[House Hearing, 113 Congress] [From the U.S. Government Publishing Office] EQUITY MARKET STRUCTURE: A REVIEW OF SEC REGULATION NMS ======================================================================= HEARING BEFORE THE SUBCOMMITTEE ON CAPITAL MARKETS AND GOVERNMENT SPONSORED ENTERPRISES OF THE COMMITTEE ON FINANCIAL SERVICES U.S. HOUSE OF REPRESENTATIVES ONE HUNDRED THIRTEENTH CONGRESS SECOND SESSION __________ FEBRUARY 28, 2014 __________ Printed for the use of the Committee on Financial Services Serial No. 113-67 ______ U.S. GOVERNMENT PRINTING OFFICE 88-529 WASHINGTON : 2014 ____________________________________________________________________________ For sale by the Superintendent of Documents, U.S. Government Printing Office, http://bookstore.gpo.gov. For more information, contact the GPO Customer Contact Center, U.S. Government Printing Office. Phone 202�09512�091800, or 866�09512�091800 (toll-free). E-mail, [email protected]. HOUSE COMMITTEE ON FINANCIAL SERVICES JEB HENSARLING, Texas, Chairman GARY G. MILLER, California, Vice MAXINE WATERS, California, Ranking Chairman Member SPENCER BACHUS, Alabama, Chairman CAROLYN B. MALONEY, New York Emeritus NYDIA M. VELAZQUEZ, New York PETER T. KING, New York MELVIN L. WATT, North Carolina EDWARD R. ROYCE, California BRAD SHERMAN, California FRANK D. LUCAS, Oklahoma GREGORY W. MEEKS, New York SHELLEY MOORE CAPITO, West Virginia MICHAEL E. CAPUANO, Massachusetts SCOTT GARRETT, New Jersey RUBEN HINOJOSA, Texas RANDY NEUGEBAUER, Texas WM. LACY CLAY, Missouri PATRICK T. McHENRY, North Carolina CAROLYN McCARTHY, New York JOHN CAMPBELL, California STEPHEN F. LYNCH, Massachusetts MICHELE BACHMANN, Minnesota DAVID SCOTT, Georgia KEVIN McCARTHY, California AL GREEN, Texas STEVAN PEARCE, New Mexico EMANUEL CLEAVER, Missouri BILL POSEY, Florida GWEN MOORE, Wisconsin MICHAEL G. FITZPATRICK, KEITH ELLISON, Minnesota Pennsylvania ED PERLMUTTER, Colorado LYNN A. WESTMORELAND, Georgia JAMES A. HIMES, Connecticut BLAINE LUETKEMEYER, Missouri GARY C. PETERS, Michigan BILL HUIZENGA, Michigan JOHN C. CARNEY, Jr., Delaware SEAN P. DUFFY, Wisconsin TERRI A. SEWELL, Alabama ROBERT HURT, Virginia BILL FOSTER, Illinois MICHAEL G. GRIMM, New York DANIEL T. KILDEE, Michigan STEVE STIVERS, Ohio PATRICK MURPHY, Florida STEPHEN LEE FINCHER, Tennessee JOHN K. DELANEY, Maryland MARLIN A. STUTZMAN, Indiana KYRSTEN SINEMA, Arizona MICK MULVANEY, South Carolina JOYCE BEATTY, Ohio RANDY HULTGREN, Illinois DENNY HECK, Washington DENNIS A. ROSS, Florida ROBERT PITTENGER, North Carolina ANN WAGNER, Missouri ANDY BARR, Kentucky TOM COTTON, Arkansas KEITH J. ROTHFUS, Pennsylvania Shannon McGahn, Staff Director James H. Clinger, Chief Counsel Subcommittee on Capital Markets and Government Sponsored Enterprises SCOTT GARRETT, New Jersey, Chairman ROBERT HURT, Virginia, Vice CAROLYN B. MALONEY, New York, Chairman Ranking Member SPENCER BACHUS, Alabama BRAD SHERMAN, California PETER T. KING, New York RUBEN HINOJOSA, Texas EDWARD R. ROYCE, California STEPHEN F. LYNCH, Massachusetts FRANK D. LUCAS, Oklahoma GWEN MOORE, Wisconsin RANDY NEUGEBAUER, Texas ED PERLMUTTER, Colorado MICHELE BACHMANN, Minnesota DAVID SCOTT, Georgia KEVIN McCARTHY, California JAMES A. HIMES, Connecticut LYNN A. WESTMORELAND, Georgia GARY C. PETERS, Michigan BILL HUIZENGA, Michigan KEITH ELLISON, Minnesota MICHAEL G. GRIMM, New York MELVIN L. WATT, North Carolina STEVE STIVERS, Ohio BILL FOSTER, Illinois STEPHEN LEE FINCHER, Tennessee JOHN C. CARNEY, Jr., Delaware MICK MULVANEY, South Carolina TERRI A. SEWELL, Alabama RANDY HULTGREN, Illinois DANIEL T. KILDEE, Michigan DENNIS A. ROSS, Florida ANN WAGNER, Missouri C O N T E N T S ---------- Page Hearing held on: February 28, 2014............................................ 1 Appendix: February 28, 2014............................................ 31 WITNESSES Friday, February 28, 2014 Campos, Hon. Roel C., Partner, Locke Lord LLP; and former SEC Commissioner (2002-2007)....................................... 7 Lofchie, Steven, Partner, Cadwalader, Wickersham & Taft LLP...... 8 Sirri, Erik R., Professor of Finance, Babson College; former SEC Chief Economist (1996-1999); and former Director of the SEC Division of Trading and Markets (2006-2009).................... 10 Spatt, Chester, Pamela R. and Kenneth B. Dunn Professor of Finance, Tepper School of Business, Carnegie Mellon University; and former SEC Chief Economist (2004-2007)..................... 11 APPENDIX Prepared statements: Campos, Hon. Roel C.......................................... 32 Lofchie, Steven.............................................. 36 Sirri, Erik R................................................ 60 Spatt, Chester............................................... 65 EQUITY MARKET STRUCTURE: A REVIEW OF SEC REGULATION NMS ---------- Friday, February 28, 2014 U.S. House of Representatives, Subcommittee on Capital Markets and Government Sponsored Enterprises, Committee on Financial Services, Washington, D.C. The subcommittee met, pursuant to notice, at 9:30 a.m., in room 2128, Rayburn House Office Building, Hon. Scott Garrett [chairman of the subcommittee] presiding. Members present: Representatives Garrett, Hurt, Royce, Neugebauer, Huizenga, Stivers, Fincher, Mulvaney, Hultgren, Ross; Maloney, Hinojosa, Lynch, Scott, Himes, Peters, Foster, Carney, and Kildee. Ex officio present: Representative Hensarling. Chairman Garrett. Greetings. The Subcommittee on Capital Markets and Government Sponsored Enterprises is hereby called to order. Today's hearing is entitled, ``Equity Market Structure: A Review of SEC Regulation NMS.'' Let me thank all the members of the panel for being with us here today. We will begin in regular order with our Members' opening statements and then proceed to the panel after that. I now yield myself 8 minutes for an opening statement. Today's hearing will focus on the structure of our Nation's equity markets--in other words, the stock market--and will provide a retrospective review of Regulation National Market System (Reg NMS) which was adopted by the SEC in 2005. I do want to thank our esteemed panel for joining us here today to provide their expert testimony on a very important topic. I also want to thank the ranking member for her attention to these important issues and the constructive bipartisan job that she has done to promote strong capital markets here in the United States. Mrs. Maloney, along with Mr. Hurt and Mr. Grimm and Mr. King, as well as Commissioner Dan Gallagher, joined me at a roundtable on market structure up in New York back in May. That was a great opportunity to hear from some of the foremost experts on the history and evolution of the equity markets and the regulatory regime governing those markets. While modern equity markets trace their origin back to an agreement signed under the buttonwood tree on Wall Street in 1792, over time these markets have become essential to Main Street as well. Companies all around the country need robust equity markets to raise capital to grow their business and create jobs. Likewise, investors require fair, efficient, and competitive equity markets so that they can do things like invest for their retirement, buy a home, or pay for a child's education. And so, I commend Chair White and her fellow Commissioners for their commitment to prioritize a review of equity markets and the rules that govern them. A comprehensive review hasn't been conducted by the SEC since 1994, yet the structure of these markets and the rules, including NMS, look much different today. Another review is long overdue, and the unanimous agreement of the SEC on this point, which seems rare these days, speaks volumes to the significance of this issue. Before Congress and the SEC can take another hard look at the U.S. equity market, however, I believe it is important to set a baseline to suggest a few basic parameters for this review. First, U.S. equity markets are among the deepest, most liquid, and lowest cost markets in the world. This does not mean that these markets are perfect, that there is no room for improvement. There is. It simply means that when we review the market structure and explore making future changes, we must keep in mind the axiom, ``First, do no harm.'' Second, a review of the equity market structure must be based on a deep set of objective data rather than anecdotes or politically convenient arguments. It follows that we should avoid, at the outset, buying into a sensational narrative in the media that portrays fast markets that rely on computer technology as inherently fragile or bad for investors before we even have a chance to collect and analyze all the data on it. I know that the very capable staff at the SEC's Division of Trading and Markets is in the process of gathering and examining quality data with their new Market Information Data Analytics System (MIDAS). I also look forward to the arrival of the Division's new Director, Stephen Luparello, who has shown an impressive grasp of these complex issues. I am pleased that the SEC appears to recognize the importance of making any future decisions on equity market structure based on empirical economic data that has been peer-reviewed and formally commented on by the public and by market participants. Third, a quality review must put everything on the table. In other words, it should be truly comprehensive. We simply will not be able to form a complete picture of how our equity markets work, and develop smart reforms to improve these markets, if we are not prepared to ask all the tough questions and reassess every aspect of market structure. This includes reevaluating the objectives and impacts of Reg NMS, and other regulations concerning equity markets, as well as congressional mandates such as the Security Acts Amendment of 1975. Last but not least, we must resist all calls to impose additional layers of complex regulations on individual market participants in order to control or influence their behavior before we understand the underlying drivers of those behaviors. While I agree that we must take a close look at high-frequency trading, broker-dealer internalization, the proliferation of order types, the maker-taker model, and trading in so-called ``dark pools,'' the first steps should be to determine how and why these behaviors and business models developed. To the extent that the regulatory regime played a role, I question whether adding another layer of new rules onto an already complex structure will do anything to actually improve this structure or protect investors. This brings us back to the subject of today's hearing. Recently, Reg NMS has been identified as a potential source of problems occurring in the U.S. equity markets. A central part of the SEC's review of the equity market structure, therefore, should be to determine whether regulations, including NMS, are driving market complexity and dislocation and incentivizing suboptimal behavior by market participants. For example, by linking all market venues together through technology, prioritizing price and speed in executing orders, and protecting only automated quotations, has Reg NMS been the primary contributor to what we may now lament as needlessly complex and fragmented equity markets? Have these efforts to link markets together to promote a national market system also led to the many recent disruptions which originate at one location and then seem to ripple throughout the system? Recent data also suggests a rise in volatility in the market post-Reg NMS. Is this because Reg NMS led to an increase in the amount of high-speed algorithmic trading in the markets? Is it related to the so-called end-of-market sweep exception of Reg NMS or the protection rule? So in addition, there are literally hundreds of different complex order types that exist in today's equity markets, and these unique order types develop as strategies to get around the market protection of top-of-the-book quotes in NMS or exploit other market participants. These are just some of the questions about Reg NMS that need to be explored. At this point, I don't believe anyone has a definitive answer to any of these questions, but they leave the door open to the possibility that the government's own rules might be at the center of the problem. That is precisely why any serious review of equity market structure must include an examination of these complex issues and ask the difficult questions. This all-encompassing review should also assess the regulatory regime that governs various intermediaries in the market, ways to improve disclosure of post-trading pricing and routing decisions to investors, and additional ideas to ensure that intermediaries are acting in the best interest of their customers. I know this will not be an easy task, but I am hopeful that Chair White, the other four Commissioners, the SEC staff, and this subcommittee will devote the necessary time, energy, and effort to study these important issues. We owe it to the investors and the issuers who depend on these markets to facilitate the appropriate flow of capital. Finally, in a recent speech on the need to review market structure, current SEC Commissioner Michael Piwowar recently succinctly noted, ``In order to move forward, we must look back.'' I sincerely agree with the Commissioner, and I look forward to beginning this through a look back on Reg NMS with today's panel. And with that, I yield back, and at this point I recognize the gentlelady from New York, the ranking member of the subcommittee, Mrs. Maloney, who has taken a lead interest in all of these issues, for 5 minutes. Mrs. Maloney. I want to thank the chairman for calling this hearing, and for your very informative conference that we had earlier in New York on market issues. And I thank all of the distinguished panel members, including the former head of the SEC. We welcome your comments today. This is a very important hearing, and I would like to thank you for your leadership and for the willingness to tackle this in a nonpartisan way. The United States has the deepest, most liquid, and most effective capital markets in the world. The U.S. stock market is 13 times larger than the British stock market and 14 times larger than Germany's stock market. The strength of our markets is a key contributor to our country's overall economic strength. We need to continually work to make sure that our markets are safe, competitive, innovative, and fair to all investors. The sheer size of our stock market is attractive for investors because they know they will be able to sell their investment quickly if they need to. Investors also know that they will get the best price available to them when they do decide to sell their stocks, which increases the attractiveness of trading in our markets. The purpose of this hearing is to review the foundation of our successful market structure, and particularly Regulation NMS, the National Market System. When the SEC passed Regulation NMS in 2005, the goals were to promote price competition, protect investors, and enhance market efficiency. Now, nearly 9 years later, it makes sense for Congress to take a step back, review the changes that have taken place, and ask what we did get right in Regulation NMS, what we did get wrong, and what can we improve? Price competition has undoubtedly increased as the number of different trading venues available to investors has exploded. Some in the markets argue that the price competition has come at the expense of market efficiency. However, as the large number of trading venues has led to fragmented markets, there is obviously a fine line between too many trading venues and too few trading venues, and whether we have the right balance is one of the issues I hope we will explore today. But if we have learned anything from Regulation NMS, it is that even small changes in market structure regulations can have large consequences. That is why I think the best changes in market structure will be grounded in data and empirical evidence. I am pleased that the SEC is already developing a tick-size pilot program to test whether tick sizes for stock trading really will enhance liquidity, and this one pilot program will look at raising it from a penny to 5 cents. And as we explore other potential changes to our market structure, we should also keep in mind that our equity markets are undoubtedly better today than they were a decade ago. Today's retail investors have better access to the markets and at lower costs than ever before. It is important not to lose sight of these benefits. I look forward to a robust, informative discussion from our distinguished panel, and I yield back the balance of my time. Chairman Garrett. The gentlelady yields back. The vice chairman of the subcommittee is recognized for 2 minutes. Mr. Hurt. Thank you, Mr. Chairman. Mr. Chairman, thank you for holding today's hearing. And I want to thank our witnesses for joining us today to examine Reg NMS and our Nation's equity market structure. Last Congress, this subcommittee led the charge to pass the JOBS Act to decrease burdensome regulations and provide incentives for emerging growth companies to access capital and public markets. While we continue to see successes of the JOBS Act, it is essential that we also ensure that our equity markets themselves are functioning as efficiently and effectively as possible. Our markets and the technology underpinning them have continued to advance quickly in the year since Reg NMS was implemented. I believe this hearing is an important opportunity to allow Members to explore how it is that our equity markets have evolved since that time and potentially where they are headed in the future. I agree with others who have called for a wholistic review of the Nation's market structure. This issue is too important and too complex for a disjointed review that could lead to unintended consequences. It is imperative that we get this right, not only for the markets but for retail investors, pensioners, emerging growth companies, and all market participants. I am encouraged that Chair White and all of the SEC Commissioners have publicly supported the idea of this review of our equity market structure. I look forward to moving this process forward so we can ensure that the United States continues to have the most efficient, competitive, and liquid markets the world has ever known. I would like to thank our witnesses again for their appearance. I look forward to your testimony. Mr. Chairman, I yield back my time. Chairman Garrett. The gentleman yields back. Mr. Lynch for 2 minutes. Mr. Lynch. Thank you very much, Chairman Garrett and Ranking Member Maloney, for holding this hearing. And I want to thank the panelists for coming forward and for your willingness to help the subcommittee with its work. This hearing on equity market structure is long overdue. It is an important issue that we need to be addressing. The U.S. equity markets are often described as the deepest and most transparent in the world, and I guess that is probably true. And it is true because the vast majority of the trading in the United States, about 63 percent this past January, is conducted on open and transparent exchanges with robust pre- and post-trade transparency. An open market obviously reduces spreads, decreases volatility, and creates a safer environment for investors. However, over the past 5 years there has been a marked increase in the volume of trades that are being conducted in dark pools or opaque alternative markets, and that is a real problem. Off-exchange trading has expanded by some accounts from 15 percent to 40 percent over recent years. There are some legitimate reasons for the use of dark pools. I know that institutional investors execute large volume trades which can't necessarily be performed well on open markets because of the likelihood that there may be some actors out there trying to game those trades. However, we are seeing a trend where trading that should normally be able to be conducted on open exchanges, public exchanges, is going off exchange, and that is a problem. We should be fostering policies which ensure that all trading can be done on open and public exchanges to the extent possible, and we should ensure that for off-exchange trading, when necessary, we still have a window to observe that trade is being done in the most transparent manner possible. I look forward to the testimony. I have some questions for you that I hope you can help us with. And again, I want to thank the witnesses for their willingness to come forward and help the subcommittee. I yield back the balance of my time. Chairman Garrett. The gentleman yields back. Mr. Scott, for 3 minutes, please. Mr. Scott. Thank you very much, Mr. Chairman. And this is indeed a very, very important hearing, a critical hearing to be able to really examine the equity market structure. Specifically, though, I think we need to really gear in on the SEC's regulations of the National Market System, which is commonly referred to as Reg NMS. There are two principles that are outlined in Reg NMS: the first one is competition among markets and competition among orders; and the second one is serving the interest of long-term investors' listed companies. The point is that while Reg NMS appears to have been a success in increasing competition among markets, given the significant growth of what is referred to as dark trading, this dark trading volume, which is now 40 percent of average daily volume in this country, is in the dark, and an increase in liquidity fragmentation, 13 equity exchanges, around 45 dark pools, and many more broker-dealer internalizers. NMS appears to have resulted in not more competition, but less competition among orders. And in addition, many large institutional investors who act on behalf of long-term investors have raised concerns about the extreme fragmentation of liquidity and a lack of disclosure coming from dark trading venues. So the ultimate question I think we have to answer today is, has order competition decreased, and what should the SEC do about this? Shouldn't the SEC be looking for ways to rebalance this? I think this is the overreaching, overarching issue in question that we have to answer today because many investors are concerned with these dark pools, and that process is not increasing competition but lessening competition, and we must do something to address that. And it would be good to examine what steps must be taken to make sure there is adequate competition. Thank you, Mr. Chairman. I yield back. Chairman Garrett. The gentleman yields back. We now turn to our panel. And again, I thank every member of our panel for being with us today. For those of you who have not testified before, I always do the admonition to make sure that you pull the microphone close to you because sometimes I can't hear up here. You all will be recognized for 5 minutes. And without objection, your complete written statements will be made a part of the record, so we ask you to summarize your testimony right now in 5 minutes. We will start, as we always do, from left to right. Former SEC Commissioner Campos, good morning, and welcome to the panel. STATEMENT OF THE HONORABLE ROEL C. CAMPOS, PARTNER, LOCKE LORD LLP; AND FORMER SEC COMMISSIONER (2002-2007) Mr. Campos. Chairman Garrett, Ranking Member Maloney, and members of the subcommittee, thank you very much for inviting me here today. It is a privilege to be here with you. And I agree that the Reg NMS and the U.S. capital market structure is a very worthy subject of your consideration. I appreciate that you are working very closely with the Securities and Exchange Commission, my old agency. As you know, I served as a Commissioner of the Securities and Exchange Commission from 2002 to 2007. During my service, I was part of the Commission that implemented Sarbanes-Oxley, and part of the Commission that, with the work of the SEC staff, adopted Regulation NMS. I was there when all of the considerations, all of the battles, all of the presentations, and all of the arguments about market structure, about different business models were debated, considered, and presented. I will be brief. My testimony and written portions of it will be a part of the record. First, I agree with the comments that have been made by the Members. Today's U.S. markets are the envy of the world. When I was a Commissioner at the SEC, I had the privilege of representing the agency internationally, and what I discovered internationally was that the largest investors of various countries invest in the United States. And I remember distinctly a manager of a sovereign wealth fund that invested billions of dollars in the United States said to me, ``I invest in the United States because I know, first of all, that my investments there are safe. If something wrong happens, I can get redress in your courts. And secondly, I can get good prices and a fast reaction.'' This feature, that the U.S. markets bring foreign capital into the United States, is a huge benefit and a huge feature of our particular markets. I agree that nothing is perfect. Any system needs to be revisited. And our National Market System, I am sure, could be improved. However, as my father used to say, and as all of you have noted, we shouldn't be fixing what isn't broken. So let me just very briefly tell you about what we thought about with the staff and the Commissioners that I was a part of when we looked at NMS. We saw a system that was not working very well. We saw traditional exchanges that gave opportunities to flow brokers to trade ahead, to give them many seconds of advantage in being able to work trades. We heard that individual investors and institutional investors were not getting fair executions and fair prices, and we heard that the markets overall were not working well. So, our first and foremost objective was to create a system in which investors were treated fairly and were treated safely. And as has been noted, the 1975 Congress actually gave the SEC the direction to establish the National Market System, and it gave the Commission the guidelines which were to be the areas that it was supposed to concentrate on: efficient execution; fair competition; transparency; market access; and dealer disintermediation. One of the things we wanted to do was to accommodate the unique features of the American system, which is that we have many different trading centers. We wanted the markets to make the choices as to which of the different trading centers and market models would survive the markets. So our system essentially had another concept, and that is that it was a system, not a building, not a buttonwood tree, but a system of many centers that needed to be electronically connected. So today, when people talk about fragmentation, be careful. If we have a system that is connected, you may have liquidity from different sources, but it doesn't mean that it is necessarily fragmented. It doesn't mean that investors today are not getting the best price. And I assure you that today, the prices and the executions investors receive are far better than they were in 2002, when I ended up voting to approve the NMS. Clearly, the markets need some regulation. Our history is clear that bad things happen when there isn't any regulation. So the question is not whether there will be regulation, but how much, and what is the right balance. Also, technology is the big issue of the day. [The prepared statement of Mr. Campos can be found on page 32 of the appendix.] Mr. Hurt [presiding]. Mr. Campos, thank you very much. The Chair now recognizes Mr. Steven Lofchie. Thank you for being here. You are recognized for a period of 5 minutes. STATEMENT OF STEVEN LOFCHIE, PARTNER, CADWALADER, WICKERSHAM & TAFT LLP Mr. Lofchie. Thank you very much for having me, Chairman Garrett and Ranking Member Maloney. My name is Steven Lofchie, and I am head of the financial regulation practice at Cadwalader, Wickersham & Taft. In addition to practicing law in the area of financial regulation for the past 20 years, I have also written a number of books on the topic including, ``The Guide to Broker-Dealer Regulation,'' which is commonly regarded as the standard text in the area. I have prepared written testimony that I have submitted for the record. Again, I am very appreciative of the opportunity to testify to the subcommittee on the rules governing the equity markets. Since 1975, the operation of these markets has been governed by the principles that Congress established in Section 11A of the Securities Exchange Act of 1934, that there should be efficient trade execution and fair competition, and that market data should be made widely available. But while the principles established in 1975 still hold true today, today's problems are not the same problems that existed in 1975. Then, the problems of the equity markets were the problems of the near monopoly of the NYSE at the time which stifled innovation, the snail's pace of trade execution, and that the exchanges were largely private clubs at which admission was limited by members. Those problems of 1975 have been remarkably well-addressed thanks to the regulatory efforts of the SEC and the technological innovation and the competitiveness of market participants. Unlike in 1975, trades are executed in milliseconds, bid and ask spreads are at a penny, numerous exchanges and alternative trading systems compete, and trade information is real time. But today's markets present different problems. Today's problems, in fact, are so different from those which existed in 1975 that they are almost the mirror of them. Instead of trading being too slow, perhaps it is too fast. Instead of too much reliance on an individual specialist, perhaps we are too vulnerable to technology failures. Instead of exchanges being private clubs where members have an interest in the support of the organization and vice versa, today the exchanges have become business organizations with distinct interests from their members. Instead of trading on a monopoly market, trading is fragmented or dispersed, depending upon your choice of words. This means that if the SEC assumes it can address the problems of today's market using the same tools and the same rules that it did in 1975, there is a danger it will worsen problems rather than resolving them. Forty years after Section 11A was adopted, as you have all noted, it is time for the SEC to take a ground up look, and it must study not only the front page matters, such as market volatility and technology vulnerability, it must also look at behind-the-scenes issues such as market data feeds and how those impact market trading incentives. The SEC must also conduct a self-examination as to its own assumptions of how markets work. The markets, as they exist today, and as they existed in 1975, are not simply the the result of interaction between buyers and sellers. They are also very much a creature of market regulation. The NYSE was able to dominate trading for so long not because it had a better market, but because rules permitted it to disadvantage competition. When the current set of market rules were adopted, the dissenting Commissioners worried that these rules would increase fragmentation and volatility. Those concerns have proved justified. In addition, it makes sense to look at regulatory structure. Does it make sense for the exchanges to regulate their competitors? And finally, I want to talk about the issue of technology failure. How do we deal with the technology failure that is such a front page issue? One of the things I have suggested in my written testimony is that we look at other models of regulation, such as the airline industry, where the focus is more on gathering information as to how a problem occurs. Thank you very much for inviting me to the hearing, and I look forward to questions. [The prepared statement of Mr. Lofchie can be found on page 36 of the appendix.] Mr. Hurt. Thank you, Mr. Lofchie. The next witness is Mr. Erik Sirri, former Director of the SEC Division of Trading and Markets. Thank you for being here, and the Chair recognizes you for 5 minutes. STATEMENT OF ERIK R. SIRRI, PROFESSOR OF FINANCE, BABSON COLLEGE; FORMER SEC CHIEF ECONOMIST (1996-1999); AND FORMER DIRECTOR OF THE SEC DIVISION OF TRADING AND MARKETS (2006-2009) Mr. Sirri. Chairman Garrett, Ranking Member Maloney, and members of the subcommittee, thank you for having me here today to testify. U.S. equity markets consist of more than a dozen registered exchanges and more than 60 market centers. Their efficiency is remarkable. Today, a modern electronic market maker that trades as much as 15 percent of a large-cap NASDAQ stock may earn as little as 1 or 2 hundredths of a penny for every share it trades. The old worries about a dominant market maker being a monopolist have been replaced by new issues concerning fair access, connectivity, computerized trading, and the robustness of systems. Reg NMS today is almost 9 years old, and still, it remains a rule with both proponents and detractors. It highlights the fact that market structure regulation is necessarily a difficult exercise. For example, traders value confidentiality for their orders because unnoticed trading results in better prices for traders' ultimate customers. Any regulatory desire to increase market transparency is constrained by a trader's desire for secrecy. Traders forced into a transparent market against their wishes will elect not to submit their orders into the market and will hold them upstairs until they are ready to trade. There is thus a limit on how much transparency can be brought to any marketplace. As a second example, not even the strictest regulations can force liquidity providers or market makers to provide liquidity to a marketplace if it is not profitable for them to do so. They will simply exit the market. This principle contributed to the demise of traditional market makers and specialists on physical exchanges like the NYSE. U.S. equity markets are generally very efficient. Changes of fees of as little as one-tenth of a cent per share will clause flow to move from one venue and cause it to be rerouted to another market center as brokers attempt to lower trading costs or earn higher rebates from their customer flow. This is both a testament to the quality and efficiency of our markets and a cautionary tale to regulators. It demonstrates how sensitive market participants' business models are to very small changes in costs and how quickly trading platforms, brokers, and investors react to changes in the competitive landscape. We should expect that any meaningful changes in equity market regulations will have large consequences in the routing and execution of orders and the business model of market participants. SEC Commissioners have been calling for a broad review of our market structure. These market structure questions are eminently amenable to empirical analysis, and any revisions to our trading rules should be preceded by meaningful and objective analysis of economic data. I believe that an encompassing, data-driven, empirical study is an important step to complete before implementing any substantive change to market structure regulation. I would like to offer two final thoughts. First, I would be remiss if I didn't highlight the need for improvements in the structure of our fixed income markets. The fixed income markets are larger than our equity markets. Investors in corporate and municipal bonds trade using an opaque network of OTC dealers, and retail investors can price spreads of as much as 5 percent. All this happens at the same time that these investors trade in equities, in percentage spread measured in tenths, and in submillisecond timeframes. I hope that in the near future, regulators will turn their focus to the trading structure of these vital markets. And second, I think it is important that any review of equity market structure include a focus on the best execution duties of brokers that handle customer orders. Existing interpretations of best execution have not kept pace with the changes in market structure and with automated trading. Examples of potential concerns include the effective access fees and liquidity rebates on broker routing decisions and the routing of nonmarketable customer limit orders to exchanges rather than to other venues more advantageous to the limit order. The Commission should, as part of its review of market structure, revisit their guidance on best execution and consider whether another approach, such as one based on policies and procedures, would be useful in augmenting any change to market structure under consideration. Thank you for your time this morning. [The prepared statement of Mr. Sirri can be found on page 60 of the appendix.] Mr. Hurt. Thank you, Mr. Sirri. Our final witness is Mr. Chester Spatt, former SEC Chief Economist. Thank you for being here, and you are recognized for 5 minutes. STATEMENT OF CHESTER SPATT, PAMELA R. AND KENNETH B. DUNN PROFESSOR OF FINANCE, TEPPER SCHOOL OF BUSINESS, CARNEGIE MELLON UNIVERSITY; AND FORMER SEC CHIEF ECONOMIST (2004-2007) Mr. Spatt. I would like to thank Chairman Garrett, Ranking Member Maloney, and the members of the subcommittee. I am pleased and honored to have the opportunity to present my views at today's important hearing. I served as Chief Economist at the SEC from 2004 to 2007, and I am currently still involved in regulatory issues. I am a member of the Shadow Financial Regulatory Committee and the Federal Reserve's Model Validation Council, among other activities. There have been dramatic changes in the structure of our equity markets over the last 2 decades, reflecting changes in technology and changes in regulation. Prior to NMS, there was decimalization, which had big impacts on our markets. NMS led to a series of changes focusing on much greater automation in the trading process by its emphasis on fast markets, and partially as a byproduct of NMS and other considerations, there has been a dramatic change in fragmentation. For example, the New York Stock Exchange share of trading in its own listings has fallen from 80 percent to 20 percent. I am pleased that the subcommittee has organized today's hearing to focus on NMS because more generally, I believe that financial regulators should undertake serious retrospective reviews of the consequences of their actions and that, at least in the past, this has not been so much of a focus. I am pleased that going forward, there is more orientation toward that, that the SEC, for example, is signaling its interest in undertaking an experimental pilot analysis with respect to decimalization, although I think my own views are rather doubtful that wider ticks will necessarily meaningfully impact IPO decisions. One thing that NMS did do is it had the effect of resolving some open issues in its day, which I think provided some clarity to the trading community, and at least some of the big changes that occurred in the aftermath of NMS just simply reflected that there were some rules of the game that were specified, whatever those rules were, and then various platforms felt comfortable to enter. In the aftermath of NMS as well, New York Stock Exchange specialists no longer retained potentially a 30-second option to send orders to other platforms through the ITS system. So NMS led to, I think, a variety of important changes. One of the most striking aspects of NMS is the structure of its order protection rule. Orders were protected, but the only orders that were protected were at the top of the book, and I think that is an important point to highlight. So in a way, NMS is a bit schizophrenic, that NMS basically says that orders at the top of the book are deserving of protection, but other orders are not. And certainly, I would not favor providing protection down the book. That would be, I think, even more prescriptive and would add to the technological burden of the rule, but I think it points to a lack of coherence within the structure of NMS, because the protection that is provided is only for orders at the top of the book. Indeed, I think that points to one of the contributors to fragmentation directly in the rule, because if you have distinct platforms as opposed to a consolidated platform, you get more protection out of NMS, because every top of the book is protected; whereas, if platforms are not separated, they have less protection. An additional important aspect of NMS is how it integrates the markets. Brokers, of course, have had longstanding best execution responsibility. NMS also has the effect of routing orders to the platforms that potentially would provide the best execution at the top of the book. But in a sense, then, NMS is providing a substitute for best execution, and I think one metric to look to, which has really not been focused on, is whether NMS in fact reduces somewhat the extent of abuse of best execution responsibilities. If NMS were successful, you should now see less abuses of best execution than previously. An important set of distortions, in my view, with respect to the trading is the ``make or take'' features of the market, which NMS provides some structure around. There are incentives to collect liquidity rebates and avoid fees for taking liquidities. But I think there are real conflict of interest issues that are raised, and in fact, I think some interference with best execution, because orders would be isolated where they don't fill most quickly. Thank you very much very much for the opportunity to speak. [The prepared statement of Mr. Spatt can be found on page 65 of the appendix.] Mr. Hurt. Thank you, Mr. Spatt. Now, we will turn our attention to questions from the Members, and I will first recognize myself for 5 minutes. It seems like everyone agrees that this is an important endeavor that we are undertaking, but I guess the question is, is how is the best way to do that and what information do we need, what information does the SEC need to be able to navigate through this? And I guess my question, and I would like to start with Mr. Campos and then just go down the line, is what data does the SEC currently have that is needed to be able to do this, and what data do they perhaps not have that they need to have to be able to make the right decisions regarding strengthening our equity markets? Mr. Campos. That obviously is an excellent question. And there is, first of all, a lot of data. My colleagues who are economists and researchers deal with that daily. But essentially, a study of whether investors are getting best execution, as was just discussed, studies as to whether the pricing tends to reflect the best price in the markets, all of that data is there. Are orders being routed from market and trading centers to reflect the best top of the book price? Again, all of those things are data that is available. And what we don't know, I suppose, are things about whether liquidity is being held back, about whether there are things going on in internalization models. I would argue that the enforcement mechanisms and the examinations have been very robust. But nonetheless, that could be looked at. Mr. Hurt. Okay. Thank you. Mr. Lofchie? Mr. Lofchie. Thanks very much. I think there is a lot of quantitative data. What I think there needs to be is more focus on qualitative data, an understanding of the motivations of market participants. I think we need to understand why do mutual funds and institutional investors prefer going to alternative trading systems rather than to trade on the exchanges? It is not enough just to look at the numbers. It is important to understand why they find one venue preferable to another, and that will help us understand how rules changes that we will make in the future will affect their incentive scheme. Mr. Hurt. Mr. Sirri? Mr. Sirri. I think we all talked about how tricky it is to trade with computers, but one of the good things about that is that you have the data. It is in electronic form to begin with. That is not how it was 20 years ago. So, the SEC has the access to a chunk of that, not all of it. I think partners in this revision have to come from industry. The street, the broker dealers, the users, they also have data in electronic form. Hopefully, as part of the process that this committee is envisioning, they will cooperate, they will do their own analysis, and they will contribute that data to the public, to the Commission, so that its analysis can be fruitful and you get a better answer to these questions. Mr. Hurt. Thank you, Mr. Sirri. Mr. Spatt? Mr. Spatt. I think much of the data is potentially available because of the electronic structure of our markets. Historically, the SEC was not in a good position to integrate the data from various platforms, given the large number of platforms and the importance of the fine time stamping, and I don't know whether those are still issues going forward. It seems to me the types of things that one would want to analyze in a serious way are to try to understand, especially the routing decision. It seems to me the routing decision is at the core of the issues. My comments earlier about the ``make or take'' decision are illustrative of that, but you can think of the routing decision more broadly. I think that is an absolutely essential feature that it is important to try to drill down on. It is also related to issues involving how orders at a higher level are packaged. How does the institutional investor piece out his order? And it is a bit related to best execution, but I think in some ways it is broader. Now, that would be data that I think typically the SEC wouldn't currently have. That would be data that would be available in the brokerage community or in the asset management community, in effect, how do they put in orders, and then what are the paths by which they execute over time. And I think understanding that would be incredibly helpful. Mr. Hurt. Thank you, Mr. Spatt. My time has expired. I now recognize the ranking member, Mrs. Maloney, for 5 minutes. Mrs. Maloney. Thank you very much. Professor Sirri, you noted in your testimony that one of the SEC's goals in passing Reg NMS was to promote price competition. With at least 58 different trading venues today, we certainly have increased competition. Some people say it is too much. As you know, many in the markets, including the exchanges, believe that we now have too many trading venues and that the markets have become too fragmented. What is your opinion? Have we reached the point where fragmentation of markets is a bigger problem than competition? Or do you think the markets are fragmented? Mr. Sirri. I think if you talked about fragmentation as being anyone's stock can trade in 50, 60, 70 places, yes, they are fragmented. But if you talk about fragmentation being they are insufficiently connected or other people are not able to get the best price across these markets, that is a tougher question to answer. The computerized trading, the private linkages help integrate those markets together, but the linch pin of it all in the end is the person who sends the order, who has the order to begin with and picks where am I going to trade it. That person has to be smart, that person has to use technology, and they have to figure out, in their routing decision, how to link. So I think while the markets are somewhat dispersed, there exists technology and smarts to bring them together. Mrs. Maloney. Okay. So you support NMS? You think it has brought the improvements? Mr. Sirri. I wouldn't say I support or don't support NMS. Like all regulation, it has its problems and it can be improved, and I think probably that is why a lot of us are here today. I think dispersion of market centers was going on before NMS came up. We had separated market centers. NMS created a platform where more of it could happen and it at the same time allowed them to be more connected. I think the empirical studies that you all are calling for will help answer the question you are asking, which is, is it too much? Mrs. Maloney. And Mr. Campos, as the SEC Commissioner who voted for Reg NMS, I would like to ask you one simple question. Is the current market structure what you envisioned when you passed it? And if not, what has surprised you? Mr. Campos. None of us--just like we have 20/20 hindsight, we don't have 20/20 foresight. We were worried initially about whether the connectivity was going to be sufficient and whether it would work. As Erik Sirri, Professor Sirri has just said, there were many markets already existing at the time that we adopted it. It would be a very arrogant regulator to believe that they can control or should control what the markets will look like in the future. So, the effort here again was to create a situation in which the technology connected and we had a market system. None of us had any idea of how many that would be, whether it would be 20, it would be 30, or maybe it would be 10. But we expected that business models providing service and value to investors would be what would determine how many existed. I think it is a unique feature of the American system to have competition among markets. And recall that some of these markets produce very positive results. There is price improvement in some of these markets where there is an execution at the midpoint. I will just leave you with that. Mrs. Maloney. Thank you. We certainly have the data elements out there, but they are not really in a way we can use them. And we created in Dodd- Frank the Office of Financial Research, and they have been in existence now for a number of years, and all they have done is proceed to give an LEI, which is an identification to every broker and person in the business, and that seems to me like a waste of time. I think the best data element is the trade itself, and that trade itself is identified with a broker and a firm. Am I not correct? I will just ask Mr. Campos or anybody? Mr. Campos. Yes. I think getting an execution at a decent price, being able to access the best price, and that can be tested, I think is ultimately the best test of the situation. Mrs. Maloney. My time is almost up, and I don't think I have time for you to answer, but I would like back in writing from you, if we were to look at this, and we have the data elements, what would be the best way to look at it? You have much more expertise than any of us because you have lived through it and you have been part of the markets, you study it every day. I think that would be very helpful to us as we look at this. My time has expired. Thank you. Mr. Campos. I would be very pleased to do that. I am sure all the other members would, too, on the panel. Mr. Hurt. Thank you, Mrs. Maloney. The Chair now recognizes the gentleman from South Carolina, Mr. Mulvaney, for 5 minutes. Mr. Mulvaney. I do have a couple of different types of questions. Mr. Sirri, I want to follow up on a question. I don't know if I understood the answer to Mrs. Maloney's question, so I will put it to the entire panel. Has Reg NMS led to too much fragmentation within the markets? I think Mr. Sirri said no, but I wonder if that is unanimous amongst the panel? Mr. Spatt? Mr. Spatt. I am not so concerned that it has led to too much fragmentation, although it may have led to too much fragmentation in particular ways. It certainly creates some incentives toward fragmentation by the focus on the top of the book in particular, but it is not so much of a concern to me on the broad issue because spreads are substantially down. Before you had a situation where a lot of the market making was occurring in a very noncompetitive way. So it is not a huge concern to me, but this is obviously a first order issue to consider. Mr. Mulvaney. Mr. Lofchie? Mr. Campos? Mr. Lofchie. I think what I am hearing from all of the panel is that fragmentation per se is not an issue, and that remarkably trades can be executed across markets much faster today than they could be in 1975 or pre-NMS. I think the real issue is why we have so many markets. Is it because it is serving the interests of market participants or is it because rules incent people to move customer orders in ways that may be inefficient in order to take fees rather than to serve their customers. And I think if we have rules that incent brokers and institutional investors to act in the best interests of their customers, then the market will decide how many exchanges and how many alternative trading systems survive. Mr. Mulvaney. Does your analysis change if we start talking about the lit versus unlit of these dark pool markets? Do we need to update the regulatory environment to allow them to compete on a more even playing field? Mr. Lofchie? Mr. Lofchie. One of the things that I think we need to look at, again, is the motivation of traders. There is clearly a tremendous incentive of traders, as Professor Sirri said, not to show their quotes on the exchange markets. And I think, given the increase of trading in these alternative trading systems, we need to understand why they provide benefits. Clearly, they do provide a benefit. And I am anxious as to any system that would force the person at the point of trade, the institutional investor, the mutual fund, the pension plan, not to trade in a way that he sees as serving the interests of his investors. Mr. Campos. Could I serve a caution? Mr. Mulvaney. Please. Mr. Campos. The term ``dark pools'' is used often, and it has sort of a sinister connotation. After all, it is dark. But the reality is that the rules regarding dark pools are very clear. They have to at least reflect the last best price. And often what they reflect is a negotiation, and there is price improvement because they tend--or at least one particular system that I am very familiar with executes at the midpoint, which is a positive for both, and then it is reported to the tape. So the actual execution and the price that they agree upon is not kept from the market. It is not a secret. And it offers something that is very important to many large institutional investors, which is that they have large block trades to execute, and if they put them in through regular execution situations they have to be shredded or so-called, split up into small. It is very expensive to do that. And so, there is a reason why many of these markets exist. They provide a service that is necessary Mr. Mulvaney. There is an efficiency that comes from that. Mr. Campos, I am going to do something unusual. I am going to go off topic, but since we have you here today, I want to ask you about something that just became public this week. It deals with the SEC, it doesn't deal with you individually, but I am curious to know your opinion of it. There was a fairly widely reported paper, I think published by the University of Virginia by two professors out of Georgia, regarding insider trading by SEC employees. Specifically, how they are able to apparently pick better times to sell stocks than the ordinary public and that they apparently, I guess the allegation is, they use information that is inside the SEC on upcoming investigations. How should we best approach the issue going forward as a committee as we want to focus on possible wrongdoing by the employees at the SEC? Mr. Hurt. Mr. Campos, because we are running up against the votes, is it possible for you to please respond in writing? Mr. Mulvaney. I would appreciate it. I wasn't aware of the votes. Thank you, Mr. Chairman. Yes, sir. Mr. Hurt. Yes. Mr. Campos. Certainly Mr. Hurt. And so, if you would please respond in writing, that would be very helpful. Mr. Hurt. The Chair now recognizes Mr. Lynch for 5 minutes for questions. Mr. Lynch. Thank you, Mr. Chairman. I would be interested in having the response to the earlier question as well. This is a great discussion, and the problem at the root of this sometimes--and I know that Congress has been late in responding to this. I think the SEC agreed to take up a study of market structure back in 2010, and that has not happened yet. One of the problems that we have is the pace at which technology changes and the pace at which government changes. We would still have powdered wigs, if we looked good in powdered wigs still. Meanwhile, technology changes at a breakneck speed. And so in a way, we find ourselves in a reactionary mode in government. We are trying to, in this case, with market structure, respond to the plumbing of these super fast trading platforms and things like that. Oftentimes, we find ourselves trying to catch up, and that has been a real struggle. So maybe there is a way we can, if the SEC gets serious about that, together we can envision a platform that might be able to address all of the concerns that we have. But let me get to my question. Not only has the volume of dark pools, of trading in dark pools has increased, but also we are seeing some individual stocks where over 50 percent of the trading in individual stocks is going to dark pools, and that is a different issue than people having large trades, trying to move those institutionally without being gamed by some of these other traders. I know that in the international literature there has been a couple of studies by Australia and our friends in Canada that have looked at the U.S. markets, and they have had real concerns about price discovery and whether our markets are as efficient as they once were. And it is interesting because both of those countries, after studying the United States, are implementing measures to preserve their price discovery process. Both are implementing ``trade at'' rules to try to preserve the ability of large trades to be done in the dark but also requires most other trades to be routed to the best price on the transparent markets. What do you think that our next step should be in terms of moving towards markets that move trades back onto these lit markets, lit exchanges, public exchanges, what do you think that the greatest incentives we could give to move some of these trades back onto, again, lit markets, public markets, NASDAQ, the New York Stock Exchange, so that the risk of--well, the risk of something happening in the opaque markets is reduced? Mr. Campos. Is that directed to me? Mr. Lynch. Yes. Mr. Campos. Thank you for the question; it is very thoughtful. First of all, I think you need to ask yourself, and the whole committee does, is it really a worthwhile goal to want to increase the volume on the exchanges per se, is that a real and a worthy goal? I submit to you that if orders are being routed correctly, if the connectivity is working and investors are getting the best price at that particular instant, that in itself is a worthy result. And the fact that volume is now dissipated may or may not be a negative. Mr. Lynch. Just to interject here. Mr. Campos. Sure. Mr. Lynch. With the rebate system, I am not sure I can tell whether the customer--in the dark pool situation. So I don't know, I don't really have a window into that, or government doesn't have a window into that to determine, with the speed of these trades, with the offering of rebates and other considerations, whether the customer is getting the best available price. I know that is the idea. Mr. Campos. Right. Mr.Lynch. But we have seen in other situations where there have been opaque markets, that whatever advantage a trader can get, they will take. That is just the way it works. Mr. Campos. I know there is a time issue, so I will make it very brief. Mr. Lynch. Yes. Mr. Campos. Again, it is a great question. One should look at it. I believe that many so-called dark pools and ATS's, if they offer price improvement, that is what has been used in Australia and other places to allow sort of a license to be in that particular-- Mr. Hurt. Thank you, Mr. Campos. Mr. Lynch. I yield back. Mr. Hurt. And I apologize to the witnesses for this time constraint. What I would like to do, if there is no objection, I think we probably have time to squeeze in two more questions, one from Mr. Ross and then one from Mr. Scott, and then we can adjourn temporarily to vote and then we will come back. And I apologize to the witnesses and to the audience for that and to the Members. But the Chair now recognizes Mr. Ross for 5 minutes. Mr. Ross. Thank you, Mr. Chairman. Commissioner Campos, do you feel that Reg NMS is the reason we have so many trading centers? Mr. Campos. Not per se. I think it accommodated it. Remember, Reg NMS was intended when we did it to allow the markets to work in the manner that markets work. Mr. Ross. So they have naturally evolved, in other words, irrespective. Mr. Campos. Exactly. And there were already many, many centers when NMS was-- Mr. Ross. And that is not a bad thing, is it? Mr. Campos. I don't think it is a bad thing at all. Mr. Ross. Mr. Lofchie, you spoke earlier in your opening statement about the monopoly of the NYSE back in 1975, and I think that some would say that back then we had two dominant exchanges, the NASDAQ and the NYSE, and they had high barriers to entry. Back then, some would argue, it was simpler and safer. Do you think that is something that we should consider going back to? Is it even possible? Mr. Lofchie. It is certainly not possible. It was clearly simpler. I don't know that it was safer. Look, there is no question that today's markets, as disbursed as they are, in fact, I think provide investors much better protection, that all of these various markets work together more quickly than the NYSE did back then. So I think we have to deal with the markets that we have and the technology that we have. There is no turning back. Mr. Ross. And technology has been good, but retail investors have been a little bit hesitant, have they not, because of technology, when you look at how technology has permeated so many areas of our world, whether it be medicine or transportation or anything. And so when you have a flash crash occurring, would you say that technology has been somewhat of an impediment, although a benefit? Mr. Lofchie. I think overall, it has been an extremely large benefit. Again, I think our ability to track information, to know whether investors are getting the best price, to link markets, if you compare the markets of today to the markets of 1975 or of pre-NMS, there is no question they are far better. On the other hand, when something goes wrong, it goes wrong big, and I think that is something that needs to be focused on. I think the SEC, with some of the moves to start markets, has made moves in that direction. Mr. Ross. In your opening statement, I very much enjoyed your discussion semantically about dark pools and protective coves versus naked bazaars. Is this more of an issue of semantics? We have probably the deepest and most transparent equity markets of anybody. And we look at dark pools, and is the first problem that we have one of semantics? Mr. Lofchie. I think there is a risk that we judge markets by their name rather than by the service that they provide. And it does worry me that when mutual funds and institutional investors are electing to trade on what we are calling a dark pool, that we are saying, oh, that is not good, because we don't like the name of it. Mr. Ross. The dark pool. But it does help retail. It helps the markets. It is a necessary tool, wouldn't you agree? Mr. Lofchie. Clearly, the way that retail investors for the most part trade in the market or participate in the market are through these institutional entities like mutual funds and like pension plans, which very much avail themselves of dark pools. Mr. Ross. Mr. Sirri, with regard to market data, and I think Mr. Lofchie's earlier testimony about more qualitative analysis of the data as opposed to just a collection of quantitative collection of data, do you feel that the SEC is doing that now and using it effectively? Are they doing more quantitative collection as opposed to qualitative? Mr. Sirri. I think relative to, say, 5 or 10 years ago, the SEC has improved on both fronts. Their quantitative data use is better than it has been, they have tooled up in that area, they have expanded the group that does such analysis, it has many more people in it now and it has more skilled people than it used to. That has improved. As to your question about qualitative data, I am not as well informed about that. I would expect they have. That necessarily involves outreach, that involves talking to people and understanding that. Mr. Ross. Right. It is more than just collection. Mr. Sirri. Absolutely. And I will tell you from having been there, there is usually no shortage of people who want to walk in the door and explain their views to you. So unless that has changed in the last few years, I expect they are hearing their views. Mr. Ross. One quick question, and, Mr. Spatt, I will give this to you. A recent Wall Street Journal article states that many Wall Street executives point to extreme complexity created by Reg NMS as the cause for technical glitches. Has the combination of technical complexity and more exchanges created an environment where glitches are more likely to occur? Mr. Spatt. There seem to be more glitches in recent years. Inherently, to the extent that the platforms need to interface with each other, that is maybe part of the source of a glitch. But I think one also has to assess the glitches from a broad perspective in terms of the everyday performance of the market. Mr. Ross. Higher volume, higher frequency may lead to more glitches. Mr. Hurt. Thank you. Mr. Ross. Thank you. Mr. Hurt. Thank you, Mr. Spatt. Mr. Ross. I yield back. Mr. Hurt. The gentleman's time has expired. The Chair now recognizes Mr. Scott from Georgia. Mr. Scott. Thank you very much. I want to go back to this issue of the dark pools, because I think we need to understand my point and the concerns about the fair competition. We, in Congress, amended the Securities Exchange Act to add Section 11A, which was to foster fair competition. Now, it is important for us to understand what these dark pools are. I am not casting a bad light on them. But what these dark pools are, they provide institutional, large institutional investors with anonymity in the equities market with the option to execute these large orders without identifying either themselves or the location of trade to the consolidated market data, and such secrecy allows market participants to prevent other traders from pricing in that arena. Therefore, this concern is certainly a legitimate concern, especially now that 40 percent of the average daily volume is in the dark. And with the increase in liquidity fragmentation--13 equity exchanges, 45 dark pools--many, many of our investors are raising concerns. So my question is, don't each of you agree that order competition as a result of this has decreased and that the SEC should be looking for ways to rebalance this? Please, each of you. Mr. Spatt. I don't agree. I agree that the issue of transparency is an important one, but I also feel that the institutional investors, how they manage their orders to some extent is part of their intellectual property. If we were to, for example, declare that we would not allow the dark pools to operate, to some extent they are going to follow very different tactics. They are going to presumably then shred their orders to a much greater degree. There is a balancing act. Mr. Scott. That is what I am asking for. I am not asking that we do away with the dark pools. I am just simply saying that there should be an examination for a more fair competition within that. Mr. Spatt. I am very comfortable with the idea of studying the issues, but I think it is important to keep in mind that there is a bunch of balancing, and that to some extent, if the rules were to change, institutional investors will change how they respond to those rules, and I think it is important to keep that in mind. And I also think it is important to keep in mind that even for dark pools, there is post-trade price reporting, for example, that is required of the dark pools as well. Mr. Scott. Mr. Sirri? Mr. Sirri. I think if you wanted to create an environment where there was more transparency in dark pools, Congress could do that and the SEC could do that, incrementally if they chose. For example, you could cause the dark pool to report when a trade occurred in that particular dark pool. That is not done today. A dark pool is not identified as such. But as to what Mr. Spatt said, I would agree with it, which is if you choose to do that then traders, as they use that particular dark pool, will change. They will do something different. Net-net, is that better or worse? I can't tell. But I think part of what gets at the answer to your question and to Mr. Lynch's question will be a comparison of how well did a particular trade do on an exchange that was lit and how well did that same trade or an equivalent trade do on a dark pool that was dark? Mr. Scott. Good. Mr. Lofchie? Mr. Lofchie. I think one of the issues that you implicitly identified, Representative Scott, is the fact that large traders may move the market. And I think the concern that all of us have, and I think likely share with you, is that when mutual funds and pension plans trade in large volume, if they are going to do that in a fully exposed manner, are they going to move the markets against them and will that end up hurting retail investors indirectly. Mr. Scott. Thanks. Mr. Campos? Mr. Campos. Representative Scott, thank you. That is a very thoughtful question. The issue here really is, can you stop human nature? People since time immemorial have made deals outside any market system. If you own stock and I own stock, we can trade it without any market. And so what you are hearing is essentially that there is a need for large investors to do their trades cheaply, which helps pensioners, which helps retirees, and they need to save money on executions and they need to get the best price. So these dark pools serve that purpose very well. Mr. Hurt. Thank you, Mr. Campos. Mr. Scott. Thank you, sir. Mr. Hurt. And I think, unless there is any objection, Mr. Huizenga from Michigan has asked to be recognized for 5 minutes. I think we can work him in before we have to run to votes, so I am going to recognize him for 5 minutes. Mr. Huizenga. Thank you, Mr. Chairman. I promise to try to fold time and space here and make it as fast as possible so we can get to votes. I was going to start by asking, and I think we have explored this quite a bit, how the rules and regulations may have pushed, not forced, but maybe pushed some of these trades off of the exchanges and into these dark pools. I think it has been explored quite a bit, and Mr. Lofchie I think asked a key question: Why are they going to these alternatives? And I am going to go to another dark and ominous place, high frequency trading, or I think as some of my friends in New York call it, automated trading, much less ominous than the high frequency sounding. But, Mr. Sirri, talking about mandating a focus on price and speed in executing trades, I am curious about your take on how Reg NMS has impacted equity markets and the investors who participate in these markets, and has it led to some of these high frequency tradings, HFTs, or is that separate in your mind? Mr. Sirri. I think certain provisions of Reg NMS certainly contributed to that, most specifically the ones that required private market linkages. Before Reg NMS, the linkages between our exchange markets was very primitive. An exchange like the New York could hold an order for 10, 20, 30 seconds and not interact with that. Today, the exchanges have to be automated, those automated exchanges are protected, and they route orders between each other on high-speed computer networks. This has gone on to the point where if you are serious about trading in these markets, you need to collocate your computers, you need to trade physically close to your market center, because like travel time, as fast as that is, that is an important determiner. Mr. Huizenga. I know there was a story not that long ago about the use of some of the military technology on communication with lasers now being utilized. I am trying to get my head wrapped around fractions of nanoseconds and the amount of information, the multiple terabytes that are being exchanged sometimes. But does anybody have a concern with the speed, what has occurred? Mr. Spatt? Mr. Spatt. Well, not necessarily a strong concern. It is surprising, though. I share your at least implicit surprise. I think what it is pointing out is that the various intermediaries must feel that these are profitable investments, and that despite incurring the costs for these investments, they are still able to make money as intermediaries, and I think that is important to keep in mind. Mr. Huizenga. Does anybody care to address what equity markets in Europe or Asia have rules equivalent to Reg NMS, how do these markets perform compared to the United States, and are there any differences in performance in part attributable to Reg NMS? I would love to hear about Canada as well. As Chair of the Inter-Parliamentary Group on Canada, we are working on a trip up there, and would love to have this conversation with my Canadian friends. Mr. Sirri. I am not sure I can speak to Canada, but I can talk generally about, for instance, Europe. Mr. Huizenga. All you have to do is add an ``eh'' on the end of the sentence and you are good. Mr. Sirri. There you go. Our markets are quite integrated relative to, say, the European markets generally. So, for example, as primitive as it sounds, they won't have an integrated quote across all their pan-European market centers. They won't even have a synchronous clock across those centers. We take for granted that all our market centers know what time it is down to a millisecond. That is not necessarily true in a pan-- Mr. Huizenga. Meaning the DAX and the CAC and everybody else aren't necessarily on the same page? Mr. Sirri. That is not necessarily integrated in that same way. So in that sense, we have a much higher degree of integration in our markets. Mr. Huizenga. Do you see them going in that direction? Mr. Sirri. I think there are different issues there. They have different incentives and they have different governing principles. They have MiFID and certain other things that govern that. I am not sure I am up-to-speed enough to tell you, but I don't think I have seen big movements. Mr. Huizenga. Have they not done that because there is a fear that it may put them at a disadvantage? I'm sorry, Mr. Campos, I think you were-- Mr. Campos. No. I was just going to add that if you are interested, I believe in Europe there is more of a protection of their particular market. It is viewed as a national asset. As we know, their governments protect major industries, major businesses. Germany has a big interest in the Deutsche Borse, and the U.K. in the LSE. But in addition to the difference that Professor Sirri just mentioned, clearing and settlements in Europe is a private matter. It is not a utility like it is here in the United States essentially. So you have additional costs to trade. This is why the U.S. markets are--one of the reasons, among many, that they are much cheaper. So, there is a big difference in that world. Mr. Hurt. Thank you, Mr. Campos. The subcommittee will now stand in recess, and we will get started again as soon as we can. Thank you. [recess]. Mr. Hurt. I am going to call the subcommittee to order. Without objection, the Chair is authorized to declare a recess of the subcommittee at any time. Would the witnesses please return to the table? I want to again thank you all for your appearance today. I think the ranking member is here. I don't think she has any other questions. I might just kind of wind up with a final question and ask for each of you to sort of comment on it. As you know, SEC Chair White and her fellow Commissioners recently supported the need to review equity market structure. What ultimately, from their standpoint and from ours, should the goal of that review be? And if you wanted to just kind of wrap up with your thoughts on that question, Mr. Campos. Mr. Campos. I appreciate the question. Thank you for the question. I think that, as we began, and in your remarks as well, the caution is not to throw the baby out with the bathwater, if I can use a common phrase. I think technology is an issue. Technology has moved faster, quicker, in ways that no one has foreseen. And I think the discussion about speed in trading is a legitimate issue to discuss. That shouldn't be confused with structure and whether we have competition appropriately among markets and among the orders. And I think the issues that technology has brought, the flash crash and other instances like that, may have to do with plumbing and may have to do with better connections and that sort of thing, and that is a separate review. Mr. Hurt. Mr. Lofchie? Mr. Lofchie. One of the interesting issues, I think, for the regulators is determining whether we need a more rules- based system or a more policy-based system. And I think one of the issues that has been raised is the difficulty of regulation keeping up with technological advancement. I think the more that we have a rules-based system, really the more difficult it is for the law to keep up with technology. And I think Professor Sirri has raised the possibility of going to a more policy-based system, and that might be one that in fact proves more flexible in keeping up with technology. Mr. Hurt. Thank you. Mr. Sirri? Mr. Sirri. Your question was about the goal of searching for these. I think the goal would be to learn as much as you can from all sectors and synthesize it before you make your decision. Sectors here are investors, they are brokers, they are market centers. You learn quantitative things, you learn qualitative things, you look at data. Then you put it together in a way that in fact many other people can't, because there are a lot of people who see pieces, but few people see it all. The SEC has the potential to see much more than anyone else. Synthesize it and then use that to inform your regulatory choices after you have synthesized. Mr. Hurt. Great. Thank you. Mr. Spatt? Mr. Spatt. I think the review in part should try to assess what have been the impacts of the major regulations from the past, including NMS and decimalization, what have been the broad impacts of these, and to what extent do the regulators feel that there are distortions in the routing process. Especially in an environment where there are as many platforms as there are, the routing decision is absolutely central to the competitive process. And I think trying to drill down on that in a variety of ways has implications for understanding some of the detailed rules, like the rules about maker-taker, it has implications for the interface between NMS and best execution. I think understanding the decision process by which firms route orders seems to me an absolutely central issue, and it seems to me potentially at the heart of the overarching theme. I think the regulators want to try to learn as much as they can. There is a wealth of data. And I think by putting the right lenses on, there is the potential to learn. And I think the regulators also ought to step back, and following on the theme of some of the prior witnesses, the regulators should step back and try to identify what are the objectives and goals and try to lay those out and potentially maybe try to consider pulling back from as prescriptive a set of rules as we currently have. Mr. Hurt. Great. Thank you. And with that, I will yield back my time. And I am pleased to recognize the gentleman from California, Mr. Royce, for a period of 5 minutes. Mr. Royce. Thank you very much, Mr. Chairman. I wanted to ask Mr. Sirri and maybe Mr. Lofchie on order protection, can you give us your best guess on what the market would look like without an order protection rule? Would markets be less connected, and would there be fewer or would there be more trading venues? What would be the evolution? Mr. Sirri. Those are the hardest kind of questions to answer, you change one thing and then what does the world look like? And the reason why they are hard to answer is because I have to tell you what the banks, what the brokerages would do next with that. It is hard to predict. I think if the world were to come to pass as you suggest, you put a lot more weight on the brokers' obligations. For example, since there is not an automated way to protect certain quotes, then brokers are going to have to do that on their own. Certain things might speed up, you might get even faster trading in some ways. But I think to the extent that you are thinking about a world where that might actually happen, you would probably have to make some other changes to go along with it, because that is, of course, just one piece of what NMS provided. So I wish I had a better crystal ball, but it is just a tough question. Mr. Royce. Mr. Lofchie? Mr. Lofchie. I am going to be bolder than Erik, but I feel comforted that he said this was a hard question. My guess would be that there would be fewer markets and that you would-- Mr. Royce. There would be fewer exchanges. Instead of 15 exchanges, there might be-- Mr. Lofchie. I think the order protection rule provides some incentive to split orders among markets rather than concentrating them. Mr. Royce. Yes. Mr. Lofchie. I appreciate Professor Sirri's remark that you really are guessing at the motivations of participants, but I think that is the challenge that the SEC faces, is to anticipate-- Mr. Royce. So this is propping up some of the smaller exchanges, presumably the existing structure that otherwise, given the efficiencies, might be collapsed. Is that your-- Mr. Lofchie. I think that would be my hypothesis. Mr. Royce. Yes. Mr. Lofchie. And, again, I think it is really about anticipating how rule changes would affect the markets. Mr. Royce. And that takes me maybe to the next question. As we look at the issue from 30,000 feet, you have investors seeking to purchase a product in a market. Required in every one of those transactions is an intermediary, a broker has to be involved in that transaction. So, Mr. Sirri, your testimony notes that it is important to have this factor of the responsibilities of brokers that handle customer orders and their best execution duties, and what does that best execution mean for the end investor? That is who we are focused on here. And what should the Commission look at in this space when considering the responsibility of brokers and ensuring the end investor receives the best experience? Mr. Sirri. The reason why that duty, the best execution duty, is important in securities markets is because individual investors in particular can't tell how well they are being treated. Mom and pop, when they place an order on their screen, they don't know whether they should be trading at 20, 20.01, 20.02 or 20.03. They just don't know. They don't have the information. That duty confers upon the broker the obligation to act in the interest of the customer whose order they are handling. Hence, it becomes more important the less sophisticated the investor is. So the Commission has always used the duty of best execution to help foster the interests of individual investors when they can't monitor things for themselves. I think it continues to be as important as it ever was, if not more important today. Mr. Royce. So my last question would be, then, what is so complex about the current system, other than there being so many trading venues, other than there being so many exchanges, and how does this complexity actually affect the average investor? Mr. Spatt. The complexity, I think, comes from many sources. There are a whole range of different types of investors with different business models, intermediaries trying to have their own business models that accommodate the needs of different types of investors. And obviously, we put those together. At a high level you see this about exchanges and platforms without exchange obligations, you see this with respect to dark pools, you see a whole range of types, and then they are interacting. And I do think that NMS has made this trading environment more complex because of the obligation to hunt for liquidity across the tops of all of these vehicles. Mr. Royce. Let me, if the chairman would indulge me, I know Commissioner Campos wrote about this at one point. If I could just finish up with your observations, Commissioner? Mr. Campos. Thank you. If we are talking complexity, as has been said, complexity comes from many sources. And it is almost like fighting the wind. It is going to keep coming, because you have many different types of consumers, let's just think of it in another context, and you have a lot of different people who want to sell consumers. So I would caution that reducing complexity in and of itself should not be the goal. Instead, fairness is the goal. Is the average small investor, for example, getting almost all the time the best price at that particular instant? If you let things like that guide you--and I know you have a great staff and you think about these things deeply--but if you let principles like that guide you, you will get through this complexity and you will be able to essentially do the proper analysis, which I know you are going to do. Mr. Royce. Thanks, Commissioner, and thanks, panel, very much. Mr. Hurt. The gentleman's time has expired. The Chair now recognizes Ranking Member Maloney for a period of 5 minutes. Mrs. Maloney. I would like to hear your comments on what you think caused the flash crash and the 3-hour stall in NASDAQ and what you can do to correct that. And one of you mentioned the churning of selling stocks all over the place in order to generate fees. I think that was you. Mr. Lofchie, in your statement, the fear of churning or moving stocks around just to get fees? One of you talked about that. Mr. Lofchie. I think I expressed a concern, Representative Maloney. Mrs. Maloney. Yes. And I would like to hear more about that. And lastly, in reading one of these news articles, they looked at a $2.5 million transaction for stocks, and the broker, they tracked it, the broker offered to buy 750 million shares of stock in order to hide the fact he was buying 2.5 million, and the author questions how that is going to distort the market, trying to hide what they are doing. So, any comments from any of you on those four questions? Thank you very much. It was very insightful and it was wonderful to have so many well-informed people speak to us today. Thank you. Mr. Spatt. I will try to take on some of the questions, but not all of the questions. On the issue of why we have these glitches, I think there are a range of reasons. To some degree, the so-called fat finger where one trader makes--one trading firm makes a big error, like being off by a zero or maybe two zeros, this has been at the root of some situations, and then as it transmits through, then the market participants, they think that it is real information and then so people react to that in a major way. This has been at the root of some of the glitches. I think to some degree, even in the flash crash, this was there. In the case of the Knight fiasco, I think the problem was they were responding to what they perceived to be a change in the rules on the NYSE, and on the first day that those changes in rules got rolled out, they started running their modified procedure against that, but without having the opportunity to pretest it, and then further reinforced by they didn't have a kill switch to stop things. So I think the stories for the glitches differ across situations. I do think that when you have many different platforms, a problem at one can feed into the others. In the NASDAQ case, it was actually in the key information channel, the SIP, and ultimately that is kind of a unique thing, but that kind of brought much of it down. With respect to your final question about the firm wanting to trade a couple million shares but then scales it up to a couple hundred million shares to try to hide its intent, this is actually a question I have thought about a lot in recent weeks. I think it is a difficult question, because the party that has a couple million shares to trade does seem to me to have a legitimate interest in not wanting the markets to immediately figure out what it is they are up to and have their investors squeezed by the other side of the market. So it tries to create what in my discipline we sometimes might call more of a randomized or mixed strategy. But I was struck in this example by how off the charts, then, the scaling up was, but it does seem to me it started from an investor trying to solve a legitimate business problem, but then clearly they pushed the envelope on it. But it seems not obvious to me where I would ultimately want to come down on that. Mr. Sirri. I think the one thing I would say to that last point, Congresswoman Maloney, is that as technology changes, the form of manipulation can change, and so your interpretation of what you call manipulation has to change along with it. You pointed to something that you probably couldn't have done 10 or 15 years ago. You can do it today, and I think the way you track manipulation, the regulator tracks manipulation has to change. Mrs. Maloney. And what about the churning for fees? Mr. Lofchie. I think the regulators need to look at not only the high profile issues, such as high frequency and algo, they need to look at more subtle issues like market data fees and to ask whether those kinds of fees are altering the way investors trade to alter the order routing decisions, as Professor Spatt has said. Mrs. Maloney. Thank you. My time is up. Mr. Hurt. I would like to thank today's witnesses for your testimony. The Chair notes that some Members may have additional questions for this panel, which they may wish to submit in writing. Without objection, the hearing record will remain open for 5 legislative days for Members to submit written questions to these witnesses and to place their responses in the record. Also, without objection, Members will have 5 legislative days to submit extraneous materials to the Chair for inclusion in the record. With that, this hearing is adjourned. Thank you. 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