Speech by SEC Staff:
Remarks at the Trader Forum 2009 Fall Workshop: Securities Markets and Regulatory Reform
James A. Brigagliano
Co-Acting Director, Division of Trading and Markets
U.S. Securities and Exchange Commission
October 8, 2009
Thank you for inviting me here today to speak to the Institutional Investor Forum. I need to begin by reminding you that the views I express today are my own and not necessarily those of the Commission, the individual Commissioners, or my colleagues on the Commission staff.
One of the important lessons of the recent financial crisis is that the structure of a financial market matters, and that it matters most in times of economic stress. I am pleased that the structures of the US-listed securities markets held together and performed well when the chips were down. In the face of the sharp spikes in volume and volatility of the last year, the markets for US-listed securities have remained open and transparent. They continued to operate in a fair and orderly manner and perform their vital price discovery function. Buyers and sellers could see current prices and expect to execute their trades promptly at the prices they saw on their screens.
One of the hallmarks of an efficient market structure is that it must fit the particular economic and technology environment in which it operates. Yet, economic conditions and technologies are continually changing. Indeed, the securities markets have thrived as competitive forces have led entrepreneurial industry participants to innovate with new technologies, new products, and new trading tools.
I believe it is the Commission's job to make sure that the core principles of the Exchange Act — fairness, efficiency, and best execution are maintained as the markets, and the environment in which they operate, change. So the challenge for regulators is to monitor these changes and update regulation when needed. The Commission currently is taking a broad and critical look at market structure practices in light of the rapid development in trading technology and strategies. I would like to take this time today to talk about several issues facing the U.S. securities markets.
Flash orders have garnered a lot of attention over the past few months. While flash orders can have many variations, the particular type of electronic flash order that currently is most used in the equity and options markets has the following features:
The order is marketable (that is, it is executable at the best displayed price for the security), but is received by a market that does not have available contra side trading interest at the best displayed price.
The receiving market "flashes" the order for a very short duration to market participants that receive that market's data feed. The flashed order is not included in the consolidated quotation data that is widely disseminated to the public.
If a market participant responds to the flash with a contra side order, the flash order will execute at the best displayed price. Otherwise, the order may, among other things, be routed to the best displayed price at another market or cancelled.
Rule 602 of Regulation NMS generally requires exchanges to include their best-priced quotations in the public consolidated quotation data. The Rule contains an exception, however, for quotations that are withdrawn if not executed immediately. This exception for flash orders originally was adopted in 1978 for what then were considered the "ephemeral" quotations of traders on a manual trading floor.
Three weeks ago, the Commission unanimously voted to propose an amendment to Rule 602 to eliminate the exception for the use of flash orders by equity and options exchanges. The practical result of the proposal, if adopted, would be to prohibit the practice of displaying flash orders with marketable prices that lock or cross displayed quotations — which is the type of flash order that is used the most in today's markets. Any flash orders with non-marketable prices would need to be included in the consolidated quotation data that is widely disseminated to the public.
As the Commission recently stated in the flash order proposing release, the Commission is concerned that the Rule 602 exception for flash orders is no longer necessary or appropriate in today's highly automated trading environment. Among other things, the flashing of order information outside of the consolidated quotation data stream could lead to a two-tiered market in which the public does not have fair access to information about the best available prices for a security that is available to some market participants. Flash orders also may detract from the incentives for market participants to display their trading interest publicly and harm quote competition among markets. Flash orders can deprive those who display their trading interest at the best prices from receiving a speedy execution at that price.
Next, I would like to talk about dark pools and the market structure concerns they raise. Dark pools can be defined in various ways. For our purposes today, I will just define them as electronic trading systems that do not display quotes in the consolidated quotation stream. Although they report their trades in the public trade stream, the public reports merely indicate that the trade was OTC and do not identify the trading center that reported the trade. In recent years, dark pools have increased their percentage of total U.S.-listed trading volume to approximately 8.5%. As SEC Chairman Schapiro stated in a speech earlier this summer, dark pools raise significant market structure policy concerns, particularly if they are able to expand their share of trading volume significantly.
I believe concerns with regard to dark pools fall into three main categories:
- inadequate post-trade transparency rendering it difficult for the public to assess dark pool trading and to identify pools that are most active in particular stocks;
- selective messaging of actionable order information (commonly referred to as indications of interest, or "IOIs") among favored market participants, thereby creating the risk that significant private markets could develop that deny fair access to the public; and
- impaired pre-trade public price discovery caused by the diversion of desirable marketable order flow from public quoting markets to dark pools.
The Commission has long been an advocate of post-trade transparency and has encouraged the markets to enhance the information made available to the public regarding transactions effected on exchanges and in the OTC market. As the Commission has stated in the past, transparency allows all market participants to assess overall supply and demand. Transparency substantially counteracts the effects of fragmentation that necessarily characterize a decentralized market structure, without forcing all executions into one market. In addition, transparency can reduce the "information gap" between investors with differing degrees of sophistication. Broad public disclosure of market information is necessary to assure the efficient pricing of securities, to maximize the depth and liquidity of the securities markets, and to provide investors with the opportunity to receive the best possible execution of their orders.
In the past several years as overall market trading volume has increased, the percentage of trading volume at certain major national securities exchanges has declined, while the percentage of trading volume at alternative trading systems, both ECNs and dark pools, has increased. ATS trades are reported to the consolidated trade streams through FINRA trade reporting facilities. The public trade reports identify these trades as OTC trades; however, they do not identify the particular ATS that reported the trade.
There is concern that the trade information reported by ATSs does not include the identity of the ATS that executed the trade, which makes it difficult for the public to assess ATS trading and to identify the ATSs that are most active in a particular stock. This concern could be addressed by increasing the level of post-trade transparency for ATSs. One alternative would be to require enhanced disclosure of the identity of ATSs, including dark pools, in the consolidated trade stream. However, large investors need to control the information flow concerning their executed trades. The disclosure of the identity of ATSs that execute large size trades may provide too much information about the parties to a transaction. Therefore, it may not be appropriate to require the identification of ATSs on trade reports in the consolidated trade stream for large size trades.
The second concern with regard to dark pools is their use of IOIs. IOIs generally are currently excluded from the definition of "bid" or "offer" and consequently are not subject to Exchange Act quoting requirements. However, many IOIs transmitted by dark pools to selected market participants implicitly convey valuable information about their available trading interest. The transmitted message may alert the IOI recipient that the dark pool has trading interest in a particular symbol, including the side, the size, and the price, permitting the recipient to reasonably conclude that sending a contra side marketable order responding to the IOI will receive an execution (i.e. actionable IOIs).
The exclusion of IOIs — that function similarly to displayed quotations at the NBBO — from quoting requirements may create a two-tiered level of access to information about the best prices for NMS stocks and discourage the public display of trading interest, subsequently harming quote competition.
Including actionable IOIs into the consolidated quotation stream would address this concern. However, large investors may need the significant size discovery benefits provided by IOIs. Therefore, it may not be appropriate to require certain IOIs of a certain size to be included in the consolidated quotation stream. In addition, to further the goal of increased pre-trade transparency, the staff is reviewing whether to reduce to a de minimis level the current 5% trading volume threshold that triggers public display obligations for ATSs.
The third concern about dark pools is that they potentially could impair the public price discovery function if they diverted a significant amount of valuable marketable order flow away from the "lit" markets — the exchanges and ECNs that display quotes in the public quote stream. Indeed, dark pools rely primarily on the price discovery provided by the public markets to run their trading mechanisms, yet if dark pool volume were to continue to expand indefinitely, their success could threaten the very price discovery function on which their existence depends. As SEC Chairman Schapiro indicated during a recent open meeting, the Commission intends to tee up issues surrounding dark pools and other market practices that have a negative impact on the public price discovery function in the near future.
Another issue that has arisen due to rapid advances in trading technology is the way in which industry participants access trading systems, particularly sponsored access. The Commission staff has been gathering facts and reviewing issues relating to sponsored access for some time. Broadly speaking, sponsored access can be defined as an exchange member providing its customers with electronic access to the exchange using the member's identifier. Under such an arrangement, the customer is provided a dedicated line or port to the exchange's execution system, so that its orders do not first pass through the member's systems before reaching the exchange. As electronic trading has become so prevalent in recent years, this type of access to exchange execution systems, which often is unfiltered, has increased significantly. The appeal of the arrangement, of course, is that it helps preserve anonymity and enables the fastest possible trading. And for some of the most sophisticated, high-volume firms in today's trading environment, every microsecond counts.
There are, however, a variety of risks involved when trading firms have unfiltered access to the markets. These risks can affect many of the participants in a market structure, including the trader's broker, the exchanges, and the clearing entities. Ultimately, the risks can affect the integrity of the market structure itself. The existing various SRO rules and member practices may not be sufficiently robust to assure effective financial and regulatory oversight of the sponsored customer by the member firm that is assuming responsibility for the customer's trading activity.
Commission staff has been working with the exchanges, FINRA, and market participants to establish an industry-wide regulatory approach to reasonably ensure that brokers and exchanges that provide sponsored access systematically limit their financial and regulatory exposure, and reasonably ensure compliance with applicable securities laws, regulations, and SRO rules. Preliminarily, I believe that this may be accomplished through a combination of pre-trade and post-trade systemic controls, contractual commitments, and the monitoring of current activity reports by appropriate compliance personnel.
The final topic I would like to mention is high frequency trading. High frequency traders have become a critically important quality of markets issue. Estimates of their percentage of trading volume generally range from 50% to as high as 75%, though these numbers depend on the definition of high frequency trading, which has not yet been settled. They particularly provide a large percentage of the displayed liquidity in the public markets. Some have suggested that high frequency trader liquidity is "bad" liquidity because their quotes generally have a very short duration (some say their cancel rates can be upwards of 90%), while others say that any liquidity that is accessible is good liquidity (and the large trading volume of high frequency traders suggests that many of their quotes are accessible).
Some high frequency trading strategies are based on figuring out when a large buyer or seller is in the market and taking advantage of that knowledge to trade against the large buyer or seller. This type of high frequency trading strategy can greatly raise the transaction costs of institutional investors. The interests of long-term investors and professional short-term traders in fair and efficient markets often will coincide. Indeed, vigorous competition among professional short-term traders can itself lead to very important benefits for long-term investors, including narrower spreads and greater depth. If, however, the interests of long-term investors and professional short-term traders conflict, the Commission previously has emphasized that "its clear responsibility is to uphold the interests of long-term investors."
I expect the Commission to raise issues surrounding high frequency trading as well as other related market structure issues in the near future.
As we move ahead with the dialogue, I look forward to input from the market participants here today and all interested parties. Thank you for listening.