Senate Banking Hearing on Equity Market Structure
Senate Banking Subcommittee on Securities, Insurance and Investment
“Regulatory Reforms to Improve Equity Market Structure”
Thursday, March 3, 2016
Key Topics & Takeaways
- CAT: Ranking Member Mark Warner (D-Va.) expressed frustration that the Consolidated Audit Trail (CAT) has taken so long to develop, noting that it has been six years since the flash crash of 2010 and saying that his patience is “wearing thin.” Luparello stressed that CAT “could not be a higher priority” and that staff is working to send a recommendation to the Commission.
- Maker-Taker Pilot: Warner asked if the maker-taker pilot would start this summer if the Equity Market Structure Advisory Committee approves the pilot recommendation. Luparello explained that it would not start in the summer, because SEC staff would still need to provide a recommendation to the Commission and hold a comment period that could “take a few more months after that.”
- Advisor Misconduct: Sen. Elizabeth Warren (D-Mass.) pointed out that there are some FINRA-registered companies where 20 percent of the advisors have records of misconduct. She stated that FINRA “obviously” is not getting these individuals out of the industry and is allowing them to work with vulnerable, unsophisticated investors.
Witness
- Stephen Luparello,Director, Division of Trading and Markets, Securities and Exchange Commission
- Richard Ketchum, Chairman and CEO, Financial Industry Regulatory Authority
Opening Statements
In his opening statement, Chairman Mike Crapo (R-Idaho) said the landscape of stock markets and trading today is substantially different from even five years ago due to technological innovations and regulations that have moved trading to automated markets. While the technology has often benefited investors by producing tighter spreads, lower costs and more efficient markets, he continued, the expansion of trading venues, increased speed and mandated interconnectedness have also raised questions on market complexity and resiliency.
Crapo recalled that in 2013, Securities and Exchange Commission (SEC) Chair Mary Joe White highlighted three fundamental policy areas to consider: 1) whether trade-through restrictions in Rule 611 of Regulation NMS should be rescinded or modified; 2) whether the current regulatory model for exchanges makes sense in today’s markets; and 3) the maker-taker fee structure. Crapo said he appreciates the data-driven approach to these issues by the SEC and the Financial Industry Regulatory Authority (FINRA), and asked for an update on progress made towards addressing them.
Ranking Member Mark Warner (D-Va.), in his opening statement, also noted the benefits of technological advances while recognizing that recent years have also seen increased volatility and periodic disruptions, such as flash crashes. He commented that it is clear much work remains to be done, and credited the SEC for undertaking a holistic review of market structure. He then offered three additional suggestions: 1) moving forward with pilot programs, specifically the maker-taker pilot; 2) examining the role of dark pools in market structure; and 3) finalizing the Consolidated Audit Trail (CAT) so that the SEC can have real-time insight into the mechanics of the stock market.
Testimony
Stephen Luparello, Director, Division of Trading and Markets, Securities and Exchange Commission
In his testimony, Luparello stated that enhancing equity market structure continued to be a primary focus of SEC efforts in 2015, as it will be in 2016. He then gave an overview of the SEC’s program for equity market structure. He stressed that the SEC’s regulatory regime “must keep pace with and adjust appropriately” to changes brought about by computer algorithms that have “introduced types of market mechanisms and trading practices that were not possible in the days of manual markets.” However, he emphasized that market structure issues are complex and highly interrelated, and so efforts to develop responses to particular issues must reflect a full consideration of the risk of unintended consequences.
Luparello said the SEC’s review of equity market structure is based on three key elements: 1) data-driven analysis; 2) a wide range of views from market participants through requests for comment, public roundtables, and the creation of the Equity Market Structure Advisory Committee (ESMAC); and 3) a comprehensive scope that includes a full appreciation of the extent to which market participants, tools, and trading venues are interrelated.
Four SEC initiatives were highlighted by Luparello as areas where developments can be expected in the coming months: 1) CAT; 2) institutional order routing transparency to help investors understand brokers’ routing decisions; 3) a rule against disruptive trading; and 4) the maker-taker pilot, on which a recommendation from an ESMAC subcommittee is expected in April.
Richard Ketchum, Chairman and CEO, Financial Industry Regulatory Authority
Ketchum, in his testimony, said questions of market structure can be broad and complex, and that it can be difficult to pinpoint what needs to be addressed. He stated that there are three key aspects of the markets that regulators and participants should always be working to strengthen: 1) market fairness; 2) market transparency; and 3) market liquidity.
Ketchum described FINRA initiatives, including the development of an innovative surveillance program to look for manipulation, frontrunning and other abusive conduct, and efforts to promote transparency in equity markets by calling for alternative trading systems (ATSs) to provide more in-depth order information. He also highlighted that the SEC, FINRA and exchanges have implemented a number of initiatives to minimize the impacts of extreme volatility since the May 2010 flash crash.
Questions and Answers
Crapo asked Luparello and Ketchum to identify their “top two proposals or actions” that must be taken, as well as a timeframe for action. Luparello listed CAT, noting that White has said it is her desire to have it approved in 2016, and an institution order routing disclosure tool that is important “to get out soon.” Ketchum agreed with the importance of CAT, but also added the maker-taker pilot and further study of the volatility episode of August 24, 2015.
Warner expressed frustration that CAT has taken so long to develop, noting that it has been six years since the flash crash of 2010 and saying that his patience is “wearing thin.” He also asked how the SEC might address the jurisdictional issue that it does not cover futures markets that can also affect equities. Luparello stressed that CAT “could not be a higher priority” and that staff is working to send a recommendation to the Commission. He also agreed on the importance of having “good vision” into other products, such as futures, especially in times of stress.
Warner commented that there are hundreds of different fee models and a high level complexity that drive fees and rebates in a non-transparent way that does a “real disservice” to investors. Having said this, he opined on his frustration that the maker-taker pilot has not begun, commenting that it would not take months of preparation. He asked for assurances that it would move forward in a timely manner. Luparello explained that the SEC is looking forward to a recommendation the EMSAC and noted that one of its subcommittees is due to make a recommendation in April. Ketchum commented that he absolutely supports a pilot program and that it is the right time to make changes to maker-taker prices.
Warner asked if the maker-taker pilot would start this summer if the EMSAC approves the pilot recommendation. Luparello explained that it would not start in the summer, because SEC staff would still need to provide a recommendation to the Commission and hold a comment period that could “take a few more months after that.”
Sen. Elizabeth Warren (D-Mass.) cited a study released by economists from the University of Chicago that looked at the records of 1.2 million financial advisors and brokers from 2000-2015 and found that one in thirteen had documented records of criminal, civil or regulatory misconduct. She commented that certain firms hire advisors with such records and cater to unsophisticated investors, and asked what FINRA is going to ensure that consumers “don’t fall into the net” of advisors with records of misconduct. Ketchum said he had also seen the study, but said factors such as prior records are a focus when FINRA conducts its examinations and investigations, which leads up to 1,000 persons a year being suspended or disbarred and firms being fined.
Warren said she appreciated that Ketchum cares about the issue, but pointed out that there are some FINRA-registered companies where 20 percent of the advisors have records of misconduct. She stated that FINRA “obviously” is not getting these individuals out of the industry and is allowing them to work with vulnerable, unsophisticated investors.
Warren then turned to arbitration awards, noting that investors are already limited by having to go to arbitration rather than a court when they feel they have been cheated, and that even when they win in arbitration, firms often do not pay the awards called for in judgments. She said securities firms do not seem to have the money on hand to pay awards, and asked what FINRA will do to address this.
Ketchum stressed that any firm that continues to do business without paying arbitration awards will be disbarred and cannot remain a FINRA member. He conceded firms not having enough capital to pay fines is a concern, and said the SEC is looking at capital requirements.
Warren expressed hope that FINRA would address the issue quickly.
Warner called for “prompt action” by FINRA, “not something that gets studied for years.” Ketchum said he hopes FINRA can take action this year, but that he will need to discuss it with the FINRA board.
Evolving Markets
Sen. Joe Donnelly (D-Ind.) noted that equity markets have become significantly more complicated and asked Ketchum to describe some of the changes. Ketchum answered that the changes have been dramatic as technological advances and SEC efforts to reduce barriers to entry and promote competition have taken hold. He said liquidity today is provided by a range of algorithmic traders, and that markets are “dramatically fragmented” across a large number of exchanges and trading systems, creating issues in best execution.
Donnelly asked if regulators have the necessary tools to keep pace with changing technology. Luparello said the SEC has improved over the years, but that there are still issues. He emphasized that the ability to analyze data in a “more nimble way” will give the SEC the ability to react in a timely fashion to market events. Ketchum said FINRA has better capabilities than ever to look across markets for manipulative behavior, but that it could be better. He again stressed the value of CAT.
Fixed Income
Crapo noted that FINRA and the Municipal Securities Rulemaking Board (MSRB) are working to finalize rules to increase disclosures of broker fees for retail trades in the fixed income market. Ketchum responded that this is an example of issues in fixed income markets, and commented that the range of price differences for similar bonds can be improved with proper disclosures that promote more efficient pricing.
Crapo asked what issues in fixed income markets should receive heightened attention. Luparello commended FINRA for its work on retail order execution transparency, and said the SEC is also spending time on trading venues that would provide more transparency. Ketchum further suggested that regulators should be working towards greater transparency and reporting of all transactions in Treasury securities.
Equity Market Structure Advisory Committee
Crapo asked about the proposals that the subcommittees of the EMSAC will be working on. Luparello stated that the EMSAC is still relatively new and the subcommittees are still considering what their focuses should be. However, he noted that one was asked to focus on the maker-taker pilot, and that recommendations on an access fee pilot and plan governance would also be helpful.
Tick-Size Pilot
Warner asked for an update on the SEC’s tick-size pilot and whether it would start by October. Luparello said he expects the pilot to begin by October, with the most recent filings from exchanges defining the pilot’s provisions in a manner more consistent with what the SEC intended.
Warner asked if it is a fair critique that the tick-size has been delayed because exchanges’ proposals were “more about preserving their own interests” than having a proper experiment.
Market-Maker Definition
Warner asked if there should be a standard definition for “market-maker.” Luparello agreed that this is an important issue, and that the SEC could provide some clarity on the incentives and obligations for market-makers.
High-Frequency Trading
Warner commented that firms may believe their algorithmic trading codes are proprietary information, but suggested that the SEC might “tag” these codes so that in the event of market turmoil it could see if they contributed to market meltdowns. Luparello answered that it is important to understand how algorithms are developed and employed when reconstructing what happens in markets during times of volatility, but that the SEC is sensitive to the idea that these codes are sometimes considered a firm’s “secret sauce.” Ketchum agreed that it would be useful to identify problems and allow for greater accountability.
For more information on this hearing, please click here.
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Senate Banking Subcommittee on Securities, Insurance and Investment
“Regulatory Reforms to Improve Equity Market Structure”
Thursday, March 3, 2016
Key Topics & Takeaways
- CAT: Ranking Member Mark Warner (D-Va.) expressed frustration that the Consolidated Audit Trail (CAT) has taken so long to develop, noting that it has been six years since the flash crash of 2010 and saying that his patience is “wearing thin.” Luparello stressed that CAT “could not be a higher priority” and that staff is working to send a recommendation to the Commission.
- Maker-Taker Pilot: Warner asked if the maker-taker pilot would start this summer if the Equity Market Structure Advisory Committee approves the pilot recommendation. Luparello explained that it would not start in the summer, because SEC staff would still need to provide a recommendation to the Commission and hold a comment period that could “take a few more months after that.”
- Advisor Misconduct: Sen. Elizabeth Warren (D-Mass.) pointed out that there are some FINRA-registered companies where 20 percent of the advisors have records of misconduct. She stated that FINRA “obviously” is not getting these individuals out of the industry and is allowing them to work with vulnerable, unsophisticated investors.
Witness
- Stephen Luparello,Director, Division of Trading and Markets, Securities and Exchange Commission
- Richard Ketchum, Chairman and CEO, Financial Industry Regulatory Authority
Opening Statements
In his opening statement, Chairman Mike Crapo (R-Idaho) said the landscape of stock markets and trading today is substantially different from even five years ago due to technological innovations and regulations that have moved trading to automated markets. While the technology has often benefited investors by producing tighter spreads, lower costs and more efficient markets, he continued, the expansion of trading venues, increased speed and mandated interconnectedness have also raised questions on market complexity and resiliency.
Crapo recalled that in 2013, Securities and Exchange Commission (SEC) Chair Mary Joe White highlighted three fundamental policy areas to consider: 1) whether trade-through restrictions in Rule 611 of Regulation NMS should be rescinded or modified; 2) whether the current regulatory model for exchanges makes sense in today’s markets; and 3) the maker-taker fee structure. Crapo said he appreciates the data-driven approach to these issues by the SEC and the Financial Industry Regulatory Authority (FINRA), and asked for an update on progress made towards addressing them.
Ranking Member Mark Warner (D-Va.), in his opening statement, also noted the benefits of technological advances while recognizing that recent years have also seen increased volatility and periodic disruptions, such as flash crashes. He commented that it is clear much work remains to be done, and credited the SEC for undertaking a holistic review of market structure. He then offered three additional suggestions: 1) moving forward with pilot programs, specifically the maker-taker pilot; 2) examining the role of dark pools in market structure; and 3) finalizing the Consolidated Audit Trail (CAT) so that the SEC can have real-time insight into the mechanics of the stock market.
Testimony
Stephen Luparello, Director, Division of Trading and Markets, Securities and Exchange Commission
In his testimony, Luparello stated that enhancing equity market structure continued to be a primary focus of SEC efforts in 2015, as it will be in 2016. He then gave an overview of the SEC’s program for equity market structure. He stressed that the SEC’s regulatory regime “must keep pace with and adjust appropriately” to changes brought about by computer algorithms that have “introduced types of market mechanisms and trading practices that were not possible in the days of manual markets.” However, he emphasized that market structure issues are complex and highly interrelated, and so efforts to develop responses to particular issues must reflect a full consideration of the risk of unintended consequences.
Luparello said the SEC’s review of equity market structure is based on three key elements: 1) data-driven analysis; 2) a wide range of views from market participants through requests for comment, public roundtables, and the creation of the Equity Market Structure Advisory Committee (ESMAC); and 3) a comprehensive scope that includes a full appreciation of the extent to which market participants, tools, and trading venues are interrelated.
Four SEC initiatives were highlighted by Luparello as areas where developments can be expected in the coming months: 1) CAT; 2) institutional order routing transparency to help investors understand brokers’ routing decisions; 3) a rule against disruptive trading; and 4) the maker-taker pilot, on which a recommendation from an ESMAC subcommittee is expected in April.
Richard Ketchum, Chairman and CEO, Financial Industry Regulatory Authority
Ketchum, in his testimony, said questions of market structure can be broad and complex, and that it can be difficult to pinpoint what needs to be addressed. He stated that there are three key aspects of the markets that regulators and participants should always be working to strengthen: 1) market fairness; 2) market transparency; and 3) market liquidity.
Ketchum described FINRA initiatives, including the development of an innovative surveillance program to look for manipulation, frontrunning and other abusive conduct, and efforts to promote transparency in equity markets by calling for alternative trading systems (ATSs) to provide more in-depth order information. He also highlighted that the SEC, FINRA and exchanges have implemented a number of initiatives to minimize the impacts of extreme volatility since the May 2010 flash crash.
Questions and Answers
Crapo asked Luparello and Ketchum to identify their “top two proposals or actions” that must be taken, as well as a timeframe for action. Luparello listed CAT, noting that White has said it is her desire to have it approved in 2016, and an institution order routing disclosure tool that is important “to get out soon.” Ketchum agreed with the importance of CAT, but also added the maker-taker pilot and further study of the volatility episode of August 24, 2015.
Warner expressed frustration that CAT has taken so long to develop, noting that it has been six years since the flash crash of 2010 and saying that his patience is “wearing thin.” He also asked how the SEC might address the jurisdictional issue that it does not cover futures markets that can also affect equities. Luparello stressed that CAT “could not be a higher priority” and that staff is working to send a recommendation to the Commission. He also agreed on the importance of having “good vision” into other products, such as futures, especially in times of stress.
Warner commented that there are hundreds of different fee models and a high level complexity that drive fees and rebates in a non-transparent way that does a “real disservice” to investors. Having said this, he opined on his frustration that the maker-taker pilot has not begun, commenting that it would not take months of preparation. He asked for assurances that it would move forward in a timely manner. Luparello explained that the SEC is looking forward to a recommendation the EMSAC and noted that one of its subcommittees is due to make a recommendation in April. Ketchum commented that he absolutely supports a pilot program and that it is the right time to make changes to maker-taker prices.
Warner asked if the maker-taker pilot would start this summer if the EMSAC approves the pilot recommendation. Luparello explained that it would not start in the summer, because SEC staff would still need to provide a recommendation to the Commission and hold a comment period that could “take a few more months after that.”
Sen. Elizabeth Warren (D-Mass.) cited a study released by economists from the University of Chicago that looked at the records of 1.2 million financial advisors and brokers from 2000-2015 and found that one in thirteen had documented records of criminal, civil or regulatory misconduct. She commented that certain firms hire advisors with such records and cater to unsophisticated investors, and asked what FINRA is going to ensure that consumers “don’t fall into the net” of advisors with records of misconduct. Ketchum said he had also seen the study, but said factors such as prior records are a focus when FINRA conducts its examinations and investigations, which leads up to 1,000 persons a year being suspended or disbarred and firms being fined.
Warren said she appreciated that Ketchum cares about the issue, but pointed out that there are some FINRA-registered companies where 20 percent of the advisors have records of misconduct. She stated that FINRA “obviously” is not getting these individuals out of the industry and is allowing them to work with vulnerable, unsophisticated investors.
Warren then turned to arbitration awards, noting that investors are already limited by having to go to arbitration rather than a court when they feel they have been cheated, and that even when they win in arbitration, firms often do not pay the awards called for in judgments. She said securities firms do not seem to have the money on hand to pay awards, and asked what FINRA will do to address this.
Ketchum stressed that any firm that continues to do business without paying arbitration awards will be disbarred and cannot remain a FINRA member. He conceded firms not having enough capital to pay fines is a concern, and said the SEC is looking at capital requirements.
Warren expressed hope that FINRA would address the issue quickly.
Warner called for “prompt action” by FINRA, “not something that gets studied for years.” Ketchum said he hopes FINRA can take action this year, but that he will need to discuss it with the FINRA board.
Evolving Markets
Sen. Joe Donnelly (D-Ind.) noted that equity markets have become significantly more complicated and asked Ketchum to describe some of the changes. Ketchum answered that the changes have been dramatic as technological advances and SEC efforts to reduce barriers to entry and promote competition have taken hold. He said liquidity today is provided by a range of algorithmic traders, and that markets are “dramatically fragmented” across a large number of exchanges and trading systems, creating issues in best execution.
Donnelly asked if regulators have the necessary tools to keep pace with changing technology. Luparello said the SEC has improved over the years, but that there are still issues. He emphasized that the ability to analyze data in a “more nimble way” will give the SEC the ability to react in a timely fashion to market events. Ketchum said FINRA has better capabilities than ever to look across markets for manipulative behavior, but that it could be better. He again stressed the value of CAT.
Fixed Income
Crapo noted that FINRA and the Municipal Securities Rulemaking Board (MSRB) are working to finalize rules to increase disclosures of broker fees for retail trades in the fixed income market. Ketchum responded that this is an example of issues in fixed income markets, and commented that the range of price differences for similar bonds can be improved with proper disclosures that promote more efficient pricing.
Crapo asked what issues in fixed income markets should receive heightened attention. Luparello commended FINRA for its work on retail order execution transparency, and said the SEC is also spending time on trading venues that would provide more transparency. Ketchum further suggested that regulators should be working towards greater transparency and reporting of all transactions in Treasury securities.
Equity Market Structure Advisory Committee
Crapo asked about the proposals that the subcommittees of the EMSAC will be working on. Luparello stated that the EMSAC is still relatively new and the subcommittees are still considering what their focuses should be. However, he noted that one was asked to focus on the maker-taker pilot, and that recommendations on an access fee pilot and plan governance would also be helpful.
Tick-Size Pilot
Warner asked for an update on the SEC’s tick-size pilot and whether it would start by October. Luparello said he expects the pilot to begin by October, with the most recent filings from exchanges defining the pilot’s provisions in a manner more consistent with what the SEC intended.
Warner asked if it is a fair critique that the tick-size has been delayed because exchanges’ proposals were “more about preserving their own interests” than having a proper experiment.
Market-Maker Definition
Warner asked if there should be a standard definition for “market-maker.” Luparello agreed that this is an important issue, and that the SEC could provide some clarity on the incentives and obligations for market-makers.
High-Frequency Trading
Warner commented that firms may believe their algorithmic trading codes are proprietary information, but suggested that the SEC might “tag” these codes so that in the event of market turmoil it could see if they contributed to market meltdowns. Luparello answered that it is important to understand how algorithms are developed and employed when reconstructing what happens in markets during times of volatility, but that the SEC is sensitive to the idea that these codes are sometimes considered a firm’s “secret sauce.” Ketchum agreed that it would be useful to identify problems and allow for greater accountability.
For more information on this hearing, please click here.