[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
______
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88-529 WASHINGTON : 2014
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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
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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.
[Whereupon, at 11:57 a.m., the hearing was adjourned.]
A P P E N D I X
February 28, 2014
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