SEC Chair White Discusses Intermediation in Securities Market; Focuses on Debt Markets, Particularly Munis

SEC Chair Mary Jo White delivered a speech at the Economic Club of New York, discussing the changing nature of intermediation and the importance of considering competition and technology in addressing market structure issues.

Chair White explained that securities markets operate within a structure of rules which is based not only on regulation, but also on the complex interaction of regulation with competition and technology. Considering this “dynamic reality,” Chair White stated that the SEC should not be chasing regulatory solutions that “fix” market structure once and for all, since the “markets are not broken and they are not static.”

Chair White emphasized the importance of understanding the broader forces at work in market structure and the regulatory choices available. She used Regulation NMS (“Reg. NMS”) as an example of the need for a wider lens in evaluating market structure issues, explaining that while Reg. NMS and high-frequency trading (“HFT”) share temporal similarities, there are more complex forces at play. According to Chair White, this is supported by the fact that there are markets around the world with high levels of HFT even though they are not governed by Regulation NMS.

She went on to discuss how intermediation has changed in equities and listed options. Chair White explained that when Congress first mandated the regulation of trading in U.S. securities, intermediation was defined by the respective functions of exchanges, brokers, and dealers; however, these functions now overlap and have been combined. According to Chair White, conflicts of interest have arisen due to dual roles that such entities play. Additionally, she stated that concerns have been raised about excessive intermediation by dealers, the costs of which are difficult to measure since they are embedded in trading profits.

Due to these developments, Chair White stated that it is essential to continually rethink how to approach intermediation in both equity and fixed income markets. In equity markets, where Reg. NMS was implemented in 2007, Chair White further stated that the current structure was created mostly through intense competition and tremendous technological changes. Chair White explained that the impact of technology and competition on intermediation in equity markets “cannot be undone through minor regulatory surgery,” as it is the culmination of over a quarter of a century of technological evolution, much of which “has benefited investors.” She stated that the SEC must be sure that any future rules are able to keep pace with developments.

In fixed income markets, where “there is no equivalent of Regulation NMS and the nature of intermediation has changed relatively little over the years,” Chair White stated that she wants technology to be leveraged to make the old, decentralized method of trading more efficient for market intermediaries to potentially benefit investors. To this end, Chair White has asked FINRA and the MSRB to prioritize two initiatives: (i) a robust best execution rule for the municipal securities market, and (ii) developing rules regarding disclosure of markups in “riskless principal” transactions for both corporate and municipal bonds. More broadly, Chair White emphasized that the SEC must take steps to ensure that the benefits of technological advances are realized by all investors in fixed income markets, explaining that she has asked SEC staff to focus on an initiative to enhance public availability of pre-trade pricing information with respect to smaller retail-size orders.

Lofchie Comment: Chair White continues a reasonable and measured approach as she orders an agency review of the markets after the publicity frenzy over Flash Boys: A Wall Street Revolt. With regard to the direction of the SEC’s review of the equity markets, it will be interesting to see the biases between exchange trading and other forms of intermediation. As to trading in the fixed income markets, it seems likely that very significant additional regulation is on the horizon. Financial regulatory history shows: (i) that regulation always grows and (ii) that any regulation that comes to the equity markets comes eventually to the fixed income markets. Hopefully, when new regulation comes, it will arrive with appropriate modification to reflect the differences between the two markets.

See: Chair White’s Speech.


House Financial Services Committee Approves FSOC Reform Legislation

The House Financial Services Committee approved two bills regarding the authority and transparency of the Financial Stability Oversight Council (“FSOC”). 

H.R. 4881, which was agreed to as amended, places a one-year moratorium on the authority of the FSOC to make financial stability determinations. The bill was approved 32-27 and would prevent the FSOC from designating any new insurance companies or asset managers as “systemically important” for one year as Congress continues to review the FSOC’s process for deeming bank and non-bank institutions to be significant.

H.R. 4387, or the FSOC Transparency and Accountability Act, was approved 32-27, as amended.  The bill would amend Dodd-Frank Section 111 to subject FSOC to both the Government in the Sunshine Act and the Federal Advisory Committee Act.  Additionally, the bill would allow members from agencies such as the SEC, the FRB and the CFTC to attend and participate in FSOC meetings, as well as allow members of the Committee on Financial Services and the Committee on Banking, Housing and Urban Affairs to attend all FSOC meetings, even if the meetings are not open to the public.

Lofchie Comment:  One of the well founded criticisms made of the FSOC is that it deviates from an important tradition of bipartisanship. Since the membership of the FSOC allows for only a single representative from the SEC and the CFTC, representation is that of only a single party. (The Board of Governors, unlike the SEC and the CFTC, is not expressly required to contain members of both parties, but it always has; further, it has a strong tradition of being non-partisan.) Decision-making by the FSOC should be based upon deliberations of the other agencies and FSOC’s recommendations should be taken into account by the other agencies. Accordingly, it seems reasonable to allow the Commissioners of the SEC and the CFTC, as well as all Federal Reserve Board of Governors, to attend FSOC meetings. Shutting out senior regulators of one party from at least observing discussions of regulatory policy does not build trust or consensus between the parties, does not allow for an exchange of opposing beliefs and would not likely lead to reasonable public policy.

See: Complete Markup of Bills and Webcast of the Meeting; House Financial Services Committee Press Release.
Related news: House Financial Services Committee Schedules Markup of FSOC Bills (June 18, 2014); House Financial Services Committee Hearing: “Examining the Dangers of the FSOC’s Designation Process and Its Impact on the U.S. Financial System” (May 22, 2014).

SEC Announces Meeting to Consider Adoption of Rules Regarding Definitions in Cross-Border Security-Based Swap Activities

The SEC announced that it will hold an open meeting on June 25, 2014 to consider whether to adopt rules regarding the application of the definitions of “security-based swap dealer” and “major security-based swap participant” to Cross-Border Security-Based Swap Activities under the Securities Exchange Act and Dodd-Frank Title VII. 

The SEC proposed the rules concerning Cross-Border Security-Based Swap Activities in May 2013. 

See: SEC Announcement of Meeting; Proposed Rules
Related news: SEC Proposal on Cross-Border Security-Based Swaps (with Commissioners’ Comments) (May 2, 2013); SEC-Proposed Rules for Security-Based Swap Dealers and Major Participants (Fed. Reg.) (May 5, 2014).


Senate Hearings on High-Frequency Trading Market Issues

Over the past two days, two Senate subcommittees held separate hearings on the topic of high-frequency trading (“HFT“) in the U.S. equity markets.

Maker-Taker Fees, Order Flow Payments and a Brokers’ Duty of Best Execution

On Tuesday, June 17, the Senate’s Permanent Subcommittee on Investigations held a hearing titled “Conflicts of Interest, Investor Loss of Confidence, and High-Speed Trading in U.S. Stock Markets.”  The hearing focused on how brokers’ incentives resulting from exchanges’ maker-taker fee structures and payment for order flow clashed with brokers’ duty of best execution to their customers. The hearing was conducted by Senators Carl Levin (D-MI), Ron Johnson (R-WI) and John McCain (R-AZ) and was split into two panels of witnesses.

The first panel of witnesses featured Brad Katsuyama, President and CEO of IEX Group, Inc. and the protagonist of Michael Lewis’s book, Flash Boys.  Also on the first panel was Robert H. Battalio, Professor of Finance, at the Mendoza College of Business, University of Notre Dame. Professor Battalio’s testimony focused on his recently published study on the relationship of order flow inducements (i.e., maker-taker rebates/fees and payment for order flow) and the quality of trade execution.  His study found that three of the four retail brokers examined for the Fourth Quarter of 2012 routed their non-marketable orders to the highest rebate paying exchange and nowhere else.  Further, his study found this practice to be inconsistent with a broker’s duty of best execution, as it resulted in decreased fill rates.

Mr. Katsuyama’s testimony echoed Professor Battalio’s sentiment that maker-taker and payment for order flow create perverse incentives for brokers.  Mr. Katsuyama also agreed with Professor Battalio that routing orders to the exchange that pays the highest rebate would be inconsistent with best execution, as those exchanges often will have the longest queue at a given price point, resulting in lower fill rates.

Throughout their testimonies, Mr. Katsuyama and Professor Battalio reiterated that currently available data is insufficient to allow customers to evaluate brokers’ execution quality. Mr. Katsuyama and Professor Battalio also agreed that additional regulation is necessary to force transparency, disclosure and the standardization of information from brokers.  In response to Senator Levin’s inquiry as to whether maker-taker should be eliminated, both Mr. Katsuyama and Professor Battalio supported a pilot study concerning whether maker-taker should be eliminated, but neither went so far as to support maker-taker’s prohibition.

Participation in U.S. Equity Markets and Conflicts of Interest

A second panel focused on how investor confidence and participation in U.S. equity markets is affected by conflicts of interest and/or the appearance of conflicts of interest resulting from payment for order flow and maker-taker pricing.

The second panel included representatives from two exchanges, Thomas Farley (NYSE) and Joseph Ratterman (BATS), one representative of the buy-side, Joseph Brennan (Vanguard), and one sell-side representative, Steven Quirk (TD Ameritrade).  Mr. Farley advocated regulation that would eliminate maker-taker rebates, coupled with a “trade-at” rule that would establish the supremacy of public quotes in order to stop additional trade volume from moving off exchanges.  Additionally, Mr. Farley focused on the need to simplify market structure in order to increase investor confidence and participation in U.S. equity markets, which, in large part, would be accomplished by eliminating maker-taker, since so many trading venues and order types exist to take advantage of different maker-taker pricing models.

The other witnesses on the second panel expressed positive views about the state of U.S. equity markets and recommended less drastic measures for addressing the subcommittee’s concerns with high-frequency trading and broker’s conflicts of interest.  These less drastic measures included increasing transparency for Alternative Trading Systems and brokers’ order routing practices, investing in technology to increase the speed of the public consolidated quote data, and a pilot study to be conducted by the SEC on the effects of maker-taker pricing.

Leadership Views

The Senators’ views throughout the hearing, particularly those of Senator Levin and Senator Johnson, were divided along partisan lines.  Senator Johnson proved skeptical of the need for any government intervention and questioned whether the effects of maker-taker were anything more than trivial, pointing to decreased trading costs over the last ten to twenty years as evidence that equity markets are working well for retail investors.  Additionally, Senator Johnson expressed concern that the negative rhetoric surrounding the HFT debate had become too sinister, but did concede that additional regulation may be necessary to, at most, increase transparency and disclosure obligations for market participants.

By contrast, Senator Levin communicated a markedly different assessment.  In his closing remarks, the Senator stressed that conflicts of interest in the market needed to be eliminated to the extent humanly possible, in effect advocating the prohibition of maker-taker fees and rebates.  He continued by calling on regulatory agencies to take quick action, and warned that, if they did not, there might be a role for Congress to play in eliminating conflicts of interest from the equity markets.

Impact of HFT on Markets and the Economy

On June 18, the Senate Subcommittee on Securities, Insurance, and Investment held a hearing titled “High Frequency Trading’s Impact on the Economy.”  The hearing focused on the broader impact of HFT on markets and the economy and not just conflicts of interest.  The hearing was conducted by Senators Mark Warner (D-VA), Mike Johanns (R-NE), Elizabeth Warren (D-MA) and Jack Reed (D-RI) and featured three witnesses:  Professor Hal Scott, Nomura Professor of International Financial Systems at Harvard Law School, Jeffrey Solomon, CEO of Cowen and Company, and Andrew Brooks, Head of U.S. Equity Trading at T. Rowe Price.

Senator Warner started off the hearing by commenting on the remarkable technological and regulatory changes that the markets have undergone and noting that, while investors have clearly benefited, there has been cause for concern, e.g., increased volatility and market disruption events like the Flash Crash.  Senator Warner also put forward several recommendations to the SEC, including:  conducting a tick-size pilot study to see whether increasing tick sizes for small cap companies would increase liquidity, expediting the implementation of the Consolidated Audit Trail so that regulators might better understand what is occurring in the market, and enhancing transparency in the market.

Professor Scott focused on the strength of U.S. equity markets and called for certain targeted reforms, such as mandating and harmonizing exchange-level kill switches, establishing order-to-trade ratios in order to reduce potentially destabilizing order message traffic, abolishing exchanges’ immunity from liability for losses from market disruptions in order to better align their incentives to monitor and/or eliminate potentially risky trading practices, and fast tracking the implementation of the Consolidated Audit Trail.  Professor Scott expressed the need for caution when assigning blame to HFT for market issues, such as increased volatility and reduced investor confidence, when there might be other causes, such as uncertainty with the broader economy.

The testimonies of Mr. Brooks and Mr. Solomon were far more critical of HFT. Senator Warren echoed their criticisms and compared HFT to skimming money from the rest of the investors without adding any benefits to the market.  In addition to a pilot study on tick size, which Mr. Solomon and Professor Scott also endorsed, Mr. Brooks recommended pilot studies on the elimination of inducements for order flow (i.e., maker-taker and payment for order flow), the implementation of a “trade-at” rule, and setting minimum trade sizes for dark pools.

Senators Warner and Johanns concluded the hearing by recognizing the complexity of issues involving market structure and HFT. Neither Senator Warner nor Senator Johanns felt there was a need for Congress to act beyond nudging the SEC forward in their review of market structure (as called for previously in a speech by SEC Chair White) and implementing the Consolidated Audit Trail.  As an incentive for the SEC to conduct their review, Senator Warner warned that, if another significant market disruption event occurred, it could result in Congress’ trying to implement line-by-line legislation of these very complex issues.

See: Video of Hearing and Testimonies.


FINRA Executive Vice President and Chief Information Officer Discusses Technology Developments in Securities Oversight

FINRA Executive Vice President and Chief Information Officer Steven J. Randich delivered a presentation at the SIFMA Tech 2014 Conference regarding FINRA technology updates and developments in securities regulation.

Mr. Randich explained that FINRA’s technology is “vital” to protecting investors and is also important because of its ability to oversee and monitor firms, detect fraud and keep investors informed.  Mr. Randich noted that FINRA’s CARDS technology is an important development that will allow FINRA to conduct ongoing “birds-eye-view surveillance,” which Mr. Randich said will complement its “boots-on-the-ground” exams.  He explained that, currently, FINRA is soliciting comments regarding the program and is pursuing the use of a standard data submission format and process for all firms. 

Mr. Randich also stated that FINRA’s Consolidated Audit Trail (“CAT”) will serve as the central place for the SEC and all SROs to observe market activity, linked accounts and broader products/asset classes for both equities and options. 

Lofchie Comment:  While FINRA believes that CARDS is an important development, on the market side, SIFMA is adamantly opposed to it.  In a speech by Randy Snook of SIFMA, Mr. Snook described CARDS as “a massive and invasive regulatory intrusion with serious privacy and security implications for the general public with added technology costs and operational burdens for the financial industry.”

See: Steven Randich’s Presentation.


IOSCO Publishes Securities Market Risk Survey

The IOSCO Research Department published a staff working paper, titled “A Survey of Securities Markets Risk Trends 2014: Methodology and Detailed Results,” which provides a detailed analysis of responses to IOSCO’s annual survey on market trends and emerging risks. 

The working paper on the survey, which was conducted in March 2014, is based on some 200 responses and aims to gather views on emerging trends within securities markets to help identify risks that may not be captured by normal statistical analysis or desk research.

The main points:

  • concerns about issues considered “macro-prudential,” especially in the areas of banking vulnerabilities and capital flows;
  • concerns about “micro-prudential” risks clustered around the areas of corporate governance, financial risk disclosure, shadow-banking activities and regulatory uncertainty;
  • while regulators see risk as emanating from illegal conduct, corporate governance, financial risk disclosure, and benchmarking issues, market participants are more concerned with risk arising from the search for yield, resolution and resolvability plans, central counterparties (“CCPs”) and market fragmentation;
  • the impact of cross-border flows, financial risk disclosure and CCPs generally has drawn more attention between 2013 and 2014 than previously;
  • respondents repeatedly cited three trends as major concerns: regulatory uncertainty, banking vulnerabilities and volatile capital flows; and
  • increased awareness that cyber crime and cyber-related issues could be a threat to systemic stability. 

See: IOSCO Staff Working Paper; IOSCO Press Release
Related news: IOSCO Meets to Discuss Market-Based Finance (June 17, 2014).