Optimizing Our Equity Market Structure<br>Opening Remarks at the Inaugural Meeting of the Equity Market Structure Advisory Committee

I am pleased to welcome everyone to the inaugural meeting of the Equity Market Structure Advisory Committee. Maintaining and enhancing the high quality of the U.S. equity markets is one of the SEC’s most important responsibilities. This Committee’s work is an important part of that and will be of great assistance to the Commission as we continue our efforts to ensure that the equity markets optimally meet the needs of investors and public companies.

We are grateful to each of the members of the Committee for agreeing to devote your time and knowledge to such an important public purpose. All of you bring valuable insights and perspectives on the markets.

I have spoken at some length on the subject of equity market structure. To allow as much time as possible to hear from all of you, I will be relatively brief in my remarks this morning, and I will post my complete statement later today on our website.[1]

The U.S. equity markets have, of course, experienced a sweeping transformation over the last 20 years. Primarily manual market structures have been replaced by high-speed electronic markets in which computer algorithms dominate trading. As I have detailed before,[2] empirical evidence shows that investors are doing better in today’s marketplace than they did in the old manual markets.

There is, however, work to be done. For example, it is not clear that investors and public companies have sufficiently reaped the rewards from improved order handling and trading technologies. Given the radical changes in trading practices, we must take care that our regulatory structure, much of which was designed when markets were manual, is updated to reflect new ways of doing business.

The SEC has taken a series of important steps to address market structure issues, both on its own and in coordination with the self-regulatory organizations (SROs). It is worth noting, for example, that concerns about extraordinary volatility — as seen most prominently in the Flash Crash — have been met with automated circuit breakers,[3] a market access rule requiring brokers to manage the risks of, among other things, automated systems for accessing markets,[4] clearer rules for breaking trades,[5] and banning so-called “stub” quotes.[6] Responding to concerns about the strength of critical market infrastructure, the SEC adopted Regulation SCI last year to reduce the occurrence of systems issues and improve resilience when systems problems do occur.[7] In February, the SROs submitted an amended plan for a Consolidated Audit Trail that will greatly improve regulators’ ability to monitor trading and enforce rules. We are all anxious for its completion and I anticipate that the plan will be published for public comment later this year. In March, the SEC proposed a rule to heighten regulation of active proprietary traders by requiring them to be FINRA members.[8] And throughout this time, the SEC has brought a series of actions against all types of markets participants to enforce rules that protect market integrity and fairness.[9]

Our work continues in a number of key areas, including enhancements to critical market infrastructure like the securities information processors. In response to my request last year, the exchanges have submitted filings to the SEC that describe their use of data feeds for handling and executing orders[10] and that clarify the operation of the order types available on their exchanges.[11] Also in response to my request, the SRO participants in the consolidated market data plans have moved forward with an initiative to provide a new timestamp on their data feeds that will greatly expand the ability of the public to assess data latency.[12] In this regard, it should be noted that the consolidated market data plans have steadily upgraded their systems to reduce average latencies from nearly one second a decade ago to less than 1/1000^th of a second today.[13]

Beyond critical market infrastructure, I have asked the SEC staff to submit several additional rulemaking recommendations to the Commission.[14] One would improve firms’ risk management of trading algorithms and enhance regulatory oversight of their use. Other rulemaking recommendations would enhance transparency of ATS operations and of broker routing practices for institutional orders. Finally, the staff is developing a recommendation for an anti-disruptive trading rule that would be tailored to apply to active proprietary traders in short time periods when liquidity is most vulnerable and the risk of price disruption caused by aggressive short-term trading strategies is highest.

Although important initiatives to address discrete market structure issues have thus already been implemented or are in development, many of the core critical questions remain to be fully assessed and this Committee will play key role in doing so.

In that spirit, I want to just briefly touch on one overarching issue that reaches across many aspects of our market structure and deserves close attention — market complexity.

As I have considered our equity market structure in my two years as SEC Chair, one characteristic that has stood out over and over is the level of complexity in today’s markets. They are highly competitive, yet fragmented among many different trading venues. They are high speed and high volume, yet the high volume of actual trades is a small fraction of the volume of orders that are sent to venues and cancelled without trading.

Complexity itself, of course, is not always bad. Complexity can be useful if it contributes to better markets for investors and public companies. Complexity clearly is good when, for example, it enables intermediaries to tailor their services to meet the varying needs of the different types of investors and public companies.

One example of such constructive complexity may be the potential refinement of market structure for smaller companies. I have noted before that we should question any assumption that our equity market structure should be “one-size-fits-all.”[15] While today’s market structure is largely the same for large and small companies, that does not mean that it is optimal for smaller companies. The tick size pilot program, which we approved last week,[16] is intended to generate useful data to help determine whether certain changes in the market structure for smaller companies are warranted. If the data indicates that changes would be helpful, implementing such changes would increase complexity to some degree, but it would be based on an empirical conclusion that investors and public companies would be better off.

In contrast, I think much of the concern expressed about our current market structure can be distilled to at least a perception that it is unnecessarily complex. And by unnecessarily, I mean complexity that is not directed primarily toward producing better markets for investors and public companies.

That kind of complexity can lead to less than an optimal equity market structure. Complexity can, for example, result in instability if the sophisticated order routing and trading systems necessary to deal with a complex structure do not operate as intended. It can create a lack of transparency for investors about how their orders are handled and executed. It can lead to unfair outcomes if professional traders using the fastest, most sophisticated tools are able to exploit the complexity in ways that disadvantage investors. Complexity can also make the always difficult task of regulators in effectively overseeing the markets and enforcing rules even more difficult.

All of these potential effects can undermine investor confidence in the integrity and fairness of the equity markets. Such confidence is essential if equity markets are to attract the investors needed to meet the vital economic purpose of promoting vigorous capital formation and economic growth. We must work to ensure that our equity market structure is fair and efficient, both in fact and as perceived by investors.

Over the last 20 years, the SEC has undertaken a variety of market structure initiatives to address changing market conditions. In reviewing these efforts, as well as the views of commenters on them, it is clear that a consistent primary focus was to promote a competitive market structure. This is particularly true of the comments on the SEC’s Fragmentation Concept Release in 2000,[17] and the subsequent proposal of Regulation NMS in 2004.[18] The focus on promoting competition is understandable given the historical dominance of the NYSE and NASDAQ in their listed stocks and some of the problems that had arisen in those markets.

When Regulation NMS was adopted in 2005, many were concerned that the new rules might in fact impair competition and preserve a duopoly for the NYSE and NASDAQ.[19] It is safe to say that those fears have not been realized. In today’s equity markets, we have eleven exchanges, more than 40 dark pool ATSs, and more than 200 broker-dealers that split the trading volume in exchange-listed stocks.[20] No single venue executes even 20% of this volume.[21] Competition among these trading venues for order flow is intense, though it may not necessarily be focused on factors that most concern investors and public companies.

Increased complexity is a product of all these trading venues and their competition. There are many different venues to which to route orders, many different orders types across all of those venues, and many different fees and rebates and payments offered by those venues. Among other things, these varying practices can create serious potential conflicts of interests for brokers when handling their customer orders.

We should look closely at our current rules to determine how and to what extent they have needlessly fostered complexity. While in the past, promoting competition was a clear focus in fashioning market structure rules, we must now examine whether the fragmentation resulting from pursuit of that goal has created complexity that does not serve interests of investors and public companies.

But critically, regulations alone almost certainly are not responsible for all of the complexity in our market structure. We also should look closely at industry practices that have developed over the years as market structure has evolved. In particular, to what extent have the interests of intermediaries, rather than those of investors and public companies, been the driving force behind these industry practices?

Addressing these issues over time means considering a wide range of specific questions that I believe are legitimately in the minds of investors and public company executives. For example:

• Why are there 11 exchanges that trade listed equities, and why are ten of these exchanges controlled by three exchange groups?[22] What distinguishes these exchanges in terms of the services they offer investors and public companies?
• Why are there hundreds of different order types across the various exchanges?[23] To what extent do these specialized orders help promote the interests of investors and public companies?
• Why are 94% of displayed orders in corporate stocks cancelled without an execution?[24] Do at least some portion of them detract from fair and orderly markets?
• Why are more than 50% of the displayed orders at the best prices in corporate stocks cancelled in less than one second without an execution?[25]
• Why are there more than 40 dark pool ATSs that trade listed equities?[26] What distinguishes these venues in terms of the services they offer investors and public companies? To what extent do these fragmented pools of liquidity exist primarily because of the interests of a sponsoring broker-dealer?
• Why, in a single week, were nearly 2.9 billion orders routed to dark pool ATSs, yet only 1% of these orders received an execution?[27]
• Recognizing that high frequency trading is not a monolithic phenomenon and that different HFT firms can employ varying strategies, why were only 49% of trades from a sample of HFT firms generated by resting orders that offer liquidity to others?[28] And why does this percentage fall to 31% in the stocks of smaller companies where liquidity is most needed?[29]
• Why did a sample of HFT firms generate 73% of quotes, which reflect displayed resting orders, yet these quotes resulted in only 43% of resting order dollar volume?[30]
• When retail brokers negotiate with off-exchange market making firms for directing customer’s marketable orders to those firms, why do the negotiations include both the level of price improvement expected for investor orders and the payment of millions of dollars to the broker?[31]
• Why do retail brokers route nearly all of their non-marketable customer orders to exchanges that pay the highest rebates for those orders?[32] Is there any data indicating that customers receive best execution of their orders at those exchanges?

These questions are certainly not an exhaustive list of those being asked by the public, nor are they ones that necessarily demand action by the Commission or this Committee. And we likely already know many of the answers that will be offered to these and similar questions. Indeed, many of the data points referenced in the questions come from analyses and white papers that are posted on the SEC’s equity market structure website.

But we should place ourselves in the shoes of investors and public companies that do not have ready access to the sources of information that the Commission and some market participants do. Speaking on their behalf, I do not believe that questions like these have received the public discussion they deserve — a discussion that is issue-focused, data-driven, and balanced, and in which claims about our current market structure, whether they be criticisms or defenses, can be adequately explored from all sides.

This Committee will provide an excellent forum for the healthy debate and analysis that is needed. In addition, as will occur today, there will be opportunities for others who are not members of the Committee to make presentations and participate in the discussions, and to submit written comments for posting on the SEC’s website for the Committee.

It is fitting that today we are starting our market structure discussion with an assessment of Rule 611 of Regulation NMS — the order protection rule. The selection of this rule for the inaugural meeting is reflective of how important it is to examine the fundamentals of our current market and regulatory structure, to explore their impact and assess their continued utility. This is not done just for an interesting discussion — although I am sure it will be that. Rather, we are about the serious business of optimizing the structure of our equity markets through a careful, data-driven assessment where no issue is off limits or any assumption unquestioned. And Rule 611 is most certainly a rule that features prominently in the discussion of market structure, with different views of its various impacts, including critiques that it has: (1) contributed to excessive fragmentation; (2) led to increased off-exchange trading; (3) harmed institutional investors; and (4) failed to achieve the objective of enhancing displayed liquidity. The Division of Trading and Markets has prepared and posted on our website a memorandum that is intended to help explore the extent to which these claims may or may not be accurate. Addressing Rule 611 will no doubt serve to highlight the other forces that have shaped our market structure, whether they be regulatory, competitive, or technological.

Obviously, there are a number of other very important aspects of our market structure that will be studied and examined at future meetings. I anticipate, for example, that the staff will circulate and publish memoranda that address topics such as the maker-taker pricing model, along with the access fee cap and lock-cross restrictions of Rule 610 of Regulation NMS, and the SEC’s regulatory approach for exchanges and other types of trading venues.

Let me close by reiterating my deep appreciation to the members of the Committee. Your work, assisted by the participation of investors, public companies, the securities industry, and the public, will greatly assist the SEC as we work together to enhance the efficiency, integrity, and fairness of our equity markets.