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.
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.
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.
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.
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.