Atomic Trading

Thank you, Reni [Saula] for that introduction.  It is a pleasure to be with all of you today.  I will start with the usual disclaimer that my views are my own and not necessarily those of the Securities and Exchange Commission or my fellow Commissioners.  The momentous market events of several weeks ago are relevant to the theme of this year’s conference—regulating the digital economy—and thus motivate my remarks. 

The market events to which I am referring are, of course, the Reddit-threaded run-up in the prices of a number of meme stocks, the subsequent run-down in prices, and the many attendant colorful stories.  At the top of the non-financial news feed were the market volatility, trading volumes, regular Joe-to-riches stories, hedge fund losses, short squeezes, gamma squeezes, glee at sticking it to the “suits,” anger at trading limitations, a jumble of emotions as stock prices fell from their highs, and debates about the intricacies of market structure.  Movies to elucidate these events are on their way.[1] 

The Securities and Exchange Commission, along with other regulators and market watchers, is still sorting through the many layers of those events, so I cannot give you a definitive assessment of what took place, let alone whether any significant regulatory changes or enforcement actions will result.  Instead, I will offer some musings on the challenges that lie before the Commission as we decide whether and how to react to these events with new or modified regulations and, more generally, as we think about stepping up our game as a regulator of the digital economy.

The digital economy enabled the past month’s remarkable market events—trading strategies crowdsourced in real time on widely available social media platforms, instant retail access to the capital markets through handy mobile trading apps, institutional high frequency trading enabled by powerful computing and communications technology responding to and interacting with the retail flows, and sophisticated technology at trading venues and clearinghouses capable of handling record trading volumes.  Add some primal emotions into the mix, and the regulator’s job in the digital economy can be a difficult one.

Before turning to the challenges of regulating the digital economy, though, I think it is helpful to recognize that, even as our markets undergo technological transformation, our jobs in many ways will remain much as they always have been.  After all, the economy, whether analog or digital, is driven by people; even regulators, at least until the robots replace us, are people.  People, with their swirling mix of rationality and emotions are unique, interesting, and complicated.  People are also fallible, frail, and often tempted to abuse power.  People respond to incentives.  Any effective and fair regulatory framework has to start with a recognition and understanding of people.

A book I read recently about a very different set of market events in a very different time brought the constancy of people’s peopleness home to me.[2]  These events, like the ones of last month, featured a colorful cast of characters whose fortunes rose and fell and who made their way onto the big screen.  The book tells the story of the uranium markets in the mid-twentieth century, the flames of which were stoked, choked, and revived by the changing policy of the U.S. government’s Atomic Energy Commission.  The book’s principal author had a bad case of uranium fever, which led him to engage in all sorts of daring adventures to stake uranium claims in the western desert and to raise money to finance them.  He describes to his wife, as she lies in the hospital recovering from an operation, his plan to sell claims to the public in what he explains might be “a real estate deal, a security deal, something similar to an oil lease,” or something else.[3]  His wife raises the possibility of jail time, which the author takes as evidence that he “should have known better than to talk business with my wife; she never has the positive-thinking attitude.”[4]  His other family members, however, were more positive-thinking; one brother explained:

I’ve already got blue-chip stock.  I’ve got gilt-edge bonds.  I’ve got my house and car paid for.  I’ve got insurance.  If I’d wanted to invest, I know where I could have put my dough.  But this was a gamble!  I don’t want another sure thing.  I want to go for the big bundle![5] 

That, the author explained, showed that his family “had the fever.  Make it or lose it, but nothing safe, sound, and secure.”[6]  You may find this hard to believe, but I promise you, I did not pull these lines off Reddit.

A lot of other people had the fever too.  The author found them and, through a mailing campaign, got them to send him money:

In mailing, I’d aimed at ordinary Joes, not the professional class, not the ones who were constantly being approached with the deals.  I wanted the little people who might never again in their lives have a chance to go for the big bundle for ten dollars down.  And the little people liked my deal.[7] 

The author reminisces about “the big boom in penny uranium stocks,”[8] during which “everyone in the frantic game of trading penny stocks knew that most of them were wallpaper, but that one of them—which one, he didn’t know—would be struck by lightning.  So buy, buy, buy, and wait for the thunderbolt from the blue.”[9]  He further observed that “[w]hen a company admitted that it didn’t own its claims and there was absolutely no evidence of uranium, the public rushed to buy stock from such honest people.”[10]  The boom went bust when the Atomic Energy Commission pulled its support for further uranium production,[11] which did not trouble the author too much: “There’d be another deal. . . Except for the stockholders.  I’d used other people’s money.”[12]

The book, despite a labyrinth of detours into wholly unrelated topics, contains many other insights into investor psychology, but I think you get the point.  People love participating in hot markets, often do so with eyes wide open to the potential for losses and fingers crossed for big gains, and frequently lose real money in the process, and not always money they can afford to lose.

Because the human participants in the digital economy are people, some aspects of regulating the digital economy look a lot like regulating any other kind of economy.  One of our regulatory obligations that does not change much with the times, for example, is—while respecting people’s right and capacity to make their own decisions—to remind people of some basic truths about participating in the markets.  The medium may change, but the message is the same.  The Commission’s Office of Investor Education and Advocacy, for example, issued an investor alert at the end of January to help investors “understand the significant risks of short-term trading based on social media.”[13]  The alert contained tips that also would have been helpful for the uranium investors of last century, including a warning about “the rapid rise in the price of an investment, reflecting a high degree of collective enthusiasm or exuberance regarding the investment’s prospects [that] is usually followed by a wide-scale selling of the investment that causes a sharp decline in the investment’s price” and reminders that you should “[n]ever feel pressured to invest right away” and that you should “not let short-term emotions about investments disrupt your long-term financial objectives.”[14]  Although the Commission’s delivery method has changed with the times,[15] our investor empowerment message is pretty much the same in the digital world as it was before the digital era.  Mr. Taylor’s uranium investors would have benefited from such a message as much as today’s investors.

So too, our role in policing the markets for fraud has not changed much.  As in the past, people often use lies to induce buys, and we bring a lot of enforcement actions to pursue these fraudsters.  Although the means of disseminating the lies are digital, the nature of the conduct is not new.  The projects for which funds are being raised may be crypto mining rather than uranium mining, but the fraudsters’ plans for the funds raised are generally the same as always—a nice house, fine dining, private school tuition, and maybe some plastic surgery just in case there is a parallel criminal action and a mug shot.

Digital economy regulators are also susceptible to the same incentives and temptations regulators always have faced.  Unchanged in the digital world is our obligation to balance our enforcement mission with the need to respect Americans’ civil liberties.  We may have new digital tools that make it easier than ever to find bad actors, but they also make it easier to trample over individual rights while doing so.  As we put these tools to work for us, we need to bear in mind that when the government watches too much of what a free people do, those people are no longer free.  We have greater and faster insight into trading activity.  We can store massive amounts of data.  We have computing power and sophisticated software to analyze and work with the data we collect.[16]  Technology enables us to examine individual registered entities remotely, rather than through in-person visits.  Structured data allows us to analyze particular registrants or look for trends or patterns across many registrants with the click of a button.[17]  We have access to effective blockchain analytics.  And, we have people expert in the use of these tools and the data they generate.  One day we may even have easily machine-readable rulebooks, which will foster compliance by regulated entities.

Our regulatory mission will remain the same even as technological developments bring new ways for the capital markets to achieve their core objectives: capital formation and investor enrichment.  To translate that into something more tangible, the goal of our markets is facilitating the flow of investors’ money to real companies so they can serve other people’s needs and then return money to investors so they can build wealth for themselves and their families.  Technology has the potential to turbocharge the capital markets’ ability to achieve this objective.  Technological turbocharging is not about speeding up this virtuous cycle.  Technology that facilitates unpredictable volatility can undermine the markets’ ability to serve investors and companies.  After all, building companies into societally beneficial ventures and building investment nest eggs are slow processes that demand patience, deliberation, and self-discipline.  Rather, technology can help markets to deploy capital well, in part by encouraging more of the population to benefit both from contributing capital and using capital to build companies.  But technology does not change our regulatory objectives of protecting investors, facilitating capital formation, and fostering market integrity.

For technology to have its maximum benefit, we will need to change our attitude.  Specifically, we tend to look at technological innovation in the markets with deep suspicion, and that mindset has to change.  Attempts to create a good experience using an attractive, easy-to-navigate interface run headlong into a dusty set of regulations written with paper, snail mail, and precise legalese in mind.  We have designed these rules to provide us with static records that are easy to examine rather than to provide actual investors with information in a format they can digest.  Investors, conditioned by their experiences with companies in all other sectors, expect more, and our rules should not prevent financial institutions from meeting these expectations.  As one commentator explained, regulators ought not to complain when “online broker-dealers provide an attractive user experience” just as other tech firms do.[18]  Embracing, rather than frowning upon, technology is the only way to achieve our objective of ensuring that investors receive, absorb, and take into account the information they need to make wise investment decisions. 

Another part of ensuring that we are not hamstringing the ability of technology to make markets work better for more people is remembering that our role is to protect investors and markets, not incumbents.  Incumbents by definition have adapted themselves well to the existing regulatory framework, market infrastructure, and established technological tools.  They may be slower to adopt new technology; indeed, it may not be in their interest to do so.  Resisting regulatory changes that would permit new ways of doing business (or insisting on regulatory changes to forestall technological innovation) may be a matter of life or death for some of these legacy firms.  We regulators should refuse to allow ourselves to be used to block new firms from coming into the industry with fresh, new ways of doing things.  We must do what is best for investors and markets.

Decentralized finance will provide a very good test for our ability to regulate with an eye toward protecting the interests of investors and markets, not incumbents.  The anti-Wall Street sentiments coursing through the market events of recent weeks and the growing realization of the power that private and public centralized entities wield in our lives have inspired some to call for throwing the legacy financial system out entirely.  In its place, they would put decentralized finance (“DeFi”).  The nascent DeFi industry—a rapidly growing corner of the crypto world with significant money involved—is working on building an alternative to the legacy centralized financial system (“CeFi”) run through smart contracts rather than financial intermediaries.  DeFi facilitates lending, trading, and investing in crypto-assets.  DeFi users trust in smart contracts rather than counterparties.  Although a work in progress with all the growing pains and rough edges that implies, DeFi’s promises of democratization, open access, transparency, predictability, and systemic resilience are alluring.  The Federal Reserve Bank of St. Louis recently published a primer on the complicated, multi-layered, fascinating DeFi landscape, which warns of risks including security vulnerabilities, scaling problems, and faux decentralization, but concludes that there is promise in the innovation happening in DeFi.[19]  We regulators, mindful of the potential upsides and downsides, need to provide both legal clarity and the freedom to experiment so that DeFi can compete with CeFi to offer investors financial services.

So what do all of these principles for regulators in the digital era mean for how we will respond to the events of the last several weeks?  Some of the sentiment driving the meme stock events seemed to have been rooted in a suspicion that the markets are not for everyone, but that their purpose is to serve only wealthy individuals and institutions.  Some participants seem to have viewed these price rallies and attendant short and gamma squeezes as a way to serve Wall Street a poisonous meal of its own making.  Popular antipathy toward Wall Street fueled by bailouts in the financial crisis of 2007-2009 is still raw, aggravated by ongoing government policies that are viewed as disproportionately benefiting large asset holders now in exchange for an inflationary tab in the future that will hit working Americans hardest. 

As securities regulators, we cannot address those concerns directly, but we do need to look for ways to ensure that the markets are working for everyone.  Technology is already being used to draw new investors into the markets and to bring capital to companies and entrepreneurs for whom capital raising has until now been difficult.  Increased participation in our markets is beneficial for the markets themselves because, as one commentator explained, “[i]t creates a number of atomized agents providing hopefully unique stimuli and insights to create a more effective and efficient market.”[20]  We need to be open to technological improvements that make the markets work better and encourage and equip more people to participate in them.  Some commentators have criticized broker-dealers for making investing too easy, or even worse, too much fun,[21] and fun does not necessarily sit well with securities regulators either.[22]  Of course, an appealing user interface is no substitute for ensuring that investors have access to the information that they need to invest wisely in light of their objectives and circumstances, but the same technology that makes investing fun can be used to educate and inform.  Indeed, as one commentary on the GameStop events suggested, regulators should be using these same technologies to reach and teach retail investors.[23]  

We also could be more proactive in embracing technology to address some of the other concerns that the events of the past month brought to light.  While the market machinery worked extremely well under the weight of record trading and high volatility even in the work-from-home COVID world, additional integration of technology into all aspects of the post-trade process might make the system work even better. 

Although trading in the digital economy is fast, the process for settling trades is not.  Indeed, until 2017, settlement did not occur until three days after the trade date, known as T+3.  A regulatory change brought the settlement cycle down to T+2.[24]  As many have been discussing in recent days, further shortening the cycle to T+1 or T+0 could yield additional benefits, including lower risk associated with open positions and reduced collateral demands.[25]  In last week’s Congressional hearing, the CEO of Robinhood went even further and called for real-time settlement.[26]  After all, crypto transactions settle quickly and effectively without a central counterparty.[27]  Smart contracts and distributed ledger technology could make the entire clearing and settlement process in the equity markets faster and more efficient.[28] 

While new technology may make real-time settlement possible, before deciding whether it is the right solution, we should fully analyze the costs and benefits.  Real-time settlement would address many of the concerns around central clearing and margin calls that we saw late last month.  Widespread adoption of real-time, or at least near real-time, settlement of transactions in equity securities, however, would require a major overhaul in the way equity markets work and could harm liquidity by raising the cost of making markets.  Certain elements of our financial system as it is currently structured work precisely because of the delay between execution and settlement.[29]  An expected drop in margin requirements might not make up for the inability to net transactions, much less the operational risks—and ensuing costs—of settling transactions on a gross basis and transferring large amounts of cash and securities throughout the day.[30]  In addition, the time built into the settlement cycle now makes error correction easier and allows for human intervention, a feature that a smart contract is designed to eliminate.[31]  These uncertainties suggest that a less ambitious approach, focusing on less immediately exciting technological improvements—such as modernizing the post-trade settlement process, which is still excessively dependent on manual intervention and non-standard practices[32]—may allow us to reduce settlement times and clearing costs in a more incremental, yet still significant, way.

Another use for technology is in improving transparency.  Many retail investors avail themselves of commission-free trading.  Most broker-dealers that offer this benefit to customers offset it with payments from market makers in exchange for the opportunity to interact with retail order flow.  On balance, this practice likely has benefited retail investors, as it has reduced the cost of making a trade and often results in a small improvement of their execution price over the official national best bid or offer.  At the same time, critics are correct when they point out the potential for conflicts of interest on the part of the broker, who may be tempted to send trades to a market-maker who offers worse execution pricing (which hurts the investor) but better payment for order flow (which benefits the broker).  The way to address this potential conflict, though, is not to ban the practice—which would eliminate a potential conflict at the cost of a likely increase in costs to the investor—but to require better disclosure.[33]  As the cost of data processing, presentation, and delivery continues to plummet, our priority should be to leverage technology to ensure that investors receive accurate disclosures about these practices and their effect on execution quality. 

Whether we are talking about trading uranium claims for the atomic energy of the past, building communities of atomized retail investors on social media today, or enabling atomic swaps in the DeFi of the future, people’s ingenuity and enthusiasm keep us regulators on our toes.  In many ways, the regulator’s job is unchanged even though the stage is set with more modern scenery.  The digital economy does pose some new regulatory challenges, but it also gives us new tools to meet those challenges.  We should use those tools with genuine care for the freedom of the people we regulate.  We should welcome the new technology’s potential to improve the way markets work and to make them work for more people.  The payoff is high: a successful regulatory framework for the digital economy will unleash its ability to empower individuals to build better futures for themselves, their families, and their communities.