Speech by SEC Chairman:
Remarks Before the Security Traders Association
Chairman Mary L. Schapiro
U.S. Securities and Exchange Commission
Sept. 22, 2010
Thank you for inviting me to participate in STA's annual conference. It's an honor and a pleasure to speak to such a large group of trading professionals about the structure of our financial markets.
Market structure is a broad and important topic, encompassing everything from the number and types of venues that trade a financial product to the rules by which they operate.
A stable, fair, and efficient market structure lies at the heart of economic growth. It helps capital markets efficiently perform their essential function of turning investor savings into business capital. Effective market structure helps make possible an economy in which businesses grow and investors achieve their financial objectives.
As you know, the Commission is in the midst of a comprehensive review of the structure of our equity markets — a review which began a year ago. In addition, market structure is an important element of the Commission's new responsibilities for OTC derivatives under the Dodd-Frank Act.
Today, I would like to discuss market structure challenges that may be making the equity markets less efficient, and how these challenges might be addressed. And I would also like to spend a moment on how we can apply the lessons we have learned in existing markets to the derivatives markets that will soon come under comprehensive regulation.
Equity Market Structure
The STA's annual conference provides a particularly appropriate forum to address these issues. Your diverse membership includes both buy- and sell-side traders, and represents firms of every size, pursuing many diverse trading strategies.
You bring a broad range of viewpoints to this discussion — as is evidenced by the comment letter that the STA submitted to the SEC in response to our market structure concept release. That single letter expressed sharp differences of opinion on a variety of issues, and was by itself a spirited and informed debate on the strengths and weaknesses of the current structure, and of steps we might take to improve it.
Your comments arrived at the SEC less than a week before May 6th — a date that has caused many to ask whether our equity market structure is well-designed to handle the high-speed, pre-programmed trading algorithms that generate much of today's trading volume.
As the Commission addresses these complex issues, the STA is well-situated to provide a voice for a wide range of views — and to serve as a catalyst for achieving a consensus on concrete steps to address any weaknesses of the current structure, while preserving its strengths.
Perhaps more vividly than anything else, the extreme volatility experienced on May 6 illuminated the need for improved mechanisms to limit destabilizing price moves and to preserve fair and orderly trading.
Soon after May 6, the exchanges and FINRA were able to implement new circuit breakers for individual stocks. And last week, the program was expanded to include all stocks in the Russell 1000 Index and a significant group of exchange-traded funds.
These have been essential steps, but I believe that we likely need to go further.
We need to examine whether there are ways to prevent erroneous trades from triggering pauses while, at the same time, ensuring that pauses can be invoked when needed. One method we are examining closely involves establishing limit-up/ limit-down style trading parameters under which trades would have to be executed within a range tied to the national best bid and offer.
This approach would prevent aberrant trades from occurring outside specified parameters, while still allowing trading to continue within the established limits. Only if trading does not resume within those parameters and within a preset period of time, would a formal trading pause be triggered. This pause would then give market participants time to establish a new price in a fair and orderly fashion.
We also need to assess the parameters that trigger circuit breakers to ensure that they are set at a level that preserves the stability and integrity of the equity markets. For example, one of the clear lessons of the market disruption on May 6, is that many of the firms that supply significant liquidity to the market have programmed their systems to pull back or to shut down when prices move atypically. In effect, these firms have adopted their own ad hoc circuit breakers.
In assessing the appropriate parameters for the rule-based circuit breakers, an important consideration will be how best to prevent these ad hoc circuit breakers from pulling significant liquidity providers out of the markets at moments of extreme volatility, thus leaving the markets to fend for themselves.
This is closely related to the question of what, if any, obligations should apply to significant liquidity-providing firms. Indeed, it's important to recognize that circuit breaker parameters and trading obligations are closely related, and that the rules governing each should be coordinated so that the market is appropriately protected in stressed conditions.
Trading Obligations for High Frequency Trading Firms
A second area that warrants close review is the regulatory scheme that applies to the most active and sophisticated participants in today's market structure — high frequency trading firms. These firms exert tremendous influence over trading. By most estimates they account for over 50 percent of daily trading volume.
And remember that these estimates reflect two-sided volume. This means that high frequency trading firms participate as either buyer or seller in the great majority of trades, particularly in the publicly quoted markets where these firms' trading is concentrated. Their enormous trading volume requires them to secure the fastest, most sophisticated tools to access the markets and to implement their strategies. Given their volume and access, high frequency trading firms have a tremendous capacity to affect the stability and integrity of the equity markets.
Currently, however, high frequency trading firms are subject to very little in the way of obligations either to protect that stability by promoting reasonable price continuity in tough times, or to refrain from exacerbating price volatility. We will consider carefully whether these firms should be subject to an appropriate regulatory structure governing key aspects of their market behavior, including both their quoting and trading strategies.
In addressing these questions, the Commission's guiding principle must be to encourage a market structure that promotes capital formation and protects investors.
But we must also be mindful of the risk of unintended consequences. For example, imposing significant obligations for market quality on some firms, but leaving other firms free to operate without those obligations — or, indeed, to take advantage of the firms with obligations — would create an unfair playing field that might, in the end, do little to promote market quality.
We must craft requirements carefully and be wary of imposing disproportionate obligations that — while attractive in theory — could, in practice, drive liquidity out of the market altogether.
Balancing these trading obligations and benefits will be a difficult task — and one into which your insights might be particularly valuable.
Appropriate Controls on Liquidity Seeking Algorithms
In assessing ways to promote market stability, we must consider both sides of the liquidity equation — liquidity demand, as well as liquidity supply.
A problem in either or both sides can lead to a liquidity imbalance and excessive volatility.
The SEC has seen aggressive liquidity-seeking algorithms flood the market with executable orders far beyond the normal volume for a stock. For example, one of the new, individual stock circuit breakers was triggered when an algorithm attempted to execute 10% of the stock's average daily volume in two seconds. Orders like this can create sudden liquidity imbalances that quickly drive prices up or down.
Broker-dealers create menus of different types of liquidity-seeking algorithms and make them available to a wide range of market participants with varying ranges of experience. The firms that use broker-dealer algorithms (or develop their own) may be high-frequency trading firms, but they also may be customers that have employed a particular algorithm that operated in an unexpected and unintended manner. Even with checks for "fat finger" errors and other problems, these algorithms can quickly generate a volume of orders that swamps the immediately-available supply of liquidity for a stock.
We need to consider whether these relatively new trading tools are subject to appropriate rules and controls. For example, are algorithms programmed with appropriate throttles that prevent them from operating in an unintended manner? An out-of-control algorithm not only can cause serious losses to the firm that uses it, it can also cause severe trading disruptions that harm market stability and shake investor confidence.
The final equity market structure concern I want to raise with you relates to market fragmentation. Currently, trading volume in U.S.-listed equities is split among eleven exchanges, approximately 37 alternative trading systems, Electronic Communications Networks, and more than 200 broker-dealers that execute orders internally. Some of these trading venues display publicly available quotations, while others do not.
One result of this fragmentation is complexity. Market participants must use a multitude of information sources and routing strategies in their efforts to obtain best execution of orders across all the different venues. The venues, in turn, compete vigorously to attract this order flow. Among other things, they offer many different order types and distribute proprietary market data feeds that are separate from the consolidated data feeds that are made public.
Given this complexity, some investors may not be in a good position to assess the practices used by the various market participants to route order flow, and by the trading venues to attract order flow. For example, are investors aware of data feeds that potentially could reveal their trading intentions?
Are they aware of potential conflicts of interest that could cause their orders to be handled in ways that may not be consistent with their best interests? And, even if they are aware, is there a way for investors to effectively protect themselves by, for example, masking their strategies?
I am concerned that the market structure has become so complex that many, perhaps most, investors may not, as a practical matter, be able to devote the resources and obtain the tools necessary to protect their interests.
Accordingly, we should consider steps to enhance the ability of investors of all types and sizes to trade fairly and efficiently. One potential area of focus is rules that would enhance transparency of trading venue practices and the practices of broker-dealers acting as agents for investors negotiating a fragmented market structure.
All of these issues are complex and interrelated. But the equity markets are too important to the economic success of our nation to shy away from doing what is needed to ensure that they operate as efficiently and fairly as possible.
New Market Structure Responsibilities under the Dodd-Frank Act
At the same time we are addressing the complex challenge of reviewing equity market structure, we are also implementing many key provisions in the Dodd-Frank Act, including developing a new market structure for security-based swaps. These new responsibilities are described in Title VII of the Act.
Broadly speaking, Title VII provides a comprehensive framework for the regulation of the over-the-counter derivatives market. It specifies the jurisdiction of the CFTC and SEC over the markets in swaps and security-based swaps, respectively. It creates new classes of market participants. And it provides for the registration and regulation of these market participants and of other aspects of the OTC derivatives market.
One of the new types of market participant created by the Dodd-Frank Act is the security-based swap execution facility, or SEF.
The Act defines a SEF as "a trading system or platform in which multiple participants have the ability to execute or trade security-based swaps by accepting bids and offers made by multiple participants in the facility or system, through any means of interstate commerce." Market participants generally are required to execute security-based swaps subject to mandatory clearing under Title VII, on a SEF or national securities exchange.
Our challenge is to cultivate the emergence of a market structure for security-based swaps that reflects the virtues of the current equities market: competition, access, liquidity and transparency. Focusing on these principles should maximize the benefits this new market structure will bring — just as it has in the equities markets. Applying these principles to the OTC derivatives market also has the potential to create a positive feedback loop, just as changes in the equities market structure — despite the significant challenges I've discussed — have, over time, increased liquidity and decreased transaction costs.
One of the key principles in any market is fair and open access. The Dodd-Frank Act provides that a SEF must "provide market participants with impartial access" and may not adopt any rules or take any actions that result in any unreasonable restraint of trade or impose any material anticompetitive burden on trading or clearing. As the market structure develops, the Commission will work to ensure that all market participants have a fair opportunity to compete in the market.
Similarly, central clearing should significantly mitigate counterparty risks in the security-based swaps market. Fair and open access to central clearing will be a key element to the new market structure for security-based swaps.
Closely related to access is the question of how to structure SEF operations to maximize transparency and competition, and thus liquidity. One way to promote these goals is to provide for greater pre-trade transparency of trading interest, while at the same time encouraging greater participation by market participants willing to provide liquidity. Any trading systems intended to qualify as SEFs should support these goals.
Another important element of a new security-based swaps market will be the increased transparency that comes from real-time reporting of all transactions. The Dodd-Frank Act provides that all security-based swaps - whether cleared or uncleared, executed over the counter or on a SEF or exchange — must be publicly reported in real time.
Many key details of this regime remain to be fleshed out in greater detail through the rulemaking process. But it's not surprising, given the experience with TRACE, that I believe that real-time reporting will have a profound and positive effect on the market. All market participants will have the same knowledge of executed trades. Customers and end-users will be able to see whether quotes they receive from dealers approximate the last-sale prices, and if they do not, ask why their quotes are not closer to the last-sale prices.
In the absence of formal mechanisms to link markets, real-time post-trade transparency — as well as pre-trade transparency — helps coordinate markets, helps reduce information asymmetries, and helps market participants demand and obtain the best prices.
Beyond just trading, access to this information has important implications for accurate mark-to-market pricing and more robust risk management that can better account for the liquidity of derivative positions.
Ultimately, the combination of robust competition, broad access, high liquidity, and increased transparency in the markets has the potential to create an important positive feedback loop, as well, with increasing liquidity, declining costs, and diminishing systemic risk.
Of course, as we have learned many times over the years, it is extremely difficult to predict how a new market will develop in this high-tech, high-speed age. And we recognize that the parallels between the existing equities markets and the emerging derivatives markets will not be exact — indeed, there are important differences between the markets and products that we must take into consideration.
But, as it takes shape over time, we will be working to embed into the security-based swap market the broad principles that have brought important benefits to the equities market.
And, we will seek to apply the lessons we have learned from our experience with the equities markets to build-in effective market structure protections for security-based swaps from the start.
It would foolish to ignore the tremendous benefits the modern equities markets bring to participants. In many ways the transformations of recent years have been a success.
But it would be equally wrong to forget that markets are not always perfect, to ignore the issues raised by high frequency trading, opacity and fragmentation, or to assume that the market structure and the rules of the road can't be adjusted and improved. It's important that we examine issues thoroughly, move deliberately and listen to a variety of perspectives as we consider actions that we might take.
As the events of May 6 have demonstrated, it's also important that we take action. There are trade-offs and hard decisions ahead. The ideas and insights experienced securities traders like yourselves can supply will be important. I look forward to working with you to assure that our capital markets continue to meet the needs of investors, companies, and the economy as a whole.