ATS sought to
achieve these purposes by exempting alternative trading systems from
exchange registration subject to conditions that imposed some but not
all of the core obligations of exchange regulation on those ATSs, and
only when an ATS reached a significant market-share threshold. These
conditions include disseminating public quotes, providing fair access,
maintaining reliable and secure systems, and ensuring the
confidentiality of orders. Under the regulations in effect today,
quoting and fair access obligations are triggered when a particular ATS
crosses a fairly high threshold in volume in a particular security.
Taking a step in the right direction, the SEC has recently proposed
lowering the threshold that triggers the obligation to publicly display
quotes from 5 percent to .25 percent. We believe the SEC should review
whether the fair access threshold should also be lowered.
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\1\ Regulation ATS Adopting Release, Exchange Act Release No.
40760 (December 22, 1998).
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Regulation ATS facilitated the development of numerous
nontransparent trading systems (informally known as ``dark pools'') and
transparent electronic communication networks, or ECNs, that
disseminate public quotes. Prior to the adoption of Regulation ATS, the
U.S. equity markets were primarily characterized by trading on
transparent floor-based exchanges, with some blocks trading upstairs on
broker-dealer block desks, and some retail orders executed internally
by over-the-counter market makers. Regulation ATS fostered new
competition from electronic trading markets, some bright, some dark.
The competition presented by these new trading centers has changed the
operations of exchanges, upstairs block desks, and over-the-counter
market makers. For example, transaction volume that occurs off of
regulated, transparent exchanges now routinely exceeds one-third of
total market volume. This shift demonstrates the growth of highly
competitive markets, but itself suggests that we are at a point where a
reexamination of our market structure is warranted.
Today we have the opportunity to step back and consider how to
ensure that the regulatory framework keeps pace with the changes that
Regulation ATS fostered. Before the adoption of Regulation ATS, the SEC
rightly identified the need to bring parity to the regulatory treatment
of registered exchanges and ATSs. Although the SEC's actions
facilitated significant innovation and lower costs for investors as a
result of the competition among the various market centers, it is
important that policymakers continue to evaluate the marketplace and
the effects of regulatory reforms to assure that they are achieving
objectives that make sense in today's market and have not exposed the
marketplace to regulatory arbitrage among participants. We must
reexamine whether the SEC achieved its parity objective with the
implementation of Regulations ATS and NMS and whether market practices
and technology have outgrown the original designs of Regulations ATS
and NMS. In particular:
ATSs that are under the 5 percent volume threshold that
triggers the public quoting requirement are able to quote
privately, using prices that are based on the public quote that
is formed for the most part by registered exchanges. There is a
cost to creating the public quote, and private ATSs are not
contributing to that cost by contributing their quotes. As off-
exchange transaction volume grows, there is a greater risk that
this pattern could harm the effectiveness and the integrity of
the public quote. The recent proposals by the SEC to address
this issue, as well as their anticipated concept release, are
important steps in the right direction.
As trading spreads across more bright and dark markets, it
becomes increasingly difficult to monitor, both for practical
data aggregation reasons and because the task of monitoring
trading is spread differently across self-regulatory
organizations, without any one SRO seeing the majority of
trading. At a minimum, the cost of surveillance of the equity
markets should be spread across all trading centers and should
be fairly and proportionately borne by each marketplace,
whether an SRO or not. ATSs do not bear direct surveillance
obligations as exchanges are required to do, and do not
contribute directly to the costs of market surveillance
conducted by other SROs. We should look to create a more
equitable and consolidated approach to marketplace
surveillance.
Registered exchanges are subject to an extensive
registration process to ensure that their trading systems
comply with national market system principles and that they are
structured and funded to operate effectively as self regulatory
organizations. Exchanges also must submit their rule changes
for prior SEC approval. It is important to recognize that this
rule review by the SEC is not a quick rubber stamp process:
many of the strongly held market structure principles of the
SEC are not expressed through notice and comment rulemaking,
but through the conditions and limitations the SEC imposes on
exchange rules through the approval process. This process often
is very time consuming. ATSs are not subject to similar
oversight, because they do not need to seek approval to operate
or file their rules for approval. As a result, ATSs are able to
modify their rules and respond to user feedback quicker than
registered exchanges, and they are not subject to the SEC's
behind-the-scenes application of market structure principles.
ATSs should be subject to SEC approval before becoming
registered, and prior SEC review and, where appropriate,
approval of their material system changes.
And, most fundamentally, there is the question of whether
trading centers that account for a substantial percentage of
all trading volume should be permitted to benefit from any
exemption from fair access and quoting obligations, at least
with respect to small-sized orders.
The regulation of ATSs requires additional changes to achieve the
Regulation ATS objectives. Not just the ATS threshold for public
quoting, but the ATS threshold for fair access should be lowered below
5 percent. In fact, to lower the quoting threshold but not the fair
access threshold is counterintuitive: it is like requiring a department
store to advertise its sale prices but allowing the guards at the door
to deny entry to all but the most privileged customers.
Other jurisdictions are undertaking similar reviews. For example,
Charlie McCreevy, EU Commissioner for Internal Market and Services, has
stated that the European Markets in Financial Instruments Directive
(MiFID), the EU's analogue to Regulation NMS, needs to be reexamined in
light of the rise of dark trading venues, which he said ``gives rise to
questions as to whether there are unfair commercial advantages for the
operators of these venues and whether the trend undermines price
discovery, market integrity and efficiency for the market as a whole.''
\2\
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\2\ Speech by Charles McCreevy, ``Towards an Integrated Approach
to Regulation Across the EU'' (September 18, 2009), available at,
http://europa.eu/rapid/pressReleasesAction.do?reference=SPEECH/09/
398&format=HTML&aged=0&language=EN&guiLanguage=en.
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The SEC's Dark Pool Proposals
In 2005, the SEC adopted Regulation NMS, with the goal of
establishing a truly integrated national market system. Since then, the
rise of dark trading venues has contributed to fragmentation,
undermining the goals of Regulation NMS. Requiring ATSs to publicly
display quotes and treating actionable indications of interests as firm
quotes under Regulations NMS and ATS would help forestall further
fragmentation by integrating many ATSs into the national market system
of displayed quotes.
Last week, the SEC proposed several rule amendments to address some
of these issues. The SEC's proposals would (1) amend the definition of
``bid'' or ``offer `` in Regulation NMS to require actionable
indications of interest to be included in the public quote stream; (2)
lower the volume thresholds that triggers the quote display obligations
of ATSs from 5 percent to 0.25 percent; and (3) require trades reported
by an ATS to identify the ATS on which the trade took place (today the
trades are reported generically as having been executed ``over-the-
counter''). These proposals represent a useful and productive first
step.
Moving forward, it is important to address the additional market
structure issues that I mentioned earlier: flash orders, high frequency
trading, colocation, and direct market access. We understand that the
Commission plans to publish a concept release exploring these topics,
and in particular whether high frequency traders are contributing to
liquidity in the displayed markets, whether long-term traders have
shifted into dark markets, and whether these changes have resulted in
greater volatility in the displayed and dark markets overall, to the
detriment of long-term investors. While, as described below, we do not
believe that high frequency trading and colocation in particular raise
these concerns, other issues like flash orders are more problematic. We
welcome the SEC's review of this area.
Flash Orders
The rapid growth and widespread use of flash orders in part
demonstrates how the regulatory framework has not kept pace with the
evolution of the market. In this regard, the SEC should be commended
for its recent proposal to eliminate flash orders. We agree with the
SEC that flash orders undermine public price discovery and the
efficient functioning of the markets by drawing liquidity away from the
displayed markets and by allowing unsurveilled information leakage. In
addition, flash orders represent a form of ``unfair access'' because a
flash order is only available to a select group of market participants,
thus the broader market is disadvantaged because a displayed order was
not given the opportunity to execute against the order that was flashed
to a select group. This undermines the incentive to display limit
orders, which play an essential role in the public price discovery
process by establishing outer limits as the market price moves. Flash
orders also create a two-tiered market as they allow select
participants to have advance access to order information in a given
security. And flash orders create the opportunity for a recipient of
the ``flash'' to trade on the public markets utilizing the information
that the ``flash'' revealed about the price movement in a security,
with no surveillance oversight of recipients of the information.
Flash orders are an example of an innovation that if left unchecked
would harm the markets and the integrity of public price discovery and
create advantaged groups. On the other hand, there are innovations in
technology and market practice that benefit the broader market. One
example of a beneficial innovation is high frequency trading.
High Frequency Trading
High frequency trading is a natural evolution of longstanding
practices of active market participants and traditional market makers.
A variety of firms engage in high frequency trading, including firms
that have evolved from more traditional market making models. High
frequency trading firms engage in various trading strategies, but
generally operate by entering orders on a highly automated and high-
volume basis, based upon proprietary algorithms. Many orders are
entered seeking rapid execution at their limit price and are cancelled
immediately if not executed instantaneously.
High frequency traders represent a significant portion of trading
volume on the NYSE and other U.S. market centers. For example, it is
estimated that high frequency traders accounted for approximately two-
thirds of all volume on U.S. equity markets over the last nine to 12
months. \3\ High frequency trading should not be confused with flash
orders. In fact, one analysis has suggested that almost all high
frequency trading takes place outside of the flash process. \4\ High
frequency traders provide substantial liquidity to the market, a
positive development that should be encouraged. We believe that absent
the liquidity provided by high frequency trading, the volatility in the
equity markets would be much greater. In addition to providing
liquidity, high frequency trading firms contribute to the narrowing of
spreads, resulting in lower transaction costs for all market
participants.
---------------------------------------------------------------------------
\3\ See, ``Rosenblatt Securities Inc., Trading Talk: An In-Depth
Look at High-Frequency Trading'' (September 30, 2009).
\4\ See, id.
---------------------------------------------------------------------------
High frequency traders invest in systems and trading algorithms
that enable them to respond quickly to price changes by entering and
canceling many orders at a time. As a result, high frequency traders
trade at higher speeds and in greater volume than many other investors.
But it is worth recalling that differences in speed and volume have
always existed, and are harmful to investors only if they are on
balance taking liquidity that would otherwise be available to other
investors, or are manipulating the market in some manner. We have not
observed either of these concerns.
Colocation
Colocation is the practice of trading firms locating their servers
at the physical location of a trading center's matching engine servers.
In today's electronic trading environment, orders travel extremely
quickly, so the physical proximity of a trading firm's server to the
market affects execution speed (at a rate of approximately 1
millisecond per 100 miles). This puts a firm located in, for example,
San Francisco at a significant speed disadvantage to one in New York.
In fact, a lack of available colocation facilities could trigger a
scramble for real estate located next to market centers on behalf of
parties that are outside the regulatory reach of the SEC or exchanges.
The practice of colocation has been commonplace in both the equities
and derivatives markets, and is the logical result of the automation of
the U.S. marketplace. As U.S. market structure has evolved (due to
Regulation ATS, Regulation NMS and other factors driving electronic
automation and fragmentation), aspects of trading technology
infrastructure (especially colocation) have started to commingle with
the market structure itself.
We do not believe that retail investors are disadvantaged by
colocation. In fact, most retail orders do not enter the market
directly, but rather through wholesalers, who instantaneously fill
orders out of inventory at prices determined by the National Best Bid
or Offer (NBBO), or place orders on exchanges using their own colocated
infrastructure. Retail investors thus benefit from the utilization of
colocation through tighter spreads, lower volatility and deeper
liquidity.
Colocation provides operational, not informational advantages.
There have always been operational differentials in the marketplace, as
a result of technological innovation and the extent to which
participants choose to compete by spending resources on those
innovations. Computers reading price feeds and making decisions have
always been faster than people in their broker's office reading a
ticker screen. As technology has become more prominent in the market,
this operational differential has become most easily measured by speed.
While operational advantages are a natural result of a competitive,
free market, informational advantages are not--they distort price
discovery and unfairly disadvantage other market participants. An
informational advantage exists when a market participant has prior
access to information that others do not have, as in the case of flash
orders. Colocation does NOT in itself allow a participant to see orders
before they hit the marketplace, as flash orders do.
The SEC is presently reviewing the way fees are structured for
exchange-owned/controlled colocation space and will require that such
colocation fees be filed as is required for any other exchange pricing.
The SEC has oversight over the exchange markets that offer colocation,
but not colocation offered by ATSs or other third parties who do not
operate marketplaces. We think it is important that the SEC consider
ways in which to fairly regulate the practice of colocation across
marketplaces, regardless of how colocation to a particular marketplace
is offered.
It is also particularly important to ensure fair access in
connection with colocation in order to prevent both anticompetitive
results for regulated exchanges and gaps in oversight regarding
colocation by third parties, such as landlords of premises where market
centers lease space to host their matching engines. It is impossible to
prevent third parties from obtaining space close to an exchange data
center and then subletting it to trading firms. Third party data center
operators--acting on their own or on behalf of market centers (some of
which are regulated and some of which are not)--are under no obligation
currently to ensure fair access. As a result, not all markets are
regulated equally, which creates competitive disadvantages among
marketplaces offering colocation and creates an opportunity for market
participants to engage in regulatory arbitrage. In addition, not all
markets offer colocation in the same manner (e.g., the NYSE will own
our U.S. equities colocation space and control the entire data center
housing the matching engines for our European derivatives exchanges,
subjecting us more directly to regulation, but our competitors might
provide it via third parties, taking it out of the realm of regulation
simply by virtue of the structuring of their real estate arrangements).
This could result in an extremely tilted playing field that allows
market participants that are significant contributors to overall
activity and volume to avoid SEC regulation.
We are working with the SEC to develop best practices for
allocation of colocation space. We welcome the SEC guidelines in this
area. We encourage the SEC to develop effective mechanisms for
monitoring the practice among ATSs and third party vendors as well.
Sponsored Access
Firms that colocate at market centers often connect to the market
center though a direct market access arrangement. Direct market access
refers to the practice for trading firms that are usually not
themselves members of a particular trading venue obtaining access to a
market center through a broker-dealer's trading identifier, thereby
allowing such trading firm to enter orders directly onto the market
center's systems. Direct market access takes at least two forms,
including: arrangements whereby a member of a market center permits a
sponsored participant to (1) enter orders directly onto the market
without first passing through the member's systems (including risk
management systems), sometimes referred to as ``unfiltered'' or
``naked'' access, or (2) enter orders directly onto the market through
the member's systems (including risk management systems).
We support the SEC's initiative to develop clear, consistent
supervisory standards for sponsoring firms in order to ensure that
there are adequate risk controls in place to minimize systemic risk as
a result of inadequate oversight of trading activity; we also support
FINRA's efforts to monitor the sponsoring firms' risk management
procedures--a role that properly belongs with a regulatory agency
capable of examining across the industry in a consistent manner instead
of in the hands of discrete exchanges with varying examination
methodologies and processes.
Conclusion
In conclusion, NYSE Euronext supports leveling the playing field
between ATSs and registered exchanges by (1) requiring ATSs that cross
a more realistic threshold in volume to be required to quote publicly,
as the SEC has recently proposed; (2) reducing the Regulation ATS fair
access threshold in parallel with the quoting threshold; (3) requiring
ATSs to contribute to their proportional cost of market surveillance
and for there to be a universal surveillance authority; and (4)
requiring ATS rule changes to be subject to regulatory oversight and
approval similar to the oversight and approval process that applies to
registered exchanges. In addition we advocate:
eliminating flash orders, as the SEC has recently proposed;
\5\
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\5\ NYSE Euronext will be submitting a comment letter on the
Commission's proposal.
encouraging high frequency traders to continue to play the
market stabilizing role that was demonstrated during the market
---------------------------------------------------------------------------
stresses experienced last year;
ensuring that there is no regulatory disparity between
market centers that offer colocation opportunities in owned
data centers and nonexchange third-party data centers that
offer colocation opportunities; and
requiring providers of direct market access to perform
pretrade monitoring of the trading activities of sponsored
participants in accordance with a uniform rule.
We believe that the SEC is working on these difficult and
complicated issues. We support the Committee's continuing efforts in
focusing on this area, and would like to thank you once again for the
opportunity to share our views today.
______
PREPARED STATEMENT OF THOMAS M. JOYCE
Chairman and Chief Executive Officer, Knight Capital Group, Inc.
Chairman Reed, Ranking Member Bunning, and Members of the Committee
thank you for the opportunity to submit written testimony in connection
with this very important hearing regarding key market structure issues;
including dark pools, flash orders, and high frequency trading (HFT).
1. Brief history of Knight
Knight Capital Group, Inc. (Knight) opened for business in 1995.
\1\ Built on the idea that the self-directed retail investor would
desire a better, faster and more reliable way to access the market,
Knight began offering execution services to discount brokers. Today,
Knight services some of the world's largest institutions and financial
services firms, providing superior trade executions in a cost effective
way for a wide spectrum of clients in multiple asset classes,
including: equities (domestic and foreign securities), fixed income
securities, derivatives, and currencies. Today, Knight through its
affiliates, makes markets in equity securities listed on the New York
Stock Exchange (NYSE), NASDAQ, NYSE Amex, the OTC Bulletin Board, and
Pink Sheets. On active days, Knight executes in excess of five million
trades with volume exceeding 10 billion shares. In 2008, Knight:
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\1\ Knight is the parent company of Knight Equity Markets, L.P.,
Knight Capital Markets LLC, Knight Direct LLC, Knight BondPoint, Inc.,
and Knight Libertas LLC all of whom are registered with SEC and various
self-regulatory organizations. Knight Capital Europe Limited and
Hotspot Fxi Europe Limited are authorized and regulated by the
Financial Services Authority. Knight Equity Markets Hong Kong Limited
is authorized and regulated by the Securities and Futures Commission.
Knight, through its affiliates, is a major liquidity center for the
U.S. securities markets. We trade nearly all equity securities.
Knight's clients include more than 3,000 broker-dealers and
institutional clients. Currently, Knight employs more than 1,000 people
worldwide. For more information, please visit: www.knight.com.
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Made markets in (or traded) more than 19,000 securities.
Executed nearly one trillion shares (roughly, 4 billion per
day)--more than any other broker/dealer or U.S. securities
exchange.
Executed more than 640 million equity trades (approximately
2.5 million per day).
Traded more than $4.8 trillion in notional value (over $19
billion per day).
The majority of the trades we execute today are on behalf of retail
investors. Although retail customers do not come to us directly, their
brokers do. We count amongst our clients some of the largest retail
brokerage firms in the U.S., including: Scottrade, TD Ameritrade,
Fidelity, Raymond James, E*Trade, Pershing, Wachovia and Wells Fargo.
In addition, we service some of the largest institutions in the
country. These institutional clients send us orders on behalf of mutual
funds and pension plans, whose ultimate clients are, of course, small
investors.
Knight has spent the last 15 years building its technology
infrastructure so that it can process millions of trades a day on
behalf of the retail investor--in a fast, reliable, cost effective
manner, while providing superior execution quality and service. Our
data centers are some of the largest and most reliable in the industry.
We spend tens of millions of dollars every year, making our technology
platform better, faster and more reliable. Today, we have the capacity
to process nearly 20 million trades per day. We have connectivity to
nearly every source of liquidity in the equities market, and our trade
response times are now measured in milliseconds. Our years of research
and development, technology platform enhancements, and connectivity to
liquidity wherever it resides is all brought to bear with a single
purpose in mind: securing best execution on behalf of our customers
(and, in turn, their customer--the retail investor). Importantly,
access to this sophisticated gateway is available to nearly every
investor in the country.
As a result, we believe that Knight is uniquely qualified to
comment on these market structure issues. At their core, these issues
revolve around notions of fair access and transparency--both of which
form the foundation for our capital markets. As you will undoubtedly
see upon the careful analysis of all of the relevant data, investors'
level of access to the markets is extraordinary and the level of
transparency in today's markets is better than it has ever been.
2. There has never been a better time to be an investor
There has never been a better time to be an investor (large or
small) in U.S. equities. Execution quality (speed, price, liquidity)
are at historically high levels, while transaction costs (explicit and
implicit) are at historically low levels.
The U.S. equity markets are the fairest, most transparent and most
liquid markets in the entire world. Remember that during the course of
the last year, a tumultuous one to say the least, the equity markets
worked flawlessly. One may not have liked the direction prices went at
times but all investors could act on their investment decisions swiftly
and with surety. The equity markets never seized up like many of the
credit markets and loan markets. In fact, they were open every day all
year, distinguishing themselves in their reliability and robustness.
An extraordinarily important fact, however, continues to be
overlooked--investors have seen substantial improvements in execution
quality. For example:
a. The amount of times investors receive a price better than the
national best bid or offer (NBBO) has risen significantly over
the years.
b. Today, the industry average execution speed for retail market
orders in S&P 500 stocks is less than one second. In 2004, it
took nearly 12 seconds to execute that same order.
c. Effective spread is a comprehensive statistic designed by the SEC
to measure the price received by an investor relative to the
NBBO, and it is often set as a ratio to the quoted spread
(i.e., Effective to Quoted Spread, or EQ)--with the lower
number indicating that the investor is receiving a better
price. In 2004, an investor looking for an execution in a
NASDAQ-100 stock could expect an EQ of roughly 115 percent.
Today, that same order could receive an EQ closer to 90
percent--over 20 percent improvement in pricing for investors.
d. The realized spread compares the execution price to the NBBO 5
minutes later. The smaller the average realized spread, the
more market prices have moved adversely to the market center's
liquidity providers after the order was executed, which shrinks
the spread ``realized'' by the liquidity providers. In other
words, a low average realized spread indicates that the market
center was providing liquidity even though prices were moving
against it for reasons such as news or market volatility.
Retail size orders (fewer than 500 shares) in NASDAQ securities
are receiving some of the lowest realized spreads in the last 8
years--supporting the thesis that market participants are
providing liquidity even though prices may be moving against
them.
The facts show that investors have benefited greatly over the years
as a direct result of the developments in market technologies. In fact,
in speaking before the Security Traders Association's Annual Meeting on
October 4, 2007, former SEC Commissioner Annette L. Nazareth stated
that,
Today, the landscape has changed dramatically. In August of
this year [2007], for example, NYSE's market share in NYSE-
listed equities was approximately 45.8 percent. For the first
time, ATSs and ECNs are now competing head-on with the listed
markets . . . What a difference true competition makes!
High speed computers, IOIs, dark pools, etc., are not the problem;
indeed, they are the culmination of our free-market system--
competition. Competition has led to better executions (both speed and
price) for investors. We should not look to impede competition; rather
we should always look for ways to enhance it. That is what keeps our
capital markets great. Former SEC Chairman Arthur Levitt got it right
when he recently said,
Investors large and small have always been served well by those
looking to build the deepest possible pool of potential buyers
and sellers, maker trades at a better price, and all as quickly
as possible . . . More liquidity, better pricing and faster
speeds are the building blocks of healthy, transparent markets,
and we must always affirm those goals.----Wall Street Journal--
August 17, 2009.
3. There are not two-tier markets
Retail investors are able to harness the connectively and
lightning-fast technology made available to them by their brokers and
the execution venues that handle their order flow. From a speed and
access point of view, investors are able to access some of the best
trading technology available today--at little or no cost.
Market venues spend hundreds of millions of dollars every year on
technology, including data centers, communication lines and
infrastructure. They look for new and improved ways to source and
access liquidity, in the most effective and efficient manner
(including, IOIs, dark pools, colocation, and countless order types).
The investor community is provided access to many of these tools and
technologies without charge (other than, of course, the small
commission they pay their broker). That's right--investors get access
to nearly all liquidity pools and they can harness some of the fastest
and most sophisticated technologies in the world. For example, as noted
above, Knight is connected to all key liquidity pools. We colocate our
computers at various market centers, and we deploy some of the fastest,
most sophisticated trading technology in the world, all of which is
brought to bear for the purpose of executing our clients' trades.
Simply put, if a retail investor gives a market order to buy 500 shares
of Starbucks to his broker and that broker routes the order to Knight
(or, many other execution venues), that order will likely be executed
at the NBBO, or better, in less than a second. The cost to the investor
is simply the commission paid to their broker (typically, less than
$10). Knight, as well as most other nonexchange execution venues,
provides access to all of its technology, liquidity, and gateway to the
marketplace at no charge to the retail investor.
We fully believe that if the SEC accounts for different forms of
market structure needed for different participants, it will conclude
that the ``little guy'' (i.e., retail investor) truly benefits from
IOIs, dark pools, and the market processes designed to facilitate the
sourcing of liquidity and enhancing execution quality. Remember, the
retail investor is not operating alone. Retail investors give their
orders to well-armed executing brokers who have access to the various
liquidity pools in the market. Additionally, brokers often turn to
executing venues (like, Knight and others) to gain further access to
the markets. Taken together (the broker and the execution venue), these
robust resources are brought to bear for the benefit of retail
investors--providing them with a vibrant gateway into the marketplace
and unprecedented access and liquidity. The investor is indeed not in
it alone. This is not ``David vs. Goliath.'' To the contrary, ``David''
has retained ``Goliath,'' leveraging resources heretofore unavailable
to retail, who swiftly and expertly accesses the market on his behalf.
4. Competition and innovation
We fully support the SEC's initiative to review the broad range of
market developments which have helped shape our equity markets in
recent years. Competition and innovation have led to advancements in
trading technologies over the last several years. In fact, Regulation
NMS helped pave the way for competition to thrive among market
participants. In addressing the STA at its Annual Meeting on October
13, 2006, SEC Commissioner Nazareth stated,
Two of the Commission's primary goals for Reg NMS are to
promote vigorous competition among markets and to remove any
competitive advantages that the old rules may have given manual
markets. All evidence to date indicates that these goals are
well on their way to being met.
Those advancements have resulted in more liquidity, more price
improvement and faster executions. Investors of all shapes and sizes
(from small retail investors to large institutions) are reaping the
fruits of those endeavors. As SEC Commissioner Kathleen L. Casey noted
on October 21, 2009,
Competition has transformed the equity markets. We have moved
light years from the slow manual trading that once
characterized the New York Stock Exchange. We have moved well
beyond the NYSE/NASDAQ duopoly. Today, the U.S. equity markets
offer more benefits to more investors than at anytime in
history. Over the past decade, advances in technology, coupled
with paradigm-shifting regulatory actions such as Regulation
ATS, have lowered barriers to entry. The resulting vigorous
competition for customer order flow among numerous trading
venues--including so-called ``dark pools''--has led to more
choices of trading centers, greater speed and liquidity,
financial innovation, tighter spreads, and lower execution
costs. Investors, particularly individual investors, have
reaped the benefits of the fierce competition that has
developed in this area. Therefore, it is imperative that we not
take any regulatory actions that would impede or
unintentionally reverse this considerable progress.
5. Sensible rule-making
We believe it is especially important to craft effective trading
rules. And there is an old saying that we believe guides this effort:
``In God We Trust; everybody else has to bring data.'' The best rule
making is based on careful analysis of all relevant facts. We urge the
SEC to look closely at the statistical evidence of how efficiently the
equities markets currently operate; to assess how much value the
current system brings to all investors; and, to insure that any
rulemaking withstands a rigorous cost-benefit analysis.
Knight has advocated repeatedly that competition, rather than
mandated and prescribed paths to trading, benefits market participants
and all investors. For example, the SEC's Rule 605 is an excellent
example of regulation that increases competition by promoting
transparency and comparability. The rule requires market participants
to post their execution statistics in accordance with standardized
reporting metrics, thus enabling order routing firms to make more
informed routing decisions to meet their clients' needs. This has
increased competition and pressured market participants to continue to
improve the execution of customer orders, while resulting in
dramatically reduced costs for investors. We believe the dramatic
decrease in brokerage commissions and the split-second executions for
most marketable orders in recent years is a direct result of these
competitive forces, not regulatory fiat. Additionally, SEC Rule 606
requires brokers to disclose on a quarterly basis the venues to which
it routed order flow, as well as any payment for order flow
arrangement. The adopting release to Rule 606 states, in part:
The purpose of requiring disclosure concerning the
relationships between a broker-dealer and the venues to which
it routes orders is to alert customers to potential conflicts
of interest that may influence the broker-dealer's order-
routing practices. Currently, Rule 10b-10(a)(2)(i)(C) requires
a broker-dealer, when acting as agent for the customer, to
disclose on the confirmation of a transaction whether payment
for order flow was received and that the source and nature of
the compensation for the transaction will be furnished on
written request. In addition, Exchange Act Rule 11Ac1-3(a)
requires broker-dealers to disclose in new and annual account
statements its policies on the receipt of payment for order
flow and its policies for routing orders that are subject to
payment for order flow. The Commission believes that disclosure
of potential conflicts of interest in conjunction with a
quantitative description of where all nondirected orders are
routed may provide customers with a clearer understanding of a
broker-dealer's order routing practices than is provided under
current rules. (emphasis supplied.)
Regardless of any payments received, the SEC and self-regulatory
organizations (SROs), like FINRA and the NYSE, have made it very clear,
that the broker's first obligation is to seek best execution. The SEC
has stated:
The Commission anticipates that improved disclosure of order
routing practices will result in better-informed investors,
will provide broker-dealers with more incentives to obtain
superior executions for their customer orders, and will thereby
increase competition between market centers to provide superior
executions. Currently, the decision about where to route a
customer order is frequently made by the broker-dealer, and
broker-dealers may make that decision, at least in part, on the
basis of factors that are unknown to their customers. The
Rule's disclosure requirements will provide investors with a
clearer picture of the overall routing practices of different
broker-dealers. The Commission contemplates that this will lead
to greater investor involvement in order routing decisions and,
ultimately, will result in improved execution practices.
Because of the disclosure requirements, broker-dealers may be
more inclined (or investors may direct their broker-dealers) to
route orders to market centers providing superior executions.
Broker-dealers who fail to do so may lose customers to other
broker-dealers who will do so. In addition, the improved
visibility could shift order flow to those market centers that
consistently generate the best prices for investors. This
increased investor knowledge and involvement could ultimately
have the effect of increasing competition between market
centers to provide superior execution. (emphasis supplied)----
See, SEC Release No. 34-43590 (November 17, 2000).
This is precisely the type of transparency which has led to fierce
competition among market centers. That healthy competition has resulted
in the extraordinary levels of execution quality retail investors enjoy
today. To that end, Knight supports the SEC's efforts to:
Place more controls on sponsored access. Market
participants must insure that those who access the market
through their MPID have procedures in place to insure they
fully conform to industry rules and regulations.
Require reporting of end-of-day trade volumes and
attribution for ATSs.
Move to a 2 percent volume threshold for ATSs.
Standardized rules and fees for colocation designed to
insure fair access to those who seek to such services.
6. The current proposals may push more liquidity into the dark
Regulation ATS sets forth a two-prong test for determining whether
quotes need to be displayed in the consolidated quote stream under Rule
301(b)(3). In short, if an ATS displays orders to its subscribers and
has at least 5 percent (.25 percent under the new proposal) of the ADV
of the stock for 4 of the preceding 6 months, it has to reflect the
order in the displayed market. So, increasing the possibility that ATSs
will break the lower thresholds will simply cause more ATSs to go
completely dark (i.e., not reflect orders to its own subscribers) in
order to avoid displaying their orders.
Additionally, indications of interest (IOIs) serve as a valuable
method of market participants to communicate with each other. By using
IOIs effectively, market participants are able to source valuable
liquidity on behalf of investors--liquidity that may not have otherwise
been available in the marketplace. So, further constricting their use
will undoubtedly have the unintended consequence of further
constricting liquidity.
It is noteworthy to reiterate the comments made recently by SEC
Commissioner Troy A. Paredes at the SEC's Opening Meeting on October
21, 2009:
[M]ore public quotes may not be the predominant result of the
rule amendments. Rather, as market participants adjust to new
public display obligations, the information contained in IOIs
might be scaled back so that IOIs, as a matter of practice, are
nonactionable and thus are not quotes that must be publicly
displayed. Presumably, if IOIs signal less information, those
looking to interact with nondisplayed liquidity would rely more
on ``pinging'' or other techniques to test liquidity across
dark pools. If this scenario occurs instead of there being a
meaningful increase in displayed liquidity, it is worth asking
whether the rule amendments before us ultimately would be
beneficial. In other words, might the status quo be preferable
to darker dark pools?
IOIs, dark pools, and better trading technologies are the tools
brokers use when seeking best execution for their clients. Further
limiting their use of these resources, we believe, will not enhance the
displayed markets; rather, it will inevitably lead to wider spreads,
less liquidity and higher costs. One only needs to turn back the clock
5 years to see evidence of this. When the exchanges had a dominant
stranglehold on the markets and volume, execution quality suffered and
trading costs for investors was exponentially higher than it is today.
7. The displayed markets are valid and robust
Some have argued that the value of the displayed markets is somehow
eroded when trading occurs off an exchange. We disagree. In fact,
trades executed off of an exchange predominately occur at the NBBO (or
better) which is completely consistent with both the letter and spirit
of Regulation NMS. Nevertheless, the majority of trading volume today
continues to take place on an exchange. In fact, NASDAQ, the NYSE,
Direct Edge and the regional exchanges account for approximately 70
percent of overall market volume. Regulation ATS and Regulation NMS
helped to break the monopoly the exchanges had on market share. In
fact, one of the ``darkest pools'' was the old specialist system on the
floor of the NYSE. For years the specialists controlled trading
information and access to data. Barriers to entry were lowered and
competition was able to flourish, forcing the NYSE and NASDAQ to
compete for market share, rather than simply demand it as a birth
right. Commissioner Casey also noted on October 21:
This trading volume migration from the incumbent exchanges to
other venues that publicly display trading interest
demonstrates the robust competition among trading centers for
customer order flow. It also demonstrates that nondisplayed
liquidity has not materially reduced the quantity of publicly
disseminated trade information. Therefore, it appears that an
obsessive focus on the rise of dark ATSs is misplaced. Quoting
venues in the aggregate are doing just fine, and the
competition among them is a good thing, not something we need
to ``correct.''
Market participants of all shapes and sizes actively trade both in
displayed and undisplayed venues. If the prices in the displayed venues
are not valid, trading firms quickly enter the displayed venues with
orders and trades until the pricing is corrected. If this did not
occur, those price dislocations would cause all venues (dark and light)
to be irrational. Thus, any suggestion that undisplayed venues do not
contribute to price discovery is illogical. Market participants trade
in both venues, insuring that pricing is rational and bona fide.
Conclusion
Knight appreciates the constructive roles this Committee and
Subcommittee have played in the oversight of the markets and the
rulemaking process. Your oversight helps to ensure that the U.S.
capital markets remain competitive and innovative, thus benefiting all
investors.
We also fully support the SEC's initiative to review the broad
range of market developments which have helped shape our equity markets
in recent years. Competition and innovation, spurred by insightful rule
changes fostered by the SEC, have resulted in dramatic improvements in
market technologies and execution quality for the benefit of public
investors--large and small. The U.S equity markets are the most liquid
and efficient in the entire world, and have performed exceedingly well
over the last several years. From an execution quality perspective, we
believe that there has never been a better time to be an investor in
U.S. equities. The advantages are considerable, including: speed and
stability, price improvement, and a significant reduction in
transaction costs. The empirical and statistical evidence available
under SEC Rule 605 shows tremendous investor benefit under the current
trading and regulatory market structure.
We echo the comments of many of the SEC Commissioners that these
important issues must be driven by the careful analysis of empirical
data, and not be driven by emotion or politics. Indeed, SEC
Commissioner Casey stated quite pointedly during the SEC's recent Open
Meeting,
[I] think it is necessary for the Commission to first develop a
deeper understanding of the whole range of U.S. equity market
structure issues before we consider adopting these amendments.
In my view, it is important that regulators act with humility.
Sometimes we don't know what we don't know, and if we rush to
regulate without a complete understanding of the extent to
which complex and dynamic activities may be interrelated, the
specter of unintended consequences looms large. The regulatory
process for rethinking market structure, like short selling,
needs to be driven by data, not politics or unfounded
assumptions.
We are confident that an independent SEC will be careful and
thoughtful in its work--and not be swayed by any market participant's
self-interest. We urge the Committee, Subcommittee, and the SEC to look
closely at the statistical evidence of how efficiently the equities
markets currently operate; to assess how much value the current system
brings to all investors; and, to insure that any rulemaking withstands
a rigorous cost-benefit analysis. We must insure that any proposed new
rules do not do more harm than good.
Thank you for your interest in these issues and for the opportunity
to contribute to this important dialogue.
______
PREPARED STATEMENT SUBMITTED BY THE INVESTMENT COMPANY INSTITUTE
The Investment Company Institute appreciates the opportunity to
submit this statement for the record in connection with the
Subcommittee's hearing on October 28, 2009, on ``Dark Pools, Flash
Orders, High Frequency Trading, and Other Market Structure Issues.''
The structure of the securities markets has a significant impact on
Institute members, who are investors of over $11 trillion of assets and
who held 24 percent of the value of publicly traded U.S. equity
outstanding in 2008. We are institutional investors but invest on
behalf of over 93 million individual shareholders. Mutual funds and
their shareholders, therefore, have a strong interest in ensuring that
the securities markets are highly competitive, transparent and
efficient, and that the regulatory structure that governs the
securities markets encourages, rather than impedes, liquidity,
transparency, and price discovery. Consistent with these goals, mutual
funds have strongly supported past regulatory efforts to improve the
quality of the U.S. markets. We therefore support the current
examination of the market structure in the United States.
Issues Facing the Current U.S. Market Structure
The current debate is very similar to that which occurred during
the last major review of the structure of our markets, specifically
during the adoption of the Securities and Exchange Commission's (SEC)
Regulation NMS. In Regulation NMS, the SEC noted that its proposals
were designed to address a variety of problems facing the U.S.
securities markets that generally fell within three categories: (1) the
need for uniform rules that promote the equal regulation of, and free
competition among, all types of market centers; (2) the need to update
antiquated rules that no longer reflect current market conditions; and
(3) the need to promote greater order interaction and displayed depth,
particularly for the very large orders of institutional investors.
Regulation NMS addressed these three categories but in the
intervening years since its adoption, the securities markets have
changed dramatically. The third category above, promoting greater order
interaction and displayed depth, continues to be of great importance to
mutual funds. As the SEC recognized in proposing Regulation NMS,
``perhaps the most serious weakness of the [national market system] is
the relative inability of all investor buying and selling interest in a
particular security to interact directly in a highly efficient manner.
Little incentive is offered for the public display of customer orders--
particularly the large orders of institutional investors. If orders are
not displayed, it is difficult for buying and selling interest to meet
efficiently. In addition, the lack of displayed depth diminishes the
quality of public price discovery.''
Problems surrounding the lack of order interaction, its causes, and
its impact on the securities markets have long confronted mutual funds.
The Institute and its members have, for many years, been recommending
changes that would facilitate greater order interaction and, in turn,
more efficient trading. A consistent theme throughout all of our
recommendations was that in order to promote greater order interaction
and displayed depth in the markets, a market structure should be
created that contains several key components, the most significant of
which are:
Price and time priority should be provided for displayed
limit orders across all markets;
Strong linkages between markets should be created that make
limit orders easily accessible to investors; and
Standards relating to the execution of orders should be
created that provide the opportunity for fast, automated
executions at the best available prices.
Investors and the Current U.S. Market Structure
The changes we have experienced in the structure of our markets the
last few years have not addressed all of the components we believe
necessary for a fully efficient market structure but great strides that
benefit all investors have been made. Trading costs have been reduced,
more trading tools are available to investors with which to execute
trades, and technology has increased the overall efficiency of trading.
Make no doubt about it, investors, both retail and institutional, are
better off than they were just a few years ago. Nevertheless,
challenges remain--posted liquidity and average execution size is
dramatically lower while volatility and the difficulty of trading large
blocks of stock have increased.
Regulation NMS, which has been largely beneficial to investors, led
to dramatic changes. The market structure in the U.S. today is an
aggregation of exchanges, broker-sponsored execution venues and
alternative trading systems. Trading is fragmented with no single
destination executing a significant percentage of the total U.S. equity
market. Some of the biggest and most active traders are high frequency
traders, who by some accounts trade close to two-thirds of the daily
volume of our securities markets. Tremendous competition exists among
exchanges and other execution venues, primarily driven by differences
in the fees they charge and the speed by which they execute trades,
with floor-based exchanges quickly becoming irrelevant.
To combat the difficulties in executing large blocks of stock,
mutual funds have demanded much greater control over their orders to
protect themselves from the leakage of information about their orders.
As such, funds have adopted new trading technologies to help them cloak
their orders and deal more directly with other institutional investors.
This provided the incentive that led to many of the technological
innovations in the securities markets including, as discussed below,
the development of certain alternative trading venues.
Trying to develop a market structure that promotes the fundamental
principles of a national market system while balancing the competing
interests of all market participants is no easy task. Nevertheless, one
point should be made clear: mutual funds' sole interest in this
discussion is in ensuring that proposed market structure changes
promote competition, efficiency and transparency for the benefit of all
market participants and not for a particular market center, exchange or
trading venue business model. Market centers should compete on the
basis of innovation, differentiation of services and ultimately on the
value their model of trading presents to investors. We are hopeful that
regulators can achieve the goals of a national market system while
focusing on the interests of the markets' most important participant--
the investor.
Dark Pools
Much of the current debate over the structure of the U.S.
securities markets have centered on the proliferation of so-called
``dark pools.'' We believe it is unfortunate that such a pejorative
term has now become ingrained in the terminology used by the securities
markets and policymakers to describe a type of trading venue that has
brought certain benefits to market participants. We therefore are
reluctant to use the term when discussing issues surrounding this part
of our market structure and urge that an alternative term be
established to describe such venues. However, since no alternative term
has yet been formally recognized and for purposes of clarity, we will
use ``dark pools'' in this statement to address these alternative
trading venues.
Dark pools are generally defined as automated trading systems that
do not display quotes in the public quote stream. Mutual funds are
significant users of these trading venues, which provide a solution to
problems facing funds when trading large blocks of securities,
particularly those relating to the frontrunning of mutual fund orders.
They provide a mechanism for transactions to interact without
displaying the full scale of a fund's trading interest and therefore
lessen the cost of implementing trading ideas and mitigate the risk of
information leakage and market impact. They also allow funds to shelter
their large blocks from market participants who seek to profit from the
impact of the public display of these large orders. The issue with
these trading venues, however, is that the benefits of not displaying
orders also lead to concerns for the structure of the securities
markets. Sheltering orders from the marketplace can impede price
discovery and transparency. As discussed above, these two elements are
critical in creating an efficient market structure.
SEC Proposals
The SEC last week set forth several proposals to bring ``light'' to
dark pools and to address concerns about the development of a two-
tiered market that could deprive certain public investors from
information regarding stock prices and liquidity. Specifically, the
SEC's proposals address concerns about pretrade transparency, including
pretrade messages sent out by dark pools in an effort to attract order
flow but that are only sent to selected market participants (so-called
``indications of interest'' or ``IOIs''). IOIs raise questions about
how ``dark'' some of these venues truly are on a pretrade basis as well
as whether these messages are similar to public quotes and therefore
should be treated as such. The proposals also would lower the trading
volume threshold required for the display of these venues' best-priced
orders.
The SEC's proposals also would address certain concerns about the
lack of post-trade transparency, particularly concerns that it often
can be difficult for investors to assess dark pool trading and to
identify pools that are most active in particular stocks. Currently,
public trade reports do not identify whether an over-the-counter trade
was reported by a dark pool and, if so, its identity. The proposals
would create a similar level of post-trade transparency as currently
exists for registered exchanges.
Institute Views
We appreciate the Government's desire to examine trading venues
that do not display quotations to the public and understand concerns
about the creation of a two-tiered market. As discussed above, the
Institute has long advocated for regulatory changes that would result
in more displayed quotes. At the same time, policymakers should take a
measured approach to making trading through dark pools more transparent
and we urge policymakers to ensure that there are no unintended
consequences for mutual funds, which must execute large blocks of
securities on a daily basis on behalf of their shareholders.
The SEC has taken an important step in this regard in its
proposals. The proposals would preserve the ability for mutual funds to
trade large blocks of securities by allowing certain large orders to be
``dark'' to address concerns about the leakage of valuable information
about mutual fund trades or the frontrunning of fund orders. We must
consider, however, whether additional steps must be taken by
policymakers to address other ways that mutual funds trade, for
example, when funds break up large orders into smaller pieces that are
executed separately. We also urge policymakers to not view the issues
surrounding dark pools in a vacuum without also examining other market
structure issues. We therefore look forward to a broader debate on
market structure that will raise important questions about numerous
aspects of our markets in general.
High Frequency Trading and Related Issues
High frequency traders and a host of issues connected to high
frequency trading have also garnered the attention of regulators. The
proliferation of alternative trading venues, including dark pools, and
the accompanying technological advancements in the securities markets,
set the stage for the entrance of high frequency traders. There are
many benefits to high frequency trading that have been cited, including
providing liquidity to the securities markets, tightening spreads, and
playing a role as the ``new market makers.'' High frequency trading,
however, also raises a number of regulatory issues including those
relating to flash orders, colocation, and the risks of certain
sponsored access arrangements, as discussed below.
Mutual funds do not object to high frequency trading per se. We
believe, however, that given the growing amount of the daily trading
volume that high frequency trading now constitutes, many of the issues
surrounding this trading practice are worthy of further examination.
Flash Orders
The SEC already has proposed to prohibit ``flash orders.'' ``Flash
orders'' are generally orders that trading venues disseminate, often
for only milliseconds, to a select group of market participants,
primarily high frequency traders, before they are displayed or traded
against displayed bids or offers. While this advantage occurs in
milliseconds, it gives a clear advantage to those who see it and have
the capability to react to it, i.e., those with the requisite
electronic connections. Most mutual funds do not allow their orders to
be flashed, primarily because the process of displaying the orders to a
select group of market participants could result in information
leakage.
The free look that flash orders provide is not new. Proponents of
flash orders argue that flash quotes are nothing more than the
electronic version of practices that previously occurred throughout the
equity markets. That is correct. For many years, the specialists at the
NYSE had the same informational advantage relative to other market
participants and for many years mutual funds asked that this
information advantage be eliminated. We continue to believe that such
information advantages, and therefore flash orders, should be
immediately banned.
Colocation
``Colocation'' is another ``fair access'' issue that has been
raised relating to high frequency trading. Colocation refers to
providing space for the servers of market participants, often high
frequency traders, in the same data center housing the matching engines
of an exchange. Colocation can serve to greatly reduce the delay
associated with locating servers far away from the exchanges which, for
high frequency traders, can mean the difference in whether they can
execute a trade. While we do not have an issue with the concept of
colocation, we believe that all investors should have an equal and
reasonable opportunity for access to a colocation facility.
Sponsored Access
Finally, sponsored access is the practice of market participants
that are not themselves broker-dealers obtaining direct access to
markets through a broker-dealer's trading identifier. Certain types of
sponsored access arrangements provide access to markets without any
broker-dealer pretrade risk management system reviewing orders being
transmitted. For high frequency traders, this type of sponsored access
saves valuable time in the execution of their trades.
Mutual funds do not often use sponsored access arrangements, as the
speed that these arrangements provide is not critical to the type of
trades funds typically execute. We recognize, however, that unfettered
sponsored access arrangements raise a series of supervision, compliance
and risk-management issues that could impact the efficiency of the
securities markets, e.g., a broker-dealer sponsoring a trader may not
have adequate controls over the trader that it has connected to an
exchange and the trader is not an exchange member subject to exchange
regulation. We therefore support proper controls over sponsored access
arrangements.
We thank the Committee for the opportunity to submit this statement
and look forward to continued dialogue with the Committee and its
staff.