Georgetown University Hosts Event on Financial Markets Quality

University and Financial Times

Markets Quality

September 17, 2015

Topics & Takeaways

  • Department of
    Labor Fiduciary Proposal
    : SEC Commissioner Piwowar warned
    that the current DOL fiduciary proposal would be “incredibly costly” for
    brokers to implement, causing them to raise prices and, in effect, price
    some investors out of the market.  He explained that the SEC tried to
    push back on the DOL proposal but that “unfortunately” the DOL was
    determined to move forward.    
  • SIP
    : Morgan Stanley’s Patel claimed that SROs make
    critical decisions “without the benefit of input from buy- and sell-side”
    participants, which is something she hopes will change going
    forward.  JP Morgan’s Ciment explained that any change to an SRO
    takes resources away from helping clients with execution and also
    increases operational risk. 
  • Cybersecurity:
    Several panelists mentioned participating in SIFMA’s cyber simulation
    exercise, Quantum Dawn 3, that occurred on September 16th
    Cunningham explained that the NYSE invests heavily in cyber protection and
    educates its employees to decrease the risk of a cybersecurity
    breach.  BATS’s Concannon explained that the volume of cyber attacks
    increases drastically on holidays, causing them to increase staff to
    thwart any attacks.  Concannon also noted that to reduce risks to the
    system, the industry shares a lot of information on cyber attacks through
    a DTCC platform. 


Interview with Michael Piwowar, SEC

led by James Angel, Associate Professor of Finance, McDonough School of
Business, Georgetown University

noted that five years after the Dodd Frank Act was enacted into law, the
pre-crisis regulatory structure remains intact and inquired what Piwowar would
prioritize if he could overhaul the regulatory system.  Piwowar responded
that most countries overseas adopt either a single or twin peaks regulatory
model (i.e. they either consolidate their prudential and markets regulator into
a single entity or keep them as two separate entities), however the U.S. has a
“rolling hills” model with several prudential regulators and two markets
regulators, which he claimed “makes absolutely no sense.” 

also noted that the U.S. added to this complexity with Dodd Frank by adding the
Consumer Financial Protection Bureau, the Financial Stability Oversight
Council, and the Office of Financial Research, as well as adding new powers to
existing regulators.  He claimed that if he could overhaul the regulatory
system, he would start over with one prudential regulator, one markets
regulator “and go from there.”  

response to what he would do differently since the August 24th
volatility events, Piwowar explained that the SEC has better access to data to
analyze and understand such volatility events, such as through the Market
Information Data Analytics System (MIDAS).  He noted that the Commission
is testing various hypotheses to understand what caused market volatility,
particularly the dislocations in exchange traded funds (ETF) markets on that
date. He added that since various ETFs are listed on different exchanges, it
offers the SEC a “natural experiment” to understand how the opening mechanism
on exchanges may have contributed to volatility on August 24th.

asked what the SEC is doing in fixed income markets, particularly since there
is expected to be volatility when the Fed decides to raise interest
rates.  Piwowar explained that the SEC is particularly focused on efforts
to enhance transparency for retail investors, such as improving:

  • best execution requirements in bond markets
    (by encouraging the Financial Industry Regulatory Authority (FINRA) and the
    Municipal Securities Rulemaking Board (MSRB) to write rules consistent with one
  • disclosure of markups (even on a principal basis); and
  • pre-trade transparency for retail investors.

response to a question from the audience regarding the complicated U.S.
regulatory structure, Piwowar explained that the self-regulatory agencies (MSRB
and FINRA) as well as state securities regulators add several additional layers
of complexity to the U.S. regulatory system.  He added that while the
Jumpstart Our Business Startups (JOBS) Act endeavors to unlock access to
capital for issuers, federal statute is very prescriptive and hampers new
developments, such as in the crowdfunding space.  Piwowar explained that
the SEC tries to “give comfort” to the states so that they don’t violate
federal rules.

audience member asked whether the FINRA’s Trade Reporting and Compliance Engine
(TRACE) could be simplified for retail investors. Piwowar responded that FINRA
would have to make such changes, but mostly “making people aware of [such
tools] is the biggest problem.”  He added that on the municipal side, the
Electronic Municipal Market Access (EMMA) has “some really cool features,”
which enable users to search for bonds with certain desired features.  

to an audience question regarding the Department of Labor’s (DOL’s)
efforts to overhaul the fiduciary standard for investment brokers, Piwowar
explained that such proposals spillover into the SEC’s jurisdiction since they
regulate brokers.  He cited a RAND study from several years ago, which
concluded that although investors were generally happy with the quality of
investment advice received, they were generally confused about the differences
between investment advisers and broker-dealers.  He warned that the current
DOL proposal would be “incredibly costly” for brokers to implement, causing
them to raise prices and, as a result, some investors would be priced out of
the market.  He cited a similar rule in the UK which had such unintended
consequences, and expressed his concern that the proposed DOL rule would
decrease some investors’ access to investment advice.  Piwowar explained
that the SEC tried to push back on the DOL proposal but that “unfortunately”
the DOL was determined to move forward.     

asked how maker-taker programs impact best execution, Piwowar explained that
such market evolutions stem from regulation, such as the market access
requirements under Regulation National Market System (Reg. NMS).  He
argued that best execution under Reg. NMS has “effectively collapsed,” and
shared that Commissioner Gallagher believes Reg. NMS caused the rise of high
frequency trading (HFT).  Piwowar added that he recently called for a
comprehensive review of Regulation NMS.

Panel on Market Stability in
the Digital Age

on August 24th

agreed that, generally, U.S. equities markets are stable and efficient, but
that volatility events, such as those experienced on August 24th,
demonstrate there are challenges that need to be addressed.  Panelists
recapped the volatility and pricing dislocations that occurred on August 24th
and agreed that the market needs to make targeted improvements,
particularly to ETF trading and the market opening process and closing auction
to enhance investor confidence in the price discovery process. 

Brooks, Vice President, Head of U.S. Equity Trading, T. Rowe Price, claimed
that markets cannot handle the order traffic, which engenders disruption. He
explained his belief that while limit up limit down rules were a “great idea,”
doubling it would be “terrible.”  Chris Concannon (BATS) recapped the
events of August 24th but claimed that the industry has not examined
what went well that day, such as how well the infrastructure performed despite
being inundated with message traffic.  He also agreed that there were
several lessons learned, particularly with regard to ETFs, limit up/limit down,
and different nonstandard halts in auctions, which he claimed destabilized
market makers. 

Patel (Morgan Stanley) agreed that markets have generally been stable and
several activities on August 24th went right, such as circuit

Cunningham noted that changes have largely worked and that August 24th
was the “first time we saw limit up/limit down under pressure.”  She
agreed with the need to improve the ETF space, but argued that auctions “ought
not be the same.”  Cunningham explained that the exchange “prioritize[d]
price discovery over speed” in re-opening on August 24th, so that
once the exchange was back online, the closing process was successful. 
Concannon countered by reiterating the importance for exchanges to “get in
early” to facilitate price discovery. Brooks suggested that the industry look
to automation to improve the opening process. 

Points of Failure

agreed that a big problem for markets is not addressing single points of
failure, including securities information processor (SIP) outages, open and
closing processes for primary markets, and central counterparties (CCPs). 

recalled that after the Nasdaq SIP outage in 2013, SEC Chair White asked the
market to address single points of failure, which still has not materialized.
Brooks noted that business continuity exercises help the markets plan for
failures in advance, and expressed the need for redundancies of key
infrastructure, including the opening process and closing auction since they
are so critical for price discovery.

explained that the NYSE is developing and improving their backup systems to
facilitate the price discovery process, and highlighted the NYSE’s closing
“cross plan,” which communicates to customers what to do if an exchange is down
during a closing auction.  Concannon explained that they are backing up
the NYSE and Nasdaq, but claimed that the industry often is not willing to
connect to backups (particularly since BATS’s backup is located in Chicago),
and recognized that it is very difficult to ask the industry to redirect trades
in certain circumstances. 

NMS, Exchange Connectivity and Fragmentation

highlighted that a benefit of Reg. NMS is that market participants can halt
routing trades to a certain venue that is having issues, and noted that
fragmentation benefited the market on August 24th, since market
participants could re-route while certain exchanges were offline. 


assured the audience that the NYSE invests heavily in cyber protection and
educates its employees to decrease the risk of a cybersecurity breach. 
Concannon echoed her comments and explained that the volume of cyber attacks
increases drastically on holidays, causing them to increase staff to thwart any
attacks.  Concannon also explained that to reduce risks to the system, the
industry shares a lot of information on cyber attacks through a DTCC platform.
Several panelists mentioned participating in SIFMA’s cyber simulation exercise,
Quantum Dawn 3, that occurred on September 16th.

Frequency Trading (HFT)

response to the moderator’s question regarding the role of HFT in market
volatility, Daniel Ciment explained that flash crashes can be caused by several
factors, not just HFT.  He also noted that it is difficult to define HFT,
and that regulators should endeavor to examine whether market manipulation is
taking place, rather than regulating a specific firm or type of trader. 

Making in Stressed Markets

noted that after a flash crash or bout of market volatility, often market
participants point to liquidity providers for pulling out of the market. 
However, she explained that the costs are too high for market makers to try to
hold up a falling market, and that no rational actor would go insolvent trying
to do so.  

Question and Answer

An audience member inquired whether buy- or
sell-side participants were able to vote in the decision to update the SIP’s
software on July 8th, which resulted in a market disruption. 
Cunningham maintained that the exchange engages in a lot of dialogue with
regulators and the industry to prepare for implications of technology and
software changes. 

claimed that SROs make critical decisions “without the benefit of input from
buy- and sell-side” participants; a situation she hopes will change going
forward.  Ciment explained that any change to an SRO takes resources away
from helping clients with execution, and also increases operational risk. 
Brooks suggested a “time out” to examine whether the existing connections are
in the best interest of clients.

response to another question regarding whether a single point of failure also
constitutes a “single point of profit,” Cunningham maintained that there are
alternatives in the market, which are important for price discovery because
they aggregate liquidity at the end of the trading day. Concannon urged the
industry to review monopolies, and claimed that there are several “accepted
monopolies” in the U.S. equities market, including utilities and SIPs. 
Concannon explained that BATS is trying to bring the buy and sell side to the
table, but said he expects their proposal to be voted down. He concluded that
the industry needs to increase transparency with SIPs. 

participant inquired whether the most ominous cybersecurity threats stem from
internal players. Cunningham explained that the exchange takes a risk-based
approach to cybersecurity, prioritizing which assets to protect the most. 
Concannon explained that the interconnection of the exchange’s networks to its
clients is very well protected, because “it would only take [infiltrating] one
access point to blow up the whole system.”

asked whether portfolio and index trackers (including ETFs) depend on
integration, Cunningham explained that the exchange recently hired an external
consultant to review the market structure for ETFs, and claimed that the
primary issue is how to increase liquidity in products and induce market makers
to make markets for such products. Concannon also suggested the industry review
limit up/limit down, and suggested that the industry develop a market
specifically designed for ETFs.

audience member requested panelists to comment on the time delays between
exchanges and SIPs.  Ciment stated that investors can decide whether they
wish to use exchanges that seek to limit latency arbitrage.  Brooks argued
that it is “not good” to allow some investors to get better information before
others, and called on the industry to address such that.  He also claimed
dark pools should no longer get a “free pass” to trade “in the closet” since
they are no longer executing large transactions. 


Panel on Empirical Evidence on Market Quality

Krista Schwartz, Professor, University of

presented empirical research on the divergence between bonds and notes,
illustrating that market frictions affect bonds and notes differently and
individual security characteristics explain cheap/richness. She also suggested
several factors that possibly explain the decline in Treasury market liquidity,
principally: 1) regulatory restrictions on the repo market; 2) rise of
e-trading; and 3) reliance on HFTs as market makers.  She concluded that
the Treasury market may be more susceptible to future shocks as a result of
this development.

Larry Harris, Professor, University of
Southern California

presented his paper on Transaction Costs, Trade Throughs, and Riskless
Principal Trading in Corporate Bond Markets.  He recommended two policy
changes to improve the corporate bond market structure: 1) increase pre-trade
transparency for retail investors, and 2) institute trade throughs for

Charles Jones, Professor, Columbia University

presented his research on pilot programs, principally the tick size
pilot.  He cautioned that the pilot should be carefully designed and
implemented to avoid spillover effects from the control stocks to non-pilot
stocks.  He also shared his predictions for the pilot’s results, such
that: 1) small cap liquidity will “always be lousy regardless of market
structure,” due to the lack of information about small firms; 2) tick size and
trade-at will have “zero effect” on institutional trading costs in these
stocks; and 3) trade-at could have potential benefits for liquidity for large

Greg Berman, Ernst & Young (formerly SEC)

explained that defining financial market “quality” is elusive and there is no
perfect information on what constitutes market quality.  He also
acknowledged the novelty of Schwartz’s research on spreads changing between
bonds and notes, which he said could have material market impacts in the

Erik Sirri, Professor, Babson College

commented that equities and bonds have different regulatory treatment, and
information asymmetries and latency arbitrage has existed since the
1800s.  He reflected on Schwartz’s research, which illustrates how
liquidity concerns impact price; and he claimed this raises concerns about
whether liquidity dislocations are priced into the net asset value (NAV) of
mutual funds.

Interview with Adena Friedman,
President, Nasdaq

shared that Nasdaq has changed dramatically over the past ten years to keep
pace with financial innovation, and since then has expanded beyond cash
equities to options and futures, as well as a broader index and financial
technology service provider.  She explained that these changes have
predominantly been driven by regulation and technology, including increased
automation and the need for speed, as well as connectivity between

asked how the issuance and capital raising process is changing, Friedman
maintained that the “human elements” of capital raising, such as instilling
trust in the investment community, is “much the same,” but explained that the
listing and trading processes are very different.

explained why market microstructure is so important, claiming that it is a
“fundamental” component of the exchange’s value proposition to ensure investors
have access to liquidity to facilitate market efficiency. She added that most
investors decide whether to invest in a stock by determining whether they could
exit with minimal impact on the selling price. 

shared what he thought is working well with market structure, as well as how
markets can improve.  Successes include the “incredible” amount of
capacity systems can manage, the level of connectivity between exchanges,
narrow spreads, and the rise of e-brokerages which allow easy self-directed
investment.  The problems she highlighted include: 1) stocks not opening
at 9:30 am which creates uncertainty and price dislocations; 2) pockets where
demand cannot soak up supply; 3) market makers cannot be expected to “catch a
falling knife;” and 4) the fact that there was not a limit up/limit down on
stocks that did not open early on August 24th

asked about the lessons learned from August 24th, Friedman claimed
the exchange would learn from that event and focus on ETFs going forward and
explained that market structure needs to catch up to recognize the role of ETFs
in the markets. 

issuers’ key concerns before deciding to list, Friedman claimed their major
area of concern is “short termism,” which she believes is a “fundamental flaw”
in equities markets.  She elaborated that shareholder activism is a key
concern for issuers, which she believes should be “monitored at least,” as well
as shorting strategies, which she claimed should be disclosed, “just as
long-interests are disclosed”.

shared her views on the progress of Nasdaq’s Private Market, which she
explained was part of the exchange’s reaction to the JOBS Act.  Friedman
claimed Private Market allows companies to stay private longer, for example by
issuing equity to employees.  Private Market provides two key services: an
equity management tool and liquidity management solution and its performance
has “exceeded […] expectations,” she claimed. 

explained Nasdaq’s role in the block chain proof of concept, claiming that she
believes block chain can help cut down on settlement cycles in the
future.  Although she shared that there is a lot of momentum trying to
make it a reality, she admitted there is a “huge” regulatory component to using
block chain in public markets, and that block chain is “really complex.” She
noted it would have significant impacts across the ecosystem, including at
CCPs, central securities depositories (CSDs), etc., so it “will take time” to
see the pilot become a reality. 

the rise of robo-investment, Friedman stated “clearly there’s demand” for such
services.  While she finds the rise of e-investment services
“fascinating,” she maintained that she is a “huge believer” in the human
component of investment advice, and believes electronic and human investment
advisory services will find become balanced.  

Panel on Disruptive Innovation in Market Structure

Frank Hatheway, Chief Economist, Nasdaq

opened by explaining that recent volatility events, such as August 24th,
mean that the “market functioned as designed, not necessarily as
intended.”  He claimed in the long run, there would have to be changes to
address the underlying problems in market structure.  He explained
Nasdaq’s role in block chain, claiming they were “discovering” how it works by
testing it. 

then commented on the increase in regulation, claiming that Nasdaq implemented
limit up/limit down in the Nordic states in three months, which he argued is
“not possible” in the U.S. due to regulation. 

Cynthia Meyn, Executive Vice President, Operations, PIMCO

provided an update on the major operational changes on the horizon for PIMCO,
such as decreasing the settlement timing to T+2.  She claimed collateral
is becoming a new asset class because of the infrastructure required to move
collateral, and conveyed that the largest source of failures is daily
margining, because many buy-side entities do not have the infrastructure to
meet daily margin calls.

claimed that in the credit default space, only the top 50 names trade on a
daily basis, despite there being over 80,000 symbols.  As such, she argued
it is difficult to gather liquidity and that she sees technology emerging to
stream pricing cyclicals.

Kashif Riaz, Managing Director, BlackRock

claimed that the proliferation of different fund types impacts the investment
universe, and that new fund vehicles constitute a new asset class (such as
passive investment vehicles).  On the decline of the traditional dealer
market, Riaz explained that dealer leverage has declined “for good
reasons”.  He shared his observation that, given how big global credit
markets have become, there may emerge some alternatives to traditional bond and
equity trading, such as through all-to-all networks, where he said a lot of
entrepreneurial activity is taking place. 

also mentioned that process enhancements to bring about latent liquidity would
be “exciting” industry advancements.  In addition, Riaz shared that at the
most liquid end of credit markets, market participants are attempting to
homogenize assets to facilitate two-way trading.  Riaz concluded that
liquidity risk, while always an important element of investment risk, is of
“growing importance” given the decline in secondary market trading of Treasuries.

response to the Federal Reserve’s (Fed’s) announcement that it will maintain
interest rate levels, Riaz explained that the “broad market expectation” was
that the Fed will raise interest rates gradually, so he did not expect there to
be severe market corrections on the back of the Fed announcement. 

R. Cromwell Coulson, President and Chief
Executive Officer, OTC Markets Group Inc.

claimed retail investors get “terrible” best execution standards and mentioned
that assuming risk is inherent in financial markets, claiming “we spend too
much time” saying fair markets mean risk-free. 

response to the Fed’s announcement that it will maintain interest rates,
Coulson explained that the Fed’s decision to “sit on its hands” is not a good
thing for the brokerage industry, which looks at aggregate transaction
activity.  Coulson claimed that it is difficult for market makers to
“build clout” on un-displayed liquidity platforms.  He also argued that
increasing liquidity and developing a best execution standard for retail
investors would be worthwhile. 

argued that the U.S. regulatory system “doesn’t work” because of state
securities regulations.  He argued that Congress and the SEC should strip
states of those authorities, and he claimed that once regulation catches up,
the advancements made in the trading space will transfer to the capital raising
space.  He also argued that increased regulation is becoming a barrier to
entry, and conveyed that smaller companies need lighter regulation to foster

Robert Gasser, Chief Executive Officer
(2006-2015), ITG

claimed that the “future lies” in innovating in other asset classes and shared
that there is “building momentum” to make changes to fixed income markets.
However, he cautioned that many new ideas face resistance from the buy side and
will “take time.” 

claimed that the exchange-traded model could work for bond markets that have
some degree of homogeneity; however, he cautioned that such efforts should not
“limit the creativity of investors.”  He also explained that there remains
a lot of Dodd Frank rulemaking to come, and that it will be “concerning” to see
how many securities are to be “forced on exchange.”  He cautioned that
over-regulation may take away from creative and more “interesting” parts of the
derivatives industry. 

claimed shareholder activism is a new asset class, and it often results in
expensive, “brutal,” fights which can be “devastating” to a company. 
While he admitted not all activism is bad, he claimed sometimes it can be

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