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U.S. Securities and Exchange Commission

Panel 2 Transcript: Market Structure Roundtable

June 2, 2010

Male Speaker:
Good afternoon, and welcome everyone — or almost good afternoon. Welcome to our third — second panel for the day, which will address high frequency trading. Our third panel, coming after the lunch break, will address the undisplayed liquidity. So we’re lucky to have with us another panel of very distinguished guests. Let me quickly run through and introduce everyone. We have Sal Arnuk, who is co-founder and partner of Themis Trading. Kevin Cronin, who is the deputy — sorry, is the director of Global Equity Trading at Invesco. David Cushing is the director of Global Equity Trading at Wellington Management Company. Michael Goldstein is the professor of finance at Babson College. Richard Gorelick is the chief executive officer of RGM Advisors. Mark Grier is the Vice Chairman of Prudential Financial. Terrence Hendershott is an associate professor of Finance and Operations and Information Technology Management at the Haas School of Business, University of California Berkeley. Stephen Schuler, the chief executive officer at GETCO. And finally, Jeffrey Wecker is the president and chief executive officer at Lime Brokerage. I’d like to thank each of you for taking time out of your schedules today to join us and to share with us your views and expertise on this very important issue.

Just briefly, by way of background, concept relief on equity market structure noted that the emergence of high frequency trading is one of the most significant market structure developments in recent years. It also noted that this term is relatively undefined. It’s typically used to refer to professional traders acting in a proprietary capacity then engage in treating strategies that generate a large number of trades on a daily basis. Estimates vary widely, but some believe that high frequency traders are 50 percent or more of the total trading volume. By any measure, they are a dominant component of the current market structure and likely to affect nearly all aspects of its performance. So, the commission and the concept relief sought to obtain comment on a full range of concerns to high frequency trading. Among other things, given the lack of a precise definition, the concept relief focused on identifying particular strategies and tools that may be used by these proprietary trading firms.

We look forward to hearing more from our panelists about high frequency traders, their trading strategies, the tools they use, and their impacts on the markets. So, as with the prior panel, we’ll proceed first with opening statements by each panelist, followed by a question and answer session that we hope will provide valuable dialogue. Just a quick reminder to each panelist as well as any member of the public, that they have the opportunity to submit written comments on any of the issues being discussed today until June 23rd under the SEC’s website. So, without further delay, please let’s begin by hearing some brief opening remarks. Again, we’ll ask if you keep your remarks to approximately three minutes in the interests of time, and we’ll proceed in alphabetical order. So, Sal, would you like to kick us off?

Sal Arnuk:
Thank you very much. I’d like to thank the commission and the staff for the opportunity to offer Themis Trading’s views on market structure and high frequency trading. We are honored, indeed. I am Sal Arnuk, co-founder and partner at Themis Trading. Themis is an institutional agency brokerage firm, which is to say we do no trading for our own account. Our only business is the best education of our clients order flow. We have been avid proponents and consumers of technological innovation during our entire careers at Themis for the last decade and at Incident the decade prior. We strongly believe in leveraging technology in positive ways for best execution and efficiency. Our clients collectively manage an excess of $200 billion in assets, and that money represents millions of long term investors. They are the owners of the market and our voice is their voice in this debate.

Broadly speaking, we feel that high frequency trading is largely not understood by many participants in the marketplace. While we believe that there may, in fact, be some beneficial types and attributes of HFT, we also know firsthand that there are dark and murkier portions. We’ve spent the last 18 months peeling away layers of questionable activities in the market in an effort to better serve our clients, and every time we find something, we share it with them and the community in effort to raise awareness and better the quality of trading everywhere. We have written articles, blog postings, and white papers that detail system and predatory issues surrounding HFT, although it is the predatory aspects that we focused mostly on. More recently, our work has had us dig into flash order types, the practice of co-location, latency arbitrage, and data feeds. We take issue with unfairness in the markets in general.

Finally, we believe that firms that engage in high frequency trading are doing exactly what we as a capitalistic and free society allow them to do. We believe their growth to the extreme level as we see the United States, as well as the increasing growth we see in other global markets, is a function of our underlying market structure, and it needs fixing. We are not surprised and don’t see why anyone would be that for-profit exchanges and ATSs, who are frequently owned by brokers and HFT firms, cater to those firms in significant and unfair ways. We feel the regulatory and refereeing rose at these trading destinations take a back seat to profitability, and this is a marked departure from our markets of just a few years ago. We applaud the SEC and the serious and comprehensive examination it has undertaken of our equity markets. We feel it is the most serious challenge ever faced by the commission and we feel we are appropriately reaching out to many differing voices and opinions.

Thank you for inviting me today. I’m at your service.

Kevin Cronin:
Sal, no, I will not yield my time to you. Sorry. Well, thank you very much, Commissioner Schapiro, and members of the commission for inviting me here today. I’m here on behalf of Invesco and hopefully investors at large with respect to mutual funds and institutional investors. Invesco is a leading independent global investment management firm, operating in 20 countries. And we have about $581 billion in assets under management. Invesco, I should disclose, is listed on the New York Stock Exchange. In the interest of time, I’m going to try to keep my comments brief. For those of you that know me, you know how difficult that is for me. I have however, submitted a more comprehensive statement of our opinions of issues for the record.

There have been many arguments set forth on the potential benefits and concerns associated with high frequency trading. Supporters of high frequency trading often note benefits such as the provision of liquidity, the narrowing of quoted spreads, and the evolution of themselves as modern day market makers. Concerns have focused on operational, informational, and access advantages relative to institutional and individual market participants. Also the potential to gain investors interests to the use of high speed computer programs and trading tools and techniques to detect the presence of and then to trade with or ahead of large blocks of securities in the marketplace. Let me elaborate on some of these benefits and concerns from Invesco’s standpoint.

Indeed, we believe there are high frequency strategies and participants that do add valuable liquidity to the marketplace. I think it was Gus earlier who commented that there are a breed of high frequency traders that bring marketplace liquidity visa vie the arbitrage opportunity between ETF’s, other derivatives and underlying instruments that compose those different derivative instruments. That’s good. That keeps [unintelligible] prices in line, and we believe that behavior is very much responsible for efficient working of capital markets. We do, however, believe that there should be a differentiation of different types of high frequency traders. Not all high frequency trading firms or strategies are created equal, and as such, we think that there needs to be a clearly distinguishable pattern or difference that’s set of the kind of high frequency trading participant in the marketplace and what they’re ultimately trying to accomplish. The only way to accomplish that is to really getting to know who these players are and what strategies they pursue.

That said, we must understand that liquidity provided by other high frequency trading strategies whose provision of meaningful liquidity is far less clear to us. As an institutional investor, a deep and liquid market is required to efficiently execute orders of significant size. If we do liquidity in small size provided by high frequency traders, it’s generally not the optimal type of liquidity the institutional investors like Invesco seek. We also must look at whether the tightening of spreads in stocks in which high frequency traders are active make up for the potential cost that may be incurred by investors due to for example, the potential increase implicit cost incurred by trading along or penny jumping that invariably goes along with posting limit orders today. Finally, we question whether high frequency traders should be anointed yet as the high frequency market makers given that it is unclear whether they are truly providing liquidity to the great majority to stocks to the marketplace and currently, have no obligation to go there in bad times.

No matter what side of this high frequency debate you may fall on, it’s clear that the issues surrounding high frequency training are right for further examination but by the SEC. First and foremost, there’s an immediate need for more information about high frequency traders and the practices of high frequency trading firms. Second, the SEC must consider whether high frequency trading firms should be subjected to starting quota obligations if they truly are to replace more traditional types of liquidity providers in the marketplace. Third, the SEC should examine the strategies employed by high frequency trading firms to determine whether certain strategies should be considered as improper or manipulative activity. Fourth, the SEC should act to address the increasing number of over cancellations in the securities markets. And finally, the incentives that are currently used assist for market participants to route orders to particular venues such as free rebates and any conflicts of interests that may arise due to these conflicts of interest need to be examined. Investors deserve a careful, facto-based examination of the issues surrounding high frequency trading to the extent that additional restrictions or obligations are imposed on high frequency trading. WE believe that any effort to impose such restrictions or obligations should be carefully considered. Invesco looks forward to working with the SEC as it continues to examine high frequency trading and other market structure issues. I thank the commission again for organizing this round table, and we look forward to answering your questions.

Male Speaker:
Thanks Kevin. David.

David Cushing:
First, thank you to Chairman Schapiro, the commissioners, and the staff at SEC for the opportunity to participate in this important discussion today. I’m going to start off by saying we applaud the SEC examination of current market structure issues and the opportunity to improve them.

Wellington Management Company is an investment advisor that manages money for investors, including mutual funds and pension plans for the benefit of individual investors. We do not trade as a broker dealer, nor do we trade for any proprietary account. Our views of high frequency trading are based on evaluation of overall market structure and where high frequency trading fits into that structure. Specifically, we support a market structure that promotes five important principles. First is liquidity, which we define as the ability to trade timely and in size where needed. Second is cost efficiency, i.e. the ability to trade at a reasonable cost. Third is price discovery, i.e. the ability to trade at the right price. Fourth, a structure that promotes fairness and integrity so that we can rely on the fact that our markets are essentially honest. And lastly, we rely on — we value safety, having the confidence that trades, when executed, will settle. And we believe that fair competition and fair regulation are the primary forces that have and continue to drive these benefits. Over the past quarter century, we have witnessed the evolution of equity market structure from centralized exchange and multi-dealer market maker models to a vigorously competitive market structure with many kinds of liquidity providers and execution venues today. In our view, this competitive market structure is a better market structure. The trading costs our clients experience today are among the lowest we have on record. Having said this, some opportunities for improvement exist. For example, we support the recent actions taken by the commission to curtail selective transmission of deem quotes by certain market operators of so-called flash trading to improve price transparency and fairness.

The questions that have been raised about market data feeds are interesting ones. On the one hand, the contents of these feeds are fully disclosed. On the other hand, the average retail investor is unlikely to hold an informed opinion about how their trade data may be revealed to others. In this case, stronger regulatory oversight may be in order. Third, market speed is another important area of focus. Markets and market information have been speeding up since markets were invented. I honestly have no idea how fast is too fast. So, for now, our focus is on fair access to markets and market data, i.e. data that leaves its source at the same time and speed for all real time users and terms of access to markets that are similarly level. Lastly, a question — the role of a market order in today’s order driven market.

Just a few comments on the recent in flash-crash before I conclude. Our view is that while the May 6th event revealed a weakness in market structure, we believe that the single stock circuit breakers recently unveiled by the commission should help mitigate that weakness. Many markets have such mechanisms and should not be viewed as a sign of weakness. This event should not be viewed as a condemnation of the current market structure, especially in light of how quickly liquidity came back after the initial shock of the events of that day. It is also important not to lose sight of the massive cost savings that the current competitive level has provided to the investing public day in and day out over the recent years. Next, it’s also important not to forget the less desirable aspects of primary market structures, especially profits for market makers that could be viewed as excessive and far less transparency for end users. Lastly, I would urge you to beware of re-imposing market maker requirements. Candidly, when the going really gets tough, those obligations are often not respected. Given the choice between going broke and getting in trouble, the latter will almost always be chosen. Lastly, high frequency traders provide important liquidity to the market, so we urge you to continue to move slowly and judiciously on this front. In closing, we applaud the commission for taking a methodical fact-based approach to addressing what we view as a serious but ultimately manageable set of issues and we look forward to continue to work with the commission on them. Thank you.

Male Speaker:
Thank you, David. Michael.

Michael Goldstein:
Hi. I’d like to thank the chairman, the commissioners, the staff of the SEC for inviting me. It’s a great honor to be here. Just a little bit of background; I guess since everybody was giving background about the very well known firms. I was an investment banker in 1987 when the big crash happened. I was a visiting [unintelligible] at the New York Stock Exchange in 1997 when we had the circuit breakers go off and wrote a paper on it. I’ve been chair of the NASDAQ Economic Advisory Board. I’m currently a member of FINRA’s Economic Advisory Council. And I’m certainly hoping that today we’re not having another flash crash, because it seems to be correlated with me.

I thought I might actually talk for a second about what Dave Cushing brought up so well, which is how fast is too fast. And I’d like to argue that there is a speed which is too fast and that we’re already at it. Right now we’re trading at the speed of light. Trades occur in one to two milliseconds or even microseconds. Now light travels, as you may remember, at 186,000 miles per second — for those of you who were paying attention in class — or 186 miles per millisecond. No information can travel faster than that. So, to give you an idea of that speed, my good friend up here, who perhaps works in Boston — it takes light one millisecond to get from New York to Boston and another millisecond to get back. So it takes two milliseconds, which time — even if you had no computing speed and perfect fiber optics and went as a crow flies, he couldn’t respond to a quote if he was up in Boston fast enough. Now, I understand co-location. My colleague on this side of me was in Austin — it takes eight seconds — eight milliseconds for light to get there, 16 milliseconds for a round trip. And my colleagues, you know, Terri for example, works in California. There it’s about 10 — at least 10 percent of the population lives in California. It takes 13 milliseconds and 27 milliseconds for a round trip. There’s a lot of trades that go on in that time period. So, I might want to argue that there could be a too fast speed.

One of the problems with going too fast is that computing takes time. And “if” statements, for example, take longer than “let” statements. And “if” statement is “If X is greater than seven then do Y.” Well a “let” statement is just, “Do Y.” Since they take longer, there’s an economic incentive for high frequency traders and other people not to put in as many “if” statements, simply because if they put them all into the computer program, it begins to get too slow. And this, I think, is an appropriate regulatory question for the SEC to look at because there are things like, “If a price drops to one penny, don’t trade.” Seems like a pretty reasonable solution. The other issue is that some of this high frequency trading — I’m not necessarily against high frequency trading. I’m just arguing maybe 20 milliseconds is fast enough or 10 milliseconds is fast enough. The high IT cost, the bandwidth and data feeds that we heard earlier, are being born by many of us who are not participating in it. And even if it was done at a pro-routed basis, I don’t need — if it was just for me, or even my mutual funds, which are at Vanguard — I may not need that level of pipe. Just as an academic, I want to let you know that all of a sudden now, the data costs for accessing the data through one of our data providers is going up by $10,000 a year just ‘cause there’s so much data coming along. The other issue I have for this is that my mutual funds, which are representing me, have to bulk up and get ready for high speed trading because everybody else is doing it kind of [unintelligible] today. This is vaguely similar to if every car on the road’s an SUV, then it’s really hard to decide to buy mini and people tend to buy bigger cars even if they don’t really them.

I guess the other costs, flipping costs, cancellations, huge message traffic, [unintelligible] limit order books, is a big problem. I’d like to point out another one, which is the regulatory side of the SEC, for example, wash sales. Wash sales — the law basically says it has to be simultaneous. This means that if two trades happen 10 microseconds or certainly three milliseconds away from each other, it’s not a wash sale because they’re not at the same time. And I’ve been involved in SEC cases where in fact, that kind of case has been made. So, there’s a regulatory aspect of going this fast as well. It’s basically impossible to trade simultaneously now. But the biggest problem really of course, is that the public is beginning to lose its trust of the general reasonableness in the market.

So, why do we have markets? We have them to efficiently allocate capital. And in fact, since we’re not communists, there’s actually a theory called the first welfare theorem that argues that a competitive allocation is good. [unintelligible] good. However, I’d like to — a lot of people argue, “Well don’t mess with this competitiveness.” But there’s a second welfare theorem that says that any one of these good solutions can be — received can be gotten to with the appropriate tax subsidy scheme. So, when Ian Domowitz was mentioning before about like, “Well you have to be careful as you move to IO”, that’s a legitimate choice of government — is to change the rules of the taxes, the subsidies, that you move us from this particular method of trading to that particular method of trading. That’s not necessarily inappropriate. The other point I want to make is that we have fast markets partly because the SEC push for it through regulation. And that, like our highways, have a minimum speed and a maximum speed. Maybe it’s time for our highways in trading to have a minimum speed and a maximum speed as well. And certainly within the purview of the SEC is the road planner — kind of central planner of our markets — sometimes the SEC puts limits on tic sizes and other things. It certainly seems reasonable for the SEC to put a limit on speed if it wishes to.

There is some concern that this would drive things off shore. I’d like to remind everybody with no disrespect to Mexico or to Canada, that the most likely place it would go would be London. It’s 3,463 miles away. It takes light 19 seconds to get there — 19 milliseconds to get there, 38 milliseconds for round trip. I think therefore, there is some room with a couple milliseconds where we will be safe in our very large boarders due to the very large oceans that we have. And I also think that the SEC may want to think about putting a charge on cancels. That might actually help a lot. Cancels are free. But, you know, if I return something to Wal-Mart or other places, I sometimes get a restocking fee. And that might solve the problem. My larger point is that I think some slow down might be okay. It might help with the limit orders. It might reduce conflicting quotes. It might help with some of the circuit breaker things that are still needed on stock. Again, even if we had a circuit breaker, the computer needs to calculate it out, and there is a problem if we’re going way too fast that even that has some delay. And then, finally, I think about the flash crafts — and I’ll end here; sorry I went a little long — is that it’s not unreasonable to not ask — I think that people pulling away from the markets is perfectly reasonable. In 1987, I watched people — dealers — not answer the phones. In 1997, you know not everybody bankrupt themselves. There is a — it seems like a legitimate decision of people to make, and I don’t think we should blame high frequency traders for realizing their programs were not designed for this and pulling away.

Thank you. Sorry I went long.

Director Robert Cook:
Thanks, Michael. Richard?

Richard Gorelick:
Okay, thank you, Chairman Schapiro, and members of the Commission and the staff for inviting me to participate in this Roundtable. I am the CEO of RGM Advisors, LLC, an automated professional trading firm in Austin, Texas. Since I co-founded RGM in 2001, with two partners, we’ve gradually grown the firms, and today we employ about 115 people. We actively trade U.S. and foreign equity securities and other asset classes using automated strategies. Our U.S. equity strategies are traded by a registered broker/dealer subsidiary. Together, with a group of three other automated professional trading firms, RGM recently submitted a comment letter in response to the SEC’s concept release on equity market structure. Before I turn to the topics addressed in that comment letter, I note that the unusual market behavior of May 6th was unacceptable. It now appears that there were many contributing factors to those events, including heavy selling in the futures markets and disparate rules of various exchanges. I’m encouraged that the SEC and CFDC have joined together and work with the exchanges and FINRA to understand the events of that day. The proposed circuit breaker rules are a responsible and appropriate initial response, and address the immediate need for system wide safeguards that are harmonized across market centers. We support these thoughtful reforms and hope to play a constructive and helpful role. We expect that this is the first step in an ongoing process to prevent similar events, while preserving the many strengths and improvements that have been made in our markets over the last 15 years.

Turning to the concept release, we welcome the Commission’s empirically driven, comprehensive market structure review, and support a regulatory environment that promotes fair competition, encourages innovation, enhances transparency, manages systemic risk, lowers costs for investors, and gives regulators the tools they need to detect and deter abuses. As noted in the concept release, the term “high frequency trading” is imprecise. A better description of the strategies conducted by RGM and similar firms is “automated professional trading.” We believe that this term more accurately distinguishes our strategies from others that also trade frequently. Professional traders have always been an important part of financial markets, providing liquidity and contributing to price discovery.

Historically, professional trading was restricted to very few players by regulation and exchange rules. This resulted in markets that were relatively inefficient and expensive for investors. In recent years, SEC regulation and technology advancements have created competitive electronic markets and facilitated automated professional trading. Today, numerous firms compete vigorously in these markets. All classes of investors, including retail and institutional, have benefitted from improved market quality, lower transaction costs and more efficient prices.

Turning to market performance, as was discussed on the first panel, any assessment of market structure should recognize the very high quality of our markets today, even in light of the events of May 6th. Numerous studies have shown that in recent years, bid/ask spreads have narrowed, market depth has increased, and commissions and trading costs have fallen. An original study conducted by my firm, RGM, which was attached to the comment letter, examined widely excepted measures of price efficiency over very short time frames and concluded that over the last four years, short term price efficiency increased, indicating that price discovery in today’s markets is much improved. This improvement tracks the transition to competitive electronic markets and the emergence of automated professional trading. We believe that automated professional trading has contributed significantly to these positive developments.

One area of discussion in the concept release is strategies. In general, automated professional traders use publicly available information to identify small mispricings in the marketplace, pushing stocks towards equilibrium prices. We strongly support the Commission’s efforts to force clear rules against market manipulation and improper use of private information for trading, such as front running. In fact, we support the creation of a consolidated audit trail to assist regulators to detect and deter those types of abuses, among other things. However, we believe it would harm market quality and all investors to restrict the use of publicly available information in open and competitive markets.

With respect to tools, it’s worth noting that co-location allows firms like RGM in Texas, and apparently I’m 16 milliseconds away from the markets in New York, and other firms across the country to compete with local Wall Street firms on a level playing field. Direct exchange data feeds allow market participants to better manage trading risks, contributing to lower trading costs and improved price discovery for investors. While we believe that all firms currently have equal access to these tools, we support efforts by regulators to ensure that they are available in a fair, transparent and nondiscriminatory manner. We would oppose efforts to make these tools less accessible. And in connection with risk, affective risk management is an essential element of market integrity. Exchanges and other market participants have developed and must continue to develop effective systems and procedures to manage risk. We support regulatory and industry efforts to further reduce risk, including market access rules and consistent erroneous trade policies across market centers. In light of the events of May 6th, these points merit even more attention.

With respect to fairness, it’s important to understand there’s no inherent conflict between investors and automated professional traders. Investors, both retail and institutional, directly benefit from the liquidity and price discovery provided by automated professional traders. Further, the tools that automated professional traders use are readily available to any market participant that chooses to deploy them. In our view, today’s market structure is remarkably open and remarkably fair.

I would like to thank the chairman, the commissioners and the Commission staff for all of their hard work. I want to emphasize that firms like ours were made possible by thoughtful regulation by the Commission that encouraged fair competition and transparency. We support your thoughtful regulatory efforts and are committed to playing a constructive role as we continue to work together on reforms that support and maintain America’s modern electronic equity markets as the highest quality, most resilient and lowest cost markets in the world. I’m happy to answer any questions you may have.

Director Robert Cook:
Thanks, Richard. Mark?

Mark Grier:
Thank you, and I’d also like to thank the commissioner and the Commission and the staff for the opportunity to comment this morning.

I’m Mark Grier, Vice Chairman and member of the board of Prudential, and it is common for me now to say this is the “other” Prudential, just to make sure you’re clear we’re not the U.K. version. As Michael was talking, I was thinking I’m going to go to work tomorrow and I’m going to listen to an actuary talk to me about something that’s going to happen in 40 years. So, in some respects, in my business model, I come from a different frame of reference.

As you might imagine, the things that are being discussed today can affect Prudential in a lot of different ways. I’m going to focus on our role as a listed company and give you some perspectives as a director and an officer of a company that’s traded on the stock exchange, and again, this is just part of the way we’re affected by the issues that we’re talking about. When I’m discussing these issues these days, I tend to refer to us as the raw material, that listed companies get put into this trading environment and we get worked over through all the different machines that run, whether they’re fundamental investors or traders or high frequency traders or everybody else out there, and I’m trying to pick out how we look as raw material and how we ought to view the state of the world and what this market means to us.

And the framework that I have in mind is a framework that begins with us running the business, and we do find ourselves more and more frequently now reminding ourselves that we manage the company; we don’t manage the stock price — because there are a lot of days when we can’t really connect to the things that are going on the markets, or, more specifically, going on with respect to our price. But we start with a fundamental environment where we run a business, and then, that fundamental environment goes into a screen that sort of defined by a whole range of traders and investors, short-term oriented, long-term oriented, and they take a million different approaches to thinking about the value of Prudential. And then they begin to interact with the market. And as they begin to interact with the market, we move into a realm that is defined by market fundamentals. And market fundamentals, particularly as they relate to the high frequency trading topic, would cover things like order flow, relative prices, patterns of pricing behavior and other things in that bucket that you would consider maybe semi-fundamental, and maybe as a separate topic, latency patterns and issues around just how and where things move through the markets. And the question for us — and it sort of is the punch line of this conversation for me — is when does that environment of market fundamentals become disconnected from the environment of company fundamentals, and become disconnected in a way that makes the market into the fundamental. And what I mean by that is that prices are being set based on this menu of market fundamentals as opposed to company fundamentals, and that prices are then sending the wrong signals that have consequences. So there’s more to it than just the way in which prices get set by whatever mechanism sets them, but that those prices then have consequences.

Now, in the grandest version and vision of information in fundamentals, everything is a fundamental. How much insurance we sell is a fundamental. What the exchange rate is, is a fundamental, but so is the order flow, and so is whatever a trader can suss out of the market through clever detective work or through reading signals, or watching for patterns in all those micro-technologies that create the flow of whatever leads to action on the part of high frequency traders. and we have high quality investors who tell us that what they want is for the market to reflect all the fundamentals. They want everything in there. They want to know how we’re doing, but they also want those market dynamics reflected in prices. And to the extent that high frequency traders are playing that role, sucking out of every available source of information or inferring from every available source of information, other aspects of the market, we have high quality investors who would tell us that they want to see that reflected in the price.

From my perspective as a public company, I think then it becomes a matter of degree. It’s when does the market become the fundamental in a way that is no longer constructive. And you mentioned earlier this morning the disconnect between value and price, and that issue came up a couple of times. When does that disconnect become so big that we ought to start to worry about it? That it’s not the right fundamentals that are driving things anymore, it’s the internal fundamentals that have taken over. And in other speeches, I’ve said sometimes the internal fundamentals take over, and we’re just off to the races. The market has a life of its own, divorced from the business fundamentals, and what you need to do is get that balance back again. So, I think, as I said, the punch line is when does the market become the fundamental in a way that’s counterproductive, and how do we want to deal with that. And then, my sub-point would be related to something Kevin said, which is, and I know it’s sort of a — it’s an abstract concept now to talk about market makers, but how do we keep the quality market makers in there? If it takes a lot of capital and wide spreads, then let’s let that happen in order to keep the markets going.

I think one issue that’s concerned me is the focus on narrow spreads and low transaction costs may drive out some of the quality participants. And I know the difference between proprietary traders and market makers is pretty blurry, but you want them in there when you need them, and you want to let spreads be wide enough to make sure that the market still functions with quality flow on both sides when the going gets tough, and if it’s expensive it takes capital. As a listed company, that’s what we want to see happen, because we’re not coming at this from that micro-dynamic; we’re coming at this from the quality of our price and how it’s being set.

So, I’ll be happy to answer questions later on. Thank you.

Terrence Hendershott:
I would like to thank the Commission and the staff for inviting me. I’m an academic and I started off being interested in technology and how it affected markets, and I chose to end up focusing on financial markets because they were investing so much in technology, and it’s been an interesting career choice.

I just have a few points that I’d like to make. So the first is that I may differ somewhat from my professor, who’s eight milliseconds away from me, that — well, I don’t want to listen to what he has to say, so. So, all our evidence is that technology has been good for markets to the extent that you want to interpret technology as speeding them up. Then all the evidence is that faster markets have been good, and these are examinations over time of specific events, of how well the equity markets functioned during the recent crisis. I think the Commission’s regulatory framework, that fostering innovation and competition via technology, has been very successful in this regard and, you know, it needs to continue in whatever form is appropriate for the new structure.

High frequency trading is combining technology and strategies. We don’t have that much data on high frequency trading. I’ve gotten some data from NASDAQ on it. Thus far, all of my results are preliminary, but I haven’t seen any evidence that they do anything bad. They seem to be like all other market participants in contributing to both efficiency and liquidity. I would like to reiterate what points that were made on the first panel, so one was that regulations should really focus on behavior as opposed to necessarily particular labels of groups, because this would be very difficult, I think, and to enforce, so if high frequency strategies or tools were profitable to employ but were somehow constrained, presumably other people would start to incorporate them. So if you could think of a hedge fund that currently might now have two strategies, one is low frequency, one is high frequency. If it just combines them, how would we go about characterizing that? I would also note that high frequency traders have much less of an advantage over the traditional or the past high frequency traders, such as market makers and floor traders. and the really interesting questions to me are, you know, why aren’t the — if these tools that they have are advantageous, why aren’t they being offered to low frequency traders, and is there anything that we could do to remove those barriers and make it easier to level the playing field? And, also, if there’s — if market structures currently favor high frequency traders, we should focus on trying to — you know, why don’t we see new markets that are more hospitable to low frequency traders? Are there market based solutions? If we think high frequency traders disappear during times of stress, in Europe, they have basically regulations and exchanges to facilitate private contracting between listed firms and market makers to provide liquidity during times of stress. And is there anything we can do to encourage that sort of a structure here?

High frequency, as the Commission noted in its concept release, these are not new strategies. You know, we have a well thought out regulatory framework. If we think there are ways that it should be modified, let’s identify what the shortcomings are in the framework and try and address those. You know, for example, if we’re worried about flickering quotes, an easy way to reduce flickering quotes is to increase the tick size. This may have other unintended consequences, but it will certainly — there are good reasons why anybody who’s trying to be a market maker or place a limit order might want to adjust their quotes almost continuously, to try and avoid — it allows them to quote narrower spreads. So, overall, I think this is an excellent opportunity for the Commission to think through a useful framework to allow technology to continue improving markets. We should try and focus on, you know, why isn’t the market, more generally speaking, providing services to low frequency trading, to the extent that it’s not, and that we really want to focus on characterizing, identifying and regulating observable behaviors.

Thank you.

Stephen Schuler:
Chairman Schapiro and commissioners, thank you for inviting me here today. My name is Stephen Schuler. I’m the co-founder of GETCO. GETCO is an electronic trading technology firm. We provide liquidity to investors in over 50 markets worldwide. Simply put, we are a market maker. We post bids and offers, and investors choose to trade with us when we have the best available price. We are a regulated broker/dealer and trade on the public markets. We make markets and equities, commodities, currencies, and fixed income. In the equity markets, we are also a designated market maker in SLP and the New York Stock Exchange, and we are a registered market maker on BATS, NASDAQ, and NYSE Arca. GETCO firmly believes our modern markets provide tangible benefits to all investors. We also believe the Commission has been thoughtful as it looks to ensure our regulatory framework keeps pace with the challenges posed by the ever evolving market structure. For example, as we noted in our comment letters, we support the FCC’s proposals on flash trading, market access, and dark pools. We also welcome the opportunity to weigh in on the issues raised in the concept release.

Today’s markets offer greater competition, choice, and transparency than ever, but the events of May 6th clearly demonstrate that additional measures need to be taken. In trying to understand what caused the drop, some have questioned the role of so-called high frequency traders. As the Commission noted in its recent concept release, high frequency traders are not one well-defined group or industry. Rather, this term includes hundreds of different participants, with varied goals, trading strategies, and risk models. This may explain why some firms, high frequency, electronic or otherwise, withdrew from the market, and other firms like GETCO did not. Regardless of the causes of the May 6th drop, we need new rules to protect against destabilizing market events during times of economic stress, and the good news is that many reasonable solutions exist. In the new term, instituting circuit breakers on a stock-by-stock basis is an important first step. We also believe the Commission should abolish stub quotes, require exchanges to eliminate clearly erroneous trades, and prevent market orders and stops from causing runaway markets. These elements all play a role in diminishing investor confidence, because they create the potential for investors to receive executions at unfair prices.

We believe the Commission should also study the obligations and incentives around market making. As GETCO noted in our short sale comment letter last year, today’s exchange requirements for market makers impose no significant quoting obligations. Greater clarity around the role of market makers should play in our markets, especially during times of high volatility, will help investors regain confidence that the U.S. markets are not only the most competitive but the most reliable. To be sure, firms such as GETCO can help buffer volatility, but no single class of market participant can prevent natural swings, sometimes dramatic ones, in prices. This is especially true in anxious times like these. As we evaluate how to prevent another May 6th, it is important the Commission and exchanges implement new rules that are uniform across the equities and futures markets. This will ensure that these measures take hold precisely when they are needed most.

And I’d like to add that I think it’s really important for us to remember what the markets were like in the past, because it’s easy to say the good old days of the markets and what happened. I was on the floor and spent 19 years on the floor of the Chicago Mercantile Exchange. I was there in 1987. People put their hands down. You know, it’s not just electronic people that are removed from the market. You know, another thing that I’d like to say is that, you know, at GETCO, we are not a black box. We’re a grey box. We created software to leverage our traders and we have people behind those. And one of the very interesting things that has happened is we became a DMM in the last six months on the floor of the NYSE. And it’s remarkable to me how similar what we do on that floor, which is really 90 to 95 percent electronic, but at times the people there have to interact with the models and the machines to make sure the right decisions are made. That’s the same thing we do off the floor at GETCO, so I think we should be careful to wish for wider spread, less competition, and more cost.

And another point I would make is that, today, the spreads, they narrow when volatility is low and they widen in a dynamic fashion when volatility gets high, because to cross the transferring risks, that’s the right thing to happen in those kind of circumstances.

So, I want to thank the Commission and the staff, and the chairman for inviting me here today. I look forward to any questions.

Director Robert Cook:
Thank you. Jeffrey?

Jeffrey Wecker:
Thank you Chairman Schapiro, commissioners, directors, and staff. I’m honored to have been invited to speak before you and my distinguished co-panelists today.

My name is Jeff Wecker and I joined Lime Brokerage as President and CEO in December, 2008. Prior to that I spent over 25 years expanding computer assisted electronic trading in the market place. Lime is an independent agency broker and a leading provider of low latency, high throughput trading technologies to the professional trading community. Lime has been active in this phase for over 10 years, and a significant percentage of our clients are high frequency trading firms. We don’t engage in proprietary trading ourselves. We don’t internalize any orders nor do we operate any dark pools, and we feel that our independent agency-only status and acknowledged expertise for developing technology provides us with a comprehensive and unique perspective of BAT electronic trading.

The U.S. equity market is the greatest in the world. The financial services is one of our major exports. The U.S. is so successful because we operate in an environment which fosters creativity, innovation, and direct investment in new ideas. We need to continue to deliver a fertile environment to allow firms to continue to innovate and maintain America’s advantage in market structure and regulation — regulation which promotes transparency and fairness. The issues surrounding the marketplace today, however, go well beyond high frequency trading. The marketplace is evolving quickly and high frequency trading is only one aspect of that evolution.
One misconception that I’d like to address is the belief that high frequency trading is primarily conducted by very large firms with extremely deep pockets. Many of Lime’s clients are one- or two-person proprietorships, starting in a basement or garage with a computer and some new ideas. We at Lime believe that market access comes with obligations, and, as a result, we applaud the SEC’s proposed regulation to curtail naked sponsored access and force real time, preorder risk and compliance obligations under the direct and exclusive control of the sponsoring broker/ dealer, thereby preventing the potential for discontinuous, destabilizing volatility in the marketplace. We agree that the rule that was drafted levels of playing field for all market participants.

I’d like to spend a few moments at this time to discuss the notion of fair market access. My definition of fair access is more about preserving the climate for innovation and value creation, rather than forcing all participants’ technology to be equal. Fair access under this definition enhances market efficiency, drives increased competition, and leads to the highest levels of direct investments in capital markets advances. Unfortunately, some proposals adopt a definition of fair access that would dramatically reduce the competitiveness of the U.S. equity markets. Fairness, in my definition, would require execution process transparency and a disclosure by broker/dealers of conflicts of interest, so that investors can control whether to opt in or opt out of various internalization, crossing, and dark pool strategies, strategies which in theory leak a customer’s order information in the pursuit of execution quality. Full service broker/dealers, with the many services they offer, are inherently conflicted. Many of their activities are not adequately disclosed to clients who trust them with their orders. In fact, the evolution of the electronic internalization efforts and new proprietary trading activities within these firms have happened so fast that regulations need to catch up to monitor adequately and prevent potential conflicts that those strategies may have with a broker/dealer’s best execution obligations.

Regarding the topic of May 6th flash crash, it’s important to point out that we saw high frequency trading firms provide liquidity in proportion to market volume, during the most volatile periods of the day. This was true of most of our high frequency customers. In most cases, those customers added liquidity rather than removed liquidity, and served to dampen the volatility that was ensuing. Last year, in some of our comment letters, we advocated stock-specific circuit breakers to allow cooler heads to prevail during periods of extreme volatility. For this reason, we applaud the circuit breaker bid test in the new short sale rule, and also applaud the stock-specific circuit breaker proposal and the post-flash crash discussions is a great start.

Unfortunately, there’s been misplaced vilification of high frequency trading in the public spotlight. Often these opinions come from uninformed parties who don’t take the time to research market structure and understand all of the facts. At Lime, we believe that the Commission is doing an excellent job at researching the key issues and understanding the facts before proposing additional regulations. We know that the Commission believes that technological innovation has been a positive development for the marketplace. High frequency trading provides a dramatic increase in liquidity, increased competition, promotes electronic efficiencies, and lowers the costs of trading both through narrower spreads and lower commissions, all of which have contributed to making the United States equity markets the best in the world, but our lead is tenuous and depends on encouraging the best and brightest minds to invest their time and effort, to invent new and improved market technology. We need all forms of investors, both long term and short term, to provide a vibrant, efficient, and innovative marketplace where price discovery and capital formation yields fruitful results for all its participants.

Thank you. I’d be happy to answer any of your questions.

Director Robert Cook:
Thanks, Jeffrey. We’ll start with questions. Chairman Schapiro?

Chairman Schapiro:
Do you want to start? Go right ahead.


Female Speaker:
Well, I’d like to come back, actually, Chairman Schapiro, to the point that you made earlier that was echoed about the disconnect between fundamentals and stock price, and maybe bring in another issue that I think is too big to handle in some ways. And I guess I’d start with Mr. Grier and ask about issues that relate to criticisms to which our publicly held companies are continually subject about their short term-ism and the fact that they are managed at the extreme in a decidedly bad, and perhaps illegal, way in terms of managing earnings and concealing that, but not really to deal with the extreme, to deal with the general notion that, philosophically, people seem to want — and I would count myself among them — companies to be managed for the long term, and yet, you’re being governed in large part by stock prices that are being decided in the short term — the shortest of the short term. Could you comment on that and perhaps be followed by anyone else on the panel?

Mark Grier:
Yeah, thank you for that question. You almost gave my answer in the form of your question. This is an issue that we have had extensive discussions about within Prudential, and it relates to the intersection between compensation and incentives and the valuation of our stock and, you know, how all of that plays out over time to reward management for doing the right things and to ensure that shareholders are rewarded for having made the right investment decisions about Prudential. And your point’s very well taken. And one of the things on my list of other consequences or aspects to the trading and valuation challenge has to do with the fact that there’s a big move to pay executives more and more often in stock and to focus on the alignment with shareholders, but the challenge for us is, as you said, we’re managing the company, we’re managing fundamentals, and we might have, with respect to most of what we do, let’s say a three- to seven-year time horizon, but we live with a daily valuation environment for the stock. We live with headlines that creates. We live with what that does to rating agencies and what that does to the price of the stock and how directors react to the headlines and the consequences of the short-term behavior of the stock.

And I think, you know, the battle that we fight is to push the focus to the long term fundamentals, to keep reminding ourselves that we do manage the company, we don’t manage the share price, and to make the bet that someday, we’ll have the coincidence of value equal to price.

But having said that, the lay of the land is that we have to think about value, we have to think about valuation, which is how all the metrics get translated into price, and then we have to think about realization, which is that question about the ultimate coincidence between price and fundamental value. And those things may or may not align very well in the short term. We keep hoping and having faith that over the long term they will and that we can manage that way. But your point is very well taken about the basic conflict between the stock price as our report card and the way in which that price gets set.

Commissioner Elisse Walter:
But I did not hear you, which I thought was interesting, call for changes in how trading is conducted because of that problem, and that’s one thing I guess I’d like you to either confirm or not.

Mark Grier:
I think with respect to the questions about the way in which trading is conducted, the basic theme that emerged in the first panel and came up several times here is the notion of a circuit breaker. And my interpretation of that would be step back and take a deep breath and let the fundamentals lineup again, because the fundamentals are out there somewhere. In the short term, we’re off the rails and we need to let the market assess the fundamentals and bring them back into the pricing environment.

So, I think my view is that the way we need to address it is to do things that every day will do the best we can to align fundamentals with market prices, and I think that means making sure that we have these mechanisms to get the fundamentals back into the pricing process when they’re divorced or disconnected.

Stephen Schuler:
If I could comment on that, Commissioner. One of the implications of your question for me is that the prices in the market are really set by a the likes of a Getco and others who are using short-term strategies, and I think that what we — and I can speak most clearly to what we do — as I said in my opening statement, we provide bids and offers for investors, long-term retail speculators, the whole ecosystem of investors to make decisions to buy or sell. We’re in the practice of trying to find the best price equilibrium in a very short timeframe. I think we have little to no effect on the long-term price of Prudential or other shares in the market. I think that is clearly set by the longer-term investors and so I don’t agree that — I of course disagree with that term “high-frequency traders” because there are so many people in the markets that use technology to apply to trading strategies.

So, the frequent turning over of stocks in the market does not mean that it leads to the different price; that is really fundamentally driven the same way it has for a long time. It’s just about the short-term pricing and equilibrium of trading, in my estimation.

Director Robert Cook:
Sal, did you want to —

Sal Arnuk:
Yeah, thank you. Thank you, Director Cook. Regarding long and short-term time horizons, I think to address — to kind of hit on what you were talking about, what I fear are long-term investors fleeing the market, and they’ll flee the market when they lose confidence. And they’ll lose confidence when they feel — when: A, they see the type of volatility that we’ve had in 2008, or that we’ve seen in March 2009, that we’ve seen in the flash crash; we’ve seen this much-elevated volatility level that we’ve never seen in years past. That’s one thing that’s going to make them less confident about being staked and owners of our market.

The second thing is a rigged game. I was surprised, respectfully, that in the first panel — which was an outstanding panel, very informative, great points of view — I learned — I questioned some of my preconceived beliefs after listening to the panel. But I was surprised that in a discussion of market structure, no one talked about the conflicts of interest of ownership, of broker-dealers owning stakes in exchanges, high frequency firms owning stakes in exchanges. And in this process, the conflicts inherent in that, the conflicts inherent in the maker-taker model, the conflicts inherent in payment for order flow.

I’m pretty sure that the online brokers don’t make their money by selling — by charging you $8 a trade; they make most of their money by taking your order and selling it to someone else who’s buying it because they can make money of it — off of it. So, in this whole procedure, in this whole circular conflicts of interest, we’re supposed to ignore that these conflicts exist and still pretend that we have a mandate and we take seriously our duty to put investor and traders’ interests first. I find that curious.

Stephen Schuler:
If I can — I’m sorry — just comment on a couple things. I think it’s tough to say that volatility just popped up in the last 10 years since the speed up of the markets. That’s just not true. That’s — the volatility in the market has been around since the 1930s, so I don’t agree with that.

A rigged game? I don’t know. I think that people might have felt like it was more of a rigged game in the late 90’s and early 2000 when there were only two places you could get your orders executed.

Now, I do agree with Sal that there are inherent conflicts that the Exchange should take a look at. And actually, in a perfect world, you should be Agency or Prop, and that’s it. We think — that’s how we feel at GETCO. So, I do agree with Sal that there are conflicts and you have to be careful about.

Kevin Cronin:
Can I take this maybe in a little bit different direction? I guess you have to start fundamentally with what is the problem we’re trying to solve for here?

It seems to me that, as I’ve read the release and I certainly understand capital markets over the years, that what we’ve tried to do in the U.S. marketplace is to create an environment that facilitates the formation of capital and long-term investment. I submit to you, if that’s still the goal here, that there are concerns, real concerns, that all of us need to be aware of. And to the extent that some of the new participants in the marketplace are eroding confidence or creating a marketplace that is dislocated from the fundamental value of companies, then we need to think about that.

From our standpoint, as I say, we think that there are parts of high-frequency trading — I’m sorry, Rich, I forget what cool term you guys gave yourselves, but automated professionals or something; I don’t know. Maybe that will stick. Dark pool still sticks; we tried a couple of other creative terms that didn’t work.

But the fact of the matter is there are a fair amount of participants that are out there that we don’t know much about. Seventy, perhaps, percent of our volume is taking place today by people in strategies and participants that we don’t know much about. I think that’s problematic. They don’t appear to be people who are interested in the long term. We could all define long term differently; I submit it’s not seven or eight seconds. They’re not investors: they’re traders.

And so I do take umbrance [sic] when you call yourself a short-term investor. You don’t know the companies that you invest in. You know nothing, fundamentally, about them. You guys just buy and sell them because that’s what the computer says.

Other participants in this marketplace really kind of do care what happens to Prudential and other listed companies. We do a lot of fundamental work. We have people entrust us with their assets. They give us their money and they want us to make sure that we have good ideas, and when we implement those ideas, that we’re not taken advantage of.

Today it’s very difficult to say that there are not segments of this market that are taking advantage of us. They use strategies that are trying to gain what we’re doing. You want to talk about proliferation of dark pools and crossing networks? Why do you think that is? Dave and I and others who participated, Gus and other buy-side guys who have been here have an obligation, a fiduciary obligation to represent the best interest of our clients and we take that obligation very seriously.

So, as this market has changed, and believe me, we were sounding the horn; the old world wasn’t working for us, and we could all debate whether this incremental decline and ultimate cost is associated with that sea change or the advent of new participants or electronic markets, and that debate will rage on probably in perpetuity. But the fact of the matter still remains that when it comes time for us implement an order, we have people who are trying to gain those by sending almost — I don’t know how many orders it is in a nano-second, micro-second, pica-second; it’s a bunch, and most of those end up being canceled. Some theorize that 90% of them are canceled. They flicker on the offering side; they cancel. They try to see if an algorithm will take them.

What’s the value of that? I think it’s a zero-sum game. Any time that someone jumps in front of my quote, all that really happens is the seller may be price improved, but I’m just going to have to move my quote up, in essence, to try to get that done. What they’ll hope is that they can sell it at the same price and make the fee rebate, or even better, if they can offer it a penny higher, they’ll make that incrementally as well.

I don’t see that as beneficial to me, I certainly don’t see it to the long-term formation — capital formation process in the U. S., and I think that behavior needs to be looked at. I’m not painting a broad brush and saying that market makers and DMMs are bad. In fact, I think people like — or firms like GETCO probably do a lot of good things in the marketplace. High-frequency trading in general doesn’t necessarily mean it has to be a bad thing, but I think there has to be some differentiation of who is who and who does what and what they rely on to be able to make money. If all that happens here is that somebody jumps in front of us, and we don’t want to post limit orders, I can’t imagine that’s a good development for any of us.

We talked about, in an earlier panel, that there needs to be incentives to post liquidity. What incentive to I or David or anybody else around here have to post real liquidity when invariably, the next second, somebody will just jump in front of us? And they don’t care about a company, and they don’t care about what really happens in 10 seconds or 20 seconds.

Director Robert Cook:
Let me jump in here. I think that Chairman Schapiro has a question.

Chairman Mary Schapiro:
Thank you. Kevin really started to walk into the area I wanted to start to explore. I actually have a lot of questions. I want to come back to one about fee differential that exists with respect to direct exchange fees and consolidated market data fees; I think that’s an important area for us to cover. And I want to come back to Steve Schuler’s point about exploring incentives around market-making and obligations and where we should go with that.

But my immediate question really comes very much out of the Concept Release where we ask about what kind of strategies are employed by high frequency traders. And a panelist on the first panel made very brief mention of two strategies, and so my first part of my question is whether anyone would like to defend order anticipation or ignition strategies?

Richard Gorelick:
I’ll take this. This is something that we talked about in our comment letter, and there were two strategies that were outlined in the Concept Release, or so-called strategies.

One of them was described as momentum ignition. We looked at that and we also looked at the rules that we see on the various exchanges, and it appears to us that’s clearly manipulative and that there is existing authority to go after those types of strategies and that that is an area where the Commission and the exchanges and this SRO should be looking at. If people are actually doing those things, then that seems to be something that there are — is valid for enforcement actions today.

With respect to the other strategy that was described, which is an order anticipation strategy, from our standpoint, it really is — order anticipation is what the market is supposed to do. What the market is supposed to do in order to provide a valid price discovery function is to be able to take all information, all publicly available information, into account and understanding supply and demand, finding out what an equilibrium price is and making that available to the markets in an efficient and quick fashion.

It’s hard to imagine that a concern over the way that some people may use publicly displayed information could lead to rulemaking that would actually make the markets work better for investors. My concern would be that if you limit the ways the people are able to use public information that what you end up with is a market that is higher cost and less efficient for investors.

Terrence Hendershott:
Could I follow-up on the order anticipation here? I would draw the distinction between that and front running, where someone has a fiduciary responsibility to the order that they’re trying to — that they may be anticipating, and that this is obviously bad, and we certainly should be worried about any sort of a firm or brokerage who’s using a dark pool or something like that to try and anticipate nonpublic information, especially if they have an ownership stake which may give them access to that information. So, there are particular kinds of order anticipation that we should be worried about and we have an existing framework to try to think about it.

David Cushing:
I would concur with those distinctions and just add that we invest a fair amount of time in basically trying to avoid being anticipated, for lack of a better way to put it.

Sal Arnuk:
Well, if I could just weigh in a little bit. I know we did a couple papers on this stuff. This is really the realm that my firm kind of jumps into, trying to protect our clients, clients like mutual funds and long-term investors, from having their — I was going to use a dirty word — their orders compromised. Sorry about that.

Female Speaker:
You didn’t use it; it’s okay.

Sal Arnuk:
I didn’t. My mom would be proud.

Anyhow, Richard, it’s one thing if you are day trading in a very hyper — a very hyper way, a very speedy way; you’re looking for aberrations in one minute volume, five second volume, ten second volume, and acting upon it.

It is an entirely different thing when you are furnishing the exchanges and ATS says, “Hey, it would be really great if I could be able to tie back the execution to the order number, if I could kind of infer how big the seller is at $87, if I could do all these different things,” which is some of the evidence we found, and the exchanges provide it. Is it public? Yeah. But should it be? No. There should be one sip.

I believe that there’s — the very fact that there’s — and this is a slightly separate issue — the fact that there is any differential between a private take that is either sold or provided, or the public sip which all the algorithms pretty much run off of, it’s like shooting ducks in a barrel of honey, because you can see them coming. If one group of order flow is using algorithms in a somewhat predictable manner — some algorithms try to be better than others and less predictable, but to some extent, they’re all predictable — if they’re going based on a set of quotes that are stale and the co-located folks are purchasing compressed data feeds with extra information that allow them to kind of reengineer the NVBO and see these guys coming, then it is a rigged game. And if it is a rigged game, you’re right to have issues — you’re right to be concerned and you’re right to question confidence and be worried about it in the long term.

David Cushing:
I would disagree that an algorithm provider that chooses to buy a slower feed and suffers for it is a victim of a rigged game. I mean, they certainly have the right to buy fast feeds as well, and I would expect those kinds of algorithms to be rooted out of the market pretty quickly.

Kevin Cronin:
And we have an obligation to understand all that, right? So, our objectives of best execution aside, we also now have become detectives to try to figure out each permutation of how each of these different things could work, and that’s our responsibility. We get that and we have acknowledged that and I think we do a very good job of implementing it.

But I do go back to the fundamental consideration which is what is the value of a potential decrease in spreads if it really ultimately retards people wanting to put limit orders on the book?

Ian is a friend of mine and ITG is an associate of ours that we’ve used for a long, long time to try to identify cost. I submit to you that today, as smart a guy as Ian is, and he’s smart — he’ll tell you about it all day long, I promise you — but as smart a guy as he is, he has to acknowledge that there are dimensions of cost that today we do not have the ability to really understand.

One of those dimensions of cost is what is the value of a quote? They are not too many people in this room, even Rich, who really understands supply and demand at a given point in time, right? And there’s a cost to that. And the cost, unfortunately, continues to be exacerbated I think because there is no incentive for us to post liquidity. And so if this activity of trying to jump in front of us or paying orders in different order venues that we use to try to conceal our interest, is that really where this marketplace should be heading? I don’t think it is.

I don’t think that we’re trying to necessarily say that all participants that are trying to find out what we’re doing is bad. I don’t think that’s the case at all. But I think there are some dimensions of that behavior that are not only questionable, but frankly, I think should be disavowed.

Chairman Mary Schapiro:
That really relates to the second part of my question, and Kevin, you started down this path. What is the value to the marketplace? And what are we to tell long-term investors or retail investors or institutional investors about the strategy that has thousands of orders entered in a second and a thousand minus 99.9% canceled within that same second. What is that doing for the marketplace?

Richard Gorelick:
Excuse me, Chairman. I think that’s a very good question and I think that it’s something the exchanges have been thinking about for a long time, and participants in the market, that really there is a cost to a quote — a quote that is unlikely to be executed, that’s far away from the market, that doesn’t add a lot of information to the marketplace, costs as much for everyone to handle throughout the entire system as a quote that’s close to the market that is likely to be executed, and that adds a lot of information to the system. So, that is an area where it’s definitely worth some consideration about whether or not the costs involved with quoting are appropriately aligned with the benefits of that quoting.

That said, the exchanges have been thinking about this for a long time. They bear a lot of the cost, although certainly, the market as whole bears many of them as well, and they’ve generally made the decision that there’s not too much volume out there that they can’t handle it. There’s not too much volume that it’s too expensive for them to handle and that the value of most of the quotations that they get does actually add value to the market.

I think this is an appropriate area to explore, but I don’t think it’s an area that’s imposing so much cost on the marketplace that it’s an immediate risk, and the risk of imposing too much cost on the quote is that you’re going to widen out spreads and hurt investors with higher costs.

Commissioner Elisse Walter:
What if you were to — and understand I’m not advocating this — what would be the consequences of imposing a minimum time that a quote had to stay alive?

Terrence Hendershott:
So, I’ll jump in. The limit order is a free option for somebody to trade, and so the longer you make them impose it, the longer the quote has to stay there, the longer the option is, the more valuable it is. Presumably, everybody who places the quote would widen their spreads accordingly.

One way you could do away with those costs is to also make market orders wait a second before they execute, and this would go back to Michael’s point about maybe we should just run a call auction every few seconds. So, you could slow things down, but if you impose costs on the supply side of liquidity, you’re probably also going to need to impose similar costs on the demand side.

David Cushing:
The question that I struggle with is that option is certainly available to the markets today. In other words, someone could come out with a market that has such a minimum quote time or a minimum execution time or runs auctions every few seconds or some such thing. I haven’t seen that yet. I would be interested to see it, but I’m not sure why the market doesn’t demand it.

Commissioner Elisse Walter:
But isn’t that tied in to the question of what does best execution really mean and the extent to which people have placed speed as a premium over other components? I think it seems to me today everybody is running so fast they’re not necessarily thinking or giving equal weight or perhaps even more weight to other factors.

Stephen Schuler:
Well, I would submit that it may be counter-intuitive to people, but speed actually reduces risk, okay? Because knowing that we can cancel our call option that we give people that trade with us allows us to create better entire markets. So, I think that speed and pricing go hand-in-hand together, so I don’t think it’s just about speed.

And secondarily, I want to comment that we are very much for regulating predatory practices by algorithms and high-frequency traders, if you might call them. We agree those are not good for the markets.

I would also like to comment that at least at GETCO, we do take a very long-term view of the markets even though we trade in the short term. In the long term, we provide a service to investors and we have a business model that we believe is aligned with what’s best for markets in the long run. We’re not looking to capture fleeting inefficiencies, because frankly, that’s a short-term business model. We’re looking to provide prices to the public to trade with that are efficient and drive efficient markets and we have a long-term business plan; we’ve been in business for 11 years, and we think and talk in our organization about the next 10 and 20 years. So, we do take a long-term approach.

Kevin Cronin:
Stephen, you do have quoting obligations because you are DMM and a registered market maker, correct?

Stephen Schuler:
We have — yes, we do, but we recently just acquired those. We stayed in the market in May 6th; we’ve stayed in it not only on the floor of the New York Stock Exchange under those obligations, we stayed in the market at BAS and Nasdaq. We were in the markets in December of 2008 during that crisis. We have always taken the philosophy of staying in the markets.

I know that some people didn’t and haven’t, but I would submit that a lot of those people weren’t high frequency or people trading in a frequent nature. They were those who were trying to reduce their risks, so they either stopped trading or were selling to try to reduce their risk.

Sal Arnuk:
If I could weigh in on the value of a quote and how it’s tied to speed, and it goes back to the issue of confidence.

You need to have the confidence that the quote that you see on your screen is accessible. And I can tell you as a trader, and I’m sure anyone who’s traded a stock on this panel could tell you the same thing, I can’t tell you how many times I saw a bid for 50,000 shares and I had an order to sell stock for a client. I go to sell the stock, and mind you, nothing’s traded three minutes before I come in, nothing is traded — I’m the only variable coming into the situation. I go to sell the 50,000 shares. I get 13,600 off. Maybe 200 shares were price improved by some nonsensical feature. I had an odd lot in the middle, you know, dark pool execution, which triggered most of the bid to cancel before I had a chance to finish selling the stock in that instant.

So, the speed is tied to the quality of the quotes. So, yes, speed is good. Speed is good when it’s good for everybody and everyone is on the same playing field. But when certain participants have this co-located advantage and are using it to make markets in ways that — I mean, I’m sure I would love to be able to put out a bid, and when someone goes to hit the bid, I’d love to pull the bid. That’s a really neat feature. I’d like to do that. I bet you I could make a lot of money if I only choose to interact with order flow that I thought I could beat. And that’s the issue.

Jeffrey Wecker:
Sal, I think that’s an unfair characterization, though. And it’s very easy to paint all of these different issues with an extremely broad brush.

I want to talk about two things. One, with respect to the conflicts of interest you mentioned earlier, I think conflicts of interest arise because financial service companies have lots of different businesses within them and those businesses sometimes appear to be conflicting with each other. It’s no different today than it was 25 years ago when there was a market-making operation and a research advisory operation. I think conflicts — we have to be careful when we’re looking at conflicts of interest. Do we want to eliminate behavior, or through disclosure do we give the investor, the customer a choice whether or not he wants to interact with that service provider? So, that’s the first thing.

I think the separate issue — well, that’s it for now.

Director Robert Cook:
Can I jump in? I think Commissioner Aguilar had a question.

Commissioner Luis Aguilar:
I was struck by Stephen’s statement that speed reduces risk and I wanted to ask a follow-up question that deals with this tension between speed and quality. Does the focus on speed, the focus of providing instantaneous execution on orders, does that make the system more vulnerable to fleeting imbalances on supply and demand and thus really more unstable? And where does that instability go? Where does the instability fall the most; is it on individual investors?

Stephen Schuler:
Well, I would answer it in this way: Certainly, the events of May 6th, be it fragmented markets, the pressure that was going on for selling, coming into that from the Greek crisis, there’s a number of things that happened that led to the events on May 6th that are clearly unacceptable, okay? But if you look at the last 10 years in the market, when the prevalence of electronic trading has really come along, I think mostly till, like, September 15th of 2008 when Lehman went bankrupt, in the times that followed, you know, speed did reduce the risk. The markets worked fabulously well — much better, I’ll submit, than they did in ‘87 and in ‘97 and other times. So, I believe the preponderance of the evidence is that speed does reduce risk.

Male Speaker:
And yet if you were one of those limit orders that got done on May 6th, I would submit that speed was the worst thing that could possibly happen to you.

Stephen Schuler:
Well, and we were some of those limit orders that got done on May 6th.

Chairman Mary Schapiro:
And so how much speed — to go back to I think it was Michael’s comment — how much speed is enough speed? And how much differential in speed, whether it’s in data feeds or trading as a result of co-location, is too much differential in speech?

Stephen Schuler:
Well, I think that it’s a — I don’t know the answer to what’s too much speed, but I do believe that it’s a very slippery slope when you start regulating, you know, how long somebody has to hold their quotes. I mean, I just — I keep making references back to when I spent time on the floor and in those markets and thinking that you could require people to keep their hands up in the face of the market crashing down on them, I don’t think it’s realistic, necessarily.

So, I think that it’s allowing — and I think Jeff made some great comments about creating a framework that allows innovation in the markets and that fairness is not, and would be a major mistake in the financial markets and in other industries if we’ve tried to slow everything down to the lowest common denominator. We would not have the most competitive financial markets in the world if we did those kinds of things. Yes, there are some differentials, but I think as some of the panelists — David Cushing spoke — the buy side is able to avail themselves of co-location services themselves, and so I don’t think that that differential is really there the way people think.

And then another point I would make is that it — and this is particularly about GETCO. We provide a service to investors. We’re not in competition with the retail or the long-term investors. We actually provide a service. We’re a middleman that helps to transfer risk from one party to another. So, that’s how I would answer that.

Male Speaker:
Michael, you had a comment.

Jeffrey Wecker:
One thing I’d like to say about Steve, though, is every market participant has the right to determine how important speed is to their own form of investing right now, and any market participant has the ability to get faster and faster speeds. At Lime, all we offer is fast data, fast access to markets, and there is no one on this panel, if they wanted to access speed, that they would have to build it themselves. They could go to service providers in the marketplace like ourselves and get it for a fraction of the cost of doing it themselves.

Michael Goldstein:
That having been said, since I brought up some issues with speed, if I could take a quick second. Speed may reduce risk, and that’s not inappropriate, but it may impose costs on others. That’s the role of government and the Commission, to decide whether that trade-off is okay. I also want to make it clear that I’m not advocating that we go back to having a minute per trade or a second per trade, but we were at 10 milliseconds per trade, like, a year or two ago. The world didn’t fall apart necessarily because we were at 10 milliseconds a trade.

This is — I guess — you know, there are limits. Taking two ibuprofen make my headache better but I can’t take the entire bottle. The fact we’ve gotten better since 1987 in speed and that’s been better is like going from walking, to horse and buggy, to actually having a car, but I’m not allowed in New York or in Massachusetts or in most states I am aware of to drive at 170 miles an hour though I can buy a car that can do it.

I guess the larger point us that there is a legitimate trade-off between somebody who is posting a quote and wants to be able to withdraw it to reduce their risk and somebody who wants to access a quote and wants to have a modicum of chance that it there. And this is a trade-off that government, in the end, sets rules and decides.

I’m not, again, going to advocate that it’s not — all I’m saying is there’s a point. Here is another example, which is that Chicago is — you know, again, I’m loving these statistics, right? — Chicago at the speed of light is about four milliseconds away. Well, unless we want to force everything to be in New York — all right, Chicago in Illinois has a legitimate claim of being part of the United States. If they want to have a financial structure, for example, that offers options and derivatives and other things, and some of those maybe we should have some arbitrage relationship with stuff that goes on in New York, all right? There is just, like, an eight millisecond turnaround there just to get those two arbs [spelled phonetically] going in speed. By that time, conceivably, you’ve had eight or nine or 10 or 20 executions, and that’s an actual problem.

Stephen Schuler:
I disagree. We’re in Chicago, and that’s not a problem for us. So, I — I mean —

Michael Goldstein:
It can’t mathematically be true. Unless you co-locate all of the computing servers and all of the markets next to each other in New York, there will be a time delay due to distance. You may not care about the eight millisecond change, but if you don’t care about it there, I’m not sure why you’re caring about it so much in the equity markets.

Director Robert Cook:
I want to make sure we get some questions in before we reach the end of our panel time.

Commissioner Troy Paredes:
So, lots of discussion around pros and cons; a lot of focus on some of the cons and some of the concerns, and my question is this: We can always point out a particular incident where we would say, “Boy, we wish it didn’t turn out that way,” and we could point out something else where we could say, “Boy, it’s great that it turned out that way.”

So, what I’m trying to figure out is how do we take the views that have been expressed and map them onto what seems to be general agreement about the overall quality of the markets, how they performed and how the performance has improved over the more recent years. I appreciate that there may still be room for improvement, but there has been, again, a whole lot of focus here on what’s wrong with the markets and where the concerns are, and I think it’s important to put it in the broader context of the ways in which our markets have in fact improved over the years.

And the question then, in addition to that, is are we missing measures of market quality? And so I said what folks tend to focus on have indicated a great deal of improvement, but perhaps we’re not focusing on the full set of characteristics that we should be focusing on.

I see Kevin’s interested in jumping in [unintelligible] —

Kevin Cronin:
You know me. So, can I just say about speed that we have spent a lot of time talking about speed and very little time talking about price discovery. So, I’m not sure that the two aren’t inversely related at some point. The more speed you have, the less price discovery you have.

So, I think the metrics of market quality have been reported to be things that are self-interest by varying participants, right? So, speed is the most important thing if you’re an exchange or a high-frequency automated trading specialist, whatever. That’s an important consideration. For us, it’s a tertiary consideration, right? The quality of the market, how many people are there interacting, buyers and sellers getting together, really trying to understand the supply and demand dynamic. In the long term, absolutely. We hope the fundamentals reflect the pricing. In the short term, that’s always subject to an imbalance of supply and demand.

So, as I look at the market structure, this thing is not entirely broken. Despite our proclivities to focus on the negative, there are a lot of great things that have happened in this marketplace. But I do think at the margin there are things that we can do, some of the suggestions we made about really examining high frequency traders and internalization and other things, that I think can prove more beneficial. It won’t necessarily solve a May 6th problem, but it certainly will take care of a lot of different issues that come up on May 7th, 8th or 9th.

Richard Gorelick:
Commissioner, thank you for that question. Kevin, to your point, I think you do bring up a lot of these anecdotal concerns and objections, and I think they’re valid. I think we need to look into them. I think we need to understand them better, and I support your call for greater transparency, but I think it’s very dangerous if we want to start regulating primarily or solely on anecdotes.

I think we do need to look at the overall market quality that we have here. And by every metric that I’ve seen, and by every metric that has been produced by this effort, by every metric that’s been published, it seems very clear that market quality has improved, specifically to the point of there’s no doubt that spreads have declined, that transaction costs have declined. There is no — no one is really seriously objecting to any of those concerns. There may be some questions about market impact, but all of the real time series that I’ve seen make it very clear that market impact has declined considerably for institutional orders over the years.

If you look at the data about price discovery — we provided a report in connection with our common letter, which I urge people to take a look at and critique any what that they like — but what we saw, and it’s very consistent with the data that we’ve seen in other data sets, including some that Credit Suisse did as part of this process, short-term price discovery has improved dramatically with much less micro-volatility than there’s ever been in the market.

And people may ask why that is. To me, the answer is very clear that it’s because of the open competition in these markets. My firm, we don’t determine the price better than anybody else at any particular time. We’re not enough on our own to set the price in the market; I suspect GETCO also is not that. But by having a vibrant, competitive market with fairness and open access, that is the — those are the ingredients that are needed to have a reasonable process to determine price discovery. And the evidence is that over the last several years as markets have become more electronic and more competitive and open, the price discovery function has improved dramatically.

Commissioner Luis Aguilar:
Rich, you said — and I want to make sure that I heard it right — there was market impact on institutional orders was minimal? Did you mean institutional orders? Where are retail orders in that spectrum?

Richard Gorelick:
I think it’s never been a better time to be a retail order than it is today. Retail size orders are small enough that most of the time they can go off at the inside without any price impact at all. So what they care about primarily is spread and, to a degree, the size on the inside. But their size requirements are much less dramatic than for institutional investors.

So, the price impact measures that I’m referring to are done by folks like ITG, and those trends over long periods of time, as we heard earlier today, are convincingly clear that price impact for institutional size orders has declined over a very long period of time, and consistently.

Sal Arnuk,:
You know, Richard and Steve, you bring up a couple of good points. First of all, there is no one type of high frequency trading, so it’s unfair to label everything with the same broad brush, and I’m sorry if I’ve appeared to have done that. But you also bring up another point which is that all studies show that this is all beneficial. Spreads are narrower, liquidity has never been deeper, things have never been better, and yet May 6th happens.

What I would like to submit and what I’d like to bring up is there aren’t as many studies criticizing high-frequency trading because the data is just real, real hard to get. If I called up your firm and said that I would like to examine your trades and your trading strategies, I don’t think you’re going to accommodate, and I don’t think Stephen’s firm is, either. And that’s why I think the Commission’s idea of a high-frequency trading tag or it allows the data to empirically speak to what’s valuable, what’s going on, what’s accurate, and what is just noise, even if it’s my noise.

Chairman Mary Schapiro:
Could I ask one last question, maybe? I know we’re a bit over time, but it’s actually kind of an operational question. The comment period closes tomorrow on the single-stock circuit breaker proposal, I believe, and there’s already obviously been lots conversation about expanding those well beyond the S&P 500. So for the trading firms, what’s the operational impact if we assume that those single-stock circuit breakers are in fact approved by the Commission and implemented by all of the trading venues?

Richard Gorelick:
From our perspective, it should be relatively light. We will have to recode some of our systems. We’ll have to observe how stocks behave around those thresholds to make sure that there’s no distortions there that we need to be able to take into account into our risk-management, but generally speaking, it should be fairly straightforward, and from what I understand, the fact that we’re building upon circuit pause infrastructure that the exchanges already have should minimize the market impact.

It’s not that this will be costless; there will certainly be some costs involved, but the opportunity to preserve the improvements in the market structure over the years at that relatively low cost while avoiding the likelihood or the possibility of a recurrence of the events of May 6th seem to tip, in our view, the balance in favor of those circuit breakers.

Stephen Schuler:
I would agree with Richard, and one thing I would say: one of our biggest concerns is that — and I said in my opening statement — having uniform pauses, and not having different pauses at different exchanges at different prices, that’s what’s going to cause problems, in our estimation. That’s going to increase the risk. In particular, even though we’re a DMM, having the LRPs at two percent when the rest of the market breaks at five percent, that’s a cause for concern for us. Uniformity we think is important.

Chairman Mary Schapiro:
Can you just go into a little bit more detail about what the implications would be of that, in terms of the risk?

Stephen Schuler:
Well, I think that when you look what happened on May 6th, I think that the intentions of slowing down the market on the floor were well intended, without a doubt. And I don’t know for a fact, but there was a lot of concern that that pushed the orders to all the other different markets and increased the cascade of selling.

Now, we don’t know that for fact. We think that there is a lot of good things in the LRP and we are a member of that exchange, but we’re concerned that the inconsistency of rules across exchanges during times of stress is not a good thing. And that’s not a time for, in our estimation, exchanges to try to differentiate themselves. That’s the time for exchanges to work together with the rest of the industry to have uniform rules so that we do have those pauses in trading and people can gather themselves and think about what’s really going on and, as Gus said earlier, the world is not really coming to an end.

Director Robert Cook:
Any other comments on the operational implications of the circuit breaker?

Okay. I think we’re at the end of our panel time. I want to thank all the panelists for sharing their time with us, and their expertise and insights; very valuable, and we appreciate that very much. Just a program note that for panelists and Commissioners, including the panelists — the other panelists for the day: We have lunch available on the ninth floor. The staff in the auditorium who can help you find your way up there, and we will be reconvening after the lunch hour at approximately 2:30. Thank you.

[end of transcript]


Modified: 06/18/2010