Friday, September 19, 2014

Commissioner Gallagher Questions Opaque Fixed Income Markets, Outdated Equity Market Structure

[This story previously appeared in Securities Regulation Daily.]

By Matthew Garza, J.D.

In two speeches delivered on Tuesday, Commissioner Daniel Gallagher asserted that the equity market structure is out of date, and expressed alarm over opaqueness in the debt markets. He called for the SEC to increase its resources and step up efforts to increase transparency in the debt markets, and undertake a holistic review of equity market structure. Gallagher’s comments were made in a morning speech to the Georgetown University Center for Financial Markets and Policy Conference on Financial Markets Quality, and a speech later in the day at the 2014 SRO Outreach Conference.

Contrary to claims that the markets are “broken” or “rigged” in favor of high speed traders, assertions that gained popularity after publication of “Flash Boys” by Michael Lewis, Gallagher said investors are doing better today than when trading was dominated by manual processes. Such claims are “overwrought,” he said, citing data showing that new technology has lowered transaction costs, improved liquidity, increased market access, and reduced volatility.

But not all is well, Gallagher said, expressing concern over the “troubling asymmetry of information” in the market structure for fixed income products, which he said was far more likely to disadvantage retail investors than high frequency trading. He called for a holistic review of the equity market structure, including Regulation NMS, the SRO model, and securities information processors (SIPs). “We need the Commission and its expert staff to reoccupy the market structure playing field,” he said.

Regulation NMS. The Commission said Regulation NMS, which he pointed out was adopted by a split 3-2 vote, should be put under a microscope and its underlying assumptions should be reexamined. He singled out the trade through rule, which requires trading centers to route orders to the venue displaying the national best bid or offer, as a good example of a rule that is “non-market based.” A better approach was suggested by former commissioners Glassman and Atkins, who recommended that the broker’s duty of “best execution” be clarified. Best execution could involve more factors than simply the national best bid or offer, he said. He also suggested that the duties of brokers should also be deliberated when considering how to prevent technology failures, rather than focusing solely on the responsibilities of the exchanges.

SRO model. With regard to the exchanges, Gallagher again called for a review of the SRO model. “We need to revisit the fundamental question of whether or not national securities exchanges should still be SROs.” The exchanges have outsourced regulatory obligations and market surveillance to FINRA, and over 35 percent of securities transactions take place on alternative trading systems (ATSs), not exchanges, he pointed out. ATSs have no ownership limitations and no requirement to file rule changes with the SEC for notice and comment, giving them a distinct competitive advantage, said Gallagher.

“We must evaluate the SROs and markets as they are today and acknowledge that, in many cases, SROs today are fundamentally different from what Congress conceived of as self-regulation decades ago,” he said.

SIPs. Securities information processors, which have been at the center of recent technology failures, were seen as a public utility according to the legislative history of the Securities Acts Amendments of 1975, the commissioner said. Today there are two exclusive primary information processors for equity transactions, one for consolidated transaction data and consolidated quotation data, and the other for transactions executed pursuant to unlisted trading privileges. Each is owned by a major exchange. This lack of competition causes problems and, moreover, reliance on SIPS results in a single point of failure, as happened in August 2013 when a failure in the NASDAQ SIP led to a suspension of all trading in NASDAQ securities. “We must reconsider whether it is appropriate to continue to rely on the utility model, a relic of a mid-1970s congressional infatuation with utilities, with its built-in delays and potentially catastrophic crashes,” he said.

Fixed income markets. While FSOC focuses on designating systematically important financial institutions, an actual systematic risk is “percolating right under their noses,” namely the risk building in the fixed income markets, Gallagher said. There is approximately $3.7 trillion in outstanding municipal bonds, and over $11.3 trillion outstanding in the corporate debt market, a demonstration of the critical role debt financing plays in the U.S. capital markets. Retail participation is high, despite the fact that these markets are “incredibly opaque to retail investors,” he said.

Demand for fixed income investments has grown faster than equities, but the spreads to Treasuries continues to narrow, leaving these markets vulnerable to outflows with only a small increase in interest rates. “Inflationary hawks” in the meantime call for the Fed to increase rates, while “doves” worry about a subpar job market. If the Fed is forced to raise interest rates rapidly, it could “wreak havoc on the debt markets,” Gallagher claimed.

The SEC’s role. To counter this risk, the SEC should require greater price transparency in these markets, Gallagher believes. The SEC can address liquidity risks by facilitating electronic dealer-to-dealer and on-exchange transactions of these products, but only if the offering of the products is standardized. “The Commission must take the lead on this issue, but it is incumbent upon industry to find an efficient and expedient path forward,” he said.