Hearing Report -- “Market Structure: Ensuring Orderly, Efficient, Innovative and Competitive Markets for Issuers and Investors” On June 20, 2012, the House Financial Services Subcommittee on Capital Markets and Government Sponsored Enterprises held a hearing titled “Market Structure: Ensuring Orderly, Efficient, Innovative and Competitive Markets for Issuers and Investors.” The hearing focused on ways in which Congress and regulators can improve the current market structure to restore investor confidence and make it easier for small and medium sized companies to access capital through successful initial public offerings (IPOs). Among the issues discussed at the hearing were dark pools and other off-exchange trading, high frequency trading, tick sizes, and the regulatory structure for exchanges and broker-dealers (BDs). The witnesses attending the hearing were: Panel I Mr. Daniel Coleman, Chief Executive Officer, GETCO Mr. Kevin Cronin, Global Head of Equity Trading, INVESCO, on behalf of the Investment Company Institute Mr. Joe Gawronski, President and Chief Operating Officer, Rosenblatt Securities Inc. Mr. Thomas Joyce, Chairman and Chief Executive Officer, Knight Capital Group Mr. Duncan Niederauer, Chief Executive Officer, NYSE-Euronext Mr. Cameron Smith, President, Quantlab Financial LLC Panel II Mr. Dan Mathisson, Managing Director, Credit Suisse Securities LLC Mr. William O’Brien, Chief Executive Officer, Direct Edge Mr. Jeffrey Solomon, Chief Executive Officer, Cowen and Company Mr. Jim Toes, President and Chief Executive Officer, Security Traders Association Mr. David Weild, Senior Advisor, Capital Markets Group, Grant Thornton, and Chairman and Chief Executive Officer, Capital Markets Advisory Partners Opening Statements Chairman Scott Garrett (R-NJ) stated that US equity markets are the best in the world, adding that he hopes to learn from the hearing how Congress, regulators, and market participants can continue to ensure US markets can remain at the top. Chairman Garrett explained that he would like to know how Congress can promote competition, increase innovation, and facilitate additional capital formation for small businesses. He noted that Representatives Patrick McHenry (R-NC) and David Schweikert (R-AZ) have introduced legislation to provide support for small companies through the creation of market quality incentive programs and increasing the tick sizes for smaller companies. Chairman Garrett explained that his priority is ensuring any change the Subcommittee recommends is thoughtful, ensuring that it will not do harm to the markets. Witness Statements Panel I Mr. Daniel Coleman argued that a review of the regulatory framework of the capital markets is vital because investor confidence has deteriorated. He added that he believes that if certain regulatory and operational changes are adopted to promote competition, price discovery, efficiency, transparency, stability and fairness, investors “will once again believe in the soundness of our financial systems.” According to Mr. Coleman, despite positive market changes over the last fifteen years, the market events of May 6, 2010 (Flash Crash) “revealed flaws in the US equity market structure,” and therefore he supports the Securities and Exchange Commission’s (SEC) and Commodity Futures Trading Commission’s (CFTC) “well-reasoned reforms.” Mr. Coleman also discussed dark pools and tick sizes, noting that GETCO believes that there are incremental market-based changes the SEC could make to promote price discovery while protecting investor choice. Such changes would include: (1) adjusting tick sizes for certain high and low priced securities, (2) treating actionable indications of interest (IOIs) as quotations; and (3) lowering the threshold for requiring display into the public quote system of IOIs and other quotations. Mr. Kevin Cronin explained that funds and their shareholders have an interest in ensuring that the securities markets are highly competitive, transparent, and efficient. He noted that investor confidence has been challenged by scandals, financial crises, and “technological mishaps.” According to Mr. Cronin, the SEC must address: (1) issues surrounding automated trading and HFT, including the number of cancelled orders in the markets; (2) the need for enhanced surveillance capabilities to detect potentially abusive and manipulative trading practices; (3) conflicts of interest that exist in the markets, particularly those regarding liquidity rebates and the creation of new and complex order types; (4) the need for increased transparency of order routing and execution practices; (5) difficulties surrounding capital formation, particularly for small and mid-sized companies, and the need to examine the implementation of higher minimum quote variations (i.e., greater than $.01) for certain securities; and (6) issues associated with undisplayed liquidity, particularly those related to BD internalization. Mr. Joe Gawronski stated that today’s market structure is the product of a gradual, 15-year evolution of government action that market forces reacted to accordingly. Yet, despite its complexity and the way in which it was created, modern market structure results in better outcomes for both retail and institutional investors than what it replaced. Mr. Gawronski conceded that there are “problematic gaps in today’s structure,” including rules regarding off-exchange trading, safeguards against systemic risk, and the quality of markets for shares of smaller companies. He argued, however, that these issues should be addressed with care because the current market structure has many benefits. Mr. Thomas Joyce argued that “there has never been a better time to be an investor” because execution quality is at historically high levels while transaction costs are at historically low levels. He stated that with the exception of the Flash Crash and NASDAQ’s handling of the Facebook IPO, the equity markets have worked “flawlessly.” According to Mr. Joyce, high-speed computers and dark pools are not the problem, but rather a product of our competitive free-market system, and that different forms of market structures are needed for different participants. Mr. Joyce agreed that a holistic examination of the US equity market structure is timely and necessary, but urged regulators to do a thorough cost-benefit analysis. He noted that Knight supports consideration of the following rule changes: (1) the “Liquidity Enhancement for Small Public Companies Act,” (2) a consolidated audit trail (CAT); (3) a review of access fees, including the elimination of the maker/taker model; (4) wider spreads for certain tiers of securities (e.g. high-priced stocks, less liquid stocks); and (5) market-maker obligations, including a time in force for market-maker quotations. Mr. Duncan Niederauer noted the lack of investor confidence in the markets and stated that the primary factor contributing to the loss of vibrancy in the pricing mechanism is the increasingly bifurcated equity market structure. He stated that while he fully recognizes the legitimate functions served by off-exchange trading models, there is a point at which the aggregate amount of off-exchange trading is detrimental to price discovery and investor confidence. According to Mr. Niederauer, Congress and the SEC need to be concerned that without action, the US is leaving itself open to a greater loss of investor confidence and market stability. He added that to solve the problem, policymakers should focus on establishing fairer and more transparent equity markets, as well as a more level playing field among trading centers and investors. To do so, he advocated a promotion of public price discovery, creation of a CAT, and a leveling of the playing field between exchanges and BDs. Mr. Cameron Smith explained that computer technology advancements and updated regulations have shifted the marketplace from an exclusive market, centered around the privileged few with seats on an exchange floor, to an open, competitive electronic environment. Through these changes, there has been a rise of automated professional trading intermediaries who, while often misunderstood, are working to bridge gaps in supply and demand between investors. According to Mr. Smith, these intermediaries help create fierce competition, which lowers investor transaction costs, improves price discovery, and lowers short-term volatility in the market. Mr. Smith noted, however, that he supports additional reform in certain areas, including regulations: (1) to ensure regulators have the data they need, such as through CATs and the large trader reporting system; (2) related to risk management and circuit breakers or limit up/limit down protections; and (3) related to fragmentation, including allowing “locked” markets and creating categories of stocks with different quote increments. Panel II Mr. Dan Mathisson stated that US markets are generally good and remain the envy of the world, adding that they have tight bid-ask spreads, decreased market volatility, and decreased market disruptions. However, he noted several improvements could make the market better. First, the Facebook IPO illustrates that exchanges should be materially liable for technology failures and should no longer have self-regulatory organization (SRO) status. Second, the market order should be eliminated to reduce the chances of large gaps in prices. Third, BDs should be able to own more than 20 percent of exchanges. Fourth, regulators should perform a review of the pricing and rebate system operated by the consolidated tape plans because the current tape revenue model is “obsolete and rife with problems.” Mr. William O’Brien noted that investor confidence is very low and offered “simple steps” to restore confidence to the market. He explained that mechanisms are needed to allow market participants to communicate more efficiently in times of stress, adding that the Flash Crash and Facebook IPO situation were not exacerbated by fragmentation, but rather lack of communication. Mr. O’Brien noted that the limit up/limit down proposal begins to address this problem, but more can be done. He added that exchanges need greater flexibility for institutional and retail market flow, and that “fair access” restrictions should be eliminated so that exchanges can implement programs targeted toward long-term investors. With respect to technology, Mr. O’Brien urged Congress to embrace automation, focusing on providing the right incentives to create a shared responsibility rather than attempting to “turn back the clock.” He added that Representative McHenry’s proposal is a “good first step” toward removing the “one-size-fits-all” mentality. Mr. Jeffrey Solomon explained that while the JOBS Act will help companies raise money, more must be accomplished to address the significant liquidity decrease for small cap stocks that has occurred over the last decade. According to Mr. Solomon, a lack of liquidity in any small cap stock makes it difficult for investors to accumulate a position. This lack of liquidity, he explained, can be directly attributed to the advent of decimalization, which reduced trading spreads, giving rise to electronic trading and reduced research coverage of small cap stocks. Mr. Solomon stated that he is not advocating for a repeal of decimalization, but that a “one-size-fits-all” proposition does not work. Mr. Solomon also noted several other trends taking place with regard to market structure in the US, including the under-coverage of small cap stocks by sell-side research analysts, a decline in “small IPOs,” or IPOs raising $60 million or less, and a decline in companies listing on exchanges. Mr. Jim Toes focused his testimony on three concerns: investor confidence; capital formation; and the quality of regulation. He explained that the primary forces causing these concerns are operational capability, decimalization, and the SEC and SRO rulemaking processes. According to Mr. Toes, fostering greater operational capability should be the foremost consideration because it is the top influence of investor confidence. He also advocated for the SEC to implement a uniform, market-wide SEC rule in lieu of piecemeal SRO rules in cases that have material market-wide implications. Further, Mr. Toes discussed decimalization, noting that it yielded significant benefits to retail investors, but affected the ability of secondary markets to perform the capital formation function. He recommended that the regulations be reviewed to remove disincentives to the commitment of capital by trading operations and supported the creation of a Commission-initiated pilot program to consider trading in pricing increments of greater than one penny. Mr. David Weild argued that the current US market structure fails to support the needs of small and mid- sized companies. According to Mr. Weild, there are four key structural challenges to fostering the growth of these companies: (1) inadequate tick sizes have eroded the economic infrastructure required to support small cap stocks, leaving insufficient revenue to pay for needed visibility and liquidity; (2) the application of the Order Handling Rules, Regulation ATS, Decimalization, and Regulation NMS have not been applied unilaterally to companies of all sizes; (3) inadequate tick sizes have undermined Wall Street’s ability to properly execute IPOs; and (4) the US stock market structure is optimized for trading big brand and large cap stocks, encouraging computerized trading and speculation at the expense of fundamental investment. Mr. Weild explained that there is “ample rationale” for treating small company stocks differently and allowing issuers to choose their own tick size within a certain range to encourage support for their stock. He added that providing better economic incentives to support small cap stocks will lead to increased IPOs and, in turn, higher rates of capital formation and job growth at both already-public companies and private companies. Discussion Marketplace Competition Chairman Garrett noted that the hearing’s “common theme” is the necessity to achieve regulatory reform that encourages additional competition in the marketplace. He highlighted Mr. Smith’s comments in his testimony regarding data, and stated that any changes should be data driven, rather than anecdotally driven. Differences between Exchanges and BDs, Rule Process for Exchanges Chairman Garrett inquired into the effectiveness of Section 916 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which attempted to streamline the filing procedures for SROs, including exchanges. Mr. Niederauer reported that while the NYSE was “optimistic” about the provision, in practice it has not worked. He added that under the current system, exchanges are unable to compete effectively with many of their peers registered as BDs because BDs are not subject to many of the same regulations as exchanges, including having to file rule changes with the SEC. Mr. Joyce disagreed, noting that there are many differences between exchanges and BDs, including the fiduciary responsibilities placed on BDs by the SEC. Mr. Gawronski noted that his company uses both exchanges and BDs, and agreed with Mr. Niederauer that the current system creates an unlevel playing field that increases fragmentation. In response to a follow-up question from Representative Michael Grimm (R-NY), Mr. Niederauer clarified that he is not advocating that BDs be subject to the same regulatory burdens as exchanges, but rather for Congress to consider removing some requirements from exchanges to level the playing field. Mr. Weild revisited this issue during the second panel, noting that from the perspective of issuers, all markets were homogenized by decimalization. He also disapproved of Mr. Mathisson’s suggestion in his testimony that exchanges should have open-ended liability, noting that this could lead to an exchange being put out of business, which would dramatically affect the economy. In response, Mr. Mathisson questioned whether an exchange subject to such liability should remain in the market, and noted that if BDs could own more than 20 percent of an exchange, there would likely be more exchanges in the market. Dark Pools/Off-Exchange Trading/Trade-At Rulemaking/Fragmentation Mr. Joyce urged Congress to “tread lightly” when considering whether to address fragmentation because data does not indicate that fragmentation is hurting investors. He explained that dark pools were established to allow institutional traders to access large orders without displaying the trade to the marketplace and subsequently move the price, adding that retail investors utilize internalization because they receive instant prices without worrying about co-location, competing with professional traders, or market data issues. Mr. Cronin also addressed internalization, noted that ICI is concerned about hidden liquidity. He explained that the price discovery mechanism does not take place in these situations, which can be detrimental, and is often not worth the minimal price improvement gained from the internalization. Ranking Member Maxine Waters (D-CA) asked Mr. Gawronski to elaborate on his testimony, which stated that the Canadian government adopted a “trade-at rule,” prohibiting off-exchange trading without significant price or size improvement, and that the Australian and European governments may also be moving toward such a regime. In response, Mr. Gawronski reiterated that the US should consider a rule similar to the Canadian rule, but added that his company utilizes dark pools and he believes dark pools play an important role in the market. He explained that the rule should solely address the off-exchange trades that look similar to on-exchange trading, with similar order sizes and/or similar pricing. According to Mr. Gawronski, these are the trades that should be pushed onto the publicly displayed markets through a rule that would require a significant size or price improvement. Mr. Joyce disagreed with Mr. Gawronski, noting that Canada and Australia are smaller than the US, and arguing that the US should not “look to smaller countries to lead the way.” Mr. Cronin noted complications surrounding the “trade-at” rule, such as whether there would have to be a move to sub-penny increments to accurately reflect bids and offers with access fees. According to Mr. Cronin, this move would be exceptionally disruptive for institutional investors. Representative Carolyn Maloney (D-NY) focused on dark pools, noting that she believes dark pools are “the opposite of what [Congress] was trying to achieve under the Dodd-Frank Act.” She inquired as to why dark pools are growing and what impact they have on US competitiveness. In response, Mr. Smith explained that he is also concerned about fragmentation and believes markets should be consolidated. Mr. Gawronski noted that approximately 15 percent of the market would be considered “dark pools,” and that one third of the market is traded off-exchange, which includes dark pools and also internalization and wholesaling activity. He added that dark pools are growing because of fee differentials that exist between dark pool markets and display markets and also because of arbitrage activity between the display market pricing and what is happening in the dark pools. In response to Representative Maloney’s comments that the Dodd-Frank Act goals were to put trades on exchanges, increasing transparency and competition, Mr. Joyce argued that dark pools were actually created to protect investors. Representative Maloney also asked why bid-ask spreads are tighter in dark pools, and Mr. Joyce explained that together bid-ask spreads make it less expensive to trade, which is a net benefit. Mr. Niederauer argued in response to a question from Representative Randy Neugebauer (R-TX) that there is “nothing nefarious” going on in the market, but rather BDs are executing in a way that is consistent with the established rules. Therefore, if internalizing is economically better and results in less regulation, it is logical they would execute there. He also disagreed with Mr. Joyce that there are clear differences between exchanges and BDs, but rather much of the activity on dark pools is similar to the trades typically displayed in the public market. Representative Steve Stivers (R-OH) noted that even if there is opacity in part of the market, exchanges serve as the “goal posts” setting pricing for the entire marketplace. Mr. Niederauer agreed, but added that customer experience is often not better in dark pools. According to Mr. Niederauer, dark pools are simply better for the BD. Broker Dealer Conflicts of Interest Ranking Member Waters asked Mr. Gawronski whether BD conflicts of interest are a problem with regard to internalization. He agreed, noting that while he is a BD, he is “embarrassed” by others within his industry that put their rebate or lower cost over best execution for customers. He added that he “welcomes” more regulation because his company is committed to customers, adding that he does not see this commitment from the vast majority of BDs. Speculation/Hedging/Market Arbitrage Representative John Campbell (R-CA) explained that there are four ways to participate in the market: investing, trading, speculating, and gambling. He noted that trading, speculating, and gambling have all significantly increased, while investing has “almost disappeared.” According to Representative Campbell, he would exchange higher costs to trade in order to gain more investors in the marketplace. Mr. Niederauer agreed, adding that the loss of investor confidence is a “call to action.” Mr. Cronin argued that regulations are necessary to address this problem. In response to a question from Representative Al Green (D-TX), Mr. Joyce argued that arbitrage is good because a healthy market requires a broad spectrum of participators, including those engaged in arbitrage. Representative Green also asked about hedging and its distinctions from gambling. Mr. Cronin noted that hedging is important for ICI’s investors, because hedging risk enables investors’ counterparties to provide investors with liquidity. On whether hedging is gambling, Mr. Coleman explained that hedging decreases risk while gambling increases risk, and Mr. Joyce added that quantifying a term like gambling “is in the eye of the beholder.” Transaction Speed Representative Campbell discussed transaction speed, noting that a broad theme of the hearing has been that the market has focused on increasing speed at the expense of public confidence. Mr. Toes explained in response that speed has a “nasty connotation,” but it actually helps investor confidence because investors want to know a stock’s price at a particular moment. Representative Campbell disagreed, noting that the speed of the market ensures that investors are unable to “hit the button quick enough” to capture the price they see on their screen. Mr. Solomon agreed, arguing that there has to be a balance. He noted that many do not care about the penny that is lost or gained due to the speed of the transactions, and added that while speed is one component, it is more important that people continue to congregate at a common point that allows for more trading liquidity. Access to Capital for Small and Mid-Cap Companies/Tick Sizes Representative Robert Hurt (R-VA) noted that trading rules and regulations have affected small and mid-cap companies disproportionately, and asked how Congress can increase access to capital in the current structure. Mr. Joyce explained that these companies trade differently, and changes must be made to create more investor interest. He added that while the JOBS Act has made significant progress, Congress must now make other changes to bring liquidity to these offerings. Mr. Niederauer added that he is in favor of allowing companies to select their own tick size and the creation of a liquidity provision program to address this issue. He explained that without these programs, companies may do an initial offering and then “get orphaned” from a research coverage point of view. Representative Schweikert returned to the access to capital issue, asking whether companies should be allowed to choose their own tick size. Mr. Coleman explained that while he is not opposed to changing tick sizes, he believes exchanges should decide. Mr. Cronin, Mr. Gawronski, and Mr. Joyce in contrast, argued that the rules should not be prescriptive and that investors are in the best place to set tick sizes. Mr. Smith noted that he favors a calibrated tick size approach, and supports implementing a pilot program to experiment with bigger tick sizes for certain companies in the future. During the second panel, Mr. Weild and Mr. Mathisson reiterated that companies should have the ability to choose their own tick sizes. Mr. Mathisson, however, questioned whether it would make a significant difference in a company’s ability to raise capital. In response to a follow-up question from Representative Schweikert, Mr. Weild explained that smaller stocks may benefit from a tick size that is close to a quarter point, as this would help the company gain after-market support. Mr. Solomon agreed, noting that there has to be an economic interest for middle men to provide research. Representative Nan Hayworth (R-NY) also discussed potential pilot projects to help companies access capital more efficiently. In response to her inquiry regarding how such a pilot program should be implemented, Mr. Niederauer offered that the panelist could consider this issue further and report back to Congress. He added that exchanges would take the lead in determining the pilot program, working with issuers, and then prior to launching they would consult investors. Mr. Cronin confirmed that ICI would support such a pilot program that would aid liquidity. Mr. O’Brien also commented on this issue, arguing that any pilot program must easily impact the success of IPOs and must also be easy for investors to understand. Regarding how large the pilot program should be, Mr. Weild supported including 500 stocks over a 2-3 year period. Representative McHenry reiterated that he has legislation pending to incentivize small companies to seek US markets, explaining that with the advent of high frequency trading, “liquidity begets liquidity,” and there is a need for liquidity support for others “on the fringes.” He asked the witnesses how such an agreement should be structured if the legislation passes. In response, Mr. Joyce explained that IPOs must be encouraged, as the majority of jobs are created post-IPO. Therefore, actions that encourage market makers to sponsor stocks and pay for research should be examined. He added that widening the tick size should also be considered as it would encourage market makers to have greater participation. Mr. Niederauer stated that he supports Representative McHenry’s legislation, and added that widening the spread makes it easier for these companies to stay on exchanges and therefore remain transparent.
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