III. Enhancing Market Structure Today and Tomorrow
Addressing the issues of our current market structure demands a continuous and comprehensive review that integrates targeted enhancements with an expansive consideration of broader changes. But we must not ignore the largely positive evidence of market quality. That reality demands careful study and deliberate action when considering fundamental changes. As we evaluate the merits of broader changes, we will also continue to assess and address specific elements of today’s market structure that work against the interests of investors and public companies.
Let me now outline the initiatives we are advancing across five broad sets of issues: market instability, high frequency trading, fragmentation, broker conflicts, and the quality of markets for smaller companies.
Preventing Market Instability
First, as I have said from the day I took office, one of the most serious concerns about today’s equity markets is the risk of instability and disruption. Technology can and has greatly increased the efficiency of our markets, but it can also allow severe problems to develop very quickly — just consider some of the systems events of the last few years at exchanges and brokers.
The SEC and the securities industry have already undertaken a series of responsive initiatives. “Limit up-limit down,” for example, is now fully implemented and moderating price volatility in individual securities. Market-wide circuit breakers are in place to address volatility across the equities, options, and futures markets.
And the SEC has taken additional steps to require market participants to address their technology risks. We adopted — and are vigorously enforcing — the Market Access Rule, which requires brokers to implement better risk controls. And last March, the Commission proposed Regulation SCI to put in place stricter requirements relating to the technology used by exchanges, large alternative trading systems, clearing agencies, and securities information processors -- the SIPs. The staff is now completing a recommendation for final rules.
We also have closely focused on certain market infrastructure systems that are “single points of failure” that can halt or severely disrupt trading when a problem occurs. Last fall, I met with the leaders of the equities and options exchanges to address strengthening these systems. Among other measures, the exchanges have responded with technology audits of the SIPs and a series of specific enhancements to improve SIP robustness and resilience. In addition, the exchanges have developed more robust SIP backup capabilities, and they expect to implement a new “hot-warm” backup, with a ten-minute recovery standard, by the end of this month.
We have made considerable progress in addressing the risk of market instability, and I look forward to the completion of these ongoing efforts in the coming months. But there is more to be done, and there is never room for complacency.
Addressing High Frequency Trading and Promoting Fairness
Recently, a lot of lively debate has centered on high frequency trading, speed, and fairness. These have been important issues for some time. Algorithmic traders, which include high frequency trading firms and a large percentage of institutional trading, likely represent well over a majority of trading volume.
These traders use a variety of low-latency tools, including co-located servers in trading data facilities and direct data feeds from trading venues rather than the slower consolidated data feeds of the SIPs. Much of the recent public focus has been on high frequency trading firms, but it is important to remember that many brokers use the same tools on behalf of their customers.
The SEC should not roll back the technology clock or prohibit algorithmic trading, but we are assessing the extent to which specific elements of the computer-driven trading environment may be working against investors rather than for them.
An area of particular focus is the use of aggressive, destabilizing trading strategies in vulnerable market conditions, when they could most seriously exacerbate price volatility. While the volatility moderators already put in place impose outside limits on price moves, even moves within those limits can be damaging. Instability arising during a broad market event may simultaneously affect hundreds or thousands of stocks, triggering many trading pauses and reopenings over a short period of time.
To address this risk, I have directed the staff to develop a recommendation to the Commission for an anti-disruptive trading rule. Such a rule will need to be carefully tailored to apply to active proprietary traders in short time periods when liquidity is most vulnerable and the risk of price disruption caused by aggressive short-term trading strategies is highest.
We also are focused on using our core regulatory tools of registration and firm oversight. I have asked the SEC staff to prepare two recommendations for the Commission: the first, a rule to clarify the status of unregistered active proprietary traders to subject them to our rules as dealers; and second, a rule eliminating an exception from FINRA membership requirements for dealers that trade in off-exchange venues. Dealer registration and FINRA membership should significantly strengthen regulatory oversight over active proprietary trading firms and the strategies they use.
I have further instructed the staff to prepare recommendations for the Commission to improve firms’ risk management of trading algorithms and to enhance regulatory oversight over their use. Given the overwhelming dominance of trading algorithms, it is time that our regulatory regime is updated to take better account of the risks when they are poorly designed or operated.
Another important concern raised by algorithmic trading is fairness for investors. Do low-latency tools, even though they are available to investors through brokers, tend to advantage certain types of proprietary trading strategies that may detract from the interests of investors? Some of the research suggests this may be the case. And a related fairness concern is the latency difference between the direct data feeds and the consolidated feeds.
As initial steps to address these issues, we will continue to focus the efforts of the exchanges and FINRA in minimizing consolidated data latency. The exchanges and FINRA have an obligation to provide data to the SIPs in a way that is not unreasonably discriminatory. They are not allowed to transmit data to direct customers any sooner than they transmit data to the SIP, and the technology used for transmitting data to the SIP must be on a par with what is used for transmitting data to direct feeds.