0001 1 THE UNITED STATES SECURITIES AND EXCHANGE COMMISSION 2 3 4 5 6 7 EQUITY MARKET STRUCTURE 8 ADVISORY COMMITTEE 9 10 Tuesday, October 27, 2015 11 9:36 a.m. 12 AMENDED: 1/12/2016 13 1/29/2016 14 15 16 17 18 19 20 21 22 23 Securities & Exchange Commission 24 100 F Street, N.E. 25 Washington, DC 20549 0002 1 PARTICIPANTS: 2 3 Chair Mary Jo White 4 Commissioner Luis Aguilar 5 Commissioner Michael Piwowar 6 Commissioner Kara Stein 7 Steve Luparello 8 9 Matthew Andresen 10 Robert Battalio 11 Michael Buek 12 Reginald Browne 13 Nancy Burke-Sanow 14 Kevin Cronin 15 Mark Flannery 16 Thomas Farley 17 Daniel Gray 18 Gary Goldsholle 19 Larry Harris 20 Richard Holley 21 Ted Kaufman 22 Richard Ketchum 23 John Kerin 24 Manisha Kimmel 25 Mehmet Kinak 0003 1 PARTICIPANTS (CONT.): 2 3 Matt Lyons 4 Joseph Mecane 5 Jamil Nazarali 6 Eric Noll 7 Maureen O'Hara 8 Joe Ratterman 9 Brett Redfearn 10 David Shillman 11 Andrew Silverman 12 Nancy Smith 13 Chester Spatt 14 Gary Stone 15 Thomas Wittman 16 17 18 19 20 21 22 23 24 25 0004 1 C O N T E N T S 2 3 Opening Remarks 5 4 5 Presentation on Rule 610 by SEC Staff 47 6 7 Presentation and Q&A on Rule 610 61 8 9 Committee Discussion of Rule 610 110 10 11 Presentation on Regulatory Structure of 12 Trading Venues by SEC Staff 161 13 14 Presentation and Q&A on Regulatory Structure of 15 Trading Venues 170 16 17 Discussion of Next Steps 239 18 19 Discussion of Recent Market Volatility 246 20 21 22 23 24 25 0005 1 P R O C E E D I N G S 2 MR. LUPARELLO: Good morning. I'd like to 3 call the meeting to order. I believe we have a 4 quorum this morning. On behalf of the Commission, 5 I'd like to thank you all for joining us today for 6 the second meeting of the SEC's Equity Market 7 Structure Advisory Committee. 8 I'd also like to thank the members for 9 your patience with us as we've worked to reschedule 10 our September 24th meeting to today. 11 With that said, on behalf of the advisory 12 committee and as the designated Federal officer -- I 13 often say financial officer, but everybody should 14 know that's wrong -- of the committee, I'd like to 15 welcome Chair White to the meeting. 16 Chair White. 17 CHAIR WHITE: Thank you, Steve, and I'm 18 also very pleased to welcome you back for the 19 October 2015 meeting of the Equity Market Structure 20 Advisory Committee. 21 I want to begin by thanking each of you 22 for your flexibility. 23 As Steve noted, when we postponed the 24 meeting from its originally scheduled date of 25 September 24th -- the road closures and other 0006 1 security measures taken for the Pope's visit that 2 day would have made travel and convening the meeting 3 for everyone very difficult. 4 You know, the discussions at our inaugural 5 meeting underscore for me how invaluable this 6 committee's insights are as the Commission continues 7 its efforts to ensure that the equity markets 8 optimally meet the needs of investors, both large 9 and small, and issuers of all sizes. 10 With the careful consideration, input, and 11 approval of each of the Commissioners, we've been 12 able to assemble a diverse group of lively, 13 respected experts to effectively represent the views 14 of key stakeholders in the equity markets, and I 15 thank you each again for your service. 16 Since we announced the formation and 17 membership of the committee in January, we've had 18 requests from other market participants with 19 valuable market perspectives, with valuable 20 perspectives of all kinds, really, to join the 21 committee. 22 Some of those requests have been 23 reiterated recently. 24 I wish we could accommodate them all. 25 While this was not practical, to ensure transparency 0007 1 of our efforts and representation of all viewpoints 2 on a committee of this kind, we've taken a number of 3 additional steps to broaden our means of obtaining 4 input. 5 These include presentations at all 6 committee meetings by expert panels, the independent 7 provision of relevant data, analysis, and public 8 briefings by Commission staff for feedback from all 9 interested parties, an open comment file, and a 10 transparent public agenda. 11 These mechanisms are designed to ensure 12 that the Commission and the advisory committee 13 benefit from the full range of perspectives on 14 important market structure topics. 15 Having said that, I believe that the 16 Commission needs to review regularly whether the 17 operation of these mechanisms is enabling all 18 significant perspectives on the issues and potential 19 policy measures to be presented. 20 As we move forward, we will continue to 21 seek and encourage input from all constituencies. 22 I also believe the Commission must find 23 ways to efficiently and effectively leverage the 24 expertise of the advisory committee so that it is in 25 a position to offer advice on a variety of very 0008 1 complex issues in a timely manner. 2 At our last meeting, committee members 3 gave us clear direction regarding the benefits of 4 forming subcommittees, permitted under the Federal 5 Advisory Committee Act and as contemplated by the 6 committee's charter and bylaws. 7 Such subcommittees would undertake a 8 detailed review and analysis of particular market 9 structure topics, including topics of the members' 10 own choosing that will help facilitate the full 11 advisory committee's consideration of those issues. 12 Indeed, the use of subcommittees and the 13 efficiencies they provide have been recognized by 14 other Commission advisory committees formed in 15 recent years, including the joint CFTC-SEC Advisory 16 Committee on Emerging Regulatory Issues and the 17 SEC's Investment Advisory Committee. 18 Steve Luparello will address subcommittees 19 shortly in greater detail, but I want to note 20 initially that any advice or recommendation of a 21 subcommittee would, of course, be presented to and 22 thoroughly deliberated by the full advisory 23 committee in a public meeting such as this one, as 24 required by law. 25 If the Commission were to take any action 0009 1 as the result of the committee's advice, it would be 2 subject to the applicable notice and comment 3 contemplated by the Administrative Procedures Act. 4 Moving to today's substantive agenda, the 5 advisory committee is taking up two important and 6 complex market structure topics: national 7 securities exchange access fees and the current 8 regulatory models for trading venues. 9 At this morning's session, the committee 10 will consider exchange access fees. 11 Investors have a broad selection of 12 execution venues to choose from, currently 11 equity 13 exchanges and more than 40 alternative trading 14 systems. 15 Competition for order flow among these 16 varied venues is intense, and as a result, trading 17 venues compete aggressively to attract and retain 18 order flow. 19 One of the more widely used fee structures 20 in the equities markets, as you know, is the maker- 21 taker fee structure, which attracts order flow to a 22 venue and incentivizes the venue's market 23 participants to provide liquidity at the most 24 competitive prices. Maker-taker fees have been so 25 widely adopted that they unquestionable impact the 0010 1 markets structure. 2 At the last meeting, many committee 3 members noted that a discussion of this fee model is 4 essential for any thorough assessment of equity 5 market structure. There are different views on its 6 merits. 7 Proponents of the maker-taker model argue 8 that it serves as an important competitive tool for 9 both exchange and non-exchange markets and also 10 promotes tight spreads. 11 Some critics argue that it creates 12 inherent conflicts of interest between brokers and 13 their customers and may distort routing decisions, 14 and that it keeps taker fees high to subsidize 15 generous maker rebates. Other critics argue that it 16 contributes to market fragmentation and market 17 complexity through the proliferation of new exchange 18 order types. 19 Today's discussion addressing these 20 various views will be very valuable. Critics of the 21 maker-taker model have made a range of different 22 recommendations about how to address the conflicts 23 presented by the maker-taker model, which I am sure 24 will be, and hope will be part of the discussion. 25 Because of the pervasiveness of maker-taker fees, 0011 1 these recommendations must be evaluated carefully to 2 assess the consequences, intended and unintended, of 3 any change. 4 A pilot to study to study this set of 5 issues has been suggested and should be seriously 6 considered. But as the tick size pilot team can 7 attest, a thoughtfully designed pilot needs to be 8 carefully designed and meticulously implemented. 9 The other matter that the committee will 10 consider this afternoon are the fundamental changes 11 in trading venue management and operation, including 12 the growth of trading conducted through ATSs, the 13 impact of demutualization, and the emergence of 14 exchange group affiliations, among other shifts. 15 These transformational events have led some 16 observers to question whether the current regulatory 17 model for trading venues is optimally serving the 18 market as a whole and providing a level and fair 19 playing field for all market participants. 20 Both exchanges and ATSs compete to offer 21 trade execution services and are subject to various 22 Commission rules, including restrictions on the 23 execution of trades at prices inferior to the 24 consolidated national best bid or offer. But there 25 are also differences. 0012 1 For example, as self-regulatory 2 organizations, exchanges are subject to a wider 3 range of regulatory requirements than those imposed 4 on ATSs. Exchanges must file rule changes with the 5 Commission. And exchanges are required to undertake 6 regulatory obligations with respect to the 7 activities of their members. 8 Because ATSs are not subject to the same 9 requirements as exchanges, they are viewed as having 10 greater flexibility in their operations and do not 11 incur the same level of regulatory costs. 12 Another difference is the participation by 13 exchanges in National Market System plans, including 14 those governing the allocation of market data 15 revenues. As you know, the National Market System 16 plans are also used in a variety of contexts, such 17 as limit up-limit down and the tick size pilot. 18 Over time, the perceived differences 19 between the services provided by the exchanges and 20 ATSs and their respective roles in the equity 21 marketplace have diminished. In particular, some 22 observers have questioned whether exchanges should 23 continue to be SROs, given most exchanges have 24 contracted their SRO functions to another SRO, 25 particularly FINRA. The Commission considered many 0013 1 of these issues in its 2004 Concept Release 2 Concerning Self-Regulation, and more recently, I and 3 others have stressed the importance of reviewing 4 whether the current regulatory model makes sense for 5 today's markets. 6 I look forward to hearing your views as to 7 whether and how the SEC's regulatory approach for 8 trading venues should be adjusted to reflect the 9 changes that have occurred in recent years. 10 Each and every one of you brings to this 11 discussion a unique and important perspective on our 12 markets, which will be of great assistance to the 13 Commission as we continue to explore the issues on 14 today's agenda. I am confident that the work of 15 this committee will help the SEC immeasurably in 16 developing ways to optimize the operation of our 17 equity markets in a manner that promotes our mission 18 of protecting investors, facilitating capital 19 formation, and maintaining fair and orderly markets. 20 Thank you, Steve. 21 MR. LUPARELLO: Thank you, Chair White. 22 I would now ask the Commissioners to make 23 their opening statements, starting with Commissioner 24 Aguilar. 25 MR. AGUILAR: Thank you, Steve. I wasn't 0014 1 sure you wanted a free-for-all, but we'll do this by 2 alphabetical order, I guess. Thank you. 3 I want to extend a warm welcome to the 4 members of the Equity Market Structure Advisory 5 Committee. I appreciate the work that you do and, 6 in turn, how this work informs the Commission's 7 efforts to fulfill its mission. I also want to 8 welcome everybody in the audience, whether 9 participating in person or via the internet. 10 Well, if we needed more proof of the 11 importance of this committee, we've gotten it. 12 Although, it's been only five months since this 13 committee's first meeting, we have already witnessed 14 two major market disruptions. 15 The first was a software glitch in July 16 that halted trading at one major exchange for 17 several hours. That event highlighted a glaring 18 shortcoming in our current market infrastructure, 19 specifically, the fact that the primary exchanges 20 still have no back-up plan for their opening and 21 closing auctions. 22 This was especially disconcerting because 23 in November 2013, the exchanges issued a public 24 statement acknowledging the importance of developing 25 backup plans for their critical functions, including 0015 1 their opening and closing auctions. 2 After the July 8th event, the exchanges 3 announced that they are again revisiting this issue, 4 but it is unfortunate that they had not acted 5 sooner. 6 The aggressive pace at which our markets 7 have been evolving in recent years -- the 8 exponential growth in the number and variety of ETFs 9 is just one example -- suggests that a proactive 10 approach is preferable to a reactionary approach. I 11 urge the staff of the exchanges and the Commission 12 to work toward developing a robust contingency plan 13 for the exchanges' vital infrastructure. I also 14 urge this committee to consider whether other 15 aspects of our market structure need to be 16 buttressed with contingency plans. 17 The second noteworthy market disruption 18 occurred on August 24th, when we witnessed how acute 19 volatility can wreak havoc with our equity markets 20 in unforeseen ways. On that day, delays in the 21 openings of certain stocks caused a spike in 22 volatility, which led to a temporary loss of $1.2 23 trillion in market value. The effects were 24 especially pronounced for exchange traded products, 25 many of which traded at sharp discounts to the 0016 1 indices they were designed to track before returning 2 to more normal levels. 3 These events laid bare certain flaws in 4 our current market structure that require urgent 5 attention. A particularly acute problem involves 6 the process for reopening trading after a halt is 7 imposed under the limit up/limit down rules. 8 Trading was halted 1,278 times on August 9 24, with trading in 257 securities being halted 10 multiple times. The reasons for this are inter- 11 related and complex, but some experts have suggested 12 that we need to examine the exchanges' re-opening 13 auctions to ensure that trading can resume as 14 efficiently as possible during periods of intense 15 market stress. This is a particularly challenging 16 issue in today's markets, where algorithmic trading 17 is now responsible for more than half of daily 18 trading activity. These algorithms may not be 19 programmed to deal with rare events like re-opening 20 auctions or extreme spikes in volatility, and this 21 may be one reason that re-opening auctions on August 22 24th struggled to attract liquidity. Finding ways 23 to address this new market paradigm is one of the 24 questions this committee will need to address. 25 Of course, the events of August 24th 0017 1 raised a number of other issues as well, many of 2 which I addressed in my remarks at the SEC's 3 Investor Advisory Committee meeting just two weeks 4 ago. I hope that the members of this committee will 5 work with the members of the Investor Advisory 6 Committee's subcommittee on market structure to 7 bring their collective experience to bear on these 8 pressing issues. 9 Now, before turning to the issues on 10 today's agenda, I note that the composition of this 11 committee has received a degree of attention in 12 recent weeks from a variety of sources. I won't 13 speak to the relative merits of these comments, but 14 I will note that, at the first meeting of this 15 committee, I expressed a concern that this 16 committee's composition did not reflect all of the 17 viewpoints that are relevant to the issues under 18 consideration. 19 To that end, it is necessary for this 20 committee to proactively solicit regular input from 21 other groups with a stake in the quality, fairness, 22 and resiliency of our equity markets, particularly 23 retail investors and issuers. In a similar vein, I 24 encourage anyone with a views on these important 25 topics to submit a comment to the committee via the 0018 1 Commission's website, or to request an opportunity 2 to appear before the committee. 3 Now, today, the committee will be taking 4 up two important issues, the use of the so-called 5 maker-taker pricing model, and the regulatory status 6 of trading centers. 7 Prior to this committee's first meeting in 8 May, I publicly released a statement that discussed 9 in detail many of the issues surrounding certain key 10 aspects of our equity market structure, including 11 the maker-taker system and competition for order 12 flow. One of the areas I analyzed involved the 13 relative merits and drawbacks of the maker-taker 14 model. In the end, I concluded that the Commission 15 should implement a pilot program in which maker- 16 taker rebates would be suspended for the most liquid 17 stocks. 18 In addition, a more recent study has 19 provided even more evidence that the conflicts of 20 interest created by the maker-taker pricing model 21 can cause investors to receive less than optimal 22 executions of their trades in some instances. 23 In light of this, I encourage the 24 committee to recommend to the Commission that it 25 begin work on a maker-taker pilot program similar to 0019 1 the one I described in my May 11th statement. This 2 program should be less complex than the current tick 3 pilot program and should not take too long to put 4 together. 5 The maker-taker pricing system and the 6 regulatory status of trading platforms are clearly 7 pressing issues that demand the committee's prompt 8 attention. But since this may be the last time I 9 have an opportunity to address the committee as a 10 Commissioner, I would like to take the opportunity 11 to pose some longer-term questions that I hope the 12 committee will consider as it holds additional 13 meetings: 14 First, a recent estimate found that 15 institutional investors now hold fully 80 percent of 16 the outstanding shares of U.S. large cap firms, up 17 from only 50 percent only 15 years ago. Given that 18 retail investors are increasingly relying on 19 professional asset managers, whose trades are 20 typically larger and more impactful, what 21 implications does this have for the structure and 22 regulatory framework of our equity markets? 23 A recent article authored by employees of 24 the Federal Reserve Bank of New York concluded that 25 market liquidity generally has not deteriorated in 0020 1 recent years. Other studies, however, have reached 2 differing conclusions. This committee should make 3 its own inquiry. In particular, the committee 4 should look at whether there is adequate liquidity 5 for institutional investors, who now play a greater 6 role in our equity markets. If not, how can our 7 market structure address the liquidity needs of buy- 8 side firms without impairing market quality for 9 retail investors? 10 o In addition, liquidity has become more 11 brittle in recent years and more apt to flee during 12 periods of market stress. The committee should 13 examine the causes of this phenomenon and how market 14 structure might be contributing to it. 15 o Third, the aggressive growth of indexing 16 in recent years has concentrated investment activity 17 in the largest and most liquid stocks. What 18 implication does this hold for market stability and 19 volatility? And, is it impairing capital formation 20 for smaller stocks? 21 Fourth, how has the growing use of so- 22 called systematic trading strategies, such as risk 23 parity, affected the stability of our markets? 24 Could it be partly responsible for the perceived 25 intensification of liquidity risks in our equity 0021 1 markets? If so, how can regulators better monitor 2 the use and the implication of such strategies? 3 Fifth, how should the Commission address 4 the problems of excessive intermediation in our 5 equity markets? Is it possible to distinguish 6 proprietary trading firms that act as liquidity 7 providers from those that engage in disruptive 8 trading strategies? If so, how should the 9 Commission address firms that employ the latter? 10 Sixth, do public exchanges still remain an 11 attractive destination for smaller and emerging 12 companies, or are venture capital and private equity 13 firms winning the race? Does the current equity 14 market structure contribute to the declining number 15 of initial listings? 16 I'm sure each of you has additional 17 questions you would like this committee to ask, and 18 I will encourage you to add it to the list, but as I 19 said, this may well be the very last time that I 20 address this committee as a Commissioner. In light 21 of that, I would like to thank each of the committee 22 members one last time for your service. But I would 23 also ask you, as I did at the last meeting, never to 24 lose sight of the fact that our equity markets need 25 to be structured, first and foremost, to meet the 0022 1 needs of investors and issuers. These market 2 participants are the very reason our equity markets 3 exist, and it is their interests that need to come 4 first. I trust you will do so. 5 Thank you. Look forward to having a great 6 day with you. 7 MR. LUPARELLO: Thank you, Commissioner. 8 Commissioner Stein? 9 MS. STEIN: That's hard to beat. Good 10 statement. 11 I wasn't going to do prepared remarks. I 12 want to welcome all of you again. You're all really 13 smart people. I look forward to the discussion 14 today, and again, reiterate you're doing this pro 15 bono and you all have very busy lives, so we 16 appreciate it. 17 I'm just going to reiterate what Mary Jo 18 and Luis said, that the events on August 24th 19 highlight how important it is that we have input 20 from you as a committee. The only constant in life 21 is change, and the market keeps changing, and we 22 need to be more nimble and change with it. 23 I am interested in both of the topics are 24 set before you today, maker-taker, you know, and 25 other types of compensation for order flow and 0023 1 attracting liquidity, and also how the SRO model has 2 evolved or not evolved, you know, going forward. 3 Implicit is that is the ATS, you know, 4 model, as well. 5 So, I look forward to a robust 6 conversation on all of those issues. 7 And then just finally, I want you to bring 8 your own issues to the table. A lot of you are out 9 there on the cutting edge of the marketplace, and I 10 think it's really important that you speak up, you 11 let us know what you think the most important issues 12 are, you help us think through, you know, these 13 things, and finally, I'm going to reiterate what 14 Luis and Mary Jo have said, is you are here on 15 behalf not just of yourselves, your company, but on 16 behalf of the American public. 17 So, reach out, talk to the folks that 18 you're representing, try to get those other 19 viewpoints to the table. The table is only so big, 20 it's always limited, but we need to hear from folks 21 who might hold a different perspective or have 22 different interests. 23 So, please be open to bringing those views 24 to the table. We need to think through this for the 25 good of everyone. 0024 1 Thank you. 2 MR. LUPARELLO: Thank you, Commissioner. 3 Commissioner Piwowar. 4 MR. PIWOWAR: Thank you, Steve. And thank 5 you to the members of the Equity Market Structure 6 Advisory Committee and to the panelists for joining 7 us today. 8 If the last meeting was any indication, 9 the discussion will be candid, informative, and 10 thought-provoking. I look forward to hearing each 11 of your views and insights. But please indulge me 12 in acknowledging one of today's panelists in 13 particular. 14 Larry Harris is a mentor, friend, 15 colleague, and co-author, and I am delighted the 16 Commission has invited him to participate today. 17 Before I proceed, I also want to thank the 18 Staff for its hard work in advance of this event. 19 Although the Commission may have good 20 intentions with respect to an equity market 21 structure review, we have been slow out of the 22 starting blocks. The recently created 23 "Accomplishments" web page on our website describes 24 only three equity market structure achievements thus 25 far. 0025 1 One, we implemented the MIDAS system and 2 launched a new website dedicated to equity market 3 structure. Two, we proposed a rule to enhance the 4 supervision of large proprietary trading firms. And 5 three, we formed the committee being convened today. 6 According to the web page, the Commission 7 is looking to the committee to, quote, "provide a 8 valuable mechanism for us to receive input and 9 advice concerning market structure issues as the 10 Commission does its comprehensive review," unquote. 11 I hope that the committee can take 12 ownership of the issues and generate forward 13 momentum for our review. As I said at the inaugural 14 meeting, I believe we should empower the committee 15 to determine which topics to focus on, and how to 16 sequence its discussions. 17 Allowing the committee to exercise its 18 independent judgment on which are the most pressing 19 matters and how they are intertwined is the only 20 path toward yielding truly pragmatic and meaningful 21 recommendations on enhancing the equity markets. 22 In that regard, I pose the following 23 questions to the committee: What are the goals of 24 the committee? In the future, how will the 25 committee evaluate its success? Not, how will the 0026 1 Commission or the Staff measure effectiveness, but 2 what are the committee's expectations for itself? I 3 challenge the committee and its subcommittees to 4 establish concrete goals, guideposts, and measures 5 of success for their work. 6 In a year's time, I want the committee to 7 be able to come back to us and say they accomplished 8 something meaningful. Then it will be incumbent 9 upon the Commission to use the committee's 10 achievements to advance truly comprehensive equity 11 market structure reform. 12 Thank you. 13 MR. LUPARELLO: Thank you, Commissioner. 14 Good morning again. As you know, my name 15 is Steve Luparello, and I am the designated Federal 16 officer of the advisory committee. 17 Up here with me are my colleagues in the 18 Division of Trading and Markets. To my immediate 19 right is Gary Goldsholle, who is the deputy 20 director. To his right is Dave Shillman, who is the 21 associate director for the Office of Market 22 Supervision. And to his right is Richard Holley, an 23 assistant director in that office who will be 24 presenting on access fees. 25 Also joining us at the table today, at the 0027 1 other end -- I think I see him down there -- is Mark 2 Flannery. Mark is the chief economist and the 3 director of the Economic and Risk Analysis Division. 4 Standard disclaimer applies to today's 5 meeting. Our views expressed in this forum are ours 6 and cannot be attributed to the Commission or 7 Commissioners, I guess, unless the Commissioners 8 themselves state it, or the body as a whole. 9 So, first off, a few housekeeping items. 10 We'll kick off the morning with a brief 11 presentation on access fees to set the stage for the 12 panelists' presentation and committee discussion. 13 We'll then adjourn for lunch and begin the 14 afternoon with a presentation on the regulatory 15 model for trading venues and for market data 16 dissemination. 17 The afternoon will follow the same format, 18 presentation by panelists followed by committee 19 discussion. 20 Finally, we'll discuss the recent market 21 volatility and events around August 24th. 22 Now that I've outlined the day's agenda, 23 I'd like to discuss the formation of subcommittees. 24 At the committee's first meeting, members 25 identified a wide range of market structure topics 0028 1 for potential committee consideration, including 2 those being discussed today, exchange access fees 3 and regulatory treatment of trading venues, as well 4 as those related to payment for order flow, 5 execution quality disclosures, high-frequency 6 trading, dark liquidity, market quality, and other 7 items. 8 To facilitate a more efficient operation 9 of this 17-member committee, a number of committee 10 members suggested that the committee consider 11 creating subcommittees to explore specific topics in 12 more depth and report back to the full committee for 13 discussion at a public meeting. 14 In the interim, committee members 15 expressed interest in potentially forming four 16 subcommittees, which I'll describe briefly. 17 First, a Regulation NMS subcommittee to 18 review the trade-through rule, access fees, sub- 19 penny rules, and other matters covered by Reg NMS. 20 Second, a trading venue regulation 21 subcommittee to review the status of exchanges as 22 SROs and potential harmonization of the regulation 23 of trading venues. 24 Third, a retail customer issue 25 subcommittee to review payment for order flow, 0029 1 improved execution quality disclosures, and other 2 market structure issues that particularly impact 3 retail investors, and finally, a market quality 4 subcommittee to review high-frequency trading, dark 5 liquidity, and other market developments, and assess 6 their impact on overall market quality. 7 I should tell you that's our description 8 at the front. Obviously, we're open to 9 conversations about the definition of those 10 subcommittees and how separate issues that were not 11 lined up there would fit within those four 12 committees. 13 The Commission staff would be on hand to 14 coordinate and support initial subcommittee 15 meetings, but I expect that the subcommittees will 16 be self-directed in terms of appointing a chair, 17 defining agendas, conducting their meetings, and 18 setting timetables for deliverables. 19 Subcommittees may certainly choose to 20 invite outside experts and consult as necessary with 21 other advisory committees and their members. 22 They may also choose to make portions of 23 their meetings open to the public. 24 We would make agendas and summary minutes 25 of subcommittee meetings available to the public and 0030 1 posted on the Commission's website. 2 I'd like to now briefly turn it over to 3 the committee for further discussion of the 4 subcommittee topic. Do the committee members 5 continue to support the creation of subcommittees? 6 If so, are the four subcommittees I just described 7 appropriate or are there better alternatives? 8 With that, I'll open it up to anybody who 9 wants to comment. 10 Rick. 11 MR. KETCHUM: Steve, I'd just underline 12 what I think the committee's conclusion was the 13 first time, and the Commission's. 14 This is now my fourth advisory 15 committee -- that's enough -- but in each case, the 16 ability to be able to have deeper conversations and 17 interact with committee members and to focus 18 discussions so that these meetings can be more 19 effective, directed, and to the points made 20 particularly by Commissioner Aguilar, more result- 21 oriented -- I have never seen an environment where 22 doing this entirely with respect to a group of 17 in 23 the whole can be as effective as focusing the 24 discussion. 25 Obviously, none of that changes the 0031 1 ability for any committee member to be able to raise 2 any issue, but I can just say, from all my 3 experience, if an advisory committee doesn't have 4 subcommittees, the value it will provide is 5 substantially less. 6 MR. LUPARELLO: Thank you, Rick. 7 MR. CRONIN: Steve, I have a question for 8 you over here, if I may. 9 So, two things. 10 First, I agree that the subcommittees are 11 a good idea. I do think that it will be important 12 to be more inclusive with respect to the 13 subcommittees. For example, in the retail investor 14 subcommittee, it certainly seems like we could be 15 adding some very real expertise in that realm. 16 But secondly, and maybe more procedurally, 17 what is our ability to break into subcommittees? Is 18 there some sort of limitation on how many committees 19 each of us could be in, or is it possible for the 20 subcommittee to be the committee? 21 MR. LUPARELLO: It is not possible for the 22 subcommittee to be the committee, because that would 23 be inconsistent with FACA, with the Federal Advisory 24 Committee Act, but I think we would take whatever 25 steps we possibly could to be inclusive, including, 0032 1 as -- Kevin, as you point out -- the fact that these 2 subcommittees would have a desire and the need to 3 avail themselves of experts off the committee, and 4 so, I think, in that sense, being as flexible as 5 possible is something we would encourage you to do 6 and support you in doing it. 7 We're also not necessarily limited to only 8 four, and people are not limited to the number of 9 committees they can be on, but we can't have a 10 construct where all or substantially all of the 11 committee is represented on the subcommittee. 12 Joe. 13 MR. MECANE: This is maybe a question or 14 just something to think about, but since two of the 15 four topics that I think we broadly agreed are under 16 discussion today, and presumably the next two will 17 be at the next meeting, do we envision that we'll 18 start the four subcommittees now, in advance, or do 19 we think it will be more of a sequential process 20 where we'll do the first two subcommittees and then 21 the second two, or is that still to be decided? 22 MR. LUPARELLO: So, there's a little 23 flexibility on that, and we certainly want to get 24 the feedback from the 17 of you. 25 We also want to be very sensitive to how 0033 1 much of a tax on your time we are. 2 So, I think, as we've thought it through, 3 we would form the four subcommittees now, but we 4 would see the two subcommittees that are focusing on 5 the issues we're presenting today, as well as any 6 adjacencies that go with that, sort of starting up 7 in earnest right away with the other two sequencing 8 a little bit after that. 9 So, we would form right away, but we would 10 expect the two subcommittees that are focusing on 11 these issues to start meeting more immediately; the 12 other two maybe a little bit after that. 13 Jamil. 14 MR. NAZARALI: A lot of our clients have 15 expressed the same concern that Kevin brought up 16 about their ability to participate in the 17 subcommittees that are discussing issues very, very 18 important to them, and while I understand we're 19 going to be able to invite them in to present, 20 etcetera, I think that there is a concern that the 21 deliberations are going to be, you know, in private 22 and that they're not going to understand what's 23 going on or how the decisions came out of that. How 24 do we address that? 25 MR. LUPARELLO: That's a great point, and 0034 1 I think the most aspect of that is to remember that 2 any deliberations that occur in the subcommittee 3 have to get presented to the full committee. 4 So, to a certain extent, you could argue 5 that that's -- there's a little redundancy to that, 6 because you have a very in-depth conversation that 7 then gets replayed, but it's very important to have 8 that conversation played out with -- with the full 9 committee. 10 So, I think we would imagine that, as the 11 subcommittee develops positions or recommendations, 12 somebody on the subcommittee would take the 13 responsibility to make that presentation to the full 14 committee and we would have a robust conversation at 15 the full committee level of anything that came out 16 of the subcommittees. 17 MR. KAUFMAN: Steve, we're a two-year 18 committee. We're through one year now. If we set 19 up the second set of subcommittees, not right away - 20 - I mean, what is your thinking about what we're 21 going to do in the next year and the sense of 22 urgency to get -- first by the problems that have 23 been created but second by the fact that we're only 24 going to be in existence for another year? 25 MR. LUPARELLO: Well, it's a little bit 0035 1 more than a year. It's also a minimum of two years, 2 so I wouldn't expect that it automatically turns 3 into a pumpkin at the end of the two-year period. 4 MR. KAUFMAN: What do we plan to do over 5 the next year? 6 MR. LUPARELLO: What we plan to do over 7 the next year is to get traction immediately on the 8 issues that we're talking about today, very far- 9 reaching, difficult issues around the regulation of 10 SROs and the presence of access fees. 11 But in the very near future -- so, when 12 Joe talked about sequencing, I don't think we're 13 looking at, sort of, nine months down the road, we 14 would take on the other committees. It would be 15 staggered but just by a small amount, probably three 16 months. 17 MR. KAUFMAN: Just to get some idea, what 18 are you thinking about, number of committee meetings 19 next year? 20 MR. LUPARELLO: We have stated from the 21 very beginning a desire to have four committee 22 meetings a year. I think, in the first instance, we 23 have adhered to that in the breach, but we continue 24 to try to move towards four committee meetings a 25 year. 0036 1 Another one of the benefits of 2 subcommittees is it's much easier for the 3 subcommittees to meet and make real progress and get 4 real traction at the subcommittee level. 5 I think that's one of -- as we heard from 6 the committee in our first meeting, that's one of 7 the real -- and as Rick just pointed out again -- 8 that's one of the real benefits of the 9 subcommittees, is the ability to meet on a more 10 frequent basis and get real traction on the issues. 11 MR. KAUFMAN: So, in the first meeting 12 next year, you'd expect a report from the four 13 subcommittees? 14 MR. LUPARELLO: I would hope for feedback 15 from the first two committees, but I wouldn't 16 necessarily assign them that responsibility in the 17 first instance. But I think that's certainly what 18 we would -- 19 MR. KAUFMAN: So, it would be six months 20 before the second set of subcommittees gave a report 21 to the full committee. 22 MR. LUPARELLO: And you would also, at 23 that point, get the benefit of the presentations by 24 the staff at the next committee meeting on the 25 topics that the subcommittees are really going to 0037 1 chew into. 2 MR. KAUFMAN: Thank you. 3 Mr. BROWNE: The four subcommittees are 4 appropriate and adequate, but I would urge you also 5 to consider a committee on exchange-traded products 6 given the growth of products and impact in the 7 marketplace on view of 8/24, and given that the 8 discussion should be woven inside of market 9 structure around ETPs, perhaps another committee 10 specifically around exchange-traded products is 11 warranted. 12 MR. LUPARELLO: I think that's an 13 excellent idea. Obviously, I'd like feedback from 14 others. Also would raise the question about whether 15 that's a standalone committee or that fits well 16 within one of the existing four committees. 17 I don't want to overburden people with too 18 many committees, and so, I would throw that out. 19 I think that's an excellent idea, that 20 that's an area of focus that we should spend time 21 on, but I'm open to whether that's a standalone 22 committee or fits well in another committee like the 23 market quality committee. 24 But I'm open to either of those 25 alternatives. 0038 1 MR. RATTERMAN: Presumably these 2 committees would likely come up with 3 recommendations. How do you see the -- either the 4 staff of R&M or the Commission responding to those 5 and follow through and determination, yay or nay, or 6 some derivative of those recommendations? 7 MR. LUPARELLO: So, in the first instance, 8 I would see that the staff of TM is just providing 9 support service to -- what I've been calling 10 concierge service -- to the subcommittees in terms 11 of setting up meetings and arranging for folks and 12 drafting initial minutes and things like that. 13 As it plays out, if the committees were to 14 create specific -- the subcommittees were to create 15 specific recommendations that were then endorsed by 16 the full committee and presented to the Commission 17 staff, I think the expectation is that the 18 Commission staff would respond specifically to the 19 recommendations, whether that's a commitment to 20 pursue rulemaking or whatever the alternatives 21 potentially would be, but certainly recommendations 22 that come from the committee would compel a very 23 careful and thought response from the staff. 24 MS. SMITH: I, too, am in favor of putting 25 together these committees and proceeding apace. I 0039 1 do have a question about how we leverage the work 2 that's going on in the other committees -- I think 3 the Investor Advisory Committee -- and they're 4 looking at some of these same issues. Is that 5 correct? 6 MR. LUPARELLO: There is a market 7 structure subcommittee of the Investor Advisory 8 Committee, that's correct. 9 MS. SMITH: So, how can we effectively 10 leverage what's going on there and maybe leap 11 forward a little bit faster having the benefit of 12 that work? 13 MR. LUPARELLO: I don't want to speak for 14 the Investor Advisory Committee. 15 CHAIR WHITE: Look, I think it's very 16 important to leverage that, you know, the work of 17 that subcommittee, and I think what we -- you know, 18 I've talked to Steve about this -- we need to really 19 set up a protocol or procedure to be able to do 20 that. 21 We haven't historically had overlapping 22 members on our various advisory committees, but we 23 certainly want to make full use of that. 24 MR. LUPARELLO: Gary points out that we do 25 give a recap of the -- of this committee's 0040 1 deliberations at the Investor Advisory Committee. 2 Perhaps we should add to the agenda the reverse, 3 where the Investor Advisory Committee, or at least 4 the market structure subcommittee, also has the 5 opportunity to make a presentation, and while that's 6 helpful, I think part of this, too, is I know that 7 the Investor Advisory Committee does spend time 8 meeting with other committees, and perhaps this is 9 another thing that's facilitated by the creation of 10 subcommittees, especially if it's something like the 11 retail customer issues subcommittee, can have an 12 ongoing liaison/relationship with the market 13 structure subcommittee of the IAC, that seemed to be 14 a productive way forward. 15 CHAIR WHITE: Which they are interested in 16 doing, as well. 17 MR. RATTERMAN: Steve, given your 18 concierge role, do you expect to attend all the 19 subcommittee meetings, somebody on the staff? 20 MR. LUPARELLO: Absolutely. I would 21 assume that's at the discretion of the chair of the 22 subcommittee, if a chair were formed, but I would 23 assume, since we are -- we think it's a very good 24 idea to do minutes and make those minutes public, 25 that one of the things we would do in that context 0041 1 is be your scriveners for the creation of minutes 2 and for whatever other -- whatever other functions 3 you think it's helpful to the staff to perform. 4 MR. STONE: To what extent are the 5 Commissioners and the staff able to help us with the 6 inclusion part of the subcommittees, making sure 7 that we identify the right people to be able to 8 participate? 9 MR. LUPARELLO: I would suggest to the 10 extent you want us. You know, also, as we invite 11 people to the committee meetings, there is something 12 of a vetting process that needs to be gone through. 13 I would assume we wouldn't want to 14 replicate that even at the subcommittee level, but 15 in terms of access to people and clearing people and 16 bringing them in and things like that, I would 17 assume that's all part of the suite of concierge 18 services. 19 MR. STONE: And procedurally, do we need a 20 motion that the subcommittees are formed and then 21 vote on it? How does that work? 22 MR. LUPARELLO: I think it's at my 23 discretion to form them. I would just ask whether 24 there are any views on the point Reggie brought up 25 about whether an exchange-traded products 0042 1 subcommittee separately should be formed or whether 2 we should make sure it is included as a priority in 3 one of the existing subcommittees and what that 4 would be. 5 Reggie, I would start with whether you 6 have a preference between those two. 7 MR. BROWNE: I think I would urge a 8 separate subcommittee, given the fact that there are 9 many issues interwoven through the four 10 subcommittees that may not be touched upon 11 adequately or representative. 12 So, perhaps a standalone committee can 13 address all four subcommittees in tandem. 14 MR. LUPARELLO: Any dissenting notes off 15 of that? 16 MR. KETCHUM: I would be perfectly fine 17 with that. I'd suggest that it might be useful to 18 form the market quality -- it's difficult for me to 19 imagine the market quality committee operating 20 without considering the overall impact of ETFs with 21 respect to August 24th and otherwise. 22 So, I wouldn't want to constrain the 23 market quality committee from looking at those 24 issues, and I think it would be useful to have the 25 committee form and have their viewpoints in making a 0043 1 decision on the value of having a separate 2 subcommittee. 3 I recognize that there are a range of ETF 4 issues from the standpoint of formation and a 5 variety of other things that go beyond market 6 quality and certainly could be there, but I think it 7 might -- at a minimum, I'd like to make sure that 8 the market quality committee doesn't have its scope 9 constrained from looking at the market issues raised 10 from ETF trading. 11 MR. NAZARALI: I think that the issues 12 around ETFs are hugely important. They're playing a 13 much bigger role in trading, and you know, you're 14 clearly someone that understands those really well. 15 I think that there's a lot of overlap, 16 though, with many other products and just examining 17 those individually out of the context of one of the 18 other subcommittees may result in a lot of 19 duplicative work, and I don't know, it seems to me 20 that it would be best dealt with within the context 21 of perhaps the quality of markets subcommittee. 22 MR. LUPARELLO: And again, I am a little 23 sensitive to too many subcommittees becoming too 24 much of a tax on the time of already very, very busy 25 people. 0044 1 Maybe I'd suggest, in the first instance, 2 that we -- we stick with the four but that we add 3 ETPs to the market quality subcommittee, and one of 4 the agenda items -- perhaps the first agenda item or 5 at the end of the first meeting of the subcommittee, 6 the subcommittee members make a determination as to 7 whether they feel like the ETP issues can be 8 adequately addressed in that context or whether it 9 needs to be split off, and that's something we can 10 certainly do in the interim between meetings, is 11 split off the subcommittee and create a separate 12 subcommittee that deals specifically with ETP 13 issues, because I am actually a little concerned, as 14 we -- as look -- as we have done our analysis, which 15 is -- which is ongoing, about August 24th, there 16 clearly are some issues that are ETP-specific, but a 17 lot of them also involve a number of the issues 18 around just the trading, and that is very much 19 insider the four corners of what we look at the 20 subcommittee, the market quality subcommittee doing. 21 CHAIR WHITE: It sounds sensible, but I 22 think we need to be sure to address it at the end of 23 that first meeting. 24 MR. RATTERMAN: Steve, just as a 25 suggestion, you know, you've suggested that we start 0045 1 off with two subcommittees in full motion. 2 Depending upon the makeup of those 3 subcommittees, if there's not a lot of overlap, I 4 don't see why we couldn't have at least three 5 subcommittees moving pretty quickly and move the 6 market quality up to one of the first ones that gets 7 started, instead of two, maybe just start three all 8 at once. 9 MR. LUPARELLO: I think that's a great 10 idea. That's another way to get that issue framed 11 and -- you know, as we've thought about starting the 12 two and keeping the two on a little bit of a delayed 13 start, obviously we were looking at today's agenda, 14 which had items that are very specific to the first 15 two we identified. 16 In the interim, since we have added a 17 discussion of August 24th, which I think implicates 18 a bunch of the issues for the market quality 19 subcommittee, I think that's actually sort of a 20 useful jumping off point or platform to start that 21 third committee sooner rather than later. 22 So, I think that's a great idea. 23 All right. As the designated Federal 24 officer -- I think that's the fourth time I've said 25 that today -- and pursuant to the charter and 0046 1 bylaws, I approve the formation of the four 2 subcommittees. 3 In terms of the next step -- and I 4 recognize that some members have already specified 5 their interest -- I would ask the committee members 6 to let me know which subcommittees they would like 7 to participate on. 8 Again, we did solicit that in the first 9 instance and got some helpful feedback, which we 10 will try to be responsive to. 11 It was not enough to flesh out all the 12 committees, and there is a separate obligation that 13 the subcommittees have that same level of balance as 14 the committee, so we will do everything we possibly 15 can to accommodate people's desires, but at some 16 point there may be assignments that go with being on 17 the committee. 18 You know, as I said, I will endeavor to 19 make assignments that match your interests but 20 subject to the needs to assure balance that 21 subcommittees are appropriate size. 22 I anticipate initially -- actually, I'm 23 not doing that anymore. 24 Finally, I would like to reiterate that 25 any advice or recommendation by the subcommittee 0047 1 will be presented to and discussed and considered by 2 the full committee at one or more public meetings. 3 Again, I appreciate all the very helpful 4 feedback. 5 I'm going to move on to the first agenda 6 item, which is access fees. It will be presented by 7 Richard Holley, who I introduced previously, and I 8 would encourage you, during the course of his 9 presentation, to challenge him or us or each other 10 with questions, issues, and observations. 11 Richard. 12 MR. HOLLEY: Thank you, Steve. 13 Good morning, everyone. 14 As you've seen, Trading and Markets has 15 prepared a memo to the committee on maker-taker fees 16 and equities exchanges. 17 Our memo isn't an exercise in persuasive 18 writing, as we are not advocating for any particular 19 world view or regulatory response. 20 Rather, the memo was intended to present a 21 balanced and objective assessment of maker-taker 22 fees by recounting their origins and summarizing the 23 current debate over how they may impact equity 24 markets and market participants. 25 I'd like to briefly summarize the memo and 0048 1 the points we discuss in it, but I'd like to start 2 with the conclusion. 3 Maker-taker fees are not inherently good 4 or bad, and like most things in life, they're 5 evaluated differently depending on your perspective. 6 Much of the current debate highlights the 7 conflicts they may pose for brokers routing orders 8 or the market structure effects they've had, but 9 less attention is paid to their potential benefits, 10 including to retail investors. One thing is 11 certain. Maker-taker fees are a force to be 12 reckoned with, and the committee can play a valuable 13 role in considering the current state of fees and 14 whether a regulatory response is appropriate. 15 Maker-taker fees started as a competitive 16 tool for non-exchange markets to compete with 17 exchanges in other markets. This competition 18 provided fertile ground for novelty structures where 19 the maker-taker fee model eventually rose to 20 prominence, because quite simply, it worked and it 21 worked well. 22 In its simplest form, maker-taker fees 23 involve a market paying a per-share rebate to 24 members whose posted interest on the market is hit, 25 and under current market rules, you only get hit if 0049 1 your posted interest is the most aggressively 2 priced. 3 So, maker-taker fees involve markets 4 incentivizing members to post resting orders, and 5 members can use those rebates to help improve their 6 prices than they otherwise may do in the absence of 7 a rebate. 8 In other words, maker-taker fees not only 9 help a market attract liquidity but they incentivize 10 that liquidity to be provided with better prices 11 where possible. 12 The taker side of the equation is 13 generally charged a per-share fee that's a bit more 14 than the per-share rebate, and the market keeps the 15 difference. 16 It doesn't stop there, though. There's 17 also taker-maker, where the maker pays the fee and 18 the taker actually earns the rebate. 19 To its credit, unlike other forms of 20 payment for order flow, maker-taker fees are 21 transparent, at least for exchanges, though any of 22 you who have dealt with exchange fee tables know 23 transparent does not necessarily mean easily 24 comprehendible. 25 Exchange fees are filed with the SEC, 0050 1 published in the Federal Register, and publicly 2 posted on the exchange's website. 3 A quick aside on the rule-filing aspect, 4 if I may. The Exchange Act lets fees go immediately 5 effective. They are not approved by the Commission, 6 although the Commission can suspend a fee if 7 questions arise as to its consistency with the 8 Exchange Act. 9 In general, the Exchange Act requires fees 10 to be reasonable in amount, equitably allocated, and 11 not unfairly discriminatory in their application. 12 So, within those standards, exchanges have a fair 13 amount of discretion to experiment with fees. 14 Access fees are a big deal, and not just 15 because they can impact your bottom line. They're a 16 big deal because NMS Rule 611, as the committee 17 discussed at the last meeting, requires trading 18 centers to prevent trading through protected 19 quotations. 20 So, when a market is at the best price, 21 it's got a bit of pricing power. That's where 610 22 steps in, by establishing an access fee cap that 23 limits the fees any trading center can charge for 24 accessing its protected quotations. 25 The access fee cap supports the integrity 0051 1 of the trade-through rule by establishing an outer 2 limit on fees to assure order routers that displayed 3 prices are, within a reasonable limited range, true 4 prices, thus helping to make quotations more fairly 5 and efficiently accessible. 6 Back when the cap was adopted, the 3 mils 7 access fee was a common ceiling for fees. Few 8 exchanges had fees above that level or earned any 9 material revenue from fees above that level. 10 Fast forward to today, where some people 11 think 3 mils is a king's ransom and a 1 second is a 12 glacial period. 13 So, what are the pros and cons of maker- 14 taker fees? 15 The first pro is that maker-taker is a 16 significant competitive tool for exchanges. 17 Why is that important? Because exchanges 18 play a critical role in the public price discovery 19 process. They provide a reliable external reference 20 that is central to the efficient functioning of our 21 capital markets. 22 Investors look to displayed prices on 23 exchanges for many reasons, to value their holdings 24 and inform their trading decisions. ATSs and 25 brokers also look to those prices as reference 0052 1 prices for the trades they execute for customers. 2 Most marketable retail order flow is done 3 off exchange these days at prices that are at or 4 better than the prices on displayed lit markets. 5 Yet exchanges have lost market share over 6 the years to non-exchange dark venues. If 7 exchanges' competitive viability is materially 8 diminished to the point where it jeopardizes their 9 role as the market's core price discovery mechanism, 10 then investors could have a problem. 11 Without maker-taker fees, exchanges' 12 ability to compete with non-exchange markets could 13 be diminished. The lower access fees could 14 counteract some of that effect. 15 Number two is maker-taker may benefit 16 retail investors by narrowing posted spreads. If 17 maker-taker fees do incentivize liquidity providers 18 to post more aggressive, i.e. better priced orders, 19 leading to artificially tighter spreads, and if most 20 retail order flow is executed off exchange at or 21 better than those better prices, then the loss of 22 maker-taker fees could wind up hurting retail 23 investors if spreads widen. 24 Whether maker-taker fees narrow posted 25 spreads may depend on the security -- that is, it 0053 1 may have more of an effect on stocks with wider 2 spreads. 3 That brings us to the cons. While the 4 cons outnumber the pros, please don't read anything 5 into that. 6 Con number one is that, where fees are not 7 passed through to the customer, maker-taker can 8 exacerbate conflicts of interest between a broker 9 and its customer, notwithstanding a broker's legal 10 duty to seek best execution of its customers' 11 orders. I'm sure you will hear more about this 12 during the presentations to follow, but the bottom 13 line is that brokers writing orders want to keep 14 their execution costs low, and for non-marketable 15 order flow, the lure of the liquidity rebate can be 16 a siren song. 17 The conflict arises because high rebate 18 exchanges likely charge high taker fees to pay for 19 those generous rebates. These high take fees, in 20 turn, likely cause the market to be ranked low on 21 broker routing tables. 22 As a result, non-marketable orders resting 23 on those markets may be less likely to trade. 24 The problem also exists for marketable 25 retail orders where a broker might prefer to route 0054 1 to low-fee markets or those quirky taker-maker 2 markets. Such markets likely pay low maker rebates 3 or charge maker fees. 4 As a result, they may attract certain 5 types of traders willing to post on relatively 6 unfavorable terms where the traders might seek to 7 glean information from the front lines of trading. 8 Con number two. Maker-taker fees have 9 spawned some market complexity, particularly in 10 order types that are designed to harness the power 11 of the rebate. Maker-taker also may encourage the 12 formation of new exchanges to experiment with 13 different pricing structures. 14 These exchanges compete vigorously on 15 price, which leads to some rather complicated fee 16 schedules that can change month to month, making it 17 a near full-time job to keep track of them all, but 18 to take advantage of these fees, exchanges have 19 developed rather intricate order types within their 20 systems that minimize latency to give traders 21 assurances of being a maker near the top of the 22 queue. 23 These order types allow traders to post 24 passively, never take aggressively, and still comply 25 with the locked markets rule in Rule 610. 0055 1 These order types add complexity to 2 exchange systems and present challenges to fully 3 describe in their written rules how they work and 4 interact with other order types. 5 As the memo discusses, much of this 6 complexity stems from the locked markets rule, which 7 requires SROs to require brokers to reasonably avoid 8 displaying an order that crosses the spread. 9 While restricting true market locks is 10 rather intuitive -- a $10 order to buy should match 11 a $10 order to sell -- maker-taker's rebate 12 structure may lead to increased instances of locked 13 markets, because displayed prices are not net 14 prices, as they don't reflect fees. In other words, 15 a locked market in the maker-taker world isn't truly 16 locked, because the net prices are not equal. What 17 may look like a locked market of $10 to buy versus 18 $10 to sell to the human eye actually could be 9.998 19 to buy versus 10.02 to sell. Further, maker-taker 20 leads some to never ever want to take unless they 21 forfeit their rebate. 22 The committee may wish to consider the 23 interplay of the locked markets rule in the maker- 24 taker fee world and perhaps whether the rule is ripe 25 for reevaluation. 0056 1 Con number three is that maker-taker fees 2 affect price transparency. 3 Because displayed prices don't reflect 4 true net prices, maker-taker fees undermine price 5 transparency, at least to the human eye. 6 I noted earlier that the fee cap was 7 intended to address this to an extent, but throwing 8 credits in with the debits can really make a mess of 9 things. 10 The committee may wish to consider the 11 extent to which these issues are material or whether 12 smart order routers have, with some effort, managed 13 to adapt and are sufficiently accessible to the 14 masses. 15 It's useful to note that this price 16 transparency issue isn't limited to maker-taker 17 fees. Other volume discount sliding scales and fee 18 caps portend similar concerns. 19 And con number four is the relative 20 generous rebates necessitate high offsetting fees, 21 which may cause some price-sensitive order flow to 22 seek non-exchange venues. 23 There may be more pros and cons, but these 24 provide a brief overview of the ones commonly cited 25 in contemporary literature. 0057 1 If the committee considers the relative 2 merits and pros or cons and wishes to consider 3 possible regulatory responses, then the memo 4 outlines several possible initiatives. 5 Number one is to reduce the fee cap or 6 outright prohibit transaction-based rebates. 7 Lowering the fee cap would likely lower 8 the maker rebate, assuming the markets want to keep 9 a slightly revenue bias between the two, and 10 outright banning rebates is self-explanatory. 11 Doing this would help address broker 12 conflicts if the economic gain or loss of maker- 13 taker is lessened. 14 It also could address price transparency 15 concerns if transaction fees decrease and displayed 16 prices more closely reflect net trading costs, and 17 it could perhaps address market complexity if 18 certain order types -- the need for certain order 19 types are lessened. 20 However, it could raise costs for retail 21 investors if quoted spreads in some types of 22 securities widen in the absence of the maker-taker 23 incentive. 24 It also could harm competition between 25 exchanges and non-exchange venues unless the latter 0058 1 are also restricted. 2 Number two, keep maker-taker but limit it 3 to where it works and eliminate it to where it's not 4 needed. 5 In particular, maker-taker may narrow 6 quoted spreads in less liquid securities but not 7 have much impact in securities where natural trading 8 interest results in naturally tight spreads, 9 subheading issues notwithstanding. 10 This approach might be tricky to 11 implement, however, and careful consideration would 12 need to be given to the mechanics, including how to 13 craft the buckets and update the groupings. A pilot 14 program could help study the effects of this 15 approach but would be complicated to design and 16 implement, and the tick size pilot may or may not 17 welcome the company. 18 Number three, require fees and rebates to 19 be passed back to the customer. This approach 20 removes a broker's economic interest in the level of 21 access fees and, thus, directly mitigates their 22 conflict of interest in routing customer orders. 23 But it could affect flat commission 24 structures if broker costs rise, and it would be 25 difficult to implement and impose a considerable 0059 1 administrative burden for brokers. It would not 2 address market complexity or price transparency 3 concerns of maker-taker. 4 Number four, incorporate access fees into 5 the public quotes. Rather than lower the fee cap or 6 ban rebates, markets could be required to 7 incorporate taking fees into their quote. So, order 8 routers could more easily see their net price to 9 take. 10 In this way, it effectively passes the fee 11 back to the customer. This could help mitigate 12 broker conflicts, allowing them to focus on routing 13 to the best price, and it may place downward 14 pressure on fees and, thus, rebates, as well. 15 Retail investors, however, could be 16 affected if their executions remain tied to 17 displayed quotes and those quotes widen. This 18 approach also would require a relaxation of the sub- 19 penny rule to allow markets to display and rank 20 prices in sub-pennies. 21 Number five is best execution guidance. 22 Providing more tailored guidance might help brokers 23 consider or remember their best execution 24 obligations in a maker-taker environment by focusing 25 their attention on the conflicts. 0060 1 Number six is do nothing. If maker- 2 taker's benefits to retail investors and exchange 3 competition are worthy of preserving, then the 4 medicine may be worse than the ailment. 5 It has been our honor to help facilitate 6 your consideration of these important issues. We 7 look forward to hearing from our panel of experts 8 and for a robust discussion among the committee 9 members. 10 Thank you for your time. 11 MR. LUPARELLO: Thank you, Richard, and 12 despite an idiot-proof script to make sure I don't 13 get off topic, I failed to follow one of the 14 instructions, so I should have invited the full 15 members of the panel to come up before. 16 Tom actually knew not to wait for me, so I 17 would invite the others to come up now. 18 I will give only the briefest of 19 introductions, in the interest of getting to the 20 substance as quickly as possible. 21 On our first panel, from left to right, we 22 have Robert Battalio, the finance professor at Notre 23 Dame. Next to him, we have Michael Buek, a 24 principal at Vanguard. To his left is Tom Farley, 25 the president of the New York Stock Exchange Group, 0061 1 then the aforementioned Larry Harris, professor of 2 finance and business economics at USC, and finally, 3 Matt Lyons, senior V.P. and global equity trader at 4 Capital Group, really an impressive group to help 5 continue to frame and elicit thoughts on this 6 conversation. 7 Robert, can I ask you to lead us off? 8 Mr. BATTALIO: Sure. Good morning, and 9 thanks for asking me here to participate in the 10 meetings. 11 In my recent research with Shane Corwin 12 and Robert Jennings, we identify four national 13 retail brokers that seemingly route orders to 14 maximize order flow payments. They sell their 15 market orders, and they send limit orders to the 16 venues that pay the largest liquidity rebates. 17 Chester and Larry and Jim Angel argue that 18 this type of routing is probably not in the 19 customer's best interest always. In our work, we 20 document a strong negative relation between 21 liquidity rebates, the level, and several measures 22 of limit order execution quality. 23 Based on this evidence, we conclude that 24 the decision of some national brokers to route all 25 of their non-marketable limit orders to a single 0062 1 venue that pay the highest rebates not consistent 2 with the broker's responsibility to obtain best 3 execution. 4 So, we think there's probably three 5 potential approaches to reduce or eliminate this 6 conflict, several of which were just mentioned. 7 The most aggressive approach would be to 8 eliminate make-take fees. While this approach might 9 eliminate the conflict that we address in the paper, 10 it's quite possible that other and possibly worse 11 conflicts could arise as a consequence. 12 Order flow is a valuable commodity, and 13 payment for order flow has a long history. For 14 decades, actors in the U.S. equity markets have been 15 actively seeking to segregate order flow into its 16 most and least valuable components. 17 Make rebates and take fees are tools used 18 by venues to attract different types of orders. 19 Order flow will not lose its value should 20 make-take rebates and fees be eliminated. It is 21 likely that the market will introduce other 22 inducements to attract the desired order flow. 23 One advantage to the make-take model is 24 that the payments are reasonably transparent. If 25 incentives to attract a particular type of order 0063 1 flow continue after the make-take model is regulated 2 away, then understanding what that replacement 3 system of inducements might look like is very 4 important. 5 It seems reasonable to wonder if the 6 payments might be less transparent than the current 7 system and thus harder to study and monitor. 8 The make-take model is only part of the 9 effort to segregate order flow in today's equity 10 marketplace. Two other examples are payment for 11 order flow and dark pools. Without a comprehensive 12 effort to address all these order flow inducements, 13 eliminating one aspect of them is ill-advised. 14 If the approach of eliminating make-take 15 fees is taken, it should not be done without a 16 thorough evidence-based review of the potential 17 unintended consequences. This could potentially be 18 done in the form of an SEC pilot program. However, 19 careful consideration would have to be given to 20 ensure that such a pilot is well-designed and to 21 whether such a pilot could even be used to 22 effectively study the alternative market structures 23 that would develop in the absence of make-take fees. 24 The second approach is to mandate that 25 rebates and fees flow through to the investor. In 0064 1 theory, this would solve the conflict of interest 2 identified by Chester and Larry. If fees and 3 rebates are passed through to the customer, the 4 broker would only be concerned about receiving the 5 commission, which is paid only if the order is 6 filled. Thus, the broker would be motivated to 7 maximize limit order fill rates, but at what cost? 8 Our analysis suggest it's often the case 9 that non-marketable limit orders execute regardless 10 of where they are sent. 11 In these situations, retail investors are 12 better off receiving a rebate rather than paying a 13 fee when their limit orders execute. This suggests 14 that even customers of brokers that pass through 15 fees and rebates directly through to their customers 16 can benefit from enlightened order routing. 17 The least aggressive approach and the 18 approach that my co-authors and I recommend is to 19 enforce the current best execution requirements on 20 brokers and to improve Rule 605/606 disclosures. 21 The current regulatory structure requires 22 that brokers provide best execution for customers. 23 Requiring that brokers rigorously demonstrate that 24 their routing practices ensure best execution for 25 clients on a regular basis, as laid out in NASD 0065 1 Notice to Members 01-22, would be a good first step 2 before initiating additional regulations. 3 It seems unlikely to us that routing all 4 non-marketable limit orders to a single venue can be 5 justified as best for the client. 6 If this approach is taken, it should be 7 combined with additional disclosures by brokers. 8 Some of this disclosure could be accomplished 9 through improvements to the 606 reports, which are 10 the best ex reports. 11 For example, brokers should be required to 12 separately report routing information for marketable 13 and non-marketable limit orders. 14 Finally, the 605 reporting should be 15 extended to individual brokers. As noted recently 16 by Joe Ratterman, in the current trading 17 environment, investors cannot in any meaningful way 18 tie 605 execution stats to the 606 routing stats in 19 order to evaluate the quality of a broker. 20 Barron's tried doing this in March in 21 their best ex and broker ranking, and the author had 22 a very hard time doing that. 23 Requiring brokers to produce monthly 605 24 reports would allow investors, academics, the press 25 to make more informed comparisons of execution 0066 1 quality across comparable brokers. 2 Thanks for giving me the opportunity to 3 speak this morning. 4 Mr. BUEK: Good morning, Chair White, 5 Commissioners, committee members, and division 6 staff. Thank you for the opportunity to participate 7 in this discussion of access fees and Rule 610 of 8 Reg NMS. 9 My name is Michael Buek, and I am an 10 equity index portfolio manager and trader at 11 Vanguard. I lead a team that is responsible for 12 managing roughly 1.8 trillion in equity index mutual 13 funds. At Vanguard, our mission is straightforward, 14 to take a stand for all investors, treat them 15 fairly, and give them the best chance for investment 16 success. 17 With that mindset, let me start by stating 18 that the U.S. equity markets are the most efficient 19 markets in the world, with a robust regulatory 20 regime that provides ordinary investors, whether 21 through mutual funds or individual brokerage 22 accounts, with easy and low-cost access to the 23 equity markets. 24 Regulatory changes, technological 25 advances, and market competition over the past 20 0067 1 years have benefited all investors as transaction 2 costs have reduced and the ability of any investor 3 to get fair price and immediate access to the 4 markets has never been better. 5 The way in which the equity markets 6 operate, however, is far from simple. On a daily 7 basis, Vanguard is responsible for trading billions 8 of dollars of other people's money, and we take the 9 responsibility very seriously. 10 Because of our size, we must establish 11 relationships with numerous brokers, ATSs and 12 exchanges. We have the responsibility to our 13 shareholders to be sure we understand how the 14 markets are connected, as well as the incentives and 15 potential conflicts of interest that exist across 16 the markets. 17 Reg NMS provide incentives for certain 18 types of conduct and imposes disclosure obligations 19 to help investors understand the potential conflicts 20 of interest that may exist. 21 To the extents the rule provides these 22 incentives or enable potential conflicts, the 23 benefits must be clear and significant. 24 More importantly, as the markets continue 25 to evolve, we must continue to reevaluate the state 0068 1 of affairs. Practices that may have developed for 2 entirely legitimate reasons may lose their value 3 over time. 4 We commend the Commission for engaging in 5 this very exercise through its thoughtful 6 consideration of equity market structure reforms 7 over the past few years and its continued work 8 through this committee. 9 Let me now turn to access fees. We think 10 it is time to challenge and test whether the current 11 maker-taker models are continuing to appropriate 12 advance the goals of our National Market System. 13 It is the Commission's responsibility to 14 ensure market structure appropriately balances the 15 objectives of Reg NMS, including the sometimes 16 conflicting objectives of facilitating fair 17 competition among market centers and promoting price 18 discovery and order interactions. 19 When they were first developed, maker- 20 taker pricing models promoted competition among 21 market centers which had been historically dominated 22 by a handful of exchanges. 23 When originally approved by the SEC, the 24 access fee cap of Rule 610 acknowledged the practice 25 of paying rebates to attract order flow, and the cap 0069 1 was intended to assure investors that their orders 2 would not be subject to hidden fees. 3 The current cap on access fees of 30 mils 4 under 610 was based on the standard prices that 5 existed at that time the rule was approved in 2005 6 and has not been updated. 7 Much has changed since 2005. As this 8 committee is aware, we have evolved to a structure 9 of 11 exchanges, roughly 40 ATSs, and numerous 10 broker/dealer internalizers competing for order 11 flow. 12 Many of these venues include some sort of 13 maker-taker model in which fees are charged for 14 accessing or taking liquidity and a rebate is paid 15 to the market participants posting or making 16 liquidity. 17 A small fraction of the access fee is 18 actually retained by the exchange or market center 19 as compensation for providing access to quotes and 20 orders. 21 What has developed over time is a segment 22 of the market that has created trading strategies 23 that are based on a desire to capture rebates and 24 avoid fees rather than competing on the fundamental 25 price of the underlying security. 0070 1 Further, we have seen the proliferation of 2 complex order types designed to assist these trading 3 strategies. Likewise, the access fees and rebates 4 under maker-taker models distort the price discovery 5 process as posted orders do not account for the 6 actual cost to trade at posted prices. 7 Finally, there is a perception that 8 certain brokers' order practices place greater 9 importance on capturing rebates and avoiding fees 10 than maximizing execution quality. 11 Because these perceptions exist, we owe it 12 to investors to examine whether the practice 13 continues to be justified. 14 As part of that examination, Vanguard 15 supports the following reforms: 16 First, we support a well-designed pilot 17 across a significant number of stock which would 18 eliminate the rebates paid under the maker-taker 19 models. We believe the pilot should encompass 20 stocks of various levels of liquidity. We would 21 encourage the Commission to design the pilot to 22 include a broad universe of stocks. There are a 23 significant number of stocks which we believe do not 24 need the incentives to post liquidity provided by 25 the maker-taker model. A broad universe of stocks 0071 1 would provide meaningful data to analyze the impacts 2 of the pilot across various types of securities. 3 Second, while this pilot wouldn't move 4 forward on its own, we believe there should be a 5 trade-at component to the pilot. 6 Like most market structure discussions, 7 any discussion of access fee and Rule 610 must 8 recognize the impacts on other regulations and 9 potential unintended consequences to the market. 10 We believe changes to the access fee 11 should also consider changes to Rule 611, the order 12 protection rule of Reg NMS. 13 Vanguard has been a strong supporter of 14 the trade-at for years. We believe publicly 15 displayed liquidity is the foundation of our 16 National Market System. 17 Because the current trade-through rules 18 permits market centers to use publicly displayed 19 quotes without price improvements or first routing 20 to the venue providing the posted price, there are 21 few incentives to publicly display liquidity. 22 Today one could argue one of the primary 23 reasons to publicly display liquidity is to capture 24 rebates under the maker-taker model. 25 If rebates are eliminated, the incentive 0072 1 to publicly display order information could 2 potentially be limited to even a greater extent. 3 This is why we believe a pilot eliminating 4 rebates should also include a trade-at component, 5 which we believe would provide appropriate 6 incentives to contribute to public price discovery 7 process. 8 We believe a trade-at structure will 9 encourage competition of displayed orders, create a 10 deeper and tighter display market, decrease the need 11 for complex order types, and decrease the overall 12 complexity of the markets. 13 While including a trade-at component to 14 the pilot would expand the scope of the pilot, it is 15 important to note that other current initiatives 16 approved by the SEC include a trade-at requirement. 17 Therefore, the infrastructure and cost 18 associated with implementing trade-at requirement 19 for certain securities will have, to a great extent, 20 already been incurred under the existing 21 initiatives. 22 We think not including trade-at in any 23 maker-taker pilot would be a missed opportunity. 24 We believe Reg NMS has been successful in 25 promoting the important goal of facilitating 0073 1 competition among market centers. 2 The incentives that enable market centers 3 to compete need to be reexamined so that we can be 4 sure the rules of road appropriately further other 5 goals of Reg NMS, particularly price discovery and 6 competition among orders. 7 Thank you for allowing me to participate 8 in today's discussion. I commend the Commission and 9 this committee for their commitment to continuously 10 improving our equity markets for all investors. I 11 look forward to participating in today's dialogue. 12 Mr. FARLEY: Thanks. You would have saved 13 me a lot of time preparing if you could have just 14 given me an advance copy of that. I could have 15 presented it as my own. 16 Good morning. Thanks so much for allowing 17 me to be a part of this. I'm Tom Farley, president 18 of the New York Stock Exchange. We're really 19 appreciative of the work of this committee and the 20 fact that this committee was pulled together, and we 21 want to do anything we can to make it a success. 22 We do think that we missed the mark in 23 terms of the composition of this committee, and I 24 raise it only because of the prior conversation 25 about subcommittees. 0074 1 It gives us concern that there is no 2 representation from listing venues for operating 3 companies nor retail broker/dealers or even U.S. 4 bank broker/dealers, and the reason why I'm raising 5 it now is just to compound that by establishing 6 subcommittees that can kind of work free from airing 7 their deliberations in the public is of considerable 8 concern to us. 9 But thank you again. 10 I just want to speak briefly about access 11 fees, if I can, if I can just preserve a couple of 12 minutes to talk about of other topics that are on 13 the agenda for later today that we will not be 14 participating on. I promise I'll keep my remarks 15 brief for all these. 16 With respect to access fees, I generally 17 do agree with Mike, and I kind of threw away the 18 script. I just want to highlight -- I thought 19 Richard did an excellent summary of the pros and the 20 cons. 21 I think, with respect to the cons, the 22 cons we worry about in terms of the maker-taker 23 regime is that it does give rise to conflicts of 24 interest, it does give rise to complexity, and I can 25 tell you, as someone who operates three equities 0075 1 exchanges, two options exchanges, it does also give 2 rise to thinking such as, oh, wow, at the NYSE, we 3 don't have, for instance, a take-make exchange. Do 4 we need a fourth exchange to have a take-make 5 exchange, which was something Richard highlighted, 6 as well. So, it does give us concern. 7 The other thing I'll highlight is that 8 it's very difficult to get unanimity about exactly 9 what we will do, because we all have vested 10 interest, let's face it. I have vested interest. 11 We all want what's best in terms of policy, and we 12 want to leave these markets better when our careers 13 are over than when we inherited them, and yet, we 14 have a paycheck and we have a company that we work 15 for. 16 I can tell you, when I speak to 17 broker/dealers, the broker/dealers who want to do 18 away with rebates entirely, more often than not, are 19 those who are net takers. 20 Those who don't necessarily want to reduce 21 rebates, if you go away and you do the research, 22 they're net makers, and so, it is difficult to get 23 unanimity on these issues, and so, I think having a 24 well-rounded dialogue and debate is excellent. 25 The last point I want to highlight on 0076 1 access fees is that if you just reduce access fees 2 and thereby reduce rebates, as Richard pointed out, 3 or you eliminate rebates entirely and you have very 4 low fees for both the maker and the taker, and you 5 do nothing else in the absence of that, as Mike 6 pointed out, you will see more and more business 7 trade away from exchanges, you will see a 8 deterioration of market quality on exchanges, and if 9 we think that -- and I know I sound biased saying 10 this, certainly, but if we think that exchanges are 11 in and of themselves a public good, then we should 12 take that into account and consider that very 13 seriously, and the reason why that is is very simple 14 math. 15 If I'm rebating a market maker, let's say, 16 30 cents per million to make a price and all of a 17 sudden I take that away, my quoted price is going to 18 be worse by 30 cents per hundred. It's just 19 economics. 20 Now I have a wider spread and it's easier 21 for off-exchange venues to then internalize away 22 from an exchange, and I've heard the argument made, 23 yes, but in a lower access fee environment, they'd 24 have less incentive, and I take that point. 25 However, I've worked with a lot of 0077 1 broker/dealers, and they're very smart, and they're 2 ethical as heck, but they are ruthless with respect 3 to exercising their fiduciary duty and putting money 4 in their shareholders' pockets, and I've yet to see 5 pennies on the ground that they wouldn't scoop up. 6 So, even if access fees are lowered in an 7 environment with those wider spreads, certainly more 8 and more would move away from the exchange, and 9 there's plenty of examples that are evidence of 10 that. 11 I just wanted to mention the trading of 12 August 24th if I could. 13 You know, we learned a lot that day about 14 market protection that was put in place subsequent 15 to 2010, market protections intended to help 16 investors. It had never been tested on such a wide 17 scale disruptive day, on a day with such extreme 18 volatility, and we learned a lot. 19 In particular, we learned a lot about 20 ETPs. Reggie mentioned ETPs and August 24th 21 earlier. We've learned a lot there. We've been 22 spending a lot of time at the New York Stock 23 Exchange, and before I focus on the changes that 24 we've made, I just want to highlight a couple 25 points. 0078 1 Number one, ETFs have been incredibly 2 important to our market structure over the last 15 3 years. If you go back to 2002, there was around 4 about 100 billion of AUM benchmarked to ETFs, now 5 there's over 2 trillion, and perhaps more important, 6 ETPs have democratized access to very sophisticated 7 investing tools for the retail public and for the 8 individual investor. 9 What do I mean by "democratize"? The 10 latest, greatest innovations of the day -- think 11 smart beta investing -- now the individual investor 12 can have access to. Asset classes that are very 13 difficult, have been difficult for decades and 14 generations, the individual investor can now have 15 access to. Think fixed income or Asian equities. 16 And finally, it just reduced cost to diversify a 17 portfolio, which is a really great innovation for 18 the individual investor, and so, I don't want anyone 19 to lose sight of that. 20 And equally important, it's easy to 21 misconstrue what happened on August 24th and the 22 days following as an ETP issue. It was not. It was 23 a U.S. equity market structure issue that impacted 24 individual stocks. It impacted ETPs, as well. 25 And they very good news is, there's fixes. 0079 1 There's fixes that we've already made, we at the 2 New York Stock Exchange. There's fixes that our 3 colleagues and competitors have made. There's fixes 4 that are in process. And there's considerable 5 industry dialogue to consider what additional fixes 6 can be put in place to protect individual investors 7 not just of individual securities but of ETPs, and 8 so, I'm very optimistic about that. 9 Given our role at NYSE -- and not to say 10 it by way of an advertisement or marketing but to 11 give you a sense of the kind of importance of this 12 issue to us -- we're 95 percent of all listed ETPs 13 in terms of AUM, and we're the largest pool of 14 liquidity by round about a factor of 2X. The next 15 closest pool of liquidity is round about half of 16 ours. The NYSE Arca pool of liquidity is what I'm 17 referring to. 18 And so, we know that and we embrace we are 19 an industry leader and we need to be an industry 20 leader, and so, we've done a number of things to 21 really kind of galvanize the ETP market structure 22 subsequent to August 24th. 23 We've hosted many industry calls. We've 24 recently retained McKenzie to do a survey of the 25 industry and then ultimately provide some 0080 1 prescriptions about how we can move forward there. 2 We've also worked with our colleagues at 3 ETP issuers, traders, even exchanges, to promote 4 harmonizing, in particular, the reopening protocols. 5 So, when you have a halt on an ETP, you 6 are, almost by definition, in a moment of distress. 7 On August 24th, you might argue it was a moment of 8 extreme distress, and you really want to make sure 9 that reopening process works well, not just on NYSE 10 Arca, and there's things we can do to improve -- in 11 fact, there's things we have done to improve -- but 12 that it's generally harmonized in a reasonable way, 13 because it's a very confusing time, and if one 14 exchange is reopening in one fashion at one time and 15 another exchange is doing it entirely different, 16 what we saw on August 24th is that can create 17 confusion. 18 And then, finally, with respect to kind of 19 promoting industry change, really rallying the 20 conversation around market makers and how can we 21 incentivize market makers to make prices during 22 these times of turbulence, and it's not just about 23 incentivizing in the traditional sense of, hey, how 24 do we remunerate them, for example; it's also how do 25 we remove roadblocks, because we saw a lot of these 0081 1 market structure protections actually prevented 2 market makers from stepping in when they needed to. 3 Some were their own. You know, it was the 4 risk protections they had set up, and they had to 5 kind of back away even from the most liquid ETPs. 6 And then some are industry protections, LULD, how 7 that interacted with the market maker's obligation, 8 so on and so forth. 9 We've already taken a number of unilateral 10 steps. I won't enumerate them all, just in the 11 interest of time, but we've widened our opening 12 auction collars, for instance, which we think will 13 be helpful. We've already started the work to 14 eliminate stop-loss orders that aren't bounded by a 15 limit. 16 And just one further example. We've also 17 extended the imbalance publications until such time 18 as every individual security is open. 19 So, I just want to leave with our sense 20 that ETPs have been a value-creating innovation, 21 really unparalleled, in our industry, and we are as 22 optimistic now as ever about ETPs as a really good 23 investing tool for institutional and individual 24 investors, and we've learned from August 24th 25 individually and as an industry, and we're on our 0082 1 way there. 2 Finally, and briefly, I promise, just with 3 respect to the conversation about the regulation of 4 trading venues, I just want to offer a few thoughts 5 for you. 6 You have to go back, actually, before the 7 '33 Act to the origin of exchanges regulating their 8 members, and then with the '34 Act, the two-tier 9 regulation came about in this country. 10 I've heard it said, you know, the 11 exchanges shouldn't be in the business of regulating 12 their members. I submit that that tone-deaf at this 13 moment in time to say let's pull regulation away 14 from these markets, let's pull an entire tier of 15 regulation that's existed for 80 years out of the 16 market, particularly at this time. 17 The trust of individual and institutional 18 investors in our market is sacrosanct, and the 19 argument should not be we have less regulation at 20 this moment in time. 21 In addition, I will add that the self- 22 regulatory function is an important one. What does 23 it mean? It's very simple in that we have to 24 surveil our markets, we have to investigate 25 wrongdoing, and we have to enforce cases against 0083 1 wrongdoers. 2 We simply would not bring cases against 3 people who are violating the rules if they could 4 turn around and sue us. That is a very simple 5 premise. 6 And I would further submit that we work 7 very hard -- we work very hard with many of our 8 colleagues here -- to make our rules as prescriptive 9 as possible, but there are rules that have some 10 element of subjective judgment that rely on facts 11 and circumstances, number one. 12 Number two, there are also times where 13 rules intersect in a way that nobody could 14 anticipate, because these markets are rapidly 15 evolving while rules are static. 16 Exchanges are in a position where we can 17 do what's best for the industry, in good faith, 18 interpret those rules, knowing that a customer will 19 not turn around and sue us. 20 At times, there can be gigantic dollars 21 and cents at risk in these gray areas, in these 22 moments of ambiguity, that if we didn't make those 23 decisions and if we didn't have some comfort that we 24 had a level of liability, it could put the industry 25 at risk. At a minimum, it could put players in the 0084 1 industry at grave risk. 2 That said, I have heard several of my 3 broker/dealer colleagues, some of whom I see in the 4 room today, say that exchanges should have a greater 5 limit of liability, which is a separate concept from 6 this limited immunity, but a higher legal limit of 7 liability for those occasions when an exchange's 8 system just plumb breaks. 9 That is a fair conversation. In fact, 10 it's a conversation we're entirely open to have, and 11 we agree with you, and so, I don't want to leave you 12 with the thought that this is, oh, we're just 13 looking to have a very low, you know, kind of 14 penalty if our system breaks. That's not it at all, 15 and that, we think, is a fair conversation, but I 16 wanted to leave you with the sense that the SR 17 status of exchanges is critically important. 18 So, thank you for letting me opine on a 19 couple of issues not directly related to this panel, 20 but in the Q&A, I'm happy to expand more on access 21 fees. 22 MR. LUPARELLO: Tom, thank you for those 23 wide ranging comments. 24 Larry. 25 MR. HARRIS: Chairman White, 0085 1 Commissioners, staff, members of the advisory 2 committee, thank you very much for this opportunity 3 to talk about a topic that many people know I'm very 4 passionate about. 5 What I'm going to speak to today will be 6 first the history of maker-taker pricing, because as 7 we evaluate what to do with it, it's important to 8 understand how we got it. Then I'm going to talk 9 about taker-maker pricing and, finally, speak a 10 little bit to some proposals to what to do about 11 these problems. 12 I'm going to skip over much that we, I 13 think, already well understand. Richard's summary 14 is very good, and Robert and the other panelists 15 have already explained some of the agency problems 16 involved. 17 So, let's talk first to the history of 18 maker-taker pricing, but I think, even before that, 19 we should cover one obvious thing that hasn't been 20 mentioned yet, which is that, without maker-taker 21 pricing, our markets operated very well before they 22 became electronic, and if we look across the world, 23 there are many markets that operate very well 24 without maker-taker pricing. So, if we're trying to 25 identify the benefits, we'll have to look very 0086 1 closely, because we're not seeing the need in other 2 places right now. 3 So, what were the benefits? 4 So, until electronic trading came along, 5 things were working very well, people using 6 traditional pricing for exchange services. 7 Let's remember that exchanges are 8 essentially just brokers. They match buyers to 9 sellers, as brokers do, and they charge commissions 10 when they do that. That's what the brokers do. The 11 traditional exchange fees was just a commission. It 12 was an exchange fee that you charge to either the 13 buyer or the seller or some combination and that was 14 that. 15 We had very well established exchanges 16 before the advent of electronic exchange matching 17 systems, and people came along and said why don't we 18 create electronic systems to match buyers to 19 sellers, and the buy side said this is fantastic, 20 because it's going to vastly reduce our cost. 21 And so, these systems opened up, and what 22 happened? Nothing. Because the people who needed to 23 do their trades -- they went to the places where the 24 trades were happening, because you can't trade where 25 there's nothing going on. And so, as much as they 0087 1 like those electronic systems, there's nothing going 2 on, because if you had a market order, you went to 3 the exchange where there were limit orders present; 4 if you had a limit order, you placed the limit order 5 where the market orders were going to come. 6 And so, the established exchanges 7 basically precluded competition from the innovators. 8 So, the innovators got very smart, and 9 here's what they did. They said we've got to get 10 some limit orders in our exchanges, otherwise we're 11 not going to get anywhere. And so they said we're 12 going to pay people when they execute limit orders 13 at our exchanges. Okay? That's the liquidity 14 rebate. 15 And of course, we can't do that without 16 charging an access fee, so we put in an access fee, 17 and so now the question is who the hell would ever 18 use a system like that? Certainly not people who 19 are sending limit orders out, because the limit 20 orders, as I already explained to you, are going to 21 execute first at the established exchanges. 22 So, the only people who could possibly be 23 doing this is somebody who is getting an exterior 24 benefit from this, not the trader themselves but, 25 rather, the broker, and this is the agency problem 0088 1 that we've already talked about. 2 Okay. So, the brokers are getting payment 3 for the order flow -- in this case the limit orders 4 -- and now the question is, well, who is going to 5 trade when they have to pay for the access fee, and 6 the answer is only when all other liquidity is 7 exhausted. 8 So, once the limit orders at 20 to buy are 9 exhausted at every other cheaper place to trade, 10 then they go to the other places, to the maker-taker 11 exchanges, and so, in this way, the electronic 12 exchanges, systems like Island and Archipelago and 13 others, got established. 14 And in the grand scheme of things, it may 15 not have been fair that the limit order traders who 16 were essentially being abused by their brokers were 17 forced to pay for the conversion of our system from 18 a traditional system to an electronic system, but we 19 established what we needed to establish ultimately, 20 is that we got more efficient trading systems as a 21 result. 22 Of course, as people looked at this, they 23 very quickly figured out that if we're going to 24 survive in this business, we have to match the fee 25 schedules that everybody else -- that these 0089 1 innovators are using, and so, once the fee schedules 2 were matched and everybody moved to maker-taker 3 exchanges, okay, the pricing system, then all the 4 advantage was lost, but electronic trading was 5 established, and we were able to move forward, and 6 Reg NMS essentially codified what had happened and 7 further facilitated it. 8 Okay. So, that brings me now to a couple 9 of observations, and I want to talk about taker- 10 maker exchanges and what to do about it. 11 First observation is the net price of 12 liquidity depends on the bid-ask spread and also on 13 taker-maker fees. The supply and demand for 14 liquidity is what determines this net price, okay? 15 Maker-taker pricing schemes and taker- 16 maker and so forth -- they cannot change the price 17 of liquidity. The price of liquidity is determined 18 by this balance between buyers and sellers who have 19 to -- buyers and sellers of liquidity, takers and 20 makers -- who have to come together in equal 21 proportions so the trades take place, okay? 22 The maker-taker system only changes how 23 the price of liquidity is distributed between the 24 bid-ask spread and maker-taker fees and the rebates. 25 That's all that's going on here, okay? 0090 1 So, we're not talking about fees that are 2 exchange fees. The exchange fee is the difference 3 between the maker fee and the taker fee, and if we 4 want exchanges to compete on fees, as we certainly 5 do, they compete on that difference. If we specify 6 one of these, we're not setting prices; we're just 7 setting a pricing standard. 8 So, this is really all about pricing 9 standards. 10 Okay. So, as it's been noted, the advent 11 of maker-taker pricing narrowed spreads, surely 12 narrowed spreads where they could be narrowed, and 13 when they couldn't be narrowed because of a tick 14 size, then they increased the non-price competition. 15 People queue up to trade. Okay? 16 So, that, of course, had some effect on 17 payments for order flow and more locked markets, as 18 been mentioned, and I want to talk a little bit 19 about that later. 20 But now let's talk about the taker-maker 21 pricing. Oh, this is really clever, okay? 22 So, first of all, why do we have taker- 23 maker pricing, and the answer is very simple. 24 Suppose there's a large queue to buy at 20 and you 25 want to get ahead of that queue. What do you do? 0091 1 Okay. Normally you just go and bid 2 another penny more at 21, but if there is a taker- 3 maker exchange, now what do you have? You have the 4 opportunity to bid at 20 and now the question is who 5 trades first? Okay. 6 So, if I am a seller and I'm looking at a 7 20 bid at the maker-taker exchange and a 20 bid at 8 the taker-maker exchange, I'm going to evaluate the 9 full cost of trading, and the full cost is pretty 10 simple. 11 If I sell to the 20 bid at the maker-taker 12 exchange, I'm going to receive 20. I'm going to 13 receive that no matter what. But I am going to have 14 to pay the access fee. 15 In contrast, if I sell at the taker-maker 16 exchange, I'm still going to receive 20, but now, at 17 the taker-maker exchange, they're paying me to 18 trade. This is a no-brainer. Okay. 19 So, I can jump ahead of the queue at 20 if 20 I want to buy. If the queue is big at 20 in the 21 maker-taker exchange, then I switch to the taker- 22 maker exchange, but it's not without cost, and the 23 cost is that if I had traded at 20 at the maker- 24 taker exchange, as a maker, I would be receiving 20 25 minus the liquidity -- plus the liquidity rebate. 0092 1 But if I trade at 20 as a maker at the 2 taker-maker exchange -- this is very confusing, 3 right? -- at the taker-maker exchange, I will 4 receive -- as a maker, I will buying at 20, okay, 5 but they will be -- I will, in addition, have to pay 6 a little bit more. Okay. 7 What's the difference? The difference is 8 about a half-cent, okay? 9 So, what's happened here? The combination 10 of maker-taker in conjunction with taker-maker has 11 created a half-cent pricing point. We think that we 12 trade without sub-pennies, but in fact, the de facto 13 trading system is that we are now trading on half- 14 pennies, more or less. Okay. It's not exactly so, 15 but that's what it is. 16 Now, there were really good reasons that 17 we prohibited sub-penny pricing when we wrote Reg 18 NMS, and the reason was that, when you have sub- 19 penny pricing, it's very easy for traders to step in 20 front of large traders and extract the option value 21 of their orders, okay, and I think this is worth 22 actually considering, because it's so important. 23 A large trader comes in and bids at 20 and 24 a clever trader steps in front, perhaps at 21, fills 25 the order, and now has an interesting position in 0093 1 the market. So, this clever trader who just bought 2 at 21 will profit to the full extent of any 3 subsequent price rise as long as they're in the 4 market. 5 But if prices look like they're falling 6 because they're watching an index or something like 7 that, they immediately turn around and sell into the 8 order at 20 and, in doing so, protect themselves, 9 and so, they have this asymmetric distribution of 10 profits. 11 If things go well on their way, they can 12 make a lot of money; if they don't go well, their 13 losses are limited. 14 There's no free lunches here. There never 15 are. 16 So, what's happening is the large trader 17 at 20 is giving up option value of their order, and 18 the buy side traders screamed bloody murder about 19 this in the period leading up to Reg NMS, to the 20 point where the ECMs all said we're going to stop 21 sub-penny pricing just to keep their business. And 22 then Reg NMS simply codified that. 23 But now we have sub-penny pricing in a 24 ridiculously convoluted system, and on top of it, 25 we've reestablished the agency problem. The agency 0094 1 problem went away when everybody matched the same 2 scheme, all right, because now, with the narrower 3 spreads, people are getting better executions, but 4 they're -- but there's money flowing to the brokers. 5 But probably the commissions are being decreased 6 and so forth. It all balances out. 7 But with the addition now of the maker- 8 taker scheme, here's what's going on. 9 The limit orders always go to the make 10 exchange, maker-taker exchange, and the market 11 orders always go to the taker-maker exchange as long 12 as there's liquidity present there, and so, the 13 brokers are going to win both ways, and a convoluted 14 system with hidden plumbing gets even more hidden 15 and more complex. 16 Okay. So, let me turn now to a discussion 17 about what to do about this. 18 So, the SEC can best promote competition 19 among exchanges by ensuring that they all use the 20 same simple pricing standard, so that the quoting 21 price will be the true trade price. 22 If exchanges want to provide quantity 23 discounts, let them go ahead and do so. I don't 24 think the SEC should be regulating pricing, but as I 25 mentioned before, they can regulate the pricing 0095 1 standard. Okay? 2 So, exchanges can discount their 3 transaction fees but not through rebates and fees 4 that are based on who makes or takes liquidity. 5 In the end, since all traders, all trades 6 must have a buyer and a seller, fees that 7 effectively alter quoted prices simply either change 8 those quoted prices in the long run or they produce 9 agency problems. There's nothing else that can 10 happen. There's always got to be a buyer and seller 11 who are matched. 12 If the SEC is concerned about the cost of 13 filling retail market orders, it should reduce the 14 tick size, but that has certain problems with it, 15 okay, and if the SEC is concerned about 16 internalization in the associated payments for order 17 flow, it should directly address the problem, 18 perhaps through at-trade rules or better, I think, 19 by simply requiring that these payments be passed 20 through to the customer. 21 These issues are not best addressed by 22 allowing a convoluted pricing system to narrow 23 spreads as this system also facilitates agency 24 problems, it increases the locked markets, it 25 discourages meaningful price competition to obtain 0096 1 order precedence, and of course, it confuses 2 investors. 3 So, in closing, note that fees charged to 4 access standing limit orders are essentially 5 kickbacks that exchanges charge people who want to 6 trade with their clients who offer limit orders. 7 This is really strange. 8 If you want to trade with my client who is 9 willing to trade, offering this limit order, you've 10 got pay me first. In any other context, collecting 11 such fees would constitute a felony, okay? But it's 12 legal in the securities markets, and I don't want to 13 claim that anybody at this table or anywhere else is 14 felonious, okay? 15 But these fees are impediments to fair and 16 orderly markets. They need to go away. 17 Now, the easiest solution to the maker- 18 taker problem and to the maker-taker problem and to 19 the internalization problem, as well, is to pass all 20 maker-taker fees and rebates and all other payments 21 for order flow through to the customers, okay? 22 All entitlements and liabilities 23 associated with order flow should lodge with the 24 traders who create these orders and not with the 25 entities that handle them. This all belongs to the 0097 1 trader. 2 Brokers should include these payments in 3 the execution price. 4 Only by following this practice can we be 5 confident that brokers and exchanges will focus 6 exclusively on obtaining best execution, which of 7 course must consider all fees and rebates that the 8 clients have to pay and receive. 9 As a consequence, brokers must -- if, as a 10 consequence, brokers must raise their commissions, 11 customers then will finally know the true cost of 12 their trading. 13 The present system allows some brokers to 14 offer commission-free trades to their customers and 15 others to substantially reduce their commission 16 rates, but we all know that there is no such thing 17 as a free lunch. 18 The vast majority of the traders who use 19 these brokers have no idea that they are indirectly 20 paying for their trades through inferior executions 21 on their market orders or through the valuable free 22 trading options that they provide to clever traders 23 when they submit limit orders. 24 This obfuscation, some would say systemic 25 dishonesty, needs to stop, and the sooner, the 0098 1 better. 2 Thank you very much for this opportunity. 3 MR. LUPARELLO: Thank you. 4 Matt. 5 MR. LYONS: I also want to echo my thanks 6 to the Commission, the Chair, and the staff to 7 invite me to come and express the views of the 8 Capital Group around these important issues. 9 I am somewhat humbled, quite frankly, 10 sitting up here next to these folks to my right. 11 All of them have expressed very pertinent views, and 12 I think that I agree with most. It seems like there 13 seems to be a common theme here. 14 But just to allow us, the Capital Group, 15 to come -- a little bit about the Capital Group. 16 We're one of the oldest asset managers in the U.S. 17 We have over $1.4 trillion in management. 18 We actively manage the assets in our 19 American Family funds, collective investment 20 vehicles, and institutional client separate 21 accounts, and at the core of it, we represent 22 millions of individual investors' savings and 23 retirements, and I think that this point is really 24 important for the committee and the Commission to 25 understand that -- I always have a little bit of 0099 1 problem when the argument is framed about retail 2 versus institutional when, at the core, we represent 3 millions of retail investors who entrust their 4 savings to us. 5 Capital Group has, at the time of Reg NMS, 6 supported the idea of displayed liquidity in the 7 marketplace, and adding to the price discovery 8 system is an important aspect of it. 9 We think that the rules of 610 and the 10 objectives of those rules were important in 11 promoting price discovery because of the order 12 protection rule. However, if you look at the goals 13 and objectives of Rule 610, the requirement of 14 market centers to permit fair access to limit order 15 books, limit fees charged by market centers for 16 access to de minimis amounts, and reduced inter- 17 market lock in cross-markets, we think that the 18 maker-taker pricing scheme, and especially the use 19 of rebates to pay for posting liquidity, has 20 undermined these goals. 21 In fact, many of the distortions we see 22 today were discussed and acknowledged by the SEC 23 when they promulgated Rule 610. 24 Back in the original comment period and 25 initial rule promotion, it was acknowledged that 0100 1 access fees tend to be the highest when markets use 2 them to fund substantial rebates to liquidity 3 providers. 4 It was also known that the practice of 5 charging high rebates and passing through -- 6 charging high access fees and passing through as 7 rebates could result in published quotes not be 8 reliable indicators of true price available to 9 investors, and in fact, in the original proposal, 10 the SEC capped the fees at 10 mils, but through the 11 comment period process, they increased them to 30 12 mils, because it was the going practice at the time. 13 Fast forward now and the access fees have 14 actually -- all of them have gone to the max of that 15 cap, and now we're passing back the majority of 16 those fees back in rebates, which is exactly what a 17 lot of the commenters were concerned about to begin 18 with in the scheme. 19 So, I think that there's really issues 20 here that need to be addressed, and I do appreciate 21 the committee thinking about these issues. 22 I created a couple of slides that I'll 23 probably refer to as I go forward here. 24 Most of the issues has already been 25 described, but I'd like to challenge some of the 0101 1 underlying assumptions that I hear constantly in the 2 debate around the benefits of the maker-taker 3 pricing scheme. 4 So, typically, we hear that it incents 5 displayed liquidity to add to the price discovery 6 mechanism, transaction costs have been reduced 7 during the period of the advent of the rebates 8 through Reg NMS, and it promotes competition among 9 trading venues. 10 These are the common themes that I hear. 11 Certainly we've heard more today in the well- 12 reasoned argument presented earlier by Richard. 13 But I think that, at the end of the day, 14 what we're talking about in displayed liquidity -- 15 and all the comments have been referring to 16 incenting market makers to display liquidity into 17 the market, and we certainly -- the Capital Group 18 certainly believes that market makers are an 19 important aspect of the market. They deserve fair 20 compensation for risk, for supplying liquidity, to 21 mediate temporal dislocations in supply and demand, 22 and they should be compensated for that. 23 However, rebates and the rebate system 24 actually creates a subsidy from takers to makers. 25 The Capital Group, for example -- and the data here 0102 1 is somewhat hard to get at. We asked our brokers to 2 give us through our messaging system when they make 3 and when they take. 4 But on net, for the data that we get back, 5 which is about 75 percent of our order flow in the 6 U.S., we're net takers. About 60 percent of the 7 time, we take; about 40 percent of the time, we 8 make. 9 So, in essence, whoever is providing the 10 liquidity on the make side and limiting their access 11 to the make side is being subsidized by our 12 investors, and in fact, I think that in equilibrium 13 -- as I think Larry talked about -- it would seem 14 that the distribution of the make and take fees 15 should be equally distributed. 16 When the prices reflect actual value, that 17 economic benefit should be evenly distributed, and 18 it's not today, so -- and certainly, you know, the 19 whole idea that a subset of the electronic market 20 making community relies on the so-called rebate 21 arbitrage points to a problem, I think, in the 22 system in terms of the economic incentives for 23 people to be there and the way those -- and the way 24 the economics are split between makers and takers. 25 So, to challenge a little bit further some 0103 1 of the assumptions that seem to be given, I provided 2 just a couple of graphs in my pages, on page three. 3 First and foremost, the idea that 4 transaction costs have come down for all investors 5 because of the liquidity rebates -- that has not 6 been the experience of the Capital Group. 7 In fact, I produced a graph here that 8 shows, from 2008 to 2015, really when Reg NMS went 9 into effect and has been effect since then, the 10 graph here shows our normalized transaction cost for 11 U.S. equity securities. 12 This is data that we get from a third- 13 party provider, ITG, who analyzes our data for us, 14 and you can see that the evolution of those costs -- 15 and the normalization is to the average cost over 16 this period, but in the early part of the 2000-2008, 17 during the finance crisis, we saw a spike in our 18 transaction costs, and then, afterwards, and from 19 2010 on, really, we've seen a pretty steady state, 20 quite frankly, of the transaction costs that our 21 investors have when we implement portfolio decisions 22 for them. 23 And it's not surprising to us, because as 24 we've looked at our transaction costs over time -- I 25 should say that the period that I used from 2008 on 0104 1 is more of a -- trying to have a consistent time 2 series data. Prior to that, some of the order 3 definitions were a little bit different in our group 4 as we've increased our ability to look at 5 transaction costs. But if you look at the period 6 from 2003 to 2004, you don't see much different than 7 the period from 2010 to 2011, quite frankly. 8 And as you look at -- and I just supplied 9 a proxy for market volatility, which we think is the 10 main driver of the transaction costs as we enter the 11 marketplace for our investors. 12 You see that our costs actually mimic what 13 happened in volatility generally. They were pretty 14 low and at an all-time low prior to the Reg NMS 15 going into effect. We had the spike from the 16 financial crisis go up, and then, afterwards, we've 17 seen volatility drop to levels seen before, and 18 again, low levels. 19 And in fact, when you hear -- I think -- I 20 hear constantly that transaction costs for all 21 investors have come down over the last 20 years. It 22 sort of also follows the pattern of the VIX if you 23 look at it over longer period of times where you can 24 draw a line -- and I have done that on a regression 25 basis -- where you do see slight drop in transaction 0105 1 costs over time. 2 I would conjecture that that's due to 3 volatility and not any sort of market structure or 4 rebates being passed on to liquidity providers to 5 incent them to display. 6 The other thing I'd like to challenge is 7 the fact that, you know, spreads have come down due 8 to the liquidity rebates, and that's the primary 9 driver, and so, I asked one of our -- ITG to give us 10 a look of average spreads over a long period of 11 time, and you can see here, I've highlighted a 12 couple of events. 13 Certainly we've seen spreads come down, 14 for the most part. 15 Decimalization happened in 2001, and from 16 2001 until the implementation of Reg NMS, most of 17 the benefits of lower spreads had already been 18 realized, and so, to argue that displayment of 19 liquidity to electronic market makers is the cause 20 for spreads being as narrow as they are today -- I 21 think you can question that, and I think it should 22 be investigated further, especially because you see, 23 after Reg NMS, there's been no material decrease in 24 spreads at all. 25 In fact, you see the same pattern I talked 0106 1 about before. In periods of volatility, the costs 2 widen out. We'd expect that. 3 But even at the lower market cap ranges, 4 you see that spreads have actually widened. 5 So, I think that a couple of those 6 assumptions needed to be addressed, and hopefully, 7 that's helpful in the way that you think about this 8 from our perspective. 9 I also think that it's important to look 10 back at the intent of Reg NMS and what it tried to 11 do originally, and it was working under the auspices 12 of the Exchange Act and the National Market System, 13 and Rule 11A3 really addresses the rules associated 14 with, you know, what should an efficient market look 15 like, and I think if you look at the rules -- and 16 I've listed them here, but really I wanted to focus 17 on the fact that I think we've failed, if you look 18 at 3C4, the practicality of brokers executing 19 investor's order in the best market, I think that a 20 lot of the conflicts of interest that we've talked 21 about address that issue, and I think it's a 22 problem. 23 And also, 3C5, which really the intent 24 was, where customer orders can interact without 25 intermediation, that was the goal of the legislature 0107 1 when they asked for the National Market System to 2 come out, and I think if you look at the markets 3 today, where 60 percent of all the order flow on the 4 exchange is intermediated by electronic market 5 makers, and in fact, the majority of that is in the 6 most highly liquid securities, that I think that 7 we've failed on that aspect, as well. 8 So, I think it's important to kind of keep 9 that in mind as you start to think about remedies as 10 we go forward. 11 You know, I don't have much else to talk 12 about in terms of the conflicts of interest that we 13 think exist today. 14 In fact, and in full disclosure, rebates 15 and the conflicts of interest that exist today 16 because of rebates is one of the reasons the Capital 17 Group invested in a commercial solution to this 18 problem, which is IEX, and it is something that we 19 feel that it's important for our shareholders to try 20 to correct, and that's why we felt it was important 21 for us to do that, and I just wanted to make sure 22 everyone understood that we had done that. 23 But really, broker routing decisions that 24 goes to the heart of their best execution obligation 25 has been spoke about, complex order types strictly 0108 1 developed for rebate avoidance, and in fact, you 2 know, the problem -- and it gets back to the 3 objectives of 610 -- having not locked markets -- 4 when you have orders on the book that you try to 5 interact with that are then re-posted away from you 6 because they are not going to pay the take fee, even 7 though they're willing to engage in a trade at the 8 same price and really give up information that 9 someone actually even tried to interact with that, 10 because they get reposted -- I think that's a 11 problem, and I think it goes to a conflict of 12 interest. 13 Finally, I think, also, that -- and this 14 is probably outside the scope of this particular 15 issue, but I think, also, that there's a conflict in 16 the fact that in the Reg NMS original promulgation, 17 there was a change to the market data scheme, and 18 that allowed the payment of quotes to be included in 19 the market data revenue split between SROs, and so, 20 when you have an incentive to get paid, I think that 21 leads to an incentive to be able to pay rebates, 22 too, and I think that that's a problem that needs to 23 be looked at, as well. 24 You know, a lot of issues around that, you 25 know, quotes have increased, I suppose, and I think 0109 1 that that's been documented by some of the academics 2 up here at the dais, but you know, if you look at 3 the quote to trade ratio, that's also increased. 4 So, I'm not sure that all those additional quotes 5 are actually being accessed by anyone. 6 Finally, and you know, thinking about the 7 complexity of the marketplace, I think fee avoidance 8 leads to a proliferation of the broker ATSs. 9 Exchanges have several models that compete solely on 10 fees and rebates. Each exchange runs different 11 competitive platforms based only on fees. 12 All this complexity, as we know, leads to 13 fragility, and I think we've seen that manifest 14 itself several times going back to mini flash 15 crashes we see in the market all the time, certainly 16 in May of 2010, the Facebook debacle. 17 There's a lot of instances where you can 18 look to where complexity has increased fragility in 19 the marketplace. 20 So, finally, and in closing, you know, the 21 Capital Group strongly recommends for this group 22 that we should eliminate rebates. 23 I think that, in and of itself, will 24 alleviate a lot of the issues that I've discussed. 25 However, I understand -- and I am 0110 1 certainly not the smartest man in this room, and I 2 don't know all the implications and unintended 3 consequences of advocating that. 4 So, I think that a prudent path forward 5 would be to do it in a pilot study against 6 eliminating rebates. We've supported the ICI and 7 their recommendations for that. 8 We applaud Commissioners and Congressmen 9 who have advocated for that, and we fully lend our 10 support to that and think it can be done pretty 11 easily and pretty cheaply. 12 And finally, I do think that you should 13 evaluate the market data scheme and the need to pay 14 to quote off of the market data. 15 Again, thank you for the opportunity to 16 express my views, and I look forward to the 17 discussion later and answer any questions or have 18 any comments. 19 MR. LUPARELLO: That's great. Thank you, 20 Matt. 21 I'll open it up to the committee. 22 Jamil. 23 MR. NAZARALI: Yeah. I'd like to make a 24 couple of comments. There's a lot there. But let's 25 start with the conflict of interest. 0111 1 You know, much has been made of the 2 conflicts of interest. From a retail broker/dealer 3 perspective, there are no conflicts of interest. 4 So, for example, for a limit order that 5 they send to an exchange, they have every incentive 6 to want that limit order to execute, because they 7 don't get paid their commission if they don't. 8 So, let's just take an average retail 9 order. The average commission is somewhere around 10 $10 a share. Average order size is 300 shares. 11 On that particular order, they make about 12 3 cents a share when that order executes. So, the 13 idea that they would place it -- that they would 14 knowingly place it on an exchange that has a lower 15 probability of execution to get a few hundredths of 16 a cent extra, which is what the difference is among 17 exchanges, is just not credible. 18 Now, I know that there's a study that 19 talks about it. Much has been made about the flaws 20 in the study. It didn't cover retail. But I think 21 that, for retail, there's a very, very strong 22 incentive to want that order to execute, because the 23 commission that they charge far outweighs the very 24 small difference in fees. 25 I think Richard did a wonderful job about 0112 1 talking about the pros and cons of maker-taker, but 2 a couple of things to point out is that, really, any 3 system is going to have a lot of pros and cons, and 4 even if we went to abolishing maker-taker, right, 5 you can't pay taker rebates, most of those cons 6 would actually still exist, right? So, let's go 7 through the cons one way one. 8 First is complexity. Complexity is going 9 to exist, because you're still going to have 10 exchanges that may charge zero and may -- you know, 11 may pay -- I'm sorry. They may charge zero to add 12 liquidity and they may charge some greater number to 13 take, and there's still going to be order types 14 where people are going to not want to make or take, 15 and there's going to be, you know, complexity around 16 queuing. In fact, you might even think that the 17 queuing gets greater because you don't have that 18 payment for liquidity. 19 In terms of conflict, that conflict is 20 also still going to exist because unless you 21 regulate exactly how much each exchange can charge, 22 some exchanges are going to charge less than others, 23 and so, that conflict of interest in where you route 24 your order, if you're a taker, isn't going to 25 disappear by getting rid of maker-taker. 0113 1 And I think the best reason for really 2 keeping maker-taker is, as many of you have pointed 3 out, spreads are likely going to widen. You know, 4 as Larry pointed out, it's not a free lunch. 5 Spreads are likely going to widen when you get rid 6 of maker-taker. 7 So, we know that spreads are going to be 8 widened, and I think that the simple reason for 9 keeping maker-taker is that adding liquidity to the 10 market is a public good. It aids in the price 11 formation, and everyone relies on that public good, 12 even if you're trading off exchange in a dark pool 13 or internalization. 14 And so, you want to create incentives for 15 people to have that liquidity, and so, I think 16 having that payment is the greatest incentive to add 17 that liquidity, which creates externalities for the 18 rest of the market, which is actually a really good 19 thing, narrows spreads, and I think doing away with 20 it would discourage that. 21 MR. HARRIS: Steve? I find it very 22 interesting that, in a discussion of taker-maker and 23 maker-taker, that we've inverted the Q&A. 24 So, I'd like to offer the question to the 25 answer that we just received, and the question is, 0114 1 retail traders -- I'm sorry -- retail brokers -- 2 what fraction of their limit orders are they sending 3 to taker-maker exchanges where they have to pay a 4 fee? 5 Because that, of course, is the way that 6 they get those limit orders executed as quickly as 7 possible. 8 MR. RATTERMAN: I'd like to take a shot at 9 that, if you don't mind. 10 I think that's a great question, and you 11 know, we have an answer. 12 The challenge in some of the studies that 13 we've seen is that retail order flow itself has not 14 been examined, but general order flow has been 15 examined. 16 Retail order flow has very unique 17 characteristics. One key factor is that, as we 18 looked at all the retail order flow that comes to 19 the BATS EDGX exchange, we found that nearly half of 20 the orders showed up at the market before the market 21 even opened, therefore establishing the highest 22 priority at each of their price points, and as a 23 result, when you look at the actual retail orders 24 that were executed, the non-marketable limit orders 25 that were executed on the EDGX exchange, one of the 0115 1 exchanges in question, 98 percent of the orders that 2 did not issue a cancel were actually executed and 97 3 percent of the orders were executed in full if their 4 price was touched anywhere in the market at any 5 point during the day. 6 So, I think, you know, the idea that 7 retail orders are chasing the market price like 8 other professional orders is the material flaw in 9 the analysis, and when you look at the behavior of 10 retail orders, they want an execution, and the 11 metrics bear out that they get that execution no 12 matter where they place their order, whether it's on 13 a make-take or a take-make, because the nature of 14 their entry into the market is setting price points 15 before anybody else does. 16 So, when you look at the actual data for 17 retail, you're see that they are getting what they 18 want, which is an execution, some vast majority of 19 the time. 20 MR. LUPARELLO: Reggie? 21 MR. BROWNE: I have a couple of comments, 22 actually. 23 One, I think if you were to study the 24 data, both implicit and explicit, the cost of access 25 to retail clients is at an all-time low, and if you 0116 1 start looking at changes to make-take, take-make, or 2 order flow, that cost of access will go up for mom 3 and pop. 4 So, that should be measured kind of taking 5 it into a point of view. 6 In terms of ETFs, again, if you take away 7 make-take models, there's a segment of the liquidity 8 population that depends on that model, and then you 9 will probably invariably reduce liquidity in some of 10 the larger ETFs, and so, you have to take that into 11 consideration, that that's a motivator for behavior. 12 And so, as you think about that change of 13 behavior, that's the outcome of that? 14 And lastly, my friend from Pennsylvania, 15 my neighbor, said something about trade-at. 16 Exchanges, from my point of view, are owned by 17 entrepreneurs and public shareholders, and so, if 18 you're advocating for a trade-at, are we picking 19 losers and winners, and are we reducing competition? 20 And that's the things I need to -- I'm 21 concerned about from a standpoint of a business 22 owner, where I dictate where I trade my flow from a 23 customer basis. 24 And so, if you reduce the amount of 25 competition in the marketplace, what's the long-term 0117 1 effect of that? 2 MR. BUEK: So, it's important to have 3 liquidity displayed in the marketplace, and to me, 4 the biggest incentive for me to place my limit 5 orders is to actually trade, not to capture a 6 rebate. 7 I'm going to place displayed limit orders 8 if the odds of me trading is higher. 9 So, if my offer comes in the market 10 without an access fee, I'm more likely to trade. If 11 my offer is there and thousands of shares can't 12 trade at that same price until I'm fulfilled, I'm 13 going to put more in the market. 14 Now, these pilots are a lot about what 15 behavior is going to change, and I don't know, but I 16 think real buyers and sellers of stock, if there is 17 a trade-at, will be more likely to place limit 18 orders in the displayed market, and in fact, you 19 might end up getting tighter markets with deeper 20 spreads, and certainly the traders who are trying to 21 buy and sell are more likely to be stable limit 22 orders. 23 They're not running away because three or 24 four exchanges just got lifted or I can't get a 25 rebate. They're staying there because they've got 0118 1 to trade it. 2 So, I know our reaction to a trade-at will 3 be we'll post more limit orders, and the market 4 makers that are out there trying to make a spread -- 5 let's see the real spread, the real net spread, 6 what's out there. 7 They can still make that without the 8 6/10ths of a cent artificial spread that's out there 9 for most to see, and we could debate it all day 10 long. Until we see how traders would react, we 11 don't know. 12 MR. LUPARELLO: Matt, then Rick. 13 MR. ANDRESEN: Okay. Well, as I pointed 14 out at our prior meeting, in my old company we did 15 create the first maker-taker pricing, and I do want 16 to correct a few factual inaccuracies about what the 17 world was like then, which is important. 18 As was noted earlier, if we're going to 19 address the position we're in now, it's important to 20 understand what happened then. 21 Contrary to some assertions, I don't think 22 things worked, quote/unquote, "quite well" in the 23 '80s and '90s. I think there were deep flaws. 24 There was -- one need only to read the 29A 25 report. One can look at the class action lawsuit 0119 1 that was brought against the NASDAQ dealers, quite 2 famously, to know that there were real issues. 3 When Island started, it cost about 25 4 cents to -- per share -- to sell Intel, which is one 5 of the largest companies, obviously, in the world, 6 especially at that time. Twenty-five cents. 7 Now, the spread in Intel, as Larry 8 correctly pointed out, is well within a penny. 9 So, we are better off, but there were many 10 things that contributed to that. There was the 11 ability for new exchanges to come out and bring new 12 buyers and sellers, with less intermediation, 13 together in the marketplace. There was higher 14 velocity of trading, because technology allowed 15 people to make more accurate prices and update their 16 desires more frequently. 17 But the access fee was not a new thing 18 then. So, when Island developed its first pricing 19 access fee, we didn't come out of it looking at our 20 costs or we didn't come out of it looking at -- out 21 of whole cloth. 22 We just looked at our competitors, and 23 back then, we really only had one competitor, which 24 was Rick and NASDAQ, and NASDAQ cost about -- 25 MR. KETCHUM: Instinet wasn't around? 0120 1 MR. ANDRESEN: Well, Instinet charged 150. 2 So, we figured that would be overly usurious to 3 charge. 4 So, in those days, if you wanted to access 5 NASDAQ, you paid a fee, and the fee in those days 6 was $2.50 a thousand, so it equated to 25. 7 So, we wanted to match that price. 8 So, we said, all right, well, let's just 9 match that price, and no one is worse off coming to 10 Island than they are accessing the price on NASDAQ. 11 So, it was at parity across those 12 marketplaces. 13 No one was making a decision about how to 14 execute one versus the other. 15 We did the rebate, as Larry correctly 16 pointed out, because we needed someone to actually 17 post an order on our system, and this was -- it came 18 out of our end. We didn't -- as all the other ECNs 19 did -- they charged the same for the maker and the 20 taker. 21 So, in those days, Archipelago, for 22 instance, charged 50 to the lifter and 50 to the 23 adder. Instinet was 150 for each. And we were at 24 25 and minus 10, proving that I was crap at 25 business. 0121 1 That existed at equilibrium from 1997 2 until about 2002. The other ECNs charged on both 3 sides. NASDAQ charged both on sides. And we were 4 the lone maker-taker exchange. 5 So, it wasn't strictly necessary for ECNs 6 to get traction to have this model. 7 What eventually happened was Island had 8 more success -- we like to think more than just a 9 pricing scheme. We had more positive attributes than 10 that. 11 But eventually, all the other ECNs matched 12 us with maker-taker pricing. NASDAQ came out with 13 2010 pricing, which led to us go to 1911, to be a 14 little obnoxious. 15 But then Instinet came out and cut all the 16 way from 150 down to 3020, and what was surprising 17 to us is, when they went maker-taker, they started 18 taking market share from us, and we're like, geez, 19 you know, our taker fee is lower, but our rebates 20 lower, maybe this equilibrium is wrong, and there 21 kicked off a frenetic year of people trying every 22 possible pricing mechanism to try to see what the 23 proper tradeoff in the no-free-lunch analogy would 24 be, and as it turns out, all of the major markets 25 ended up settling around 3020. 0122 1 Keep in mind this is 2002. It wasn't 2 until half-a-decade after that that we got Reg NMS 3 and the codification, for good reason, of the 30 4 being a cap, because we didn't want highwaymen, as 5 we used to call them, putting out a super high 6 rebate and a super high take fee and using the order 7 protection rule of Reg NMS to force people to access 8 that usurious price. 9 So, when I look at this -- you know, the 10 collapse of -- the Capital Group -- the very helpful 11 chart that showed the collapse, it is worth noting 12 that much of the benefits of electronic trading, 13 much of the benefits of liquidity, rebates, other 14 things, were baked into the marketplace, as I think 15 Capital is correctly pointing out, really around the 16 time of decimalization, because that's the 2001-2002 17 time horizon. 18 So, I wanted to make sure that everyone 19 understood that there was a much longer session of 20 events and a much more market-driven searching for 21 what the right tradeoffs to these are that we're 22 still grappling with today. 23 MR. LUPARELLO: Thanks, Matt. 24 Rick. 25 MR. KETCHUM: I would basically agree with 0123 1 what Matt said. Certainly in the environment that 2 existed pre-decimalization and pre-dominance of HFT 3 liquidity-making, there were a lot of reasons that 4 ECNs attracted order flow, and certainly not just 5 maker-taker. 6 Without getting into my conclusions on a 7 lot of this stuff, which I think should await 8 further discussion with my colleagues and 9 subcommittees and, of course, in public, I want to 10 follow through your logical chain to make sure I 11 understand it, because recognizing you raised a 12 variety of what I guess I would call policy 13 reservations and perhaps best execution reservations 14 with respect to maker-taker, if I understood your 15 chain correctly, it ran basically through a 16 development that resulted in, I believe, if I quote 17 you right, rough equilibrium until taker-maker was 18 added to the mix, at which point you suggested again 19 it created the variety of biases and problems that 20 you identified with respect to the beginning of 21 maker-taker. 22 So, I guess my question is, off that 23 chain, putting aside just your preferences for not 24 having a rebate environment, is it really necessary 25 to do much more than to eliminate taker-maker in 0124 1 order to get at some of the worst impacts of the 2 pricing scheme? 3 MR. HARRIS: That's correct. When 4 everybody is pricing to the same standard, then you 5 don't have these agency problems that we discussed 6 before. 7 So, if it's all taker-maker and with 8 essentially the same fees, as would likely be, then 9 bid-ask spreads compress some. 10 The order routers can't really choose 11 among different exchanges based on the differences 12 in their rebate rates, because they're all going to 13 essentially be the same, and so, presumably they'll 14 be choosing only where they're going to get best 15 execution. 16 But we still have a hidden pipeline in 17 which revenues and dollars are flowing in ways that 18 are not immediately apparent to people who aren't as 19 familiar with the markets as we are. 20 Are they hurt by that? To some extent, 21 every misrepresentation of cost is potentially 22 harmful, because people make decisions based on 23 their perceived cost, but in the grand scheme of 24 things, maybe they eventually learn, and given that 25 we're talking about, really, generally small numbers 0125 1 on a per-trade basis, it perhaps doesn't matter that 2 much. 3 But I will note that these numbers 4 certainly add up to big numbers, and the very fact 5 that we are all convened at this table to discuss 6 this issue makes it obvious that there are a lot of 7 very strong vested interests in the sum-total of 8 these monies that are transferred. 9 So, to answer your question directly, if 10 everybody were at 2030 or 3020 or however you want 11 to state it or some small variation around that, 12 then at least the agency problems would go away. 13 MR. LUPARELLO: Tom, and then Matt. 14 MR. FARLEY: Just briefly, Reggie posed a 15 question about trade-at, and I think several of the 16 panelists, three or four, raised the potential for 17 trade-at to be an improvement, and there were some 18 that maybe even a better improvement would be 19 passing through fees, but several of us raised 20 trade-at, and Reggie asked are we picking winners 21 and losers if we implement a trade-at, not to put 22 words in your mouth. 23 Was that the question? 24 MR. BROWNE: That's correct. 25 MR. FARLEY: I just wanted to make sure I 0126 1 got it right. 2 I just wanted to point out, I think, to 3 some extent, you are picking winners and losers, and 4 it may sound coy, but the winner is the investor. 5 You're choosing the public quote and the 6 lit quote and you're rewarding that investor who 7 makes that public and lit quote and therein 8 rewarding the rest of the marketplace by having a 9 more firm public quote. 10 You're increasing competition of orders in 11 the central marketplace. 12 However, I think -- my guess is, 13 underlying that question, if not from you, Reggie, 14 maybe from other colleagues, because I've had this 15 conversation with many, is this question of 16 conflicts of interest. 17 Hey, easy for you to say, Tom, you run the 18 New York Stock Exchange and a trade-at rule would 19 ultimately bring business to the New York Stock 20 Exchange, and I think that's absolutely right, and 21 that's why it's important to get conflicts on the 22 table and to have this conversation in a full and 23 fair way, and to give you an example of some of 24 that, getting it on the table, we made round about 25 $200 million from matching equities trades, and that 0127 1 is a big deal to us, it absolutely is. 2 It represents, I don't know, 15 percent of 3 New York Stock Exchange revenue, about 6 percent of 4 overall ICE revenue, still an important factor, and 5 there's additional revenue we bring in for data 6 revenue, so on and so forth, but there's successful 7 broker/dealers that make that in a week, and so, I 8 think we should get on the table what that 9 conversation looks like and make sure we are 10 choosing the institutional investor and making the 11 decision based on the institutional -- pardon me -- 12 on the investor, making the appropriate decision. 13 In our view, we think part of the 14 conversation should be economic, and in fact, we've 15 long advocated for a pilot that would include 16 elimination of rebates, as several of our colleagues 17 have described, and the trade-at, but also really 18 addressing access fees in a way that makes the 19 industry comfortable that exchanges wouldn't somehow 20 make, you know, some lion's share of the rents. 21 And finally, I will point out -- because 22 the end of your question, I believe, was about 23 competition, could it potentially reduce 24 competition, or maybe I interpreted that. 25 Our sector, as everyone knows and is 0128 1 written about very often in the press, is hyper- 2 competitive, and I think it's a good sign that IEX 3 has finally become an exchange. I think it's a good 4 sign that National Stock Exchange is rebooting. 5 And I think what you would see in a world 6 where we eliminated rebates and we complement it 7 with a trade-at, is it would get even more 8 competitive and you'd see even more venues choosing 9 to become exchanges, which is good, because they're 10 lit, by definitely, and now there's more of a 11 transparent public quote for the market to rely 12 upon. 13 MR. LUPARELLO: Matt. 14 MR. ANDRESEN: One other point I wanted to 15 make about costs and fees -- so, we're spending a 16 lot of time today, rightly, talking about the 17 conflicts created by the costs of accessing a 18 particular quote, and I think it's -- I've certainly 19 long advocated, since the amount that I'm sure 20 Capital spends or Vanguard spends for an 21 institutional agency execution -- that commission 22 rate has steeply declined over the last 5 and 10 23 years, I would imagine. 24 The access fee cap, if you think about 25 something being indexed to inflation, that is the 0129 1 number we should think about indexing to. 2 So, if 30 was the cap we thought was 3 reasonable when, you know, a broker might get 5 4 cents a share in commission, then if we're now at 5 less than a penny per share, that is certainly worth 6 considering, and I think I support the Commission's 7 on-the-record comments about exploring how best to 8 get to where we can address that. 9 But I do want to make sure -- make a point 10 that I don't think gets a lot of press around this, 11 and that is the other fees that exchanges charge for 12 access that are often just as material to the end 13 user and just as material to exchange. 14 So, if you're a new company, which we'd 15 all like to think -- and we've heard a lot of good 16 things about how it's good to have new companies and 17 good to have new entrants -- the costs of entry to 18 the marketplace have never been higher, and as an 19 example, if you want to get the fastest data feed 20 from one of the largest equity markets, it can cost 21 you sometimes $25,000 a month to have access to 22 that. 23 It's $300,000 a year, and when you're 24 going out and lining up all the costs of getting 25 people and office space and all of that, that is a 0130 1 material driver. 2 It's not clear to me in this world, in 3 this construct, the post-Reg NMS construct, how 4 there's any pricing power for the customer to ever 5 dissuade exchanges from continuing to come out with 6 new feeds that have to raise that. 7 There's even fees for -- certain exchanges 8 run their own data centers. So, they're in the 9 business of controlling the matching engine and 10 controlling your access within that data center. 11 You know, co-location is nothing more than 12 renting a little piece of a data center. The data 13 center that happens to hold the matching engine has 14 real value. So, if you look at the cost of renting 15 in a data center like NY4 in New Jersey, which has 16 lots of dark pools and foreign exchange matching 17 platforms and so forth, all of the costs of being in 18 that data center are higher than being in another 19 data center elsewhere in the world. 20 You look at -- but the highest costs tend 21 to be the ones where the exchanges own the data 22 center themselves. 23 So, I will -- as an example, when you're 24 in a data center, you have your little rented 25 cabinet, but then you have to connect it to the 0131 1 world, and the way you do that is called a cross- 2 connect, and a cross-connect is nothing more than a 3 plug that you push into one of your machines and a 4 plug that you push out into some other machine 5 outside of your cabinet. 6 In a data center that doesn't have any 7 exchanges in it, the cost for that is usually around 8 about $50 a month. 9 For exchange ones, this is usually over 10 $300 a month, and one particular exchange charges 11 well over $1,000 a month, and you pay it, because 12 you have no choice and there's no pricing power to 13 argue against it, and we have to, I think, consider 14 this in addition to considering the access fee 15 question. 16 I think we'd be remiss if we didn't, as a 17 committee, also consider these other somewhat 18 hidden, obfuscated fees that are a barrier to entry 19 to new liquidity providers and new entrants in the 20 market place. 21 MR. LUPARELLO: Met first, then Jamil. 22 MR. KINAK: Thanks. 23 So, just going back to the trade-at, I 24 think we're all convened here, obviously, to talk 25 about access fees, in general, right, and whether 0132 1 they create complexity, undue conflict in the 2 market, and everything like that. 3 What a pilot with just reduction of maker- 4 taker or removal of rebates would measure is whether 5 or not liquidity goes elsewhere or what it does. 6 A trade-at provision is completely 7 different. You can test for trade-at even without 8 touching maker-taker, and what Mike's arguing for 9 right now is saying, hey, I would put more limit 10 orders on an exchange if there was a trade-at. 11 That's a completely different component. 12 And if you create two different categories 13 where you have no maker-taker or reduction in maker- 14 taker and then a trade-at component, you're not 15 really -- you're not sure which one you're measuring 16 for, right? 17 Because Mike might put more liquidity on 18 an exchange regardless of what that fee might be, 19 because he's not incurring that fee anyway, because 20 a trade-at component forces others to have to go 21 there. And it's regardless of what that fee model 22 is. 23 What we're trying to test for is what that 24 fee model is really representing and how it creates 25 that complexity and conflict in our market. 0133 1 So, I applaud NASDAQ to do a study like 2 that, and one of the things they found out is that 3 brokers -- a lot of them don't actually route for 4 fees. They route for size of orders that are 5 displayed. 6 So, maybe trade-at does help that, because 7 maybe there is a larger amount of displayed size, 8 but we have to have a very clean pilot in order to 9 be able to test for things, to determine if things 10 work appropriately. 11 So, if we do a pure rebate removal model 12 and we realize that everything migrates to the dark 13 or that spreads widen, then we know, and we can 14 always migrate back to a different model. That's 15 why it's a pilot. 16 But if we start adding things like trade- 17 at, provisions to change 611 or any other kind of 18 convoluted technique to that, we won't know exactly 19 what impact each of those categories is creating. 20 MR. BUEK: I think you can have trade-at 21 without maker-taker. No question about it, you can 22 have a protected quote that comes with a high fee. 23 So, I never -- you can have maker-taker, 24 and I'd be very interested to see what happens with 25 maker-taker abolished, but the fear you have with 0134 1 everything going to the dark without the rebate 2 providers out there, you would lure more liquidity 3 to the market, I feel, if you also had trade-at 4 protection by posting liquidity. 5 MR. KINAK: But you would lure more 6 liquidity to the market just with a trade-at 7 provision. It's regardless of what take fees are, 8 right? 9 I mean, obviously, we want to make sure we 10 want to make sure the take fees aren't so absurd as 11 to force people to have to go to a lit market where 12 they have to pay a high fee regardless, but a trade- 13 at provision basically forces more lit liquidity. 14 That's all it does. 15 There's nothing else to that, and there's 16 no way to test whether or not now that reduced make- 17 take fee has really had any substantial benefit or 18 not to the market. 19 MR. STONE: I actually agree with Met. 20 The question that we're asking about trade-at is how 21 do you incentivize display, and so, the real answer 22 to that is actually looking at Reg ATS and the 23 threshold. Right now it's at 5 percent 4 out of the 24 past 6 months. Concept Release wanted to lower it 25 to, I think, half-a-percent, a quarter-percent, and 0135 1 it was never enacted. 2 So, how do you push that stuff back? And 3 that's more of the question, because when you look 4 at the first ECNs, the first ECNs always displayed 5 didn't have really dark order types, and we were 6 able to display into the marketplace. 7 It was actually the dark order types when 8 I think it was Island went dark for the ETFs that 9 all of the sudden we started promulgating it, and 10 then NASDAQ institutionalized it in their exchange 11 status in 2002. They were the first ones to codify 12 it for an exchange. 13 So, I actually have a question for the 14 panel. Can I ask that? 15 MR. LUPARELLO: Absolutely. 16 MR. STONE: Okay. So, my question is 17 this. 18 So, Matt and Mike, you guys are the 19 institutions. 20 Professor Harris, you said that -- and I 21 think, Richard, you said it, also -- that if we -- 22 that you believed that there was -- there was 23 benefit to the tiered structure of access fees. My 24 question is, from a practical aspect, Mike and Matt, 25 how do you guys handle the pass-through if you don't 0136 1 know what the actual rebate is until the end of the 2 month based upon the volume tier that you hit? 3 Don't you have to flatten everything out 4 as a matter of practicality for you guys? 5 MR. LYONS: Yeah, I think it would be -- 6 in a scheme where we only got periodic updates in 7 terms of what those fees are to be able to pass them 8 through on a pro rata basis to the several clients 9 and accounts we deal with would be an incredible 10 administrative burden, I believe. 11 I do think that any tiering schemes that 12 the exchanges place after the fact, if we could get 13 information on those fees at the time of execution, 14 which is technically feasible through a fixed 15 message, it would be rather minimal in terms of 16 administrative burden. 17 MR. STONE: But you would have to have a 18 flat structure in order to do that. 19 MR. LYONS: Yeah. We couldn't change 20 intraday. 21 MR. BUEK: I agree. It would be very 22 complex. 23 Now, if you could argue the maker-taker 24 structure was worthy and really adding to market 25 quality, we deal with conflicts all the time, so we 0137 1 could work through pass-through pricing, it would be 2 very, very complicated and, hopefully, worth it for 3 maker-taker to exist in the marketplace for market 4 quality. 5 Even right now, without passing through, 6 we spend a lot of time monitoring our brokers to ask 7 where they're posting and taking liquidity, where 8 the rebates are, where the fees are, and we spend a 9 lot of time, and it's, you know, adversarial, a 10 little bit. 11 So, I hope all that effort is worth it for 12 the current structure that we have, especially that 13 30-mil fee is -- it's almost a testament to how 14 great the market quality has become, where 30 mils 15 was de minimis in 2005, now it's a huge number, and 16 it really is hard -- that economics, based on our 17 current commission structure, is very large. 18 MR. LUPARELLO: We have our own queuing 19 problems here. Can I get Kevin first and then 20 Maureen and then Joe and then Joe, and I'll let you 21 two Joes figure out what order. 22 MR. CRONIN: Now that's market complexity. 23 So, I have an observation, which is it 24 sounds like access fees are the one thing that a 25 number of us can agree that there is an issue here. 0138 1 I think, maybe despite what Jamil was saying, I do 2 think that there are conflicts of interest that, 3 from a institutional perspective, are real and that 4 have real consequences, and as a result of that, it 5 is reasonable for us to take a step back and examine 6 this in a way that really does lend credibility to 7 this process and ultimately to getting the right 8 answer, and it certainly seems like, within the 9 context of that, that developing a pilot program -- 10 I mean, frankly, if left to my own devices, I would 11 probably err to the side of eliminating the rebate 12 structure altogether, but acknowledging the problems 13 that that might create, I would certainly agree to a 14 pilot program which was thoughtful and really was 15 trying to get to the issues, Mike, because I think 16 you described it appropriately, which is we seem 17 like we're trying to solve for an issue of having 18 market makers display liquidity, and my friends, 19 that's not how you get a great quality market over 20 time. You have to have investors have an interest 21 and an incentive in posting limit orders. 22 So, I would be interested to hear, if any 23 of you have a comment, if when we're talking about 24 this whole notion of a pilot program, if it wouldn't 25 be more sensible to not so much get wrapped around 0139 1 the trade-at rule but really think about it 2 differently, from an investor's perspective, what 3 will incentivize more of an interest in us, and 4 certainly several people on this panel, posting 5 liquidity, and the question is, is it that you would 6 look at a program to eliminate rebates for the 7 highly liquid stocks where we know there's probably 8 not much benefit to be had in terms of incremental 9 benefit of cost -- transaction cost analysis, 10 certainly, but on the other hand, really kind of 11 think about the bigger issue, frankly, that I've had 12 with market structure, which is mid-cap and small 13 cap stocks, which have not really benefited from the 14 advancement of market structure. 15 So, I'd just ask each of you, if you were 16 considering a pilot, that maybe tiered access 17 instead of a removed or complete, you know, 18 elimination of maker-taker might be a more sensible 19 way to approach this. 20 MR. LUPARELLO: So, let me jump in 21 quickly. Having said that we would not instruct 22 subcommittees and they should go their own way, it 23 would seem to me that a subcommittee thinking about 24 what a well-designed pilot would look like would be 25 a very effective use, and so, if we spend some of 0140 1 that time, the remaining time we have on this topic, 2 having the broader conversation about, as Kevin just 3 teed up, what a well-designed pilot would look like, 4 I think that would be very productive. 5 Let me make sure I have this right. 6 Maureen, Joe Mecane, Joe Ratterman, Manisha, 7 Chester. 8 MR. HARRIS: Do you want the question 9 answered? 10 MR. LUPARELLO: Yes. Sure. 11 MR. HARRIS: Okay. So, the way to get 12 people to display liquidity is to protect them from 13 the people who would exploit them if they displayed 14 their liquidity. 15 So, the way to do that is to provide them 16 with a significant tick so that people can't front 17 run them with the order matching -- the quote 18 matching strategy that I described in my 19 introduction. 20 So, how does that interact with the maker- 21 taker pricing? It's because we have the taker-maker 22 pricing at the same time that we're trading 23 effectively on half-pennies instead of pennies. 24 So, if you want to get some of those 25 institutional orders out of the dark pools, that's 0141 1 where they flee, because they don't want to be front 2 run by people who are exercising this strategy, and 3 this strategy goes by many different names, but it's 4 well known. So, let me give you just another name. 5 Somebody says, hey, I see a large order 6 there, so I can lean against that order when I'm 7 doing my trading strategy. That leaning is an 8 extraction of the option value of that order. 9 So, if we get rid of at least taker-maker, 10 then we'll bring the tick size back to a full 11 penny, and in that way, we'll at least deal with the 12 -- to some extent -- the institutional provision of 13 liquidity, because the way you avoid getting taken 14 by that strategy is you hide your liquidity either 15 by using hidden orders or going to dark places. 16 And as far as the at-trade with respect to 17 retail order flow, if you want to get that out of 18 the internalizing dealers, then you just have to 19 take some of the benefit out of it. 20 Right now, the benefit comes from a 21 relationship between the broker and the 22 internalizing dealer, and if you don't address that 23 relationship, you're not going to get anything done. 24 We shrink the spreads. That just shrinks 25 the payment for order flow. If you increase it, the 0142 1 payment for order flow increases, and then 2 commissions decrease, and you get a little bit more 3 of that dishonesty that I spoke of before. 4 MR. FARLEY: Two sentences to respond. It 5 will be two sentences. 6 I completely agree with you, Kevin, on the 7 need to focus on rewarding displayed liquidity. I 8 do think a trade-at does that to some extent, so 9 that your displayed liquidity isn't traded against 10 in the away markets, number one. 11 Number two, such a pilot would have 12 reduced take fees, reduced fees that ultimately 13 would benefit you, as well. 14 MR. HARRIS: Another quick response. If 15 you take the market data revenue that's currently 16 being generated in this market and devote more of it 17 to reward exchanges who are displaying liquidity, 18 then you'll get more liquidity displayed, because 19 they'll rebate that revenue back. 20 So, that was the fourth prong of Reg NMS 21 but never really got implemented, because that 22 revenue wasn't -- the revenue devoted to the display 23 of liquidity was not as great as it might have been. 24 MR. LUPARELLO: Maureen. 25 MS. O'HARA: I want to join in on the 0143 1 debate here a little bit and point out that I do 2 think that we have to be a little bit careful of 3 letting the best be the enemy of the good. 4 I do think there are some things that we 5 might all agree on, and I think Kevin brought this 6 up, and Matt, as well, that the access fees now are 7 probably just too high. So, whether you think they 8 should go down to zero, the make or take, or they 9 should go down to something that more closely 10 approximates where we're going, I think is something 11 we might actually be able to agree on at least to 12 get halfway there. 13 When I think about this general issue, one 14 of the things that strikes me is that, you know, 15 however we sort this out, the markets are going to 16 optimize against whatever we do, and I think one of 17 the things that's interesting is we often talk about 18 the smart order routers that go out and they -- you 19 know, they're purposely designed to go grab the 20 rebates, and of course, that's exactly how good 21 brokers work now. 22 But good brokers also have smart order 23 placers who now figure out exactly where am I going 24 to put these limit orders so that they are going to 25 execute in the shortest amount of time, and you 0144 1 know, we kind of miss that when we think that 2 there's only one side of this execution. 3 An issue that I haven't heard brought up 4 but that worries me equally, if not as much as what 5 has been brought up, is the challenge that, when you 6 need liquidity, you need it in times of high 7 volatility, right? 8 On a normal day, when not much is 9 happening, people are happy to throw orders onto the 10 limit book. There's no problem getting a display. 11 There's no problem getting your orders filled. 12 The challenge we have is what happens when 13 the volatility goes up and placing the limit orders 14 gets really scary, and so, there's sort of an 15 interesting question about an entirely different 16 structure that almost has a time-varying maker fee 17 that allows, you know, the maker fee to reflect the 18 need for the liquidity and the need to reward people 19 for doing that. 20 Now, I recognize this is complex and it 21 goes against our discussion now, but I just want to 22 point out that I think liquidity is not homogenous, 23 and we need to think about the bigger problem, and 24 we all admit that when markets are volatile, 25 liquidity becomes brittle, and we might want to 0145 1 think a little bit about how all this fits into 2 that. 3 MR. MECANE: Two quick observations and a 4 general question. 5 Slightly echoing Maureen's point, I mean 6 one simple observation is that the access fee cap of 7 30 cents, when it was put in place in 2005-ish, was 8 at a time when spreads were roughly 30 to 40 percent 9 wider than they are today. 10 So, very simply, without even getting into 11 the mechanics of what happens in a reduced rebate 12 world, you could very much make the case that what 13 was de minimis and what was meant to be de minimis 14 is no longer de minimis and is clearly driving some 15 level of behavior. 16 The second observation, back to the point 17 Met was making, I just think, again, too complicated 18 to get into right now, but just to make the point, I 19 think the corollary of trade-at and access fees is 20 oversimplifying what is a much more complicated 21 debate that also brings in counter-party 22 segmentation, and I think, by definition, everyone 23 would agree trade-at will bring more liquidity into 24 the public markets. That's, I think, kind of an 25 accepted fact. I think what that needs to be 0146 1 debated against is the reduction in flexibility that 2 that comes with and whether that net tradeoff is the 3 right balance. 4 So, the general question I had, maybe for 5 Larry but for Matt or for Mike, also, is as we think 6 about potentially constructing a pilot, right, it 7 strikes me that, you know, there's all these 8 complicated counter-opposing actions that would 9 happen if we reduced access fees or banned rebates 10 or some combination of the two of them, and it's 11 hard to know what the net effect of all those 12 changes are. 13 So, it would seem that one of the benefits 14 of a pilot would be trying to learn, before we did 15 something too broad, about, you know, to use Matt's 16 point, what are the unintended consequences of these 17 types of changes? 18 The question I have is what do we think 19 we'd be looking to measure as the net benefit of 20 these pilots? And it could be a couple of things. 21 It could be maybe we don't think much will 22 change, but we think it's a cleaner way of operating 23 and it makes people more clear about how the market 24 operates, or is it more substantive, that we think 25 we'll actually see narrower spreads, more displayed 0147 1 liquidity, etcetera, etcetera? I just think it's 2 important to kind of define what we'd be trying to 3 achieve if we went down this path. 4 MR. LUPARELLO: Joe Ratterman, then 5 Manisha, then Chester, then Jamil. 6 MR. RATTERMAN: I just need to go on 7 record and, you know, give a personal perspective 8 that I believe trade-at, while it sounds good in 9 bringing more liquidity to the displayed markets, 10 and it's hard to argue that that's a good thing, it 11 will decimate competition that the SEC has worked so 12 hard to delicately balance. 13 Their mandate, let's not forget, is to 14 balance quote competition and venue competition, and 15 it will decimate venue competition. 16 You know, we haven't talked about it in a 17 while, but 35 to 40 percent of the volume every day 18 goes off away from the displayed markets. 19 So, with trade-at, in one fell swoop, we'd 20 simply take that model off the table, and it's gone, 21 and now we have competition between displayed 22 exchanges, which have significant limitations, and I 23 know for a fact that there are several firms that 24 like the ability to break up their orders and send 25 them across varied types of market centers to get 0148 1 executions in different ways to limit the market 2 impact of their trading. 3 And so, not all trading should go on 4 displayed markets is where I'll start, and so, 5 trade-at will decimate competition. It will change 6 it dramatically. So, we need to take that very 7 carefully into consideration and look at all the 8 parties, some of which are not here today. 9 Also, I think that we're giving a little 10 short shrift to the role that market makers do play 11 today. 12 Now, I totally agree with Mike and others 13 that, you know, have said that they'll put their 14 limit orders in the displayed markets if there's a 15 trade-at, because they'd be incented to do so, but 16 I'd postulate that there is not enough liquidity 17 from firms like that and individual investors to 18 find buyers and sellers to come together at the 19 right price, at the right time, every time, and 20 market makers provide that glue, a time gap between 21 one investor and another. 22 They make up a pretty significant part of 23 our market today. 24 So, a lot of these discussions about get 25 rid of rebates, we don't need market makers, all we 0149 1 need is the real investor, the real investor does 2 not make up enough of the market to trade every time 3 they want to at the right price, and so, we need to 4 be careful about how some of these suggestions might 5 actually disincent market makers, drive them from 6 our marketplace, and turn them into net removers, 7 and then I think we can guess where that might go. 8 NASDAQ's pilot, we applaud, and I think it 9 failed to yield valuable lessons because it was done 10 on one market, and I would ask that the committee 11 that's talking about this maybe encourage the SEC to 12 get in the middle and suggest a market-wide pilot 13 along those same lines. 14 I think the way in which it was conducted, 15 the securities that were selected, the results 16 before, during, and after, and the way they were 17 published was exactly the right mark, but would only 18 have valid results if we all went the same direction 19 on the same securities at the same time, and I think 20 that's where it will be difficult for the exchanges 21 to do that on our own, to come together and do that 22 as a group, but if you drive us, we'll do it. So, 23 I'll put up my hand and say I would participate in 24 that pilot. 25 I think, you know, it's talked about a 0150 1 lot, the 30-cent access fee is clearly outsized. 2 I don't think anyone here has once argued 3 that -- clearly in a one-size-fits-all world, 30 4 cents is too high. We all agree on that. 5 You know, I've proposed -- the company has 6 proposed a tiered approach. Sometimes more 7 incentive for illiquid securities can help drive the 8 quote tighter, and for very liquid securities, we 9 probably don't need much of a rebate, maybe 10 potentially not even any rebate to incent liquidity. 11 So, there might be an approach that's more 12 than one-size-fits-all but tiered, but before we go 13 there, because that does add complexity, I would put 14 on the table a suggestion that we take a group of 15 securities, we do it across the industry, all 16 venues, not just exchanges, but all venues have the 17 same pricing constraints, and then measure the 18 results of that, and then we can start to decide 19 whether we go up and down from that. 20 Do we go to elimination of rebates or do 21 we allow rebates to stay high for some securities? 22 So, a tiered approach is kind of a second 23 stage, but let's complete the analysis on a market- 24 wide reduction in access fee and let's still let the 25 SEC drive the industry to compete on venue and 0151 1 quote. 2 Again, I just -- I'm very concerned about 3 decimating the competition that has yielded a lot of 4 the results that Richard pointed to. 5 So, I think that's it for me. 6 MR. LUPARELLO: Manisha. 7 MS. KIMMEL: Great. I just wanted to 8 comment on the implementation issues discussed. 9 With respect to passing through costs, I 10 think -- I reached out to several retail 11 broker/dealers, and they think that's a very 12 complicated and -- we're talking about disparate 13 systems, billing systems, and execution and confirm 14 systems that just, today, do not even talk to each 15 other. 16 Given tiering, it's especially difficult 17 to think about how you would do that sort of 18 aggregation over the month and how that whole 19 process of giving back rebates would happen. 20 So, from an implementation perspective, 21 the pilot program, focusing on just one variable, 22 that being access fees, makes a lot of sense. 23 When you look at how fees change on a very 24 regular basis today, it is not a huge implementation 25 burden if we were to do a pilot, and I think the 0152 1 NASDAQ pilot is great in that the data collected was 2 not extra data that had to be collected. 3 So, we have a model for data collection 4 that doesn't impose any new burdens the way a tick 5 size pilot will. 6 To the point on trade-at, I think let's do 7 one variable at a time. Unless the trade-at model 8 was identical to tick size, we're introducing yet 9 more complexity, and I don't know that we need it 10 just yet, and I'm not sure it makes it easier to 11 know, really, what the net effect is. 12 MR. LUPARELLO: Chester. 13 MR. SPATT: I wanted to address further 14 the issue of the pilot design. I think that's 15 really crucial for the empirical results to emerge 16 to be informative, you know, and I think even some 17 of the pilots that the Commission has rolled out 18 over time have had a range of designs, and some of 19 the designs, I think, have worked -- either have or 20 maybe will -- some maybe will work less well than 21 others. 22 I think maybe one of the cases which is 23 the gold standard here was the pilot that was 24 originally designed when Larry was chief economist 25 on the repeal of the up-tick restrictions on short 0153 1 sales. 2 You know, it certainly had some very good 3 features, one of which, by the way, was that it was 4 across markets, and it wasn't an issue about 5 volunteers. 6 You know, the market makers -- they didn't 7 have to volunteer. They weren't asked to volunteer. 8 The operating companies weren't asked to volunteer. 9 You know, I think if one goes the route of 10 looking for volunteers, whether it be at the level 11 of the platform, the operating company, the market 12 maker, that's not a good approach. 13 I would not be inclined to commingle this 14 with an at-trade rule, in part because I'm not very 15 sympathetic to an at-trade rule, but also, in 16 addition, because I think it's important to have a 17 clean pilot, and I think that's a confounding issue. 18 You know, maybe there's a case to have a 19 variation with that. I'm not sure there is a case 20 for that, but certainly I would also do something 21 where one didn't impose the at-trade aspect. 22 The issue of different liquidity buckets - 23 - and I think Kevin pointed out before that what 24 potentially might emerge might be very different in 25 the most liquid stocks and some of the less liquid 0154 1 stocks, and I think that seems like a pretty 2 fundamental point that should be built into the 3 design, and indeed, that suggests kind of a possible 4 aspect of the design that I think might be very 5 useful, which might not be to do everything at the 6 same time. 7 I think, in some other contexts, it's been 8 helpful to roll out these types of natural 9 experiments, to some extent, at different points in 10 time for different buckets. 11 So, the first one might start with the 12 most liquid stocks, then maybe some months later 13 roll it out for middle liquidity stocks, and then 14 roll it out for less liquid stocks, and that would 15 then produce a variety of information, because it 16 would allow basically a range of different types of 17 analyses where you would see what the introduction 18 was, where you'd have a control, the control being 19 the group where you didn't roll things out. 20 So, that would provide, I think, even more 21 information than just a straight static control, and 22 so, I think that would potentially enhance the 23 design. 24 You know, the issue came up about what 25 kinds of things would we measure. I think that's 0155 1 obviously something to sort of think further about, 2 but obviously, you know, measurements associated 3 with what can we measure about the depth but 4 especially what can we measure about the actual 5 effective spreads, what can we measure about -- what 6 do we see about volume, what do we see about 7 volatility. 8 These would seem to be among the kinds of 9 statistics that might be information, and there may 10 well be others, as well, but we should look for 11 measures across a variety of different domains. 12 But I think the broad point I want to just 13 conclude with is just to emphasize that the design - 14 - I do think that the design issues are absolutely 15 critical to getting the most information that we can 16 out of a pilot. 17 MR. LUPARELLO: I'm afraid I've lost track 18 as to who has time priority. 19 Jamil. 20 MR. NAZARALI: I just wanted to add our 21 support to -- if we're thinking about a pilot 22 design, it's really important not to do one-size- 23 fits-all, because if you look at the problems -- 24 like if you look at taker-maker, what symbols are 25 most traded on taker-maker exchanges, it's really 0156 1 the most liquid names that have the thickest queue, 2 right? And they're really constrained by that one- 3 cent minimum price variation, and so, a lot of 4 people trade on their -- want to get queue position 5 two to trade in between the spread, and so, you 6 know, focusing some of the reduction of access fee 7 on those stocks won't have the effect of broadening 8 the overall spreads. 9 And then, you know, as Joe pointed out, 10 for the less liquid names, we want to encourage 11 liquidity, right? So, we may want higher access 12 fees for some of those to see if it really does 13 encourage liquidity. 14 I definitely think we should not have a 15 trade-at provision in there, and the reason for that 16 is, you know, if we're looking at the benefits, 17 there may be some small benefits, but the worst 18 thing about trade-at is that it eliminates 19 competition, right? 20 So, as Joe pointed out, you're going to 21 get rid of 40 percent of the volume and you're going 22 to get rid of choice, and you're going to have three 23 exchange groups that control 99 percent of all 24 volume. 25 When you have three for-profit businesses 0157 1 that control all of the volume, you're going to see 2 increase in fees over time. That won't come out in 3 the pilot. I mean, you only have to look at the 4 market on open auctions to look at what happens when 5 you have reduced competition. You only have to look 6 at -- you know, as Matt pointed out, before 7 competition, the spreads between maker-taker were 8 10-20. What are they now? They're now, you know, 9 2/100ths of a cent except on opening auctions, 10 because there's a monopoly there. 11 And so, I think that if you have that 12 trade-at pilot, you may see some small benefits, but 13 you're not going to see all the costs, which is 14 going to a market where we have less choice, less 15 competition, and over time will result in much 16 higher fees. 17 MR. RATTERMAN: Just real quick, I want to 18 retract my comments, because I kind of like the idea 19 of being part of the monopoly. So, I didn't realize 20 it was going to work out that way. 21 MR. LUPARELLO: That one-third market 22 share is sounding pretty good right now. 23 Eric. And then I think that will be it 24 for the panel unless anybody else has a last 25 comment. 0158 1 Mr. NOLL: If I could briefly respond to 2 Jamil, though I tend to be very sympathetic with his 3 position on trade-at, I would say, though, that you 4 have to keep in mind the difference between venue 5 competition and order competition, right? So, if 6 we're after -- it depends, ultimately, what the goal 7 is and the balancing act between those two things. 8 Fewer venues but a higher order 9 competition may have a net benefit or a net quality 10 for the market, as opposed to just competition 11 between venues and less order competition. 12 So, I think that's a balancing act that 13 you always have to keep in mind as you're going 14 forward with how you want to set this up. 15 The other two points I wanted to make 16 really briefly is -- one is there is nothing 17 mandated, as far as I remember from my days at 18 NASDAQ, that requires any exchange to have a maker- 19 taker program. 20 Most of the exchanges adopted those 21 programs because they were the most effective way to 22 incent liquidity and provide competition. 23 If the Commission itself or trading in the 24 markets more generally were open to other kinds of 25 liquidity ideas on how to incent the provision of 0159 1 liquidity, it's quite possible for any exchange or 2 any venue, for that matter, to introduce a new way 3 to incent liquidity in the marketplace. 4 So, you know, we've talked about maker- 5 taker a lot today, almost as if it's a mandated 6 rule, and I think what the reality is, it is a 7 function in the marketplace that's worked very well 8 for exchanges, but there is nothing inherent in that 9 model that says this is what we have to do. 10 Any exchange could take a -- or any other 11 venue could take a chance and say, look, I'd like to 12 recreate a specialist system, I'd like to do a new 13 market maker system, and try to find out an 14 incentive scheme to incent that kind of liquidity. 15 So, while I'm generally sympathetic for a 16 pilot, I also don't think they're absolutely 17 necessary. 18 I mean, one of the reasons why we've ended 19 up where we have, I think, is -- one is a reluctance 20 on the part of the Commission to consider turning 21 back the clock to looking at time and place 22 advantages for market makers, which were mostly 23 eliminated during Reg NMS, and other kinds of market 24 structures, and an unwillingness of the exchanges to 25 take a chance to introduce those. 0160 1 So, I think, absent, you know, sort of 2 real negativity around maker-taker, real distortion, 3 I'm not sure that forcing the issue on the 4 marketplace is necessarily the right thing, and that 5 goes to my final point, which is there's also, I 6 think, a bit of a presumption that, as we talked 7 about maker-taker, that it's about exchanges 8 competing with one another. 9 I prefer to think of maker-taker as a 10 transparent way to incent liquidity provision. It 11 is a substitution in many ways of what used to be a 12 time and place system for market makers or New York 13 specialists, and it replaced that system as the time 14 went on. 15 So, if you're going to reduce the 16 incentives eliminating the maker-taker program, I 17 think it's incumbent on us to think about, well, are 18 incentives for liquidity provision necessary? 19 I happen to think that they are, and then 20 what should those be? 21 What are the fair, transparent ways to 22 incent liquidity provision in the marketplace, 23 albeit whether it's from a market maker or other 24 market participants, but I think by just looking at 25 it on a one-sided basis and saying we're going to 0161 1 get rid of this because we think that this is a 2 distorted system, I think you have to solve the 3 other side of the problem at the same time and think 4 about what are we going to do to incent that 5 liquidity, particularly in small and mid-cap stocks, 6 to address Kevin's earlier point. 7 MR. LUPARELLO: That's great. This has 8 been a wonderful conversation, and I really want to 9 thank the panelists for their contributions. It's 10 been outstanding. 11 We're going to break for lunch now. The 12 committee members will be shown where to go to get 13 fed, and thanks for this fine conversation and the 14 one that's going to follow this afternoon. 15 Thank you. 16 (Whereupon, at 12:28 p.m., a luncheon 17 recess was taken.) 18 A F T E R N O O N S E S S I O N 19 MR. LUPARELLO: Thank you. Welcome back. 20 We're going to begin the afternoon session 21 with a presentation on the current regulatory model 22 for trading venues and for market data 23 dissemination. 24 Nancy Sanow is going to tee the issue up, 25 and then we're going to turn it over to the 0162 1 panelists, and it's a tall order to have a 2 conversation that followed off the good one this 3 morning, but I suspect this is the group to do it. 4 So, Nancy. 5 MS. BURKE-SANOW: Thank you. 6 Well, welcome back to this afternoon's 7 session of the Equity Market Structure Advisory 8 Committee, and as Steve pointed out, this afternoon 9 we'll focus on the regulatory model for trading 10 venues, particularly with respect to the trading of 11 NMS stocks. 12 Recently, the differences in the way the 13 Commission regulates national securities exchanges 14 and alternative trading systems, or ATSs, and the 15 role that exchanges play in the collection and 16 dissemination of market data have come under greater 17 scrutiny and attention by market participants, and 18 to offer some of the differences between exchanges 19 and ATSs. 20 Pursuant to Section 6 of the Exchange Act, 21 among other things, exchanges must carry out the 22 purposes of the Exchange Act and comply with and 23 enforce compliance by their members and their 24 associated persons with the exchange's own rules, as 25 well as the Exchange Act and the rules and 0163 1 regulations there under. 2 They must prevent fraudulent and 3 manipulative acts and practices, promote just and 4 equitable principles of trade, and protect investors 5 and the public interest. 6 They also must provide for the equitable 7 allocation of reasonable fees, must not permit 8 unfair discrimination, and must not impose any 9 unnecessary or inappropriate burden on competition. 10 In turn, the Commission oversees the 11 exchanges through its authority under the Exchange 12 Act to examine them for compliance with the Exchange 13 Act and rules there under, to take enforcement 14 action against any wrongdoing, to approve or 15 disapprove exchanges' proposed rule changes, and to 16 adopt Commission rules pertaining to exchange 17 regulation. 18 Regulation ATS, adopted in 1998, was 19 designed to provide an alternative regulatory 20 framework for certain emerging automated trading 21 platforms that offered execution services that were 22 comparable to exchanges. 23 Under Regulation ATS and related Exchange 24 Act rule, an alternative trading system is exempt 25 from the statutory definition of exchange provided 0164 1 that it complies with the requirements of Regulation 2 ATS, including that it register as a broker/dealer 3 and not exercise any self-regulatory powers. 4 In addition to registering as a 5 broker/dealer, an ATS must become a member of an 6 SRO, such as FINRA, file Form ATS with the 7 Commission to provide basic information about such 8 matters as its operations, subscribers, and order 9 entry and execution procedures, amend its Form ATS 10 to report any changes to its operations, and 11 maintain records, including an audit trail, of 12 transactions. 13 If an ATS meets a threshold of 5 percent 14 of the average daily share volume in an exchange- 15 listed stock and displays prices to more than one 16 person -- that is, it's not a dark pool ATS -- the 17 ATS must provide its best priced orders for 18 inclusion in the consolidation quotation data that 19 is made widely available to the public and provide 20 broker/dealers with the ability to access its best 21 priced orders and comply with the fair access 22 requirements with respect to its services. 23 The different regulatory regimes in which 24 exchanges and ATSs operate today involve varying 25 obligations and benefits, and while ATSs compete 0165 1 with exchanges in offering trade execution services, 2 ATSs have fewer regulatory obligations. 3 ATSs are not required to conduct market 4 surveillance or discipline their members. ATSs have 5 more flexibility in the operation of their 6 businesses and exchanges, because they are not 7 subject to Section 6 of the Exchange Act and its 8 requirements regarding, among other things, unfair 9 discrimination, barriers on competition, or the 10 equitable allocation of fees. 11 ATSs can modify their business practices 12 more readily than exchanges can, because they are 13 not required to file their rules with the Commission 14 before implementing them. 15 At the same time, ATSs do not receive some 16 of the benefits that flow from being an exchange. 17 For example, exchanges have the ability to make 18 protected quotes under Rule 611 of Regulation NMS, 19 exchanges have limited immunity from private actions 20 when fulfilling their SRO responsibilities, and 21 exchanges and FINRA, as SROs, help shape market 22 structure policy through their participation in 23 joint national market system plans and through 24 coordinated SRO rule filings. 25 In addition, exchanges receive a benefit 0166 1 from the right to participate directly in market 2 data revenues. Pursuant to the 1975 Securities Acts 3 amendments and Regulation NMS, the exchanges and 4 FINRA must act jointly to disseminate consolidated 5 quotation information that reflects the national 6 best bid offer in NMS stocks, as well as 7 consolidated reports of transactions in those 8 securities. Fees charged by the exchanges and FINRA 9 for consolidated market data must be filed with the 10 Commission and must be both fair and reasonable and 11 not unfair discriminatory. Representatives of the 12 securities industry and other constituencies 13 participate in the fee setting and other governance 14 processes of the consolidated market data plans 15 through advisory committees. 16 So, self-regulation produces inherent 17 conflicts between an exchange's commercial interests 18 and its business and its regulatory 19 responsibilities. 20 Given exchanges' dual roles as both a 21 business and a regulator, a potential conflict of 22 interest can exist of an exchange funds its business 23 operations at the expense of regulation. 24 This conflict is heightened when an 25 exchange demutualizes and becomes a for-profit 0167 1 business. The exchanges historically were member- 2 owned and -operated entities. Today, however, all 3 U.S. exchanges are demutualized shareholder-owned 4 entities. 5 Consequently, another exchange 6 constituency has been created to non-member 7 shareholders who may seek to emphasize the 8 exchange's businesses interests over its regulatory 9 obligations. 10 Further, in recent years, the market for 11 execution services traditionally dominated by 12 exchanges has become increasingly competitive both 13 among exchanges and between ATSs and exchanges. 14 This heightened competitive business 15 pressure on exchanges has raised concerns that the 16 tension between exchanges' regulatory duties as SROs 17 and their commercial interests could be exacerbated. 18 In addition, many ATSs are operated by 19 large broker/dealers that also are members of an 20 exchange, and their interests and the exchange's 21 interests may conflict. Thus, an exchange, as an 22 SRO, can be placed in a position of overseeing a 23 competitor. 24 The vigorous competition among exchanges 25 and ATSs also has raised the broader policy concern 0168 1 that regulatory distinctions between exchanges and 2 non-SRO trading venues such as ATSs may no longer be 3 warranted. 4 Some have questioned whether the 5 exchanges' status as SRO provides them with 6 commercial and competitive advantages that remain 7 appropriate in the current market environment. 8 Many exchanges in recent years have turned 9 to FINRA to perform regulatory functions with 10 respect to their members and, to some extent, their 11 markets. 12 Some of these arrangements, namely those 13 approved by the Commission pursuant to Rule 17D2 14 under the Exchange Act, relieve the delegating 15 exchanges of their SRO responsibilities. 16 Other arrangements, known as regulatory 17 services agreements, or RSAs, are, by contrast, 18 private contracts between parties over which one SRO 19 performs regulatory functions as an agent for 20 another SRO and do not relieve the contracting SRO 21 from ultimate responsibility. 22 To the extent that an exchange contracts a 23 portion of its regulatory activities to another SRO, 24 a key justification underlying self-regulation may 25 be less compelling, namely that the proximity of 0169 1 exchanges to the securities markets, and their 2 expertise, make it more efficient and effective for 3 them to be the front-line regulators of their own 4 markets. 5 On the other hand, it may be argued that 6 some of the conflicts faced by exchanges may be 7 mitigated when regulation is performed by an SRO 8 less directly influenced by the business of the 9 exchange. 10 In conclusion, it has been the prevailing 11 view that our Nation's current regulatory structure 12 for trading venues has functioned reasonably well. 13 The Commission last undertook a 14 comprehensive review of the self-regulatory system 15 in 2004, when it issued its Concept Release 16 concerning self-regulation and, at the same time, 17 proposed rules on the fair administration and 18 governance of SROs. 19 Given recent developments in the 20 securities markets, however, it may be appropriate 21 to reevaluate that structure and its ramifications 22 for exchanges, ATSs, and other trading venues. 23 Among the relevant topics that could be 24 considered in that reevaluation are our system of 25 self-regulation generally, including its advantages 0170 1 and drawbacks, possible ways to improve the current 2 system, and when the system as a whole continues to 3 be appropriate today. 4 MR. LUPARELLO: Thank you very much, 5 Nancy. 6 Let me quickly introduce our panel, who 7 will take us deeper into this conversation. 8 Going from my left to right -- I think 9 I've got it right this time -- is John Kerin, CEO 10 and president of the Chicago Stock Exchange. Next 11 is Brett Redfearn, who is the head of market 12 structure strategy at JPMorgan. To his left is 13 Andrew Silverman, managing director and global co- 14 head of electronic trading at Morgan Stanley. And 15 at the end is Tom Wittman, who is executive V.P. and 16 the global head of equities at the NASDAQ Group. 17 So, John, maybe you can lead us off? 18 MR. KERIN: Thank you. Good afternoon, 19 everybody. 20 I'm John Kerin, CEO of the Chicago Stock 21 Exchange. I started with the exchange 27 years ago, 22 in 1988, as a software developer working on the 23 exchange's real time trading systems. 24 During that time, I have witnessed a 25 tremendous amount of change as the U.S. National 0171 1 Market System evolved to its present state. 2 While technology has been the primary 3 driver behind speed and efficiency improvements, it 4 has primarily been new regulations that have driven 5 material market structure change. The combination 6 of Reg ATS, decimal pricing, and Reg NMS, viewed 7 collectively, are directly responsible for our 8 present market structure. 9 CHX believes that meaningful enhancements 10 to market structure that primarily benefit the 11 public investors requires an intellectual honest and 12 candid discussion among market participants and 13 regulators. 14 We believe that the ongoing colloquy 15 between members of the new Equity Market Structure 16 Advisory Committee provides such transparency, and 17 CHS looks forward to many constructive interactions. 18 Regarding exchange SRO status, much has 19 been said recently about the role of SROs in the 20 financial markets. Specifically, protected 21 quotations and regulatory immunity have been cited 22 as no longer necessary in today's markets. 23 Some even assert that SROs enjoy a 24 competitive advantage over other trading centers. I 25 completely disagree with this view and I question 0172 1 the motives of these commentators. 2 While constant improvement is needed for 3 our markets to remain the best in the world, 4 undermining SROs and other fundamental market 5 infrastructure is not the answer. 6 Unlike other entities, SROs perform unique 7 functions of generating capital through listing 8 equities and price discovery for those equities in 9 the secondary market. Furthermore, SROs are 10 required, under the Exchange Act, to, among other 11 things, design rules that prevent fraudulent and 12 manipulative acts and practices, protect investors 13 and public interests, and disallow unfair 14 discrimination between customers, issuers, brokers, 15 and dealers. 16 SROs are the most regulated entities in 17 the industry, and I strongly believe that 18 dismantling this regime will result in a regulatory 19 race to the bottom. I believe that incremental 20 improvements are needed to our market, but the 21 solution is not to attack what works but, rather, to 22 address the various conflicts of interest that have 23 developed as the markets have evolved. 24 Regarding conflicts, we support the 25 creation of this committee and its efforts to 0173 1 address market structure issues. However, focusing 2 on Rule 610, 611, maker-taker, access fees, misses 3 this fundamental issue of conflicts. 4 Conflicts are pervasive throughout the 5 industry. I believe that the good of the investing 6 public should come before the bottom line of the 7 individual firms. 8 We believe that conflicts within SROs have 9 largely been addressed in that all exchanges have 10 adopted member ownership limitation rules that 11 prevent undue influence from members that we 12 regulate, and Rule 19B4 ensures that any initiative 13 that we seek to implement is consistent with the 14 requirements of the act which effectively addresses 15 conflicts between the exchanges and its members. 16 However, we do not believe that enough has 17 been done to address the inherent conflict of 18 interest that arises when a broker, acting as agent 19 for a customer, utilizes customer orders to further 20 their own interests. 21 I believe that many of today's market 22 structure issues would be solved if brokers had to 23 function as fiduciaries when executing orders on 24 behalf of their customers. 25 Market data revenue. We believe that the 0174 1 purpose of market data revenue is to fund the 2 regulatory obligations of SROs and, thus, market 3 data revenue distribution is properly governed by 4 the SROs. 5 We also believe, however, that trading 6 centers are drivers of market data, and thus, more 7 could be done to equitably share market data revenue 8 among those market participants responsible for its 9 creation but within the current CTA UTP structure. 10 We encourage trading centers that are not 11 exchanges to look to FINRA to enhance its revenue- 12 sharing program. CHX shares access market data with 13 its participants pursuant to transparent rules 14 approved by the SEC. 15 Regarding regulation, we believe that 16 exchanges are best suited to regulate their own 17 markets. Every night we run 55 different regulatory 18 reports looking for various rule violations. 19 These reports scan every single order 38 20 times, every single trade 37 times, and looks at 21 windows around the NBBO for when these orders came 22 in or trades were created. 23 When introducing new functionality, our 24 regulatory and compliance departments are involved 25 from project inception and remain involved through 0175 1 the design and development process so that 2 surveillance reports are custom-tailored to our 3 rules and environment and are ready when the 4 business logic is activated. 5 Additionally, when possible, logic is 6 built into our systems that either forces compliance 7 with the rules or makes the activity easier to 8 surveil. In my opinion, a one-size-fits-all 9 approach to surveillance and regulation cannot 10 provide this level of oversight. 11 We do not support amendments to Rule 15B91 12 that would force broker/dealers, including those 13 regulated by CHX, to join FINRA. 14 We believe competition to promote 15 regulatory innovation is good and that it is 16 inappropriate for the Federal Government to allow 17 one business to become a regulatory monopoly. 18 We understand that the cross-market 19 benefits FINRA provides, but once in place, can't 20 give anyone, including CHX, access to all market 21 data necessary to effectively perform cross-market 22 surveillance. 23 In light of this value, it is inexcusable 24 that we, as a group, SROs and the SEC combined, have 25 spent three years and millions of dollars and have 0176 1 managed to only narrow our selection to six 2 technology providers. 3 We need to get serious about delivering 4 this important tool. I believe the SEC needs to 5 hire a capable technology leader and appoint them as 6 project manager. 7 In conclusion, the key to addressing these 8 conflicts and inequities is genuine cooperation and 9 fair competition between market participants with 10 strong guidance and leadership from the SEC. 11 I truly believe that reinforcing the 12 current market structure while addressing fiduciary 13 conflicts and rectifying inconsistencies between 14 regulatory initiatives will best promote and protect 15 the interests of the public investor. CHX stands 16 ready to do its part. 17 Thank you. 18 MR. LUPARELLO: Thank you, John. 19 Brett. 20 MR. REDFEARN: Okay. Thank you. 21 Commissioners, Director Luparello, members 22 of the SEC committee, Equity Market Structure 23 Advisory Committee, thank you very much for the 24 opportunity today to speak to you on the regulatory 25 structure of trading venues. 0177 1 I'm Brett Redfearn. I run market 2 structure strategy for JPMorgan, and in this role, 3 my responsibilities include being a member of the 4 UTP CTA limit up -- CTA SIP advisory committee, the 5 limit up-limit down advisory committee, also on the 6 board of directors of BATS Global Markets, and chair 7 of SIFMA's equity markets and trading committee. 8 A couple of things about JPMorgan. As 9 most of you know, it is a global leader across 10 banking markets and investor services, serving 11 corporations, governments, and institutions in 60 12 countries. 13 Our firm provides strategic advice, raises 14 capital, manages risk, and provides liquidity in 15 markets around the world with a global roster of 16 7,200 clients. 17 We operate a full suite of trading 18 businesses, including cash, derivatives, portfolio 19 trading, and electronic trading, which combined 20 account for about 8 to 9 percent of the total daily 21 volume of U.S. equity markets, or approximately 600 22 million shares a day. 23 I really appreciate the opportunity to 24 speak to you today on this topic, and it might not 25 be one of the most exciting topics in the market 0178 1 structure debate, but it certainly is one of the 2 most important. 3 The current regulatory model and related 4 governance structure is the fundamental underpinning 5 of our marketplace, and the policy decisions made 6 regarding SRO governance are interlinked with most 7 of the other critical market structure issues that 8 we're talking about. 9 Given the limited time today and the fact 10 that this is a very big topic, I'm going to try to 11 limit my comments to one specific issue, with a 12 specific focus on National Market System plans and, 13 in particular, the collection and dissemination of 14 market data, those plans generally known as security 15 information processors, or the SIPs. 16 At the outset, it's important to make 17 clear that our recommendations regarding governance 18 for the SIP plan or NMS plans generally, we believe, 19 applies to all the NMS plans, not just the take 20 plans. 21 So, first of all, as you know, NMS plans 22 are the creation of the '75 amendments to the 23 Securities & Exchange Act. At that time, in 1975, 24 the world was a very different place. We went over 25 some of the changes earlier today. 0179 1 The equity exchanges were not-for-profit, 2 member-owned, and mutualized organizations. The 3 exchanges were not publicly traded. They did not 4 engage in a broad array of the diversified 5 businesses that they engage today. And the original 6 mutualized nature of exchanges ensured a member firm 7 and investor linkage to the plan governance that 8 largely deteriorated in the demutualized world. 9 NMS plans are basically a form of 10 decision-making, a form of governance, and a 11 construct to operate major aspects of our National 12 Market System. In addition to the plans used to 13 govern and operate the SIPs, other NMS plans are 14 also in effect. As you know, we have the limit up- 15 limit down plan, we have the plan for the 16 consolidated audit trail, the tick pilot, and it 17 would appear it's possible there could be more of 18 these plans as we consider other pilots down the 19 road. 20 So, they're used for our fundamental 21 market data infrastructure, soon our underlying 22 regulatory infrastructure, and some of the most 23 significant market structure recommendations that we 24 have on the table right now, including what we have, 25 a limit up-limit down, the tick pilot, and 0180 1 potentially others. 2 The key governance issue with these plans 3 is this, that unlike the boards of exchanges or the 4 boards of something like the DTCC, NMS plan 5 participants or board members are exclusively 6 representatives of the self-regulatory organizations 7 or exchanges in FINRA. 8 As noted today, exchanges are for-profit, 9 publicly traded companies that run businesses that 10 no only compete with broker/dealers but also compete 11 with the very market data products that are offered 12 by the SIPs. 13 Today's NMS plan governance fails to 14 address and mitigate this conflict of interest. 15 NMS plan governance, in our view, should 16 be reevaluated and updated to fit today's business 17 realities and the inherent conflicts of interest of 18 these plans must be addressed and balanced, better 19 aligning interests to reflect a more holistic view 20 of this marketplace. 21 An important part of the solution is to 22 address this governance model and to ensure broader 23 industry representation. 24 At a minimum, NMS plans should include 25 voting representation from broker/dealers and asset 0181 1 managers. In addition, I would argue that the 2 requirement for unanimous approval of any of the 3 major changes can be paralyzing and should be 4 modified. 5 So, speaking specifically for a second 6 about the SIP plans, there's two fundamental 7 conflict of interest that I'd like to address. 8 The first one is that, among current plan 9 participants, there's basic disincentive to invest 10 in the SIPs and to make them competitive products. 11 The more money that is invested in the SIPs, in both 12 capital and operating costs, the less net revenue 13 that's left for revenue sharing among the exchanges. 14 This creates an inherent disincentive to 15 invest. 16 A better SIP is more likely a more 17 expensive SIP. However, a more expensive SIP would 18 take expected revenue directly out of the pockets of 19 the exchange participants that are sitting at the 20 table. 21 This issue, I think, was highlighted in 22 the evaluation of the three-hour trading halt that 23 happened at NASDAQ -- or for the NASDAQ SIP in 24 August of 2013, which resulted from a flaw in the 25 software code of the NASDAQ UTP SIP. 0182 1 Observers have highlighted that this 2 failure was, at least in part, a consequence of a 3 lack of investment in this important part of our 4 market infrastructure, and this issue was not just a 5 NASDAQ problem; this issue was a fundamental problem 6 of the governance model of the SIP as a whole within 7 the UTP plan. 8 Now, lately, the plan participants are, 9 indeed, making greater investments and improvements 10 in the SIPs, driven largely by Chair White's demands 11 for action plans back in September 2013, after the 12 outage. 13 However, these efforts are limited in 14 vision and inadequate to bring the SIP 15 infrastructure up to the standards of the private 16 marketplace that the private marketplace is 17 otherwise addressing. 18 Conflict number two. SRO participants in 19 the equity SIP plans are selling market data 20 products that directly compete with the SIPs. 21 Unlike the SIPs, 100 percent of the revenues from 22 competing proprietary market data products go to the 23 exchanges that are selling the data. 24 These proprietary data products are far 25 superior to the product produced by the SIPs such 0183 1 that broker/dealers, including my firm, must 2 purchase all of these proprietary data feeds from 3 exchanges to provide competitive trading products 4 for our clients. 5 The latency issues associated with the 6 SIPs today are so well known that, for 7 broker/dealers who are providing electronic trading 8 products, using the SIP is considered uncompetitive. 9 In client meeting after client meeting, we 10 regularly have to reiterate, no, we use the direct 11 feeds, we don't use the SIP. 12 The SIP latency issue is the topic of an 13 academic paper that was published a couple of years 14 ago by Ding, Hanna, and Hendershott that concluded 15 that algorithmic trading systems experience high 16 costs if they are not using proprietary data feeds 17 provided by exchanges. 18 In a paper titled "How Slow is the NBBO?" 19 they compare the SIP to proprietary data feeds and 20 conclude that the speed at which investors receive 21 new information is a form of differential 22 information across investors and latency in the 23 public or SIP data is a source of unfairness across 24 investors and reduces transparency to those 25 investors using SIP data. 0184 1 So, the current SIP structure is resulting 2 in unnecessary and hidden costs on investors, and 3 the persistence of this situation is somewhat 4 difficult to understand in light of the Commission's 5 own words in its 2012 order against a major exchange 6 related to violations of Rule 603A. 7 As stated in that order, quote, "The 8 disparities in data transmission that Rule 603A 9 prohibits can have important consequences that risk 10 undermining investor confidence and interfering with 11 the efficiency of markets." 12 At the time of the order, the director of 13 the SEC's Division of Enforcement stated, quote, 14 "Improper early access to market data, even measured 15 in milliseconds, can, in today's markets, be a real 16 and substantial advantage that disproportionately 17 disadvantages retail and long-term investors. 18 "That is why SEC's rules mandate that 19 exchanges give the public fair access to basic 20 market data. Compliance with these rules is 21 especially important given exchanges for profit 22 business interests." 23 So, fixing the SIPs and improving the 24 fundamental market infrastructure in the U.S. equity 25 markets, I don't think can be accomplished without 0185 1 first fixing the underlying governance model behind 2 that. 3 It's simply not in the business interests 4 of all of the participants around the table to do 5 so. 6 Also worth noting, there are some other 7 issues with the consolidated audit trail where we 8 think there's other conflicts of interest that 9 potentially arise there. The SROs will, indeed, at 10 some point, have an opportunity to decide how much 11 of the cost burden of the cap to accept themselves 12 and how much to place in the broader investment 13 community, and with SROs alone having a vote in 14 making the ultimate determination, there is a 15 question about which entities would likely have to 16 bear the bulk of these new sets of costs. 17 So, in light of this, a couple of 18 recommendations: 19 NMS plan governance should be updated and 20 modified. These plans should, at a minimum, include 21 representation from broker/dealers and asset 22 managers with voting rights both to better reflect 23 the holistic view of the market and to help arrive 24 at policies that will best serve all market 25 participants. Unanimous voting decisions should be 0186 1 eliminated. 2 Such governance changes are necessary to 3 ensure a more diversified and inclusive set of views 4 on how these critical market structure plans and 5 related issues should evolve in today's post- 6 demutualized world. 7 A more inclusive set of views will help 8 ensure a better outcome for all investors, one 9 that's focused on quality and resiliency of the SIP 10 product offering and not overly concerned about 11 extracting as much revenue as possible from the 12 SIPs. 13 Such changes would make the governance of 14 the plans consistent with the statutory fair 15 representation requirements governing the SROs 16 themselves. 17 Now, while some may suggest this is 18 unworkable or hard to get done, it's worth 19 considering again that exchange boards always 20 include industry representatives along with exchange 21 officials or the DTCC, as I mentioned earlier, which 22 is an important financial services company providing 23 clearing and settlement services. 24 That board, in addition to FINRA and ICE, 25 includes representation from clearing agencies, 0187 1 broker/dealers, clearing banks, and investment 2 institutions. 3 I'm not aware of anything in the Exchange 4 Act or the applicable rules that clearly prohibits 5 industry members from fully participating in 6 governance of these plans or any other NMS plans 7 with rights equivalent to the exchanges in the 8 administration of the affairs of the plans. 9 So, some suggest that industry 10 participation is available through the advisory 11 committee structure that we have today. However, I 12 would suggest that advisory committee participation 13 is not highly impactful. 14 While advisory committee members are 15 provided an opportunity to air their views, they're 16 given no substantial voice in the actual decision- 17 making of the plans. They're excluded from working 18 groups and other discussions where key roll-up-your- 19 sleeves work is taking place, and in addition, much 20 of the meaningful business and related decision- 21 making of plans occurs in executive sessions from 22 which advisory committee members are excluded. 23 So, when the NMS plans were enacted in the 24 '75 amendments, exchanges were member-owned 25 mutualized organizations. This approach ensured a 0188 1 direct member firm connection to plan governance. 2 Since demutualization and the evolution of 3 exchanges into publicly traded companies, this 4 linkage has deteriorated. 5 So, I'll say this. I know that BATS is 6 going to introduce an amendment to the CTA/UTP plan 7 tomorrow looking at possible governance changes. 8 I'm going out on a limb, but I think it's 9 unlikely that it's going to get a unanimous vote, 10 which is what it would need to change the governance 11 structure there, assuming if it even gets a second. 12 So, it is important that the Commission 13 take action in this area to address this governance 14 issue, and with that, we believe to ensure a 15 healthier outcome for our market data 16 infrastructure, regulatory infrastructure, and 17 mechanisms to address extraordinary volatility. The 18 ultimate objective is to ensure the right governance 19 model is in place to enable a more competitive, more 20 fair, and more resilient market data infrastructure 21 for all investors. 22 Thank you. I look forward to discussing. 23 MR. LUPARELLO: Thank you, Brett. 24 Andrew. 25 MR. SILVERMAN: Good afternoon. 0189 1 I would like to thank the Chair, the 2 Commissioners, and the Trading and Markets staff, to 3 start, for giving me this opportunity. I do find 4 this important and exciting to talk about today. 5 I look forward to our discussion and to 6 presenting Morgan Stanley's views on the important 7 topic of the regulatory structure of equity trading 8 in the United States. 9 Exchanges and ATSs do provide market 10 functionality that have some similarities, but they 11 also have very key differences. 12 These similarities and differences should 13 be weighed very carefully when considering any 14 regulatory changes. 15 Given that Morgan Stanley has been an ATS 16 operator since 1999, I'd like to begin with my 17 remarks in this area. 18 Reg ATS, adopted in '98, served an 19 important purpose in facilitating much needed 20 competition in the trading of securities and 21 automating -- and automating the broker function. 22 Due to rapid advancements in technology 23 that I don't think any of us anticipated at that 24 time, some brokers have taken differing 25 interpretations around what is permissible under Reg 0190 1 ATS, often couched in very low-level technical 2 details of the implementation of their trading 3 infrastructure. 4 It could be said that some brokers, I 5 think, lost sight of their roles as a broker in the 6 marketplace in their eagerness to grow their volumes 7 in dark pools. 8 Morgan Stanley's philosophy around its 9 dark pools has always been to leverage technology to 10 enhance our role as a broker in seeking best 11 execution for our clients. 12 Morgan Stanley has never sought to compete 13 directly with exchanges with regards to overall 14 volume traded in any of its dark pools. 15 This approach contrasts with the approach 16 taken by some of the other dark pools operators 17 under Reg ATS. 18 Among the critical issues left to the 19 interpretation of brokers was whether the dark pools 20 would accept or pursue liquidity providers or market 21 makers in order to provide their dark pools with 22 additional liquidity. 23 If dark pools were to accept providers, my 24 question is what were the permissible rules of 25 engagement around these participants? 0191 1 These questions were left to the operators 2 of broker dark pools to decide for themselves. 3 In some cases, aggressive order handling 4 practices that involve the use of indications of 5 interest, or IOIs, to solicit liquidity were 6 employed without transparency to the end client. 7 This practice was key in allowing some 8 brokers to establish critical mass quickly in their 9 dark pools. 10 At Morgan Stanley, we did not use IOIs to 11 solicit liquidity. In fact, we established rules of 12 engagement that were transparent to our clients and 13 created obligations for our liquidity providers. 14 The second issue I'm raising is the role 15 of liquidity providers in modern markets, which is 16 an issue that is critical to both, in my opinion, 17 ATSs and exchanges, enabling the smooth functioning 18 of our markets. Yet, we still don't have any 19 meaningful regulation that clearly defines the 20 benefits and obligations that apply to the liquidity 21 provider whether on exchange or otherwise. 22 The lack of significant obligation 23 manifests itself in times of market volatility when 24 liquidity providers are needed the most. 25 The current lack of clarity around the 0192 1 liquidity provider has also led to a contentious 2 atmosphere in this marketplace. 3 Given little guidance, today's, I'll say, 4 de facto market maker were left to carve out their 5 own advantages, often in the form of co-location and 6 fast market data feeds, among other things, which we 7 all know soon became a very important profit center 8 for exchanges. 9 From there, the race was on to entice 10 market makers with special order types and pricing. 11 All of this created an air of mystery 12 around these market makers or high-frequency 13 traders. 14 By having meaningful regulation that 15 clearly defines the role of the market maker, 16 whether they are participating on exchange or off, 17 we can take the mystery out of the market maker. 18 In the past, people may not have always 19 liked the specialist model, but at least they knew 20 who he or she were and their rules of engagement, 21 which were subject to regulation. 22 We are absolutely not endorsing a return 23 to the specialist model. Rather, we are pointing at 24 and highlighting the benefit of knowing which market 25 participants are obligated to provide liquidity and 0193 1 under what terms. 2 The third issue I am raising is the status 3 of exchanges today. 4 The exchange and its role has change 5 significantly, with many exchanges becoming for- 6 profit public companies. The development has led to 7 fierce competition among exchanges, which has both 8 positive and negative aspects to it. 9 On the positive side, we now have a very 10 resilient -- and I want to underscore that -- a very 11 resilient equity marketplace that can withstand a 12 major outage of a primary exchange, as we saw on 13 July 8th of this very year. 14 While there are varying opinions regarding 15 the pros and cons of fragmentation of venues and 16 liquidity caused by this competition, it is an 17 undeniable benefit, guys, that fragmentation makes 18 our market more resilient in the face of inevitable 19 technology outages experienced by market 20 participants. 21 A negative side of fierce competition 22 between exchanges is that the drive to increase 23 profits conflicts with the idea of being an SRO and 24 fulfilling the utility function that was originally 25 envisioned by Congress. 0194 1 Specifically, are for-profit exchanges 2 best positioned to drive market structure changes as 3 if they are an unbiased participant acting solely in 4 the public interest? 5 There are several high-profile examples of 6 exchange decisions that illustrate this conflict. 7 I'm going to bring up one. 8 One example involved the rushed rollout of 9 its retail liquidity program within a relatively 10 short period of time after regulatory approval. 11 This could be viewed as a contributing 12 factor to a well-known event that resulted in a 13 crisis for a major broker. 14 A factor to some degree in this example is 15 the competitive drive for increased exchange profits 16 and market share. 17 This, combined with the exchange's 18 limitation on liability really does seem like a 19 recipe for the possibility of questionable decisions 20 being made that may favor exchange profitability at 21 the expense of market stability. 22 So, now that we've addressed the roles of 23 the ATSs, liquidity providers, and exchanges in 24 today's marketplace, let's turn to whether the rules 25 regulating exchanges and ATS should be or can be 0195 1 harmonized. 2 As discussed, exchanges and brokers each 3 serve vital but different roles in the marketplace. 4 Any potential regulation must take into account 5 these differences. 6 One area where rules for both exchanges 7 and ATSs could be harmonized is defining the role of 8 the liquidity provider in a way which accounts for 9 both exchanges and ATSs. They have to be tied 10 together. 11 Another area that should be harmonized is 12 requiring for-profit exchanges to accept appropriate 13 -- appropriate liability. 14 The immunity from liability granted to 15 exchanges by Congress was during a different time, 16 when the exchanges served as public utilities and 17 not the as for profit commercially driven public 18 companies they have become. 19 There are areas where regulation should 20 not be harmonized given the distinct roles -- and I 21 want to highlight, the distinct roles played by 22 brokers and exchanges in the marketplace. 23 I will highlight one area, which is 24 access. 25 A broker having discretion over who may 0196 1 access their pools is vital -- and I want to 2 underscore that -- is vital to creating a desired 3 environment for investors to achieve their trading 4 objectives. 5 The exchanges, on the other hand, are 6 required to provide access to their platforms to all 7 brokers who choose to become members, but it's 8 important to note, which we all know around this 9 room, but I'd like to state it anyway, that this 10 requirement also comes with a benefit, including 11 protected quote status requiring all brokers to send 12 orders to them. 13 So, in closing, the U.S. equity markets 14 are the best functioning markets in the world. Both 15 retail and institutional investors receive arguably 16 the highest execution quality that they have ever 17 received. 18 But our markets are also not perfect, and 19 I believe that clearly defining each market 20 participant's role and responsibility based on the 21 specific function that each participant serves will 22 allow us to improvement our markets going forward. 23 That said, I'd like to thank you again for 24 this opportunity, and I appreciate the Commission's 25 and committee's willingness to tackle these complex 0197 1 and very important issues. 2 Thank you. 3 MR. LUPARELLO: Thank you, Andrew. 4 Tom. 5 MR. WITTMAN: Thank you, Chair White, 6 Commissioners, committee members, for the 7 opportunity to testify today. 8 As my written testimony points out, while 9 the regulatory structure of trading venues is an 10 important topic, I don't think it is part of the 11 long and complex list of significant market 12 structure issues that we face. 13 As such, I respectfully suggest it takes 14 this committee's focus off the ball. 15 We think that the current SRO regulation 16 works. There is little doubt or disagreement that 17 the SEC regulates exchanges and markets effectively 18 or that the exchanges regulate their members 19 effectively. 20 We all know the markets around the world 21 copy and adapt our systems of securities regulation 22 to their markets. Although not perfect, we feel the 23 exchanges under the self-regulatory model have done 24 a good job at protecting investors while also 25 preserving the resources of the SEC. 0198 1 For NASDAQ's part of regulation, it's at 2 the heart of everything we do. 3 Our regulatory program oversees trading on 4 our markets, as well as the initial and continued 5 listing of companies. The regulatory team also 6 works closely with the Commission to gain approval 7 of rule changes and to implement market-improving 8 exchanges through the NMS plans. 9 We invest heavily in technology to 10 automate our regulatory program, which enables our 11 staff to focus on regulatory tasks that people are 12 best at: designing and refining our regulatory 13 systems, investigating potential rule violations, 14 and making critical regulatory judgments. We also 15 invest in our people and hire new expertise as the 16 regulatory landscape changes. 17 We have a longstanding regulatory service 18 agreement with FINRA. The agreement assigns some 19 responsibilities to FINRA that build on its history 20 and expertise while NASDAQ retains the obligation to 21 supervise FINRA's performance. 22 Regardless of whether it's done 23 internationally or by FINRA, the bottom line is that 24 we have the final authority and responsibility to 25 oversee all regulation of our markets. 0199 1 The committee has a real opportunity to 2 recommend beneficial changes to market structure. 3 We know that the U.S. markets can work better. The 4 issues I see as important to address are access fees 5 and novel ways to improve market quality for Main 6 Street investors. 7 You have my full statement, but I wanted 8 to quickly summarize a few key points. 9 Number one, I encourage the committee to 10 recommend that exchanges be allowed to innovate and 11 experiment with access fees and incentives to 12 improve market quality. Pricing is a fundamental 13 market structure issue, and innovation and 14 experimentation in pricing should be encouraged by 15 the Commission. 16 NASDAQ conducted a relatively small-scale 17 experiment reducing access fees and rebates for a 18 handful of securities, but I think there should be 19 more done here with a larger cross-market 20 experiment. I know the previous committee talked 21 about that, and we're committed to doing this. We 22 did run our pilot. We did have some results from 23 that pilot. And I've said publicly that it would 24 have been more productive to have multiple exchanges 25 do that. So, as I heard the previous talk about 0200 1 this, we are committed and willing and able to take 2 a look at this again after we have completed our 3 first pilot. 4 Number two, I think the committee should 5 also consider ways in which we can help issuers of 6 less liquid securities improve their liquidity in 7 the markets. We believe issuers should have the 8 choice to compensate market makers that support 9 their securities, with the goal of better spreads 10 for the investor and enhanced liquidity. 11 Number three, as I mentioned the last time 12 I was before this committee, given the intense price 13 competition, we question the time and resources 14 spent by the Commission analyzing whether exchanges 15 have fully justified proposals reducing their fees. 16 Nearly 40 percent of the executions occur 17 on venues that lack not only pre-trade price 18 discovery but operational and fee transparency. 19 Yet, NASDAQ has encountered difficulty in 20 gaining Commission approval for fee reduction for 21 members that transact the most volume across three 22 of its auction exchanges. 23 I ask again, in what other industry would 24 a company be prohibited from lowering prices for 25 the most valued contributing investors? 0201 1 Exchanges should be free to experiment in 2 other ways to protect the true Main Street 3 investors. Equity exchanges like NASDAQ have 4 attempted limited programs to support retail 5 investor orders. Options exchanges have customer 6 priority, but more can be done and should be done 7 here. 8 We applaud the Commission for creating a 9 committee charged with such an important mandate. 10 We also thank the members of the committee for their 11 time and thoughtful consideration of those issues. 12 We'd like to respectfully note, however, 13 that we believe the committee should take steps to 14 increase its transparency. We also observe that the 15 committee lacks representation from various 16 participants that have a vested interest in market 17 structure as non-financial public companies, 18 individual investors, retail broker/dealers, and 19 exchange with listing operating companies. 20 We think this lack of diversity is a 21 mistake and note that the listing exchanges play a 22 critical and indispensable role in the U.S. economy 23 and market structure. 24 We look forward to working with this 25 committee. Thank you for your invitation and 0202 1 participation today. 2 I also want to make just a couple of other 3 comments based on what I've heard here. 4 Exchange-owned utilities versus publicly- 5 owned for-profit exchanges. I personally work for 6 the Philadelphia Stock Exchange, which is a member- 7 owned organization, and I can tell you that, 8 unequivocally, the decisions we made about market 9 structure and running that exchange, we're better 10 off where we're at now than we were, you know, back 11 in the late '90s. 12 Obligations of market makers, as some 13 point out here, are very important, and also I'd 14 like to point out that exchanges in lit venues, if 15 you take a look at the high volatility times, like 16 August 24th, you saw that the amount of off-exchange 17 trading almost was cut in half as flow moved to the 18 lit venues, which just underscores the importance of 19 the lit venues in the capital formation. 20 Thank you. 21 MR. LUPARELLO: Thank you, Tom, and thank 22 you to the whole panel. 23 I open it up to the committee. 24 Jamil. 25 MR. NAZARALI: I think Brett makes some 0203 1 really important points about SIP and governance. I 2 think, as other folks have pointed out, though, the 3 SIP is now almost secondary as a data source, and 4 you know, every ATS has to subscribe to the direct 5 feeds, every major liquidity center has to subscribe 6 to the direct feeds. 7 As Matt pointed out very accurately, it's 8 not just the direct feeds. There are, you know, 9 cross-connects. There are the boxes that you rent 10 within the data centers. And all of those are ways 11 that the exchanges can extract rents from trading. 12 And there's a real danger that we create a 13 two-tiered market, because these fees have been 14 going up dramatically over the last couple of years. 15 16 I mean, you're seeing tripling, 17 quadrupling, in some cases 10X fees over a short 18 period of time, as technology costs have come down, 19 as virtually every other cost has come down of 20 trading, and so, I think that there is a real danger 21 that, number one, you're going to limit new 22 competition, because the barriers to entry are going 23 up; number two, you really create a two-tiered 24 market access where those that can afford the fast 25 data feeds will pay that, and virtually everyone 0204 1 else can't. 2 And I think it's really, really important 3 that we expand our regulatory oversight over the 4 entire gamut of market data that the exchanges can 5 charge and not just the SIP, because it affects 6 everyone here. 7 MR. LUPARELLO: Joe. 8 MR. RATTERMAN: I'd just confirm Brett's 9 statement that we would also support a broader 10 representation around the NMS plans, not just the 11 SIPs but others, and that we are filing a proposal 12 tomorrow officially with the regularly scheduled SIP 13 quarterly meeting to propose a buy-side and a sell- 14 side voting representation on the SIP operating 15 committee. 16 So, that is true, and we'd certainly like 17 to have support from the other SROs to include that 18 representation. 19 MR. LUPARELLO: Gary. 20 MR. STONE: So, I have a question for the 21 panel. So, Brett and Andy, you guys run ATSs. 22 Are you heavily regulated? Because there 23 is a dichotomy and a sort of perception that ATSs 24 aren't regulated and exchanges are more heavily 25 regulated. 0205 1 MR. REDFEARN: I think our view is that 2 the Reg ATS and the ATS landscape has evolved, and 3 I'm not sure if we've found the right balance of 4 regulation in that space. 5 Our view is that it probably took too long 6 for the industry to get to a point where they made 7 the Form ATSs public. 8 So, we support that Form ATSs should be 9 public documents. 10 And it also probably -- there's a 11 significant disparity around the amount of 12 disclosures that are provided around ATSs to the 13 community. 14 Now, when our clients ask us questions 15 about how does your ATS work and what do you do, we 16 certainly try to answer that in as much detail as 17 possible, but it's safe to say that that information 18 could be provided in greater detail in a more 19 consistent format across the industry. 20 So, you know, I believe that it is an 21 objective of the division to try to put forth some 22 additional rules that would require both that ATSs 23 be public and that a lot more detail is included 24 around order types and matching logic and tiering 25 logic, and you know, a handful of other things, and 0206 1 we would be supportive of a rule along those lines, 2 and we think that that would take that to another 3 level. 4 And I think that we've also been 5 supportive of the FINRA initiatives to have more 6 displayed information about volume that's happening 7 off exchange. 8 So, the work that's been done so far in 9 transparency has been illuminating. I think that 10 the next stage of this, which is the non-ATS volume, 11 will be further illuminating. 12 So, we think that is another step in the 13 right direction. 14 Lastly, I would add that I think that Reg 15 SEI does something that we haven't really seen too 16 much before. When that rule came out, they said, 17 you know, there are some ATSs that are really small 18 and we're going to -- you know, we're not going to 19 subject them to a whole hell of a lot more 20 regulation, but for those that are getting pretty 21 big, like, you know, over 1 percent of notional 22 volume, we think they should also be subject to the 23 provisions that are in Reg SEI, and so, we think 24 that's another positive step in the direction of 25 bringing ATSs, at least bigger ATSs, closer in the 0207 1 range of how exchanges are regulated. 2 So, I don't think we're there yet, but I 3 think we're making some very important steps in the 4 right direction. 5 MR. SILVERMAN: I agree with Gary. I 6 agree with Brett on the transparency aspect. We're 7 all for that. And I think that's the easiest thing 8 that this committee can push and get through. It 9 should be. 10 But with regards to your specific 11 question, are we being regulated, we have best ex 12 obligations that I live and breathe at every single 13 day. That's number one. 14 Number two, if we have a substantial 15 change to our pool, we do have to file that, also, 16 with the SEC and also the ATSR that we have to 17 submit forms on that were reviewed or if there was a 18 denial of access to anybody. 19 So, we are regulated, but it all falls 20 under the guise of best execution. 21 MR. KERIN: Can I just highlight some of 22 the differences between exchanges and ATSs from the 23 regulatory perspective? 24 At exchanges, all are welcome. When they 25 do arrive, they're all treated the same. 0208 1 All the rules internal to the system treat 2 everybody consistently. We do not trade against 3 those. Our rules are public, and before 4 implemented, they are approved by the SEC. 5 So, there is an active back-and-forth 6 between our legal department and the SEC with regard 7 to what's allowable. 8 So, there's significant differences today. 9 MR. REDFEARN: I would just -- I think 10 it's worth noting, however, that at exchanges, you 11 are, indeed, protected markets and that all of us 12 have to route to a quote, regardless. 13 We have to prove to our clients every day 14 that we're offering service and execution, whatever 15 it is that they want to come back to, and as soon as 16 a client is not comfortable with that answer, they 17 check a box, and they can check a box that says I 18 don't want to trade with your ATS, I don't want to 19 trade with any ATS, I don't want to trade with any 20 market makers in your ATS. 21 So, there's a significant amount of choice 22 that is provided in that, but one thing that's very 23 different is it's not a protected market and it's 24 not an exchange where people have to go to 25 regardless. 0209 1 MR. KERIN: I just thought it appropriate 2 to highlight the regulatory differences, and they're 3 very different. 4 MR. LUPARELLO: Rick. 5 MR. KETCHUM: I wanted to follow up, 6 Andrew, on a couple of statements you made with 7 respect to the fact that you thought that one area 8 where there should be consistent regulation was with 9 respect to defining the role and obligations of 10 liquidity providers. 11 I'd be interested in your expanding on 12 that, also just in how you would define liquidity 13 providers. Are you talking about an opt-in 14 registration type liquidity provider? Are you 15 talking about generally firms that in one way or 16 another engage in strategies that are market making 17 strategies? 18 MR. SILVERMAN: All right. So, let's go 19 to the -- how should it be consistent? 20 So, I need to talk -- I don't want to be a 21 commercial, but I need to talk a little bit about 22 Morgan for a moment. Since we went live with our 23 NMS pool in 2008, our liquidity providers -- it was 24 always agency before principal. 25 I mean, that's very important, and we then 0210 1 have a class -- we only have two classes in our pool 2 where we have agency principle and we have liquidity 3 providers. Liquidity providers, even though they're 4 agency to me, do take a back seat to my agency flow. 5 I am looking for natural crossing first 6 before -- and I want to exhaust when I have natural 7 in my pool before the liquidity providers are there. 8 I think that is very important to highlight, and 9 when I think about the days of the New York Stock 10 Exchange, they had a negative obligation, right? 11 They wanted agency -- through the Dodd 12 system -- had to trade prior. 13 So, that should be, in my opinion, 14 consistent from pools and exchanges, and if you did 15 that, then the liquidity providers become what they 16 should be, is providing liquidity, and I think 17 that's very important to this marketplace. 18 Also, you could look at, is a market maker 19 providing liquidity, meaning sitting on the bid or 20 offering, or are they reaching across the market, 21 and what is the percentage of the time they're doing 22 one versus the other, because if they're always 23 reaching across the market, in my opinion, they're 24 not a liquidity provider. So, you do need to define 25 who they are, put rules of engagement, and then, you 0211 1 know, let them bring their liquidity to on- and off- 2 exchange, and I really feel that you can harmonize 3 it, and if we had a subcommittee, I think we would 4 all come to terms relatively quickly on what the 5 rules of engagement should be across exchanges, 6 ATSs, that would then, back to my statement, 7 demystify -- I think that's important -- what a 8 market maker is and how they should act through the 9 -- you know, through the course of the entire day. 10 MR. LUPARELLO: Joe. 11 MR. RATTERMAN: Andy, just to follow on, 12 first of all, thank you very much for your comments. 13 I found a lot of areas here where I feel like they 14 resonated well, so across the board, you know, your 15 comment about Reg ATS was vital, you know, for 16 competition stimulation at the time. I completely 17 agree that that has generated a lot of competition. 18 BATS is a unique entity that came from the 19 Reg ATS world into the exchange world. I've kind of 20 seen both sides of that regulation, and I think it's 21 appropriate, and you know, your comments that 22 fragmentation, while it does have some complexity 23 and downside, has created a resiliency that we've 24 all benefited from, and I don't want to let that go. 25 We have benefited from that fragmentation with 0212 1 outages. 2 And so, really, I just have some questions 3 for some follow-on. 4 With regards to exchanges should accept 5 appropriate liability limits, I don't disagree with 6 that. I think, today, we have a liability -- each 7 exchange has a limitation liability around system 8 outages and, you know, what we would owe to the 9 market for system outages. So, I think that bridge 10 has already been crossed. 11 I'm curious if you have other areas, 12 specifically, that you had in mind where exchanges 13 today have immunity but should accept some level of 14 appropriate liability limits and delineate those, if 15 you have those thoughts. 16 And then, also, on the fair access, I 17 think I heard you say that you'd prefer not to have 18 fair access be pushed on to ATSs, and in general, I 19 agree with that statement, as well, but there is a 20 threshold by which, in today's regulatory world, 21 above 5 percent, you would be pushed into the fair 22 access world. 23 So, I personally believe there should be 24 some limit. Otherwise you become a large part of 25 price formation, and not everybody is entitled to 0213 1 participate, and so, you have to have some kind of 2 threshold. 3 So, I'm curious if you think that's, black 4 and white, shouldn't happen or if you have a 5 different idea for the threshold. 6 MR. SILVERMAN: No, I think where the 7 threshold is for fair access is very fair at 5 8 percent, and I personally would leave that, and you 9 know, with -- regarding, you know, your -- what you 10 first said about exchanges, I just want to highlight 11 and I think it's important to note that I believe 12 that -- and I think Tom could back this up -- we're 13 one of the larger liquidity providers to the 14 exchanges. 15 I don't view a dark pool as my core 16 offering or my identity. I sit there every day and 17 I figure how can I execute an order that's best for 18 the client under best ex, and the reason I bring 19 this up, you know, with regards to what you 20 mentioned in the beginning in the fees, we are a 21 large provider on the exchange, if not the biggest. 22 So, I'm not here to bash an exchange whatsoever, at 23 all. 24 But I also want to just highlight that the 25 fees that the exchanges that are charging us in the 0214 1 non-transactional -- we're talking about port fees, 2 market data fees, and co-lo fees, are going up, and 3 they're going up in the face of competition from 4 exchanges -- I'm sorry -- from dark pools. 5 If we hurt dark pools and we hurt that 6 competition -- and this is not a U.S. issue, I 7 believe this is a global issue -- what's going to 8 happen -- and back to some of the comments I heard 9 before -- if we remove some of the, I would say, 10 competitive pressures on the market, I believe those 11 non-transactional fees will continue to go up and up 12 and up, and then we start going down, I think, a 13 slippery slope of anything more expensive, people 14 consume less. They consume less, it changes for- 15 profit centers. You're going to have to somehow 16 make up that lost revenue. You'll do that in the 17 form of non-transactional fees. And I think we're 18 starting to go down a bit of a spiral, Joe, of where 19 we are headed with regards to liquidity in today's 20 markets. 21 So, even though we are one of the biggest 22 providers -- and I just need to highlight that, 23 because at the end of the day, we're going to have 24 less and less -- we could have less and less 25 liquidity, and where I think we're going to end up, 0215 1 the big are going to get bigger, and I think who 2 it's going to hurt are the smaller market makers, 3 and I believe you do need market making in the 4 system. 5 You do need market making in the system. 6 You're going to hurt some of the smaller market 7 makers, and I do have conversation with them, and 8 I'm starting to feel that and hear that, and some of 9 the smaller broker/dealers can't afford some of 10 these non-transactional costs. 11 So, I just don't think it's -- it's 12 wonderful, because you're pulling out some of the 13 competitive pressures and some of the participants 14 in the market. 15 MR. ANDRESEN: I think that's very well 16 said, and I want to just make a comment to put that 17 in sharp relief, that I'm struck by -- Joe, I don't 18 know if it was you said -- or maybe, Jamil, you said 19 that -- you noted that, from a practical 20 perspective, it sounds like, in 2015, the SIP is 21 viewed as not enough to comply, it's not good 22 enough. 23 I would point out that the SIP fees have 24 gone up in the last year. So, that would be sort of 25 equivalent to like Volkswagen picking now to like 0216 1 dramatically improve their sticker prices, and that 2 shows the degree to which these -- I like your term 3 -- non-transactional fees have become completely 4 decoupled from supply and demand, and from merit. 5 MR. LUPARELLO: Gary. 6 MR. STONE: So, this actually raises a 7 really good point, okay, about the SIP versus direct 8 feeds, and so, there are two issues. 9 The first one is, is that, if I'm a broker 10 and I'm routing using my direct feeds but I am 11 matching versus the SIP, which happens more often 12 than not, what have I done to my customer, and if -- 13 I disagree with Jamil completely on this one. 14 I think the SIP is more relevant in terms 15 of how people are using it, and I don't think as 16 many people do direct feeds as we think that they 17 are. 18 We've seen a lot of surveys that actually 19 say the opposite, that a lot of the dark pools are 20 actually using the SIP to match, whereas the broker 21 is now using direct feeds to route. 22 You know, we always thought that that was 23 inconsistent. You either -- used one feed for your 24 entire system, because it would put your customer at 25 a disadvantage. 0217 1 And so, I guess what I wanted to do is ask 2 the panel -- I mean, first of all, is my impression 3 about the fact that we're using -- we have a double 4 standard -- is that true? And how much are people 5 harmed by the fact that the SIP is so slow in that 6 capacity? 7 MR. REDFEARN: I would just start by 8 saying that, first of all, in our ATS, we use it -- 9 as I mentioned earlier, we don't use the SIP, we use 10 the direct feeds, right? So -- and that's 11 important. 12 It's important because the -- you know, 13 clients want to know that you're using the fastest 14 possible data that you can so that the individuals 15 or the participants that are potentially trading in 16 that pool don't have an advantage over your data, 17 and this is a lot of what the IAX business 18 proposition is about, as well, and trying to figure 19 out, you know, ways of dealing with these different 20 data speeds in the marketplace. 21 I would argue that, when we talk about 22 Form ATSs becoming public and becoming enhanced, I 23 think, similar to what the Commission has done 24 recently, where they asked all of the exchanges to 25 file and say what are the data feeds that you're 0218 1 using in your own market, it's a relevant question, 2 and I would argue that, in that filing, one of the 3 things that should be included is, indeed, the data 4 feeds that are being used. 5 I would take it a step farther, because 6 it's not just what data that you're using; it's how 7 good you are at consolidating that data. 8 So, if somebody takes in direct data 9 feeds, there's a lot of messages that come over 10 these. It is a technological feat to be able to 11 take in those messages, aggregate them, create an 12 NBBO, and do so in single-digit microseconds or, you 13 know, a very small number of microseconds. 14 The SIPs themselves are ranging in the 500 15 microsecond range of doing so just for the SIP data, 16 and so, that's another thing. 17 So, I think, yes, it's a very important 18 thing. I think more disclosures in that area would 19 be helpful, because the more transparency we have, 20 the more that we can see these issues that are 21 potentially out there. 22 MR. WITTMAN: I also had a couple of 23 points. 24 So, the SIP has gotten faster. As it 25 leaves, at least, the NASDAQ core and goes to the 0219 1 SIP, it leaves to go to the SIP the same time it 2 leaves to go to prop. The prop data feeds, though, 3 are a little more inclusive, because they have depth 4 of book, where the SIP does not. 5 So, there's a difference in the kind of 6 data there, and I would argue that if we had a 7 system problem, you could almost rely on the prop 8 data to continue to trade if the SIP was down, 9 because there are so many consumers of that prop 10 data, and going into a trading halt there may be 11 doing more harm than good. 12 So, that's just trying to illustrate the 13 point, and I think there are -- I don't know if -- 14 I've heard someone else from a exchange quote the 15 number of transactions that happen on their exchange 16 that are a result of reading prop data. It's a 17 pretty high number. 18 So, I don't have that data myself. We can 19 get that data and maybe share it, if that's of 20 interest, but there's a big usage of the prop data. 21 MR. REDFEARN: But it is safe to add that 22 there is one major exchange in this country that 23 uses SIP data for all of the away markets, and if 24 the SIP went down, that market would not be able to 25 essentially be Reg NMS-compliant, and so, there are 0220 1 broader issues, and also, a lot of the retail. 2 So, when NASDAQ -- I believe that, right 3 now, even if it was only 10 percent of the 4 transaction volume in the United States is using the 5 SIP, I believe the notion is that, if the SIP was 6 out, the market would have to halt. 7 MR. BROWNE: I have a question, actually. 8 What's the view of exchanges operating 9 core, non-core operations? I saw the outcome of RLP 10 and also Facebook. As exchanges accept higher 11 liability thresholds, should the exchanges have a 12 higher regulatory capital requirement, and if so, is 13 that a barrier to entry, and to what degree, just 14 for panel comment. 15 MR. REDFEARN: When you talk about raising 16 the liability limits, I think that's a good idea, 17 and I think there's general support for that, 18 because where it is now -- I forget the numbers, but 19 you know, half-a-million dollars, one million 20 dollars -- I mean, it's pretty low. That needs to 21 be adjusted significantly up. 22 Then the next concern is that, well, you 23 know, if we had a problem, we wouldn't want to have 24 the risk of going out of business, because that 25 would be bad for the National Market System. 0221 1 So, let's say the number was $25 million. 2 Should there be regulatory capital to cover that? 3 That seems to me to be a reasonable alternative to 4 ensure that there's -- you don't have that broader 5 systemic risk issue or whatever associated with a 6 system error. 7 MR. SILVERMAN: I would say that, as Basel 8 III has put more Tier I capital requirements on the 9 banks, if there -- I would say we should see larger 10 requirements by the exchanges. 11 MR. KERIN: We, at this point, don't 12 accept liability, so we're not directly impacted by 13 that question, but I do want to go back to Gary's 14 comments about market data revenue, just to point 15 out, we give ours away. We're not large enough to 16 sell it. 17 But being a participant in the plan, we 18 recognize that there are conflicts within that and 19 that you've got the effective voting members over 20 these SIP bodies that are running competing 21 businesses, and I agree with Brett's point that they 22 are more incented to invest in their own 23 infrastructure than in that of the public's. 24 I would actually like to see, you know, if 25 exchanges want to sell additional data, to do it 0222 1 through the SIP, so you can almost guarantee, then, 2 that those infrastructures would be sound and robust 3 and very capable of withstanding all sorts of 4 failures. 5 MR. STONE: It's not just the market data. 6 It's the port fees. It's all the connectivity, as 7 well. 8 But I actually have a question for -- and 9 this is going to be really technical, and I 10 apologize, but there are two different standards in 11 the market. 12 One of them is, is I send a quote, I get 13 an ask, and then I send it again, and that's 14 basically -- that back-and-forth is how the SIP 15 basically works when people are submitting things, 16 whereas the other one is I just blow it out there, 17 and if it gets there, great. 18 That's generally the difference between 19 multi-cast and UDP. 20 Does it make sense in your mind that 21 multi-cast is reliable enough that we change the way 22 the SIP works in that way so it becomes faster? 23 MR. KERIN: Just to kind of clarify, the 24 link between the exchange and the SIP is TCP, not 25 UDP, and then the messages that emanate from the 0223 1 exchanges on their private book feeds are multi- 2 cast, which is a form of UDP, and that's inherently 3 faster, but unreliable. 4 So, it's really a tradeoff in terms of 5 speed versus reliability, and I understand the 6 question, and that would certainly get the 7 information to the SIP more quickly, and the SIP 8 could then multi-cast it out. I don't know that 9 that solves all the problems, because there's still 10 going to be a speed differential between somebody 11 sitting right next to the exchange listening to a 12 UDP feed versus having to take the trip through the 13 SIP. 14 You're dealing with kind of the laws of 15 physics at this point. 16 MR. LUPARELLO: Joe. 17 MR. RATTERMAN: I just wanted to kind of 18 circle back on the limitation of liability, you 19 know, the suggestion from Brett and Andrew that 20 maybe the liability number should go up, and I just 21 want to make sure that -- or at least put out there 22 that there's different functions that exchanges do, 23 some of which, I would suggest, none of us want the 24 exchanges to be liable for. 25 You know, when you're interacting in the 0224 1 middle of a trade and processing errors and trade 2 breaks and other regulatory functions of the 3 matching without some kind of systemic error in the 4 background, I think those behaviors and those 5 actions by exchanges, probably, we all want to be 6 immune, so that the exchanges can act quickly and 7 decisively, and so, I want to ask if you were, you 8 know, specifically talking about errors and failures 9 of the systems and liability associated with that, 10 which all the exchanges do have some liability, and 11 you know, those could go up or not, and we could 12 talk about that, but I think there's areas that 13 exchanges perform functions where you probably don't 14 want any liability and immunity is vital to the 15 healthy functioning of what the exchanges do as an 16 intermediary to all that activity. 17 MR. REDFEARN: My view would be that the - 18 - I think Reggie pointed out that there are sort of 19 core exchange services and non-core exchange 20 services, and if something is very fundamental to 21 the basic operations of an exchange in a 22 marketplace, I believe they should be categorized 23 differently than those that are non-core. 24 So, if an exchange comes out and says 25 we're going to offer, you know, algorithmic trading 0225 1 services like you offer or we're going to, you know, 2 create some sort of really cool routing service 3 that, you know, pings all the dark pools or 4 something like that, things that are outside of core 5 exchange services, that at that point in time, yeah, 6 they should -- it should be much more like a normal, 7 I think, broker/dealer regulation, and I'm not sure 8 whether or not the limited liability applies at all. 9 I think that you're right, there are other 10 things that are core to the exchange. I'm not sure 11 if, for system issues, there should be no liability. 12 13 I think that there still should be some 14 liability there, and probably higher than it is 15 today, but those two definitely should be 16 differentiated, clearly, because these new 17 businesses should be, you know, sort of outside of 18 that regime. 19 MR. SILVERMAN: And Joe, one thing that I 20 mentioned earlier was the RLP program. I'm not sure 21 what the increased liability would be, even in a 22 core function, but for me, I don't think I've ever 23 seen -- and maybe I'm wrong -- something approved on 24 the RLP, approved, tested, and go live in such a 25 short period of time. 0226 1 If there was -- put it this way -- a 2 little bit more liability, and we could all figure 3 out what that is at some point in time -- we'll 4 never come to agreement today -- would that have 5 slowed it down by a month to bring that new process 6 in a more methodical manner, because I think we all 7 are in this for where we're going to be in a year, 8 not where are we going to be next month. 9 And if we're going to have to -- if we're 10 going to focus on where we're going to be next 11 month, that's a very bad behavior, and in my 12 opinion, if you up the liability to something that 13 would hurt, that would make people think twice. 14 MR. WITTMAN: Andy, I can say, 15 unequivocally, there is no limit of liability that 16 would change my decision on how I implement software 17 functionality, hands down, no doubt. That's one 18 thing that keeps us up at night. That plays no -- 19 it plays into it zero in implementing software for 20 the United States markets. 21 MR. LUPARELLO: Joe, then Jamil. 22 MR. MECANE: I was going to ask a separate 23 question, but I would agree -- having been in New 24 York at the time of RLP, I don't know that immunity 25 is necessarily a factor in any of those types of 0227 1 rollout decisions. 2 But the question I was going to ask -- 3 John, you mentioned that market data is used to fund 4 regulation, and then, Brett, you mentioned, I think, 5 in your opening statement that consolidated audit 6 trail was coming, and some of the cost of 7 consolidated audit trail needed to be assessed. 8 So, I guess my question is, are we taking 9 the right holistic view around a lot of these, you 10 know, regulatory fees as they evolve, and you know, 11 I'm just worried that, you know, if we deal with 12 everything piecemeal and don't step back and look at 13 the different pieces holistically, that we end up 14 with a little bit more of a convoluted structure. 15 So, I'm just curious how those two things 16 are being coordinated, if at all. 17 MR. REDFEARN: This is a huge topic. When 18 we looked at this topic initially for this panel, 19 it's sort of like when you think about the whole 20 exchanges and SROs and how would you split that and 21 how would it work? It's a very big question. 22 I think there's going to be some very 23 interesting subcommittee meetings on that topic. 24 The reason I focused on the NMS plans is 25 because that's very tangible. That seems to be one 0228 1 that can be addressed, that can be dealt with sooner 2 rather than later, and that's extremely fundamental 3 to so many different things that are on the table 4 today. 5 And so, you know, our view is that, as we 6 work through the bigger sets of questions that are 7 on the table and that have been raised here today, 8 there's no reason, in my mind, why we wouldn't be 9 able to say this is one that is showing critical 10 issues, we can identify them right away, we can make 11 some governance changes, and we can get this process 12 going. 13 I'm not sure if something that is at least 14 that obvious to me needs to wait until we figure out 15 the whole, you know, SRO exchange question on a 16 macro level, but I don't think it's conflicting with 17 the end goal. I think it's just one of the early 18 adopters that we could bring to bear. 19 MR. WITTMAN: Just one more statement 20 about that. I'm having a hard time understanding if 21 we're looking at exchange revenue models or if we're 22 looking at market structure, and how does it change 23 market structure, what can we do to look at it, 24 because I really do want to look at this market 25 structure. 0229 1 You see new exchanges come up and, you 2 know, the liquidity providers and firms can vote 3 with connectivity and actually joining in supporting 4 that new venture. I mean, exchanges -- new 5 exchanges come up, there's more option exchanges 6 being lost, and then, you know, one next month and 7 then one a couple months later. 8 So, I just want to make sure that I 9 understand what the concern is, a revenue model or 10 is it actually market structure? 11 MR. NAZARALI: So, I'll comment on that, 12 but I have a question for you and for John. 13 So, on that, I think it's both, because 14 the revenue model is actually a market structure 15 question, because you know, as we've discussed here, 16 you really need all of those services to really 17 trade in the markets. 18 You need the direct feeds. You need to 19 pay the port fees and the session fees and the 20 cross-connects and everything else, and so, it is a 21 market structure issue. 22 My question to you guys is that, you know, 23 this industry is the only one that I am aware of 24 where a for-profit public company regulates its 25 customers and competitors, and I understand that you 0230 1 guys think that that's important, but what is it 2 that you guys do that someone else couldn't do? 3 All those regulatory functions that you 4 described -- why couldn't some other entity do that? 5 Why does it have to be within your four walls? 6 MR. KERIN: The question is, could 7 somebody else do it better, and I don't think so. 8 We are on-site, on the premises. The market reg 9 department is involved from the idea through the 10 project design, ensuring -- to the writing of the 11 rules, working with the SEC. 12 The regulatory systems, to the extent that 13 they can built into our matching engines are, and 14 when they're not, we try to make it as easy as 15 possible for our downstream regulatory systems to 16 pick them up, and that functionality is ready when 17 the switch is thrown, and it's specific to our 18 systems and our environment. 19 I don't know if that answers your 20 question, but I think we do that better. 21 In terms of conflicts, the regulatory 22 department, in part, reports to me, but they also 23 report directly to our regulatory oversight 24 committee, so as to ensure that there's some 25 separation there. 0231 1 MR. WITTMAN: I think, also, I think we do 2 it better. We've got a lot of experience, and we 3 partner with FINRA to kind of break up some of the 4 work. 5 We're selling a piece of technology 6 worldwide for surveillance. So, it says that, you 7 know, we understand surveillance, we're able to sell 8 it to the broker/dealers and other entities and 9 exchanges around the world. I think we do it very 10 well, and I think we partner with FINRA and have the 11 work split up the right way, and I don't think it's 12 broken. 13 MR. RATTERMAN: I think the simplest 14 answer is the SEC told us that we have to do this. 15 It's a distributed model that happened so many years 16 ago, so that's what's in effect today. 17 So, to your question, could it be done a 18 different way? Surely. It's not done a different 19 way, because by mandate, we're asked to carry out 20 those functions. 21 So, the entire regulatory structure in the 22 U.S. would have to change dramatically to make sure 23 that function was done by somebody. Could it go 24 back to the SEC? Could it go to FINRA? How does -- 25 how do you carry that out with a single body? It 0232 1 could be done. 2 You know, I'll go along with these guys 3 and say that I think that the competition for 4 regulation has created potentially better results 5 than a monopoly regulator, but it's not the fact 6 that it's the only way it could be done, but today 7 it's done that way because we've been told to. 8 MR. LUPARELLO: Rick. 9 MR. KETCHUM: So, I was just going to ask 10 Brett a question, but I probably can't totally 11 resist this. 12 So, let me first say I would agree with a 13 number of things said here. The system is not 14 broken. I think, actually, with respect to the 15 regulation that FINRA provides -- some of our 16 regulatory responsibilities come from statute and 17 relate to ourselves, particularly in relating to our 18 oversight of ATSs and trading away from exchanges. 19 But with respect to the exchange trading, 20 I think there is real value added from the 21 standpoint of the exchange oversight, from the 22 standpoint of allowing -- with requiring that 23 responsibility, ensuring that the exchanges are 24 focused on their regulatory responsibilities at the 25 same time they're looking at market issues and not 0233 1 short-circuiting them, and I think that, even were 2 it not from a statutory standpoint, I think that 3 design works well. 4 I have been involved, like John, in a 5 situation where I did it out of an exchange 6 environment, and I agree with him, it can be done. 7 I'd respectfully disagree with him that it is easy 8 and that there aren't conflicts that put a great 9 deal of pressures in the decision-making. 10 So, I think there's value in sharing that 11 responsibility with FINRA, but you'd expect me to 12 say that. 13 But anyway, that really wasn't why I had 14 my light on. I wanted just to ask, Brett, from your 15 experience -- so, living with a public board and 16 also making nominations with regard to industry 17 members of that board, there are a lot of you, and 18 you have a lot of different business models and a 19 range of other things. 20 I think every SRO involved in a plan would 21 love to find a better environment with respect to 22 the industry. 23 How would you envision this happening? 24 Would you be satisfied with a nominating committee 25 of the plans, nominating a representative on the 0234 1 management side and the broker/dealer side? 2 There would need to be a process in 3 identifying how you include broker/dealers and asset 4 managers in the plans. What would you suggest would 5 be the best way of doing that? 6 MR. REDFEARN: You know, we have a dynamic 7 in play right now with the advisory committees where 8 the actual plan participants on the ones who would 9 normally suggest who might be on the advisory 10 committees. 11 Recently we learned that or we realized 12 that the individual markets, then, could actually 13 also appoint advisors outside of the normal, who are 14 the institutional guys, who are the others, and I 15 think that was successful. 16 But in terms of this process, I'm not 100- 17 percent sure, Rick. I think that -- it would seem 18 to me that the industry would have to find 19 mechanisms by which they would be able to nominate 20 potential representatives independently. It could 21 be the trade associations. 22 It could be -- I mean, you've got, you 23 know, between FIF and STA and SIFMA and others, 24 there are representative groups within the industry 25 that could potentially put forth names, but we would 0235 1 have to come up with something that simply was not 2 representative of, you know, sort of that one 3 constituency in the marketplace, and I think -- 4 again, I think it's just really important, because 5 without a broader array of views, I don't think we 6 get over some of these hurdles that I mentioned 7 earlier. 8 But I think there's some work that needs 9 to be done. 10 What do you think we should do? 11 MR. KETCHUM: I think I'll wait for the 12 subcommittee for that. 13 MR. REDFEARN: I'd be happy to talk to the 14 subcommittee about it later. 15 MR. LUPARELLO: Manisha. 16 MS. KIMMEL: We've got SROs on the panel 17 and around this table. 18 I'm just curious. Do you think the NMS 19 plan process is broken or is the right way to go on 20 a lot of these initiatives? I'd be interested in 21 all the SROs' perspective. 22 MR. WITTMAN: You know, I think we could 23 probably make some enhancements to it. I think 24 maybe what -- you know, what Brett's asking for is a 25 lot more than what I think is probably necessary 0236 1 based on the issues at hand or what we have to get 2 done, and it's probably different with each dynamic, 3 whether it's limit up-limit down and looking at 4 that, whether or not we're going to look at a access 5 fee across all exchanges, or SIP governance. I 6 think that it has all different varying levels of 7 what might need to be done there. 8 But once again, I don't think all these 9 things are very broken. We had a lot of 10 participation from the outside in limit up-limit 11 down. 12 So, the question is, you know, what do we 13 think did not work there, what worked well? There 14 was participation from the outside. 15 MR. KERIN: I agree that the plan is, in 16 general, working. They work well. As you pointed 17 out, for limit up-limit down, we've got the tick 18 test, we've got a group for CAT, albeit CAT is going 19 a little slower than I'd like it to go. But I'm 20 happy with the way it works. 21 MR. RATTERMAN: From our perspective, 22 again, putting our money where our mouth is, we're 23 putting a proposal on the table tomorrow to include 24 industry participation around the SIP operating 25 committee. 0237 1 You know, I think that industry 2 participation like we see in exchange boards, in the 3 DTCC board, is a good model and there's no reason 4 why that shouldn't apply to all NMS plans, and so, 5 that's where we stand. 6 MR. KETCHUM: I think generally the plans 7 have been functional. They've taken a burden away 8 from the Commission, and that's a good thing. 9 I'd love to see ways for the industry 10 participation to work and work efficiently and 11 provide clearer input, although I think, 12 particularly watching a number of the exchanges, 13 there's been great effort to try to feed that input 14 in. 15 So, I don't think there's been an effort 16 in any way to close it out, but finding efficient 17 ways to make that better, I think, is well worth the 18 effort. 19 MS. KIMMEL: And I'd just say, from an 20 implementation perspective, you know, I hear 21 concerns from broker/dealers and vendors about, you 22 know, not being part of the formation of the NMS 23 plan and being able to weigh in on the 24 implementation, sort of the -- you know, the why may 25 be decided at the exchange and SEC level, but the 0238 1 how is really critical to get done as part of 2 formation, and then I think the other big issue is 3 the cost-benefit and why they're excluded from NMS 4 plans. I think there's a lot of lack of 5 understanding there. 6 MR. RATTERMAN: I'd just like to provide 7 one clarification. I agree with Rick that the plans 8 have been working well in general. There's clearly 9 areas where they haven't been. 10 The inclusion of the industry at full 11 voting would have the governance, you know, benefit 12 that is obvious, but I think the other benefit would 13 be the perception that the industry is involved, and 14 so, I think that we're kind of in agreement that the 15 plans haven't completely fallen apart in all regards 16 everywhere. Some of them are working well. But I 17 think the perception is an easy give to include the 18 industry in this. 19 MR. LUPARELLO: With that ringing 20 endorsement of the plan structure, are there any 21 other questions on the SRO topic? 22 Very good. Thanks again to the panelists. 23 That was great. 24 We're going to break for no more than 5 to 25 10 minutes, because I've been told that the FO is 0239 1 entirely being judged by his ability to close this 2 meeting on time. So, we will reconvene at exactly 3 3:10. 4 (Recess.) 5 MR. LUPARELLO: It has occurred to me that 6 we have not informed the moderator of the next panel 7 that we are a little bit ahead of schedule. So, he 8 is on his way down. 9 So, maybe we can flip the order and we can 10 discuss next steps while we're waiting for our 11 moderator to -- Dan Gray, who will lead us in the 12 conversation about the recent market volatility, to 13 arrive from upstairs. 14 From a next steps standpoint, I think 15 clearly what we want to shoot for is, as we've 16 talked about, the formulation of the subcommittees, 17 very quickly, we will do everything we can to 18 facilitate that and to have that happen in the 19 coming days and to hopefully enable the 20 subcommittees to start meeting as early in the next 21 month or so, so that the next time the committee 22 convenes, there will be subcommittee work that could 23 be part of the committee agenda. 24 I think we will also look for a date for 25 the next committee meeting sometime in January. 0240 1 We hear and are very appreciative of the 2 committee's both incredibly busy schedules and 3 complex calendars, and what we will try to do is lay 4 out at least blocks of a few days in each of the 5 coming quarters, so we can start narrowing down the 6 potential dates throughout the year, as opposed to 7 try to live quarter to quarter, which turns out to 8 be a once-every-five-months cycle, which I think is 9 to the dissatisfaction of everyone. 10 Anything else from a next steps standpoint 11 before I start juggling while we wait for our 12 moderator? Anything else on the next steps agenda 13 item? 14 That's great. 15 Obviously, the Commission, taking note of 16 the events of August 24th, is undertaking a fairly 17 careful analysis. 18 That analysis comes out of both the 19 Division of Trading and Markets and DERA and focuses 20 on a variety of issues, one of which, as we've heard 21 about earlier today, involves the intersection of a 22 variety of the market structure pieces, including 23 limit up-limit down, and the intersection with that 24 on ETPs. 25 Mark and his staff have been intimately 0241 1 involved in that from the beginning. 2 That also relates back nicely to requests 3 for comment we did about ETPs in the summer, where 4 we asked a variety of questions, including how the 5 market is structured and how these products react to 6 liquidity stresses and the like. 7 MR. FLANNERY: Thank you, Steve. 8 We have some folks and TM has some folks 9 and they pretty quickly got on top of this data, 10 because in fact, if you're a financial economist, 11 August 24th was a great day. It was really a lot of 12 good data for us to look into all sorts of 13 questions. So, whatever pain there was elsewhere, 14 there's a little bit of compensation. 15 The two, I guess, really, broad features 16 of the performance of the market involve the limit 17 up-limit down halts, of which there were 1,278, 18 compared to an average day of about 40, and the fact 19 that the limit up-limit down halts involved 20 primarily -- 80 percent of them involved ETFs, ETPs. 21 On top of that, we had instances of ETPs, 22 particularly in the first hour, trading 23 substantially away from what everybody thought was 24 their net asset value, and of course, one of the 25 problems was with the fairly substantial number of 0242 1 items, of names not open for trading, you couldn't 2 tell for sure what the net asset value was, but you 3 look at some of these disparities and you're pretty 4 sure there were big differences. 5 So, we have been, first of all, trying to 6 document the extent to which the limit up-limit down 7 -- sorry -- the extent to which this behavior was 8 specific to ETPs, as opposed to corporates, and the 9 answer is that there was an immense increase in 10 transactions volume of illiquid -- relatively 11 illiquid, meaning less than 1,000 shares a day, 12 average daily volume -- there was like a 70-fold 13 increase in the transactions volume for that 14 illiquid kind of ETF in the first 15 minutes on the 15 24th. 16 There was about a 50-time increase for the 17 corporates. 18 So, there was a huge increase in the 19 demand -- the apparent demand for liquidity at that 20 time. At the same time, with respect to the ETPs, 21 there was a noteworthy drawback in the amount of 22 liquidity being provided, and so, we've got a chart 23 -- I don't know if it's in here. 24 There's a chart floating around that shows 25 the week before and on Monday, the 24th, what did 0243 1 the book look like? What did the depth of the book 2 look like for the SPY ETF? And the answer won't 3 surprise you, which is it looked very thick and very 4 deep the week before, and it looked very thin at 5 9:35 on the 24th, and it got somewhat deeper as the 6 day went on, but it never approached the depth of 7 the week before. 8 So, it looks like there is some corporate 9 influence here. It also looks like there's 10 something special about the ETFs in terms of the 11 problems they ran into. 12 It was not just the small ETFs, somewhat 13 surprisingly. 14 I think, early on, some people thought 15 that this was a case where there were thinly traded 16 ETFs, high-frequency traders providing all the 17 liquidity, they couldn't see the underlying prices, 18 and so, they just pulled back. 19 It turns out that the more deeply traded 20 ETFs were as likely to have a limit up-limit down 21 suspension as the less deeply traded ETFs, and the 22 other thing that was interesting was the bigger 23 ETFs, measured by assets under management, were 24 somewhat more likely to have at least one trading 25 halt than the small ones. 0244 1 So, we looked at big and small both in 2 terms of trading volume, where there wasn't much 3 difference across the sizes, and in terms of assets 4 under management. 5 Now, what I can't tell you is whether the 6 large guys had more trading halts or if they were 7 just more likely to have at least one. 8 So, I don't remember or I don't remember 9 knowing whether the multiple trading halts, many of 10 which were on the way up, back on the way up -- 11 whether the multiple trading halts were more likely 12 in the small ETFs than the large ETFs, but the 13 likelihood of there being at least one limit up- 14 limit down trading halt was -- in the larger ETFs -- 15 was about two to three times as big as it was in the 16 smaller ones, which I found sort of surprising. 17 The policy issues that warrant discussion 18 on the basis of this, I suppose, include 19 understanding better what the New York open is 20 about. It does appear that the failure of stocks to 21 open in a timely way in New York interfered with the 22 arbitrage mechanism and the trading of at least some 23 of the ETPs. 24 So, that's one issue, is to understand 25 better what are the good things about that and what 0245 1 are the bad things, and I think we heard earlier 2 today that they've already changed some of their 3 opening rules. 4 The other thing that we're very interested 5 in -- and DERA is involved in sort of a white paper 6 about ETFs, and one of the issues, of course, with 7 trading these things is how close and how they stay 8 -- the prices stay close to the value of the 9 underlying. 10 So, the fact that they traded so far away, 11 in many instances, from the underlying is sort of 12 problematic or worth looking into further, we think. 13 Almost all of that trading away from the 14 underlying was finished by about 10:00 o'clock, 15 maybe 10:30 at the latest. 16 So, it was an early -- early in the day 17 when the markets were disrupted and we didn't have 18 everybody open, but still, the question about why 19 they traded -- why they traded so far away from, in 20 some cases, what appears to be their underlying 21 remains an open question. 22 There's sort of a disclosure question, I 23 suppose, as to whether or not we ought to be asking 24 ETFs to disclose more about potential liquidity 25 problems, and I think I had a fourth one, but I 0246 1 didn't write it down, so I can't remember the last 2 example. 3 But that's sort of a summary of the high 4 points. 5 Steve, do you want to add -- 6 MR. LUPARELLO: I will ask Dan maybe to 7 update a little bit on the level of review we have 8 done and what our plans are to communicate that 9 review. 10 I think one of the things -- and Mark hit 11 it perfectly -- there are certainly -- there's 12 plenty of data to analyze, and coming out of that 13 data, there are areas that we have preliminarily 14 concluded are ripe for both additional study and 15 perhaps policy recommendations. 16 I think getting a reaction from this 17 committee as to whether we've got that list right or 18 wrong, we're over-inclusive or under-inclusive, 19 would be very beneficial to the staff. 20 MR. GRAY: I guess I'd just add a couple 21 of things to what Mark said. 22 One, it's a, fortunately, rare day, but in 23 that respect, a really valuable day in which to try 24 and learn everything you can about how the market 25 operates under stress. 0247 1 I think sort of the first -- you have to 2 highlight when you talk about the day is to 3 recognize there was a lot of selling that Monday 4 morning, even prior to the 9:30 a.m. open, and the 5 selling was relatively insensitive to what the 6 prices were from the previous Friday close. 7 So, even before the regular open hours, 8 regular hours opened at 9:30 on that morning, two of 9 the most active equity products -- the SPY, which 10 tracks the S&P 500, was done a little more than 5 11 percent. The QQQ, which tracks the NASDAQ 100, was 12 down more than 7 percent, and in fact, both of the 13 most active futures products on those indexes had 14 been limit down at their pre-market limit down level 15 of 5 percent for an extended period going into the 16 open, and because of that, in fact, were actually 17 paused for 5 minutes going into the opening auctions 18 on the equity exchanges, and when you got to the 19 opening auctions on the equity exchanges, it 20 confirmed that there was a lot of selling. 21 The majority of particularly the larger 22 cap stocks opened at least 5 percent down from their 23 previous Friday close. 24 After the open, there was additional 25 selling, and both at the open and after the opening, 0248 1 as Mark mentioned, volume across the board was much 2 higher than normal, but particularly for ETFs and 3 ETPs. 4 The day provides a really good opportunity 5 to review some of the mechanisms that have been 6 adopted in recent years to address volatility. 7 One of them, obviously, is limit up-limit 8 down plans. So, we're looking at that very closely. 9 One point on it is corporates were 10 relatively not affected. 11 So, only eight -- for example -- eight out 12 of the S&P 500 stocks experienced a limit up-limit 13 down pause. Only two of the NASDAQ 100 stocks 14 experienced a limit down pause. But as Mark 15 mentioned, a very large number, certainly on a 16 percentage basis, of the halts -- 84 percent of the 17 halts were experienced by ETPs. 18 So, we've looked at that very closely, and 19 when you start digging into the data, you see that 20 the number of halts or the percentage of symbols 21 with a halt were highest in the ETPs that focus on 22 U.S. equities, and in that particular class, 40 23 percent of U.S. equity ETPs experienced a halt, 24 which is obviously a high number. 25 One of the things that leaped out to me, 0249 1 well, that means, even in the most affected ETP 2 class, more than half of them did not experience 3 even a single halt, and in fact, in more than half 4 of the class, the volatility they experienced was in 5 line with the volatility that were experienced 6 across the board among U.S. corporates. 7 So, I think a threshold issue is why, 8 among seemingly similar ETPs, focused on a similar 9 asset class, did some have a very high level of 10 volatility with a lot of halts, some had no halts 11 and sort of in-line volatility? That's a really 12 interesting question. 13 At first glance, it looks somewhat 14 idiosyncratic on what did and did not have a 15 problem, and I would reiterate what Mark said. If 16 you look -- market cap -- if you just look at market 17 cap alone, that doesn't tell you the answer, because 18 at least as a rate of -- percentage of the number of 19 the very large cap or the large cap ETFs versus the 20 small caps, it was fairly similar in terms of which 21 ones traded with a lot of volatility and which of 22 them had limit up-limit down pauses. 23 So, I think that's a threshold issue, sort 24 of is there anything that you could discover looking 25 at the data to try and evaluate, among seemingly 0250 1 similar products, some traded with a lot of 2 volatility, some didn't. 3 But then, of course, once a product did 4 have some volatility, then there are issues, because 5 those products tended to not just have one halt, for 6 example, but they would have multiple halts, in 7 addition. 8 So, that raises a lot of issues in terms 9 of, you know, the structure of the limit up-limit 10 down plan and some of the exchange reopening 11 procedures, processes, etcetera, that are worth 12 looking closely at. 13 I think those are the highlights. 14 MR. LUPARELLO: Jamil and then Joe. 15 MR. NAZARALI: So, a few questions. 16 You know, one thing that undoubtedly 17 contributed to the volatility -- or, I'm sorry, to 18 the trading of ETPs was the fact that a lot of the 19 underlyings didn't open on time, and so, there's not 20 continuous pricing for those. How are you guys 21 thinking about whether or not the SEC should 22 mandate, you know, all stocks have to be open at 23 9:30, because you know, on an automated market, 24 there's no problem opening everything. How are you 25 guys thinking about that? 0251 1 MR. LUPARELLO: We haven't use the phrase 2 "data-driven" yet, so we'll use it here, right? 3 That's a very important part of the analysis. We 4 have to look at the quality of the market in the two 5 different alternatives of market structure for how 6 things open, right? 7 If there's a compelling argument that one 8 way is clearly better than the other, that would 9 inform a policy decision, and so, that analysis is 10 ongoing, but I think preliminary reviews from a 11 variety of different constituencies haven't led to a 12 glaring or easy conclusion one way or the other, at 13 least thus far. Obviously we're pretty early into 14 it. 15 MR. GRAY: One interesting data point to 16 that question is we've looked at -- in terms of 17 seemingly similar products trading differently, the 18 NASDAQ 100, obviously all stocks listed on NASDAQ, 19 all opened at 9:30. The QQQ is a very actively 20 traded product on that index and also traded at a 21 fairly significant discount to what is the 22 underlying, and they were all open on NASDAQ and 23 elsewhere. 24 So, I think this is one of the reasons I 25 was highlighting this question, is sometimes I think 0252 1 explanations can be a little over-broad, so they 2 might apply to some but don't necessarily apply to 3 others, so we're, you know, trying to parse through 4 the data in terms of what explanation might work for 5 different types of problems, is a really important 6 thing to do. 7 MR. LUPARELLO: Joe and then Reggie. 8 MR. MECANE: I'm just curious if you're 9 taking a step extra to look at what extent stop 10 orders might have contributed to the liquidity 11 demand. I know that gets thrown around a lot, I 12 think, at least in the flash crash, that was shown 13 to be a decent portion of it. 14 It might just be interesting in terms of 15 that liquidity demand that I think Mark mentioned, 16 how much of it was active liquidity demand versus 17 passive liquidity demand and maybe whether there's a 18 remedy that addresses that distinction. 19 I know it's hard, because you have to go 20 to the broker to try and get that information, but 21 it's just a question. 22 MR. GRAY: Yes, we're definitely going to 23 look at that. The stats I was just giving you were 24 all readily available with public information, so 25 getting that level of information requires more 0253 1 time, but we have already made significant steps in 2 -- folks in DERA, in particular -- in getting that 3 data from the sources. So, we definitely want to 4 look at that. 5 MR. LUPARELLO: Right. But the remedy 6 there is also a challenge, right? What do you do 7 with that information? Because I feel like, 8 throughout the years, every time there is an event, 9 there is education and warnings about the dangers, 10 benefits and dangers of using stop orders, and then 11 they seem to sort of pop up at the worst possible 12 time. 13 So, the remedy -- the remedy doesn't 14 necessarily make itself easily available. 15 MR. MECANE: I mean, there might be 16 something -- I mean, this is more Jamil's world, but 17 maybe there's something with the industry or with 18 the market makers that are holding a lot of those 19 orders in those times of stress that maybe could be 20 collaboratively discussed. I'm not sure of the 21 answer. 22 MR. LUPARELLO: Reggie. 23 MR. BROWNE: I filed a comment letter. I 24 won't go through the letter at all, but a couple of 25 points to highlight, there's a sense of urgency from 0254 1 the ETF industry to place market structure issues 2 surrounding ETPs to the forefront in every aspect 3 and have it interwoven inside of decision-making 4 when it comes to market structure, and that 5 obviously wasn't the case in the past. 6 Look at 8/24, 40 percent of the dollar 7 volume on the exchanges was ETFs, and so, it's a 8 material impact if the market structure is not 9 harmonized around the behavior of ETFs, ETF 10 participants, and ETF order deliverers. 11 There's a couple of areas that I think 12 it's worth, I guess, highlighting. 13 One, limit up-limit down. ETFs are 14 derivative, and the ability for ETFs to stay tightly 15 wound to its fair value is ability to actually hedge 16 or offset risk, and so, with limit up-limit down, 17 you've got also look at Reg SHO, the ability to sell 18 short, particularly if a stock is down 10 percent 19 and it's halted for successive days. 20 And then clearly erroneous. There is a 21 segment of the ETF liquidity providers, HFT, that I 22 read the comments that there was still uncertainty 23 around clearly erroneous and trades being busted. 24 If something is trading down 30 percent, what's the 25 likelihood of that trade to remain and a domino 0255 1 effect from hedging activity. 2 So, I think the Commission -- this is more 3 of a personal opinion -- that the Commission should 4 broadly cast perspective around clearly erroneous 5 and even adopt a policy around it's never busted but 6 adjusted. 7 There's some disagreement from the retail 8 community about that, but from the HFT, I think 9 there is certainty that they can do hedging activity 10 with certainty. 11 We talked about exchange harmonization 12 around NASDAQ and New York, but also, automation of 13 123D in New York. I was a member of the New York 14 Stock Exchange. I know the professionals there. 15 They take great pride in their work product and what 16 they do. 17 But automating the indications allows 18 arbitragers to predict where stocks may open, and 19 that was not -- it wasn't available for us to do 20 that. 21 There needs to be some education from the 22 order deliverers to broker/dealers, not to 23 platforms. I think the platforms do a great job, 24 but some of the FA's on the platforms adjudicating 25 their responsibility for the customer orders, 0256 1 placing stop orders, stop loss market orders, in 2 those days, was a contributor to some of the 3 imbalances or equilibrium problems around ETF and 4 ETF arbitrage, and that should be tightly looked at, 5 behaviors of the various participants. 6 And then, you know, I think Reg SHO needs 7 to be modernized. You know, there is a big economic 8 cost to spreads if we can't sell short or also if we 9 can't borrow or if there has to be a closeout effect 10 over, you know, a short period of time. 11 The economic loss is actually inside the 12 spreads, and you see those in thinly traded ETFs. I 13 don't call them illiquid. I call them thinly 14 traded, because if you look at the underlying basket 15 and there's a billion dollars of liquidity, in 16 theory there's a billion dollars of opportunity for 17 someone to get exposure to. 18 So, it's really the thinly traded ETFs 19 that need to be looked at. 20 And then I also urge the Commission and 21 the various departments, when you're looking ETFs 22 and the behavior on 8/24, look at them in the 23 various buckets. Look at cash ETFs. Look at fixed 24 income and how they behave. Look at developed 25 markets and emerging markets and how they behaved, 0257 1 and look at commodities and inverse and leveraged. 2 Just don't characterize ETPs or ETFs as 3 one. Break them down in different buckets and 4 understand the behaviors as such. 5 Industry -- I've heard a chorus of 6 comments. There is a strong body of willingness to 7 impart views, thoughts, to help be a solver of 8 market structure around ETFs going forward. 9 Thanks. 10 MR. LUPARELLO: Chester, then Gary, then 11 Rick, then Jamil. 12 Mr. SPATT: So, my comments are closely 13 related to Ricky's, which -- I thought those 14 comments were really terrific. 15 I think as one looks at the situation 16 involving August 24th and especially the ETFs, I 17 think it's important, obviously, to look at the 18 relationship between the details of the composition 19 of the ETFs and especially how Commission -- 20 different Commission rules may have interfaced, and 21 I think here there may well be some issues of 22 unintended consequences, so to speak, of various 23 Commission rules, including perhaps limit up-limit 24 down, and it would seem like that would be an issue 25 that could be sorted out to some extent in the 0258 1 cross-section of ETFs, depending upon what the 2 composition of the different portfolios was and what 3 the nature of the problems were. 4 But you know, I think, also, with respect 5 to Reggie's suggestion about Reg SHO and fails to 6 deliver, similarly, I think that same kind of 7 approach might be applied as one looks cross- 8 sectionally in terms of the composition of these 9 buckets and to what extent there would have been 10 those problems in some of the ones that were 11 problematic versus the ones that weren't 12 problematic. 13 MR. STONE: So, I just have two 14 suggestions. 15 The first one is, as Reggie points out, 16 that ETFs are derivative, and so, I would look at 17 two things. 18 The first one is, is most relevant market 19 center not only for the ETF but also for the 20 underlying stocks in that. 21 If you think about what is the algorithm 22 doing, it's taking in data. Well, if the data 23 starts skewing, market risk things pop in and say I 24 don't know where the hell it is, I'm out, and all of 25 the sudden it starts happening. 0259 1 So, if you can narrow it down that these 2 were isolated to a certain place that was the most 3 relevant market center for that ETF, that tells you 4 that that market center is having problems trying to 5 get the stuff out the door. Similarly, if the 6 underlying is focused on one particular market 7 center, the same thing can occur. 8 So, that's just my first comment. 9 The second one is, is that I think there 10 needs to be some guidance from the Commission on 11 this one, in that market orders themselves, under 12 15c3-5, actually are not really allowed, because you 13 need to know, ultimately, what the exposure is at 14 the time the order is sent, and you know, that data 15 is perfect. 16 That's exactly what you wanted to stop 17 when you put the rule in after the flash crash. You 18 only want to send limit orders, because you don't 19 want things triggering and all of the sudden 20 everything going down to zero. 21 And so, my question is, is at that time, 22 first of all, I don't understand how brokers are 23 still accepting market orders or stop market orders, 24 but more importantly, 15c3-5 was applied to brokers, 25 wasn't applied to exchanges. So, I don't understand 0260 1 how exchanges can actually accept those orders, as 2 well. 3 So, just two things. 4 MR. LUPARELLO: Rick. 5 MR. KETCHUM: I'm pretty sure you're going 6 to cover all this, but just to confirm, so you're 7 going to look particularly on limit up-limit down, 8 particularly in the first five minutes of the day, 9 when it looked at the range of wider spreads on 10 limit up-limit down, look at the couple milliseconds 11 with respect to the price reset after you come out 12 of a limit up-limit down, and the last one, harder, 13 but it would be really interesting, where you can 14 get access to the data, from the standpoint of 15 queued orders, as to if this was pure limits, 16 whether there would have been bounces in trading 17 during the five-minute period that couldn't happen 18 by the nature of how the limit up-limit down works? 19 MR. LUPARELLO: I think those are all 20 great. 21 Jamil and then Joe. 22 MR. NAZARALI: So, Reggie made some great 23 points, and there's one thing that he made that I 24 just wanted to comment on, and that is Reg SHO. 25 As a market maker, Reg SHO substantially 0261 1 impedes our ability to provide liquidity to the 2 market, and particularly with ETFs, where, really, 3 what you're doing is an arbitrage of the ETF and its 4 various components, you could always trade that and 5 have a two-sided quote if you're able to hedge 6 properly, and so, you know, we would urge you to 7 take a look at the data and look at when a stock 8 goes Reg SHO and look at, you know, the ETFs that 9 it's a major component of, because we know that, for 10 us, there's a big impact on our ability to provide 11 liquidity, and I would suspect, for the market as a 12 whole, it impairs the quality of the market and 13 liquidity. 14 MR. LUPARELLO: So, just to be clear, 15 you're talking about the price test after a 10- 16 percent move aspect of SHO, not the rule as a whole. 17 MR. NAZARALI: Yes. And also the ability 18 -- the requirement to close out your position after 19 two days, because when we're in that, we're not 20 providing as much liquidity. 21 MR. RATTERMAN: The points have been made, 22 so I'll keep my comments shorter than I was going 23 to. 24 You know, I think the bottom line is, from 25 August 24th, that we have to open the market on 0262 1 time. That's just the bottom line. 2 You know, I'm not going to comment on the 3 differing market models. You know, I think a 4 competing market model world is great. 5 I would just argue that, if there's going 6 to be a competing market model to the rest of the 7 markets which are electronic, that they should be 8 hired and staffed accordingly so that the markets 9 open on time, and if the market model that's relying 10 on humans, you know, is -- it doesn't have the 11 capacity to execute, then it needs to be enhanced. 12 So, the markets have to open on time. 13 ETFs are, as we have all said, are a 14 derivative of constituents, and if some of those 15 constituents aren't open, it's impossible to make a 16 market in the overlying ETF. So, a vast majority of 17 the problem seems to have been cleared up by 10:00 18 o'clock and happened before 10:00 o'clock, 19 indicative of the vast number of securities, I 20 think, 200-plus of the S&P 500 weren't open 15 21 minutes into the day. That's just -- you know, that 22 can't happen again. 23 So, in terms of recommendations, I think 24 we can look at limit up-limit down in light of 25 August 24th and make sure that our parameters are 0263 1 right for highly volatile days. So, I think that's 2 an awesome opportunity to go back and say were those 3 parameters the right parameters just in general, and 4 to Reggie's request earlier, I think a subcommittee 5 here that talks about ETFs should look very 6 carefully at the safeguards that have been put in 7 the system related to ETFs and how the underlyings 8 in the ETF are linked inextricably and how those 9 should be examined together, and maybe the limit up- 10 limit down construct doesn't work perfectly when you 11 have a security derived from another, and that 12 should be looked at again. 13 So, those are my points. 14 MR. LUPARELLO: Kevin. 15 MR. CRONIN: So, maybe an observation. 16 First, it's probably worth mentioning that 17 ETFs have been functioning pretty well otherwise. 18 We're talking about an isolated event where there 19 was an opening which was, as all of us experienced, 20 highly volatile, and there was a lot of sellers, and 21 there was a lot of question marks about what the 22 right prices were. 23 So, in that environment, it's not atypical 24 or illogical to see there be dislocations as we saw. 25 Obviously, the problem is that the mechanisms that 0264 1 we have in place to deal with it aren't sufficient 2 yet. 3 And some of that is related to markets 4 being better connected. For example, the SPDR we're 5 talking about, if it can be halted down 5 percent 6 limit at CME, is it logical for it to be able to 7 trade down more than that on the open at the 8 exchange? 9 I'm all for opening things, don't get me 10 wrong. I think it's a bad idea to say, just because 11 it's going to go down to a percent we don't like, 12 it's better not to open it. I think it is better to 13 get it open. 14 But I do think what we're talking about 15 here is a mechanism that just needs some refinement. 16 I can say this with my hand over my heart and some 17 level of credibility. 18 One of our ETFs was one of the ones that 19 was mentioned here, was halted on the way down five 20 times; on the way up, it was halted seven times. 21 So, I think we spent a lot of time when we 22 developed limit up-limit down thinking about how to 23 halt it. I don't think we spent nearly enough time 24 on how to reopen it, and so, maybe there's some 25 energy around that that can be helpful. 0265 1 The other thing is, this whole notion of 2 market orders and stop loss orders, I think, take 3 the brunt of the blame here, but I do think that 4 people really need to understand that the use of a 5 market order in that kind of opening can be eye- 6 opening. 7 When you get your report back and you see 8 something down 20 percent -- and let's be clear, as 9 I think I recall, GE opened on time, and it was down 10 20 percent. 11 So, there has to be some realization that 12 market orders and the way that people interact on 13 these kinds of days can have an impact. 14 The other thing I will say, just my last 15 part of this, is we have to be very careful. 9:30 16 is a great time, but it's not a magic time. So, 17 part of what we look for as long-term investors is 18 to make sure that there is a balance between opening 19 it at 9:30 but also being sensible about the prices. 20 Witness my friend in GE that traded down 21 quite substantially and I think, by all accounts, 22 was the wrong price. 23 So, I think we would just articulate a 24 position around being sensible. Opening it in an 25 absolute sense at 9:30 isn't always necessarily the 0266 1 right thing. There is clearly a balance to be 2 struck between the right price and the right time. 3 MR. LUPARELLO: Eric. 4 MR. NOLL: A couple of comments. 5 One, following up on some of the things 6 that Kevin said, remembering that this is 7 derivative, we might be -- we may want to look at 8 this slightly differently than looking at where NAV 9 was and what a discount or premium to it was. 10 On days of market stress, it's axiomatic 11 that things end up with the correlation of one, and 12 products that represent the entire market lead the 13 rest of the prices. 14 So, in this particular case, the Qs, the 15 SPDRs, the other ETFs may have actually been setting 16 what appears to be the fair price and the bad prices 17 were the underlying stocks. 18 So, I think it's important to keep in mind 19 that it was, in fact, a derivative, and the 20 derivative might have been leading the market at 21 that point, as opposed to responding to the prices 22 of the underlying. 23 The other thing, though, I would encourage 24 people to do is look at the iNAV that is published 25 intraday. You know, I remember from my experience 0267 1 of having worked at NASDAQ, wanting to introduce an 2 order type that was tied to the iNAV that was being 3 published and told, no, don't do that, because the 4 iNAV prices are terrible and there's huge variation 5 of quality between providers. 6 So, how important that was or is important 7 intraday for market participants probably ought to 8 be something that we ought to look at, and whether 9 they're published as frequently as they should be 10 and update as often as they should. 11 And then, to Kevin's point, the reopening 12 process of limit up-limit down has been problematic 13 since it's been introduced. 14 So, they have always had thin liquidity in 15 them, and almost every single one shows a cascading 16 stair effect. They either cascade down or cascade 17 back up, and in days of market stress, that's 18 obviously even worse. 19 So, something's wrong in the way the 20 system is designed of having enough liquidity and 21 market participation in that reopening auction 22 process to allow it to open at what would be 23 considered to be the new fair trading price. 24 So, I would, you know, urge the Commission 25 and others to spend a lot of time thinking about 0268 1 what is that new -- that change to that reopening 2 auction. 3 MR. LUPARELLO: And I would say there we 4 have asked and the participants in the limit up- 5 limit down plan have taken on that issue of, are 6 there ways to make the reopen more efficient and try 7 to get away from this idea of sequential halts 8 before the market reaches an equilibrium price. 9 MR. BROWNE: I know that there's a couple 10 of academics exploring the relationship between iNAV 11 and the secondary market price and collars around 12 that. 13 I would just urge that there are -- there 14 has been several instances where ETPs have traded 15 significantly over fair value when you could not 16 arbitrage in the local market, particularly in 17 international securities such as the country of 18 India, the country of Egypt, or any other barriers 19 that ETF -- or Greece, most recently -- where an ETF 20 was the only mechanism for risk transfer, but the 21 underlying securities were not available. 22 So, we look at iNAV and boundaries around 23 that, take that in consideration, particularly in 24 cash, U.S. cash ETFs, where there is a large index 25 weight that's not available, the ETF will price that 0269 1 into its pricing and then price that way. 2 So, this is one data point. A lot of data 3 is coming out of it. I would caution a regulatory 4 approach that is cautious in the outcome, and don't 5 be so quick to overshoot looking for an outcome that 6 is yet tested, and so, I advocate for empirical data 7 to come back and give a reasonable perspective at 8 some point in time. 9 MR. LUPARELLO: On the empirical data 10 point, I would point out that there is a data paper 11 that is currently being finalized by the staff, and 12 we hope to have that out very soon, and we will 13 share that directly with the committee at the time 14 that it's made public, but that's just our first 15 step in terms of the ongoing analysis. 16 Any other comments or questions? 17 Very good. 18 Again, any other thoughts or comments 19 generally or on next steps. 20 Yes, Gary. 21 MR. STONE: I was just wondering if we 22 could talk a little bit about the NYSE almost not 23 being able to conduct their closing auction. 24 So, you know, there's a bunch of different 25 standards in the market as to what actually happens, 0270 1 because we still -- the SROs are working on 2 something, but we still have this time period that, 3 if it does happen, how do you actually close 4 something? 5 So, there's like -- we did a -- TAB did a 6 survey and they found that there was something like 7 four or five different methodologies that people use 8 to close their stocks. 9 My question for the committee is, is that 10 something that we want to try and take up and maybe 11 do it with the Investor Advisory Committee to 12 actually come up with a standard? 13 Because you talk about like, you know, 14 outliers of things happening, maybe the solution is 15 just to fall back on that rather than doing 16 something complicated like a different type of 17 auction, falling back on auctions, which causes 18 major system changes. 19 MR. LUPARELLO: So, I will say that that's 20 a great conversation to have, and I would certainly 21 encourage the committee or a subcommittee to take 22 that up. 23 I will also say that there are some 24 developments, as the listing markets have said, that 25 are in flight around those issues, around the 0271 1 ability to move an auction from one market to 2 another market, and how you actually price in a 3 consistent way when it's too late in the day to 4 actually have a closing auction. 5 So, not to say that there isn't plenty of 6 opportunity to opine on that both before and after 7 the SROs come up with their proposals, but there is 8 a substantial amount of work that started pretty 9 much on July 9th that's in flight. 10 Any other thoughts? 11 MR. RATTERMAN: Maybe just one, to leave a 12 little bit on a positive note. 13 I know that we all agree that, on August 14 24th, that the nature of the security itself caused 15 the securities not to trade, necessarily, the way 16 we'd want them to, and so, we do need to look 17 carefully at ETFs in that regard, but the other 18 thing I don't think I heard anybody say was that, in 19 terms of market volatility and market activity, 20 volumes, etcetera, that was probably one of the 21 biggest days since October of 2008, and other than 22 the ETF, you know, linkage issue, I think the 23 markets performed really, really well, and there 24 were no other, you know, headlines about the markets 25 falling apart on one of the busiest days in the 0272 1 history of all of us. 2 So, a lot of the work that's been done by 3 the Commission to put in place the resiliencies, I 4 think, panned out behind the scenes, and they 5 worked, and so, no one complained about them, but we 6 also didn't hear much. 7 So, I just want to point out that the 8 markets held together without exception and that we 9 can fix it, but let's not lose track of the other 10 things that have worked. 11 COMMISSIONER AGUILAR: Just quick, why my 12 counsel is going around, only because ETFs has been 13 talked a lot, and you don't have the benefits of 14 some questions I posed to the Investor Advisory 15 Committee a couple of weeks ago about the events of 16 August 24th. 17 These are questions, count on greater 18 minds than mine, such as those around this table, to 19 try to work out solutions, and so, I thought you may 20 want it, because it was questions posed to a 21 different committee, and I'm sure you're too busy to 22 keep up with everything that's going on. So, I 23 thought it would be helpful. 24 MR. LUPARELLO: Thank you very much, 25 Commissioner. 0273 1 And with that, I'll entertain a motion to 2 adjourn the meeting. We have multiple motions. Can 3 one of them be converted to a second? 4 (Moved and seconded.) 5 MR. LUPARELLO: All right. With that, all 6 in favor? 7 With that, we're adjourned. 8 Thank you very much, and I hope to see you 9 again in January. 10 (Whereupon, at 3:51 p.m., the meeting was 11 adjourned.) 12 * * * * * 13 14 15 16 17 18 19 20 21 22 23 24 25 0274 1 PROOFREADER'S CERTIFICATE 2 3 In The Matter of: EQUITY MARKET STRUCTURE 4 ADVISORY COMMITTEE 5 File Number: OS-1027 6 Date: October 27, 2015 7 Location: Washington, D.C. 8 9 This is to certify that I, Nicholas 10 Wagner, (the undersigned), do hereby swear and 11 affirm that the attached proceedings before the U.S. 12 Securities and Exchange Commission were held 13 according to the record and that this is the 14 original, complete, true and accurate transcript 15 that has been compared to the reporting or recording 16 accomplished at the hearing. 17 18 _______________________ _______________________ 19 (Proofreader's Name) (Date) 20 21 22 23 24 25