Remarks From Baruch College’s Financial Markets Conference
Executive Vice President, Market Regulation
New York, NY
Good morning. It’s a pleasure to be here.
Let me thank Bob Schwartz, first, for the invitation to talk with you this morning, and second, for his tireless work to foster a greater understanding of trading and securities market structure. As always, Bob has laid out a very thoughtful and provocative theme for the conference, “40 Years of Experience with NMS: Who are the Winners and What Have We Learned?” It looks like we are in for a treat today with all the excellent panels and I would like to share my views on the National Market System.
Many of us have been in this business a long time—long enough to appreciate how the 1975 Act Amendments to the Securities Exchange Act of 1934 and the rules promulgated by the SEC to create the National Market System have set the stage for the last 40 years of innovation in the markets. The pace of change since 1975 has accelerated through the decades, leading to what are the most efficient markets in the world. While the changes have not always been welcome—indeed, they have been very contentious and painful for some—they’ve brought a variety of positive effects for investors and issuers, and spurred a technological revolution that continues to this day.
To put it in perspective, today, FINRA analyzes on average 40 billion market events a day through its surveillance systems; and on August 24, 2015, we successfully handled 75 billion events. We handle more data in a single day than what MasterCard processes in a year and Visa processes in six months. And because the National Market System allowed for more infusion of technology, the industry is now even starting to discuss execution speeds in picoseconds, or one trillionth of a second. The industry also talks about upgrading connectivity by swapping the “dated” fiber-optic cables, famously described in “Flash Boys,” with microwave dishes that can convey data in almost half the time, allowing high-frequency traders a way to squeeze profit from miniscule price discrepancies in assets traded around the world. And lastly, exchange data centers are now an amalgamation of exchange trading engines and their customers’ computers so that latency is at a minimum.
All these changes are grounded in the wide latitude the SEC gave to markets and market participants to determine the best structure to achieve the objectives of the National Market System. So, in addition to Bob’s questions, I would like to pose two more: Did the SEC give the markets too much discretion? And, if so, is the result a market that is now out of control?
It’s important to note that these are not simply academic questions. The fairness and efficiency of our financial markets have an impact on investor confidence and capital formation, and our markets are a key component of America’s competitive strength within the global economy. So it’s critical that we get the answers right.
For a little more perspective on the impact of NMS, let’s take a trip down memory lane. Before 1975, there were no consolidated data feeds for quotes or trades. Off-board trading restrictions limited competition among exchanges and broker-dealers. Options listings were allocated in lotteries much like the NFL draft. And the norm was fixed commissions with excessively high trading costs, which meant retail investor participation in the market was a fraction of what we see today.
The Securities Act Amendments of 1975, which mandated the creation of a national market system, spurred far reaching change in the equity markets. There are five objectives for the National Market System: one, the efficient execution of transactions; two, fair competition between markets; three, the availability of quotation and transaction information; four, the best possible execution of orders; and five, where consistent with other goals, the execution of orders without the participation of a dealer. With these objectives in mind, in a flurry of proposals and approvals starting in the mid- to late 70s, the SEC created Securities Information Processors to bring about the consolidation of quotes and trades for equities and options. The Intermarket Trading System, or ITS, was implemented. ITS was a rudimentary linkage among the stock exchanges that was an enormous change at the time that allowed non-members to access liquidity on an exchange and was designed to ensure that customers received the best prices available. Many off-board trading restrictions were lifted and the options listing lottery was abolished for a system that rewarded market share based on the quality of markets, not an exclusive assignment. Later, in the 1990s, the SEC adopted the Order Handling Rules, which required market makers to publish customer limit orders in their quotes and abolished the “two-tiered” market structure where a market make could simultaneously display a public quote and a superior, non-public quote in a private electronic trading system. Next, the shift to decimalization in 2000 led to a sea change in the over-the-counter market, with spreads dramatically narrowing and firms acting as their clients’ agents rather than trading with them as market makers.
The implementation of Regulation National Market System, or Reg NMS, in 2007, ushered in another period of incredibly rapid change and provided the catalyst that led to enhanced technology and competition. Perhaps the greatest changes were the more fulsome automation of the NYSE, the movement away from the floor-based specialist model, the joys of access fees and maker/taker and other pricing models, and the advent of dark pools created to facilitate the execution of block orders in a market with shrinking quote sizes and the potential for greater order leakage. We’ve also seen a dramatic shift in where trades are executed and how trading volume is spread among venues. The NYSE and NASDAQ once had an overwhelmingly dominant share of the market for their issues, but a substantial portion of that volume has shifted to other upstart venues, including the BATS family of markets and the revamped Pacific Stock Exchange, now known as NYSE ARCA, as well as the 40 or so ATSs out there.
So, who are the winners of the regulatory changes over the last four decades? Clearly investors and because of that issuers. Investors now benefit from lower trading costs, tighter spreads, timely executions at firm quotes, a wider variety of order types to achieve their investment objectives, and the availability of multiple, innovative trading platforms. However, with our National Market System, it is never that straightforward or clear cut. While investors have benefitted, the regulations have also created a more complex, fragmented market, with liquidity dispersed among many trading venues. Ironically, as the SEC has continued to seek to improve the National Market System, where the centerpiece is lit markets, a significant byproduct of these efforts has been the proliferation of “dark pools” where the lack of transparency seems antithetical to the objectives for NMS. In addition, we also are becoming much more of an order-driven market with registered market makers playing a much less prominent role in the provision of liquidity.
And this brings me back to the questions I posed: Did the SEC give too much latitude to the market as NMS developed? Were the guardrails for innovation established by NMS placed too far apart?
I think the answer is absolutely not. But there are many who think otherwise. Some believe high frequency trading should be banned, or at least seriously curbed. There are those who believe the speed at which trades occur and quotes are updated is the root cause of dramatic fluctuations in the market. There are some who believe firmly in human intervention. But history tells us that trying to stop technology is a fool’s errand, particularly market technology. Looking at all the changes the markets have experienced in just the past ten years, it is clear that we likely don’t know what is around the corner from a technology perspective and it would be dangerous to rein in the market and not make use of the available and evolving technology.
One of the things we have learned about NMS over the years is that it is an evolutionary process, not a utopian destination point. I think there also are several other lessons learned about NMS that we should keep in mind as the markets evolve.
First, NMS regulations in the past have tended to apply a one-size fits all approach where a particular rule applies to all NMS issues. Given the differences in market characteristics across issues in terms of volume, liquidity and other attributes, it is not entirely clear that it is best to apply one set of rules designed for highly capitalized, actively traded issues to all issues. I think it is a very positive development that the SEC is conducting the tick-size pilot and potentially looking for a more nuanced and stratified approach to regulation. The data this pilot provides will deepen our understanding of how tick sizes affect market quality and help us consider new regulatory initiatives that can improve trading in small-cap securities.
Second, we need to continue to focus on maximizing intended consequences and minimizing unintended consequences by applying more data analytics to the rule making process and conducting more robust cost/benefit analyses. I’m not so sure that the SEC anticipated all the issues that have flowed from access fees, but it was very encouraging to hear that there was consensus among SEC staff and market participants at the SEC’s recent Equity Market Structure Advisory Committee Meeting to develop a pilot to evaluate trading without maker-taker inducements.
Third, given the pace of technology changes, we need to make sure that market regulations are as nimble as possible. This is important because if you look at the National Market System rules promulgated over the last ten years they are becoming increasingly detailed and more proscriptive than the broad policy rules issued in the early NMS releases. I think Regulation NMS, the SEC’s Direct Market Access Rule, the recently implemented Regulation SCI and the proposed rules for the Consolidated Audit Trail are all perfect examples of how much more detailed the SEC’s trading-based rules have become. As the SEC’s trading rules become more technical, it will be important for the SEC to modernize them lest they contain standards that while acceptable now may not be in the future. Let me give you one example. Regulation NMS contains a “flickering” quote exemption that allows a firm to ignore a protected quote if the quote was displayed within one second of a trade through. To some, a second is an eternity. To the extent possible, hopefully the SEC will consider pushing more detailed rule writing down the SROs, as was successfully the case with the limit up/limit down process.
Given the evolving nature of NMS, I’d like to close by touching briefly on a few areas where we should consider further examination.
First, with respect to the extreme intraday volatility that occurred on August 24, 2015, when the Dow dropped 1,089 points at the open—the largest intraday decline in the 119-year history of the Dow, were it not for the trading pauses and limit up/limit down procedures put in place after the 2010 Flash Crash, the fluctuations would have been more dramatic. To my earlier question, the event illustrated not a market out of control, but the value of having appropriate controls in place. However, the volatility and extended trading halts in some instruments highlighted several aspects of the trading pause process that need to be reevaluated. Namely, the need for more coordinated openings across exchanges, the application of the limit up/limit down process when stocks come out of a halt, and the application of the limit up/limit down process to ETPs.
Second, the Execution Quality Reports required by SEC Rule 605 have now been in place for 14 years. While this rule continues to provide benefits to investors, it was developed with a market maker model in mind and the market was far less automated then. This is another example where a rule could be modernized to leverage better analytics for the benefit of investors.
Third, while we will talk a lot about market structure today, it is equally important to keep our regulatory structure in mind too given the level of market fragmentation. In today’s market, bad actors consciously disperse their trading activity across markets, asset classes, and broker-dealers in an attempt to hide their footprints and avoid detection. It is absolutely critical that regulators have a bird’s eye view across markets. At FINRA, through our Regulatory Service Agreements with exchange clients, we are able to put the pieces of the puzzle together for 99 percent of the listed equity market and 65 percent of the listed options market. Even though the markets are widely fragmented, FINRA's ability to pull together data across exchanges and alternative trading systems allows us to see one big, virtual market instead of a disjointed patchwork of individual markets. With our cross-market surveillance program, we can run dozens of surveillance patterns and threat scenarios across the data we gather to look for, among other things, layering, spoofing, algo gaming, wash sales and other manipulative and distortive conduct. These sophisticated patterns allow us to detect things that we had not been able to see before. For example, 47 percent of our cross-market alerts identify potential manipulative activity by two or more market participants acting in concert. And 67 percent of our cross-market alerts identify potential manipulation by a market participant on multiple markets. As strong as our cross-market surveillance program is, the implementation of the SEC’s proposed Consolidated Audit Trail, or CAT, will take surveillance to the next level. By having unique identifiers for accounts, better order audit trail information for options, more detailed information about each trade, and linkages between related equities and options trades, among other things, surveillance systems should reduce false positives and false negatives, with the result being quicker and more exacting investigations that will better serve investors.
In addition to the equity and options markets, the fixed income market structure is also ripe for deeper analysis. Recent developments in the bond markets raise questions about market structure and the role of transparency. Specifically, with TRACE-eligible securities we are seeing increased trading on ATSs, greater use of request-for-quote processes, and more executions of customer orders on an agency or paired basis. Among the issues we should consider is how we can apply the principles of the national market system to TRACE-eligible securities. For example, is there a role for pre-trade transparency that will afford investors better information to assess prices and valuations? Let me note that FINRA understands the industry’s concerns about pre-trade transparency telegraphing what a market participant with a large order is doing, and that issue has to be addressed. But, as the fixed income market continues to expand, it’s time we look more closely at whether we can bring the benefits of a national market system to fixed income.
Continuously reevaluating regulations in light of rapid market changes is essential. The changes we are talking about today will be the subject of market structure conferences for years to come. Bob Schwartz, the future of your conference appears quite secure. But more importantly, these changes are a sure sign that upon its 40th birthday, the National Market System is alive and well, even as we continue to work on it. Our markets are living, breathing, vital things that continue to evolve, and they require a smart, strong, adaptable regulatory framework to guide that ongoing evolution in the interest of investors.
Thanks for listening. I’d be happy to take any questions you have.