Dec.The Impact of Technological Innovation on Exchanges

AT TODAY’S SENATE BANKING SUBCOMMITTEE ON SECURITIES, INSURANCE AND INVESTMENT HEARING, members discussed the impact of technological innovation and new regulations on exchanges and dark pools with industry participants. 

In his opening remarks, Chairman Jack Reed (D-R.I.) highlighted the “tremendous technological innovation,” and subsequent regulation, that is changing the landscape of U.S. equity markets. He said the adoption of Regulation ATS and Regulation NMS led to the proliferation of new trading platforms and has “put a premium on speed,” giving an advantage to firms that can place orders first and take advantage of minuscule price differentials between the trading venues. 

He also noted the explosive growth of high frequency trading in recent years, and the benefits that it has had on the market and investors. However, he said the increasing use of automation and advanced computing technology has raised questions about the effect that these processes have on the stability, fairness and integrity of U.S. markets. In closing, Reed questioned whether markets are fair and transparent enough, and pondered whether “the rules of the road” need further changes to keep up with the speed of innovation. 

In his brief remarks, Ranking Member Mike Crapo (R-Idaho) noted the increase in market disruptions due to software errors since the Flash Crash of 2010, and stated that U.S. market infrastructure should be able to handle a trading error or a technology failure more effectively. Referencing the Securities and Exchange Commission’s (SEC) October technology roundtable, Crapo expressed interest in “kill switches” and circuit breakers, and said he would monitor the implementation of these safeguards. 

In his opening statement, Joseph Mecane of NYSE Euronext stated that electronic trading has lowered the costs and speed of execution, and improved transparency. He said the decimalization of markets in 2001 sped the trend toward computerized trading and led to decreasing spreads and declining institutional commissions. Mecane noted that the SEC’s Regulation NMS, which established a national best bid or offer (NBBO) into the marketplace, caused exchanges to compete on speed. He said the regulation also led to more activity occurring in dark markets, off of exchanges, and resulted in: 1) lower incentive for market makers to trade less active securities; 2) a negative effect on price discovery; and 3) less incentives for companies to go public.    

Mecane suggested that the overall market structure be simplified to reduce the complexity and fragmentation of the market. He stated that the SEC is best suited to make these structural changes, and that they should continue their work on its “Concept Release on Equity Marker Structure” by proposing additional transparency, fairness, and long-term capital formation changes. He added that additional consideration should be given to: market maker obligations; the Sub-Penny rule; the Order Protection Rule; tick sizes for illiquid securities; and overlap between broker-dealers and exchanges. He noted that the SEC’s CAT proposal is a “vital component to ensuring effective surveillance in a highly fragmented marketplace.” 

Daniel Mathisson of Credit Suisse said the U.S. equity markets are “better than they have ever been and are the envy of the world.” He stated that the adoption of decimalization, Reg. ATS and Reg. NMS have improved equity market quality, efficiency, fairness, but noted that there is still “plenty of room for improvement.” He said the SEC is addressing market issues effectively and Credit Suisse fully supports the agency’s forthcoming market structure reforms, including, the Consolidated Audit Trail (CAT), Limit up/Limit down, circuit breakers, and the creation of the SEC’s Office of Analytics and Research.  

Mathisson told the Committee that while exchanges have transitioned from a non-profit to a for-profit business model, they have retained “quasi-governmental” status as Self-Regulatory Organizations (SROs) which has proven to be “costly to investors, unfair to broker-dealers, and rife with conflict for the exchanges.” Referencing the Facebook initial public offering, he stated that this status leads to a “dangerous situation” in which exchanges have “absolute immunity” from civil liability, allowing them to operate in “reckless manner” because they do not bear the costs of their own failures. Further, he said the “enormous revenues from market data” that exchanges earn are “way out of proportion” with the costs of their self-regulatory responsibilities.  

In closing, he suggested that regulators remove the SRO status of the for-profit exchanges and urged regulators to engage in a comprehensive review and overhaul” of the market data revenue plans. 

Eric Noll of NASDAQ OMX stated that computerized trading has a “proven track record” of delivering benefits to investors and market participants and said that “trading anomalies,” such as the Flash Crash in May 2010, are “isolated incidents” and not “symptoms of deeper market structure concerns.” Noll said exchanges, unlike Alternative Trading Systems (ATSs), have the authority and responsibility to oversee broker-dealers as they interact with the market and have improved compliance by supplying regulators with “vital information about trends and performance” of U.S. capital markets.  He added that exchanges maximize transparency, help price discovery, add liquidity, and tighten spreads.  

In light of recent market failures, Noll said exchanges have reformed their rules for breaking trades, instituted single-stock circuit breakers, updated market-wide circuit breakers, and will implement the Limit-Up/Limit-Down mechanism in February 2013. He added that NASDAQ has developed tools to help broker-dealers manage their obligations under the Market Access Rule, and that it supports the implementation of “Peak Net Notional Exposure levels, or kill switches.” 

On the issue of high frequency trading (HFT), Noll said the practice “generally adds value to the market” according to academic reports, but to alleviate concerns, NASDAQ has developed new alerts and surveillance mechanisms to detect potential “bad actors.” He noted that detected violations have resulted in large fines and expulsion of firms and individuals from the securities industry. He also said charges have been applied to discourage excessive messaging techniques used by high frequency traders. 

In his opening statement, Robert Gasser, CEO and President of the Investment Technology Group (ITG), said Reg. ATS sparked an “intense competition” for liquidity and reduced execution costs, but increased market fragmentation and introduced more complexity. However, he said Reg. ATS, and the resulting changes in investing behavior and market structure, have not damaged price discovery or harmed capital formation.   

In closing, Gasser said that investors have become “disenchanted with equities” and have pulled money out of equity mutual funds since 2008. He recommended implementing the following five initiatives to restore investor confidence: 1) implementation of the SEC’s Consolidated Audit Trail (CAT); 2) application of the “Market Wide Circuit Breakers” and “Limit-Up Limit-Down Plan” to all market centers; 3) imposition of excessive quote traffic costs on market participants; 4) distribution of market data equally to all participants; and 5) monitoring of market-wide risk by a central clearing house that would have connectivity termination authority. 

Question and Answer 

Reed questioned the panelists on the costs of market complexity and the proliferation of dark pools. Gasser responded that complexity creates opacity in the market and said the increase in off-exchange trading is harming price discovery. He added that the “micro-second speed” of HFT is subject to the law of diminishing returns and is a “vast over-achievement” that creates suspicion among investors.  

Noll disagreed with Gasser and said the increase in off-exchange trading is not harming price discovery and touted the important role that ATSs and dark pools play in the marketplace. He also mentioned that the CAT will give the SEC the tools they need to access the market and regulate it more effectively.  

Mathisson disputed the assertions of both Noll and Gasser that off-exchange trading is increasing, noting that there has only been a three percent increase in off-exchange trading since 2007, according to recently released statistics. He said Credit Suisse does not support a speed limit on trading, but does support the implementation of other regulatory safety measure such as the limit-up, limit-down rule and kill switches.  

Mecane said the SEC must engage in a holistic review of the entire market and that issues of complexity and fragmentation cannot be viewed in isolation when determining proper levels of regulation and oversight. He added that there is a need for industry-wide best practices, policies, and procedures.  

Crapo asked Mecane to update the Committee on the industry’s progress implementing kill switches. Mecane said the Depository Trust & Clearing Corporation (DTCC), various SRO’s and the industry are engaging in active dialogue on the subject and they hope to have a framework together in the first quarter of next year.  

Crapo also asked if the SRO title should be removed from exchanges. Mecane encouraged a “holistic review” of the benefits and obligations of an SRO and noted that they have immunity in their regulatory role, but it is not a “blanket immunity.” Noll stated that immunity should be supported as exchanges “provide fair access to all investors under all circumstances,” and serve a valuable function that no other market participant does. Gasser said there must be consequences for a system-wide failure and exchanges must take some responsibility when there is a market failure. 

Sen. Kay Hagan (D-N.C.) asked why adverse selection is occurring in dark pools. Gasser stated that adverse selection can occur in “lit and dark pools,” and said the highest quality execution occurs when institutions interact directly with each other. Noll said there is a need to avoid negative externalities that can arise because dark pools rules are not public and are not required to serve all investors.  

Reed asked if the proliferation of order types has increased complexity too much, and if there should be a standard set of order types for exchanges and alternative markets. Mecane responded that order type evolution is a result of demand and said that if the markets are simplified, there will be less need for exotic order types. He added that the order types of exchanges are publically filed, but any inaccurate disclosures should be addressed.   

Mathisson stated that dark pools are not required to submit their order types for approval, but they do file them with the SEC. He added that complex order types are more likely to fail than simple ones and that there is a blurry line between types provided by exchanges and those of dark pools.  

Noll said order types have evolved for regulatory reasons, and they perform a function electronically that was previously done manually. Gasser added that he is hesitant to prevent further innovation in order type development.  

Crapo asked the panelists to explain quote flickering and its impact on the market. Mathisson replied that quote flickering occurs when a market participant shows a bid or an offer for a very short amount of time and keeps changing it repeatedly. He said quote flickering imposes large technological costs on firms, especially those without expansive technological infrastructures, because the behavior requires servers to process large amounts of information.  

Gasser recommended the implementation of a tax on quote flickering because the practice provides “no benefit,” and added that flickering puts stress on infrastructure and leads to less volume and liquidity in the market. Noll said quote stability is an important goal and that Nasdaq imposes fees for excessive messaging. Mecane agreed that message traffic is a “high cost for the industry” and that some of it arises due to Reg. NMS and the large number of venues available to trade on.  

For testimony and a webcast of the hearing, please click here.