The Nexus of Equity Market Structure and Investor Relations: Remarks at the 2019 Annual Conference of the National Investor Relations Institute

Good morning. And thank you Mike for the kind introduction.

I am delighted to have this opportunity to speak at NIRI’s annual conference on the topic of equity market structure, with a focus on its nexus with issuers and their investors. Staff in the Division of Trading and Markets, which I oversee, are responsible for coordinating the SEC’s market structure policy, and often participate in events sponsored by the securities industry. This opportunity is extremely important to me because it is less often that I have a chance to speak directly to the issuer community. I feel strongly, though, that the topic of equity market structure is one that is important to bring into the dialogue between the Division and issuers like yourselves.

Over the last 12 years, the structure of the U.S. equity markets has undergone a remarkable transformation. Many market mechanisms and practices that had endured for decades have fallen by the wayside. As is true of many aspects of modern life, the forces of technology and competition have been the key drivers of these changes. And, as you might expect, these changes have challenged regulators as we seek to assure that our rules keep pace with the markets.

This morning, I want to spend my time updating you on the nature of today’s equity markets and on what the SEC has done, and is doing, to help assure that the equity markets continue to meet the needs of issuers and their investors. Before I go further, though, I must remind you that the views I express today are my own and do not necessarily reflect those of the Commission or its staff.

I. Overview of Today’s Equity Markets

When I began my professional career in the 1990s, the U.S. equity markets looked quite different than they do now. At that time, trading in the great majority of large U.S. companies was dominated by traders interacting on the trading floor of the New York Stock Exchange in lower Manhattan. And this same NYSE trading floor had dominated trading in U.S. stocks for decades. The world of the old NYSE specialists and floor brokers in colorful jackets has been largely replaced by sophisticated designated market makers, or DMMs, on Broad Street and high speed data centers in New Jersey.

The forces of technology and competition, punctuated by key regulatory changes, led to a sweeping transformation of the old, manual market structure. Particularly beginning in 2007, with the implementation of a set of SEC rules called Regulation NMS,[2] trading volume shifted rapidly away from the NYSE floor to a variety of trading venues, most of which are highly automated. Today, the changes in the U.S. equity markets can be characterized by two words — fragmentation and speed.

Fragmentation

Fragmentation means that trading volume in U.S.-listed stocks is divided among many different trading venues. These venues currently include 13 live exchanges, 32 alternative trading systems, known as “ATSs,” and more than 100 registered broker-dealers, some of whom provide their own dealer trading platforms.

While the precise percentages fluctuate from month to month, the 13 live exchanges collectively execute around 63% of volume in U.S.-listed equities. And while the three largest exchange groups each own between 3 to 5 individual exchanges, no single exchange has even a 20% market share, and the exchange groups rarely go far above 20% when including all of their combined markets. Still, we can expect further fragmentation in exchange volume going forward. A new exchange recently registered with the SEC, and two other groups have publicly discussed their plans to register as new exchanges. 13 live exchanges could conceivably become 16 soon enough.

The second major group of trading venues are ATSs, also known as dark pools. ATSs must be operated by registered broker-dealers, and, in aggregate, they currently execute around 14% of listed equity volume. Dark pools do not display their available trading interest, but allow their participants to interact in a more discreet fashion. Many institutional investors looking to trade in large size prefer to interact in these dark pools when possible as a means to transact without signaling their trading intentions to the market.

The third major group of trading venues are registered broker-dealers that execute trades internally. These firms execute around 23% of listed equity volume. Some of these firms operate as wholesale market makers and execute a large share of retail investor orders. Others are large multi-national firms that offer a wide variety of services to their customers, including agency brokerage and capital commitment for institutional investors.

Given the large number of equity trading venues, the order-routing decisions of brokers are critically important to the proper functioning of our markets and to minimizing the potentially adverse effects of fragmentation. As I will mention a bit later, enhancing the transparency of order-routing decisions, along with improved disclosure of trading venue operations are important to help inform those decisions. As such, enhancing transparency has been and will continue to be a top priority of the Division.

Speed

The second word characterizing changes in the U.S. equity markets is speed. The great majority of equities trading on exchanges now is conducted through computer algorithms. These algorithms operate at incredibly fast speeds, in an entirely different frame of reference than traders manually interacting on an exchange floor. Trading speed now is measured in millionths of a second, or microseconds, and is moving toward nanoseconds – billionths of a second.

Instead of a trading floor in Manhattan, the locus of exchange trading now is now largely in suburban data centers in places like Mahwah, Secaucus, and Carteret, New Jersey. These data centers contain rows and rows of server racks, and vital trading advantages can go to those trading firms that have their machines “co-located” in these racks. In addition, exchanges now sell a spectrum of data products and connectivity services in their data centers that have helped fuel a low-latency arms race. These include proprietary data products with expansive trading information, as well as low-latency connectivity services, such as 40 Gb cross-connects and microwave transmission of data among geographically dispersed data centers. These data products and connectivity services can shave crucial microseconds off of the latencies of competing brokers and trading firms.

The cost of the low-latency data products and connectivity services sold by the exchanges can be substantial. Last year, an industry group submitted a petition for rulemaking to the SEC in which it calculated that the cost of obtaining the fastest data and connections to the major exchanges in 2017 was $194,000 per month.[3] The industry group represented that this was an increase from $72,000 only five years earlier. The rapidly increasing costs of the low-latency arms race raises important questions under the SEC’s governing statute for market structure — the Securities Exchange Act of 1934, otherwise simply known as the “Exchange Act.”

II. SEC’s Oversight of Market Structure

In general, the Exchange Act charges the SEC with a three-fold mission: to protect investors, to maintain fair, orderly, and efficient markets, and to facilitate capital formation. I think about these objectives every day.

In the specific context of equity market structure, Section 11A of the Exchange Act directs the SEC to facilitate the establishment of a national market system, or “NMS.” Among other things, the NMS should assure the following:

• economically efficient execution of securities transactions,
• fair competition among market participants,
• the availability of market data to investors and broker-dealers,
• brokers’ ability to obtain best execution for investor orders, and,
• the direct interaction of investor orders to the extent practicable.

Given the important role of exchanges in the NMS, Section 19 of the Exchange Act assigns the SEC responsibility to assess exchange rules, including their fees. Among other things, the SEC must assess whether an exchange’s proposed rule change provides for the equitable allocation of reasonable dues, fees, and other charges, does not permit unfair discrimination, and does not impose an undue burden on competition.

We are focused on meeting these statutory responsibilities for the NMS and for exchange rules. To this end, the SEC has taken a series of actions over the years to address the fragmentation and speed that now characterize the U.S. equity markets.

III. Strengths of U.S. Equity Markets

Before getting to these steps, however, I think it is important to maintain perspective by recognizing the tremendous strengths of the U.S. equity markets. These were recognized in the Department of the Treasury’s 2017 report on the health of the U.S. capital markets.[4] The Treasury Report emphasized that, despite some issues to be addressed, the U.S. capital markets are “the largest, deepest, and most vibrant in the world and of critical importance in supporting the U.S. economy.”[5] It also noted that the equity markets are the “largest U.S. capital market, with major equity indexes considered bellwethers for the U.S. economy.”[6]

Indeed, the U.S. equity markets are far larger than those of other major economies. This is true in absolute terms: the market capitalization of U.S. equities in 2018 was $30.4 trillion, compared to $11.5 trillion in the EU countries, $6.3 trillion in China, and $5.3 trillion in Japan.[7] The U.S. equity markets are also quite large in relative terms when compared with GNP — U.S. equity market capitalization was 165% of GNP in 2017, compared to 128% in Japan, 78% in EU countries, 71% in China.[8]

One of the bedrock reasons for the size and strength of our equity markets is the continued participation of Main Street investors. At least 52 percent of U.S. households are invested directly or indirectly in the capital markets.[9] As Chairman Clayton noted in Congressional testimony last month, this level of retail investor participation stands out against other large industrialized countries.[10] Broad investor participation in our capital markets is a significant competitive advantage for our economy. It has been achieved through many years of effort among investors, issuers, other market participants, and the SEC.

IV. SEC Initiatives to Improve Market Structure

These SEC efforts have included important steps to update our rules as equity markets evolved into the automated, fragmented, and high-speed markets of today. For example, the SEC approved new volatility moderators across our markets targeted at providing greater stability in stressed market conditions.[11] The SEC also targeted the potential for technology problems to disrupt markets by requiring broker-dealers to establish risk management tools for their algorithmic and other trading activities,[12] as well as by requiring exchanges and large ATSs to strengthen the integrity and reliability of the automated systems that are at the core of today’s market infrastructure.[13]

And just last year, the SEC took two important steps that focused on broker transparency as a primary tool to address market fragmentation. Both of these broker transparency initiatives were recommended in the Treasury Report[14] and also were strongly supported by institutional investors, including the pension funds, mutual funds, and ETF issuers that are among the largest corporate shareholders.

First, the SEC adopted new rules requiring much greater operational transparency from broker-operated dark pools that trade listed stocks. With this new, publicly available information, market participants will have the ability to better assess features of ATSs to inform decisions on where to route orders among the many venues that trade listed stocks.

And second, to give investors better information about how their brokers route customer orders, the SEC adopted new rules requiring enhanced disclosure of broker order-routing practices. Among other things, institutional investors will have access to detailed reports summarizing the routing of their own orders. And retail investors will have more information about broker arrangements with trading venues, including payment for order flow arrangements. Each of these improved disclosures will enable better insight by investors into broker order routing practices, including areas where there may be potential conflicts of interest.

V. Trading and Market’s Agenda for Market Structure

I will use my remaining time to mention some of the items that are at the top of the agenda for the equity markets and that you likely will be hearing more about in the coming months.

Thinly-Traded Securities

First, Trading and Markets staff is exploring ways to improve the quality of the market for thinly-traded securities. Today, we have a single market structure for all exchange-listed stocks, regardless whether they trade 10,000 times per day or 10 times per day. All NMS securities can trade in microseconds, with 1 cent trading increments and on over 50 venues. This market structure may not be optimal for all types of securities, and especially thinly-traded securities. In April of last year, the Division of Trading and Markets held a Roundtable on Market Structure for Thinly-Traded Securities to discuss the particular challenges facing companies and investors in this segment of the market.[15] Roundtable participants presented a wide spectrum of viewpoints, including those of issuers, retail and institutional investors, exchanges, and broker-dealers with expertise in trading less-active securities.

One way to address illiquidity, which was discussed at length at the Roundtable, is the Department of the Treasury’s recommendation in its Capital Markets Report to allow issuers of thinly-traded securities to fully or partially suspend unlisted trading privileges for non-listing exchanges, while continuing to allow off-exchange trading in these securities as a potential means to maintain some competition among trading venues. Simply put, this means: Among exchanges, only the primary listing market may be able to trade participating securities. This initiative should not be focused solely towards addressing fragmentation by helping to aggregate liquidity in one location; it should be geared towards enabling innovative market structure solutions for thinly-traded names that currently may be thwarted by today’s one-size-fits-all rule set. Alternatives that could be explored further include periodic auctions, manual market making, or another innovation that one of the primary listing exchanges develops.

Chairman Clayton has asked the Division of Trading and Markets to explore this issue, and staff is considering whether to recommend that the Commission publish a policy statement that would outline a potential path to enhance our market structure for thinly-traded securities.

Transaction Fee Pilot

Another important equity market structure initiative on the SEC’s agenda is a transaction fee pilot. Let me provide some context. Exchanges with the largest market share today have adopted what is known as a “maker-taker” fee structure. In this fee structure, maker-taker venues may offer large rebates to attract liquidity supplying orders. They may then rely on this liquidity to attract marketable orders, to which they charge a high transaction fee in order to both offset the cost of the large rebates and to ensure a profitable transaction pricing model. The exchanges generally retain a small part of the transaction fee as compensation, after paying the rebate.

The maker-taker fee structure has raised several issues and concerns among market participants and has been the topic of much debate. We have heard from market participants that it contributes to market complexity, market fragmentation, and order routing conflicts for broker-dealers. We have also heard that it can result in certain participants trading solely for rebates, which may contribute to a false view of market liquidity and additional challenges for investors. On the other hand, others have told us that maker-taker pricing enhances liquidity and results in narrower spreads for securities. While many market participants have suggested that something should be done to address maker-taker pricing and transaction fees; there is less agreement about what specifically should be done.

In response to this, the SEC adopted a final rule for a transaction fee pilot in December of last year.[16] This pilot is designed to generate empirical data that will help the SEC and the public assess whether the rules governing exchange access fees continue to promote fair, orderly, and efficient markets today. The rules also currently impose a cap on transaction fees of 30 cents per 100 shares, or 30 mils. The transaction fee pilot reflects the Commission’s commitment to retrospective review of our rules, particularly rules that significantly affect a wide range of investors.

The pilot was born out of a principal recommendation from the SEC’s Equity Market Structure Advisory Committee, which was comprised of a variety of market participants and investor representatives.[17] The Treasury Report also supported a pilot program on transaction fees.[18] The final rule was the result of a great deal of analysis and deliberation. Many commenters weighed in on the proposal.

Commenters opposed to the pilot included the major exchange groups and certain corporate issuers. They were concerned, among other things, that limiting fees and rebates could lead to wider spreads and reduced liquidity in some stocks. As a result of the comment process, the Commission reduced the scope and overall size of the pilot while ensuring the receipt of information necessary to conduct a review and analysis of transaction fees.

The major exchange groups subsequently filed petitions for judicial review against the SEC to stop the pilot. Pending a decision on these petitions by the Court of Appeals and further order of the Commission, the SEC agreed to stay the start of the pilot itself, but has required the exchanges to begin collecting data on July 1 of this year in a pre-pilot period that must occur before a pilot can begin.[19]

Given the importance of this issue for market structure and to issuers, there are a few points that I would like to address today in relation to the pilot.

The U.S. equity markets have been subject to a regulatory fee cap of 30 mils that was established in 2005. This fee cap has not been addressed or amended in the last 14 years, despite significant changes in the equity markets during that period.

As we think about the pilot and the existing fee cap and fee structures, we should understand the impact of the existing 30 mil fee cap. Today, on four of the largest five exchanges by volume, the price to take liquidity is set at the 30 mil cap. For these exchanges, market forces alone have not moved the transaction rate off of that cap. Moreover, the final rule for the pilot includes a no rebate bucket. Many asset managers submitted comment letters supporting the zero rebate group and raised a variety of issues, including rebate trading, excessive intermediation and broker conflicts. Including a zero rebate bucket will also enable us to assess the continued appropriateness of any fee cap in one or more segments of the market, and to test equilibrium pricing for transaction fees.

There are different policy solutions available to the Commission. The Commission could simply lower the cap, eliminate the cap, or something else based upon its judgement. The pilot program is intended to gather data to facilitate an empirical assessment of the effect of exchange transaction fees and rebates broadly by testing the effects of changes to exchange fees and rebates on the markets and market participant behavior. And this data should help to provide information as to how the maker-taker model impacts order routing behavior and how fees and rebates at varying levels impact execution and market quality. This data would also enable an assessment of how the results may vary among different types of stocks. The program will automatically sunset after one year unless the SEC affirmatively acts to extend it for an additional year.

I think it’s important to point out that nearly every institutional investor that submitted a comment supported conducting a pilot and testing a zero rebate group. I am looking forward to this important initiative to empirically test fees and rebates in our equity markets.

Market Data and Market Access

The third item on the market structure agenda I want to raise with you this morning is related to market data and market access. By market data, I mean quotations and trade reports. By market access, I am referring primarily to different aspects of connectivity to exchanges. As I noted earlier, when discussing the speed of today’s equity markets, it is clear that technology has shifted this regulatory landscape in fundamental ways over the last 14 years.

We currently have what can be generally described as a two-tiered system of market data and market access in the U.S. equity markets. With respect to market data, there are consolidated data feeds that are jointly operated by the exchanges and FINRA. These utility data feeds, known as “core data,” are required by regulation and are intended to meet the essential data needs of most market participants. But there are also an array of proprietary data products and access services that exchanges and other providers sell to the marketplace. The second set, the proprietary products, generally are faster and more content rich than core data. The proprietary products also are much more costly than core data.

Last Fall, the Division of Trading and Markets hosted a Roundtable on Market Data and Market Access.[20] Many panelists at the Roundtable raised concerns that core data may be no longer sufficient for them to trade competitively in today’s markets.[21] Several panelists noted, for example, that core data could no longer be considered timely in today’s high-speed markets, and that the content of core data may not provide some key information necessary to trade optimally.[22] Some panelists went further and asserted that they did not believe that core data was sufficient for brokers to achieve best execution for their customers.[23] These panelists included institutional investors and the brokers who serve them. Institutional investors, such as mutual funds and pension funds, represent millions of individual investors who rely on institutions to help them participate in the U.S. equity markets. The market data concerns raised by institutional investors and their brokers therefore implicate the interests of Main Street investors.

Retail brokers also expressed concerns about core market data at the Roundtable. They argued that the fee structure and related audit process for core data imposes costly administrative burdens on retail customers and their brokers.[24] The burdens cited include the requirements for retail customers to qualify for lower fees as non-professional users and for retail brokers to prove the non-professional status of their customers.[25] The difficulties of providing core data for retail investors have led some brokers to provide to their customers in many contexts a more limited type of data feed sold by the exchanges. These so-called “top-of-book” proprietary data feeds do not necessarily provide complete market information, such as the best available quotes, particularly in thinly-traded securities.[26]

I am interested in the effects that this two-tiered structure of data and access may be having. In particular, I want to ensure that the market ecosystem continues to meet the Exchange Act requirements for efficient markets that are not unfairly discriminatory and that promote fair competition among market participants. While these are complex issues, I want to highlight a few potential effects of two-tiered data and access.

First, what is the effect of the rapidly increasing cost of securing the fastest access to our equity markets, particularly on smaller brokers and trading firms that may not have the large volume needed to cover these high fixed costs? We should explore the extent to which the high fixed costs of proprietary data and access products lead firms to exit the market, thereby increasing the concentration of trading activity among fewer firms. One of the keys to maintaining the highest level of liquidity in a financial market is to have as many participating firms as possible that employ a range of different trading strategies.

A second concern here is related to fairness: we should explore the extent to which the high fixed costs of the best proprietary data and access products may have resulted in smaller firms, that cannot reasonably afford such products, to trade at a competitive disadvantage to others.

Another potential effect of two-tiered data and access relates to retail investors. I am concerned that, because of cost concerns, brokers are providing retail investors with limited top-of-book data covering only a subset of exchanges, instead of the more complete core data with the full NBBO. The major exchange groups that oversee the sale and pricing of core data also sell these partial market data feeds. While these other products may result in some cost savings to brokers, retail investors may not always be receiving the fulsome information they need to optimally participate in the equity markets. This is particularly a concern for thinly-traded securities where the exchanges’ top-of-book data products are more likely to show spreads that are wider than would be shown by core data. As I discussed earlier, I am concerned about liquidity in thinly-traded securities, an issue that is not necessarily helped when the quotes being displayed to retail investors do not always include the inside quotes.

When the SEC last addressed core data and access concerns in 2005, it emphasized that “one of the Commission’s most important responsibilities is to preserve the integrity and affordability” of core data.[27] Yet we heard repeatedly from investors, brokers, and data technology firms that these core regulatory objectives have not been sustained in today’s marketplace. Chairman Clayton has asked the staff to examine these issues closely and develop recommendations that would consider the concerns about core data that were highlighted during the Roundtable. I anticipate that you will hear more about these topics in the coming months.

Conclusion

In conclusion, the Division of Trading and Markets is intensely reviewing a series of important questions and policy initiatives that I believe should be of great interest to issuers and their investors as they participate in the U.S. equity markets. As we assess how to best update our regulatory policies for our ever-evolving equity markets, we will remain true to the Commission’s core mission to protect investors, to maintain fair, orderly, and efficient markets, and to facilitate capital formation.

I expect that we will be able to engage on some of these topics further in the upcoming panel. And I invite any of you to come visit us in Washington D.C. as your input and engagement is extremely helpful to our process of policy formation.

Thank you.