Remarks From the Financial Policy Joint Conference on Market Fragmentation, Fragility and Fees
Lead Director, FINRA Board of Governors
FINRA/University of Maryland Center for Financial Policy Joint Conference on Market Fragmentation, Fragility and Fees
Thank you, Jonathan, for that overly kind welcome.
It's always a treat to be at a gathering like this. One of the fine traditions of the investment business is how the cumulative effect of our work—the work of academics, regulators, and practitioners—has always been the driving force for evolution in market efficiency, effectiveness, and security. A conference like this is part of how that happens. You're here to discuss topics at the forefront of pressing issues affecting market integrity and investor confidence.
Tomorrow at lunch you'll hear from Rick Ketchum, the most experienced securities regulator in the business. He'll bring perspective from his and FINRA's dual roles as 1. the overseer of most of the U.S. equity market and, 2. the overseer of the broker/dealer community. Keeping the markets operating efficiently and protecting investors is at the heart of what Rick and his team do every day.
Tonight, I'm here to offer my insights from the perspective of the practitioner—the person who has spent a career in the markets and had the privilege of spending that career associated with what I consider the best investment management firm in the world. My views are not informed by the experience of trading securities all day, every day. Nor do I have the perspective of a hedge fund manager, whose time frames are minute by minute, day by day, week by week. Rather, my perspective is that of someone who's had the opportunity to serve people who put their first thousand dollars in an IRA, hoping and trusting that it will be safe and that it will be there, compounded many times over, years from now, when retirement comes. My perspective is that of someone who's served billion-dollar institutions that are trying to build financial security so that they can be part of the great engine that keeps economies strong and people employed, now and for generations to come. Simply stated, I take the long-term view. I take the holistic view—the view from 30,000 feet: How will the topics that you're researching and writing about and discussing affect that $1,000 IRA holder...that college endowment...that foundation...that pension plan—all these things that affect real people in their real lives, now and years down the road.
I'm also here to wish you all very fruitful discussions at this conference. Because what you do affects what we do. It always has. Just a few examples of academic theory that have had a profound impact on investment management will make that point readily clear:
1. Efficient market theory. It's been incredibly well-debated over time by luminaries like Paul Samuelson and Eugene Fama. It will be debated until the end of time. But much of the business that Vanguard is built upon...much of the business that is done today in the securities markets...is based on that efficient market hypothesis.
2. Options-pricing theory. This has had very practical applications. The work of Fischer Black, Myron Scholes, and Robert Merton has influenced so many things from investment strategies to corporate governance and pay.
3. The power of diversification. From Harry Markowitz to James Tobin, the simple concept of "Don't put all your eggs in one basket" is now commonly accepted practice when investors are putting their portfolios together. It's also been an underpinning of the growth of the mutual fund industry.
4. Behavioral influences. The contributions of Daniel Kahneman, Amos Tversky, Richard Thaler, and others about investor behavior have led directly to innovation in retirement plans—think auto-enrollment...and single-fund choices—think target-date funds. Again, affecting real people in their real lives. We have empirical evidence that these things increase participation in retirement plans. They are helping millions of people be more financially ready for retirement.
Impressive and transformational work.
So I'll leave that academic work to you. I'll leave the pure regulatory commentary to Rick tomorrow, although you'll hear a bit of that from me as well. One of the great privileges I've had in my career is being deeply associated with FINRA and the NASD before it—as well as serving on panels and commissions for the SEC and CFTC—so I have had the opportunity to participate in and see up close what engaged, responsible, and thoughtful regulation can to do ensure the integrity of the markets and the confidence of investors.
I'm going to base my remarks to you today on 5 strongly held beliefs of mine:
- The markets are not rigged.
- You can't reverse technology and speed.
- The benefits of market evolution for investors are stunning.
- "Outlaw high-frequency trading" is an imperative that makes good headlines and no sense.
- Sunshine is the best disinfectant.
So, let's jump in.
1. The markets aren't rigged.
I'll start out by addressing one bit popularized by one of my favorite authors, Michael Lewis. I'm sure most of you have seen clips of him discussing his book "Flash Boys," about high-frequency trading, where he announces that the markets "are rigged." It's a great way to promote a book, but I can tell you from somebody who's been around the markets for three decades plus, his hyperbole is just plain wrong. The markets are not rigged.
That's perhaps the most important message that a practitioner like me can share with you. Now, are there reasons that one can impute that investor confidence is challenged? Absolutely. There are lots of theories, but I can ascribe confidence issues to two demographic reasons, neither of which has to do with individual investors thinking the markets are rigged.
I'm in the cohort of the first reason: 60 years old now; 28 years old in 1982. Just out of grad school, starting a job in the investment business at Vanguard. And the universal IRA came along. The universal 401(k) came along. And for the next 18 years, it's a bull market...in stocks and in bonds...in U.S. markets and in non-U.S. markets. So my generation was raised in an extraordinarily favorable investment environment. As the 20th century neared its close, we could be excused for assuming that returns would always be double-digit and nearly always positive.
One of my favorite stories that I tell around Vanguard is that even when the markets were so good, in our regular communications to shareholders we'd say, "Don't be lured into complacency by spectacular short-term returns. Think long term." Then, in 1999, I received one of my more memorable pieces of correspondence from a client—a sincere but skeptical shareholder letter that started out:
"Dear Mr. Brennan, I really appreciate Vanguard's philosophy. I love the fact that you think long term, and that you preach to us to be cautious and think long-term. Could you please explain to me what is long term? 5 years? 10 years?15 years? And why shouldn't I think that stocks would return 15 to 18% a year [they've actually earned 20%], because 15 years MUST be long term."
Well, whether 15 years was long term or not, after an 18 year bull market, my correspondent, like millions of others in her generation, then had meaningful money at work—and at risk—when the lost decade of returns in the new century occurred. In fact, if you had invested, say, $2,000 in your IRA each year and $5,000 in your 401(k), and it was invested in the stock market (a common, admittedly aggressive asset allocation for investors with nearly 40 years until retirement), your nest egg would have been $850,533 by the end of 1999. You would then have lost $301,703 in the next three years.1 That's a 35% drop in your balance; and it certainly seems like a fortune to someone who was really a good "saver," rather than an investor. It's easy to see why your confidence would be low.
Fast forward to a new generation, who joined the workforce and began investing in the new century. It's not a pretty show:
- They begin with an excruciating bear market.
- They get out of that bear market, and things are moving along pretty well. Then they get the worst bear market and the worst financial crisis in since the Great Depression.
- Things start to get a little better, we get the bottom of the stock market about 18 months in the rearview mirror, and the Flash Crash happens. Can we understand why a new generation of investors may have a lack of confidence in the market? It's just as justifiable as my generation who watched their hard-earned nest eggs collapse from the NASDAQ bubble to the end of this century's first decade.
Market situations and environments are the best determinant of investor confidence. Investor confidence has little to do with a sense of the markets being rigged. Most investors trust their investment managers to worry about such things.
2. You can't reverse technology and speed.
I try in my public endeavors to avoid three topics:
- politics—we're in Washington (I always love to avoid politics)
- religion (That's a no-win)
- and sports
But I'm going to use a sports analogy here for you. It's used when evaluating talent. It's very simple...and very true: You can't teach speed. You can wish for speed, you can wish for height, but "wishin' ain't gettin'." I can wish to run the marathon in 2 hours and 6 minutes and win the Olympics in Rio de Janeiro two years from now. But, sadly, it won't happen.
Paraphrasing that personnel evaluation technique, this axiom is just as true: You can't reverse technology and speed. You can't reverse speed in the markets. You can't reverse the advantage of time, place, and technology. Much of the flawed premise about the markets being rigged has to do with this idea that the rapid progression in speed that comes with advances in technology is a.) new (it isn't) and b.) unfair (it's not that either.) You can wish to prohibit or reverse technological advances that beget competitive advantage, but wishing is about all you can do.
The idea that one can ignore technological advances and intellectual advances driven by practitioners' work or academics' work is fallacious. You can wish for it, but it's not gonna be. It's very important to understand that—people in the markets understand it; the popular press does not—you can't reverse technology and speed.
3. The benefits of market evolution over time for investors are stunning.
What gets ignored in the fuss and noise about speed and technology is this: The benefits of market evolution for investors are stunning. So much secular good has occurred because of speed...because of technology...because of regulatory and structural changes in the markets over the last two decades. Those benefits sometimes get lost in all the shouting about this event or that event; this business strategy or that one.
Perhaps the biggest benefit of all is how much money that used to go to intermediaries now accrues to investors—remaining in Vanguard clients' pockets and in their IRAs and 401(k)s—and at Fidelity, and T. Rowe Price, and so many other places. I don't mean because of declining management fees on funds. I mean because of the rapid and permanently lower transaction costs in our security markets.
- A great example of this is the work FINRA has done in the fixed income markets, with TRACE—Trade Reporting and Compliance Engine. It's a platform where all broker/dealers who are FINRA member firms must report transactions in corporate bonds. It was highly controversial, reviled by Wall Street when it was put into place in 2002. Yet the proof is in the pudding, so to speak: According to academic research, it has saved the fixed income investor billions of dollars in transaction costs. In fact, in a meeting one day, one of my good sell-side friends in the industry heard that number. He looked at me and, speaking for his firm, said, "That was OUR billions of dollars." As a committed buy-side guy, I view it as actually our clients' billions of dollars.
- Less well known is what's gone on in the equity markets. At Vanguard, our transaction costs across sectors and countries in the equity market are down 80% since the turn of the century. An 80% decline in costs in 14 years! You think about how much money gets put to work at a firm like Vanguard every day...every week...every month of the year. Multiply that times what it costs to put the money to work, and 80% of what used to go to the intermediary now goes to that person in his IRA or to that endowment...that foundation...that pension board. It's a stunning change. Driven by technology. Driven by speed.
All of that, in my view, is a critical part of why the premise that "markets are rigged" can be so damaging. It can be damaging because policy makers and regulators could accept it as truth. It is not truth. Markets have changed, markets have evolved, markets are more competitive, markets are arguably less forgiving—but they are not rigged.
Advances in technology and speed are not popular when a flash crash happens, or when markets go down by 40 or 50% as they did in the global financial crisis. But that is part and parcel of what happens in markets. Aberrations occur. Bear markets occur. But that's just the natural flow, and that's one of the reasons capitalism works the way it does. Never forget that the major beneficiaries of what's happened in this evolution, whether it's structural with many different trading venues or it's tactical in the way trading occurs, are the end investors. They are you and me and millions like us.
4. "Outlaw high-frequency trading" is an imperative that makes good headlines and no sense.
Now, I don't mean to be Pollyanna about these advances. There are things that can be improved in the structure and in the oversight of the markets.
First up—trading venues. We have nearly 50 trading venues today in the markets. That creates fragmentation. In my opinion, that's simply too many. There are rules which encourage proliferation of trading venues, but the marginal utility of so many trading venues is close enough to zero that one wonders why they exist.
It's in that vein that I applaud Chairman White of the SEC when she says that she wants to look at market structure, the number of venues, the nature of those venues, and why that many exist. It's an incredibly worthwhile endeavor to ensure that the progress in the markets continues without the downside of fragmentation and, as we've seen now and again, the opportunity for organizations to take advantage of their clients instead of enrich their clients.
The whole market structure issue is one that will play out over an extended period of time, I suspect, built on the good that came out of a national market structure—Reg NMS—and enhancements that can be made to learn from our nearly decade long experience with this regime.
High-frequency trading is, of course, another area that can certainly bear some scrutiny. The more breathless discussions about high-frequency trading being by definition bad remind me very much of another era, a couple of decades ago, when the term "derivative" was seen as synonymous with"speculative" and therefore bad. The most articulate way of fending off that presumption that I ever heard was when an older friend of mine said, "You know what the first derivative was?" I said, "No." And he said, "Money." Money is a derivative. Cash is a derivative. That piece of paper in your wallet, that one-dollar bill, is a derivative. It has no inherent value unto itself. But it is a very effective demonstration tool in a meeting when there's a little hysteria about "derivatives."
HFT has, in many ways, a similar reputation. It is presumed that somehow bad guys are doing bad things. Here's the reality: There will always be bad guys in the market...and they should be driven out of the business. But, the dominant majority of high frequency traders are not bad guys. In fact, the advent of HFT is a key reason that trading costs at a firm like Vanguard have declined by 80%. It's because these trading organizations, using technology and speed, have come in to replace less efficient, less effective, higher-cost systems for making markets.
You hear people say, "Outlaw high-frequency trading!" But it would be darn hard to do. It's generally accepted that high-frequency trading comprises 50% of market volume. If you pulled 50% of market volume out of the markets today, think about what that would do to liquidity and trading costs to the people who a firm like Vanguard serves.
Remember the analogy to derivatives. Our markets wouldn't work without derivatives. Yet after the crash of '87 when portfolio insurance, which was a derivative-based system, blew up, all derivatives were tarred with the same brush. It would be a body blow to the markets if high-frequency trading met with a similar fate. "Outlaw high-frequency trading" is an imperative that makes good headlines...and no sense.
Are all high-frequency traders creating beneficial net impact? No. Are there challenges in the high-frequency-trading area? Absolutely. Regulators like FINRA find them, root them out, stop them, and penalize them. Many of the current trading strategies are no different, really, than traditional trading strategies. It's just that now they're faster and technologically driven. Other strategies have come along—momentum ignition or quote spoofing or excess wash sales—that would benefit from scrutiny. Do they meet the letter of the law? I don't know—that's for Rick and his team to answer—but they clearly violate the spirit of the law. The ones that are merely enhanced versions of what's been going on since the Buttonwood Agreement of 1792 should be encouraged. They create value. Those that create discontinuities or worse in the markets should be eliminated.
5. Sunshine is the best disinfectant.
Let me finish up this evening with a couple of ideas for solutions. The markets are not rigged. Speed and technology are here to stay. They've created stunning benefits for investors. Outlawing high-frequency trading makes no practical sense. But there are these problems that I've talked about. Occham's Razor might be the best tool we have. I believe that simple fixes could probably shrink the number of venues and reduce some of the confidence challenges in the market. One of those fixes could be, simply, the pure light of day. I'll share with you my preference for three priorities for attention from regulators with an eye toward the goal of simplification. None of them is revolutionary, but they're important nonetheless.
The first one would be to create a Trade-At rule, which would encourage better competition between exchanges and dark pools and other nontraditional trading venues. It would make internalization strategies compete with truly open market trades. And, it would add breadth and depth to the information the market has about order books throughout the system.
The second fix would be to alter what appears to me to be a flawed incentive system in the maker-taker pricing scheme that exists. Right now the 11 exchanges are allowed to charge a maximum fee to transact against posted bids and offers. They can also pay a maximum rebate to those who post bids and offers. The issue is that these pricing schedules are all over the place...and this creates complexity, inefficiency, and poor incentives for brokers and exchanges. There has to be a simpler way to allocate orders.
The third area to address is the availability of data to all market participants. There has been much discussion about the direct market data feeds provided by the exchanges. These proprietary data feeds provide certain market participants with a snapshot of the markets moments before the same information is disseminated more broadly through the consolidated market data feed—the "SIP." The structure should not create the appearance of an informational advantage. Market participants who choose to invest in technology to act on market data faster than others are not the issue. Rather, it is the unequal access to information that raises the appearance of an unfair market. Regulators' attention to improving the integrity and resiliency of market-wide data feeds must be a top priority.
Many of the challenges in our current market structure and practices bring to mind the words of Justice Louis Brandeis, who wrote in 1913, "Sunlight is said to be the best of disinfectants." It still is, 101 years later. Maximum transparency, and ready and fair access to quality information, are the keys to ensuring that markets work best. Whether it's a trade-at rule that would force firms to show the breadth and depth of their order book...or whether it's consistency in the speed of information flow for publicly available data feeds—those kinds of things create transparency...bolster confidence...and create more efficient, effective, and low-cost markets.
And that is what I see as the mission of that powerful triumvirate of academics, regulators, and practitioners: to maintain, improve, and safeguard financial markets for all investors everywhere who rely on those markets for their financial well-being. It is a lofty mission worthy of all of our best thoughts and efforts.
Thank you all for your attention. Here's wishing you every success in your discussions tomorrow and in all of your academic endeavors.
1 Example assumes that contributions were made at the beginning of each year, with 100% invested in equities. A portfolio comprised of 60% equities/40% bonds would've totalled $579,156 for the period 1981-1999 and would've lost $56,718 in the ensuing bear market (1999-2002). The 60/40 example assumes that the portfolio was rebalanced annually. In the examples, stocks are represented by Wilshire 5000 Index; bonds by Barclays Capital U.S. Aggregate Bond Index.