Remarks at the Security Traders Association Annual Conference
Chairman and CEO
Palm Beach, FL
As prepared for delivery.
Thank you Jim [Toes] for that introduction, and thanks STA for the invitation to join you this morning.
Today, I want to reflect on recent market structure changes and the volatility that has defined the markets over the last year. Since the flash crash of May 6, the markets have not really stabilized. The CBOE Volatility Index has hovered between 35 and 50 since August 2011 with no apparent end in sight. Given no relief-based macroeconomic news, as the SEC considers a proposal to introduce limit up/limit down restrictions to complement single stock trading pauses and a proposal to narrow the triggers for and shorten market-wide circuit breakers, I think it's a good time to assess whether the markets have been sufficiently shored up in response to May 6 and whether we should be thinking about additional steps, consistent with continuing to facilitate efficient price discovery and market liquidity.
I'll also talk about FINRA's vision to evolve how we regulate firms and the markets to better detect risk and manipulative behavior. Our vision anticipates change as the norm and works to prevent—rather than just react to—problems.
Let me begin with an update on rulemaking activity and some changes coming out of the integration of FINRA and the NYSE's market surveillance departments.
Starting with the Manning Rule—in September of this year, the new "Manning" rule went into effect. The rule integrates and consolidates FINRA's customer order protection rule with NYSE's Rule 92. Among other things, the new rule updates and simplifies the provisions to better reflect current market and trading practices and provides a uniform industry standard with respect to customer order protection.
The NYSE harmonized its rule, which we believe will have the beneficial effect of reducing regulatory duplication and allowing for more efficient and effective compliance by joint FINRA and NYSE member firms. Consistent with the former "black box" exception in NYSE Rule 92, the most significant change to FINRA's rule was the acknowledgment that retail order flow in NMS stocks can be walled off from a firm's market-making desk, provided there is an adequate information barrier in place separating the two areas, and providing that customers receive adequate disclosure of the arrangement. Assuming there are sufficient information barriers, a trade on the market-making desk would not give rise to an order protection obligation for a retail order on another desk. Accordingly, given the importance of adequate information barriers under the rule, they will be a high priority item for TMMS examiners.
Integrated Audit Trails and Surveillance
As part of the NYSE integration, FINRA has aggregated data across all FINRA, NYSE and NASDAQ equity markets and is in the process of developing comprehensive cross market surveillance patterns that will examine trading activity across all markets at one time, rather than having multiple patterns survey each market separately. A significant enhancement to FINRA's audit trail is the expansion of OATS to include all NMS issues and the elimination of the NYSE's OTS system. The first phase of the OATS expansion is scheduled for this Monday, October 17, and will be completed by early November. As OATS expands to include these issues, OTS will be eliminated. With the expansion we anticipate that OATS will handle over one billion order events each day.
FINRA's consolidation of all the market data for integration into new cross-market surveillance patterns will drive new efficiencies and effectiveness and help us identify problematic trading activity more quickly. Having access to uniform, consolidated data means we will be better equipped to detect improper conduct and stop it before it spreads. And our automation and data mining will allow more efficient identification of atypical quoting or trading, while also helping us pinpoint firms that need additional scrutiny.
Indications of Interest
Another rulemaking proposal that I'd like to make you aware of doesn't relate to the integration of NASD and NYSE, but it's one that I'd like to get your input on. It concerns the handling of indications of interest, or IOIs. The proposal is a follow on to a Regulatory Notice that FINRA put out in 2009 reminding firms that they need to be truthful and accurate in how they label natural IOIs. While we believe the 2009 Notice was helpful, we received some comments that without a clear definition of a "natural" IOI there is still the potential for misuse of natural IOIs. Namely, that buy side traders may attempt to reach out to a natural IOI only to find that there is no longer any trading interest behind the IOI and the buy side has tipped its hand. As a result, we propose that a firm must have an order in hand to call it a natural IOI. This proposal frankly has not been without debate within FINRA and its committees and so we are asking for comments on the proposal and have posed several questions in the Notice. We appreciate Jim and STA reaching out to FINRA to discuss this issue, and I look forward to your comments.
Market structure issues
Now, let me now turn to the broader topic of market structure issues, which the SEC and CFTC have focused on since the 2010 flash crash—and which will require our continued focus in order to restore investor confidence in the U.S. financial markets.
Last February, the Joint SEC-CTFC Advisory Committee on Emerging Regulatory Issues, on which I served, issued its recommendations. The panel supported several initiatives the SEC has put in place or is currently considering since the flash crash, including single-stock trading pauses, the limit up/limit down framework, and the ban on stub quotes and naked access. I will talk more about some of these initiatives later. And let me emphasize that any statements I make today do not reflect the views of the advisory committee.
The outcome of the flash crash and the underlying issues are in many ways not surprising; indeed, they are natural outgrowths of the SEC's efforts in recent years to promote market competition and efficiency through technological innovation. These efforts, from the wide-ranging changes to the NASDAQ market that occurred in the '90s through Reg NMS, dramatically changed how exchanges operate and interact with each other. These developments promoted transparency, enhanced competition, reduced barriers to entry and fostered electronic trading. In addition, decimalization, sub-penny pricing, and a myriad of tape rebate and liquidity provision programs, also have had a profound impact on the markets.
The byproduct of these changes is fairly predictable. They have created an environment marked by higher volume, very aggressive competition and low spreads. And liquidity is spread across multiple books and in some cases across books that are not transparent. When these conditions are combined with free and extremely cheap access to electronic trading, the result is an environment where liquidity can very quickly disappear.
Today's version of electronic trading is not inherently good or bad. But it reflects a few basic strategies, most of which are fundamentally a combination of liquidity providers' strategies combined with opportunistic short-term trading during periods of volatility. By design, many algorithms perform well during volatile markets; however, it is difficult to design algorithms to perform well during periods of extreme volatility where fundamental assumptions of the market are challenged. This was the case on May 6, 2010 (as it was in October 1987, although on a less automated basis). During turbulent market conditions, one of two things tends to happen with trading algorithms. Either the algorithms become passive and withdraw from the market until humans running the algorithm determine it is time to reenter the market. Or the algorithm becomes aggressively speculative, and determines it's time to sell without regard to logic.
The SEC-CFTC study revealed that the large amount of liquidity provided from internalized sources and ATSs tends to pull back for the same logical reasons as HFT algorithms. You have all the sell activity pouring into books that are extremely thin and you get the reaction and reality of the flash crash, where there is a sudden and severe liquidity gap before computers can re-engage in the marketplace.
So how do we solve the problems that underlie this trading environment? Several initiatives the SEC put in place after the flash crash have contributed to a better market environment.
First, in a highly volatile market environment, it's absolutely critical to have pauses and limits that work in a way to allow human beings to make a determination that the market has not been fundamentally changed and to convey that there are buying or selling opportunities. It was an important step to move to pauses as quickly as possible. And it was equally important to expand the pauses to all securities. The pauses are operating on a pilot basis and the recent expansion to a wider group of securities will permit continued review and assessment of their operation.
The pause framework has limitations because it doesn't address the single erroneous trade that's an outlier that can cause the markets to stop unnecessarily. That is why in May of this year, the exchanges and FINRA, in consultation with the SEC, filed an NMS Plan proposing to adopt market-wide limit up-limit down requirements that would prevent trades in individual NMS stocks from occurring outside of the specified price bands. The limit up-limit down requirements would be coupled with the pauses and would reduce the negative impacts of sudden, unanticipated price movements, like those experienced on the afternoon of May 6, 2010.
The Joint CFTC-SEC Advisory Committee also recommended a review of the current operation of the market-wide circuit breakers. In September, FINRA and the exchanges filed with the SEC proposals to update the existing market-wide circuit breakers by, among other things, reducing the market decline percentage thresholds necessary to trigger a circuit breaker, shortening the duration of the resulting trading halts, and changing the reference index to the S&P 500 to measure a market decline.
Second, the SEC provided greater certainty with respect to "busting" trades in situations involving multiple stocks. One of the great things about pauses, and an even better thing about limits, is that hopefully we can move to an environment where there will be virtually no erroneous trades. But we still live in a world where those pauses are not perfect, and where they don't apply across all stocks. So the rules that provide clarity from the standpoint of what happens with respect to multi-stock events is an important step by the SEC to build consistent expectations across markets when these events occur. When people don't know whether their trades are going to stand or whether a hedged position will become unhedged, they have one more reason to pull out of the market, and that should be avoided whenever possible.
Third, a step that I think is absolutely critical for the integrity of our markets going forward is the SEC's action on naked access and the requirement that anyone directly interacting with the marketplaces be a broker-dealer. This move provided greater clarity, building on FINRA's efforts to emphasize the supervisory obligations that are necessary in this environment. Our examination teams are starting to review some firms' procedures for compliance with the SEC's new market access rule, which I note is a policies and procedures rule not a prescriptive rule. We anticipate working with the SEC and other SROs to help refine and educate firms on best practices in this area.
As a result of these developments, we believe that the markets are less susceptible to another flash crash-like event. However, while we have taken important steps to restrain free falling (or rising) markets, fundamental questions remain about how we ensure sufficient market liquidity so that we don't become over-reliant on volatility bumpers in an environment where computers are driving virtually all trading decisions. Some of the difficult questions we have to consider include:
- Should high frequency trading be subject to affirmative and/or negative obligations?
- Are there enough incentives for HFT traders to remain market-makers in good times and in bad?
- Is there some point in the operation of HFT strategies where high cancel/replace rates and low quote to trade rates mean that HFT firms should bear more of the costs of their strategies?
- Should there be "peak period" pricing during high volume periods?
- Should internalizers be required to provide price improvement and adhere to market-maker-like requirements to execute customer order flows?
The issues sit squarely on the SEC's plate at this point, although we at FINRA remain keenly interested. It will take a lot of thought and input from organizations like STA to help get to the right answers.
Consolidated Audit Trail
Yet, even with these issues being debated, critical surveillance gaps still remain—underscoring the need for a mandated consolidated audit trail. Last year, the SEC issued a rule proposal on a consolidated audit trail, and SEC staff has recently said that it expects to take action on the proposal this fall. A consolidated audit trail would ensure that data can be reviewed across all markets and participants. It would also provide for direct and more timely access by the SEC and SROs to comprehensive, uniform audit trail data.
It's clear that we need more granularity to make us more effective in identifying market integrity issues. As participants continue to change the way they access and trade in the market, our audit trail must keep pace. To that end, we need more data on sponsored access and large trader relationships, while balancing the incremental benefits of collecting that data with the burden on firms.
We believe that OATS, which as I noted before will very soon apply to all NMS issues, is an important foundation for a consolidated audit trail and could be modified to achieve many, if not all, of the SEC's stated goals more easily, economically and quickly than developing an entirely new system. This approach recognizes and benefits from the significant investment by the industry in developing systems to be OATS-compliant. FINRA estimates that it would take 18 months to adapt OATS to achieve the requirements for CAT at a fraction of the $4 billion the SEC estimates for CAT.
Ultimately, a consolidated equity audit trail would be the first step to expansion of uniform audit trail requirements across all products and with that, cross-market and cross-product surveillance. In the meantime, FINRA is refining and retooling its automated surveillance patterns to detect trading manipulation in a market where high frequency and algorithmic trading predominate.
Exam and Surveillance Issues
I'd like to close with some comments related to a couple of the market structure issues I mentioned earlier, and how we're continuing to evolve our examination and surveillance programs to address areas we're concerned about.
Let me begin with direct market access. As I noted earlier, our examiners are starting a comprehensive review for compliance with the SEC's new market access rule. Beginning in September, our Member Regulation and Market Regulation examination teams began reviewing a cross section of firms with varying business models. By the end of the year, we expect to initiate approximately 30 examinations. And next year, where relevant, our examiners will examine for compliance with the rule during all FINRA examinations.
What we'll be looking for during these examinations are a firm's policies and procedures for financial risk management controls, and supervisory procedures for preventing the entry of erroneous orders, assuring compliance with marketplace rules, such as Regulation SHO and Regulation NMS, and monitoring for manipulative conduct such as wash sales, marking the open and marking the close, among other things. We are particularly interested in how firm personnel are utilizing surveillance reports to review customer and firm proprietary trading activity. In addition, we expect firms to have rigorous controls around system security as well as the process by which they authorize customer access. When a firm is relying on a third-party service provider, our examiners will be carefully reviewing how the firm is meeting its obligation to have direct and exclusive control over the system. Similarly, if a firm has delegated its obligation to establish regulatory risk management controls for certain customers to another broker-dealer as allowed under the rule, our examiners will be looking to see if there was proper due diligence and adequate documentation of such arrangements. Lastly, we will be examining how firms annually review the effectiveness of their risk management controls and supervisory procedures and how they comply with the new certification requirements in the rule. As we learn more about how firms are complying with the market access rule, we plan to work with the SEC and other SROs to educate firms on best practices.
Circling back to the earlier discussion on trading algorithms, I'd like to reiterate how important it is for firms to have vigilant programs in place to monitor the algorithms that they deploy. It is not okay to simply allow algorithms to continue to operate without evaluating their results and their impact, their incremental changes over time and how they work in periods of excessive volatility. Recognizing that traders operating algorithms need reasonable flexibility to adjust to changing market conditions, such evaluations are not impossible; they don't require the re-engineering of every application that's been designed. But that discussion, understanding and level of testing is something that we expect. I think the new SEC rule is absolutely critical to ensuring market integrity both with regard to market volatility and disruptions, and also with regard to concerns about manipulation.
I'd also like to address some recent articles in the press about regulators asking for firm's trading algorithms. While I absolutely believe that with the right facts it is appropriate for FINRA to ask for the codes, you should know that we only ask for codes in the context of investigations where we have exhausted all other means to obtain the information we need. We have only asked for the codes on rare occasions and limit who can access the information. We fully appreciate the confidentiality concerns and are willing to work with firms when requests are made.
With respect to high frequency and algorithmic trading, we are focused on the detection of so-called "momentum ignition" strategies, where an entity will seek to create the appearance of legitimate market movement by entering non-bona fide orders or even effecting wash sales to bait other market participants to enter the market. We are building our surveillance patterns to be flexible to recognize many variations on this theme, as we realize that these strategies continually evolve as legitimate market participants adapt their own trading behavior to avoid repeatedly being disadvantaged by the same scheme, and potential manipulators respond in kind.
We are continuing to look at purported instances of "quote stuffing," in which extremely high levels of message traffic occurs in a particular security. While we have been able to explain many of these instances as unintended consequences of changes to parameters in algorithms, underscoring again the need for robust supervision, testing, and controls, we will continue to be vigilant in evaluating these circumstances to determine whether the conduct may be intentional and manipulative.
In addition, we continue to focus on wash sales, marking the close, spoofing, frontrunning and improper attempts to impact opening and closing spins on markets. Another area of concern is options mini-manipulation, where there are bursts of well-timed equity trades that have an impact on corresponding leveraged options positions.
We've also made some changes to FINRA's trading examination program—commonly referred to as the TMMS program. Traditionally, TMMS has focused on NASDAQ and OTC market makers. As the markets have changed and market-makers now account for less volume, the TMMS program similarly has changed, and TMMS now examines large order-entry firms, alternative trading systems and some non-market making desks of firms. The program also has changed because TMMS now conducts equity and options trading exams for eight SROs. For firms subject to an options trading exam and an equity trading exam, we seek to conduct a combined exam to get a more holistic view of the firm.
The breadth of the rules we examine for also has grown in scope, as we now cover Reg SHO, Reg NMS, supervision of direct market access and electronic communications. For example, in addition to reviewing policies and procedures and retention, TMMS examiners also review the context of emails, instant messages, and SMS text messages for indications of potential rule violations and trading abuses. These reviews have been very fruitful.
TMMS exams are designed to complement surveillance reviews by focusing on areas that are difficult to identify through a surveillance report. For example, in terms of equities, we conduct a best execution review of institutional orders over a certain size to determine if the firm is stepping ahead or frontrunning the customer. For options, our examiners reverse engineer trading scenarios to identify the steps that an order flow provider follows prior to entering an order into his or her order management system. We use electronic communications, as well as a firm's account statements to monitor for frontrunning activity that may otherwise be difficult to detect.
The examination staff is also in close contact with other FINRA examination teams to identify any risk areas that are a concern.
Addressing the issues I've talked about today will depend on FINRA and the industry anticipating change and being prepared to respond to developments in the markets. This proactive approach will enable us to more effectively pinpoint vulnerabilities and abuses—and combat them—before they destabilize pockets of the financial system.
Ultimately, the success or failure of these reforms will also depend on all of you making a commitment to compliance and engaging in the rule making process. The foundation of a healthy financial system will always be a workforce that possesses a strong sense of what's right and what's wrong, and acts accordingly.
I am confident FINRA and the industry can realize this vision, and do so in a way that fosters more effective regulation, greater investor protections and a more stable financial system.