Senate Banking, Housing and Urban Affairs Subcommittee on Securities, Insurance, and Investment Hearing
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Thank you, Chairman Warner, Ranking Member Johanns, and members of the Subcommittee for permitting me to testify before you today on the impact of high frequency trading on investor confidence and capital formation in U.S. equity markets. I am testifying in my own capacity and do not purport to represent the views of any organizations with which I am affiliated, although some of my testimony is based on the work of the
The Committee was formed in 2005 to address the issue of competitiveness in our primary public equity capital markets and issued a report in 2006 detailing the threats to our primary markets and suggestions for improvement. n1 Just as regulatory changes can lead to competitiveness concerns in our primary markets, the same is true of our secondary markets. Therefore, any changes in our secondary market trading must be assessed for their competitive implications, particularly given the current relative competitive strength of our secondary markets vis-a-vis those abroad.
The CCMR tracks, on a quarterly basis, thirteen measures of the competitiveness of the U.S. public equity market. n2 We have found that while the competitiveness of our primary markets has suffered over the past six years, our secondary markets remain strong with roughly 50% of global exchange trading occurring on U.S. exchanges. n3 The CCMR is currently undertaking a review of market structure issues with a focus on dark pools, internalization, decimalization, exchange backup systems, and the subject of today's hearings, high frequency trading.
"High frequency trading" or "HFT" is a topic that has generated significant attention in recent years and increasingly in the last few months. The widespread public interest in this topic was intensified following the 2010 "flash crash" and more recently, with the publication of
Let me be clear at the outset, that I believe the net effect of HFT activity in our equity markets has been positive. Transaction costs are at historic lows, liquidity is at historic highs, and volatility has stabilized. These features of today's market not only benefit both retail and institutional investors, but also positively affect capital formation, and by extension, promote job creation. The fact that HFT is the subject of a best-selling book and has generated vocal opposition both within the financial industry and across the American public more broadly, does not, in itself, justify drastic regulatory change. There is nothing new about the advantages of speed to traders. You may recall that the Rothschilds used carrier pigeons to bring them news of the outcome of battles in the Napoleonic wars. n4 While the speed with which they obtained this information gave the Rothschilds an advantage, the markets generally benefitted from the speed by which the new information got into the market, even if those who actually traded with the Rothschilds were at a disadvantage.
My primary concern is that the recent frenzy over HFTs draws attention away from other important market structure issues. For example, as a member of the
Critics of HFT point to the
Another common misconception regarding HFT and our current equity market structure is that HFTs have somehow caused an increase in transaction costs for individual retail investors. In fact, transaction costs for retail investors are at historic lows, as evidenced by current bid-ask spreads and retail brokerage commissions. Since 2006, the average effective bid-ask spread on
However, bear in mind that retail investors only directly account for approximately 15-20% of daily stock market volume. n12 Since many retail investors access the equity markets indirectly through institutional funds or advisors (such as mutual funds, pension funds, or private wealth advisors), institutional cost reduction is highly relevant to retail investors as well. In 1950, over 90% of U.S. equities were held directly by households. n13 That number has dropped to less than 40% in 2013 n14 and this is primarily high-net worth individuals. Household ownership of mutual funds has risen from 5.7% in 1980 to 46.3% in 2013 constituting 90% of mutual fund assets. n15 Collectively mutual funds own 30% of the U.S. stock market capitalization. n16 Clearly, what is good for institutional investors is also beneficial for the small investor.
The institutional investors that primarily trade on behalf of the small investor constitute roughly 25-35% of average daily stock trading volume in the U.S. n17 And today institutional trading costs are historically low. Based on institutional trade data compiled by leading finance academics, the average transaction cost for an institutional order of 1 million shares for a
In addition to transaction costs, market volatility and more importantly severe market dislocations are also a primary concern for all investors. Critics of HFT contend that HFT strategies have led to a significant increase in stock market volatility caused merely by HFT trading activity, rather than changes to the fundamentals of stocks. However, respected market structure experts continue to believe that volatility is largely driven by macro-economic concerns and not HFT activity. Stock market volatility, as proxied by the CBOE Volatility Index ("VIX"), understandably rose during the heart of the financial crisis, but has since fallen to its lowest levels in seven years. Intraday volatility of individual stocks also remains low. Professor
Thus, it is hard to argue that the U.S. equity market is "broken" as a result of the emergence of HFT activity. Nonetheless, there is always room for targeted improvement of the current regulatory structure, including with respect to certain practices of HFT traders. But we should proceed cautiously and thoughtfully so as not to chill legitimate market functions. There are risks to implementing any changes which must be assessed -for example, bid/offer spreads could widen or exchange volumes (and with it liquidity) could drop.
As a first step, we must precisely identify what practices warrant further regulatory scrutiny. Defining high frequency trading is far from straightforward. For example, many institutional traders place relatively small trades with high frequency, but whether this is a unique and potentially abusive investment strategy or whether this is simply an optimal trading strategy that has evolved with automated trading (for e.g. to execute a large block trade without exposing the size of the order), is a baseline question. Technological advances mean that modern trading is done electronically with orders no longer being given to a broker on an exchange floor. And trading is getting faster every year. We can't put the genie back in the bottle;
At the same time, there are certainly many general risks that come with automated and faster trading. We need to make sure our rules keep up with industry technology.
Regulation has not kept pace with technological advances. As
Market instability is something everyone agrees we need to avoid, to the extent possible. In our fast-paced world, our markets are particularly susceptible both to fat finger mistakes and errors, as well as intentional, manipulative behavior by certain market participants. The incredible speed at which we now trade can exacerbate errors, and quickly.
We need to ensure the safety and soundness of our markets. Fortunately, as I have previously mentioned, the
Critics of HFT contend that HFT firms have access to proprietary data feeds from the exchanges that provide them with information before other traders, allowing them to "front run" the market. However, it is important to be clear that trading on information that is publicly available is different than a broker trading ahead of a customer, which is patently illegal.
Additionally, there is growing public interest in a practice called "co-location," which refers to traders locating their data servers in the same physical space as exchanges to facilitate faster trading and profits, which along with proprietary data feeds gave rise to latency arbitrage. In general, latency arbitrage entails the ability of HFTs to synthesize quotes from all exchanges faster than other market participants, thus enabling HFTs to trade on those quotes at a profit. One could argue that this activity closes the gap between divergent prices in similar ways as other forms of arbitrage. While critics question the "fairness" of allowing certain traders to benefit from their physical proximity to an exchange or access to proprietary data feeds, proponents of the practice point out that the
Another issue to consider is the increasing technology "arms race" occurring among HFTs. To beat out competitors, HFTs invest more heavily in powerful and expensive technology to gain an edge over the competition. But increased competition among HFTs may further reduce costs for the rest of the market as HFT margins decline.
Much discussion recently has also revolved around the "maker-taker" pricing system that developed roughly 17 years ago, well before the rise of HFTs. n25 On a trading platform with "maker-taker" pricing, the liquidity taker pays a fee and the liquidity provider receives a rebate. The first venue to introduce maker-taker pricing was Island ECN in 1997. n26 While some have introduced various criticisms of maker-taker pricing, this is neither a system nor a problem created by HFTs. The maker-taker pricing system can exist in low frequency trading environments and HFT environments alike.
Finally, I note that certain critics of HFTs are also highly critical of the "dark pools" where these traders, along with other institutional investors, increasingly trade. It is estimated that 15% of stocks are now executed in dark pools, where information about orders is not publicly displayed. n27 Critics suggest that dark trading inhibits the pricing function of secondary markets, and also question their opacity more generally. It is important to note, however, that neither dark pools nor market fragmentation more generally are "problems" that arose because of HFT. The automation of equity trading following the
I would now like to present a few specific proposals that I believe could be helpful in ensuring the safety and security of our automated world.
First, regulators should consider mandating and harmonizing exchange-level kill switches. A kill switch is a mechanism that would halt a firm's trading activity when a pre-established exposure threshold has been breached, thus stopping erroneous orders and preventing any further uncontrolled accumulation of positions. For example, if a trading firm typically only holds
Second, we might consider addressing the volume of order message traffic, which can create market instability, by establishing order-to-trade ratios. Electronic order instructions are used to direct the placement, cancellation and correction of orders. Since 2005, order flow has increased by 1,000% while trade volume has increased by only 20%. n28 As was experienced during the 2010 flash crash, a spike in orders and cancellations can exacerbate market volatility and overwhelm the exchanges' infrastructure. The current market structure only places costs on trade executions, thereby allowing market participants to generate excessive order-message traffic without internalizing the costs of the negative externalities just described. Regulators should assess why order volumes have increased and consider charging fees for extreme message traffic, keeping in mind that any order-to-trade ratios should depend on the liquidity of the stock.
Third, regulators should consider abolishing immunity that exchanges have from liabilities for losses from market disruptions based on their SRO status. For example, NASDAQ received immunity from liability for half a billion dollars of losses incurred by brokers from the
In addition to the proposals discussed above, I wanted to address two recent suggestions by
White has also asked her staff to propose a recommendation that would subject unregistered active proprietary traders to the
Finally, I'd like to address the topic of decimalization. As I mentioned up front, I eagerly await the specifics of the
Thank you and I look forward to your questions.
n1 Comm. On Capital Mkts. Reg., Interim Report Of The Committee On Capital Markets Regulation (
n2 Comm. on Capital Mkts. Reg., Competitiveness Measures, http://www.capmktsreg.org/education-research/competitiveness-measures/
n3 Id.
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n5
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n7 Id.
n8 Id.
n9
n10 Id.
n11 See The Citadel Conversation, Q1 2013, available at https://www.citadelsecurities.com/_files/uploads/sites/2/2013/06/The-Citadel-Conversation with-Larry-Tabb-and-Jamil-Nazarali.pdf
n12
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n16 Id.
n17
n18
n19 Id.
n20
n21 Id.
n22 See NYSE Circuit Breakers, available at https://usequities.nyx.com/markets/nyse-equities/circuit-breakers.
n23
n24
n25
n26 Id.
n27
n28
n29
n30 Id.
n31 A trade-at rule requires brokers and dark pools to route trades to public exchanges, unless they can execute the trades at a meaningfully better price than available in a public market. It is unclear how the
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