Remarks From the Brookings Institution
Chairman and Chief Executive Officer
As prepared for delivery.
Good morning. First let me thank Martin Baily for the invitation to talk with you this morning. Martin, I also want to commend you for the work you do here in Washington to bring about a greater understanding of business and the economy and, specifically of financial regulation.
It’s a pleasure to be here today to participate in this important discussion on the role of equities in the economy. I want to focus my remarks this morning on one aspect of this broad topic—the important role of the securities markets for retail investors.
Having been involved in securities markets regulation for the better part of 37 years, I have a great appreciation for the regulatory changes over the years that made the U.S. securities markets more accessible for retail investors. The 1975 Act Amendments to the Securities Exchange Act of 1934, which mandated the creation of a national market system, and the implementation of Regulation National Market System, or Reg NMS, in 2007, brought a variety of positive effects for investors and spurred a technological revolution that continues to this day. As a result of these regulatory changes, 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.
Investors today can pay as little as $4.99 for a stock trade and get instantaneous electronic confirmation. Compare that to 1975, when it would have cost an investor hundreds of dollars to buy 500 shares of a blue-chip company. Because fixed costs were the norm, an investor buying 100,000 shares of the same blue chip stock would have paid the same amount per share for the trade. The excessively high trading costs of the ’70s also meant retail investor participation in the market was a fraction of what we see today.
Since the 1980s the number of households owning equities—whether individual stocks or mutual funds—has increased significantly. Today, nearly 54 million, or 43 percent of, U.S. households own mutual funds, which represents a significant component of the savings and investments of many U.S. households. This growth isn’t all due to the regulatory changes. As companies have shed their defined benefit plans and shifted instead to defined contribution plans, consumers have assumed the greater responsibility for wealth building and retirement saving. According to the Investment Company Institute’s 2015 Profile of Mutual Fund Shareholders, between mid-2000 and mid-2015, assets held in mutual funds increased from $7.1 trillion to $16.1 trillion. And ICI’s 2015 Fact Book tells us that retail investors hold the vast majority—89 percent—of that $16 trillion in mutual fund assets.
Looking at these statistics we can come to one conclusion: the securities markets are of great importance for retail investors, and retail investors are important for the securities markets.
Now the questions posed for this event: “…what role equity markets can play for individual retirement security, small business investment and whether they can jumpstart American innovation culture by fostering the transition from startups to billion dollar companies” are exceptionally wide ranging and beyond my reach to deliver in a single talk. But they all begin with the fundamental question of whether the efficiency, flexibility and fairness of the equity markets is sufficient to encourage retail investors to participate directly and indirectly in the marketplace to a degree that supports continuous and diverse capital raising. It is this more narrow question that I will structure my remarks around.
Essential Elements of an Equity Market Structure
The only constant to describe the equity markets has been change. And when you examine the changes that have occurred as a result of technology and regulatory action it is breathtaking. The Securities and Exchange Commission, through enacting its Order Display Rule, Decimalization and Reg NMS made a momentous decision to increase competition, reduce barriers to entry and expand the interaction of orders. These changes also caused a shift from an environment where the NYSE and Nasdaq Stock Market accounted for the vast majority of equity trading and where single specialists or a relatively small number of market makers dominated price discovery to equity markets characterized by fragmented trading across a dozen or so exchanges, more than 40 Automated Trading Systems and a countless number of active traders who directly impact price formation. As I discussed earlier, the result has been a market, which, by classic statistical measurements, delivers the ability to handle vast amounts of trading volume at considerably lower cost to both retail and institutional investors.
And yet this “success story” is greeted with substantial concerns regarding the market’s lack of transparency, tendency towards periods of extreme volatility, allegations of unfairness and, finally, concerns of creating an inhospitable environment for smaller public companies. In the last few years, we’ve heard a lot about allegedly rigged markets. While I can assure you that the markets are not rigged, the concerns I described earlier raise valid questions about the structure of the markets.
Since it underlines much of the perception of unfairness by investors, let’s start with the concerns raised by extreme volatility, with the May 2010 flash crash operating as the logical starting point. I won’t spend time restating the specifics of the extraordinary volatility that day but instead focus on the conclusion that notwithstanding the positive impacts gained from a more competitive open-market structure in normal trading times, the flash crash demonstrated that the equity market when placed under pressure was considerably more fragile. The reason for this fact was not difficult to discern. In the previous centralized market environment, most orders travelled to a single market providing the specialist with the opportunity, when faced with a sudden imbalance of buy and sell orders, to call an immediate trading halt and effectively impose a new price setting auction before reinstituting continuous trading. This was not so easy in the highly electronic, fragmented environment in 2010.
While the majority of high frequency trading effectively employ market making and self-arbitrage strategies across the equity and derivative markets, they suffer from the limitations of algorithmic coding which generally avoids addressing extreme market volatility because of the risk of other market participants having access to superior market information. Accordingly, when market making algorithms encounter exceptional imbalances of buy and sell orders they tend to drop out of the market until a human trader concludes that it is safe to return. This creates effectively a vacuum in liquidity just when it is most needed.
Since the May 2010 flash crash, the SEC, FINRA and U.S. stock exchanges have implemented a variety of initiatives to minimize the impact of extreme volatility. These initiatives have created a multi-faceted safety net for the markets and are designed to promote investor confidence. Among the changes, regulators adjusted the market-wide trading pause, which gives market participants an opportunity to assess their positions, valuation models and operational capabilities when extreme periods of volatility occur.
On top of that, we implemented a limit up/limit down initiative, which addresses the type of sudden individual stock price movements that the market experienced during the flash crash. Under the plan, a limit up and limit down mechanism prevents trades in national market system stocks from occurring at prices outside of certain ranges. And if the changes in price are more significant and prolonged, the limit up/limit down plan would trigger a trading pause in that security.
We had an excellent opportunity to evaluate the effectiveness of these changes last August 24th, when the Dow plummeted more than 1,000 points within the first 10 minutes of trading. The events of last August illustrated not a market out of control, but the value of having appropriate controls in place. Were it not for the limit up/limit down procedures, the market fluctuations last August would have been more dramatic. There were more than 1,200 trading pauses that day, with more than 1,000 occurring in exchange-traded products, many of which were repeats in the same ETP. Clearly, the August events showed that refinements to these processes are serving a crucial function, but also showed that additional enhancements are necessary.
For example, while the index recovered a portion of the early losses, the extreme volatility raised questions about the operation of exchange-traded funds, and equities, more generally. One of the issues that day was the big gaps between the value of underlying indexes and the exchange-traded funds that track them. ETFs combine aspects of mutual funds and conventional stocks. They operate like a mutual fund by offering an investor an interest in a professionally managed, diversified portfolio of investments. Unlike mutual funds, however, ETF shares trade like stocks on exchanges and can be bought or sold throughout the trading day at fluctuating prices, whereas mutual funds are priced just once at the end of the trading day. On August 24th, unusual trading affected many of the major ETFs. While trading volume surged, public display of trading interest—or liquidity—dropped. And we saw pricing volatility in ETFs partially because of the conflicts between halts on the underlying stocks within the indices and the pricing of the index.
The volatility and the issues we saw with ETFs offer up a great opportunity for the SEC, with input from its recently formed Equity Market Structure Advisory Committee of which I’m a member, to take another look at the effectiveness of the initiatives put in place after the 2010 Flash Crash, as well as our market structure generally. Among the issues ripe for review are:
- the opening processes on primary listing exchanges;
- the operation of the limit up/limit down at the opening of trading, at re-openings after a trading pause and where the price is rebounding;
- the use of single market prices rather than consolidated prices for index calculations at times when the primary market opens outside its normal process;
- the use of stop orders, which become market orders when triggered and can execute at a price substantially worse than anticipated by the investor, particularly in volatile markets; and
- whether market maker quoting obligations are stringent enough to promote market stability.
Liquidity in the U.S. markets has thrived because of confidence in the markets, and investors need to be sure that markets will operate predictably. And it’s important for us as regulators to implement programs that minimize the impact of market volatility and to limit market disruption.
The second point I want to raise is market fairness. Investors must have confidence that they can access current, accurate, bona fide market prices that reflect true investor supply and demand.
Market structure must provide retail investors with accurate prices and low trading costs. Having been in this business for a long time, I’ve been part of many significant regulatory changes that have benefitted investors. It is critical that any equity market structure review focus on retail investor confidence. The Equity Market Structure Advisory Committee, of which I’m a member, also has been focused on that aspect of the markets and has been considering initiatives to protect investor interests and promote investor confidence. These initiatives include finding ways to provide more granular and meaningful information to investors and seeking opportunities to educate retail customers on things like order types and market volatility.
One of the concerns raised by the new market environment is whether information that is available from all trading venues allows investors to assess valuations in a timely and accurate manner, and enables regulators to investigate and analyze market events. FINRA has taken steps to enhance transparency in the markets.
Dark pools are one area where we have taken action. A substantial percentage of trading today takes place in dark venues, which are not transparent in many respects. For example, the orders placed in a dark pool are not displayed; and while a trade, once executed within a dark pool, is reported to the tape, the trading by an individual dark pool is not separately identified. So while dark pools have their place in the financial market ecosystem, subject to appropriate regulation, we are right to be concerned about their lack of transparency.
We have taken steps to increase market transparency of alternative trading systems, including dark pools. We currently make the volume and trade count information for equity securities executed in an ATS available on the FINRA website, and plan later this year to start providing additional data about the levels of block activity within ATSs. And starting this month, we will begin publishing the remaining equity volume executed over-the-counter by FINRA member firms, including the trading activity of non-ATS electronic trading systems and internalized trades. This information will be available free of charge to all users on FINRA’s website, and will help investors better understand a firm’s trading volume and market shares in the equity market.
Competition and regulatory changes have also led to a more complex, fragmented market. In today’s increasingly fragmented market, bad actors can consciously disperse their trading activity across markets, asset classes, and broker-dealers in an attempt to hide their footprints and avoid detection. It is part of our job at FINRA to monitor what’s happening in the market and ensure that the markets operate fairly.
It is absolutely critical that regulators have a bird’s eye view across markets. Through our agreements with exchange clients, FINRA monitors trading in 99 percent of the listed equity market and 65 percent of the listed options market. We have the ability to pull together data across exchanges and alternative trading systems to see one big, virtual market instead of a disjointed patchwork of individual markets.
We developed an innovative cross-market surveillance program that allows us to run dozens of surveillance patterns and threat scenarios across the data we gather to look for manipulation and frontrunning, as well as layering, spoofing, algorithmic gaming and other abusive conduct. This sophisticated surveillance allows us to detect activities that we were not 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 60 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, which will collect, identify and link orders, trades and quotes in equities and options from all market participants, would also go a long way toward improving the ability of regulators to surveil the market. Currently, regulators don’t have a single database with comprehensive and readily accessible order and execution data. Each regulator uses its own separate audit trail system to track information relating to orders in its respective markets. For its surveillance, FINRA must gather and merge large volumes of data from different entities to analyze market activity. A consolidated audit trail that functions on a near real-time basis would significantly enhance regulators’ ability to monitor and analyze trading activity. 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, regulators’ surveillance systems should be able to zero in on problematic trading, with the result being quicker and more exacting investigations that will better serve investors.
As the markets continue to evolve, there are several other lessons that we need to keep in mind. In particular, I would like to focus on the impact of decimalization and the minimum pricing variation in which securities can be quoted and traded, particularly because of the concerns that have been expressed that decimalization has contributed to the decline in IPOs in recent years.
Our market structure and regulatory framework often take a “one-size-fits-all” approach and apply to securities consistently no matter what the size, make up or growth stage of the underlying company.
Some of you may recall that not all that long ago, securities traded in fractions. During the late 90s and early 2000’s, the SEC, the exchanges and FINRA worked to phase-out fractional pricing and phase in decimal pricing. With decimalization in place, the SEC also established an MPV of one penny as part of Regulation NMS.
Since the move to decimalization more than a decade ago, the nature of trading, the structure of the markets, and the roles of market participants have changed significantly. There are concerns that the one penny MPV may have a detrimental impact on trading and liquidity of small- and mid-sized companies. Studies have raised questions regarding whether decimalization has reduced incentives for underwriters to pursue public offerings of smaller companies, limited the production of sell-side research for small- and mid-cap companies, and made it less attractive to become a market maker in the shares of smaller companies.
The SEC recently issued a report on decimalization, which was required by the JOBS Act. The study included a review of the academic literature related to the impact of decimalization on the U.S. equity markets. While the academic literature indicated a number of potential benefits from decimalization, such as an overall reduction in effective and quoted spreads, there was some evidence that, at least for some small cap stocks, the decline was not statistically significant. The academic literature also found, post-decimalization, evidence of a decline in quoted depth on average, smaller trade sizes, and an increase in the total time to work institutional orders. The SEC’s report also noted that the United States has a flat, “one size fits all” tick size regime, as compared with many foreign jurisdictions that have adopted tiered regimes where the tick size varies depending on the price level of a stock.
The SEC staff also held a Decimalization Roundtable with participation from a wide range of market participants, academics and others. While many of the panelists believed there were factors other than decimalization contributing to the decline in IPOs in recent years, there was broad support among the panelists for the SEC to conduct a pilot program to gather further information, particularly with respect to the impact of wider tick sizes on liquidity in small capitalization companies. While there was support for such a pilot, there also was concern that an increase in minimum tick sizes may raise costs for investors. Ultimately, the SEC concluded that legitimate questions have been raised as to whether the minimum tick size regime for the U.S. equity markets should be refined and mandated that there be a targeted short-term pilot program to assess whether wider minimum tick sizes for small capitalization stocks would enhance market quality to the benefit of market participants, issuers and U.S. investors.
In response to the SEC’s mandate, the exchanges and FINRA have implemented a National Market System (NMS) plan that requires wider quoting and trading increments for certain small-cap equity securities on a pilot basis. The criteria for the securities to be included in the pilot include a market capitalization of $3 billion or less, consolidated average daily volume of one million shares or less and a closing price of at least $1.50. The pilot consists of the three test groups of 400 securities each and a control group.
Test Group One securities must be quoted in five cent minimum increments, but may continue to trade at any price increment that is currently permitted. Test Group Two securities must be quoted in five cents minimum increments and can only be traded in five cent minimum increments. And finally, Test Group Three securities must be quoted and traded in five cent minimum increments and are also subject to a trade-at prohibition, whereby trading centers are not be permitted to execute an order for a pilot security at a price equal to a protected bid or protected offer unless one of the enumerated exceptions apply.
The Tick Size Pilot Plan also includes extensive data collection requirements to be used in evaluating the pilot, including data relating to market quality, market maker participation and market maker profitability. We will provide the data to the SEC and publish it on an unattributed and aggregated basis to make it widely available for research and analysis. The pilot goes into effect this October, with pre-pilot data collection already started this month. The pilot should provide meaningful and measurable data to determine whether wider minimum tick sizes for small cap stocks would enhance market quality to the benefit of market participants, issuers and U.S. investors including the effect of tick size on liquidity, execution quality for investors and volatility.
While I could talk about market structure all day, the concerns of investors obviously go way beyond market design. Equally damaging to healthy capital markets are the all too numerous industry compliance breakdowns that have harmed investors. Whether it be regarding the packaging of sub-prime mortgages, the marketing to retail investors of complex and illiquid products, the lack of transparency of many direct and indirect fees and the shocking efforts to manipulate a range of market indexes, these failures have lead investors and clients to question the industry’s commitment to put their interests first.
Now there has been an overwhelming regulatory response to these events, some of which FINRA has taken but ranging across Dodd Frank to the most recent inflection point of the DOL’s rulemaking regarding retirement plans. Whatever the effectiveness of these efforts, however, I think it is important to recognize that rules alone cannot address the very real challenges that financial firms have in ensuring that “good people” do not take actions that harm their clients and expose their firms.
Accordingly I want to take a minute to talk about the culture at broker-dealer firms. After nearly 40 years in the securities industry, I can say unequivocally that firm culture has a profound influence on how a securities firm conducts its business. And I’ve seen over the years how a culture that doesn’t value ethical behavior leads to failures for the firm and significant harm to investors. Some industry experts estimate that fines and litigation costs to firms, or their parent companies, related to cultural failures have totaled more than $300 billion since 2010.
It’s important that the securities industry embrace a culture that puts investors first. A culture that consistently places ethical considerations and client interests at the center of business decisions helps protect investors and the integrity of the markets.
FINRA has been focused on firm culture, conflicts of interest and professional ethics for some time now, and we think firms should also be paying keen attention to these related areas. In 2013, we issued a Report on Conflicts of Interest that highlighted some best practices. We’re also concerned about conflicts that a firm’s compensation system may create. Specifically, conflicts in the compensation area can impact the quality of advice provided to investors, especially to retail investors.
This year we began reviewing how firms establish, communicate and implement cultural values, and whether cultural values are guiding business conduct. We are looking at a number of factors, including how a firm communicates and reinforces values directly, implicitly and through its reward system. We are also interested in how a firm measures compliance with its cultural values, what metrics, if any, it uses and how it monitors for implementation and consistent application of those values throughout its organization.
In our reviews, FINRA will assess five indicators of a firm’s culture: whether control functions we value are within the organization; whether policy or control breaches are tolerated; whether the organization proactively seeks to identify risk and compliance events; whether supervisors are effective role models of firm culture; and whether sub-cultures (e.g. at a branch office, a trading desk or an investment banking department) that may not conform to overall corporate culture are identified and addressed.
We are only at the beginning of our review, so it’s premature to draw any broad judgments. However, we have observed that many firms are paying more attention to their culture and how they manage conflicts of interest. We continue to work with firms improve their focus on culture. And we will continue to work with firms to ensure the industry fully embraces a culture that puts investors first.
These interrelated areas show clearly how investor protections are interwoven with investor confidence. Investors must have confidence that activity in the market is transparent, protects investors from unnecessary excess volatility, and allows for a realistic assessment of value, liquidity and fairness. And they must have confidence that the professionals with whom they work are not putting their own interests ahead of their customers. So it is imperative that regulators and the industry continue to work together to strengthen these related areas to uphold the integrity of our financial markets, and rebuild investors' trust in the securities markets.