Remarks Before SIFMA's 14th Annual Fixed Income Legal & Compliance Conference
Commissioner Troy A. Paredes
U.S. Securities and Exchange Commission
New York, New York
September 24, 2009
Thank you for the kind introduction. It is a pleasure to have the opportunity to speak at SIFMA's 14th Annual Fixed Income Legal and Compliance Conference here in New York. Since this is the first time I have spoken at a SIFMA event, I would like to start by acknowledging the important contributions that SIFMA and its members make to our efforts at the Commission to fashion a regulatory framework that responds to the needs of investors and other market participants. The SEC's mission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. I welcome the continuing dialogue with you, as I do with others, as we strive to advance the public interest in each of these respects.
Before I go further, I must say that the views I express here today are my own and do not necessarily reflect those of the U.S. Securities and Exchange Commission or my fellow Commissioners.
I've had the honor and privilege of serving at the SEC since August of last year, and it is hard to believe how quickly the time has flown by. It goes without saying that the past year has been challenging. Collectively we have confronted difficulties and uncertainties recalling the stresses and turbulence of the Great Depression. Among other things, the steady flow of concern has prompted a serious reconsideration of the financial regulatory framework both in the U.S. and abroad. The SEC itself has been very active, advancing a number of initiatives relating to such matters as credit rating agencies; money market funds; custody of investment adviser client assets; proxy access; corporate governance and executive compensation disclosures for public companies; and short selling.
* * *
I'd like to focus the balance of my brief remarks this morning on an additional — and complex — area that is under active consideration both inside and outside the SEC: market structure. There are many interconnected aspects of market structure, all of which need to fit together for our markets to function smoothly and efficiently.
Last week, the Commission took up one aspect of our markets: flash orders. The Commission's flash order proposal would amend Rule 602 of Regulation NMS to prohibit the flashing of marketable orders.1 Let me take a moment to reiterate a few of the points I highlighted at the Commission's open meeting.2 As always, I look forward to considering the comments we receive on all of the agency's ongoing rulemakings.
First, a thorough and unbiased assessment of flash orders must account for the potential benefits of flash orders that are lost if a ban is imposed. Flash orders present certain concerns, such as the prospect of discouraging displayed liquidity, but these concerns need to be weighed against the benefits of flash orders to determine the net impact of a ban and whether one is warranted at this time.
The identified benefits of flash orders include the potential to induce liquidity into the market from those who are unwilling to have their quotes displayed publicly, leading to opportunities for better execution; affording market participants lower fees than charged for executing against displayed liquidity; and otherwise reducing transaction costs for investors who are unwilling to display. The proposal release describes these benefits in more detail.
Second, given that benefits do flow from flash orders, is there a less restrictive alternative to a ban that may strike a more appropriate balance? For example, would requiring that flash orders be made available to any market participant free of charge address the "two-tiered market" concern that many have recognized, even if responding to flash orders in practice requires certain technological capabilities in which not all market participants have invested? Would requiring that an order can only be flashed by a broker with the consent of the investor submitting the order remedy concerns that flash orders may disadvantage the investor whose order is flashed? What if instead of banning flash orders, flash orders were required to offer some form of price improvement? The middle-ground options that these questions pose for the regulation of flash orders may adequately respond to the identified concerns without foregoing the benefits of flash orders entirely. This is to say that the regulatory evaluation of flash orders should, like other initiatives the Commission undertakes, be characterized by rigorous cost-benefit analysis.
Third, it is important to note that if the Commission's proposal is adopted, the Rule 602 change could constrict aspects of trading beyond flash orders. In other words, the reach of the proposal is not necessarily limited to flash orders. The proposal release, for example, considers that the amendment might impact so-called "price improvement auctions," as well as certain trading floor activities.
This raises a general caution to be mindful of when regulating in any respect — namely, the impact of regulation may extend beyond the intended purpose. It is difficult to fashion a regulatory regime narrowly to achieve desired results while avoiding undesirable collateral consequences. Accordingly, it is incumbent upon lawmakers to spend the time and effort necessary to appreciate the full range of possible results, both for better and for worse, and to be willing to scale and refine regulations when needed.
* * *
Attention is focused not only on flash orders, but on a range of other important features of market structure, including co-location, direct sponsored access, dark pools, and high-frequency trading. I don't have time this morning to discuss these topics in detail. Instead, I would like to offer some thoughts to guide how we analyze these and any other market structure matters that may present themselves. Here are three basic guidelines.
First, competition and choice are fundamental. Exchanges and other trading venues need flexibility to innovate new products, services, and trading opportunities that advance the varied interests of market participants by affording them choice. Investors are the ultimate beneficiaries when innovation spurs robust competition among different trading venues. Markets become more efficient, execution improves, and trading costs fall.
Second, research, development, and innovation need to be rewarded. Market participants, including investors, brokers, and trading venues, expect that they will be rewarded when they invest in the latest technology and develop their skills to gain a market edge. When the regulatory regime erodes a market participant's opportunity to profit from its legitimate competitive advantage, the incentive to innovate is dampened.
Third, the analysis of markets and their regulation should be grounded in data to the extent possible. Any market analysis should start by recognizing that the U.S. enjoys the benefits of high-quality markets. U.S. equity markets, for example, opened and closed everyday and transactions cleared throughout the market turmoil of last year. There always is room for improvement; but it also is possible that regulatory changes that constrict market operations and trading activities may do more harm than good by denying markets needed flexibility. One way to reduce the likelihood that regulation will be counterproductive is to focus on data. It is one thing to posit that a problem exists; it is another to demonstrate it empirically. Data has a way of disciplining decision making and can help channel regulatory efforts to where they are most productive.
Returning to flash orders for a moment with this in mind, as I said at the open meeting, I am particularly interested in any data that commenters can provide demonstrating how the current low volume of flash order trading has impacted securities markets.
* * *
In concluding, let me broaden out the discussion by addressing the regulation of risk more generally. Risk is unavoidable. When we regulate one risk, something else pops up. The responsibility we have as lawmakers is to engage in the kind of demanding analysis that will best position us to identify and evaluate the range of consequences — both good and bad — that attend our decisions so that we can make conscious tradeoffs.
This charge is particularly challenging when regulators try to get ahead of the curve, as we should. Regulators need to be forward looking, anticipating what will happen, not settling for understanding what has happened. We can study the past, but it is only the beginning of what it means to assess risk, a predicate before regulating it.
That said, caution is in order. Consider some market activity — it could be flash orders, dark pool trading, high-frequency trading, or perhaps something else. One might imagine a set of circumstances under which the activity could deteriorate market quality in some notable respect. However, if those circumstances have not yet actually obtained, is the potential that they might obtain a sufficient basis for regulating? Is it enough to speculate that the concern might materialize or should we require a rigorous assessment of the probability that the concern will materialize and the magnitude of the harm if it does? Perhaps some risks are too speculative to be a cognizable basis for regulatory action.
More to the point, some risks are worth taking if avoiding them is too costly because legitimate, wealth-creating enterprises and transactions are stifled. In other instances, efforts to clamp down on certain practices and activities may have unintended adverse effects, some of which could exacerbate the concern the regulation targets. This is a particular risk when it comes to regulating complex dynamic markets. Indeed, with sufficiently competitive markets, market discipline may effectively substitute for burdensome regulation that runs the risk of going too far.
All of this bespeaks caution before enacting prophylactic regulations. It is possible to be too precautionary. Good data helps guard against this.
* * *
It is not enough to offer regulatory guidance in concept. The Commission needs to be able to execute on it. To best position the agency to fulfill its mission, we need to have the right blend of skills.
The SEC staff has extensive knowledge and expertise and is extremely hardworking and dedicated to serving the public interest. However, the SEC needs to be staffed with more economists and other non-lawyers with a deep understanding of financial markets. Our increasingly complex markets will be better served if the Commission has more economists, quantitative analysts, and others with strong backgrounds in trading and finance actively engaged in every aspect of what the SEC does. When it comes to market structure, the Commission also could benefit from deeper expertise in industrial organization, not just financial economics and trading. For an agency that regulates the world's largest securities markets to be so dominated by lawyers is ill-advised.
* * *
I'd like to thank SIFMA again for inviting me to speak to you this morning and to thank you for listening. I'm sure you'll enjoy the rest of the program.