AT TODAY’S SENATE BANKING SUBCOMMITTEE HEARING, members discussed the evolution of computerized trading, recent technical glitches, and reform efforts with industry experts. The hearing comes in the wake of a series of damaging technical and software glitches over the past two years including the “flash crash” in May of 2010 and the recent Knight Capital incident.
In his opening remarks, Chairman Jack Reed (D-R.I.) addressed the advantages and disadvantages of computerized trading, including the benefits for small investors, but highlighted the recent string of computer glitches and their costly effect on investor confidence, market volatility and initial public offerings. He said that although US capital markets are the most “resilient, transparent and liquid markets in the world,” regulators have been unable to keep up with the rapid evolution of computerized trading, opening the door for risky and manipulative trading strategies and systemic failure. Reed also questioned whether the advent of computerized trading has shifted the markets’ focus from long-term capital formation and if exchanges still have control of their trading systems. In closing, Reed advocated for clearer “rules of the road” for high frequency and algorithmic trades.
Ranking Member Mike Crapo (R-Idaho) echoed Reed’s statement concerning the advantages of computerized trading and acknowledged its faults. He said half of all American households participate in the capital markets and the “health and competitiveness of these markets has a direct effect on the broader economy,” as part of a larger point that the impact of computerized trading does not just affect large institutional traders. Crapo closed by noting that while technological improvements have led to greater efficiency in the capital markets, there have been “too many technological failures” since the Flash Crash of 2010.
Also of note, both Reed and Crapo said that the Securities, Insurance and Investment Subcommittee and the Full Committee will be conducting more hearings on computerized and algorithmic trading.
In his opening statement, David Lauer, a Market Structure and High Frequency Trading (HFT) Consultant for Better Markets Inc., said the technological revolution that is sweeping Wall Street has had advantages and disadvantages for the equity markets, but rules of the road must be established to protect the equity market. Citing recent statistics, he said HFT is now accounting for 50-70 percent of equity market volume daily, a “dramatic rise” in marketplace fragmentation and a 24 percent increase in market volatility – as measured by the standard deviation of the price of stocks – in the last decade. Additionally, Lauer noted the correlation between the rise of HFT and the decrease in initial public offerings (IPOs), diminished investor confidence, and the “exodus” of retail investors from the stock market.
Lauer also expressed concern that the new electronic marketplace has “several structural inefficiencies.” “This should not be construed to say that all HFT is bad, but there are two important points to make: first, the structural inefficiencies present in the market have created a massive misallocation of resources into technology that provides no social benefit, and structural deficiencies in market structure have allowed for nefarious or accidental actions to disrupt the market,” he said. In closing, Lauer identified several areas regulators should explore as they address the rise in computerized trading, including unified trading rules, unique identifiers for trading desks and the elimination of pay-for-order flow practices.
In his testimony, Larry Tabb, CEO of the TABB Group, outlined the advantages and disadvantages of computerized trading, noting several of the issues that Lauer expanded on. Tabb also highlighted the effect of computer trading failures on investor confidence and market volatility. However, he said that the current structure of the US equity market still has demonstrable benefits for every kind of investor, from the small individual investor to the technologically sophisticated institutional investors. Additionally, Tabb noted that investor confidence will return to our markets when two major things happen – US equity market performance increases and new market structure regulations take effect, especially reforms that reduce market fragmentation.
Tabb also discussed several changes to fortify the markets, including circuit breakers, a ban on trade breaks, kill switches and enhanced direct-access rules, but told members that regulators do not have the adequate tools to identify and limit manipulative or abusive investing strategies. As Congress seeks regulatory and policy reforms to protect investors, he said lawmakers should take care not to do any harm to the markets, which Tabb defined as “doing anything radical.” He suggested Congress address the following areas: market fragmentation, the broker/ATS solicitation process, better Minimum Price Variations management, and greater transparency of order types and routing mechanisms.
In his opening statement, Chris Concannon, Executive Vice President of Virtu Financial, said despite an “unprecedented” number of claims that computerized trading has made US equity markets “horribly broken, unfair and dangerous,” the claims are “short on facts and long on press coverage.” While Concannon acknowledged that the US equity market is “overly fragmented and unnecessarily complex,” due in part to HFT and other computerized trading strategies, he said the market is still “the most dynamic and efficient market in the world… envied by nations and financial centers around the globe.”
Despite his spirited defense of computerized trading, Concannon identified three areas that lawmakers should focus on as they look for ways to reduce the frequency and impact of technical glitches, including: 1) the choice of a single market structure for all listed companies; 2) the market’s failure to enhance market maker obligations; and 3) the industry’s current risk management standards including the implementation of specialized “kill switches” that provide exchanges with a systemic shut-off of a firm if it exceeds prescribed or pre-set trading limits, and “drop copies,” which provide a real-time copy of a firm’s trading activity.
Andrew Brooks, Vice President and Head of U.S. Equity Trading for T. Rowe Price Associates Inc., echoed previous concerns with the rise of computerized trading, noting his clients’ “growing distrust of the casino-like environment” that computerized trading has fostered. Specifically, Brooks expressed concern with the following: new order routing practices, including the maker-taker model, payment for order flow and the internalization of orders; current co-location practices which have led to market-data arbitrage; unregulated HFT and its effects on market integrity; the effect of a dramatic rise in market data on Regulation NMS; and the destabilizing effect of new HFT strategies. Brooks said recent regulatory actions, including the Consolidated Audit Trail, Large Trader ID, and limit up/down initiatives, are all improvements to market integrity, but more must be done to protect the markets and investors.
Question and Answer
Reed asked the panelists if trading has become “too fast” and if there are ways to “slow trading down.” Lauer said the issue of speed is a “critical one” in today’s marketplace, but trying to slow things down is difficult due to the complexity of today’s algorithmic trading methods. He said that the industry has already found the “limit to speed’s effectiveness,” but implementing a minimum quote life is a good first step towards curbing the “obsession” with speed. Lauer added that more creativity and pilot programs are needed to address this issue. Brooks said his clients are telling him that the “marginal return for investors is negative” with each increase in speed. He also questioned the obsession with being faster and who benefits from the speed, but did not offer any concrete ways to slow trading down.
Concannon echoed the sentiment that speed is one of the “more difficult issues to address,” because if it is decided that speed must be regulated, it raises the question of “what speed should the industry move at.” However, Concannon defended the pursuit of speed, noting that faster trading systems have reduced market frictions. Tabb agreed with several of the points made by the other panelists, adding his concern that managing speed regulations would be “extremely difficult.”
Reed asked the panel to expand on two issues that each panelist commented on in their written statement: market fragmentation and market making obligations. All of the panelists agreed that fragmentation is a serious issue that leads to market arbitrage, but none were able to offer tangible recommendations to fix the issue. In regard to market making obligations, Concannon said, in the past, market makers had “strict obligations, but exceptional benefits,” including exclusive rights to the market. However, he said the industry made a decision that the benefits enjoyed by market makers were unfair and converted to an “all-to-all” model, which has light market making obligations, but improved liquidity. Concannon added that market makers today provide “great top-layer liquidity,” but must offer better depth of liquidity. Tabb and Lauer both agreed that market making obligations should be “the cornerstone of any reform effort” to the computerized trading industry.
Reed asked Tabb to comment on the proliferation of dark pools and whether a unified set of rules should be applied. Tabb said the “lit exchanges” would like to create a more equal playing field with dark pools, but added that linking dark pools with lit exchanges could introduce more systemic risk to the system by inadvertently allowing for a cascade effect. He added that “one market structure does not fit all,” but acknowledged that it is a complicated issue that he does not have a solution for. Additionally, Concannon and Brooks said that adding more structure to dark pools would remove protections for buy-side firms and could “dampen innovation.”
Reed also asked the panelists to comment on whether new regulations are needed for for-profit exchanges. Brooks said it is “frustrating” when exchanges have a for-profit motive and are interested in growing volume because “investors are interested in growing liquidity not volume.” However, he said that for-profit exchanges are viable, but the industry needs some guidance because there is a level of unfairness in today’s markets that “is the worst I [Brooks] have ever seen.” Concannon and Tabb discussed issues with proprietary feeds and co-location, but indicated that both problems are not major concerns. Lauer disagreed with Tabb and Concannon about co-location, noting that “no other regulated industry allows access to information to be sold for the benefit of an institution that can act before another institution…co-location reeks of non-public information.”
Additionally, Reed asked the panelists if there are ways to manipulate commodity markets, referring to recent events in the petroleum market. Lauer said “the answer is simply, yes.” He added that the current speed of trading systems make manipulating markets easier, like the practice of “quote stuffing.” Tabb agreed, but said investors with large long positions are engaging in more manipulative practices because they have more on the line and more capital than smaller players.
Crapo asked Concannon if his organization has a system in place to prevent an erroneous event. Concannon said his firm has several systems in place, which his firm refers to as “filters,” that can trigger a lockdown of the trading system if a trade exceeds preset limits. He said fail-safe systems, like the one his firm uses, have been in existence for several years and is a part of the Securities and Exchange Commission’s (SEC) market access rule.
Crapo asked the panel for their perspective on a recent Wall Street Journal article that described the practice of “slide-and-hide.” Concannon described the “slide-and-hide” order type to Crapo and Reed and noted that it is not an order used by investors. He said this order type is mainly used by professional traders, but is still not well understood market-wide. Lauer and Brooks said “slide-and-hide” and other similar order types are “an example of “unjustified complexity” that is being introduced into the market. Lauer added that the approval system for new order types “needs to be revisited,” and would help to restore investor confidence in the market. Tabb said the article is an example of why a greater amount of transparency is needed in respect to order types.
Crapo also asked the panelists to list their top three focus areas that the SEC’s technology roundtable should concentrate on during their meeting on October 2, 2012. Lauer said the SEC should focus on market technology standards, trading system fail-safes, and ways to increase the SEC’s technological capabilities. Brooks said they should focus on order routing practices, payment mechanisms and market data arbitrage. Concannon said the SEC should focus on the testing of procedures and infrastructure when glitches occur and general risk management practices. Tabb agreed with the other panelists, adding that a focus on the ineffectiveness of past SEC rulemakings, market defragmentation and implementing a consolidated audit trail would also be helpful.
For testimony and a webcast of the hearing, please click here.
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