Speech by SEC Staff:
Keynote Speech of the SIFMA Dark Pool Symposium
James A. Brigagliano
Deputy Director, Division of Trading and Markets
U.S. Securities and Exchange Commission
New York, New York
January 21, 2010
Thank you for inviting me to speak at this symposium sponsored by the Securities Industry and Financial Markets Association. These events are an extremely important forum for the kind of industry/regulator dialogue that is critical to robust financial markets. I remind you that any views I express today are my own and not necessarily those of the Commission, the individual Commissioners, or my colleagues on the Commission staff.
As all of you are well aware, this is a busy time for those of us who work on market structure issues. Last fall, the Commission issued proposals relating to flash orders and dark pools. Just the last week, the Commission approved publication of a concept release and a separate proposal on market access. Those releases are now on the Commission's website. Furthermore, the Chairman has asked the staff to prepare recommendations for Commission proposals on large trader reporting and a consolidated audit trail. It is also conceivable that additional rulemaking proposals will flow out of the concept release. I will discuss each of these matters, but by way of introduction, I think it would be worthwhile to examine the statutory and theoretical underpinnings of these various Commission initiatives.
To do so, we have to look at Section 11A of the Exchange Act, which was adopted as part of the Securities Act Amendments of 1975. Section 11A sets forth some important findings made by Congress regarding the securities markets. First, Congress found that the securities markets are an important national asset that must be preserved and strengthened, and that new data processing and communications techniques create the opportunity for more efficient and effective market operations. In addition, Congress found that it is in the public interest and appropriate for the protection of investors and the maintenance of fair and orderly markets to assure the following five objectives: (1) the economically efficient execution of securities transactions, (2) fair competition, (3) the availability of quotation and transaction information, (4) the practicability of brokers executing investors' orders in the best market, and (5) an opportunity for investors' orders to be executed without the participation of a dealer. Finally, Congress found that the linking of all markets for qualified securities through communications and data processing facilities will foster efficiency, enhance competition, increase the information available to market participants, and contribute to best execution of investor orders.
Having laid out these findings, Congress directed the Commission to use its authority under Section 11A to facilitate the establishment of a national market system. Congress's choice of the word "directed" is quite significant. It means that Congress imposed an affirmative obligation on the Commission to establish a national market system consistent with the findings set forth in Section 11A. Appropriately achieving each of these objectives requires a balanced market structure that can accommodate a wide range of participants and trading strategies.
Over the years, these findings and principles have guided the Commission as it seeks to keep market structure rules up-to-date. The markets are constantly evolving, and even a set of rules well designed to govern today's markets could become obsolete over time. The Commission's task is made more challenging because its guiding principles can at times be difficult to reconcile. For example, the objectives of promoting best execution and opportunities for orders to interact without dealer participation can be difficult to reconcile with the objective of promoting competition among markets. The latter goal can result in a greater number of markets and market fragmentation, which may make it harder for investors to efficiently locate the best-priced contraside interest.
The Commission's task has been to facilitate an appropriately balanced market structure that promotes competition among markets, while minimizing the potentially adverse effects of fragmentation on efficiency, price transparency, best execution of investor orders, and order interaction. An appropriately balanced market structure also must provide for strong investor protection and create an environment where businesses can raise the capital they need to grow and benefit the overall economy. Given the complexity of these tasks, there clearly is room for reasonable disagreement as to whether the market structure at any particular time is, in fact, achieving an appropriate balance of these multiple objectives. Accordingly, the Commission believes it is important to monitor these issues and periodically give the public an opportunity to submit their views on the matter. The just issued concept release is intended to provide such an opportunity.
As the concept release notes, in recent months the Commission has heard a variety of concerns about certain aspects of market structure, particularly high frequency trading and undisplayed liquidity. And, the place to begin consideration of the possible impacts of new trading activities is to consider more broadly the performance of market structure as a whole, particularly for long-term investors and businesses seeking to raise capital. Assessing overall market structure performance should help provide context for particular concerns, as well as guide the nature of any regulatory response that may be appropriate to address those concerns. The concept release asks a series of questions about how the current market structure is performing and how such assessments of market quality can be appropriately measured. Today, I'd personally like to invite your thoughts on this important subject. The Commission and its staff benefit greatly when you share with us your data and your observations on that data.
The concept release then goes on to ask a number of more detailed questions. On the subject of high frequency trading, the concept release asks, What types of strategies are used by the proprietary trading firms loosely referred to as high frequency traders, and are these strategies beneficial or harmful for other investors? Is the overall use of any harmful strategies by proprietary trading firms sufficiently widespread that the Commission should consider a regulatory initiative in this area?
An issue related to high frequency trading is co-location. Some of the questions that the concept release asks are, Do co-location services give proprietary trading firms an unfair advantage? If so, should firms that use these services be subject to any positive or negative obligations?
On the subject of dark liquidity, one of the most important questions is, Has the trading volume of undisplayed trading centers (such as dark pools) reached a sufficiently significant level that it has detracted from the quality of public price discovery? The concept release asks a number of other questions regarding dark liquidity, including, If more individual investor orders were routed to public markets, would this lead to narrower spreads and ultimately improve order execution quality for individual investors beyond current levels? Are a significant number of individual investor orders executed in dark pools and, if so, what is the execution quality for these orders?
These are but a small sample of the questions raised by the Commission in the concept release. The Commission emphasized that it is interested in receiving comments on all aspects of equity market structure that the public believes is important, and that the discussion in this release should not be construed as in any way limiting the scope of comments that will be considered.
The Commission also stressed that it has not reached any final conclusions on those issues, and the discussion and questions in the release should not be interpreted as slanted in any particular way on any particular issue. The Commission intends to consider carefully all comments and to complete its review in a timely fashion. At that point, it will determine whether there are any problems that require a regulatory initiative and, if so, the nature of that initiative.
In addition to the concept release, the Commission has recently issued several rule proposals on discrete market structure matters that present heightened concerns about the integrity or fairness of the market. One such specific proposal — relating to market access — was approved by the Commission for publication at the same time as the concept release. The proposing release was made public just a few days ago, and the 60-day comment period will run until late March.
The proposal is designed to minimize the risks that broker-dealers incur when they access the market on behalf of their customers or themselves. In some circumstances, a broker-dealer allows a customer to trade using the broker-dealer's MPID. This gives the customer access to an exchange or ATS. This arrangement is known as sponsored access or direct access.
To take it one step further, under some access arrangements, the customer simply bypasses the broker-dealer entirely. Through this type of arrangement, known as "unfiltered" or "naked" access, the customer places orders that flow directly into the markets. The orders do not first go through the broker-dealer's systems and are not subject to any pre-screening by the broker-dealer. Such "unfiltered" arrangements occur mainly to give a customer — often a high frequency trader — a fraction of a second advantage in the high speed transactional world that exists today.
Chairman Schapiro has likened unfiltered access to giving your car keys to a friend who doesn't have a license and letting him drive unaccompanied. The proposal issued last week would, in short, require that if a broker-dealer is going to loan his keys, he not only must remain in the car, but he must also see to it that the person driving observes the rules before the car is ever put into drive.
Under the new proposal, broker-dealers with market access or that provide market access to others would be required to put in place effective pre-trade risk management controls. These controls would effectively prohibit "unfiltered" access. The controls also would help promote greater awareness by broker-dealers of trading by customers who are otherwise given access to an exchange or ATS. More generally, these controls would require brokers to implement effective financial and regulatory risk management controls and supervisory procedures on a market-wide basis. Such controls would help reduce the chances of an erroneous order due to a computer malfunction or human error, a potential breach of a credit or capital limit, or a failure to comply with regulatory requirements. These controls should help to reduce risks to broker-dealers and the markets as a whole and would help strengthen the vital gatekeeper functions that broker-dealers have historically played in maintaining the integrity of the markets.
Some observers have theorized that one result of this proposal could be that some trading firms that currently use naked access will register as broker-dealers. That outcome would result in such firms becoming subject to the direct regulatory and supervisory jurisdiction of the Commission and at least one SRO. These new broker-dealers would be subject to a variety of prudential Commission and SRO rules, including (if adopted) proposed Rule 15c3-5 under the Exchange Act, which would require all broker-dealers with market access — not just those that provide market access to others — to have effective pre-trade risk management controls.
Let me now turn to an earlier proposed rulemaking, that regarding flash orders. 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 was originally adopted in 1978 for what then were considered the "ephemeral" quotations of traders on a manual trading floor. The Commission is concerned that this exception may no longer be necessary or appropriate in today's highly automated trading environment. The flashing of order information outside of the consolidated quote 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 thus undermine the efficiency of public price discovery.
Over 90 commenters have offered their views on the flash order proposal. Most commenters support elimination of flash orders in the equity markets and were in general agreement with the Commission's reasons for doing so. Some commenters, however, generally disagreed and others raised particular issues with prohibiting flash orders in the options markets. They cited differing market structure practices in the options markets which resulted in lower cost executions for customers using flash orders. For example, access fees in the equities markets are capped, while no such cap exists in the options markets. Thus, according to the commenters, the benefits of using a flash order process in the options markets may be greater than in the equities markets. The staff of Trading and Markets will continue to analyze this and other issues raised by commenters as we work to prepare a recommendation for Commission consideration.
Next, I will briefly discuss the proposed rulemaking on dark pools. The comment period on that proposal remains open until February 22. The proposal seeks to strengthen the regulation of dark pools by addressing practices that create a "two-tiered" market and by taking steps to increase market transparency. One proposed change would require actionable IOIs to be treated like quotes and subject to the same dissemination rules. Another proposal would lower the trading volume threshold applicable to ATSs for displaying and providing execution access to best-priced orders. Currently, if an ATS displays an order in a stock to more than one subscriber, it must display that order publicly only when its trading volume in that stock is 5% or more of the stock's average daily volume during four of the last six months. The Commission's proposal would lower that threshold to 0.25%. Taken together, these two proposals should largely eliminate the two-tiered market created by actionable IOIs, where only selected market participants have access to the best-priced orders. They also should promote transparency to the extent that IOIs and the orders of other "lit" ATSs are included in the public quote stream. These proposed rule amendments are designed to enhance the fairness of the markets and bolster the efficiency and transparency of the national market system.
A third prong of the dark pool proposal is to require real-time reporting by ATSs, including dark pools, of their identity as part of the consolidated trade data. Currently, ATSs must report their trades to the tape, but the tape print does not reveal which ATS executed the trade or indeed whether the trade occurred on an ATS at all. The Commission's proposal would help investors to identify sources of liquidity in particular stocks in real time and help assure that reliable ATS volume information is publicly available.
Each of the three prongs of the dark pool proposal includes an exclusion for large trading interest. Thus, the proposal would exclude from any quoting obligations any actionable IOIs for $200,000 or more that are communicated only to those who are reasonably believed to represent current contra-side trading interest of equally large size. This exclusion is designed to help investors to trade efficiently in large sizes. The proposal also would exclude the identification of the ATS for trades having a principal value of $200,000 or more, to prevent potential detrimental information leakage that could interfere with the ability of institutions to trade large blocks efficiently. The exceptions for large-size orders reflect the Commission's effort to balance the 11A goals of market transparency and best execution for such orders. Once the comment period closes, the staff will analyze the comments and prepare a recommendation for Commission consideration.
Another proposal that the Commission will likely consider in the not-too-distant future relates to large trader reporting, which is authorized by Section 13(h) of the Exchange Act. Such a proposal could help provide the Commission with certain baseline information about major market participants whether or not they are registered, and ready access to their trading information. Such a system could require each large trader to self-identify to the Commission upon achieving "large trader" status. The large trader could then be required to provide to each of its broker-dealers a unique identification number issued to it by the Commission. Broker-dealers could be required to maintain trading records for each large trader, and provide to the Commission upon request any transaction information for any large trader.
Finally, I would also like to mention the work being undertaken within the Commission to create a consolidated audit trail to enhance market surveillance. Certain mechanisms are already in place to coordinate surveillance among markets. For example, the Intermarket Surveillance Group — an industry organization created in 1983 — provides a framework for the sharing of information and the coordination of regulatory efforts among exchanges trading securities and related products to address potential intermarket manipulations and trading abuses. But given the development of the markets, there is general consensus that additional steps can and should be taken to improve intermarket surveillance.
Chairman Schapiro has expressed her commitment to improving intermarket surveillance. As a step towards fulfilling that commitment, she created an inter-division task force to work with markets to explore ways to establish a comprehensive consolidated audit trail for orders and executions across all markets. While we recognize that such a proposal would require a substantial effort by the SROs and their members, a consolidated audit trail could be an invaluable regulatory tool to enhance the ability of the SROs and the Commission to detect illegal activity across multiple markets, and would greatly benefit investors and help to restore trust in the securities markets. With today's fast, electronic, and interconnected markets, there is a heightened need for regulators to have a robust consolidated audit trail and execution tracking system.
These are challenging times in the securities markets and complex issues we face. I cannot tell you with certainty what a perfect set of market structure rules looks like, or provide specific details about future rulemaking issuing from the Commission. But I am certain that the comments from you who are here today will inform our deliberations and make the end product much better. Thank you for your time.