And I am asking the exchanges to develop proposed rule changes to disclose how — and for what purpose — they are using data feeds. For example, which data feeds are used to execute and route orders? And which feeds are used to comply with regulatory requirements, such as trade-through rules? Brokers and investors could use the enhanced transparency to better assess the quality of an exchange’s execution and routing services.
Each of these measures target specific elements of today’s technology-driven market that may work against, or at least not optimally for, the interests of investors and companies. We also are evaluating whether the evidence supports broader measures that would further advance those interests without creating unintended adverse consequences.
We must consider, for example, whether the increasingly expensive search for speed has passed the point of diminishing returns. I am personally wary of prescriptive regulation that attempts to identify an optimal trading speed, but I am receptive to more flexible, competitive solutions that could be adopted by trading venues. These could include frequent batch auctions or other mechanisms designed to minimize speed advantages. They could also include affirmative or negative trading obligations for high-frequency trading firms that employ the fastest, most sophisticated trading tools.
Such obligations would be analogous to the ones that historically applied to the proprietary traders with time and place advantages on manual trading floors.
A key question is whether trading venues have sufficient opportunity and flexibility to innovate successfully with initiatives that seek to deemphasize speed as a key to trading success in order to further serve the interests of investors. If not, we must reconsider the SEC rules and market practices that stand in the way.
Enhancing Market Transparency and Examining Trading Venue Regulation
Another market structure concern is fragmentation. Order flow in exchange-listed equities is divided among many trading venues — 11 exchanges, more than 40 alternative trading systems, and more than 250 broker-dealers. The competition for order flow among these venues is intense, and it benefits investors by encouraging services that meet particular trading needs and by keeping trading fees low. Having multiple trading venues also can help avoid trading disruptions if one venue has an isolated problem — order flow often can be immediately shifted to other venues.
This proliferation of venues, however, also raises issues. One is their interconnectedness — the potential for one or more systems to malfunction and disrupt other systems, or to interact with other systems in unexpected ways. Another is the increase in the percentage of order flow that is handled and executed by dark trading venues. The percentage of trading volume executed in dark venues increased from approximately 25 percent in 2009 to approximately 35 percent today.
Dark trading venues generally reference the quoted prices displayed by the lit exchanges and do not publicly display quotes or otherwise provide pre-trade transparency of the prices at which they will execute orders. And the consensus of the research is that the current extent of dark trading can sometimes detract from market quality, including the informational efficiency of prices.
Dark venues lack transparency in other important respects. Although the trades of dark venues are reported in real time, the identity of participants in the dark venue is not disclosed to the public. And dark venues generally only provide limited information about how they operate. ATSs, for example, file a form with the SEC on some aspects of their operations, but the forms are not publicly available under current rules.
Transparency has long been a hallmark of the U.S. securities markets, and I am concerned by the lack of it in these dark venues. Transparency is one of the primary tools used by investors to protect their own interests, yet investors know very little about many trading venues that handle their orders.
Just this week, FINRA began disseminating aggregate information on trading volume of ATSs. This is a useful first step, but ATSs represent less than half of dark venue volume. To remedy this gap, I fully support FINRA in considering an expansion of its trading volume disclosure regime to off-exchange market makers and other broker-dealers.
I also have asked the SEC staff to prepare a recommendation to the Commission to expand the information about ATS operations submitted to us and to make the information available to the public. As you have seen in the recent media, some operators of dark venues began offering greater transparency to their operations this week, but a broader effort is needed.
While this expanded information will be an important tool for investors, we must continue to examine whether dark trading volume is approaching a level that risks seriously undermining the quality of price discovery provided by lit venues.
We also are continuing to consider whether more fundamental changes are needed to bring our regulatory structure in line with the significant market changes of the last decade. Importantly, we will be considering whether the SEC’s own rules, such as the trade-through rule of Regulation NMS, have contributed to excessive fragmentation across all types of venues.
We also will be considering whether the current regulatory model for exchanges and other trading venues makes sense for today’s markets.
The SEC last comprehensively considered trading venues in the 1990s, which led to the adoption of Regulation ATS. The 1990s approach draws a sharp distinction between exchanges and other trading venues, a distinction that has been blurred considerably over the last 20 years. A core focus of our comprehensive review will be whether and how the SEC’s regulatory approach for trading venues should be changed to reflect significantly changed conditions.
Mitigating Broker Conflicts
A fourth area of concern is broker conflicts and how they are exacerbated or mitigated by different trading venues. Most investors rightly rely on their brokers to navigate the dispersed market ecosystem on their behalf. But monitoring the execution quality and costs of orders can be difficult for even the most sophisticated investors, given the number of trading venues and order types available to brokers.
The cost to the broker for executing in different venues can vary widely. Some venues make payments directly to brokers as a means to attract particular types of order flow. These payments include the liquidity rebates paid by exchanges that use a “maker-taker” fee structure. They also include payments offered by off-exchange market makers to retail brokers for the marketable order flow of their customers.
When fees and payments are not passed through from brokers to customers, they can create conflicts of interest and raise serious questions about whether such conflicts can be effectively managed.
Broker conflicts and other improper practices that have harmed investors have, of course, long been a focus of the SEC’s enforcement program. In one case, for example, the SEC brought fraud charges against a brokerage firm and two former employees who caused many institutional clients to pay substantially higher amounts than disclosed for the execution of orders. In another case, the SEC charged a broker operating as an ATS and two of its top executives with failing to disclose to customers that the vast majority of their orders were filled by a trading operation affiliated with the ATS.
As one step to more generally address these issues, I have asked the staff to prepare a recommendation to the Commission for a rule that would enhance order routing disclosures. Rule 606 of Regulation NMS currently requires some public disclosure of broker order routing practices, but it does not cover the large orders typically used by institutional investors. The rule proposal would address this gap by requiring disclosure of the customer-specific information that a broker is expected to provide to each institutional customer on request. While some brokers already voluntarily provide some of this information, a rule is necessary to ensure that the disclosed information is useful, reliable, and uniformly available on request to all institutional customers.
Another source of broker conflicts is the large number of complex order types offered by the exchanges, which have been a recent focus of the SEC’s examination program. The majority of these order types are designed to deal with the maker-taker fee model and the SEC’s rule against locking quotations.
I am asking the exchanges to conduct a comprehensive review of their order types and how they operate in practice. As part of this review, I expect that the exchanges will consider appropriate rule changes to help clarify the nature of their order types and how they interact with each other, and how they support fair, orderly, and efficient markets.
In addition to these specific measures, we are considering more generally the questions relating to conflicts, including whether and how to further mitigate or eliminate potential sources of conflicts between brokers and customers. Exercising care in this area, however, is very important, because a number of fee structures are intertwined with many aspects of the current market structure, including the trading strategies that generate quotes on the public exchanges.
Building Quality Markets for Smaller Companies
The final market structure issue I want to highlight today is the quality of the equity markets for smaller companies. The number of domestic companies listed on U.S. exchanges now has dropped in half from the highs of more than 7,000 in the 1990s. This decline has largely resulted from a reduction in the number of IPOs, particularly IPOs of smaller companies.
While there obviously are a variety of factors at play here, the decline of new public companies is reducing the growth opportunities for U.S. investors. If the downward trend continues, the strength of the U.S. equity markets can be compromised.
In enhancing market structure, we must focus closely on the particular needs of smaller companies and their investors. As you know, I instructed the SEC staff last fall to move forward on work to develop a pilot program to allow wider tick sizes for the stocks of smaller companies. I anticipate that the Commission will soon complete its review of the terms of such a pilot, which will inform our broader understanding of how to build more robust markets for smaller issuers. I am also open to other ideas on ways to achieve this vitally important objective.
IV. Looking Ahead
I expect that the specific measures I have identified today to be considered by the Commission in the coming months. While our review in each of these five areas has already resulted in discrete actions targeting specific issues, the more fundamental policy questions demand — and are receiving — close attention at the SEC. While we do not require perfect solutions, our regulatory changes must be informed by clear-eyed, unbiased, and fact-based assessments of the likely impacts — positive and negative — on market quality for investors and issuers. Continued engagement by all market participants on these issues is critical.
To facilitate this engagement, the SEC staff will populate our market structure website with summaries of key issues that provide a framework for further analysis, identifying areas that the staff is focused on and where public perspectives are essential. I am also recommending to the Commission that the SEC establish a new Market Structure Advisory Committee comprised of experts with a diversity of backgrounds and viewpoints. The new committee will serve as an additional forum and resource for reviewing specific, clearly articulated initiatives or rule proposals.
We will continue the disciplined, data-driven approach to market structure that has marked the last year. Our comprehensive review and follow-up actions will ensure that our equity markets continue to operate fairly and efficiently, and in a manner that both optimally protects investors and promotes capital formation.