SEC Equity Market Structure Advisory Committee
Securities
and Exchange Committee
Equity
Market Structure Advisory Committee meeting
Tuesday,
February 2, 2016
Key
Topics & Takeaways
-
August
24th Highlighted Various Structural Concerns: Committee members
and panelists highlighted that the causes of August 24th were the
result of a confluence of various factors, both external and structural. The
structural issues highlighted included the lack of pricing information,
uncertainty around clearly erroneous rules, and disparate re-opening auction
procedures following a limit up-limit down trading halt.
- Evaluate Market
Mechanisms Rather Than Ban Certain Order Types: Mecane argued that it
is preferable to design a Limit Up-Limit Down (LULD) mechanism in a way that
can withstand selling pressures, rather than banning specific order types used
by investors. He suggested that additional “behavioral protections” could
be layered on top of market mechanisms. Committee members were mainly in
agreement that improving investor education regarding the risks of using
certain order types, particularly market and stop orders, is needed.
-
Payment for Order Flow vs. Internalization: Committee members
highlighted their concern that payment for order flow and internalization while
related, are often conflated as one. Committee members were in agreement
regarding the quality of execution that retail investors receive and supported
improved disclosure through standardized reporting and investor education.
Speakers:
-
Mary Jo White, Chair
- Kara Stein, Commissioner
- Michael Piwowar, Commissioner
- Daniel Gray, Division of
Trading and Markets
- Stacey Cunningham,
Chief Operating Officer, NYSE
- Hubert De Jesus, Co-Head Market Structure & Electronic
Trading, BlackRock
- Frank Hatheway, Chief
Economist, NASDAQ
- Paul O’Donnell,
Managing Director, Morgan Stanley
- Members of the
Equity Market Structure Advisory Committee
Opening
Remarks
In
her opening
remarks, Chair White explained that the Equity Market Structure Advisory
Committee will consider issues surrounding market volatility on August 24th,
2015 as well as a number of issues affecting retail and institutional
customers, including how certain order types used by customers operate, payment
for order flow, and execution quality and order routing disclosure. White
pointed to the Commission’s research
note on the equity market volatility on August 24th, which she
explained examines the opening and re-opening auction processes, performance of
exchange-traded products (ETPs) during market volatility, and the operation of
the limit up-limit down (LULD) pilot on a day with market-wide
volatility.
White
foreshadowed that the Committee would discuss the use of certain order types by
retail investors which may present risks to investors particularly during
periods of market volatility. She also explained that the Committee would
examine payment for order flow, which she said “does not necessarily violate [a
broker’s] best-execution obligations” but “raises the potential for conflicts
of interest.” White signaled that Commission staff is working on a
rulemaking proposal to “enhance transparency of the order routing practices of
broker-dealers for institutional investors.”
Finally,
White noted that the four recently-launched subcommittees under the Committee
would provide a status update on their work on Reg. NMS, trading venues,
customer issues and market quality.
Stein
underscored the importance of the issues under consideration by the Committee,
including the lessons learned from the extraordinary market volatility on
August 24th and issues affecting investors, particularly retail
investors in the current equity market structure. Stein underscored the
importance of launching the Consolidated Audit Trail (CAT), noting that it is
“years behind schedule” and that there is “no greater task” before the
Committee is to get it off the ground.
Regarding
equity market volatility, Stein explained that “investors and issuers need to
be able to count on the effective operation of [U.S. equity] markets in times
of stress.” She argued that stop orders, execution quality reporting, and
payment for order flow arrangements all affect “investor confidence” and
expressed her “deep concern” about certain order types being used by retail
investors during the market volatility on August 24th. Stein
closed by expressing specific interest in whether retail investors are
“uniquely disadvantaged” in some way by the current market structure.
Michael Piwowar, SEC Commissioner
Piwowar
underscored the importance of the Commission’s ongoing review of U.S. equity
market structure, and he claimed that the SEC staff’s research note reveals
there is “room for improvement” in the market volatility mechanisms, which he
argued makes an “excellent jumping off note” for the Committee’s
deliberations.
Daniel
Gray, Division of Trading and Markets
Gray
summarized the Commission’s research note and highlighted areas where the
volatility mechanisms on August 24th differed from the flash crash
of 2010. Gray explained that there were “significant issues” experienced on
August 24th, including issues with the opening auctions on primary
listing exchanges, breakdown in arbitrage of ETPs, a LULD process that did “not
seem to work very well,” and significant imbalances in the reopening auction
that the market could not handle.
Stacey Cunningham, Chief Operating Officer,
NYSE
Cunningham
encouraged the Committee and SEC to explore the interconnected nature of
individual issues being addressed by the subcommittees, and to undertake
comprehensive equity market structure reform that takes into account how market
participants will change their behavior in response to policy actions.
Cunningham explained that NYSE retained McKinsey to assess events on August 24th,
which she explained led to NYSE’s proposals in its paper
on equity market structure issues.
Cunningham
summarized several factors that she said contributed to the market volatility
on August 24th, including: (i) market uncertainty as to whether a
market wide circuit breaker would be triggered; (ii) uncertainty for market
makers as to whether they would be able to hedge their positions; (iii) concern
that trades could be busted under clearly erroneous rules,; (iv) risk
management systems that pulled many market makers out of the market briefly;
and (v) opening and reopening procedures that “hindered timely and transparent
openings.”
Cunningham
claimed that “it was a conscious policy decision to adopt a fragmented marketplace,”
and while she noted that market resiliency is a benefit of a more fragmented
marketplace, she argued that “liquidity isn’t free” which is the downside of
fragmentation. Cunningham explained that exchanges are more dependent on
voluntary liquidity providers than ever before. She made several
recommendations, including: (i) renewing focus on investor education
(particularly on the risk of using certain order types); (ii) LULD refinements
to improve price discovery during market-wide volatility events; and (iii)
enhancements to NYSE ARCA rules and procedures to improve transparency and
enhance the automated opening process. She noted that NYSE has already widened
the reopening auction collars and is actively making changes to automatically
extend trading halts.
Hubert De Jesus, Co-Head Market Structure
& Electronic Trading, BlackRock
De
Jesus noted that BlackRock is a strong advocate for market structure changes,
as evidenced by its viewpoint
on August 24th. De Jesus explained that market
participants need valuation clarity especially during times of market stress,
and argued that inconsistencies between erroneous trade guidelines and the LULD
trading bans in a volatile market diminished certainty of execution. De Jesus
recommended addressing the lessons learned from August 24th by
making several market structure rule changes, better educating investors about
how certain order types behave in market volatility and illiquidity, having a
more proactive dialogue between market participants, and harmonizing trading
rules across the entire equity market ecosystem. De Jesus lent support
for revising LULD rules to consider revising price bands at opening auctions,
recalibrating the length of the limit state, and harmonizing reopening
procedures across exchanges to maximize liquidity and minimize imbalances. He
further suggested that there is “value” in considering whether market wide
circuit breakers should have been invoked on August 24th.
Frank Hatheway, Chief Economist, NASDAQ
Hatheway
suggested that the Commission consider how any of its rule changes will
interact with other independent actions being taken across the industry in
response to August 24th. He also suggested simulating market
structure changes in order to lower both the costs and risks associated with
making such rule changes.
Hatheway
summarized several factors that he argued worked well on August 24th,
including market infrastructure and technology, plans operated by the self-regulatory
organizations (SROs), market data feeds, routing to major trading centers,
among other things. He also explained that the new market mechanisms
(such as LULD) performed as designed, even though that does not mean it “worked
as intended.” Hatheway criticized a “one size fits all” response to
August 24th, and explained that he does not support exchanges being
forced into the same opening and reopening processes. He further
cautioned against eliminating SROs’ authority, noting that erroneous executions
can occur in a variety of “unique” and “extraordinary” circumstances.
Paul O’Donnell, Managing Director, Morgan
Stanley
O’Donnell
stated that there is no single cause and no simple fix to the equity market
structure issues that led to volatility on August 24th. He
noted that pricing mechanisms did not function as expected, which led to
pricing dislocations, and he urged market centers to make changes to allow
liquidity to enter during market stress. O’Donnell claimed that the
market volatility mechanisms worked “as designed” but the state of the global
equity markets impacted trading and pricing in the U.S. O’Donnell noted that
since NYSE invoked Rule 48, there was no public dissemination of imbalance data
outside of the trading floor, and he argued that this adversely impacted the
willingness of market participant to provide liquidity since they had “little
to no information” on which to base pricing decisions.
O’Donnell
argued that exchanges should publish imbalance and indicative prices as widely
as possible in order to attract liquidity, and that auctions should wait to
find a reasonable clearing price at which such imbalances should be offset.
O’Donnell offered several recommendations, including: (i) widening the collar
to help find a market clearing price; (ii) slow auctions with large price moves
to allow market participants to source additional liquidity; (iii) the
securities information processor (SIP) should publish trading bands and
reopening indicators simultaneously; (iv) regulators should analyze non-public
data to determine liquidity taking on the morning of august 24th;
and clearly erroneous rules should be amended to LULD process so that all
trades executed in bands will stand.
Committee Discussion
Importance
of Stop-Loss Orders to Retail Investors
Jamil
Nazarali, Senior Managing Director & Head of Execution Services highlighted
the importance of stop-loss orders to retail investors, and claimed that they
work well most of the time. However, he suggested that there should be
more investor education around stop orders, including for financial
advisors.
Amending
Reopening Process after LULD
Joseph
Mecane, Managing Director, Barclays suggested tweaking rules to eliminate
re-opening auctions after the LULD mechanism is triggered. He suggested
implementing floating bands that readjust periodically to absorb the impact of
big imbalances as a result of trading pauses and halts in the market. In
limit states, market seems to recover and liquidity seems to stay more active in
a limit state than it does around the pauses. Tweaks may work but
question whether there is a more efficient way for mechanism to work without
stopping the market.
Eric
Noll, President & CEO, Convergex Group, agreed that the reopening auction
is not performing the way it should. He explained that the purpose of
LULD is to stop flash crashes in individual securities, but that the auction
process is not a necessary component. Rather, Noll argued that it is necessary
to give people time to reassess what the fair trading value is and allow them
to trade freely at that price.
Nazarali
explained that a main inhibitor of market corrections is that the LULD often
limits trading repeatedly in a security. He suggested that the trading
bands be widened to allow a security to recover after a steep decline in its
price.
Harmonized
vs. Adjustable Trading Bands
Stephen
Luparello, Director of Division of Trading and Markets, asked whether it was
preferable to harmonize trading bands or have wider bands around the opening
and re-opening process than throughout the day. Cunningham suggested that
stocks that have triggered a LULD trading pause during double-wide bands be
allowed to recover more easily than others. De Jesus argued that it makes sense
to have trading bands that are “simplistic in nature” rather than fluctuating
throughout the day to ensure certainty.
Access to Imbalance Information
Cunningham
explained that NYSE started publishing imbalance information after 9:35 a.m. in
October 2015, as well as a price range that is broader than the indicative
opening price would be when a security is going to move with the boarder
market. However, on volatile days, she explained that the exchange lifts those
market protections because the broader market is moving.
Cunningham
further explained that mandatory indications – such as the price range at which
the exchange is looking to open – are published through the SIP. However,
the automated imbalance information (with more specific pricing information)
goes out through proprietary exchange feeds.
Mecane
argued that it is preferable to design a LULD mechanism in a way that can
withstand selling pressures, rather than banning specific order types used by
investors. He suggested that additional “behavioral protections” could be
layered on top of market mechanisms.
Customer Issues
Michael
Coe, Office of Market Supervision, Division of Trading and Markets
Coe
summarized the Division of Trading and Markets memorandum that focused on key
issues affecting customers in the current equity market structure. Notably, Coe
highlighted the risks of market order and stop orders, providing that while
such orders are very popular with retail traders, such order types can present “significant
risks,” especially during periods of market volatility. Coe provided an
overview of payment for order flow arrangements, in which cash payments are
provided by over-the-counter (OTC) market makers to retail broker-dealers in
exchange for retail marketable order flow, noting that rather than prohibiting
the practice, the Commission prefers a disclosure-based approach. Lastly, Coe
discussed execution quality reports and provided that while institutional
orders are not included in Rule 605 and 606 reports, the Commission is
currently working on a rule to address this.
Jeffrey
Brown, Senior VP-Legislative & Regulatory Affairs, Charles Schwab
Brown
noted the Schwab’s motto is to look at issues through our “clients’ eyes”.
Brown stated that Schwab clients use market and stop orders and that
“two-thirds” of the time, Schwab is a “market order shop” Brown stated that the
market order itself is not a problem, it is their usage that can be
problematic. Accordingly, Brown highlighted that client education is important.
Brown further noted that stop orders have a use, as that most individuals do
not sit in front of a trading screen all day. Brown acknowledged however that
they are typically triggered as the market is falling, and this is “not a
recipe for good execution”. Brown reiterated the importance of educating retail
investors with respect to the usage and risks of market and stop orders.
Brown
discussed payment for order flow arrangements and noted that the Division of
Trading and Markets memorandum lacked a key detail how such arrangements
developed, notably the inadequate execution of retail orders on the national
securities exchanges, which resulted in the development of systems to provide
better execution to retail clients. Brown stated that this structure has
“blossomed into a competitive market structure” for better market quality, with
retail investors “receiving better execution quality than ever before”.
Brown also noted that Schwab retail clients typically on average receive better
than the midpoint, and that Schwab looks to mitigate conflict of interests by
limit the range that is paid per share and that routing is based on execution
quality, not the payment received for order flow. Brown stated that
payment for order flow allows Schwab to maintain “world class systems and
services” for their clients and that he believes that such arrangements have
provided real value to customers.
Frank
Childress, Managing Director, Wells Fargo Advisors
Childress
noted that the Division of Trading and Markets memorandum was very balanced and
that retail investors have “never had it better.” Childress stated that the
memorandum correctly lays out the concerns with respect to market and stop
orders, in that they occasionally “don’t work as intended” Childress stated
that education is the primary tool to address these concerns and that
eliminating stop orders would eliminate investor choice.
Childress
stated that Wells Fargo retail broker-dealer does not accept payment for order
flow. Childress noted however, that while the memorandum correctly indicates
that the rates paid for marketable retail order flow has historically
increased, since 2015 such payments are no longer “trending up.” Childress
stated that any suggestion to pass the payment on to investors would be
complicated and difficult to validate. Rather, Childress suggested that the
preferred solution is to enhance disclosure. Lastly, Childress provided that
Wells Fargo is strong supporters of execution quality reports and that 605
reports “need to be updated.”
Dennis
Dick, Member – Capital Markets Policy Council, CFA Institute
Dick
highlighted that August 24th, 2015, was an isolated event, with many
large cap stocks falling more than 10 percent. Dick questioned how the industry
could better protect individual investors in times of market stress. Dick
stated that eliminating or restricting market and stop orders could result in
additional problem, and that additional education is needed.
Dick
expressed his concerns with the increasing amounts of off-exchange trading and
“nominal price improvement”. Particularly, he stated that there is an
unquantifiable cost of missed trading opportunities for limit traders when
retail order flow is internalized or executed by OTC market makers. Dick
outlined three policy considerations, specifically: (1) requiring that
OTC market makers provide meaningful price improvement; (2) enhancing order
execution statistics; and (3) accompanying any requirement to increase routing
to exchanges with a reduction of access fees.
Christine
Parlour, Professor of Finance & Accounting, Haas School of Business, UC
Berkeley
Parlour
asked two central questions with respect to payment for order flow
arrangements: (1) whether commissions make retail investors better off; and (2)
what a world would look like without payment for order flow. Parlour stated
that payment for order takes valuable order flow, removes it from the market,
which in turn results in other market participants who provide liquidity, to
have “less incentive to compete aggressively.” Parlour stated that if payment
for order flow was not in the market, “spreads would be tighter and more robust
liquidity provision”.
Committee Discussion
Payment for Order Flow vs. Internalization
Nazarali
stated that he believed that payment for order flow and internalization as
concepts were being conflated. Nazarali noted that nearly all retail
broker-dealers send their order flow to wholesalers, regardless of payment for
order flow arrangements, due to better execution that their clients receive.
Nazarali stated that if you were to ban payment for order flow, firms that have
an integrated model will have an advantage and it would generally be less
transparent. Nazarali noted that “investors have a choice” and they can choose
to go with a firm that accepts payment for order flow or a “full-service firm
that does not.”
Mecane
agreed that the concepts are interrelated, however the remedies are different
between the two. Mecane noted that there is “no clear answer” as to whether the
benefits to retail investors outweigh those for other market participants. Noll
stated that he does not believe one class of investors deserves more price
improvement than any other class of investor. Kevin Cronin, Global Head of
Trading for Invesco, noted that the focus should be on “long-term investors.”
Matthew
Andresen, co-CEO of Headlands Technologies, agreed that these were two separate
issues. He stated that if payment for order flow were removed, participants
would still not likely see the order flow, as retail broker-dealers route to
the venues or participants that “provide the best execution.” He noted that
access fees on an exchange and the total cost of execution can be much higher
than payment for order flow or internalization. Lastly, Andresen noted that in
the event of calamity, “brokers provide protection to their clients” and
“exchanges are not in this business.”
Payment
for Order Flow and Innovation
Reginald
Browne, Senior Managing Director and Global Co-Head of the ETF Group, Cantor
Fitzgerald & Co, stated most retail firms reinvest the money received from
payment for order flow arrangements back into their trading platforms. He noted
that those that do not tend to have higher cost of access, and be stated that
the industry does not want to reduce competition or innovation, even if such
innovation is dependent on payment for flow to bring it to the market.
Performance
of Non-Payment for Order Flow Firms vs Payment for Order Flow Firms
Mehmet
Kinak, Vice President, Global Equity Market Structure and Electronic Trading,
T. Rowe Price, posed the question to Childress if firms that did not receive
payment for order flow received better execution quality than those that did.
In response, Childress stated that based on publically available data, those
that do not receive payment for order flow have marginally better execution
statistics.
Mandatory
Minimum Price Improvement
Maureen
O’Hara, Cornell University, highlighted that concepts such as mandatory price
improvement seem “sensible in the real world,” however their actual application
is much different in practice. For instance, O’Hara noted the negative impact
that has resulted in Canada with similar requirements. Lastly, she noted that
while we may not like payment for order flow, on balance “retail is doing
better.”
Conflating
Order Flow With Mental State
Noll
provided that he believed that participants were conflating uninformed order
flow with mental state. He noted that retail investors are fairly
sophisticated, and that while there order flow may be “uninformed,” this does
not mean retail investors are not sophisticated.
Enhanced
Disclosure
Nazarali
and Mecane were in agreement that to address conflicts, one option to be
considered would be to enhance Rule 606 disclosures.
Mark
Flannery, Director and Chief Economist, Division of Economic and Risk Analysis,
Securities and Exchange Commission, asked whether any of the panelists report
the payment received back to the client following execution. Brown stated that
clients are noted that payment for order flow may have been part of the
transaction, however due to the payments information only available at the end
of the month, disaggregating it per transaction is difficult since it is not
known at the time.
Manisha
Kimmel, Chief Regulatory Officer – Wealth Management for Thomson Reuters,
wondered whether there have been any efforts to bringing Rule 605 style
reporting to retail brokers. In response, Brown stated that his firm has been
providing this information for years and is currently working with other firms
to enhance these disclosures. Childress noted however that there would be a
“significant burden” to develop this information, however he believed that his
firm would “fair well in comparison”
Non-Marketable
Limit Orders
Brown
in response to a question by Kinak, stated that non-marketable limit orders are
routed to a market maker, which in turn is posted to the primary listing
exchanges and BATS. Kinak stated that increased disclosure of the performance
of such order types on the exchanges is needed.
Investor
Education
Chester
Spatt, Carnegie Mellon, was curious as to the importance of education,
specifically what to the panelists do currently. Brown stated that his firm is
working on developing warning screens and that an explanation of order types is
available on their website.
Subcommittee Reports
Kevin
Cronin, Chair, Regulation NMS Subcommittee
Cronin
stated that the subcommittee is focused on developing practical and sensible
recommendations on the areas under review including access fees, market data,
and Rule 611. Cronin provided that the subcommittee is focused on ensuring the
a broad range of interested constituents are included in the dialogue,
including retail investors, market makers, as well as the large exchanges, such
as NYSE and NASDAQ.
Eric
Noll, Chair, Market Quality Subcommittee
Noll
provided that the subcommittee has held two meetings thus far, and he indicated
that speaking invitations have been extended to the large exchange groups. Noll
noted that the subcommittee is utilizing the August 24th events as a
starting point, with a focus on opening auction procedures, LULD harmonization
with clearly erroneous rules, and market maker benefits and obligations. Noll
stated that the subcommittee is anticipated providing a recommendation to the
Equity Market Structure Committee by the April 2016 meeting.
Richard
Ketchum, Chair, Trading Venues Regulation Subcommittee
Ketchum,
Chairman and CEO of FINRA, stated that the subcommittee has held two meetings
thus far, and that its primary focus will be evaluating the regulatory
environment for exchanges vs. ATS and NMS Plan governance. With respect to NMS
Plan governance, Ketchum stated that the subcommittee is evaluating how to
effectively provide the most useful interactions from both the buyside and
sellside.
Manisha
Kimmel, Chair, Customer Issues Subcommittee
Kimmel
stated that the subcommittee is currently evaluating data related to investor
confidence and literacy. Additional, Kimmel noted that a subcommittee to the
subcommittee has been formed to evaluate investor understanding of equity
market structure. Moving forward, Kimmel highlighted that the committee will be
evaluating Rule 605 and 606 reports, and that the subcommittee is interested in
broker-dealer input.
More
information about this event can be accessed here.
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Securities
and Exchange Committee
Equity
Market Structure Advisory Committee meeting
Tuesday,
February 2, 2016
Key
Topics & Takeaways
-
August
24th Highlighted Various Structural Concerns: Committee members
and panelists highlighted that the causes of August 24th were the
result of a confluence of various factors, both external and structural. The
structural issues highlighted included the lack of pricing information,
uncertainty around clearly erroneous rules, and disparate re-opening auction
procedures following a limit up-limit down trading halt.
- Evaluate Market
Mechanisms Rather Than Ban Certain Order Types: Mecane argued that it
is preferable to design a Limit Up-Limit Down (LULD) mechanism in a way that
can withstand selling pressures, rather than banning specific order types used
by investors. He suggested that additional “behavioral protections” could
be layered on top of market mechanisms. Committee members were mainly in
agreement that improving investor education regarding the risks of using
certain order types, particularly market and stop orders, is needed.
-
Payment for Order Flow vs. Internalization: Committee members
highlighted their concern that payment for order flow and internalization while
related, are often conflated as one. Committee members were in agreement
regarding the quality of execution that retail investors receive and supported
improved disclosure through standardized reporting and investor education.
Speakers:
-
Mary Jo White, Chair
- Kara Stein, Commissioner
- Michael Piwowar, Commissioner
- Daniel Gray, Division of
Trading and Markets
- Stacey Cunningham,
Chief Operating Officer, NYSE
- Hubert De Jesus, Co-Head Market Structure & Electronic
Trading, BlackRock
- Frank Hatheway, Chief
Economist, NASDAQ
- Paul O’Donnell,
Managing Director, Morgan Stanley
- Members of the
Equity Market Structure Advisory Committee
Opening
Remarks
In
her opening
remarks, Chair White explained that the Equity Market Structure Advisory
Committee will consider issues surrounding market volatility on August 24th,
2015 as well as a number of issues affecting retail and institutional
customers, including how certain order types used by customers operate, payment
for order flow, and execution quality and order routing disclosure. White
pointed to the Commission’s research
note on the equity market volatility on August 24th, which she
explained examines the opening and re-opening auction processes, performance of
exchange-traded products (ETPs) during market volatility, and the operation of
the limit up-limit down (LULD) pilot on a day with market-wide
volatility.
White
foreshadowed that the Committee would discuss the use of certain order types by
retail investors which may present risks to investors particularly during
periods of market volatility. She also explained that the Committee would
examine payment for order flow, which she said “does not necessarily violate [a
broker’s] best-execution obligations” but “raises the potential for conflicts
of interest.” White signaled that Commission staff is working on a
rulemaking proposal to “enhance transparency of the order routing practices of
broker-dealers for institutional investors.”
Finally,
White noted that the four recently-launched subcommittees under the Committee
would provide a status update on their work on Reg. NMS, trading venues,
customer issues and market quality.
Stein
underscored the importance of the issues under consideration by the Committee,
including the lessons learned from the extraordinary market volatility on
August 24th and issues affecting investors, particularly retail
investors in the current equity market structure. Stein underscored the
importance of launching the Consolidated Audit Trail (CAT), noting that it is
“years behind schedule” and that there is “no greater task” before the
Committee is to get it off the ground.
Regarding
equity market volatility, Stein explained that “investors and issuers need to
be able to count on the effective operation of [U.S. equity] markets in times
of stress.” She argued that stop orders, execution quality reporting, and
payment for order flow arrangements all affect “investor confidence” and
expressed her “deep concern” about certain order types being used by retail
investors during the market volatility on August 24th. Stein
closed by expressing specific interest in whether retail investors are
“uniquely disadvantaged” in some way by the current market structure.
Michael Piwowar, SEC Commissioner
Piwowar
underscored the importance of the Commission’s ongoing review of U.S. equity
market structure, and he claimed that the SEC staff’s research note reveals
there is “room for improvement” in the market volatility mechanisms, which he
argued makes an “excellent jumping off note” for the Committee’s
deliberations.
Daniel
Gray, Division of Trading and Markets
Gray
summarized the Commission’s research note and highlighted areas where the
volatility mechanisms on August 24th differed from the flash crash
of 2010. Gray explained that there were “significant issues” experienced on
August 24th, including issues with the opening auctions on primary
listing exchanges, breakdown in arbitrage of ETPs, a LULD process that did “not
seem to work very well,” and significant imbalances in the reopening auction
that the market could not handle.
Stacey Cunningham, Chief Operating Officer,
NYSE
Cunningham
encouraged the Committee and SEC to explore the interconnected nature of
individual issues being addressed by the subcommittees, and to undertake
comprehensive equity market structure reform that takes into account how market
participants will change their behavior in response to policy actions.
Cunningham explained that NYSE retained McKinsey to assess events on August 24th,
which she explained led to NYSE’s proposals in its paper
on equity market structure issues.
Cunningham
summarized several factors that she said contributed to the market volatility
on August 24th, including: (i) market uncertainty as to whether a
market wide circuit breaker would be triggered; (ii) uncertainty for market
makers as to whether they would be able to hedge their positions; (iii) concern
that trades could be busted under clearly erroneous rules,; (iv) risk
management systems that pulled many market makers out of the market briefly;
and (v) opening and reopening procedures that “hindered timely and transparent
openings.”
Cunningham
claimed that “it was a conscious policy decision to adopt a fragmented marketplace,”
and while she noted that market resiliency is a benefit of a more fragmented
marketplace, she argued that “liquidity isn’t free” which is the downside of
fragmentation. Cunningham explained that exchanges are more dependent on
voluntary liquidity providers than ever before. She made several
recommendations, including: (i) renewing focus on investor education
(particularly on the risk of using certain order types); (ii) LULD refinements
to improve price discovery during market-wide volatility events; and (iii)
enhancements to NYSE ARCA rules and procedures to improve transparency and
enhance the automated opening process. She noted that NYSE has already widened
the reopening auction collars and is actively making changes to automatically
extend trading halts.
Hubert De Jesus, Co-Head Market Structure
& Electronic Trading, BlackRock
De
Jesus noted that BlackRock is a strong advocate for market structure changes,
as evidenced by its viewpoint
on August 24th. De Jesus explained that market
participants need valuation clarity especially during times of market stress,
and argued that inconsistencies between erroneous trade guidelines and the LULD
trading bans in a volatile market diminished certainty of execution. De Jesus
recommended addressing the lessons learned from August 24th by
making several market structure rule changes, better educating investors about
how certain order types behave in market volatility and illiquidity, having a
more proactive dialogue between market participants, and harmonizing trading
rules across the entire equity market ecosystem. De Jesus lent support
for revising LULD rules to consider revising price bands at opening auctions,
recalibrating the length of the limit state, and harmonizing reopening
procedures across exchanges to maximize liquidity and minimize imbalances. He
further suggested that there is “value” in considering whether market wide
circuit breakers should have been invoked on August 24th.
Frank Hatheway, Chief Economist, NASDAQ
Hatheway
suggested that the Commission consider how any of its rule changes will
interact with other independent actions being taken across the industry in
response to August 24th. He also suggested simulating market
structure changes in order to lower both the costs and risks associated with
making such rule changes.
Hatheway
summarized several factors that he argued worked well on August 24th,
including market infrastructure and technology, plans operated by the self-regulatory
organizations (SROs), market data feeds, routing to major trading centers,
among other things. He also explained that the new market mechanisms
(such as LULD) performed as designed, even though that does not mean it “worked
as intended.” Hatheway criticized a “one size fits all” response to
August 24th, and explained that he does not support exchanges being
forced into the same opening and reopening processes. He further
cautioned against eliminating SROs’ authority, noting that erroneous executions
can occur in a variety of “unique” and “extraordinary” circumstances.
Paul O’Donnell, Managing Director, Morgan
Stanley
O’Donnell
stated that there is no single cause and no simple fix to the equity market
structure issues that led to volatility on August 24th. He
noted that pricing mechanisms did not function as expected, which led to
pricing dislocations, and he urged market centers to make changes to allow
liquidity to enter during market stress. O’Donnell claimed that the
market volatility mechanisms worked “as designed” but the state of the global
equity markets impacted trading and pricing in the U.S. O’Donnell noted that
since NYSE invoked Rule 48, there was no public dissemination of imbalance data
outside of the trading floor, and he argued that this adversely impacted the
willingness of market participant to provide liquidity since they had “little
to no information” on which to base pricing decisions.
O’Donnell
argued that exchanges should publish imbalance and indicative prices as widely
as possible in order to attract liquidity, and that auctions should wait to
find a reasonable clearing price at which such imbalances should be offset.
O’Donnell offered several recommendations, including: (i) widening the collar
to help find a market clearing price; (ii) slow auctions with large price moves
to allow market participants to source additional liquidity; (iii) the
securities information processor (SIP) should publish trading bands and
reopening indicators simultaneously; (iv) regulators should analyze non-public
data to determine liquidity taking on the morning of august 24th;
and clearly erroneous rules should be amended to LULD process so that all
trades executed in bands will stand.
Committee Discussion
Importance
of Stop-Loss Orders to Retail Investors
Jamil
Nazarali, Senior Managing Director & Head of Execution Services highlighted
the importance of stop-loss orders to retail investors, and claimed that they
work well most of the time. However, he suggested that there should be
more investor education around stop orders, including for financial
advisors.
Amending
Reopening Process after LULD
Joseph
Mecane, Managing Director, Barclays suggested tweaking rules to eliminate
re-opening auctions after the LULD mechanism is triggered. He suggested
implementing floating bands that readjust periodically to absorb the impact of
big imbalances as a result of trading pauses and halts in the market. In
limit states, market seems to recover and liquidity seems to stay more active in
a limit state than it does around the pauses. Tweaks may work but
question whether there is a more efficient way for mechanism to work without
stopping the market.
Eric
Noll, President & CEO, Convergex Group, agreed that the reopening auction
is not performing the way it should. He explained that the purpose of
LULD is to stop flash crashes in individual securities, but that the auction
process is not a necessary component. Rather, Noll argued that it is necessary
to give people time to reassess what the fair trading value is and allow them
to trade freely at that price.
Nazarali
explained that a main inhibitor of market corrections is that the LULD often
limits trading repeatedly in a security. He suggested that the trading
bands be widened to allow a security to recover after a steep decline in its
price.
Harmonized
vs. Adjustable Trading Bands
Stephen
Luparello, Director of Division of Trading and Markets, asked whether it was
preferable to harmonize trading bands or have wider bands around the opening
and re-opening process than throughout the day. Cunningham suggested that
stocks that have triggered a LULD trading pause during double-wide bands be
allowed to recover more easily than others. De Jesus argued that it makes sense
to have trading bands that are “simplistic in nature” rather than fluctuating
throughout the day to ensure certainty.
Access to Imbalance Information
Cunningham
explained that NYSE started publishing imbalance information after 9:35 a.m. in
October 2015, as well as a price range that is broader than the indicative
opening price would be when a security is going to move with the boarder
market. However, on volatile days, she explained that the exchange lifts those
market protections because the broader market is moving.
Cunningham
further explained that mandatory indications – such as the price range at which
the exchange is looking to open – are published through the SIP. However,
the automated imbalance information (with more specific pricing information)
goes out through proprietary exchange feeds.
Mecane
argued that it is preferable to design a LULD mechanism in a way that can
withstand selling pressures, rather than banning specific order types used by
investors. He suggested that additional “behavioral protections” could be
layered on top of market mechanisms.
Customer Issues
Michael
Coe, Office of Market Supervision, Division of Trading and Markets
Coe
summarized the Division of Trading and Markets memorandum that focused on key
issues affecting customers in the current equity market structure. Notably, Coe
highlighted the risks of market order and stop orders, providing that while
such orders are very popular with retail traders, such order types can present “significant
risks,” especially during periods of market volatility. Coe provided an
overview of payment for order flow arrangements, in which cash payments are
provided by over-the-counter (OTC) market makers to retail broker-dealers in
exchange for retail marketable order flow, noting that rather than prohibiting
the practice, the Commission prefers a disclosure-based approach. Lastly, Coe
discussed execution quality reports and provided that while institutional
orders are not included in Rule 605 and 606 reports, the Commission is
currently working on a rule to address this.
Jeffrey
Brown, Senior VP-Legislative & Regulatory Affairs, Charles Schwab
Brown
noted the Schwab’s motto is to look at issues through our “clients’ eyes”.
Brown stated that Schwab clients use market and stop orders and that
“two-thirds” of the time, Schwab is a “market order shop” Brown stated that the
market order itself is not a problem, it is their usage that can be
problematic. Accordingly, Brown highlighted that client education is important.
Brown further noted that stop orders have a use, as that most individuals do
not sit in front of a trading screen all day. Brown acknowledged however that
they are typically triggered as the market is falling, and this is “not a
recipe for good execution”. Brown reiterated the importance of educating retail
investors with respect to the usage and risks of market and stop orders.
Brown
discussed payment for order flow arrangements and noted that the Division of
Trading and Markets memorandum lacked a key detail how such arrangements
developed, notably the inadequate execution of retail orders on the national
securities exchanges, which resulted in the development of systems to provide
better execution to retail clients. Brown stated that this structure has
“blossomed into a competitive market structure” for better market quality, with
retail investors “receiving better execution quality than ever before”.
Brown also noted that Schwab retail clients typically on average receive better
than the midpoint, and that Schwab looks to mitigate conflict of interests by
limit the range that is paid per share and that routing is based on execution
quality, not the payment received for order flow. Brown stated that
payment for order flow allows Schwab to maintain “world class systems and
services” for their clients and that he believes that such arrangements have
provided real value to customers.
Frank
Childress, Managing Director, Wells Fargo Advisors
Childress
noted that the Division of Trading and Markets memorandum was very balanced and
that retail investors have “never had it better.” Childress stated that the
memorandum correctly lays out the concerns with respect to market and stop
orders, in that they occasionally “don’t work as intended” Childress stated
that education is the primary tool to address these concerns and that
eliminating stop orders would eliminate investor choice.
Childress
stated that Wells Fargo retail broker-dealer does not accept payment for order
flow. Childress noted however, that while the memorandum correctly indicates
that the rates paid for marketable retail order flow has historically
increased, since 2015 such payments are no longer “trending up.” Childress
stated that any suggestion to pass the payment on to investors would be
complicated and difficult to validate. Rather, Childress suggested that the
preferred solution is to enhance disclosure. Lastly, Childress provided that
Wells Fargo is strong supporters of execution quality reports and that 605
reports “need to be updated.”
Dennis
Dick, Member – Capital Markets Policy Council, CFA Institute
Dick
highlighted that August 24th, 2015, was an isolated event, with many
large cap stocks falling more than 10 percent. Dick questioned how the industry
could better protect individual investors in times of market stress. Dick
stated that eliminating or restricting market and stop orders could result in
additional problem, and that additional education is needed.
Dick
expressed his concerns with the increasing amounts of off-exchange trading and
“nominal price improvement”. Particularly, he stated that there is an
unquantifiable cost of missed trading opportunities for limit traders when
retail order flow is internalized or executed by OTC market makers. Dick
outlined three policy considerations, specifically: (1) requiring that
OTC market makers provide meaningful price improvement; (2) enhancing order
execution statistics; and (3) accompanying any requirement to increase routing
to exchanges with a reduction of access fees.
Christine
Parlour, Professor of Finance & Accounting, Haas School of Business, UC
Berkeley
Parlour
asked two central questions with respect to payment for order flow
arrangements: (1) whether commissions make retail investors better off; and (2)
what a world would look like without payment for order flow. Parlour stated
that payment for order takes valuable order flow, removes it from the market,
which in turn results in other market participants who provide liquidity, to
have “less incentive to compete aggressively.” Parlour stated that if payment
for order flow was not in the market, “spreads would be tighter and more robust
liquidity provision”.
Committee Discussion
Payment for Order Flow vs. Internalization
Nazarali
stated that he believed that payment for order flow and internalization as
concepts were being conflated. Nazarali noted that nearly all retail
broker-dealers send their order flow to wholesalers, regardless of payment for
order flow arrangements, due to better execution that their clients receive.
Nazarali stated that if you were to ban payment for order flow, firms that have
an integrated model will have an advantage and it would generally be less
transparent. Nazarali noted that “investors have a choice” and they can choose
to go with a firm that accepts payment for order flow or a “full-service firm
that does not.”
Mecane
agreed that the concepts are interrelated, however the remedies are different
between the two. Mecane noted that there is “no clear answer” as to whether the
benefits to retail investors outweigh those for other market participants. Noll
stated that he does not believe one class of investors deserves more price
improvement than any other class of investor. Kevin Cronin, Global Head of
Trading for Invesco, noted that the focus should be on “long-term investors.”
Matthew
Andresen, co-CEO of Headlands Technologies, agreed that these were two separate
issues. He stated that if payment for order flow were removed, participants
would still not likely see the order flow, as retail broker-dealers route to
the venues or participants that “provide the best execution.” He noted that
access fees on an exchange and the total cost of execution can be much higher
than payment for order flow or internalization. Lastly, Andresen noted that in
the event of calamity, “brokers provide protection to their clients” and
“exchanges are not in this business.”
Payment
for Order Flow and Innovation
Reginald
Browne, Senior Managing Director and Global Co-Head of the ETF Group, Cantor
Fitzgerald & Co, stated most retail firms reinvest the money received from
payment for order flow arrangements back into their trading platforms. He noted
that those that do not tend to have higher cost of access, and be stated that
the industry does not want to reduce competition or innovation, even if such
innovation is dependent on payment for flow to bring it to the market.
Performance
of Non-Payment for Order Flow Firms vs Payment for Order Flow Firms
Mehmet
Kinak, Vice President, Global Equity Market Structure and Electronic Trading,
T. Rowe Price, posed the question to Childress if firms that did not receive
payment for order flow received better execution quality than those that did.
In response, Childress stated that based on publically available data, those
that do not receive payment for order flow have marginally better execution
statistics.
Mandatory
Minimum Price Improvement
Maureen
O’Hara, Cornell University, highlighted that concepts such as mandatory price
improvement seem “sensible in the real world,” however their actual application
is much different in practice. For instance, O’Hara noted the negative impact
that has resulted in Canada with similar requirements. Lastly, she noted that
while we may not like payment for order flow, on balance “retail is doing
better.”
Conflating
Order Flow With Mental State
Noll
provided that he believed that participants were conflating uninformed order
flow with mental state. He noted that retail investors are fairly
sophisticated, and that while there order flow may be “uninformed,” this does
not mean retail investors are not sophisticated.
Enhanced
Disclosure
Nazarali
and Mecane were in agreement that to address conflicts, one option to be
considered would be to enhance Rule 606 disclosures.
Mark
Flannery, Director and Chief Economist, Division of Economic and Risk Analysis,
Securities and Exchange Commission, asked whether any of the panelists report
the payment received back to the client following execution. Brown stated that
clients are noted that payment for order flow may have been part of the
transaction, however due to the payments information only available at the end
of the month, disaggregating it per transaction is difficult since it is not
known at the time.
Manisha
Kimmel, Chief Regulatory Officer – Wealth Management for Thomson Reuters,
wondered whether there have been any efforts to bringing Rule 605 style
reporting to retail brokers. In response, Brown stated that his firm has been
providing this information for years and is currently working with other firms
to enhance these disclosures. Childress noted however that there would be a
“significant burden” to develop this information, however he believed that his
firm would “fair well in comparison”
Non-Marketable
Limit Orders
Brown
in response to a question by Kinak, stated that non-marketable limit orders are
routed to a market maker, which in turn is posted to the primary listing
exchanges and BATS. Kinak stated that increased disclosure of the performance
of such order types on the exchanges is needed.
Investor
Education
Chester
Spatt, Carnegie Mellon, was curious as to the importance of education,
specifically what to the panelists do currently. Brown stated that his firm is
working on developing warning screens and that an explanation of order types is
available on their website.
Subcommittee Reports
Kevin
Cronin, Chair, Regulation NMS Subcommittee
Cronin
stated that the subcommittee is focused on developing practical and sensible
recommendations on the areas under review including access fees, market data,
and Rule 611. Cronin provided that the subcommittee is focused on ensuring the
a broad range of interested constituents are included in the dialogue,
including retail investors, market makers, as well as the large exchanges, such
as NYSE and NASDAQ.
Eric
Noll, Chair, Market Quality Subcommittee
Noll
provided that the subcommittee has held two meetings thus far, and he indicated
that speaking invitations have been extended to the large exchange groups. Noll
noted that the subcommittee is utilizing the August 24th events as a
starting point, with a focus on opening auction procedures, LULD harmonization
with clearly erroneous rules, and market maker benefits and obligations. Noll
stated that the subcommittee is anticipated providing a recommendation to the
Equity Market Structure Committee by the April 2016 meeting.
Richard
Ketchum, Chair, Trading Venues Regulation Subcommittee
Ketchum,
Chairman and CEO of FINRA, stated that the subcommittee has held two meetings
thus far, and that its primary focus will be evaluating the regulatory
environment for exchanges vs. ATS and NMS Plan governance. With respect to NMS
Plan governance, Ketchum stated that the subcommittee is evaluating how to
effectively provide the most useful interactions from both the buyside and
sellside.
Manisha
Kimmel, Chair, Customer Issues Subcommittee
Kimmel
stated that the subcommittee is currently evaluating data related to investor
confidence and literacy. Additional, Kimmel noted that a subcommittee to the
subcommittee has been formed to evaluate investor understanding of equity
market structure. Moving forward, Kimmel highlighted that the committee will be
evaluating Rule 605 and 606 reports, and that the subcommittee is interested in
broker-dealer input.
More
information about this event can be accessed here.