Speech by SEC Staff:
Remarks at the Security Traders Association of Chicago Mid-Winter Meeting
Elizabeth K. King1
Associate Director, Division of Trading & Markets
U.S. Securities and Exchange Commission
January 23, 2009
Thank you very much for inviting me to Chicago this year to provide the SEC update. The SEC, like the rest of the federal government is in transition right now. I am hopeful that this transition will be short-lived since, as you likely heard, Mary Schapiro was confirmed last night as the SEC's new Chairman. Before I begin I must remind you that my comments today represent my own view and may or may not represent the views of the Commission or my colleagues on the staff.
Over the last few years, the U.S. securities markets unquestionably have faced difficult challenges. On the equities side, the industry completed its implementation of Regulation NMS in March 2007. As you know, Reg NMS was the most sweeping regulatory change of U.S. market structure since the 1970s. On the options side, the penny trading pilot began in January 2007 and has been expanded over the last two years to cover more than half of options volume. In addition, several options exchanges have introduced the maker-taker pricing model, which has changed trading dynamics and posed further challenges for market participants in navigating a changing market structure.
After only a few months experience with trading under Reg NMS and penny pricing, the crisis in the credit markets began in earnest in the summer of 2007. Trading volume and price volatility immediately spiked higher, and they have continued to break record after record as the credit crisis unfolded. In tough trading conditions such as these, a market structure truly is given its acid test. Perhaps the most basic aspect of this test is simply a market's ability to continue trading in a fair and orderly fashion, particularly on those extraordinarily difficult days when volume and volatility reach uncharted territory.
I believe that the U.S. markets for exchange-listed securities have passed this test with high marks. Order routing and trading systems have operated smoothly with only isolated problems, even in the face of recent, difficult economic and market conditions. The exchange-listed markets have been able to fulfill their price discovery function that is so vitally important to the public. Participants in the stock and options markets generally have been able to buy and sell when they want to do so at prices that are in line with the quoted prices they see on their screens — although these prices may be moving quickly.
Notably, many of the technology systems that have held up during the credit crisis had only recently been put into service when it began. When implementing Reg NMS, for example, many exchanges and firms developed new order handling and execution systems with much greater speed and capacity than the old ones. In addition, exchanges and firms greatly expanded their overall level of connectivity among other exchanges and firms. They made these changes both to meet the new regulatory requirements and to respond to competitive pressures for more efficient trading. The upgraded systems and expanded connectivity have served the securities industry well. Their solid performance is a credit to the expertise and hard work of participants throughout the industry, including exchanges, sell-side firms, buy-side institutions, technology vendors, and many others.
The solid performance of the markets for exchange-traded stocks and options can be contrasted with severe problems that have cropped up in purely OTC markets for financial instruments that are largely unregulated. Unfortunately, poor performance attracts a great deal of public attention, while good performance is not particularly newsworthy and is generally taken for granted.
Today, I want to highlight two essential elements that characterize financial markets that are well-organized and regulated and capable of withstanding tough times, yet are lacking in poorly organized and unregulated markets that seem to fail just when they are needed most by their participants. You are unlikely to be surprised to hear that transparency is the first element. In an efficient, well-functioning financial market, participants have access to reliable information to guide them throughout the trading process. Such information enables them to understand the nature of the instruments they are trading, to see the prices at which the instruments have traded in the past, and to see the quotes at which others are willing to buy and sell in the future. The second element also is unlikely to surprise you — confidence in a market's infrastructure. In difficult trading conditions, market participants must have confidence that if they seek to buy or sell an instrument, the trade will be efficiently executed, cleared, and settled — both when they initially establish a position and when they want to liquidate that position in the future.
Needless to say, transparency and a confidence-inspiring infrastructure are not novel principles of financial market structure. Given that history teaches over and over again that transparency and confidence are essential for financial markets, it is most unfortunate that financial instruments trading in unorganized and largely unregulated markets have caused so much damage — damage that has spread out to other markets and to the economy in general. These instruments — which include the now familiar alphabet soup of MBOs, CDOs, CDSs, and ARSs — have attracted systemically important levels of volume, yet without the well-considered market structure protections put in place for exchange-listed securities.
Credit Default Swaps
In recognition of the need to strengthen the oversight and the infrastructure of the over-the-counter derivatives market, in November, the President's Working Group on Financial Markets, in which the SEC Chairman is a participant, announced a series of initiatives. One of these initiatives is the development of one or more central counterparties for credit default swaps, for which recent events have underscored the need.
A well-regulated and prudently managed central counterparty for CDS has the potential to significantly reduce counterparty credit risks to market participants. A CCP can also reduce systemic risks by preventing the failure of a single market participant from having a disproportionate effect on the overall market. A central counterparty can also facilitate greater market transparency and encourage a more competitive trading environment, which could decrease transaction costs, improve price transparency, and contribute to an increase in market liquidity.
Exemption for Central Counterparties and other Market Participants
To facilitate the operation of central counterparties for CDS, on December 24th, the Commission exempted LCH.Clearnet from the requirement to register as a clearing agency. The Commission also provided exemptions to other market participants, including LCH.Clearnet clearing members and broker-dealers. Importantly, the Commission did not exempt these market participants from the antifraud provisions of the securities laws and retains the ability to investigate potential violations and bring enforcement actions. Further, the exemption does not extend to those securities law requirements applicable to broker-dealers that are especially important to protecting funds and securities, ensuring proper credit practices, and safeguarding against fraud and abuse.
These exemptions are temporary — expiring on September 25, 2009 — and subject to conditions designed to ensure that important elements of Commission oversight apply, such as recordkeeping and Commission staff access to examine LCH.Clearnet facilities. In addition, to further the goal of transparency expressed by the PWG in November, LCH.Clearnet is required to make publicly available on fair, reasonable, and not unreasonably discriminatory terms end-of-day settlement prices and any other pricing or valuation information that it publishes or distributes.
From now until September, when the temporary exemption expires, Commission staff will review LCH's central counterparty activities in more detail, as well as evaluate whether registrations or permanent exemptions should be granted.
Commission staff is prepared to recommend that the Commission approve comparable exemptions to other central counterparties that meet the requirements shared by SEC staff with each interested central counterparty.
Class Exemption from Exchange Registration for CDS Exchanges
Also on December 24th, the Commission issued a separate temporary exemption to any exchange that effects transactions in CDSs from the requirements under the Exchange Act to register as a national securities exchange. This exemption is designed to facilitate the development of exchanges that trade CDS. Exchanges that take advantage of this exemption would be subject to conditions similar to those applicable to alternative trading systems, but would not be required to register as broker-dealers.
Interim Final Temporary Rules
Finally, to facilitate the operation of one or more central counterparites for the CDS market, the Commission also approved interim final temporary rules providing exemptions under the Securities Act, the Exchange Act and Trust Indenture Act. The exemption applies to certain CDS that are issued and cleared by a clearing agency registered with the Commission or exempt from registration.
Short Sale Regulation
One of the other reactions to the recent market conditions has been a renewed interest in the arena of short sale regulation. The Commission — as you may have noticed — took a number of actions in the short sale area during the past year. I will provide a quick summary of the initiatives that remain in effect.
Elimination of Regulation SHO's Options Market Maker Exception
Following an extended notice and comment process, in September, the Commission eliminated the "options market maker exception" to the close-out requirements in Regulation SHO. As a result, fails to deliver in threshold securities that result from hedging activities by options market makers are no longer excepted from Regulation SHO's close-out requirements.
Also, as part of the September emergency order, the Commission made immediately effective Rule 10b-21, a "naked" short selling anti-fraud rule. This new rule had previously been published for comment. It, in part, targets seller's representations regarding long sales by emphasizing that it will be a violation of section 10(b) of the Exchange Act for any person to submit an order to sell an equity security if such person deceives a broker or dealer or a purchaser about its intention or ability to deliver the security on or before the settlement date, and such person fails to deliver the security on or before the settlement date.
Interim Final Temporary Rule 204T
The Commission also adopted a temporary rule — Rule 204T — that requires clearing agency participants to close-out fails by purchasing or borrowing the security by no later than the beginning of trading on T+4. Registered market makers, options market makers, and market makers required to quote in the OTC market have until T+6 to close-out fails. Fails that result from long sales also have until T+6 to be closed out.
The Commission received a large number of thoughtful comments on Rule 204T, which the staff is currently reviewing. In general, the commenters suggested that the Commission make various changes to the rule that would give them more flexibility in closing out shorts. One of the common themes in the comments was that the time period for closing-out fails should be extended. Some suggested changing the standard to T+6 for everyone. Others suggested that changing the close-out deadline to the end of the day, rather than the beginning of the trading day as the rule currently requires, would reduce volatility and give more flexibility to participants trying to purchase securities to close-out fails. Commenters also suggested that the requirement to buy to close-out fails on T+6 be changed to allow borrowing the stock to close-out the short. A de minimis exception was also suggested, i.e., fails below some level would not be subject to Rule 204T
The staff is evaluating these comments and expects to make a recommendation to the Commission in the near future. If the Commission does not take further action on Rule 204T, it will expire on July 31, 2009.
Short Sale Disclosure Rule
Also as part of the Commission's September emergency order, the Commission made immediately effective a rule requiring that institutional money managers provide the Commission with confidential reports of their new short sales of certain publicly traded securities. These money managers were already required to report their long positions in these securities. The public comment period ended on December 16, 2008, and Commission staff are currently reviewing the comments.
The Short Sale Disclosure Order will expire on August 1, 2009 if the Commission does not take further action on it.
Commission staff members are closely monitoring the effects of all of these actions. As part of this effort, our economists will be conducting additional empirical analyses. Among other issues, the economists hope to study the impact of the various rule changes on failures to deliver, short sales, the lending market, ETFs, options, and arbitrage.
Short Sale Prices Tests
Recently, there have been calls to reinstate some type of price test. In June 2007, the Commission approved amendments that removed the short sale price test restrictions, known as the "uptick" rule. The Commission's decision to remove the tick test was based on significant changes in the marketplace since the rule's adoption, comments received from the public after the Commission proposed removal of the rule, as well as results from a pilot that temporarily suspended the "uptick rule" and SRO short sale price tests of certain securities.
In response to renewed discussions about price tests, the staff will continue to evaluate whether recent market events warrant restoration of a price test, including circuit breakers or a bid test.
Options Market Structure
Let me turn now to options market structure issues.
Since January 2007, the options exchanges have been quoting certain options in pennies. Currently certain series of 63 classes, representing approximately 50% of the total industry trading volume, are being quoted in pennies. The exchange rules that allow quoting in smaller increments in these 63 classes is scheduled to end on March 27th.
The Commission has received reports from each of the exchanges analyzing the impact of penny pricing on market quality and systems capacity. The Commission's Office of Economic Analysis also has done an analysis.
A notable positive outgrowth of quoting in finer increments is that average spreads in these series have narrowed across all price and activity levels. Because spreads narrowed significantly in those options quoted in pennies, the options exchanges have reduced or eliminated their exchange-sponsored payment for order flow programs in those classes.
In addition, quote traffic has increased significantly. However, the staff has not seen significant problems in market participants' ability to handle the increased quote traffic.
Finally, not surprisingly, depth at the inside price fell with the implementation of finer quoting increments.
Before March 27th, I expect that the Commission will need to consider exchange rule proposals to extend or expand the exchange rules that allow for quoting in smaller increments. There is difference of views among market participants about the relative weight that should be accorded the benefits of narrower spreads on the one hand and the potential costs associated with smaller size at the inside on the other. The benefits, in the form of cost savings to customers, from narrower spreads is easy to measure. The potential costs associated with smaller size at the inside is more difficult.
There continues to be debate about the impact this decrease in size is having, or will have, if any, on the ability to effectively execute large-sized orders. I would expect — as we saw in the equity market — that trading strategies will change as market participants adapt. The availability of depth of book information, which several of the options exchanges are making available, becomes more important. In addition, undisplayed liquidity is harder to measure but, nevertheless, an important source of liquidity. Of significant importance is access to non-displayed liquidity, wherever it may reside.
The staff's observations on the penny pilot are that we have seen a lot of benefit in terms of decrease in spreads — these are lower costs directly to market participants. We see this benefit across options, regardless of price or trading activity. Though we have been looking, there is not any obvious line where the benefits of pennies cease or are outweighed by the costs of less size at the inside or increased message traffic.
I anticipate that some exchanges may propose to expand to additional classes quoting options in pennies. For this reason, the staff is discussing with market participants what the parameters of an appropriate expansion would be. There have also been suggestions by exchanges to change the options within a class that are quoted in pennies, which we are similarly evaluating.
Access to Displayed Prices
It is also critical that each market provide fair, efficient, and effective access to all displayed prices. The Commission addressed the issue of access to the stock markets in Regulation NMS. One of the fundamental objectives of our national market system is to ensure fair and efficient access to each of the individual markets. In this regard, the new approach to intermarket linkage currently being proposed by the options exchanges appears to be designed to improve the access of market participants to displayed prices on the exchanges.
This proposed plan would allow exchanges to route orders using their own routing arrangements, as is permitted in the stock markets by Regulation NMS. These "private linkages" should provide the exchanges with flexibility and allow them to take advantage of advances in routing technology and free the options exchanges from the need to maintain connections to and support a centralized linkage hub.
Notably, the proposed plan introduces the concept of Intermarket Sweep Orders to the options markets. As under Reg NMS, ISOs would be an exception to the general trade-through prohibition. It will be interesting to see whether this proposed initiative would address some of the concerns expressed about penny quoting by improving the ability of institutions to trade in large size.
Markets can also raise barriers to access though fees. Prior to implementation of Reg NMS, there were disputes among participants in the market for Nasdaq stocks with respect to fees for access to quotations, and problems had arisen with respect to intentional barriers to access, particularly involving fees. The access rule adopted under Regulation NMS was designed to address these issues. It provides for a private linkage approach, with standards designed to prohibit unfair discrimination against non-members access to displayed quotations. It also imposes limits on fees for accessing quotes, to ensure that the benefits of strengthened price protection and more efficient linkages are not undermined by excessive fees, and to ensure that displayed prices represent the true prices actually available.
As in the equity markets, fees can be used by options exchanges to impede fair and efficient access to displayed quotes. The Commission received a petition asking the Commission to institute a rulemaking to limit the fees that options exchanges can charge to non-members to obtain access to quotes to $.20. While no formal Commission action has been taken, the Commission has received several, well-considered comments on this issue. Because of the important policy objective of fair access, and the regulatory requirement under the linkage plan to avoid trading at price inferior to prices displayed on an exchange, the staff will need to consider whether and how to address the fees charged by exchanges to access their quotes in making any recommendation to the Commission.
Thank you for once again inviting me to join you at this conference and I am happy to answer any questions.