Hearing of the Securities, Insurance and Investment Subcommittee of the Senate Banking, Housing and Urban Affairs Committee - "Computerized Trading: What Should the Rules of the Road Be?"
Hearing
I would like to thank Chairman Jack Reed, Ranking Member Crapo, and all my colleagues on the Securities, Insurance, and Investment Subcommittee for holding this hearing.
Millions of American workers and their pension funds have long put their savings into the US capital markets in hopes of a better retirement and better future. In recent years, though, a number of headline-grabbing events have raised serious questions about our markets in the minds of ordinary Americans, sophisticated investors, policy makers, and regulators.
Are our markets too fragile and vulnerable to collapse?
Are our markets fair for all investors?
And are investors, who we need to fund the growth and development of our companies and our economy, fearful about subjecting their savings to these markets?
Nearly two years ago, some of you joined with members of the Permanent Subcommittee on Investigations, which I chair, in a joint hearing to examine the efficiency, stability, and integrity of the U.S. capital markets. At that hearing, held in the wake of the so-called Flash Crash, experts raised a number of important issues, and we highlighted a number of potential regulatory improvements.
I am pleased that the SEC took some steps to limit dangerous holes in our market regulation, such as unlimited, unsupervised direct market access. And just recently, the SEC finally issued a rule that will someday create a consolidated audit trail. These and other recent steps are a good start, but they are little more than Band-Aids. As anyone who has watched or participated in the markets in recent years knows, more must be done.
It is time for a broad re-examination of the actual workings of our markets. When the horse and buggy gave way to the automobile, our national infrastructure needed an upgrade. During these tumultuous times, while we as a country learned how to take advantage of this great new innovation, there were innumerable horrific accidents: cars running into older horse-drawn vehicles; cars running off the edges of unpaved roads; and cars simply crashing into one another.
What our country learned is that everything needed an upgrade. The roads themselves needed upgrades. They needed to be wider and more stable to bear the heavier traffic. The cars themselves needed to be safer. And the drivers needed an upgrade. They needed to adopt and follow "rules of the road," like when to make a left hand turn and what to do when an emergency vehicle drives by. These upgrades needed to be enforced. Roads need to be inspected, as did the cars driving on them. Drivers needed to be tested, and police officers needed to ensure that drivers followed the rules.
As the cars got faster over the next several decades, the benefits and needs for upgrades grew as well. We needed seatbelts and airbags. Roads needed to be wider, straighter, and bridges sturdier. Drivers needed to be smarter too. Those driving unique vehicles, like tractor trailers and busses, needed further training. And enforcement also needed upgrades. Because police officers can't be everywhere at once, speed cameras and red-light cameras have started to pop up.
The goals of all of these innovations were simple: (1) minimize the number of crashes, and (2) make the crashes that do occur less harmful.
In recent years, our capital markets have undergone a transformation that is no less stunning. The old New York Stock Exchange floor has been hollowed out. The screaming that once typified the floor is now replaced with the whir of computers. Traditional market makers have given way to computer trading firms with servers located right next to the computers of the trading venues.
Computerized traders use automated trading systems to very quickly place and cancel orders -- more than 90% are cancelled -- to make markets and arbitrage very small price differences between markets. In this very competitive industry, milliseconds can be the difference between millions in profits and significant losses. Because of that, computerized trading firms now pay thousands of dollars a year for the right to special proprietary data feeds from exchanges and other execution venues. Many rent space, for another hefty sum, to collocate their servers at execution venues. Doing this reduces the response time by a few milliseconds, which is worth millions of dollars to these firms. Orders to buy or sell stock are diced by computers into small bits, routed in milliseconds to any of several dozen venues, and executed in fractions of a second. All while other computerized trading programs are looking to sniff out those orders, and sneak in front of them for a profit.
Investors who hold onto stocks for weeks, months, and years comprise less of the market than ever, giving way to computer trading programs holding onto stocks for fractions of a second.
It is not surprising that this rapid development has resulted in more than our share of crashes, the most notable of which was the Flash Crash. And there are plenty of lessons to be learned from just that event.
But, since then, numerous other crashes and technological errors have roiled the markets. Many investors were shocked to see the failure of the IPO of BATS Global Markets. BATS is itself a major exchange on which investors trade more than 500 million shares a day. Yet, due to a computer glitch on BATS's own systems, its IPO went haywire and ultimately had to be shelved.
Just a few months later, another high profile IPO faced a different set of technical glitches. This time, trading glitches at Nasdaq left investors who tried to buy shares of Facebook, one of the most well-known and valuable IPOs in recent memory, with no idea whether their trade had been completed for hours, and, reportedly in some cases, days. Now, Facebook stock is worth barely half of its initial value, and lawsuits continue to be filed as Nasdaq, the underwriters, and investors fight over the damage.
Still another computerized trading error occurred last month. This time, Knight Capital, one of the largest market makers, nearly collapsed when a rogue trading program went unchecked for just about 40 minutes. Despite new rules intended to stop wild price swings, millions of unintended trades flung prices and volumes in about 150 stocks all out of whack. Ultimately, a seemingly small programming glitch cost Knight about $440 million and forced them to sell off a 73% stake in the company, nearly wiping out existing shareholders.
These accidental trades were one of the first significant tests of the rules that the SEC put in place after the Flash Crash. Most of those protections weren't triggered. While this is certainly a warning to other firms about the dangers of a single software error, it should also be a warning to regulators about the strength and security of our markets.
And these incidents don't include the dozens of "mini-crashes" that have occurred in single issuers. For a company and their employees, it must be more than a bit discomforting to watch your stock price spike and plummet over minutes, often for no discernible reason. It's past time for some more upgrades.
Regulators don't yet have effective systems to stop catastrophic collapses, and they lack the ability to see all of the activity that's occurring in all of the venues in a way that lets them understand what's going on. The consolidated audit trail was proposed years ago. It doesn't cover nearly enough activity, and is still years away from being a reality.
Regulators don't seem to know what the traders are really doing. While so-called "naked access," wherein traders are given unfettered access to the trading markets without real oversight, is banned, there are still no driving tests for these traders. There are still no licenses for these traders, unless they opt into them.
System failures are not the only concerns with our markets. There are very real questions about whether our US capital markets are fair. Since the joint PSI/Securities Subcommittee hearing in 2010, there have been a number of high-profile instances where some market participants have been given preferences over ordinary investors, and where our opaque market structure has allowed trading abuses that have victimized unwitting investors to go otherwise undetected.
Recently, the Wall Street Journal reported how some exchanges have created special order types that allow sophisticated algorithmic traders to jump the line and take advantage of ordinary investors. In some cases, exchanges are creating order types for sophisticated traders to use that are designed not to trade. Some are hidden from few. These orders aren't about maintaining fair and transparent markets. Just the opposite.
Also recently, the NYSE settled charges by the SEC that it sent its data feeds to certain customers faster than the data it provided to other market participants. Collectively, these reports show that some traders seem to be given a leg up on the rest of us. They get information faster. They process it faster. And they are given tools to take advantage of that information to the detriment of the rest of the market.
One of the more offensive examples of this type of favoritism is in so-called "flash orders," where a venue "flashes" an order to a select group of favored customers before showing that order to the rest of its members. What's to prevent one of those favored customers from taking advantage of that information to the detriment of the customer whose order was flashed? Not much. Senator Schumer and I, and others, have called for the banning of this practice. But, years later, that still hasn't happened.
There are other fairness risks. Given the complexity of order routing, and the incentives of the current "maker/taker" model, brokers are often faced with a conflict of interest. They can send an order to a venue with the best price, or they can send it to the venue which gives them the most profit. If these decisions were made by humans, we could ask them why they make particular decisions. But they aren't. These decisions are buried deep within the codes of smart order routers. Institutional traders and ordinary investors alike should wonder whether the smart order router is really working for them or their broker. To be sure, many brokers are fulfilling their duties to their customers and getting the best executions, but how is the customer to know? How is a regulator going to know?
Another significant challenge is the lack of transparency in the off-exchange trading venues. In a case last year, the SEC fined Pipeline Trading Systems, a dark pool operator, for trading in front of customers, taking advantage of their role in the center of the marketplace. While Pipeline was supposed to be matching up buyers and sellers, it was secretly trading against its customers, often for a profit. Is this type of activity happening at other dark pools? Most of them disclose that the firm itself may take the other side of a trade. So should it be ok if the customer knows that he's likely to be taken advantage of? What's his alternative? Is it to post the order on the New York Stock Exchange and be taken advantage of there?
I look forward to today's hearing, and we should all look forward to pressing our regulators to address these questions. For more than a century, American markets have been the envy of investors across the world. We must continue to examine the regulations and structure that has been put in place to ensure that today's equity market is fair for all and has the right protections in place to prevent technical glitches from causing a collapse.
Once again, I wish to thank Chairman Reed and Ranking Member Crapo for holding this important hearing today. I hope this hearing will lead to a strengthening of our markets to ensure that they remain the best in the world in coming years.
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