Oversight of the SEC’s Division of Trading and Markets

House Committee on Financial Services

Subcommittee on Capital Markets

Oversight of the SEC’s Division of Trading and Markets

Thursday, June 22, 2023

 

Topline

• Members on both sides of the aisle asked the SEC to consider a staggered approach for implementing their four market structure proposals.
• Democrats and Republicans raised concerns over the impact of the SEC’s market structure proposals on capital formation and liquidity.

Witnesses

• Haoxiang Zhu, Director, Division of Trading and Markets, Securities and Exchange Commission
• Jessica Wachter, Chief Economist and Director, Division of Economic and Risk Analysis, Securities and Exchange Commission

Opening Statements

Subcommittee Chair Ann Wagner (R-Mo.)

In her opening statement, Wagner explained that given the unprecedented and historic volume of rulemakings being advanced at the SEC under Chair Gensler, it is imperative that Congress holds public hearings. She noted the Division of Trading and Markets (DTM) impacts a wide variety of stakeholders participating in public markets, including millions of retail investors. Wagner discussed the SEC’s four December 2022 proposed rulemakings, which she said will dramatically alter the current market structure. She said the SEC conceded the economic effects of these proposals are unknowable and warned that the SEC should only issue regulations that are absolutely necessary. Wagner noted she will introduce the SEC Regulatory Accountability Act and concluded that U.S. equity markets must remain the envy of the world.

Subcommittee Ranking Member Brad Sherman (D-Calif.)

In his opening statement, Sherman urged the SEC to address payment for order flow, explaining that current SEC regulations seem to say that any price improvement constitutes the very best price. He noted the current system causes investors to lose $1.5 billion each year. Sherman congratulated the SEC for finally going after crypto exchanges and concluded by expressing his concerns about the SEC’s swing pricing proposal, citing its discriminatory effect for those living on the West Coast and in Hawaii.

Full Committee Ranking Member Maxine Waters (D-Calif.)

In her opening statement, Waters noted Republicans seem reluctant to hear what Chair Gensler thinks about their crypto markets bill and would rather discuss legislation to give Wall Street avenues to sue the SEC over any future rulemaking.

 

Testimony

Haoxiang Zhu, Director, Division of Trading and Markets, Securities and Exchange Commission

In his testimony, Zhu explained that the primary task of the DTM is to oversee the trading of securities, noting that as technology and market practices evolve, the role of the Division evolves with it. He discussed the three layers of market activities and intermediaries that come under the remit of the Division: marketplaces, broker-dealers, and clearing agencies, including clearinghouses and central securities depositories. Zhu added that clearing agencies are important for the efficient clearance and settlement of securities transactions. He noted the DTM oversees 24 national securities exchanges, about 100 alternative trading systems, over 3500 broker-dealers, 48 security-based swap dealers, 7 registered clearing agencies, and over 300 transfer agents. Zhu added that in fiscal year 2022, the Division processed about 2000 filings from SROs, including exchanges, FINRA, and clearing agencies.

Zhu concluded by outlining the four broad areas encompassing the DTM”s current rulemaking work:

finishing the mandates from the Dodd-Frank Act of 2010, strengthening the U.S. Treasuries market in marketplaces, broker-dealers, and clearing agencies, updating rules on equity market structure, and focusing on the interaction between financial regulation and technology infrastructure.

 

Dr. Jessica Wachter, Chief Economist and Director, Division of Economic and Risk Analysis, Securities and Exchange Commission

In her testimony, Wachter explained how the Division of Economic and Risk Analysis (DERA) provides support to every aspect of the Commission’s mission from rule writing to enforcement, noting that high-quality economic analysis is an essential part of SEC rulemaking. She noted that for Commission rulemakings, DERA’s Office of Policy Economics conducts an economic analysis that examines the costs and benefits, as well as effects on efficiency, competition, and capital formation of that rulemaking. Wachter explained that the economic analysis contains: a statement of the need for the proposed action, a baseline against which to measure the likely economic consequences of the proposed regulation, alternative regulatory approaches, an evaluation of the benefits and costs—both quantitative and qualitative— of the proposed action and the main alternatives, and an analysis of the effects on efficiency, competition, and capital formation.

 

Question & Answer

Market Structure Proposals

Wagner emphasized that each of the SEC’s four market structure proposals are significant and will impact millions of investors. She noted the four rules are scheduled to go into effect simultaneously, and asked how the SEC will measure how each of the four rules contributed to a better or worse outcome for investors. Wagner also asked if it would make more sense to implement the rules incrementally. Wachter said the SEC is measuring the economic effects against the baseline, which is standard practice.

Rep. David Scott (D-Ga.) asked if the SEC would consider delaying the other three equity market structure proposals until they can use the updated Rule 605 data. Zhu noted that comment was expressed by many commenters in the file. Scott emphasized that comprehensive and accurate data is critical to enable market participants to make the most informed decisions.

Rep. Greg Meeks (D-N.Y.) said he heard from a number of stakeholders that the process for developing the four equity market structure proposals was different than when the SEC adopted Regulation NMS. He asked why the SEC took a different approach. Zhu said the SEC engaged with the public extensively, meeting with industry and other market participants.

Rep. Bryan Steil (R-Wisc.) asked if Wachter agreed that the Order of Competition Rule conflicts with the Best Execution Rule. Wachter said no. Steil said he disagreed, and asked how Wachter would respond to people who believe that a conflict exists. Wachter said the criticisms of these proposals are in the comment file, adding that the Commission would respond to them after a careful evaluation. Steil concluded that the SEC’s lack of transparency is a concern, while describing the market structure proposals as a radical overhaul of our markets.

Rep. Dan Meuser (R-Pa.) asked if the SEC would consider taking things one rule at a time so industry can respond. He explained that industry feels that the SEC is moving too rapidly with regulations that they don’t have time to comment on. Zhu said the SEC is trying to keep their rulebooks updated, noting the market is evolving quickly, which forces them to act quickly.

Meuser asked why the SEC wouldn’t let Rule 605 be implemented and build off of it, rather than just implementing multiple new rules. Zhu explained that the other rules serve a different purpose.

Rep. Wiley Nickel (D-N.C.) noted small R&D companies in his district are worried that the suite of equity market structure proposals, particularly the Order of Competition Rule, would have a series of negative effects on their ability to raise capital. He explained that without effective markets, it will be harder for the biotech industry to deliver critical drugs to patients.

Nickel asked if Wachter agreed that under the proposed rules, retail orders for smaller, less liquid stock would receive worse execution quality compared to the current status quo if nobody shows up for an auction. Wachter said the SEC believes the proposals would improve price efficiency and capital formation. She added that their economic analysis shows that companies who are not part of the S&P 500 will experience greater gains from the proposal.

Nickel asked why the SEC failed to do a deeper dive into the capital formation for these critical small companies. Zhu deferred to his colleagues in the Division of Corporation Finance.

Nickel concluded that several studies have found the proposals would increase costs for retail investors, and emphasized his concerns over reports that commission free trading could cease to exist.

 

Climate-Related Disclosures

Rep. Juan Vargas (D-Calif.) noted climate change presents a direct threat to our nation’s capital markets and economic growth. He asked Wachter to discuss her understanding of capital markets as it relates to climate-related information and the upcoming climate disclosures rule. Wachter explained that many companies are voluntarily disclosing climate-related risks, but noted the disclosures are not consistent due to the lack of a regulatory framework. She added that the lack of consistency makes these disclosures less useful for investors. Wachter concluded that there is investor demand for this information, and the lack of consistency makes it more costly for everybody.

Rep. Sean Casten (D-Ill.) asked if the climate disclosure proposal was partly motivated by the need to create a standard set of regimes. Wachter said the motivation was to bring more consistency. She noted there is an information asymmetry problem which the proposals are intended to address, thereby improving liquidity and capital formation.

Casten asked Wachter to address concerns that this rule would burden small businesses and farmers.

She replied that the rule would not require small businesses and farmers to disclose anything if they are not public reporting companies. Wachter explained these concerns may come from the reporting of Scope 3 emissions if material. She added that all companies are allowed to use estimates.

Casten asked Wachter if markets will operate more efficiently with standardized climate disclosures.

Wachter said yes.

 

SEC Proposed Rule 10B-1, Security-Based Swaps

Rep. Bill Huizenga (R-Mich.) discussed SEC proposed rule 10B-1, Position Reporting of Large Security-Based Swaps. He noted the Commission repeatedly mischaracterized the academic research it relied on to support public disclosure of its positions, and said he worried this made the agency legally vulnerable to challenges in court.

Rep. Frank Lucas (R-Okla.) noted the SEC’s proposed rule 10B-1 would require public dissemination of security-based swap positions and explained that market participants are concerned this rule would deeply harm market liquidity. Lucas asked if the DTM had considered a phased approach to implementation. Zhu noted the DTM reopened the comment period for this rule, adding that comments in the file have mentioned a phased implementation. He said this is something the Division is considering very carefully.

Lucas asked if the SEC had discussed this rulemaking with the Treasury, the FED, or the OCC. Zhu said the rule is a Dodd-Frank rule and fulfilling a Congressional mandate. Lucas emphasized that the SEC should discuss the rule with regulators because of the potential effect it will have on their responsibilities.

 

Swing Pricing

Sherman said the SEC is getting it wrong on the proposed Swing Pricing rule, which he said will deter investments in equity mutual funds. Sherman added that Swing Pricing looks like a giant junk fee.

Sherman asked if the SEC has done a peer-reviewed economic analysis on how swing fees would deter interest in Americans investing in mutual funds. Wachter said yes. Sherman asked how the SEC determined the proposal won’t deter people from investing in mutual funds. Wachter replied those costs are in their economic analysis, to which Sherman noted he’s concerned about the effect on investors, not the cost.

Sherman concluded there is not a single mutual fund seeking investment that thinks investors would choose them if they adopted a swing pricing system. He noted swing pricing is currently available to all mutual funds, but none have chosen to adopt it.

 

Enhancing Safeguards for Registered Investment Advisers Rule

Rep. Zach Nunn (R-Iowa) noted the SEC Investment Management Division proposed the Enhancing Safeguards for Registered Investment Advisers Rule, under the guise of protecting customers’ assets.

He explained the rule goes well beyond its stated intent and would impose new rules that are impossible to comply with.

Nunn asked if Zhu was aware the proposal would require registered investment advisers to use qualified custodians for client assets, including their derivative contracts Zhu deferred to his colleagues in the Investment Management Division.

Nunn asked if Wachter was consulted on this rulemaking. Wachter said DERA performed an economic analysis. Nunn asked if the SEC consulted with the CFTC about the rule’s potential impact on the CFTC’s merchant clients. Wachter replied that there were conversations with the CFTC prior to the proposal.

 

Cost Benefit Analysis

Rep. Stephen Lynch (D-MA) asked Wachter to walk him through the rulemaking process. He also highlighted the industry’s use of cost-benefit analysis as a weapon against rulemaking. Wachter explained that the SEC’s economic analysis has five components, including costs, benefits, and alternative approaches.

Waters said critics argue that cost benefit analysis can have substantial shortcomings and is used by opponents of regulation to either dilute or strike down regulations. She explained cost benefit analysis is inherently biased in favor of the regulated industry because the cost of compliance is generally much easier to quantify in dollar terms than the benefits of regulations.

Waters asked Wachter about her thoughts on the risks of biased day. Wachter said she’s aware of these criticisms and agreed that biased data is a problem.

 

Government Securities Dealers

Rep. French Hill (R-Ark.) noted there is bipartisan, bicameral opposition to the SEC’s Treasury dealer proposal. He explained that the SEC is trying to sweep up people who are Treasury buyers and suddenly rule them as dealers. Hill asked how many firms would be impacted by this rule and its definition. Zhu said between 20-30 entities.

 

 

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