A hearing before the Senate Banking Committee on the SEC’s regulation of the equity markets revealed a growing consensus that Regulation NMS, while it has served nobly over the past years, is in need of comprehensive reform to reflect dynamically changing markets. The testimony demonstrated that many of the concerns raised by market participants and investors are the outgrowth of SEC Regulation NMS, noted the Committee’s Ranking Member Mike Crapo (R-ID), and the overall patchwork approach to market trading infrastructure and stability taken by the SEC in the past. Senator Crapo sounded a word of caution as the SEC engages in a comprehensive review of market regulation. While it is important and prudent for regulators to periodically review existing regulations to ensure that they are still appropriate in today’s automated world, said the Ranking Member, any such holistic review of regulation should be based on empirical analysis, data-driven, and incorporate the input of market participants, industry and the investors who make the investments. In other words, Senator Crapo believes that everyone should have a seat at the table in this important discussion and everyone must be willing to roll up their sleeves to find the right solutions.
While much has been made recently of the potential dangers of automated trading, noted Senator Crapo, what is often forgotten is that technology and innovation have benefitted investors by leading to tighter spreads, lower costs and more efficient markets. Today, he noted, an individual retail investor has an easier time participating in the equity markets than at any time in the history of those markets. With fees under $10 a trade, the spreads between bid and ask prices for most stocks are as narrow as they have ever been, and with trading being done in a matter of sub-seconds rather than minutes, retail investors have been able to enjoy greater involvement in, and access to, the markets. To continue this level of investor participation, he emphasized that Congress and the SEC must ensure that the markets have the resiliency and capabilities to handle the evolving speed and complexity of today’s trading world.
Senator Richard Shelby (R-AL), a former Chair of the Banking Committee, expressed concern about investor confidence in the equity markets, particularly with retail investors. This is an overall concern of Senator Shelby as high frequency trading and dark pools become more pervasive in the equity markets. The very term ``dark pool’’ can impact investor confidence in the markets, again, particularly with retail investors.
Jeffrey Sprecher, ICE CEO, ( and in November of last year, ICE completed its acquisition of NYSE Euronext), testified that, while Regulation NMS sought to increase competition among markets and consequently increased fragmentation, the costs associated with maintaining access to each venue, retaining technologists and regulatory staff, and developing increasingly sophisticated risk controls are passed on to investors and result in unnecessary systemic risk. The fragmentation also decreases competition among orders, he noted. Orders routed to and executed in dark trading centers do not interact or compete with other orders, which detracts from the price discovery function that participants in lit markets provide. The lack of order competition in a fragmented market negatively impacts markets in the form of less liquidity, information leakage and wider spreads.
While Regulation NMS achieved its goal of increasing competition among markets, said the ICE CEO, the pendulum has swung too far at the cost of less competition among orders. Action must be taken to correct these trends and rebalance the trade-offs of yesterday, and consequently build the confidence of individual investors and companies seeking to access the public markets and to bring back the balance set out in the Securities Exchange Act of 1934.
The ICE CEO detailed a number of measures that should be taken. For example, he said that order competition should be enhanced by giving deference to regulated, transparent trading centers where orders compete and contribute to public price discovery information. Limited exceptions could apply for those with unique circumstances. He also called for a ban on maker-taker pricing schemes at trading venues. Rebates that were used to encourage participants to quote on regulated, transparent markets add to complexity and the appearance of conflicts of interest.
Mr. Sprecher urged a lowering of the statutory maximum cap on exchange fees. Regulation NMS set a cap of what regulated transparent markets can charge to access a quote. In combination with giving deference to regulated, transparent markets and eliminating maker-taker rebates, the SEC should require lowered exchange access fees.
He also called for a revamp of the current market data delivery system. ICE supports the SEC taking a closer look at the current Securities Information Processors and proprietary data feeds to adopt policies that promote fairness. More broadly, in order to increase transparency in the way that markets operate, the SEC should demand that all trading centers report trade executions in real time, and all routing practices should be disclosed by those trading centers and brokers who touch customer orders.
Kenneth Griffin, CEO of Citadel, a global asset management firm, testified that as the SEC considers various reform ideas and assertions about problems with the current equity market structure, the Commission needs a rich set of data to analyze methodically, which will ensure that the SEC has the best information available when making these critical decisions.
He said that Regulation NMS and the foundational regulations that preceded it, along with technological advances, have helped unleash an enormous degree of competition among market centers. But in recent years, the costs that each new market center imposes on the market in terms of additional complexity and operational risk have started to outweigh the marginal benefits of a new competing market center.
Mr. Griffin said that specific regulatory action is needed to restrike this balance by requiring that market centers have sufficient resources and make sufficient investments in operational excellence. Over time this will reduce fragmentation by eliminating marginal market centers that rely on the low cost of market entry and operation.
More granularly, the Citadel CEO called for a reduction in access fees to reflect declining transaction costs and the broadening of caps on access fees. Under Regulation NMS, he explained, the charge to liquidity takers in today’s maker-taker system is called an access fee. The current NMS maximum access fee of 30 cents per 100 shares is now significantly greater than the cost of providing matching services by the exchanges, he noted, and should be reduced to reflect the current competitive reality. Exchanges are permitted to share the access fees they charge with liquidity providers in the form of exchange rebates. A meaningful reduction in the maximum access fee would materially reduce such rebates.
In general, exchange rebates encourage exchanges and liquidity providers to be more competitive. Exchange rebates also reward and encourage displayed liquidity, which greatly benefits the price discovery process. Banning exchange rebates would dampen competition between exchanges and would result in less posted liquidity and could result in wider quoted spreads. Mr. Griffin noted that the SEC has wisely focused on disclosure and other mechanisms to manage any potential conflicts of interest that may arise as a result of these fee structures.
Citadel believes that a reduction in the minimum tick size for the most liquid low priced securities combined with a reduction in the maximum permitted access fee would serve the best interests of all market participants. More importantly, he urged the SEC to close gaps by adopting an access fee cap in important segments of the market that have no access fee cap. Specifically, he asked the SEC to expand the access fee cap to include quotes that are not protected by Regulation NMS. He also urged the Commission to implement a parallel and proportionate access fee cap for sub-dollar stocks. The SEC should also move forward with its proposed rulemaking to cap access fees in the options markets.
BATS Global Markets CEO Joe Ratterman applauded the SEC’s plan for a continuous and comprehensive review of the state of the national market structure under Banking Committee oversight. Such a review is timely, he testified, because changes after the implementation of Regulation NMS reflect a relatively recent and dramatic evolution in the manner in which securities trade.
Specifically, Mr. Ratterman supports the review of current SEC rules designed to provide transparency into execution quality and broker order routing practices. In particular, Rules 605 and 606 of Regulation NMS require execution venues to periodically publish certain aggregate data about execution quality and require brokers to publish periodic reports of the top ten trading venues to which customer orders were routed for execution over the period, including a discussion of any material relationships the broker has with each venue. In his view, the publication of this data has helped better inform investors about how their orders are handled.
Nonetheless, he continued, these rules were adopted nearly 15 years ago and the market has evolved significantly enough to warrant re-examining whether additional transparency could be provided that would benefit investors. For example, advances in technology now permit significant market events to occur in millisecond time frames, and audit trails are granular enough to capture that activity.
However, the current requirements of Rule 605 effectively allow a trading venue to measure the quality of a particular execution by reference to any national best bid or offer in effect within the one-second period that such order was executed. Given the frequency of quote updates in actively traded securities within any single second, compliance with this requirement may not in all cases provide adequate transparency into a particular venue’s true execution quality. In addition, the scope of Rule 605 could be extended to cover broker-dealers, and not just market centers. Transparency could further be improved by amending Rule 606 to require disclosure about the routing of institutional orders, as well as a separate disclosure regarding the routing of marketable and non-marketable orders.
The BATS CEO also noted that all exchanges are given a significant competitive advantage regardless of their size by virtue of the order protection rule under Regulation NMS. While this was necessary in an era where legacy exchanges routinely ignored their competitors, he noted, current practices have reduced the need for regulatory protections of smaller venues. Recent events provide evidence that market forces ultimately can correct for venues that add only marginal value. The existing concentration of exchanges among scale providers means that in some cases the marginal operating cost for a new exchange is near zero.
The cost and complexity of connectivity to a small venue for market participants, however, can be substantial. Thus, he urged the SEC to revise Regulation NMS so that, until an exchange achieves greater than a de minimis level of market share, perhaps 1 percent, in any rolling three-month period, they should no longer be protected under the order protection rule; and they should not share in any NMS plan market data revenue.