0001 1 THE UNITED STATES SECURITIES AND EXCHANGE COMMISSION 2 3 4 5 6 7 EQUITY MARKET STRUCTURE ADVISORY 8 COMMITTEE MEETING 9 10 11 Wednesday, February 2, 2016 12 9:30 a.m. 13 14 15 16 17 18 19 20 21 22 23 Securities and Exchange Commission 24 100 F Street, N.E. 25 Washington, D.C. 20549 0002 1 PARTICIPANTS: 2 3 COMMITTEE MEMBERS: 4 Matthew Andresen 5 Reginald Browne 6 Kevin Cronin 7 Brad Katsuyama 8 Ted Kaufman 9 Richard Ketchum 10 Manisha Kimmel 11 Mehmet Kinak 12 Joseph Mecane 13 Jamil Nazarali 14 Eric Noll 15 Maureen O'Hara 16 Joe Ratterman 17 Nancy Smith 18 Chester Spatt 19 Gary Stone 20 21 SEC COMMISSIONERS: 22 Mary Jo White, SEC Chair 23 Michael S. Piwowar, SEC Commissioner 24 Kara M. Stein, SEC Commissioner 25 0003 1 PARTICIPANTS (CONT.): 2 3 SEC STAFF: 4 Michael Coe 5 Mark Flannery 6 Gary Goldsholle 7 Daniel Gray 8 Stephen Luparello 9 David Shillman 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 0004 1 C O N T E N T S 2 3 PAGE 4 Welcoming Remarks 6 5 Chair White 6 Commissioners 10 7 Director of the Division of Trading and 15 8 Markets Stephen Luparello 9 Presentation on Market Volatility by SEC staff 16 10 Presentation and Q&A on Market Volatility 25 11 Stacey Cunningham, Chief Operating 25 12 Officer, NYSE 13 Hubert De Jesus, Co-Head, Market Structure & 35 14 Electronic Trading, BlackRock 15 Frank Hatheway, Chief Economist, NASDAQ 41 16 Paul O'Donnell, Managing Director, Morgan 50 17 Stanley 18 Committee Discussion on Market Volatility 56 19 Presentation on Customer Issues by SEC staff 104 20 Presentation and Q&A on Customer Issues 21 Jeffrey Brown, Senior VP-Legislative & 112 22 Regulatory Affairs, Charles Schwab 23 Frank Childress, Managing Director, Wells 120 24 Fargo Advisors 25 0005 1 C O N T E N T S (CONT.) 2 PAGE 3 Presentation and Q&A on Customer Issues (cont.) 4 Dennis Dick, Member - Capital Markets Policy 129 5 Council, CFA Institute 6 Presentation and Q&A on Customer Issues (Continued) 7 Christine Parlour, Professor of Finance & 143 8 Accounting, Haas School of Business, 9 UC Berkeley 10 Committee Discussion on Customer Issues 145 11 Subcommittee Updates 190 12 Discussion of Next Steps/Adjournment 201 13 14 15 16 17 18 19 20 21 22 23 24 25 0006 1 P R O C E E D I N G S 2 MR. LUPARELLO: Good morning. I would like to 3 call the meeting to order. I believe we have a quorum 4 this morning. 5 I understand we have two members, Rick and Ted, 6 on the phone. Ted, I heard you. Rick, are you on the 7 phone as well? 8 MR. KETCHUM: Yes, I am. 9 MR. LUPARELLO: Great. Thank you for joining. 10 On behalf of the Commission, I would like to 11 thank you all for joining us today for the third meeting 12 of the Equity Market Structure Advisory Committee. 13 With that, on behalf of the Committee and as 14 the designated federal officer, I would like to welcome 15 Chair White to the meeting. 16 CHAIR WHITE: I think that is my cue also. 17 MR. LUPARELLO: That is, in fact, your cue. 18 CHAIR WHITE: Thank you, Steve. And good 19 morning. And, again, thank you all. I think I got 20 around to almost everybody to thank you for being here 21 today. 22 As reflected in today's agenda, you are 23 continuing to consider, really, a range of the most 24 important and complex market structure issues. At prior 25 meetings, the Committee discussed rule 611, the order of 0007 1 protection rule of reg NMS, exchange access fees, and the 2 current regulatory models for trading venues. Today the 3 Committee will take up the issues accompanying the market 4 volatility occurring on August 24th and then discuss a 5 number of issues affecting retail and institutional 6 customers, including certain order types used by 7 customers, how they operate, payment for order flow, and 8 execution quality and order routing disclosure. 9 We are very pleased to welcome today's 10 panelists, both topics. They bring with them years of 11 market experience and great knowledge. Thank you for 12 taking the time to join us. And I look forward to 13 hearing from each of our panelists, what their views and 14 perspectives are. 15 We at the Commission, of course, also have a 16 sharp focus on optimizing the structure of our equity 17 markets. Since your last meeting, the Commission issued 18 a proposal to address one significant aspect of trading 19 venue regulation: transparency of ATSes. The proposal 20 seeks to shine a light on how ATSes operate and on the 21 potential conflicts of interest that they may present. 22 The comment period on that particular proposal closes on 23 February 26, 2016. 24 Your discussion this morning on market 25 volatility and the events of August 24 is both important 0008 1 and timely. As you know, a key element of the SEC's 2 approach to market structure issues has been to conduct 3 rigorous data analysis. 4 In late December, SEC staff posted a research 5 note on the Commission's equity market structure website 6 addressing the operation of U.S. equity markets under the 7 stress conditions of August 24th. The paper provides 8 detailed empirical data and other information to help 9 assess trading on that day. Among the issues addressed 10 in the paper are the opening and reopening processes at 11 the primary listing exchanges, the effects of market 12 volatility on trading and certain ETPs and corporate 13 stocks, and the operation of the limit up-limit down 14 pilot plan on a day with market-wide volatility. 15 I know that members of this Committee and our 16 panelists have also reviewed issues raised by the events 17 of August 24 and look forward to hearing everyone's views 18 on potential responses. The August 24 paper and other 19 analyses will help provide a strong, sound empirical 20 basis for further consideration of steps to refine 21 current trading rules in order to optimize the operations 22 of controls over volatility. 23 Your second panel will consider how market 24 structure affects retail and institutional customers. To 25 facilitate this discussion, the staff posted a memorandum 0009 1 on the Committee's webpage that summarizes several 2 important issues affecting customers. One topic 3 discussed is the use of certain order types, specifically 4 market orders and stop orders. These order types may 5 present potential risks to investors, especially during 6 periods of short-term market volatility. 7 A second issue and important one for customers 8 is payment for order flow. Payments by OTC market makers 9 to retail brokerage firms for marketable retail customer 10 order flow is a longstanding practice. The Commission 11 has stated that a broker accepting payment for order flow 12 does not necessarily violate its best execution 13 obligations, but the Commission has also recognized that 14 the existence of payment for order flow arrangements 15 raises the potential for conflicts of interest for 16 broker-dealers handling customer orders. 17 Still another issue impacting customers is 18 disclosure to them of how their interests are being 19 served by their broker-dealers. Some market participants 20 have recommended that enhancements be made to the 21 execution quality and order routing disclosures required 22 by rule 605 and 606 of reg NMS. Again your agenda today 23 is spot on in considering potential improvements to these 24 rules as SEC staff is developing a rulemaking proposal to 25 enhance the required disclosures, including how to 0010 1 enhance transparency of the order routing practices of 2 broker-dealers for institutional investors. 3 So I look forward to hearing your views as to 4 whether and how these rules can continue to provide 5 meaningful information and possible ways to enhance the 6 disclosures for all investors. 7 At your last meeting, as you know, the 8 Committee formed four subcommittees focused on regulation 9 NMS, trading venues regulation, customer issues, and 10 market quality. Since October, the subcommittees have 11 been hard at work. And as part of today's agenda, each 12 subcommittee chair this afternoon will provide a brief 13 status update on their respective subcommittees. And I 14 look forward to hearing their reports. 15 So let me close again by thanking you for your 16 commitment of time and expertise to the work of the 17 Committee. Your perspective and ideas are invaluable as 18 we examine how to optimize today's equity market 19 structure. 20 Thank you. 21 MR. LUPARELLO: Thank you, Chair White. 22 We will now ask the commissioners to make their 23 opening statements, starting right to my left with 24 Commissioner Stein. 25 COMMISSIONER STEIN: I am going to make some 0011 1 brief remarks. I want to welcome all of you here, 2 excited that we are finally having our third Equity 3 Market Structure Advisory Committee meeting. 4 Today's agenda covers two important areas of 5 concern: the extraordinary market volatility that 6 occurred o August 24, 2015 and certain issues affecting 7 investors, particularly retail investors, in today's 8 market. 9 Before I briefly discuss these two items, I 10 would like to take a moment to thank Chair White for her 11 recent comments about the importance of getting the 12 consolidated audit trail for the CAT off the ground. It 13 is now nearly six years since the Commission's 2010 14 initial proposal. And this critical project is years 15 behind schedule. In my view, the Commission and the SROs 16 have no greater task than to get this system built. 17 Chair White has arranged for a project manager at the 18 Commission to help shepherd it along. And I look forward 19 to the achievement of key milestones this year that will 20 bring the CAT into existence. 21 Turning to today's agenda, we have an 22 incredibly experienced and talented panel to discuss 23 equity market volatility. Many market participants feel 24 that the extraordinary volatility that occurred on August 25 24, 2015 may have been exacerbated by the operation of 0012 1 certain rules. Today's staff presentation and panel 2 discussion should help all of us in thinking about 3 operation of the markets on August 24th and to examine 4 proposals to enhance the resiliency. Investors and 5 issuers need to be able to count on the effective 6 operation of our markets in times of stress. 7 The second item on the agenda will examine the 8 use of certain types of orders, as Chair White mentioned, 9 market orders and stop orders, payment for order flow 10 arrangements, and execution quality reporting. These are 11 all issues that impact the quality of an investor's 12 experience and investor confidence. In particular, I am 13 deeply concerned about the relationship between certain 14 types of orders that happen to be used primarily by 15 retail investors and the volatility on August 24th. Did 16 these investors receive fair treatment on that day? Are 17 retail investors uniquely disadvantaged in some ways? 18 These questions go to the concerns expressed by some that 19 our current market structure favors the interests of 20 certain investor groups over others. 21 I am looking forward to today's discussion 22 regarding how to enhance the quality of the investors' 23 experience in the marketplace; in particular, retail 24 investors. 25 Finally, I look forward to the reports of each 0013 1 of the subcommittees as well as hearing how you will 2 engage with others to ensure that all interested parties 3 can weigh in and contribute to your important work. 4 I very much appreciate the time and the 5 attention that each of you have dedicated and are 6 dedicating to the important work of this Committee. As I 7 have said before, each of you has a tremendous 8 responsibility to put your own business interests aside 9 and speak for the markets as a whole. I am counting on 10 you. The American people are counting on you to 11 recommend appropriate changes and improvements to our 12 equity market structure. 13 I look forward to today's analysis and 14 discussion about what is best for our markets. And, 15 again, thank you for your pro bono activities in this 16 area. 17 MR. LUPARELLO: Thank you, Commissioner Stein. 18 Commissioner Piwowar? 19 COMMISSIONER PIWOWAR: Thank you, Steve. 20 Welcome, everyone, to today's meeting. I first 21 want to express my appreciation to the members of the 22 Committee for your level of engagement, especially within 23 the subcommittees that have been constituted since our 24 last meeting. I understand the subcommittees' efforts to 25 identify, prioritize, and analyze issues regarding our 0014 1 current equity market structure are underway. And I look 2 forward to the updates this afternoon. I am confident 3 your insights will continue to challenge the Commission 4 as we consider equity market structure improvements. 5 I also want to thank the panelists in advance 6 for your contributions to the discourse. 7 Finally, I would be remiss if I did not 8 acknowledge the staff's substantial efforts in connection 9 with this event. 10 As with prior meetings, the topics on today's 11 agenda are important components of an ongoing review of 12 equity market structure. I am pleased that we are not 13 shying away from these complex issues. 14 The staff's research note regarding the trading 15 on August 24th of last year is an excellent jumping-off 16 point for this morning's discussions. The events of 17 August 24th provided a test of how our markets operate in 18 times of extreme volatility and revealed that there is 19 room for improvement. 20 The various customer issues that will be 21 discussed this afternoon, the risk of using certain order 22 types, the potential conflicts presented by payment for 23 order flow arrangements, and the development of more 24 meaningful execution-quality reports, also represent 25 opportunities for refinement of our regulatory approach. 0015 1 What we hear today is inevitably going to introduce a 2 lot of new issues and questions. 3 I hope this discussion will provide direction 4 on where the Committee and the Commission should focus 5 their energies. Thank you. 6 MR. LUPARELLO: Thank you, Commissioner 7 Piwowar. 8 Let me quickly introduce the Commission staff. 9 To my right is Gary Goldsholle, deputy director of the 10 Division of Trading and Markets. To his right is David 11 Shillman, who is the associate director of the Office of 12 Market Supervision. And slightly around the corner is 13 Dan Gray, feeling a little bit disconnected from his 14 fellow staffers by being perpendicular, who is the acting 15 head of our Office of Analytics and Research. And, 16 speaking of disconnected but only physically, not 17 substantively, down to Mike's left is Mark Flannery, who 18 is our director of the -- what is DERA? -- the Division 19 of Economic and Research -- I always -- 20 (Chorus of "Risk.") 21 MR. LUPARELLO: Risk. Risk. Sorry. OAR and 22 DERA are just too much for me to handle. 23 CHAIR WHITE: Can't take him anywhere, 24 actually. 25 MR. LUPARELLO: Yes. No. Exactly. So, with 0016 1 that, I will actually read our standard disclaimer, 2 instead of just trying to remember it off the top of my 3 head. "The staff's views expressed in this forum are 4 ours and cannot be attributed to the Commission or the 5 commissioners or the body as a whole." 6 So let me head a couple of quick housekeeping 7 items. We will start, as the chair has said, with a 8 brief presentation on market volatility and the events of 9 August 24th to set the stage for panel presentations and 10 committee discussions. We will then adjourn for lunch 11 and begin the afternoon with the presentation of the 12 customer issues that we have teed up. And after that, we 13 will follow with Committee discussion of both. Finally, 14 we will hear from the four subcommittees on the work they 15 have done since their formation at the last meeting. 16 So, with that, I will turn it over to Dan, who 17 will tee up the staff paper on August 24th. And then I 18 will invite the panelists to come up and make their 19 presentations. 20 MR. GRAY: Thank you, Steve. 21 Good morning, everyone. As Commissioner 22 Piwowar mentioned, the research note on August 24th is 23 intended to be a first step in this process of evaluating 24 what happened. And, to that end, there is a lot of data 25 in the report. And it does not address the issue or 0017 1 provide recommendations about what should be done. That 2 is the second step that we have moved onto. And I know 3 today's discussion is going to be very helpful towards 4 that goal. 5 One of the consistent types of feedback we have 6 on the report is, "Wow. That is a lot of data. That is 7 great, but what does it all mean?" So I thought it might 8 be helpful today to at least give one person's view on 9 how you might organize all the data that is in the 10 report. 11 I think the first thing that might be useful to 12 highlight is the fact that how August 24th may have 13 differed from the flash crash, the broad market flash 14 crash, back in May 2010. In that case, broad market 15 prices sort of in the middle of the afternoon for no 16 seemingly particular reason suddenly declined very 17 substantially very extraordinarily, down more than 5 18 percent, and then almost as quickly recovered. And in 19 that respect, August 24th is different because, even 20 leading into the 9:30 opening of regular trading hours on 21 the equity markets, there was very substantial selling in 22 the premarket. And, you know, the primary price 23 discovery vehicles for the broad market, which would 24 include the SPY; the ETP; and the S&P500 E-mini, the 25 futures product, were both down very substantially, you 0018 1 know, 5 percent, heading into the open, which is very, 2 very unusual. 3 So I don't think you could attribute that 4 selling to -- and these are retail interests. You know, 5 that is sort of selling in the futures and elsewhere is 6 probably coming from broader sources. So you had that 7 element of the day heading into the 9:30 open. And at 8 that point, the opening auctions on the primary listings 9 exchanges opened to substantial volume but that was 10 consistent with the premarket trading of down around 5 11 percent. And then there was a very substantial surge. 12 And additional selling seemed to be price-insensitive 13 selling that, at least in my view, the broad market 14 handled relatively well in the sense that it declined 15 another 2 percent that absorbed a lot of that selling and 16 then recovered relatively quickly. So I think in terms 17 of the nature of the selling and the size of the decline 18 on the broad market is an important distinction between 19 the flash crash and 2010. 20 Of course, there were some significant issues 21 on August 24th. Otherwise we wouldn't be here today 22 talking about them. And I think if you look at the 23 report, you might be able to divide them into three 24 categories. One would be there seemed to be a breakdown 25 in arbitrage in the significant minority of ETPs, not a 0019 1 majority but a minority. 2 Second, once ETPs entered the process under 3 limit up-limit down of having a pause in reopening, that 4 process did not seem to work very well. 5 And, then, third, unlike the great majority of 6 corporate stocks, there were a few corporate stocks that, 7 in fact, did flash crash in the sense of having this very 8 sudden deep downturn and then an equally sudden recovery. 9 And, in particular, there were six very large corporate 10 stocks that did that. And I think on any other day, that 11 would have gotten a lot of focus, maybe hasn't got a lot 12 of focus on August 24th because here were a lot of other 13 issues, but it is certainly from the standpoint I think 14 of market structure important to understand why those 15 very large corporations behave that well. 16 So in the few minutes I have left, I thought I 17 would highlight a few of the key data points in the paper 18 that may bear on those three broad categories of 19 problems. First, on the arbitrage breakdown in a 20 minority of ETPs, we focused on the fact that the 21 majority of ETPs did not experience those problems. And 22 that is not just sort of an academic or theoretical 23 issue. I think it is important to assess that when you 24 are assessing the really important issue of which 25 products had the problem and then why did they have the 0020 1 problem. And, in particular, explanations that are very 2 broad that might apply to ETPs, you have to at least ask 3 the additional question of if this was very significant, 4 why did it not seem to affect a majority versus the 5 minority of the ETPs that had the problem? 6 A second data point in the paper is that 7 relating to this issue of why seemingly similar ETPs 8 behaved differently, there seemed to be a strong 9 correlation with this metric of secondary market turnover 10 rate, which is the ratio of the volume on a normal day in 11 a product compared to its size, the number of shares 12 outstanding. So while it doesn't explain everything, all 13 of the disparities, on August 24th, there was a very 14 strong correlation in the sense that it wasn't that the 15 correlation was with the size of the ETP alone and it 16 wasn't that the correlation was with the trading volume 17 of the ETP alone. It was, in fact, the comparison of 18 what it normally trades at to its size. And to the 19 extent that an ETP had a lot of trading volume on normal 20 days relative to its size, it seemed to be less subject 21 to extreme volatility on August 24th. 22 On the second category of issues, relating to 23 the limit up-limit down process, I think it is important 24 to recognize that this actually did seem to be an ETP- 25 related issue, a relatively small number of corporates 0021 1 actually triggered limit up-limit down pauses. For 2 example, only 8 out of the S&P500 companies actually had 3 a limit up-limit down pause. And the great majority of 4 the more than 1,200 pauses that occurred on August 24th 5 were in ETPs but not only that, they were in a relatively 6 small number of ETPs in the sense that more than half of 7 the limit up-limit down pauses were repeats in the same 8 symbols. And more than half of them actually occurred 9 when the market was trying to recover, not during the 10 downturn but when it was trying to recover. So I think 11 that is important in evaluating the process, important to 12 keep that in mind. 13 A key data point here is related to the 14 imbalances and the reopening auctions on NYSE Arca, which 15 is the dominant listing exchange for ETPs. NYSE Arca 16 imposed price collars on reopening prices on August 24th, 17 which means that when there were significant imbalances 18 in the reopening auction, which there were, they did not 19 get executed in the auction. So it was very likely that 20 after the auction print went off, those significant 21 imbalances went immediately into the continuous market, 22 which if you look at the number of repeat pauses was not 23 able to handle those imbalances very well. So that is a 24 significant issue to think about. 25 And, then, finally, a tidbit in the public data 0022 1 on where a lot of the selling pressure came from on 2 August 24th after the actual opening auctions is in the 3 imbalance information for NYSE Arca. And, somewhat 4 startlingly for the pauses that occurred when the market 5 was on its way down, more than 90 percent of those 6 imbalances, significant imbalances, in the auction came 7 from market orders; whereas, when the market turned and 8 was going back up, more than 90 percent of the imbalances 9 came from orders that had limit prices, which would seem 10 to indicate there was a pretty significant difference in 11 the nature of the selling pressure on the way down than 12 in the order flow that came in on the recovery. 13 And, then, finally, the third issue relating to 14 particularly the very large corporates that did 15 experience flash crashes, they all displayed a pretty 16 similar pattern in the sense that the declines did not 17 happen until after the opening on the primary listing 18 market and they would tend to open, you know, consistent 19 with what the broad market was doing, about 5 to 6 20 percent down in an opening auction that had very 21 significant volume in the auction. 22 But at that point, a very large amount of 23 selling interest came into the market; in fact, over the 24 next minute or so, more volume than actually was executed 25 in the opening auction on the primary. And this selling 0023 1 pressure led these stocks to decline as much as 15 or 16 2 percent in a minute. 3 So one of the issues there is you might think, 4 "Well, gee. I thought limit up-limit down bands at the 5 opening for these stocks was 10 percent. How could they 6 decline 16 percent in 1 minute?" And the answer is when 7 you get down into the very details of how the price bands 8 are calculated under the limit up-limit down plan, 9 immediately after the opening, it does allow these 10 symbols to move more than you might expect. So that was 11 one of the factors that came out on August 24th. 12 I think more generally, this issue of the 13 nature of both the selling interests that contributed to 14 the increase in demands for liquidity as well as the 15 nature of the supply of liquidity that interacted with 16 that selling interest is an important issue for 17 continuing examination, which we are looking at or 18 particularly looking at. 19 The staff is looking at nonpublic regulatory 20 data that gives you more information on the source in 21 terms of the market participants of where that interest 22 came from. So that is an important issue that we will be 23 looking at going forward. 24 MR. LUPARELLO: Thank you, Dan. 25 And that is an important point to close on, 0024 1 that although the August 24th report that we just put out 2 is very detailed and very comprehensive, it just 3 represents at this point a preliminary analysis. And 4 access to additional data and additional time may lead to 5 further evaluations and conclusions. So I appreciate 6 that. 7 I would ask the Committee if they have any 8 questions of Dan and his paper before we move on to our 9 panel presentation. 10 (No response.) 11 MR. LUPARELLO: I think that speaks to the 12 comprehensiveness of your statement. 13 So let me ask our first panel to come up. If 14 folks could join us, we will get started. And I will 15 make a note in the future to give consistent instructions 16 as to whether folks should come up before or during. So 17 that is a DFO takeaway from this. 18 Let me quickly introduce our panel going from 19 my left to right. We have Stacey Cunningham, who is the 20 chief operating officer of the New York Stock Exchange. 21 To her left is Hubert De Jesus, who is the co-head of 22 market structure and electronic trading at BlackRock. To 23 his left is Frank Hatheway, who is the chief economist at 24 NASDAQ. And to his left is Paul O'Donnell, a managing 25 director at Morgan Stanley. So, Stacey, why don't we 0025 1 start with you. 2 MS. CUNNINGHAM: Great. Thanks. I first want 3 to again thank you. We really appreciate the opportunity 4 to participate and present at today's Committee meeting. 5 I have been asked to speak on the topic of this 6 morning's panel, which is market volatility. And there 7 are a couple of things I just wanted to open up with 8 there. The Equity Market Structure Committee has been 9 convened to address a number of key topics relevant to 10 today's market structure. And while it makes sense to 11 tackle those topics to tackle a broader review of equity 12 market structure by breaking it down into smaller pieces, 13 we do think it is worth noting how interconnected each of 14 those issues actually is given the way that our markets 15 have evolved. 16 As the Committee dives into topics like rule 17 611 and trading fees and market volatility, customer 18 issues, et cetera, it is important to consider how the 19 different paths we might take and the policy decisions we 20 might make, protections we will put in place, that they 21 can impact other areas that are simultaneously also under 22 review. And we aren't likely to have success if we are 23 viewing those topics just in isolation and not viewing 24 the collective. 25 To further complicate things, some market 0026 1 professionals can be very quick to adjust their behavior 2 based on the evolving landscape. So while not easy to 3 the extent that we can avoid designing changes purely 4 around current behavior, if we can also attempt to 5 identify and anticipate how might participants react to 6 those changes, it is going to help minimize unintended 7 consequences of the measures that we are implementing to 8 strengthen our markets. And it is somewhat like trying 9 to put a puzzle together, but the shapes of the pieces of 10 the puzzle are changing while you are doing that. So we 11 need to try and anticipate what is going to happen there. 12 Significant market events can often be a 13 catalyst for the industry to work together to identify 14 gaps in our market structure and address them. And while 15 we can observe the impact of the steps that we have taken 16 to close those gaps under normal market conditions, we 17 don't often have the opportunity to see how they fare 18 under extreme stress, especially market-wide stress, for 19 some time, perhaps even years. And, in fact, the events 20 of late August and specifically the morning of August 21 24th provided us with that first opportunity to assess 22 under extreme market-wide stress the protections that 23 have been implemented following the 2010 flash crash. 24 I think these themes are important because as 25 an industry, our work is never done. We are constantly 0027 1 looking to review the past, analyze and examine the 2 present, and try and simultaneously foresee the future. 3 And we need to move very quickly when given the 4 opportunity and presented with significant events. And 5 it is with this goal that NYSE published a report last 6 week with our observations and proposals regarding market 7 volatility. You can find that report on our website, but 8 I will touch on some of the themes in it today. 9 Soon after the August events, NYSE retained 10 McKinsey and Company to conduct market research on the 11 recent volatility in trading. McKinsey interviewed a 12 broad group of market participants. And the results of 13 those conversations along with our own data analysis and 14 conversations that we had with participants are really 15 what led to the proposals that are in our paper. 16 As an industry, we have rightfully spent most 17 of our time focusing on how we can continue to improve 18 since August, but I would like to take the opportunity to 19 highlight a couple of areas where we did see the benefits 20 of our progress over the past few years. Efforts to 21 strengthen infrastructure and technology over the past 22 few years have been very successful. 23 When we compared August 24 to 2010, we didn't 24 see some of the technology issues that we saw back in 25 2010. Market data delivery continued to work well. 0028 1 Post-trade systems continued to work well. So we didn't 2 have some of the issues. And I think it is worth noting 3 that we have made progress on that front. In spite of 4 the heightened volatility, increased message traffic, we 5 didn't see the issues we had in the past. 6 The SEC has also made significant progress with 7 access to relevant data. Within just a few months, the 8 SEC was in a position to provide the meaningful analysis 9 that we have already heard a little bit about today in 10 their research note. We have already seen the benefits 11 of their prioritization of things like the MIDAS system. 12 In some cases, the early views on what led to some of 13 the market disruption that day turned out to not 14 necessarily be what the data really showed. So I think 15 it is important that we have access to that data as we 16 are solving the right problems. And it is worth 17 highlighting. 18 During the last week of August, I also think it 19 is worth noting that the market was reacting to a true 20 global volatility event. It wasn't a fat finger error or 21 a software malfunction. It was a bona fide reaction to 22 volatility in the market. And we highlight in our paper 23 how that played out that morning. 24 Our view of the data clearly identified two 25 simultaneous phenomena the morning of August 24th. 0029 1 First, which is typically the most volatile period of the 2 day in the early morning and, as Dan alluded to as well, 3 there was a significant surge in retail market orders 4 sent to exchanges for the opening process. And it 5 contributed to selling pressure, both into the opening 6 and right after the opening. In our markets, we observed 7 a six-fold increase in market order activity, in both 8 individuals stocks on NYSE and on NYSE Arca/ETP, on NYSE 9 Arca and ETPs, during just the first half-hour of 10 trading. So we saw six times the number of market orders 11 we normally see. And that coincided with at the very 12 same time significant broad-based withdrawal of liquidity 13 provision, both on exchange and off exchange. 14 We observed that the top-of-book consolidated 15 liquidity was down 35 percent in the top 100 NYSE stocks, 16 down 50 percent in the top 100 NASDAQ stocks, and down 17 roughly 80 percent in just buying Q's looking at the two 18 most active ETFs. Liquidity remained much lower 19 throughout the day. So while we have this influx of 20 market orders looking for prices, we are seeing a 21 withdrawal of liquidity. 22 And, based on McKenzie's research as well as 23 our own conversations with participants, there were a 24 number of factors contributing to market maker behavior 25 that morning and why they were backing off of the market. 0030 1 Aside from the global volatility and declining global 2 markets, the futures were in a limit state. 3 There were a number of securities triggering 4 LULD. There was a proliferation of LULD. There were 5 fears that we might trigger a market-wide circuit 6 breaker. With the futures being in a limit state, it 7 wasn't clear what might happen and if market makers were 8 going to be unable to hedge those positions. There were 9 concerns that CE trades might be busted, determined and 10 busted, in 2010. There were thousands of clearly 11 erroneous trades that were busted. So while we didn't 12 see that in August, it wasn't quite clear to market 13 makers that that wouldn't be the result. This is the 14 first time during a market-wide event market makers saw 15 the impact of their risk systems that they put in place 16 as a result of the market-wide access rule. Those 17 systems are there to protect from situations like this, 18 but this is the first market-wide volatility event where 19 they really could see how those levels were set. And 20 many of them were pulled out of the market briefly. 21 And then also again there were opening and 22 reopening procedures that hindered, you know, timely and 23 transparent openings. And market makers were observing 24 that as well. 25 So that kind of brings us to the 0031 1 recommendations that we have presented in our report. 2 Admittedly, the solutions that we suggest mostly address 3 the symptoms of a larger issue. Frankly, it is simpler 4 to tackle the symptoms than it is to address, really, the 5 underlying issue that is at the core of our market 6 structure today. And it was a conscious policy decision 7 to adopt a fragmented marketplace. And there are pros 8 and cons to that decision. You know, in normal market 9 conditions, competition has reduced trading costs. There 10 are dozens of trading venues for investors to choose with 11 varying pricing models or even market models in some 12 cases. However, you know, another benefit I just want to 13 mention, too, is the resiliency of our markets, which we 14 have seen also in recent times that that is another 15 benefit of a more fragmented marketplace. 16 But liquidity isn't free. And when you hit 17 extreme volatility, that is really where you see the 18 downside of having a fragmented marketplace. And, as 19 true investor liquidity has migrated largely off 20 exchanges into 40-plus alternative venues, exchanges have 21 become much more dependent on voluntary liquidity 22 provision from electronic market makers than ever before. 23 And it might be a tradeoff that we are willing to make, 24 but we should make that tradeoff knowingly and 25 consciously if that is what we are choosing. 0032 1 So our recommendations outlined in the paper 2 fall generally into four categories. First, there needs 3 to be a renewed focus on investor education. And, as we 4 heard a little bit this morning about stop orders and 5 market orders, really, the risks associated with unpriced 6 orders in a more fragmented marketplace is probably not 7 widely understood by retail investors. Stop orders 8 provide a level of protection in normal market 9 conditions, but they do the opposite of that in volatile 10 conditions. And I am sure that that is not widely 11 understood by retail investors. So on NYSE, we won't be 12 accepting stop orders anymore. And we think it is 13 appropriate for brokers to be managing that relationship 14 with their customers so that they understand those risks 15 and can encourage and highlight the value of putting a 16 limit price on an order. 17 We did receive a lot of investor pushback when 18 we announced that, but we do think it is in the best 19 interest of investors, at least to highlight the risks 20 associated with it. 21 But one thing I just want to mention is, you 22 know, market fragmentation can exacerbate market 23 volatility, which can lead to customer issues. So, as I 24 mentioned when I first started speaking, is all of these 25 topics really are very closely related. And so I know 0033 1 this afternoon is about customer issues, but volatility 2 and fragmentation and 611, they are all very closely 3 aligned. And we need to look at them holistically as 4 well. 5 Second, our report proposes a number of LULD 6 refinements. While LULD rules have mostly functioned 7 very well since implementation, this was our first 8 opportunity to see them act market-wide. It continued to 9 work well for most securities, but there were others 10 where price discovery was impaired, particularly in a 11 handful of ETPs or some ETPs. 12 There were multiple halts. And many halts 13 occurred when the doublewide bands tightened and while 14 the market was recovering. So our proposals include 15 adjusting those doublewide bands to allow for recovery to 16 ensuring the bands are in effect immediately when a 17 security opens, to consolidating interest into that 18 reopening price discovery process from other venues so 19 that it is a more robust price discovery. Harmonizing 20 automated LULD of reopening procedures across exchanges, 21 synchronizing clearly erroneous and LULD bands. 22 In reviewing the potential of extending limit 23 states beyond 15 seconds, I think there were 5,500 LULD 24 halts, and only 23 percent of them ended up triggering a 25 trading pause. So it does seem that that limit state is 0034 1 helpful and probably worth looking at what we can do 2 there. 3 Third, ensuring appropriate incentives for 4 market makers to help increase liquidity during times of 5 volatility, this is the hardest one to sell for. I mean, 6 it is really the problem that liquidity isn't in the 7 market. And it is the hardest one to address. One area 8 that we think is worth exploring during volatile times is 9 exempting market makers from Reg SHO restrictions. 10 Another thing to look at is how market makers 11 may have implemented the market access rule. And already 12 we have heard from market makers that the experience of 13 August 24th has allowed them to take a look and revise 14 some measures. So I don't expect that we would see 15 exactly the same events, even if it were to happen 16 tomorrow. I think the industry has learned a lot from 17 what has happened already. I mean, we ourselves have 18 made a number of changes, which the fourth category is 19 where we outline some of the enhancements that we have 20 implemented or plan to implement on NYSE and NYSE Arca in 21 our rules and procedures. 22 So on NYSE, we are focused on improving 23 transparency of our preopening indications and enhancing 24 the automated opening process to open our stocks more 25 efficiently on volatile days. So we talk through in our 0035 1 paper how we plan to do that. 2 On Arca, we are widening, we widened already, 3 the reopening auction collars and are making changes to 4 automatically extend trading halts in the case of 5 substantial order imbalances. So while we have 6 identified areas that we can improve on the reopening 7 auction, I do want to say that we think it is important 8 for the industry to address those things together to 9 provide a sense of consistency across the organization. 10 Thank you again for allowing NYSE to 11 participate today. And we look forward to working with 12 this group in providing any insight we can contribute to 13 improve the stability of our markets so that we have a 14 safer environment for both investors and issues. Thanks. 15 MR. LUPARELLO: Thank you very much, Stacey. 16 Hubert? 17 MR. DeJESUS: Good morning. I would like to 18 thank the Chair, the commissioners, the Trading and 19 Market staff, and the Committee members for the 20 opportunity to come and discuss the equity market 21 volatility of August 24th, 2015. 22 My name is Hubert DeJesus. And I am co-head of 23 BlackRock's market structure and electronic trading team. 24 In this role, I am responsible for assessing and driving 25 key market structure changes as well as setting the 0036 1 electronic trading strategy for BlackRock. 2 As many of you may be aware, BlackRock, 3 together with its affiliates, is a leading asset 4 management firm serving institutional and individual 5 clients worldwide. BlackRock is also the investment 6 adviser to the iShares family of exchange-traded funds. 7 So as a fiduciary for our clients and a prominent sponsor 8 of ETFs, we are strong advocates for market structure 9 improvements which seek to protect investors and promote 10 fair and orderly markets. 11 We believe that the events of August 24th have 12 provided the industry with an opportunity to assess the 13 efficacy of reforms implemented in the wake of the 2010 14 flash crash and enhanced market mechanisms and guardrails 15 in order to improve the U.S. equity market's ability to 16 cope with extreme volatility. 17 Before I continue, I just wanted to note that 18 you all have been furnished a BlackRock ViewPoint on the 19 events of August 24th, which will provide additional 20 detail and background, more so than I can cover in the 21 next 10 minutes. 22 So as we discuss the market volatility of 23 August 24th, I think it is very important to keep the 24 events of the day in context. For the majority of the 25 trading session, as Stacey has mentioned, the market 0037 1 function remained accessible to investors, despite record 2 trading volumes and price volatility. 3 August 24th was the second highest trading day 4 in history. And exchange-traded products were 37 percent 5 of that volume. So overall many aspects of the market 6 worked well, even though the first hour of trading was 7 impaired. 8 On the morning of August 24th, we saw numerous 9 individual stocks and U.S.-listed ETPs that invested in 10 U.S. equities, which experienced several price 11 dislocations. Many ETPs traded at deep discounts from 12 the value of their underlying holdings due to a temporary 13 disruption in ETP arbitrage mechanism. U.S.-listed ETPs 14 that invested in U.S. equities were the most affected by 15 this breakdown. ETPs listed in other countries and ETPs 16 which invest in bonds or non-U.S. equities generally 17 traded normally. So this is suggestive that the issues 18 were primarily concentrated within U.S. equity market 19 structure. 20 The first hour of trading on the 24th exposed a 21 number of structural flaws in the U.S. equity market, 22 which interacted with each other in a problematic 23 fashion. Specifically, the flow of pricing information 24 was impeded by opening delays. Trading was disrupted by 25 numerous limit up-limit down halts. Suboptimal reopening 0038 1 procedures added to the disorder. And heightened 2 uncertainty discouraged liquidity provision. 3 Furthermore, the use of market and stop orders that seek 4 liquidity at any price amplified the situation by 5 aggressively adding to the selling pressure during a 6 period of already reduced liquidity. 7 These issues adversely impacted the ETP 8 arbitrage mechanism by impairing the three core 9 requirements for the arbitrage to function properly. 10 First, valuation clarity was missing. As transparency on 11 prices of ETPs and their underlying holdings was obscured 12 by delayed openings, trading pauses, and breakdowns in 13 correlations between related instruments. Access to 14 execute the arbitrage trade and accompanying hedges was 15 compromised due to the numerous trading halts observed 16 during the morning. 17 And, finally, inconsistencies between erroneous 18 trade guidelines and limit up-limit down price bands in 19 an extraordinarily volatile market diminished certainty 20 of execution for market makers. 21 There is no single solution to the disruption 22 observed on August 24th as it was a confluence of 23 different market structure factors. So, consequently, we 24 believe that it is important to address the events of 25 August 24th holistically through a number of market 0039 1 structure rule changes, better investor education, and a 2 more proactive dialogue across all market participants. 3 A key principle behind our recommendations is 4 the harmonization of trading rules across the entire 5 equity market ecosystem, inclusive of stocks, futures, 6 options, and exchange-traded products. Consistency, both 7 across securities, such as between stocks and futures, 8 and across different rule sets, such as between the limit 9 up-limit down plan and clearly erroneous execution 10 policies, will reduce uncertainty and unnecessary 11 complexity. 12 In terms of market structure enhancements, we 13 support revisions to the limit up-limit down rules to 14 consider eliminating wider price bands at the open and 15 close to recalibrate the length of the limit state, to 16 harmonize our reopening procedures across exchanges to 17 maximize liquidity, minimize imbalances, and relax price 18 constraints. 19 While we recognize the preference to have 20 continuously open markets, we believe there is value in 21 considering whether market-wide circuit breakers should 22 have been evoked on August 24th or if their performance 23 may be compromised when too many stocks are delayed or 24 halted. 25 We urge exchanges to promote transparency and 0040 1 timeliness around their auction processes, particularly 2 during conditions of extraordinary volatility. And we 3 recommend that clearly erroneous execution guidelines 4 should be aligned with limit up-limit down price bands to 5 create certainty of execution for all market 6 participants. Education efforts should focus on teaching 7 investors how to navigate modern U.S. equity markets. 8 There is room to improve investor awareness of how order 9 types behave during periods of excessive volatility and 10 reduced liquidity. 11 We believe that a collective effort is required 12 among all market participants to identify and advocate 13 for reforms, which will improve the resiliency of the 14 U.S. equity market. Issuers of both stocks and exchange- 15 rated products have a critical role to play in 16 considering how exchange processes and roles contribute 17 to fair and orderly markets in their securities. 18 In closing, August 24th reminds us that moments 19 of high volatility and discontinuous pricing may be a 20 persistent aspect of today's markets. It is imperative 21 for the industry to strengthen the equity market's 22 ability to cope with periods of extraordinary volatility. 23 And we are encouraged by the Commission's commitment to 24 work with market participants to find solutions that will 25 improve the investor experience and reinforce market 0041 1 confidence. 2 Thank you again for this opportunity. 3 MR. LUPARELLO: Hubert, thank you very much. 4 Frank? 5 MR. HATHEWAY: Thank you, Steve. Good morning, 6 Chair White, commissioners, Committee members, fellow 7 panelists. I thank the Commission and the Committee for 8 inviting me here today to discuss the assigned topic of 9 market volatility with a particular emphasis on the 10 events of August 24th and the research note on those 11 events released by the SEC staff in December of last 12 year. 13 I am pleased to follow my colleague Tom Wittman 14 in appearing before the Committee to discuss the 15 important issues the Committee faces. At previous 16 meetings of the Committee, Tom offered NASDAQ's views on 17 equity market structure; in particular, rule 611, our 18 strong system of self-regulation, the importance of 19 equity markets to our global economy. I share Tom's 20 opinions on these issues but will not repeat them today. 21 For 15 years, it has been my privilege to 22 provide NASDAQ with data-driven analysis for our many 23 businesses. I have also provided data-driven analysis on 24 a number of occasions to the Commission and the staff and 25 to the general public. Let me say there are pitfalls to 0042 1 be avoided, even when working with the highest-quality 2 data, not the least of which is that no data-driven 3 solution is immune to the vagaries of time and the 4 consequences, intended and unintended, of that solution. 5 At its best, data analysis provides an 6 impartial view of all of the facts. And the staff is to 7 be commended for their efforts to be impartial. Once we 8 agree on the facts and what the data is, we can begin the 9 difficult process of agreeing on what the data means and 10 the even more difficult process of agreeing what to do 11 about it. 12 When we consider the research note, we are 13 looking at the markets following a single major event. 14 The singular nature of the event confounds the 15 interpretation of the data in the research note as cause 16 and effect are deeply intertwined, as I expect we will 17 hear today. 18 Furthermore, because August 24th was a 19 significant event, there will be numerous reactions to 20 it, as Stacey alluded to. One challenge for the 21 Committee and for the SEC will be in determining how any 22 Commission actions will interact with other independent 23 actions being taken across the industry. 24 Because of these challenges, I would like to 25 make two process recommendations, in addition to the 0043 1 specific structural changes I will be talking about 2 today. First, the August 24th research note should not 3 be a one-time event. The impact of the various responses 4 being put into places as we speak should be evaluated in 5 the not-too-distant future, even in the absence of 6 another major trading event. 7 Second, at the 2014 STA annual meeting, our Bob 8 Greifeld talked about the desirability of simulating 9 market structure changes in order to lowering the costs 10 and risks associated with change. The process of 11 responding to the events of August 24th reminds us of the 12 desirability of such a tool. 13 The starting point of data-driven analysis is 14 establishing facts on which we can agree. I did not 15 identify any facts in the research note where there is 16 material disagreement with our own independent analysis. 17 Nor do I identify any facts in Stacey's remarks, 18 Hubert's remarks, or Paul's prepared report that I 19 disagree with. We seem to have a common set of facts. 20 So we are off to a good start. 21 As the research note has already been presented 22 and a couple of my colleagues on the panel have already 23 spoken, I offer only some condensed interpretations on 24 what went well. Market technology worked considerably 25 better than on May 6, 2010. After May 6, the Commission 0044 1 staff deeply involved with the SROs, changing the 2 operation of the market, new market plans were put in 3 place, implemented by the SROs. And, generally speaking, 4 those worked. 5 The operation/performance of major trading 6 centers was equal to the dramatic increase in activity, 7 market data feeds, method demands placed upon them, 8 routing. Remember 2010? Routing between major trading 9 centers proceeded without declarations of self-help, 10 unlike five years before. 11 The new market mechanisms seemed to perform as 12 designed. Limit up-limit down, pauses, halts, and 13 reopens took place. All right? Short selling curves 14 were imposed. Very few trades were broken under the 15 standardized clearly erroneous processes of the SROs. 16 And, as near as we can tell, the software for monitoring 17 the market-wide circuit breakers correctly made the 18 determination not to halt trading. But, as we have 19 learned in the past, working design doesn't always mean 20 working as intended. 21 There is an important research note. Race 22 conditions occurred between the limit up-limit down bands 23 and trade executions. Seemingly innocuous and 24 idiosyncratic differences among the exchanges in their 25 opening and reopening processes produced significantly 0045 1 different outcomes, as people have already commented. 2 Not in the research note but reported elsewhere 3 and again alluded to by my fellow panelists was a belief 4 that trades at prices like the to be considered 5 unacceptable to an investor remained unbroken by the 6 SROs. Of greater concern is the research note also found 7 that many issues identified as problematic in 2010 remain 8 problematic now. Market orders, including many likely 9 associated with the retail investor stop loss orders, hit 10 the markets in time when the markets were less than able 11 to execute them smoothly. Decoupling occurred between 12 CFTC and SEC-regulated index products, between index 13 products and their underlying assets. The amount of 14 available liquidity on order books was much less than 15 normal. And trading pauses in the equities and futures 16 markets remained out of sync. Those issues were a 17 challenge in 2010 and remain a challenge today. 18 Finally, an even greater and of greatest 19 concern, the implications in the research note of the 20 market's ability to identify and handle a systemic event. 21 The market-wide circuit breakers based on the S&P index, 22 as reported by S&P, did not trigger. The circuit breaker 23 might have triggered had it followed either the S&P500 24 futures price or the net asset value of the S&P500 as 25 determined by consolidated trading. 0046 1 Already announced changes in exchange opening 2 processes may tie the S&P500 index more closely to its 3 NAV. The market-wide circuit breaker may well trigger if 4 a repeat of August 24th were to occur. And the general 5 sense of market participants I have is that there is 6 relief that the market-wide circuit breakers did not 7 trigger. It would have been a difficult thing to deal 8 with. That sense does not inspire confidence in what may 9 happen next time. 10 In our view, industry participants are already 11 addressing many of the gaps identified in research notes 12 where systems worked as designed but not as intended. 13 The SRO participants in the limit up-limit down bands are 14 working to address leaky bands and eliminate race 15 conditions or at least the race conditions identified on 16 August 24th. Individual SROs are changing their opening 17 and reopening rules and procedures that were criticized 18 in the 24th. Both are aware of the efforts, and we fully 19 support them. 20 I would like to focus the remainder of my time 21 on the issues which are proving more problematic. The 22 idiosyncratic differences between exchange trading 23 mechanisms will remain once the announced changes are 24 complete. We endorse that. We have criticized certain 25 one-size-fits-all aspects of our current market structure 0047 1 and do not believe the exchanges should be forced into a 2 single common design for opening and reopening the wide 3 range of securities that we list. 4 Innovation and competition have benefited 5 investors, will continue to do so, and should not be 6 stifled. Many of the remaining issues can be put under 7 the broad umbrella of addressing unusual market 8 conditions. 9 Rather than going through a list of suggestions 10 for addressing the concerns raised by August 24th, I 11 offer a few thoughts on what the main tools at our 12 disposal are supposed to do. These are my views of the 13 main purposes of these mechanisms. You may have your own 14 perspectives. 15 Clearly erroneous execution rules are primarily 16 intended to protect brokers and their clients from 17 financial loss associated with fat finger trading errors. 18 The best purpose I can come up with for short sale 19 constraints -- and economists don't like short sale 20 constraints -- is that short sale constraints reduce the 21 risk of market disruption due to manipulative or 22 speculative short selling. Trading pauses, either in a 23 securities market -- they are futures markets. They are 24 designed to allow liquidity to return to order books 25 after it has been depleted. 0048 1 Individual security trading halts allow the 2 markets to gather and respond to information, maybe 3 information about order flow that affects trading in that 4 security. And, finally, market-wide circuit breakers 5 limit the consequences from a systemic event. And if 6 only there were a bright line between each of these 7 threats that all of these mechanisms were designed to 8 address, things would be much easier. But they are not. 9 Therefore, we can only strive for something that is 10 better than today, not perfect. 11 We endorse synchronizing the CE, clearly 12 erroneous, rules and limit up-limit down bands for normal 13 trading. We do not endorse eliminating SRO clearly 14 erroneous authority because in our experience -- I should 15 point out here that I have been breaking trades for 16 NASDAQ for over 10 years now. In our experience, 17 erroneous executions can occur in a variety of unique, 18 extraordinary, and occasionally amusing circumstances. 19 Our limit up-limit down process is in the process of 20 being refined by the plan's operating committee. Sync 21 harmonization with clearly erroneous rules, timing gaps, 22 tier calculations, wit to the bands are all under active 23 consideration. And we endorse reviewing and potentially 24 changing these issues. 25 The question of market order is, first and 0049 1 foremost, let me say NASDAQ does not accept market 2 orders. We haven't for a long time. We do not accept 3 hold stop loss orders either. So we do have a different 4 perspective here than some of the other market 5 participants. But more generally market orders 6 presuppose that the order is small relative to the market 7 and that the order is also uncorrelated with other market 8 orders; in other words, that there is a market capable of 9 absorbing both the market order and any other concurrent 10 orders out there. When that is not the case, there is 11 not a market. 12 There are a variety of proposals to address 13 market order ways that are being discussed. I am 14 skeptical of whether they would be successful and suggest 15 that the limit up-limit down process is being modified by 16 the plan and the changes being made by individual SROs be 17 allowed to demonstrate whether they can address this 18 issue. Simply put, if we become more adept at switching 19 from continuous trading to well-functioning auctions, we 20 may well address the issues associated with market order 21 ways. 22 Finally, widespread decoupling, market-wide 23 loss of liquidity, and ultimately the activation market- 24 wide circuit breakers are all symptoms of a potential 25 systemic event. While, thankfully, rare, the number of 0050 1 once-in-a-lifetime experiences I have had in my 30 years 2 in the industry indicates that these events are not rare 3 enough. We cannot plan in detail for these events, but 4 we can better identify. A futures industry using the 5 futures price and the securities industry using the S&P 6 index price is calculated by the index provider seems an 7 obvious disconnect, which should be addressed as soon as 8 possible. A much greater challenge is preparing the 9 industry to reopen after such an event. And that 10 deserves more time and effort from all of us. 11 I thank the Chair, the commissioners, and the 12 Commission and the Committee for their time and 13 attention. We appreciate the Committee's thoughtful 14 consideration of these issues and welcome the opportunity 15 to work with the Commission and the Committee to consider 16 important changes to market structure for the benefit of 17 investors and listed companies. I look forward to your 18 questions. 19 MR. LUPARELLO: Thank you, Frank. 20 MR. O'DONNELL: Good morning. My name is Paul 21 O'Donnell, head of electronic trading product in Morgan 22 Stanley's Institutional Equities Division. I would like 23 to thank the chair, the commissioners, the staff, and the 24 Committee members for giving me this opportunity to 25 participate in the discussion regarding market volatility 0051 1 and the events of the morning of August 24, 2015. 2 I will make some brief comments about the 3 events of the day, which has been covered in depth by the 4 staff and others. And I will conclude with some 5 recommendations. 6 The events in the equity markets on August 24th 7 were driven by many interrelated factors. There was no 8 single cause, and there is no simple fix. Most notably, 9 the pricing mechanisms that normally keep instruments 10 trading at efficient prices relative to each other did 11 not function as expected, leading to price dislocations 12 in the opening minutes of the trading day. In situations 13 of market stress, market centers need to allow for 14 liquidity to enter the market while preventing price- 15 insensitive orders from creating further disruption. 16 August 24th was the first real test of the 17 changes put into place in the aftermath of the flash 18 crash. While some things worked as designed; for 19 example, we did not see stocks trading at one penny, 20 there are still improvements to be made. 21 In order to understand the events of that 22 morning, we must remember the state of global equity 23 markets over the preceding days. The S&P500 closed down 24 3.2 percent on the Friday. Asian and European markets 25 were down 5 percent to 8 percent over the weekend and 0052 1 into Monday morning. We were in the midst of a global 2 selloff. 3 As the staff observed in its report, the E-mini 4 futures was limit down at 5 percent, from 5.15 on Monday 5 morning and at 9:25 went into a 5-minute trading halt 6 prior to the U.S. equity market open. In other words, 7 one of the most liquid instruments in the world, which 8 acts as a major input to many U.S. equity pricing models, 9 was not trading and, therefore, not providing price 10 signals. In addition, market participants were facing 11 the real possibility that a market-wide circuit breaker 12 might trigger and the entire market would halt for 15 13 minutes. 14 The New York Stock Exchange invoked rule 48 15 intended to streamline the opening of NYSE securities 16 amid a market disruption. The consequence of this action 17 was that there was no public dissemination of imbalanced 18 data or opening indications outside the NYSE floor after 19 9:35. In a time of market stress, the willingness of 20 market participants to provide liquidity is driven, in 21 part, by transparency of pricing. At a time when 22 liquidity was most sorely needed, most market 23 participants had little to no information on which to 24 base trading decisions. 25 I note that the NYSE has since partially 0053 1 altered this practice. Imbalance information now 2 continues until the stock opens, but dissemination of 3 opening indications is still not required when rule 48 is 4 invoked. 5 As the staff report also notes, the opening 6 minutes of trading were characterized by heavy volume and 7 a lack of audible depth, suggesting an influx of 8 liquidity takers while liquidity providers were largely 9 absent. Further analysis of nonpublic data, such as 10 OATS, is required to understand the nature of the 11 liquidity taking flow. As the market opened, many 12 securities saw severe price dislocations and entered 13 limit down holds as liquidity demand overwhelmed supply. 14 Many securities experienced multiple halts before prices 15 stabilized. 16 Given the repeated cycle of halts and reopening 17 auctions on these securities, we should revisit the 18 operation of opening and reopening auctions on the U.S. 19 listing exchanges to understand where they are operating 20 effectively. Opening and reopening auctions are designed 21 to aggregate liquidity and find a clearing price, which 22 should be in line with subsequent trading levels. While 23 such price discovery will never be perfect, the repeated 24 nature of halt suggests that many of these auctions did 25 not find a reasonable clearing price. At the end of the 0054 1 presentation, I will make some recommendations designed 2 to improve the operation of these auctions. 3 As identified in the staff report, many of the 4 selling balances as the market declined consisted of 5 market orders. The New York Stock Exchange reports a 6 six-fold increase in market orders during the first 30 7 minutes of tradings, specifically from firms handling 8 retail flow, and hypothesizes that many of these market 9 orders were a result of stop-plus orders that were 10 triggered, as I think everybody on the panel has noted. 11 While market orders are legitimate and 12 reasonable autotype in normal market conditions with a 13 stable far-side market, stop orders are placed in advance 14 to execute at a later time in unknown market conditions. 15 One thing that is certain is that a sell-stop order will 16 trigger on a downtick. However, whether that downtick is 17 short-term or part of a sustained decline is not knowable 18 at order entry time. As I previously noted, an analysis 19 of nonpublic data would allow regulators to determine 20 whether this influx of market orders was, in fact, driven 21 by stop-loss orders and whether a regulatory response is 22 required regarding the use of such orders. 23 Another area of uncertainty, which has also 24 already been noted related to the disconnect between 25 clearly erroneous rules and limit up-limit down rules. 0055 1 Given this disconnect, liquidity providers were facing a 2 situation where trades within limit up-limit down bands 3 might still be busted under clearly erroneous rules, 4 creating a further disincentive to provide liquidity. 5 Allow me now to conclude with some suggestions 6 of improvements that could be introduced into the U.S. 7 equity market based on the lessons learned from the 8 events of August 24th. First, in order to attract 9 liquidity, exchanges should publish information about 10 imbalances and indicative opening prices as widely as 11 possible until the security opens. 12 Secondly, auctions should not execute if there 13 is remaining a market over-imbalance but should wait to 14 find a reasonable clearing price at which such imbalances 15 will be offset. 16 Third, there should be a price-monitoring 17 extension built into exchange auctions. Such a mechanism 18 would provide a price collar around the execution or 19 price of an auction. This collar would widen over time 20 until a clearing price is found. This mechanism would 21 slow auctions with larger price moves, allowing market 22 participants to source additional liquidity and provide 23 greater confidence that the price move is warranted. 24 Fourth, the SIP should publish limit up-limit 25 down bands simultaneously with the reopening indicator. 0056 1 So there is no period of time after the reopen, during 2 which there are no published limit up-limit down bands, 3 as was the case on August 24th. Lifting market should 4 honor these bands when transitioning from auctions into 5 continuous trading. 6 Five, we suggest that regulators conduct an 7 analysis of nonpublic data, such as OATS, to determine 8 the source of the liquidity taking flows seen on the 9 morning of August 24th. Based on the results of that 10 analysis, regulators should consider rulemaking to 11 require that all stop orders be entered with a limit 12 price. 13 And, six, clearly erroneous rules should be 14 amended to ensure that short of a technical malfunction 15 of the limit up-limit down process, all trades executed 16 within the bands will stand. 17 In closing, U.S. equity markets are resilient 18 and liquid. We have made improvements since the flash 19 crash, but there is work still to be done. Thank you 20 again for this opportunity. I applaud the Commission and 21 the Committee for its efforts on these important issues. 22 MR. LUPARELLO: Paul, thank you. 23 I will now open it up to the Committee as well 24 as the Chair and commissioners to ask questions of the 25 panel. Jamil? 0057 1 MR. NAZARALI: Thanks. I would like to give 2 our perspective on a couple of themes that we heard from 3 the panelists. And I would like to thank you guys all. 4 Those were some very good comments. 5 One of the things that we heard from many of 6 the panelists is that Reg SHO restrictions impede the 7 ability of market makers to provide liquidity in the 8 market. And as the largest liquidity provider in the 9 market, I will tell you unequivocally that Reg SHO does 10 restrict our ability to provide liquidity in the market, 11 and that is a really bad thing. Number one, it results 12 in less overall liquidity. And, number two, it impedes 13 our ability to do arbitrage between various markets, 14 arbitrage between ETPs and individual stocks. 15 And I would also offer that many of the Reg SHO 16 rules as they are interpreted don't really make sense. 17 So, for example, according to the FINRA interpretation, 18 we have to count all sell orders out there into our 19 position but not our buy orders. Given the number of 20 venues that we trade on, that means that we are short in 21 virtually every name that we trade, despite actually 22 being long, but we have to count it as being short. And 23 that really impedes our ability to trade. 24 The second thing I would like to comment on is 25 from our client's perspective, you know, there is a lot 0058 1 of talk about market orders and stop orders contributing 2 to the volatility on 8/24. And, undoubtedly, that is 3 true, and we need to think about investor education, et 4 cetera, but I think it is important to point out that 5 both of those order types are quite important to retail 6 investors. 7 So, for example, stop orders, most of the time 8 they work pretty well. They allow a retail investor who 9 is not really watching the market every day to place an 10 order that will then trigger at some other time when, you 11 know, they might not be looking at it and they want to 12 trigger it. 13 Having said that, we should consider more 14 investor education. There is certainly the case that 15 many retail investors didn't understand what a stop order 16 was. And we got a lot of comments like "Why didn't my 17 order execute at $20? My stop was at $20." Even more 18 alarming, we got a lot of those comments from financial 19 advisers that were entering orders, stop orders, at those 20 prices. And that is actually of great concerns because 21 if financial advisers don't understand how those orders 22 work, then there is really a missing education piece. 23 So we should undoubtedly look at those orders, 24 look at investor education, look at perhaps a popup that 25 when you place a stop order, you know, this order could 0059 1 execute at a price materially different than the price 2 that you put in. Are you sure you don't want to put a 3 limit price? That might be helpful, the same with a pre- 4 open market order. You know, some retail broker-dealers 5 already do that. Some of them default to everyone is put 6 in a limit order unless they specify a market order. But 7 those are all things that we think are important to 8 consider. 9 MR. LUPARELLO: Thank you. 10 Reggie? 11 MR. BROWNE: I would like to thank Dan and 12 staff for that ADHP report on 8/24. Largely I think the 13 industry realizes it wasn't an ETF-specific event but 14 more of a market structure event. And that report 15 highlights that, more from a liquidity provider, when I 16 think of some of the difficulties of that day, pricing 17 exchange-traded products. And largely it stems around 18 the opening procedures around exchanges. 19 If you look at the S&P and you had a five- 20 minute halt, you look at the NASDAQ 100 future and how 21 that went down past 7 percent. When the arbitrage 22 mechanism is unavailable in U.S.-listed equities from ETF 23 perspective, highly correlated instruments, like futures, 24 take on the arbitrage effect. So you switch to a future. 25 And that is why their futures went below 7 percent that 0060 1 day. 2 I think that the inability to find price 3 discovery through opening indications was a huge 4 component of the ability to, you know, price U.S. 5 baskets, but also, too, with limit up-limit down, on the 6 way down, the inability to open ETFs -- really, market 7 maker in a couple of hundred ETFs, the inability to find 8 equilibrium to open and then excessive halts caused a lot 9 of disruption in our ability to make a fair market. We 10 didn't withdraw. It is just we had an inability to make 11 a fair market at that time. 12 And, with the limit up-limit down bands, I keep 13 hearing consistency around time-based. And I think 14 Morgan Stanley and Paul O'Donnell had referenced a point 15 around finding equilibrium through liquidity. I urge the 16 exchanges to look at limit up-limit down based on 17 liquidity metrics. Wait until offsetting liquidity 18 materializes before we reopening or determining a 19 clearing price. It is essential that the various 20 exchanges harmonize and even force liquidity into the 21 primary listing venue in order to determine equilibrium 22 of prices to find a clearing price, you know, for a 23 security, whether it is corporate or ETFs. 24 And, lastly, I hope that we don't conclude that 25 we need price bands around indicative fair values of 0061 1 ETFs. I have heard some of that commentary from 2 academics and some practitioners. ETFs work very well 3 when the underlying market is open, fully trading, and 4 fully for arbitrage. And when we have external 5 artificial barriers, that process breaks down pretty 6 quickly. If you have those barriers in place around 7 indicative fair value, the fair value that may be 8 published could be wrong and cause more confusion. 9 I do agree about some participants have heard 10 it directly, you know, clarity around clearly erroneous 11 and limit up-limit down bands. I applaud the New York 12 and other exchanges for trying to harmonize limit up- 13 limit down to the clearly erroneous. I mentioned it at 14 the last Committee how some participants still had some 15 confusion, but that confusion seems to be waning. But 16 broadcasting that trades consistently will not be broken 17 if they are inside those bands is important. 18 MR. LUPARELLO: Joe, then Eric. 19 MR. MECANE: So just one thought/reaction that 20 I will put out there for comment. And I have talked to a 21 few people in this room on this thought. But, especially 22 reacting to Dan's comments, it seems like a lot of what 23 we are talking about has to do with the reopening auction 24 process after limit up-limit down. And so, you know, 25 just recategorizing Dan Gray's items, we talked about 0062 1 repeat pauses, recoveries coming out of pauses, big 2 imbalances after pauses, market and stop orders and their 3 impact on those imbalances. And I will use Hubert's 4 point on the thinner ETPs potentially not working in the 5 arbitrage mechanism potentially because of the halts that 6 were happening around those products. 7 So one thought is we could go the path of 8 tweaking a lot of the rules around the pauses to try and 9 get them to work in a more functioning manner, but 10 another idea is -- and I say this as someone who had some 11 responsibility in the creation of pauses as part of the 12 limit up-limit down mechanism -- is we could eliminate 13 the idea of auctions and reopening auctions around limit 14 up-limit down period. And so you could have the idea of, 15 let's say, floating bands that readjust periodically. 16 And those could potentially absorb the impact of whether 17 it is big in balances as a result of stops and markets or 18 it could be better ways for the market to recover from 19 those types of events because I think what happens, my 20 sense from just looking at the data and just knowing how 21 some market participants react is we enter these pause 22 states. And people pull out their liquidity and don't 23 reenter it back into the auction mechanisms until there 24 is this reopening event. 25 And my sense is what is happening is that is 0063 1 overwhelming any available liquidity in those auctions 2 and causing these dislocations that we are then talking 3 about, well, how do we deal with those dislocations? And 4 I am just not sure it is a solvable paradigm because 5 unless you get the other side of that liquidity to come 6 in, it is going to dislocate, as opposed to what seems to 7 happen in the limit states and some of the data in the 8 paper reflects the fact that the market seems to recover 9 and liquidity seems to stay more active in the limit 10 states than it does during the pauses. 11 So I would just put out there for consideration 12 there is clearly a path of tweaking all of the rules and 13 maybe doubling the bands or changing them in the reactive 14 state, et cetera. And those tweaks may work and be one 15 way to deal with it, but I would just question if there 16 is a more efficient way for the mechanism to work without 17 actually stopping the market, which seems to be what is 18 causing a lot of what we are talking about today. 19 MR. LUPARELLO: Eric? 20 MR. NOLL: Joe beat me to it. So I actually 21 think that it is a great idea for reform around limit up- 22 limit down. You know, clearly the theoretical construct 23 is when you get to an auction, it should reopen at the 24 new fair trading price. And what we have seen, not just 25 on August 24th but historically with limit up-limit down, 0064 1 is that doesn't happen. So, even during normal market 2 conditions, you tend to have a cascading staircase effect 3 around limit up-limit down when stocks trigger it. So 4 that all goes to the fact that the reopening auction is 5 not performing the way it should. 6 So, rather than trying to fix that, if you 7 will, and tweak with us, the whole purpose in my opinion 8 of limit up-limit down is to stop flash crashes in 9 individual securities. It is to make sure that the 10 markets remain orderly. 11 The auction process isn't a necessary component 12 of that. What is a necessary component is that people 13 have time to reassess where the fair trading value is. 14 So if a stock hits a limit down, say, trades limit down 15 for 15 seconds, 30 seconds, whatever the timeframe should 16 be, the bands could then readjust to that new trading 17 price. Stock could then freely trade around that new 18 trading price. But trading will be orderly. It will 19 still be in a staircase fashion. But you won't even halt 20 the stock. And then you don't have to worry about the 21 reopening process, the reopening auctions. Stock will 22 continue to trade through. It may be a simpler and 23 easier solution than trying to fix the auction. 24 MS. CUNNINGHAM: Can I respond to that? 25 MR. LUPARELLO: Absolutely. 0065 1 MS. CUNNINGHAM: I think that is a great 2 example of the LULD plan, how market participants changed 3 behavior once it was in place. So what we saw was 4 liquidity leave the market once the auctions came in. 5 And so that is what we are trying to solve for. And I 6 think it is absolutely worth looking at those limit 7 states because it might be the right approach. 8 One thing that I think we just need to be 9 careful or at least aware of as we look at that is how 10 other asset classes might be impacted. And, you know, if 11 we are in an extended limit state but not actually 12 halted, what happens in the options markets or in other 13 places. So not that we shouldn't go down that path, but 14 we just need to make sure we are looking at all 15 securities. 16 MR. LUPARELLO: Jamil? And before you go, I 17 should correct here that that chart's interpretation 18 which is troubling to you is actually ours, not FINRA's, 19 but that is -- 20 MR. NAZARALI: Okay. Sorry. 21 MR. KAUFMAN: Thank you, Steve, by the way. 22 MR. NAZARALI: Okay. So talking about limit 23 up-limit down, you know, another potential improvement 24 which I think that we saw a lot, you know, Dan mentioned 25 that more than half of all of the LULD who were repeat 0066 1 states was particularly when there was a very large price 2 movement on the opening print, to get back to the fair 3 price, we just kept hitting limit up-limit down or limit 4 up, I should say. And we should consider having more 5 congruous kind of if it is dropped by 30 percent, it 6 shouldn't have to go up 5 percent at a time or you had 7 the doublewide in the first 15 minutes and then it takes 8 2 steps to get back to where it was. And so we should 9 consider having something where if it is dropped by this 10 much in one print, it can go back up by that much in the 11 same print. 12 MR. LUPARELLO: Joe? 13 MR. RATTERMAN: I am not going to add too much 14 to what was said because I am in violent agreement with 15 almost everything. I just want to point out -- and this 16 is also reemphasizing something that was said on the 17 panel -- that we have done I think a great job of 18 identifying when things should be paused or looked at 19 which said the limit up-limit down detection mechanism I 20 think has worked pretty darned well. And, really, what 21 we are talking about here is, how do you find the best 22 price after you determine that? 23 And so it is no small feat to have actually 24 determined that we should enter limit up-limit down 25 states or pauses in the security on a very volatile day. 0067 1 And I think that is a big win for market structure. And, 2 really, we are talking about optimizations here on how to 3 find the best price afterwards. In my mind, that is a 4 really good problem to try and solve. 5 MR. KAUFMAN: Steve? 6 MR. LUPARELLO: Yes? 7 MR. KAUFMAN: Just one point. I want to come 8 back to Jamil's, which I think is really important. And 9 it goes with small investors. It isn't about investor 10 education. If you are someone that has a day job and is 11 not staring at a screen, for most of the year, stop 12 orders and market orders improve your ability to sleep at 13 night. So I think that doing those stop orders and 14 market orders is just going to cut out a whole bunch of 15 folks that cannot contribute and the only way they can 16 contribute when this really is a problem just a small 17 percentage of the time. 18 MR. LUPARELLO: Thank you, Ted. 19 If I can ask one question that we have heard 20 from a number of folks, the need to harmonize bands 21 between the wider opening bands and the bands throughout 22 the rest of the day, although you then get to different 23 points of view on whether that means the opening should 24 be narrower or the day should be wider, too. I guess do 25 the panelists or sort of the Committee have a view on 0068 1 that or is just harmonization in and of itself a 2 beneficial thing? 3 MS. CUNNINGHAM: One of the things that we have 4 considered was if a stop has triggered an LULD trading 5 pause and it was during a period of doublewide bands, 6 that you allow it to recover. So you treat it a little 7 bit differently because it has already triggered a pause. 8 And, coming out of that, you allow it to recover more 9 easily than you would others. 10 MR. O'DONNELL: I think that is fair. And I 11 think Jamil's point about some of the level of asymmetry 12 is good, too. If you come down an amount, open an 13 auction, anywhere between were you reopened and where you 14 were before is fair game. You probably don't want to go 15 too much further without stopping. But that kind of 16 dynamic is good, too. 17 MR. DeJESUS: Okay. I think it makes sense to 18 have bands that are simplistic in nature because these 19 are events that are happening at a very, you know, 20 volatile -- at a time when there is very little 21 confidence, you know, in the pricing of that stock. So I 22 don't think it makes sense to have bands that are 23 changing over time. It kind of makes sense to have a 24 consistently wide band at the open and at the close. 25 MR. HATHEWAY: If you are going to tie them to 0069 1 CE, you are talking because of what clearly erroneous is 2 for. You are creating a lot more financial risk now. 3 Maybe people would respond to that by being more careful, 4 but you are creating a lot more financial risk. And we 5 may face a situation where someone is going to go broke 6 if we widen out the CE levels to meet wider bands. 7 MR. LUPARELLO: Jamil? 8 MR. NAZARALI: Steve, I want to comment on what 9 you said. And then I have a question for Frank. 10 I would broaden the harmonization, as some 11 panelists have suggested, to other financial markets; so, 12 for example, the futures and equities, because I think 13 that makes a lot of sense. So we agree with the 14 harmonization but think it should be broader. 15 The second question is for Frank. Frank, you 16 guys recently announced that you are going to have 17 effectively limit up bands or stopping the open auction 18 from opening at a price that differs too much from the 19 previous closing price. I would love to hear your point 20 of view on why you guys decided to go alone versus 21 looking for something more market-wide, so effectively a 22 market-wide limit up-limit down, rather that do some 23 NASDAQ-wide one. 24 MR. HATHEWAY: Well, we have always had bounds 25 on the opening and closing auction. They can't go to 0070 1 infinity or zero. And so what we have done is change the 2 way the open works. And, consequently, the reopen 3 process would be part of that. The reason to do it now I 4 think gets back to what I said in my remarks, where we 5 are about competing with some members of the panel, some 6 of the members of the Committee. And if we think we have 7 an idea, it is a better idea. We are going to implement 8 that. The plans have their place. And they are 9 wonderful for coordinating things, but they are not 10 necessarily the best and the fastest ways you can go 11 about innovating if you think you have an idea that will 12 work for the market better. 13 MR. RATTERMAN: Just to answer your question 14 from my perspective, Steve, it seems like before August 15 24th, there wasn't a lot of dialogue about are the bands 16 too tight or too narrow, that they were effectively 17 capturing moves that we wanted them to capture and on a 18 very volatile day, we had a lot of capturing. But, 19 really, I don't think the problem was capturing the 20 moves. It was finding the new price after the fact. So, 21 just as a direct answer to your question, I would suggest 22 that where we have the bands is probably about right. 23 Nothing is perfect. But that really wasn't the issue. 24 The issue was, what do you do after you have captured a 25 price move? How do you get the right price as quick as 0071 1 possible? 2 MR. LUPARELLO: Gary? 3 MR. STONE: Frank, I think you are 100 percent 4 right and Stacey, too. You guys have a right to serve 5 your issuers in the way that they want to be served. And 6 through that is through the opening and closing process. 7 So I don't support the fact that the Commission comes 8 down and says it all has to be electronic. If New York 9 thinks that the specialist opening a stock in certain 10 situations is good because the issuer wants that, then 11 they should be allowed to do that. That is how they 12 compete in getting listings as Joe and he starts going 13 into the exchange-traded funds area. 14 I did want to come back to one thing. Ted, I 15 agree with you about stop orders, but I don't think that 16 they should be handled at the exchange level. I agree 17 with Stacey that it is a brokerage operation and it 18 should be handled by somebody who is actually going to be 19 accountable to that customer for best execution. The 20 exchanges don't have that responsibility or at least they 21 shouldn't have that responsibility. And as our markets 22 have evolved, we sort of have melded a lot of the broker 23 stuff inside the exchange because the ATSes, which were 24 part of broker-dealers, became exchanges. And that 25 didn't get pulled out. And so I think this is a case 0072 1 where it is really the brokers are the ones who are 2 properly serving that end customer, not the exchanges. 3 The only other thing I just wanted to ask, 4 really, is that we didn't really talk about what Frank 5 talked about, which is the coordination between the 6 futures market and the exchange-traded fund market. The 7 reality is that ETPs are not equities. They are equity- 8 like. And so their sister and arbitrage mechanism really 9 has to be tightly coupled. My question is just, is there 10 something in I guess the definition of halts, where the 11 exchange couldn't halt the ETP where you are the listing 12 exchange based upon what is happening in the future 13 because the Q's and the SPIs are basically the same thing 14 on the futures market as in the ETP market. 15 MR. HATHEWAY: I think from our angle, there 16 really is no reason we couldn't link. On a practical 17 question, going back to what Paul said in his remarks, 18 suppose we are both halted. All right? We have got to 19 reopen. Who goes first? How do you go first? What do 20 you look at to get that pricing signal? And this bleeds 21 on into the discussion about how you reopen from the 22 market-wide without any of the pricing signals that you 23 would normally be relying on at 9:30 in the morning, even 24 on a day like the 24th. But I do think if we are -- 25 having these unanticipated or at least uncoordinated 0073 1 decouplings doesn't really benefit anyone. 2 MR. LUPARELLO: Maureen? 3 MS. O'HARA: I actually have a question about 4 some of the new proposals, particularly at the NYSE, 5 which I think again the NYSE, you know, is to be 6 congratulated for moving quickly to try and look at some 7 of the issues. 8 I think the opening auction is the one that I 9 find particularly important to focus on. And if you 10 think about sort of what you want markets to do, you want 11 liquidity in price discovery. Typically in the opening 12 auction, those two things can come together. What we 13 have seen on the 24th is you didn't have that because you 14 don't have these stocks opening, which then, in turn, 15 impedes the ability to price anything else and impedes 16 liquidity everywhere else. So, to me, the open becomes 17 sort of the focus for a lot of what August 24th taught us 18 we have to really make changes in. 19 It sounds as if your proposals are to now 20 provide more imbalance information, which I think makes 21 sense, but it didn't sound like you were going to provide 22 indicative prices up until you open. Is that correct? 23 And if you are not, why not? 24 MS. CUNNINGHAM: Actually, let me clarify what 25 we have already done and what we are doing. 0074 1 MS. O'HARA: Okay. 2 MS. CUNNINGHAM: So in October, we started 3 publishing imbalance information until the opening of 4 securities. 5 MS. O'HARA: Right. 6 MS. CUNNINGHAM: So that is automated imbalance 7 information. It comes out every day. And that is with 8 indicative pricing information. 9 The NYSE also publishes a price range that is 10 broader than just what the indicative opening price would 11 be when a security is going to move out of line with the 12 broader market. Those are protections that are just to 13 offset volatility. And they work really well for us on 14 normal days. On a day when the overall market is 15 volatile, we lift that because the whole market is 16 moving. And everything would be indicated. 17 The proposals that we have outlined in our 18 paper are to increase the transparency of those 19 indications, even on a volatile day. So that if 20 securities are going to move more significantly in the 21 broader market, we are still putting those out. So rule 22 48 had lifted those obligations of sending out those 23 indications when there was a market-wide event. And the 24 changes that we have designed around our rules eliminate 25 the need for rule 48 because we are going to continue to 0075 1 publish those indications as it is tied to a move in the 2 futures market in the morning. So we will send out 3 indications. We will just widen those parameters. 4 We have parameters that govern both the 5 automated opening functionality that the designated 6 market makers can leverage. And we have parameters 7 around their indications. 8 So the way that we are addressing improving the 9 opening process and improving transparency and efficiency 10 is allowing those parameters to adjust for volatility so 11 that we are still sending out those indications and 12 allowing more things to be opened in an automated 13 fashion, even during market volatility. So our proposals 14 do actually address those concerns. 15 MR. CRONIN: Can I ask, the data dissemination 16 you speak of, is that available to all market 17 participants or is that only from one of your direct 18 feeds? 19 MS. CUNNINGHAM: The publication of data that 20 goes out each day is available in our feeds, in the 21 direct feeds. The indications go out to the SIP as well. 22 MR. CRONIN: For the record, the more 23 transparency that everybody gets, the better this 24 mechanism will work for all. 25 MS. CUNNINGHAM: Yes. I think that is standard 0076 1 across exchanges today. I don't know. Correct me if I 2 am wrong, but we can certainly look as an industry to 3 improve the amount of information that gets disseminated. 4 MR. CRONIN: Yes. 5 MR. ANDRESEN: I just have a follow-up 6 question. Frank, can you expand more on your comment 7 around the clearly erroneous within the limit up-limit 8 down bands? 9 MR. HATHEWAY: Well, right now the clearly 10 erroneous guidelines are in single-digit percentages for 11 most stocks and most prices, as you know. The bands are 12 5, 10. Doublewides would be twice that if you widen out 13 bands and the clearly erroneous becomes harmonized with 14 the bands, you obviously make the threshold for breaking 15 a trade, much larger than it is today. 16 From our perspective -- this is from the simple 17 operational side -- there are fewer trades we have to 18 break. This is going to be fewer that will get anywhere 19 near that or whatever. But from your perspective, from 20 the risks you guys will have to take financially or your 21 former firm or Joe's or some of the other ones, you are 22 going to be on the hook potentially for a trade that is 23 10 percent away. That would be within a wider band, 24 would be outside the clearly erroneous bands of today. 25 And that is a risk for you, particularly if there are a 0077 1 lot. People have in my experience put in program trades 2 wrong. And so now you are talking about a very large 3 volume of securities. 4 MR. ANDRESEN: So one suggestion that I know 5 has been made in the past and I think is worth 6 resuggesting is -- and it has been talked about much more 7 on the options side than equity side -- is the concept of 8 adjusts, instead of busts, of trade. So there is a lot 9 of concern on a day like August 24th as we look to try to 10 figure out where liquidity went, why did the volatility 11 go up, why did the available liquidity go down, why did 12 liquidity providers shrink in the face of a lot of active 13 price-taking action? 14 In my experience and observation, not knowing 15 one's position, not having certainty around one's 16 position is the number one way to ensure that people 17 don't make markets and don't make tight markets. So, 18 even if there maybe is a P&L after-the-fact implication 19 to having a trade you have already done and executed 20 changed in price, you still know, "Well, right now I am 21 long this much," "I am short this much," or "I am flat." 22 And as long as you know where you stand, your appetite 23 for going into the next reopening will be much greater. 24 MR. HATHEWAY: So let me make sure I 25 understand. So what you are suggesting, we would not 0078 1 harmonize CE and the limit up-limit down bands. Instead, 2 there would be a range of CE that would produce an 3 adjustment, rather than a break? 4 MR. ANDRESEN: Right. 5 MR. HATHEWAY: Got it. 6 MR. ANDRESEN: I would say it is a separate 7 issue from whether you harmonize to limit up-limit down, 8 whether you keep those at the current range, whether you 9 expand them. I think a more surgical strike to 10 addressing some of the timidity around reentering the 11 markets would be addressed by allowing large market 12 makers with books to know exactly what their positions 13 are and have certainty around that, instead of waiting 30 14 minutes to get a ruling. 15 MR. LUPARELLO: So I will quickly put in a plug 16 for the Commission's market access rule reducing the 17 likelihood of incorrectly placed orders. And then I will 18 turn it over to Chester. 19 MR. SPATT: I think this is a very important 20 issue. I mean, it just seems to me obvious from first 21 principles. If we are going to have rules that break 22 lost of trades and especially if there is uncertainty at 23 the time of execution about whether these trades are 24 going to get broken, it is obvious that there is going to 25 be a lot of disruption to liquidity in our markets. I 0079 1 mean, here we just listened to conversation about what 2 happened on August 24th. 3 My high-level take-away from this is we have 4 got so many rules, so many different, rules, in place 5 that disrupt the liquidity provision process that 6 collectively these rules have been counterproductive. 7 But, just slicing in to this particular rule, I am 8 surprised that a platform is anxious to, in effect, break 9 a lot of trades if I am understanding this. You know, it 10 seems to me that ex-ante liquidity provision is extremely 11 important and especially uncertainty around that. 12 But, even putting aside the issue of 13 uncertainty, we want to encourage liquidity provision 14 precisely in these states of the worlds that are 15 otherwise sort of so problematic, like in late August. 16 MR. HATHEWAY: Yes. Well, we are not anxious 17 to break trades. And if I have created that impression, 18 I certainly want to correct it. It is a consequence of 19 what we have to do as an SRO. There is a clearly 20 erroneous process. It has been around for as long as I 21 have been with NASDAQ. And that works by breaking trades 22 in equities. It could work by adjusting trades. It 23 could work in a number of ways. The focus we had earlier 24 in this conversation has been to eliminate the need to do 25 that entirely. And where it seemed to be going in a 0080 1 somewhat different direction as we talk about widening 2 the bands and then what do we do for the risk that that 3 creates for the brokers. 4 MR. SPATT: I think the financial services 5 firms -- and, you know, I believe in the industry. And 6 let me be clear about that. But I think the financial 7 services firms, they need to own their process for 8 submitting orders. And they need to invest enough in 9 their process to ex-ante deal with these issues. And if 10 you are going to break things too much ex-post or maybe 11 if you are going to break things at all ex-post, they are 12 not going to have sufficient incentives to deal with this 13 process ex-ante. And I think that is obvious from the 14 point of view of economic principles. 15 MR. LUPARELLO: So this is a very important 16 issue, but I think it is worth noting that there is a 17 large correlation between the CE bands and the limit up- 18 limit down bands, not perfect. And so the number of 19 scenarios where a trade will be inside the bands but 20 still be outside the CE bands is actually quite limited. 21 I think one of the things that the staff discovered in 22 the aftermath of August 24th was there was a perception 23 that there was a greater likelihood of trades getting 24 broken than, in fact, the way the rule sets or 25 constructed that they would get broken, making that a 0081 1 very important issue. But it is a limited construct. 2 MR. SPATT: That is fair enough. And I am 3 pleased to hear that, but I still would advocate that I 4 think exchanges should put themselves in a position of 5 being advocates for ex-ante-encouraging liquidity 6 provision. I think that is the best place for our 7 capital markets to be. 8 MS. CUNNINGHAM: Can I just add one thing on 9 that front? 10 MR. LUPARELLO: Sure. 11 MS. CUNNINGHAM: So while we didn't see a lot 12 of trade breaks on August 24th, we did see a number of 13 trades that would have qualified to be broken had they 14 been submitted in a timely fashion. So a lot of them 15 weren't broken because they just weren't requested to be 16 broken. That is how the rules are laid out, which we got 17 a lot of negative feedback from retail clients on it 18 because they weren't happy with their execution. 19 So I think where Frank and I are focused is we 20 don't want to break trades, but we also want investor 21 confidence to stay strong in the market. And if they 22 feel like they are going to end up having these 23 executions that they can't prevent, that is an issue. 24 And I think that adjusting trades works well in the 25 options markets. It works well for market professionals. 0082 1 But to adjust a retail trade outside of the bands of its 2 limits, when we are encouraging them to put limits on 3 their orders is a hard thing to consider. 4 So I am not sure that this is the right answer, 5 but maybe one thing that we can look at is, do we want to 6 have a limit state at the clearly erroneous level to 7 actually prevent the trades from occurring and then walk 8 down to a trading pause that would really be around the 9 band level? And, you know, we haven't thought that 10 through but something to think about. 11 MR. LUPARELLO: This might not be the order you 12 raised your hands, but this is the order I saw you. So 13 Brad, Jamil, Reggie. 14 MR. KATSUYAMA: Sure. So I think what Matt 15 brought up I think is a really good point. From a risk 16 perspective, not knowing your position is a far greater 17 risk. Just notionally, it is 100 percent notional risk, 18 as opposed to a price adjustment understanding that you 19 are somewhere close to where the price is. So the 20 adjustment on a risk basis relative to the trade being 21 broken is actually orders of magnitude greater. So I 22 actually think from that perspective if you view it in 23 terms of notional at risk and we are trying to encourage 24 people to provide liquidity in times of duress, also when 25 you are looking at edge case scenarios, so they are less 0083 1 frequent, but they are much more frequent in the 2 scenarios that we are discussing today, I actually think 3 it makes a ton of sense to look at exactly kind of what 4 he outlined in terms of the adjustment relative to the 5 break because from a notional risk perspective, it is far 6 greater to be at risk of a break, as opposed to saying, 7 "Okay. You did execute, but here is the adjustment." 8 And that is 3-4 percent, 5 percent versus 100. So I 9 think it actually makes a lot of sense to view it from 10 that perspective. 11 MR. NAZARALI: I agree with Matt and Brad on 12 adjust versus bust, but I don't think that we need 13 clearly erroneous rules anymore. I mean, they were put 14 in place after the flash crash because every exchange had 15 its own rule, but now that we have limit up or limit 16 down, we really don't need those rules. And I think 17 that, you know, I agree with you that the problem was 18 probably more perception than anything else. But if you 19 remove the rule, you are not going to have that. And I 20 would strongly suggest that they are now antiquated given 21 limit up-limit down. And they should be removed. 22 MR. LUPARELLO: Reggie? 23 MR. BROWNE: I think, speaking from a market 24 maker standpoint, if you had adjust, not bust, it would 25 put a greater confidence for market makers to apply 0084 1 capital into the marketplace. 2 However, one of the things that we should talk 3 about or highlight is that if you do submit a clearly 4 erroneous, you know, request, there comes a FINRA 5 investigation. And that basically governs human behavior 6 of wanting to want to put in a clearly erroneous 7 violation. 8 So perhaps what we should do or think about or 9 my point of view is go to an environment where you can 10 adjust to trade, not bust it, and reduce the regulatory 11 risk of dealing with FINRA with a market access problem. 12 As I said, that is one of the reasons why you probably 13 get a lot of requests on those days because they just 14 don't want to deal with it. 15 And then one other thing I would like to 16 highlight or at least get your view is on aberrant 17 trades, where you can take a trade off tape, but the 18 trade still stands. I think that is a gross injustice to 19 the retail investor most likely that is on the opposite 20 end of that trade, where it is not reported on the tape, 21 but the trade does go on. Can I get your view on that 22 perspective? 23 MS. CUNNINGHAM: Yes. It actually is reported 24 to the tape, but it is not used to count the high or low 25 of the day. And the retail investors, I understand the 0085 1 complexity around that. And, again, why they would have 2 concerns around aberrant trade is because their trade 3 standing at a price that is deemed, you know, not to set 4 the limits of the day. 5 But, again, I think it comes down to preventing 6 those trades in the first place. And I think that is 7 where we should really focus our energy so that if we 8 don't have those traders, we don't have to worry about 9 busting them or marking them aberrant. 10 MR. LUPARELLO: Joe? 11 MR. RATTERMAN: Yes. I was looking around the 12 room. I might be the only guy that was in the office 13 when we were called to the principal's office on May 10th 14 of 2010. 15 (Laughter.) 16 MR. LUPARELLO: I was, but I was in a different 17 job. 18 MR. RATTERMAN: Okay. I recall very clearly 19 that we were all very embarrassed as an industry about 20 the amount of trade breaks and the dislocations. And 21 limit up-limit down was put out as a vision about how to 22 make it better. We did some circuit breakers in the 23 meantime. And we finally have limit up-limit down. But, 24 just to reemphasize Stacey's and Jamil's point, the 25 vision all along was that limit up-limit down would 0086 1 completely eliminate clearly erroneous once and for all 2 and that trades that were allowed to trade in price 3 within a band would stand, no matter what. And we would 4 not allow trades outside of those bands. 5 And so I think the vision here is to get to the 6 point where clearly erroneous goes away. And maybe the 7 reason why we are not there yet is that this limit up- 8 limit down mechanism still needs a little tweaking before 9 we get it exactly right. 10 And, to your point, Steve, we are very close, 11 but I just would encourage the Commission to keep that 12 vision in mind and keep moving us forward as an industry 13 to get to the point where clearly erroneous goes away and 14 limit up-limit down becomes the tradable band, everything 15 in there stands. And I think that is the original 16 intent. We are just not quite there, but we can still 17 get there. 18 MR. O'DONNELL: Yes. I have got a few thoughts 19 on that. I agree with Jamil, you know, and the others. 20 In a world where limit up-limit down is functioning, we 21 don't need clearly erroneous bands. 22 And you said that there weren't very many, that 23 the exceptions are small. But the perception is real. 24 And we have spoken to a bunch of participants. And 25 people were really concerned that -- 0087 1 MR. LUPARELLO: That is exactly right. 2 MR. O'DONNELL: -- that we are going to end up 3 with thousands of busted trades in some unknown position. 4 So I think that perception, you know, time of market 5 uncertainty is a problem. 6 And, to address Frank's concern, I don't think 7 -- certainly we are not advocating widening limit up- 8 limit down. It might have been briefly discussed. I 9 mean, Joe said they are about right. I think they are 10 about right. We stopped at about the right time at 9:30. 11 The problem is, now what do you do? We didn't reopen 12 very well. We didn't get to that next step. Maybe the 13 right answer is don't have an auction but have some sort 14 of limit band that cascades, sort of finds the right 15 level, or maybe it is run a longer auction, but we 16 shouldn't be afraid about, "Hey, something is wrong with 17 this stock. I am not going to open it until I find an 18 equilibrium price," which may not be, you know, the 19 designated five minutes. Maybe it's 5, 10, 15, 20 20 minutes for a really big price move. 21 The question is, once we have hit the situation 22 where we have all of these incoming market orders, 23 liquidity providers had stock for a variety of very 24 rational reasons on their part. We can't rush to reopen 25 the market in that case. We have got to find the right 0088 1 equilibrium point before we get going again. 2 MR. HATHEWAY: On the point about executions 3 within the bands, there can be technical errors. Say, 4 for example, we do a million million share prints down a 5 dollar within the bands. Trades can't stand. They have 6 got that trade. We can go to the SEC for the authority 7 to break it. But somebody is out a dollar, a million 8 dollars a million times. Those trades would be broken. 9 And we just really would have to talk about at the time 10 what is the mechanism that would be followed between 11 trade date and clearing that that trade is broken because 12 nobody has a quadrillion-dollar bank account to clear 13 those trades. 14 MR. LUPARELLO: Gary? 15 MR. STONE: So I just wanted to ask a question. 16 So we talked about futures coordination. I think it is 17 really important. So to the panel, is that something 18 that the Commission should be working with the joint 19 CFTC-SEC working group -- I think it is a working group - 20 - or is that something which should be handled by the 21 industry working together, coming back to the regulators 22 with a proposal? 23 MS. CUNNINGHAM: I think it is going to have to 24 be on both sides of the house. You know, I think that we 25 would need coordination at the regulatory level as well 0089 1 as the industry working to find solutions that we think 2 would work well. And they are not easy problems to 3 solve, but I do think we need to address them. 4 MR. LUPARELLO: Brad? 5 MR. KATSUYAMA: This is for Stacey and Frank. 6 So I heard, Stacey, in response to Kevin's question, you 7 said that the imbalance information for the auctions is 8 published over the SIP. I didn't believe that to be the 9 case. I was just wondering if that was a new feature 10 that was put in or if this was at some point since August 11 24th that has changed or -- 12 MS. CUNNINGHAM: The mandatory indications go 13 out to the SIP. The automated imbalance information goes 14 out through the exchange feeds, as I believe it does in 15 other places as well. And we have a number of different 16 ways to get that at various price points. 17 MR. KATSUYAMA: So what is in the mandatory? 18 MS. CUNNINGHAM: That is a price range 19 information. So that is the supplemental information 20 that the DMMs put out with -- you know, it says, "It is 21 $50, $51 is the price range that we are looking to open." 22 The more specific automated imbalance information with 23 the negative pricing goes out through the feeds every 24 day. 25 MR. KATSUYAMA: Got it. And under rule 48, are 0090 1 the mandatory prices consistently published in the SIP or 2 they don't have to do that anymore? 3 MS. CUNNINGHAM: So rule 48, which is no longer 4 relevant in our proposals for our new opening processes, 5 only impacts the price range indications. It doesn't 6 have any impact on the automated imbalance information 7 that goes out every day. 8 The one deficiency we had on the automated 9 imbalance information back in August was that it stopped 10 at 9:35. So we have extended that already to the opening 11 of securities, but rule 48 was never a factor in that. 12 MR. KATSUYAMA: So what shows up on the SIP is 13 a DMM a manually keyed-in price range? 14 MS. CUNNINGHAM: A price range, yes. 15 MR. KATSUYAMA: Okay. Thank you. How does 16 that work on NASDAQ? 17 MR. HATHEWAY: Well, we don't have anybody to 18 manually key anything in. So the data we disseminate on 19 the auctions goes out to the prop feeds, through the 20 exchange feeds, but I think back to when we introduced 21 our auctions in 2004. We had a hell of a time getting 22 anyone to carry any data about our auctions and had to 23 build our own website to get it out to the industry. So 24 it has been an interesting change from, really, nobody 25 wanting the data to a lot of demands for it. 0091 1 And, more broadly, should this kind of 2 information be in the SIP? Well, that is part of some of 3 the other discussions on other topics. You guys have met 4 on what should be the scope of the SIP. 5 MR. LUPARELLO: Nancy? 6 MS. SMITH: Hello. And thank you for your 7 comments. 8 I would like to go back to the question about 9 orders, market orders and stop orders, and get your 10 views. I have heard many of you saying, "Well, we just 11 need more investor education" as one of the answers 12 there. What scale of effort do you think we would need 13 in the investor education area to really be effectively 14 educating people as to the risk and when to place these 15 orders or not? 16 And, then, secondly, I would also like your 17 thoughts on if, instead of getting rid of them, as some 18 would like to do, how would you target certain risky 19 trading times and say, "Let's have a halt maybe on those 20 types of orders"? So how do you balance those two 21 efforts, the investor education? 22 MS. CUNNINGHAM: I think one of the things that 23 may be discussed this afternoon is some of those issues. 24 But at a high level, the education could happen on 25 multiple levels. And one of them is just logging into 0092 1 your online account and having that alert saying, "Is 2 that what you are sure you want to do?" and giving some 3 education at that point. 4 There also could be an alternative to when you 5 enter, when an investor goes to enter a stop order, they 6 may be given a choice to say, "Do you want to enter a 7 stop order or do you want to be given a price alert when 8 that stock triggers at a certain price?" And then at 9 that point in time, which might be months later, you can 10 make a decision then. And being faced with that choice, 11 investors might think about what do they really want to 12 do? Do they want to go into a market we are not quite 13 sure what market conditions are or do they want to be 14 able to enter their order, not think about it? 15 I think as we look to come up with solutions 16 like that, that might just raise awareness because I 17 don't think investors are even thinking about the risks 18 that are associated with stop orders. I think that will 19 help. 20 MR. DeJESUS: So I think this is an effort 21 that, really, we tell broker-dealers and broker-dealers 22 in general need to participate in. I think one thing 23 that is important, too, is to understand what the 24 alternatives are. Right? You know, instead of using 25 stop orders, you can use stop limit, you know, orders 0093 1 instead so that investors can specify a price at which 2 they are unwilling to sell the security. Instead of 3 market orders, we can use, you know, marketable limit 4 orders, where you are basically specifying a limit price 5 that is either above the offer for a buy order or 6 slightly below the bid for sell orders so that investors 7 can really specify, you know, at what level they are 8 unwilling to purchase a security. 9 I think it is very important when you look at 10 the current market, where there are very discontinuous 11 events, when a stop limit is triggered, it is likely it 12 is going to be triggered because there might be earnings 13 news on the stock and the stock could be down. You know, 14 it could get down 3 or 4 percent. And so investors I 15 don't think are really understanding the conditions under 16 which their orders are going to get triggered. 17 MR. O'DONNELL: Yes. I think education is 18 tough here. You know, I think somebody mentioned -- it 19 might have been Jamil -- that people assume if they have 20 got a $20 stop, they are going to get a $20 execution. 21 Teaching them that that is not the case is very, very 22 difficult. Saying to them, "Hey, if you thought about a 23 $20 stop price, there is probably a price in your head at 24 which you are going to call your broker and complain." 25 Maybe it is $10. Maybe it is $15. Somewhere in there, 0094 1 you should put a limit price on it. 2 I don't think it is that much of an ask to say 3 to someone "Think about what price you would really want 4 to sell this stock at. Put a limit price in there 5 because that is a" -- you know, the exchanges have 6 mentioned, "Oh, they don't take stop plus orders anymore. 7 They put that obligation on the brokers," which is me. 8 We got a stop order from someone months ago which we 9 accepted because it looked fine. And now it has 10 triggered in a volatile market. Now I have got a held 11 market order on my hands that I have to execute in a 12 broken market. I am in a very difficult situation at 13 that point. If I have got a limit price on, it makes a 14 much easier conversation. 15 MR. HATHEWAY: On the education point, I have 16 no objection to brokers putting up pop-ups to warn 17 people, but I have some doubts about how effective they 18 would be. I mean, in my professor days, there were no 19 bad students, just bad teachers. 20 So I think it is more incumbent on us to figure 21 out "Okay. We are going to get these ways." Single 22 stock, market-wide, they happen. They have been 23 happening since I joined NASDAQ and so probably well 24 before that. What do we do? And I don't think the 25 continuous market modality works well when everybody is 0095 1 trying to go the same way. 2 That is why during my prepared remarks, I was 3 saying we want to keep switching between options and 4 continuous market, as the limit up-limit down process 5 does, and to simply get better at doing it. 6 MR. LUPARELLO: Gary? 7 MR. STONE: I just have a question. I mean, 8 one of the other responses to the flash crash was 15c3-5 9 from FINRA. Under that, you have to know what capital is 10 at risk. And so my question is, is there guidance needed 11 on the 15c3-5 whether or not brokers should even be 12 taking in market orders? Because you can't really 13 process a market order and know what the capital hit is 14 going to be as to whether or not the customer can handle 15 it, especially if there are margins. 16 MR. LUPARELLO: So I will look to Dave to 17 correct me if I am wrong or add, but when you look at 3-5 18 and both for rules around committing capital as well as 19 rules to prevent fat finger, right, they tend to be set 20 at a level where the level of capital that is committed 21 could be the problem. But you could have market 22 dislocations based on a 1,000-share market order. And 23 none of the filters are designed at that level of 24 granularity. So there are a lot of protections that come 25 with the market access rule. Preventing dislocating 0096 1 executions of smaller market orders isn't going to be one 2 of them. 3 MR. STONE: Maybe guidance should be expanded 4 that it should. 5 MR. LUPARELLO: Well, I think then it gets back 6 to sort of a lot of these questions about, you know, 7 taking away investor choice. Right? Do you really want 8 to interfere with investors' access to be able to use 9 market orders or even stop orders that in the vast 10 majority of times tend to work along the lines of what 11 the investor wants to get done because there are cases 12 where later on it becomes a very difficult balancing 13 question. 14 MR. CRONIN: The other thing to consider is 15 that it is not just about the outcome for that investor 16 whether they were able to sell at the market. It is the 17 tangential consequence to the rest of the market by the 18 accumulation of those orders. So maybe there is a 19 greater responsibility not only to that specific investor 20 but to the general market to say, "Look, if we accept 21 these kind of orders, particularly on a certain kind of 22 day," August 24th, "it probably is not in the best 23 interest of the individual consumer. And it most 24 certainly doesn't seem to be in the best interest of the 25 broader market." So maybe that is really where the 0097 1 conversation should be. 2 If you have a certain kind of market that sets 3 up now 5 percent, you know, we have circuit breakers and 4 limit up-limit down. Maybe there is something that could 5 at the broker level trigger a market order becoming an 6 order that has a 10 percent collar. I don't know. Pick 7 a number. But, at least as you educate your investors 8 around that kind of circumstance, this would seem to 9 triangulate around all the kinds of things we are trying 10 to solve for. 11 MR. LUPARELLO: And, again, I think a lot of 12 firms have imposed super marketable limits on their 13 market orders in the way they are entered. But at some 14 point if your customer has a market order and that market 15 order doesn't get fully filled, as Paul was talking about 16 before, you have got a held order where you haven't met 17 the terms of that order. And that creates a conflict 18 that is not that easy to resolve. 19 MR. CRONIN: Well -- and I don't mean to speak 20 for Matt -- by professional investors, I in my entire 21 career never put in a stop loss order, right? Trillions 22 of dollars later, I am happy to say that that never 23 happened. 24 And the second thing is we don't use market 25 orders. Why is that? Because we understand the perils 0098 1 of them. I think if investors more broadly understood 2 those perils, maybe they will listen, maybe they won't. 3 But I think they become, you know, informed consumers. 4 And then it is their responsibility. In different kinds 5 of market environments, I think there is a greater 6 responsibility to the market itself to not allow those 7 orders to overwhelm the system. 8 MR. LUPARELLO: To be discussed more in detail 9 this afternoon. 10 And Jamil? 11 MR. NAZARALI: I mean, I am happy to hold those 12 thoughts until this afternoon if you would like. 13 MR. LUPARELLO: No, no. Go ahead. 14 MR. NAZARALI: Okay. I mean, so I agree with 15 you that that was the case on 8/24, but I think that 16 market orders and stop orders have very valid uses most 17 of the time. And most of the time retail investors are 18 entering a relatively small market order. And if they do 19 enter large ones, which sometimes happens, our market 20 access controls will stop it. And we will call the 21 retail broker-dealer and, you know, then they will call 22 the investor. I think what you can't do, though, is you 23 can't make a decision to change a held order into a not 24 held. 25 So, for example, in a very volatile market, if 0099 1 you see, you know, 1,500 share orders, I mean, you are 2 obligated to execute those and to send them to the market 3 because you don't know what is going to happen. What 4 might happen is that you could hold those back and you 5 could put a 10 percent collar on it, as you suggest, or 6 in some other way change the nature of the order. And 7 the market could keep going down and down and down. 8 And then those retail investors are going to 9 look to you "Why didn't my order get executed?" And if 10 you sent it to the market right away, yes, it would have 11 been executed 10 percent down, but that is a lot better 12 than 50 percent down." So I think it is really complex. 13 MR. LUPARELLO: Joe and then Eric. 14 MR. MECANE: I would just simply suggest that 15 we don't treat the two issues as mutually exclusive. I 16 think we should have a valid discussion about whether 17 education or even banning not having a strong opinion on 18 that is worthwhile. But it seems like the primary goal, 19 especially for this conversation, should be how do we 20 design the limit up-limit down mechanism in a way where, 21 even if we have this wave of selling, whether it is super 22 marketable limits or whether it is market orders or stops 23 or whatever, we get comfort that the market mechanisms 24 are able to protect people from it. And then if we think 25 we need to put additional behavioral protections on top 0100 1 of it, great. And we will talk about that this 2 afternoon. But I would think we should still try to 3 design the market to be able to absorb them regardless. 4 MR. NOLL: So, you know, sort of tying a couple 5 of these issues together, it has been some of my 6 experience that at times of market stress, when stop-loss 7 orders are being executed or large market orders are 8 coming into the marketplace, that what ends up happening 9 with those orders is they flood to the LIT markets at 10 that point. Right? So prior to that, liquidity is being 11 provided off exchange in different kinds of mechanisms. 12 And then at a time of market stress, those orders tend to 13 be slammed over and going to the one venue at that point 14 that probably is not ready to take that in terms of 15 liquidity provision. Right? We saw that on the morning 16 of August 24th, which is liquidity was down 17 significantly, but the flood of orders coming in was 18 stronger. 19 So I think one of the things we have got to 20 think about, you know, education, yes, you know, should 21 these orders be banned/not banned, not used. But how do 22 we solve that liquidity provision problem. Jamil 23 mentioned earlier that, you know, maybe exemptions to the 24 short sale and some other things around that to provide 25 liquidity, but to me I think the issue is less about, 0101 1 hey, this is a bad order type. That is about investor 2 choice. 3 I think the real issue here is how do we make 4 sure that we have valid price-discovering liquidity at 5 times of market stress because the 24th was the most 6 obvious example, but all of us who have been in this 7 business for a while can point to individual names that 8 happen every day where there is a stock that there is a 9 flood of sell orders between 9:30 and 9:45 in the 10 morning, primarily triggered by stop-loss, where 11 everybody is coming to the exchange. 12 How do you solve that liquidity provision 13 around that moment or around those moments, as opposed to 14 saying, "Well, we are just not going to allow those order 15 types anymore"? I don't think that solves the problem. 16 I think you just push the problem around that way. I 17 think we have to get to the core of, how do you solve 18 that liquidity provision problem? 19 MR. LUPARELLO: Joe? 20 MR. RATTERMAN: You know, Kevin, neither you 21 nor I has probably ever placed a stop order or a limit 22 order or a stop order or a market order. I totally 23 agree. But we are also watching our screens frequently 24 during the day. 25 You know, having talked directly with the 0102 1 retail brokerage firms just recently, they would tell us 2 that a market-based approach here is the right answer, 3 that, you know, investors need solutions to these 4 problems, but the market could probably come up with 5 them, as opposed to taking away order types to try and 6 prevent these catastrophes. 7 I liken it -- maybe this is a terrible analogy, 8 but I liken it to changing lanes on a highway. It is a 9 very dangerous thing to do. And oftentimes, it results 10 in a catastrophic accident. Some vehicle manufacturers 11 have put little indicators in the window that, "Hey, you 12 have got someone beside you. Maybe now is not a good 13 time to change lanes." You know, that is a good solution 14 that the market came up with to prevent, you know, these 15 kinds of things. 16 So I would just yield back to the retail 17 brokers who said that, you know, they would like to try 18 and solve this with their own technology, rather than 19 take away these order types. 20 MR. CRONIN: I am not suggesting taking them 21 away, far from it. I said that there should be education 22 around these orders and people have to understand the 23 potential outcomes by their use and caveat emptor. But, 24 on the other hand, what I am suggesting is the cars 25 behind your analogy, who are now involved in a multi-car 0103 1 crash, who had nothing to do with the situation, are 2 dealing with the consequences of the multi-car crash. So 3 it seems responsible of there are ways that we can 4 address that beforehand. 5 We are not in a perfect place for liquidity 6 formation, certainly on the opening. You know, 7 inconsistencies aside, you know, we have seen evidence, 8 not only on the 24th, but in isolated, you know, single 9 stock events, that there could be a much better mechanism 10 to really understand supply and demand. When you have 11 48-plus destinations for an order to go to, obviously 12 your understanding of supply and demand is quite a big 13 compromise relative to what it used to be. 14 So transparency is the answer in a number of 15 these different concerns that we have, but I am not 16 suggesting that retail investors shouldn't have access to 17 these kinds of orders. I am suggesting that in certain 18 circumstances, we probably need to think about those 19 orders in the broader context of the market. 20 MR. LUPARELLO: Great. I have contingencies 21 for being behind schedule. I have no contingencies for 22 being ahead of schedule. But why don't we thank the 23 panel very much for their contribution. 24 We will take a break for lunch now. Let's try 25 to reconvene at 12:45. I will also say that while we 0104 1 were offering lunch, it is not a working lunch. And we 2 will not be offended if you choose to do something else 3 as a Committee for the next hour, but lunch is available. 4 (Whereupon, at 11:39 a.m., a luncheon recess 5 was taken.) 6 A F T E R N O O N S E S S I O N 7 MR. LUPARELLO: Welcome back, everyone. We are 8 going to begin the afternoon session with a presentation 9 on issues affecting customers in the current equity 10 market structure. Michael Coe of the Division of Trading 11 and Markets is going to tee up the issues. And then we 12 are going to turn it over to our panelists. 13 MR. COE: Thank you, Steve. 14 In support of the Committee, the Division of 15 Trading and Markets has prepared a memorandum addressing 16 certain issues that affect retail investors in the 17 current market structure. I will summarize that. And 18 the memo is also on the website. These issues are the 19 risks of using certain order types, the potential 20 conflicts presented by payment for order flow, and the 21 development of improved execution of quality reports. 22 Before I begin, I would like to thank Marsha 23 Dixon, Leah Mesfin, and Andrew Siosan for their 24 substantial contribution in preparing the paper. 25 Two of the order types most popular with retail 0105 1 investors, market orders and stop orders, can present, as 2 discussed this morning, significant risk during periods 3 of short-term market volatility. Market orders remain 4 popular with retail investors, many of whom enter orders 5 outside of regular trading hours because it is 6 impracticable for them to trade during their working day. 7 And retail investors can use stop orders to try to 8 protect a gain or to limit potential losses of a position 9 they already hold. 10 Market orders and stop orders face a common 11 risk, though. Those who submit them rely on robust and 12 orderly quoting and trading activity to provide an 13 execution at a reasonable price. On a volatile trading 14 day, however, as discussed this morning, that execution 15 price can deviate significantly from recently traded 16 prices, even with the protections of limit up-limit down. 17 Stop orders also present an additional risk. 18 They may be triggered by a temporary price decline that 19 has rapidly reversed, resulting in an execution that does 20 not reflect an investor's desire to trade in response to 21 fundamental moves. 22 In light of these risks, some exchanges have 23 recently eliminated stop orders from the rule book. But 24 the vast majority of stop orders are held by broker- 25 dealers. And, therefore, stop orders continue to pose 0106 1 these risks. 2 There are a range of possible approaches to the 3 risks posed by these order types. One commonly used 4 approach is to educate investors. So renewed efforts 5 could be undertaken by regulators and market participants 6 to enhance investor education in this area. Another 7 approach would be to place restrictions on the use of 8 these order types. For example, broker-dealers and 9 exchanges could require that all retail investor orders, 10 including stop orders, include a limit price. This 11 approach, however, would involve tradeoffs between 12 protecting investors from unexpected price movement and 13 providing certainty of execution. 14 Other possible alternatives would be to limit 15 or prohibit the use of market orders in particular 16 situations to prohibit the use of stop orders for 17 particularly volatile securities or even to eliminate 18 stop orders altogether. But, as noted in the discussion 19 earlier today, these order types remain popular tools for 20 retail investors and can function well in orderly market 21 conditions. 22 The paper also discusses payment for order 23 flow. And, as used in the paper, this means the cash 24 payments made by over-the-counter market makers to retail 25 brokerage firms in exchange for retail customer order 0107 1 flow. Currently most marketable retail customer orders 2 are either internalized by an integrated broker-dealer or 3 are routed to an OTC market maker for execution. Market 4 makers are interested in trading with retail customer 5 order flow because, by doing so, they can avoid adverse 6 selection by more informed traders. And typically 7 dealers that pay for retail order flow will guarantee 8 executions for that order flow with some amount of 9 average price improvement over the NBBO and with a 10 separate payment to the retail broker for the customer 11 orders. 12 The Commission has stated that a broker-dealer 13 does not necessarily violate its best execution 14 obligation merely because it receives payment for order 15 flow. At the same time, the Commission has noted that 16 the existence of payment order flow raises the potential 17 for conflicts of interest. Specifically, the economic 18 incentives created by payment for order flow can create 19 potential conflicts for the broker's duty to seek best 20 execution when routing its customer orders. It is also 21 possible that in the absence of payment for order flow, 22 market makers could have incentives to quote more 23 competitively and thereby improve prices received by 24 customers. 25 On the other hand, some have argued that 0108 1 payment for order flow indirectly benefits customers by 2 subsidizing low Commission rates and other customer 3 services. Additionally, retail market will orders routed 4 pursuant to payment for order flow arrangements are 5 generally executed quickly and at the NBBO or better. 6 To date, the Commission has pursued an approach 7 based primarily on disclosure to address concerns about 8 the potential conflicts of interest caused by payment for 9 order flow arrangements. One alternative to address 10 these concerns would be to prohibit the practice on the 11 grounds that it presents a conflict of interest too 12 significant to be adequately addressed by disclosure and 13 best execution obligations. 14 If payment for order flow were banned, however, 15 market participants might develop other less transparent 16 means to induce order flow, which could give rise to 17 similar concerns, yet be more difficult to monitor and 18 control. For example, the issues arising from payment 19 for order flow are difficult to distinguish from those 20 that arise when an integrated broker-dealer internalizes 21 its own customer orders. 22 Additionally, the Commission has in the past 23 discussed requiring the payment for order flow be passed 24 through to retail customers, which could also eliminate 25 the potential conflicts. Some, however, have questioned 0109 1 whether the solution could work practically in a market 2 environment where orders take a circuitous route from 3 initiation and completion and they have also questioned 4 whether investors would want to move from a fixed 5 Commission schedule to a more complicated schedule based 6 on commissions plus potential rebates or fees. 7 Alternatively, more detailed guidance could be 8 provided for broker-dealers on how to effectively address 9 the potential conflicts created by payment for order flow 10 arrangements and internalization consistent with their 11 best execution obligations or brokers that receive 12 payment for order flow or that internalize might be 13 required to conduct a rigorous assessment of alternative 14 order execution opportunities on venues where those 15 potential conflicts do not exist. 16 Finally, another option could be to require 17 broker-dealers to provide their customers with detailed 18 information about the specific amounts received under any 19 payment for order flow arrangement. 20 Finally, the paper addresses execution quality 21 reports. 22 Today broker-dealers often have the choice of 23 internalizing customer orders or routing them across 24 myriad venues, including exchanges, LIT or dark 25 alternative trading systems, and OTC dealers. This could 0110 1 make it more difficult for customers to assess how well 2 their brokers fulfill their best execution duties or to 3 evaluate the impact of potential conflicts of interest. 4 In 2000, the Commission adopted rules requiring 5 market centers to publicly report execution quality 6 statistics and requiring brokers to publicly disclose 7 their order-routing practices. These rules were later 8 incorporated into regulation NMS as rules 605 and 606. 9 Some market participants believe that the availability of 10 605 and 606 reports has not only provided better 11 information to customers but also spurred competition 12 among brokers to seek out higher-quality executions, 13 which, in turn, has motivated market centers to improve 14 their execution quality. The equity markets, however, 15 have changed significantly since the adoption of these 16 reporting requirements. Accordingly, a number of 17 suggestions have been made to update these rules to 18 better reflect the current market structure. 19 Currently execution quality and order-routing 20 statistics appear in separate reports, which can make it 21 difficult for retail investors to evaluate the execution 22 quality achieved by the brokers. Therefore, some have 23 suggested that broker-dealers be required to produce a 24 combined report that allows retail customers to evaluate 25 the execution quality that the broker actually achieves 0111 1 at each venue to which it routes it customers' orders. 2 Some market participants have also suggested 3 that the specific information disclosed in rule 605 and 4 606 reports should be updated to reflect changes in the 5 market. For example, requiring order execution speed to 6 be disclosed with much finer granularity might be 7 helpful. Another suggestion is that additional data be 8 disclosed, such as data regarding additional order types, 9 odd lot orders, and market-opening auctions. And other 10 specific suggestions are outlined in the staff's paper. 11 Finally, some suggestions have addressed the 12 fact that rules 605 and 606 reports do not include 13 institutional orders. And many institutional investors 14 have said that it is difficult to understand how their 15 orders are handled by their brokers and that it is, 16 therefore, difficult to assess best execution. To 17 address these concerns and other, the chair has directed 18 the Commission staff to develop a rulemaking proposal 19 that would enhance the disclosures required of brokers 20 with respect to their routing of institutional orders. 21 Thank you. 22 MR. LUPARELLO: Michael, thank you. 23 Let me introduce our panel. Going from, again, 24 facing them left to right, we have Jeff Brown, senior VP 25 of legislative and regulatory affairs at Charles Schwab. 0112 1 Welcome, Jeff. Next to him is Frank Childress, the 2 managing director at Wells Fargo Advisors. 3 Michael, I seem to have caught what you have. 4 Next to him is Dennis Dick, a member of the 5 Capital Markets Policy Council at the CFA Institute. 6 And, finally, we have Dr. Christine Parlour, a professor 7 of finance and accounting at UC Berkeley. 8 Jeff, let's start with you. 9 MR. BROWN: Madam Chair, Commissioner Stein, 10 Director Luparello, and Gary and the staff and the 11 Committee, thank you for having me here today. As I 12 reflect on it, this is the third MSAC meeting and second 13 time I have appeared. And I was going to just say if it 14 makes it any easier, you could just appoint me to the 15 Committee and I would be here all the time. But it is 16 worth a try. 17 (Laughter.) 18 MR. BROWN: In any case, we are really happy, 19 Schwab is happy, to be here today to talk about customer 20 issues. Customers are the essence of what we do. We 21 have grown to be a firm of two and a half trillion 22 customer assets under custody through our focus on 23 customers and even our motto of "Look through clients' 24 eyes." You know, we try to see everything through how 25 our clients would see things. And so these issues that 0113 1 you have laid out in your staff memo are very important 2 to us. And maybe I will just dive right in to, you know, 3 the market order and stop orders. 4 Now, you should know that Schwab clients use 5 market orders and marketable limit orders more than any 6 other. About two-thirds of the time, we are a market 7 order shop. And that is because our clients when they 8 see a price and the execution systems are so efficient 9 that they can see a price and go get it. And so limits 10 on particularly market orders, you know, would trouble 11 our clients and trouble us. 12 Now, naturally any time you are using an 13 unpriced order and you are relying on the marketplace to 14 price it for you, you take risks. And that risk is 15 really accentuated when you are dealing with volatile 16 markets and not just volatile markets. We are really 17 talking about falling markets because when markets are 18 rising rapidly, there are always natural sellers, those 19 who are long sell for a profit. But when you are 20 falling, you have to have either someone who wants to 21 create a position or cover a short position. There are 22 far less natural buyers. And, therefore, it is a falling 23 market we are talking about. And so entering market 24 orders into those markets, it creates greater risk. 25 And we certainly make that known, particularly, 0114 1 say, the last month, you know, January, was very volatile 2 and on the down side. And so our clients get very 3 nervous. So we try to coach them to, you know, don't 4 overreact to markets. Don't overreact to a particular 5 moment of where a stock is trading and enter a market 6 order into something, particularly illiquid stocks, when 7 liquidity is dried up everywhere in a rapidly falling 8 market. 9 So it is not to us that the market order is a 10 problem. It is when it is used. And we would encourage 11 and we do encourage and we educate our clients about that 12 use and when not to use them that could create a problem 13 for them. 14 Now, stop orders, again, many of our clients 15 obviously they can't focus on the markets all day long. 16 They don't sit in front of the trading screen and watch 17 prices. But they may have a profitable position. There 18 is a use for stop orders. Now, naturally stop orders 19 have, you know, maybe an increased risk because they are 20 usually triggered when markets are falling. And then you 21 are injecting a market order. If it is just a plain stop 22 loss order, it is a market order into a lower market. 23 You all know that is not a recipe for 24 necessarily a good execution, but even putting a limit 25 price on those doesn't necessarily eliminate some risk 0115 1 because the client might miss the next trade and then be 2 sitting there at a limit price when the market is trading 3 lower and lower and lower. And they won't even know 4 about it because they are not watching their screen. The 5 whole purpose of a stop order is to provide some 6 protection while they are not necessarily watching the 7 market. 8 And so, for these reasons, we still believe 9 there are very valid important uses for both market 10 orders and stop orders, but the education has to be 11 emphasized, you know, encouraging our clients to, 12 particularly with stop orders, review them, you know, 13 refresh the price maybe because, you know, as stocks 14 move, you may want to change where your stop position 15 should be triggered and, you know, that process because 16 one of the things that happens often is the people enter 17 stop orders and they forget about them. And they sit out 18 there. And they don't even remember that they entered a 19 stop order. And suddenly they are executed in one day in 20 a flash move that they never anticipated. Yes, they had 21 forgotten about it and they had changed their mind about 22 it. So there is an effort to make sure that clients are 23 aware of where they hold our orders. And so, for that 24 reason, you know, we would encourage you to consider the 25 importance of these orders and not just automatically 0116 1 consider that we ought to stop and protect people from 2 themselves. 3 Now I will turn now to maybe a meatier issue 4 that we are going to debate today, which is payment for 5 order flow. You know, in reading the staff's memo about 6 how payment for order flow may have developed, you know, 7 I was kind of struck by, yes, it is true that OTC market 8 makers came about when they were able to get real-time 9 data and to compete with exchanges, but the thing that 10 was left out in my view was that exchanges had failed to 11 provide even adequate execution quality to retail 12 investor orders. 13 And firms like Schwab, we had to find an 14 alternative because we couldn't just in good faith turn 15 our orders over to people who weren't going to treat them 16 fairly or even, you know, provide a decent price. So 17 what did we do? At Schwab, we created an execution 18 broker. And it was a division of Schwab. I was actually 19 general counsel of that division. And we were able to 20 then develop a system to provide better execution for our 21 clients and know that where they would be executed would 22 be better than what they were going to get somewhere else 23 and we would have some recourse if we had a problem. 24 Now, we ultimately decided that that system, 25 you know, needed scale. It needed focus. And so we sold 0117 1 our execution division. But we continued to use the 2 system because we knew how it was built and we knew the 3 fairness of the prices it generated. So now this 4 structure has blossomed into a very competitive market 5 structure that offers us numerous participants who 6 provide better and better execution quality. And 7 ultimately that is the key to this. 8 I would say today retail investors get better 9 execution quality than they have ever gotten before 10 through this system and through the competition that goes 11 on within this system. Now, when I say "execution 12 quality," let me just talk about how Schwab looks at 13 this. Now, we use a measurement called effective spread 14 over quoted spread. I won't go into the details of that, 15 but when we look at all of our orders from 1 share up to 16 9,999 shares, we run our numbers to come up with an 17 average effective spread over quoted spread. And that 18 number for us is 49 percent today on average. Now, what 19 does that mean? It really kind of means that when a 20 client comes in to buy a security, he is going to get 21 better than the midpoint of the quote and the bid or 22 offer; in essence, a 25 percent discount to the spread 23 when an order arrives on average. 24 So, you know, you will hear talk about how the 25 price improvement numbers are just a mil ahead of the bid 0118 1 or a mil below the offer. It is not the case. The 2 system is very competitive. And the execution quality is 3 very high. 4 By comparison, an average number for the 5 exchanges is 115 percent, which means on average, price 6 disimprovement to the bid-ask spread that exists at the 7 moment of order arrival. So I will let you judge. You 8 know, where would you send your orders? You know, you 9 are going to want to send them where they are going to 10 get the best prices. 11 Now, that doesn't mean that we end there. We 12 look at our price improvement numbers. Our average share 13 at Schwab -- our average order -- excuse me -- is 823 14 shares. Our average price improvement on that average 15 sized order is $6.06. Now, that is nearly what we charge 16 for a commission, but the payment for order for a piece 17 of that on the average 823-share order is 82 cents. So 18 our clients, the value proposition coming from the 19 wholesale execution firms, our clients are getting seven 20 and a half times what we receive in that value 21 proposition. We think that demonstrates, you know, our 22 commitment to our clients. 23 Now, clearly we do receive a payment. And that 24 is a potential conflict. And it is permitted, though, 25 under common law to mitigate the conflicts. And we try 0119 1 to do that. One of the ways we do that, unlike the 2 numbers in your memo where it showed quite a broad range 3 of payment for order flow prices per share that firms 4 receive, at Schwab, we limit our wholesale vendors to a 5 very, very narrow range, almost the same price. It goes 6 from $.0008 per share to $.001. And our average payment 7 per share is $.0009. Well, that narrow range limits any 8 incentive for Schwab to route orders based on the amount 9 we receive. We don't do that. We route orders based on 10 the quality of execution those firms provide. And we 11 have mapped them against each other to make sure that 12 they understand that if they want to do more business 13 with Schwab clients, they have to do a better job at 14 execution quality. 15 So, as we look at that, there is still a 16 payment to us. Now, as your memo indicated -- and Mr. 17 Spatt was part of that -- there is a statement that these 18 funds flow indirectly back to the client. We agree with 19 that wholeheartedly because these payments allow us to 20 maintain world-class systems and in-services to care for 21 our clients. So we fully think that this is a system 22 that works to the benefit of our clients. 23 Now, one of your suggested alternatives was to 24 ban payment for order flow. Well, you know, if you think 25 about it, even if you eliminated the payment to Schwab, 0120 1 would we change where we route our orders? I mean, the 2 execution quality isn't going to change at the wholesale 3 broker-dealer level. They are going to still provide as 4 much better execution. We will still go to them. If you 5 want to force or flow back to the exchanges, you have to 6 say, "Wait a minute. We are going to band off exchange 7 trading." And I don't think anyone wants to go there 8 because that has been a part of our market for many, many 9 years. 10 So before we think leaping to maybe a simple 11 solution, you know, it is not going to drive what you may 12 want it to drive to. So while I could filibuster on and 13 on about some of this, but I will finish by just saying I 14 do believe that what has been created and the competition 15 among the firms that provide this service is of real 16 value to our customers. 17 Thank you. 18 MR. LUPARELLO: Thank you, Jeff. 19 Frank? 20 MR. CHILDRESS: Thank you to the Chair and the 21 Commission and the Committee for the invitation to share 22 my thoughts on behalf of Wells Fargo. I work at Wells 23 Fargo Advisors, which is the retail broker-dealer within 24 Wells Fargo. There is also another broker-dealer that 25 deals with the capital markets side. We are nonmarket- 0121 1 making. We are an agency, the only broker-dealer really 2 targeted at retail investors. 3 My compliments to those that organized the 4 customer issues paper. It is very balanced and succinct. 5 First and foremost, I am in the camp that feels that 6 retail investors of U.S.-listed equities have never had 7 it better and enjoy remarkable access; speed; liquidity; 8 transparency; price improvement; and, perhaps most 9 importantly, choice. The challenge today is to manage 10 those one or two events that happen each year, dates and 11 events that are tattooed in our mind. It would be May 6, 12 August 24, and others that we know well that materially 13 stress our market structure and fuel skepticism of the 14 public of the integrity of our markets. 15 I will focus on the topics raised in the 16 customer issues paper. I may touch on a few other market 17 structure issues that also impact retail investors and 18 just a couple of statistics to sort of back up my initial 19 comments. Alluding to some of the same statistics that 20 Jeff was talking about, if you go back to 2009, that 21 effective over quoted spread in the marketplace, public 22 marketplace was about 116 percent, so, again, something a 23 little bit more than the national best bid or offer. 24 Today the public numbers are around 61 percent. 25 So I will talk about it a little bit later in 0122 1 the 606 recommendations, but we would prefer to look at 2 that in a way of spread capture, a little more retail- 3 focused metric perhaps. But back in 2009, if you 4 interpolate that into a spread capture, we were about 8 5 percent over the national best bid or offer in terms of 6 execution quality. And today we are capturing about 20 7 percent of the spread. Those are public numbers. As 8 Jeff indicated, his numbers are better than that. Ours 9 are better than that as well. 10 So, additionally, spreads in the S&P500 just 11 since 2000, since the initiation of rule 5 and rule 6, 12 now 605 and '6, spreads in the S&P500 stocks were about 13 20 basis points. Today it is about 3 and a half. Today 14 in the public marketplace, share price improvement is 15 around 80 percent. So 82 percent of all orders actually 16 get price improvement, 94 percent are executed at the 17 quote or better. Those are public figures. I think our 18 individual firms are better. 19 As we talk about order types, the paper 20 appropriately lays out concerns about market and stop 21 orders and the potential steps to address. Keep in mind 22 this is another example of something that works extremely 23 well to the benefit of retail investors the large 24 majority of the time. But, as we mentioned, we have 25 occasional events where orders don't work as intended. 0123 1 Education I think we have talked about it a 2 lot. It is a primary tool that we can use. It is 3 essentially a no-brainer. We all have the responsibility 4 to educate our investors and provide material so they can 5 educate themselves. That is the responsibility of all 6 entities: regulatory agencies, broker-dealers. 7 The paper referenced the SEC's investor alert 8 talking about trading basics and addressing stop and 9 limit orders. That is certainly a starting place. I 10 think each broker-dealer has their own educational pieces 11 available to their clients. And I can assure you that we 12 along with probably most other broker-dealers have 13 reviewed and added to those documents since the 14 volatility that we experienced on August 24th. That was 15 certainly we saw unprecedented activity in stop orders. 16 And we have certainly enhanced our education since then. 17 Some of the things that we have done is 18 certainly updating internal education, educational pieces 19 that we had already. We have created videos addressing 20 volatile markets available to our retail financial 21 advisers. We have added edits to the system. And we had 22 other edits that were already in the system. So if you 23 pull up a quote line, you will see specific references in 24 less liquid securities that you may want to consider 25 using a limit if somebody has entered a stop order. 0124 1 Additionally, if somebody enters, begins to enter, a stop 2 order, if they don't have a limit on it, we have a little 3 essentially a popup that outlines that you may want to 4 consider a limit when you enter the stop order. 5 We implemented some new things post-November 6 24th. We have seen a pretty material reflex in our 7 retail investors, an increase of about 35 percent of 8 movement to limit orders over just stop market orders. 9 So we believe that is a trend in the right direction 10 still with a lot of work to do because there are still 11 predominantly stop to market orders. 12 Some of the recommendations restrict or 13 eliminate. Again, consistent with the theme, it seems 14 like the paper does a good job of outlining the 15 challenges to restrict or eliminate. There is some 16 precedent for restricting market orders. We do have rule 17 5131, which prohibits the use of market orders prior to 18 the opening of an IPO. A lot of firms take that a little 19 further, including ourselves. And we restrict it for the 20 first day of an IPO trading. But that is an example 21 where we already have that in the marketplace, and it 22 seems to work okay. 23 In my view, eliminating the stop orders would 24 reduce choice. Retail investors do rely on them in many 25 cases. They are valuable tools for retail clients and 0125 1 advisers for managing risk within their portfolios. 2 Moving on to payment for order flow, I think 3 the paper again outlined well. You are correct to 4 isolate and focus on the market maker to dealer payments 5 for marketable flow, market orders specifically. That 6 said, I have a different view on a couple of the points 7 in the paper. 8 The paper correctly points out the increasing 9 dollar amounts in 2013 and 2014. And although we don't 10 at Wells Fargo Advisors accept payment for order flow 11 from dealers for equity flow, I think the rates took a 12 material U turn in 2015. And I think the payments are no 13 longer trending up, as the paper suggests. 14 There has been significant attention and 15 rhetoric by the industry participants, including SIFMA, 16 FIF, STA, and certainly the regulators on payment for 17 order flow. And it seems to have had a pretty 18 significant impact on payment for order practices as I 19 hear about them. 20 The rates disclosed in these firms' 606 21 disclosures would indicate that the firms are much closer 22 to the lower end of the range referenced in the customer 23 issues paper than they are to the top and in some cases 24 below the low end of the range. As you mentioned, there 25 is still a duty of best execution, but in most cases, 0126 1 these firms are executing the vast majority of their 2 orders inside the NBBO and providing a robust trading 3 platform with extremely low cost. 4 Just a common example, as Jeff laid out, an 5 example of average trade being 800 or so shares. So the 6 most common stock that any of us trade is Apple. If you 7 consider buying 1,000 shares of Apple, the payment for 8 order flow aspect of that in most firms would be 9 somewhere around $1 to $1.20 on a $95,000 transaction. 10 So it is a relatively small part of the overall picture. 11 Potential steps to address payment for order 12 flow issues. Prohibit was the first one. The paper 13 references concerns about firms developing less 14 transparent ways to induce order flow. I would be less 15 concerned with that and more concerned with the impact in 16 the self-directed space that provides significant choice 17 at a low cost for a large group of clients in the 18 marketplace. 19 Passing the payment along, it seems client- 20 friendly initially, but I think it would be extremely 21 complicated to try and implement. It would be costly. 22 And also it would be difficult to validate. 23 Enhance the guidance and disclosure. This is 24 certainly part of the answer, but I think it has also 25 been a little bit self-correcting. Most firms do or are 0127 1 really very explicit with their disclosures. If you were 2 to look at a typical online or the larger online firms, 3 they are very specific as to exactly how much they take 4 from each individual market maker that they are accepting 5 payment for. 6 As we finish up going into the execution 7 quality reports, we are a strong advocate for appropriate 8 disclosures and transparency. As suggested earlier, 605 9 and 606 are outdated. And they need to be refreshed. 10 But from my perspective, routing disclosures and the 11 implementation of rule '5 and '6 have had a material 12 impact on the exceptional execution quality that retail 13 investors enjoy today. It is an extremely competitive 14 marketplace out there. Our retail investors enjoy 15 amazing execution quality delivered by the group of 16 market makers that exist out there today. 17 Within 605, there is definitely room for 18 refreshing as the market has changed materially since 19 2000. Many of them have to do with timestamps and speed 20 measures. But just a couple I will highlight: eliminate 21 executive speed bucket categories; including odd lot 22 orders as they become an increasingly large part of the 23 market, particularly with very large dollar price stocks. 24 So many of these odd lot orders are pretty material sums 25 of money. 0128 1 Eliminate realized spread reporting. It is a 2 measurement that has a five-minute look-back, which today 3 would be looking back five weeks I think. Require quoted 4 spreads to be included in the electronic 605 data file. 5 Include a per-order notional value threshold cap. So 6 along the other side of the odd lots, currently a $5 7 million Google order is a 605-covered order. And perhaps 8 we could look at a notional value, instead of a share 9 amount. We would suggest that we exclude some of the 10 more professional order types, like IOCs and ISOs, that 11 are really focused on institutional-type orders. 12 Perhaps a couple of new metrics, a time at 13 quote for nonmarketable limit orders to show the average 14 time elapsed between the time an order is represented at 15 the best bid and the time it gets executed. And spread 16 capture that I referenced earlier currently derives 17 statistics similar to an EQ. It is sort of the flipside 18 of it. But it shows the average net percentage of a 19 spread given this price improvement. 20 For 606, just a couple I would throw out: 21 split the limit order category into marketable and 22 nonmarketable; eliminate separate reporting for the 23 different tape feeds to consolidate the reg NMS issues; 24 and also exclude professional order types. 25 Just concluding, I definitely feel there are 0129 1 areas for opportunity. But events like today are 2 fundamental to moving forward and identifying issues that 3 where we have challenges are usually brought about after 4 a significant event. All industry participants seem to 5 be engaged. We heard this morning of some of the 6 reflexes that the New York Stock Exchange is doing to 7 make adjustments appropriately to the opening process and 8 the limit up-limit down process. We are continually in 9 an iterative self-correcting process, but I think 10 bringing folks together from all different parts of the 11 industry, like events like today, certainly help us 12 manage moving in the right direction. So thank you. 13 MR. LUPARELLO: Dennis? 14 MR. DICK: Good afternoon. My name is Dennis 15 Dick. And I am a member of the Capital Markets Policy 16 Council at CFA Institute. I am also a proprietary 17 trader and equity market structure analyst at Bright 18 Trading, LLC. I would like to thank the Chair, the 19 commissioners, the staff, and the Committee members for 20 allowing me to speak before you here today on a number of 21 customer issues, including the use of market and stop 22 orders during times of market stress, the potential 23 conflicts and issues created by payment for order flow 24 arrangements, and rule 605-606 reporting. 25 August 24th was an extraordinary event marked 0130 1 by large increases in trading volume, drastic reductions 2 in liquidity, and significant price dislocations. The 3 stocks of hundreds of major companies, including widely 4 held names, such as General Electric, J.P. Morgan, 5 Johnson and Johnson, by more than 10 percent in just a 6 matter of minutes, some much more than that. 7 The lower bands of the limit up-limit down 8 circuit breaker mechanism were quickly reached on many 9 individual securities, leading to hundreds of individual 10 volatility pauses in ETFs and stocks. These temporary 11 halts led to market confusion and significant reductions 12 in ETP liquidity as market participants could not 13 accurately calculate the value of their underlying 14 holdings. 15 Any trader or investor who held their positions 16 through those opening few minutes was not severely 17 impacted because the market rebounded significantly from 18 those opening lows. However, this rebound could not help 19 those investors who had used stop or market orders to 20 protect themselves from further losses during the severe 21 opening decline. That is because these stop orders may 22 have triggered and executed prices significantly lower 23 than previously quoted prices and may have been a 24 contributing factor to further declines in individual 25 stocks overall. 0131 1 The question is, how do we better protect 2 individual investors during times of market stress? And, 3 furthermore, should we limit the use of stop or market 4 orders during periods of market instability? 5 The intention of the stop order is to limit 6 losses. And many individual investors incorrectly assume 7 that the price they specify in their stop order will be 8 the same price at which they will likely be executed at. 9 Better educating investors of what the functioning of 10 stop order is, especially during periods of market 11 instability, would be a good start. However, restricting 12 or limiting the use of stop or market orders could lead 13 to a number of issues. Many individual investors do not 14 have the ability to monitor the markets on a regular 15 basis. 16 By requiring these investors to include a limit 17 price on their stop orders, the investor runs the risk 18 that a stop order may not be executed at all. While this 19 is advantageous to the investor if the stock price 20 recovers, it could be detrimental to the investor if the 21 stock price does continue to move lower, leaving the 22 investor with more serious losses than if a limit price 23 in the stop order had not been specified. 24 Also, restricting the use of market orders 25 during periods of market instability has a potential to 0132 1 frustrate investors. Many retail investors may fail to 2 realize that you can put a limit price to sell a stock 3 below the current bid price. Those investors could run 4 the risk of chasing the stock price with limit orders. 5 So, for example, if the stock is bid at 25 to 6 25.01 and you are an investor that doesn't understand you 7 can put a 24.95 sell order, maybe you think you can only 8 put a 25 sell order, so you put the 25 sell order in, but 9 by the time your order gets there, the market has now 10 moved to 24.98 to 24.99. You cancel. You update. You 11 now hit the 24.98. I am missing that bid as well. Now 12 let's try this again. Imagine the frustration in those 13 missed executions, especially on a day like August 24th. 14 A better approach might be to require brokers 15 to use automated warning systems during times of market 16 stress. For example, when investors place stop or market 17 orders with their brokers during periods of market 18 instability, an automated warning screen could advise 19 them to use caution when placing stop or market orders 20 due to excessive market volatility and potentially reduce 21 liquidity. 22 Communicating with investors about potential 23 reductions in liquidity in volatility would be a step in 24 the right direction, but circuit breakers, warning 25 systems for stop or market orders are mere Band-Aids for 0133 1 potentially larger underlying market structural issues, 2 including significant reductions in liquidity during 3 periods of market stress. 4 I have got a presentation here. I am going to 5 focus mostly on this slide here. And I will explain in 6 more detail as I go along. So one issue that CFA 7 Institute has raised in the past is the rising levels of 8 off-exchange trading, the effects it can have on 9 displayed market liquidity. Payment for order flow 10 arrangements, where OTC market makers purchase order flow 11 from retail brokerage firms and directly trade against 12 those orders can have the potential to disadvantage and 13 discourage displayed liquidity providers. 14 Consider the following hypothetical example in 15 exhibit 1. Here is the sequence of events from the 16 trades in exhibit 1. At time 10:17:20, stock XYZ has a 17 national best bid and offer, NBBO, of $25 to $25.20. 18 At 10:18:25, a retail trader places a limit 19 order to buy 100 shares of stock XYZ at $25.05. Broker 20 routes this order to Arca, where it represents the entire 21 new national best bid. And the new NBBO is now $25.05 to 22 $25.20. 23 At 10:20:25, a trader from a retail brokerage 24 places an order to sell 100 shares at $25.05. So they 25 are trying to hit the $25.05 bid that they see on their 0134 1 screen. The retail brokerage has a payment for order 2 flow arrangement with an OTC market maker, and it routes 3 the order to the OTC market maker for execution. OTC 4 market maker executes the order for its own account at 5 $25.05.01, providing .001 price improvement to the 6 marketable sell order. 7 I can appreciate what Jeff was saying earlier, 8 saying, you know, with his price improvement numbers, 9 those were fantastic. But I still see these trades. I 10 see these trades happening at $25.01, $25.999. And so 11 these trades are still occurring. 12 At 10:22:35, another trader from a retail 13 brokerage sends a market order to sell 100 shares of 14 stock XYZ. The broker routes the order to its OTC market 15 maker. OTC market maker matches the displayed bid, 16 executing the trade at $25.05 for its own account. No 17 price improvement on this trade. Trade is reported to 18 FINRA trade-reporting facility. Again the limit order 19 trader setting the price is left unfilled. 20 At 10:22:40, the original limit order trader 21 becomes more aggressive, raises their bid for 100 shares 22 to $25.10, posted again on Arca. New NBBO is now $25.10 23 to $25.20. 24 At 10:27:32, a retail trader from a different 25 brokerage sends a market order to sell 300 shares of 0135 1 stock XYZ. So he is trying to sell 300, somebody is. 2 This guy only wants 100 but is still not going to get 3 filled. The retail brokerage routes the seller to its 4 OTC market maker, and the order is executed at $25.10.05. 5 That is the third trade in your tape, providing .005 6 price improvement to the 300-share market order. Trade 7 is again reported to FINRA TRF. Original limit order 8 trader sitting on Arca at $25.10, setting the market, 9 taking on the adverse selection risk, is left unfilled. 10 At 10:28, the original limit order trader tries 11 a different tactic. They cancel their order at $25.10, 12 place a hidden order to buy 100 shares on Arca at $25.05. 13 New NBBO is now $25 to $25.20 because the $25.05 order 14 is hidden and not part of the displayed NBBO. 15 At 10:32:59, a retail trader sends a market 16 order to sell 100 shares of stock XYZ. And, again, the 17 retail brokerage routes the order to its OTC market maker 18 for execution. OTC market maker transacts directly 19 against the order at $25.0001, giving .001 price 20 improvement, but the hidden order at $25.05 is left 21 unfilled. So somebody is bidding $25.05 hidden. Retail 22 trade is actually executed at $25.0001, so 4.999 cents 23 below the $25.05 hidden order that is on the exchange. 24 At 10:41:32, frustrated by the lack of 25 execution, original limit order trader cancels the hidden 0136 1 order and sends a market order to buy 100 shares of stock 2 XYZ. Their broker has a payment for order flow 3 arrangement and routes the order to the OTC market maker. 4 OTC market maker executes the buy order at $25.19.99, 5 stepping ahead of the displayed order and providing .001 6 price improvement over the displayed national best offer. 7 In summary, the limit order trader missed an 8 execution on four separate occasions as the marketable 9 order flow, which could have interacted with the trader's 10 posted limit order, was routed away from the public 11 exchange. 12 There are a number of concerning issues that 13 this hypothetical example raises. The first is nominal 14 price improvement. Like I said, you know, .049, that is 15 a different story, but .001 price improvement, that seems 16 pretty nominal to me, but here is a concerning point, 17 too. The entire above sequence of trades would appear as 18 a net benefit to all customers when disclosing the 19 respective 605 reports. Price improvement over the 20 national best bid and offer is achieved on four separate 21 occasions: .001 in the first trade, .005 in the third 22 trade, .001 in the fourth trade, and .001 on the final 23 trade. But does this nominal subpenny price improvement 24 to the marketable order flow justify taking an execution 25 away from a displayed liquidity provider; the second 0137 1 point, unquantifiable cost from missed trading 2 opportunity? 3 The limit order trader in the above example 4 missed an execution on four separate occasions. Had they 5 chosen not to pay the spread and if the stock price moved 6 higher, the trader may have never been filled on their 7 limit order. In this case, the losses from the missed 8 trading opportunity would be unquantifiable. In our 9 example, however, the trader's costs are quantifiable 10 because they paid up to the $25.20 ask price. But it 11 would have been better by nearly 15 cents had its 12 original limit order at $25.05 been executed. Despite 13 the trader being economically worse off, the 605 report 14 would show price improvement of .001 of a penny because 15 they bettered the $25.20 displayed offer. So this would 16 appear as a net benefit to this customer. 17 Third point, missed opportunity for significant 18 price improvement. The marketable order flow routed to 19 and executed against by OTC market makers has no 20 opportunity to interact with the hidden liquidity on the 21 public exchange. In our hypothetical example, the fourth 22 trade, in which the trader sends a market order to sell 23 100 shares and has executed $25.0001, received price 24 improvement of .001. But the trader missed the 25 opportunity to interact with the hidden limit order, 0138 1 which was posted on Arca at $25.05. This amount of price 2 improvement over the national displayed bid would have 3 been $.05. So again the 605 report shows a net benefit, 4 the .001 price improvement to the trader, which, in 5 reality, the trader would have been better to have its 6 marketable order routed to the public exchange. With 7 hidden exchange volume accounting for 9.1 percent of 8 total volume in the third quarter of 2015, many 9 marketable orders could be missing out on the chance to 10 receive significant price improvement if those orders 11 were routed to the public exchange. 12 Reduced competition. The over-the-counter 13 market, maker benefiting from the payment for order flow 14 arrangement, did not have to display any liquidity but 15 was able to reap the awards of receiving the execution. 16 The payment for order flow arrangement reduced its need 17 to compete aggressively in the displayed market for key 18 priority by eliminating the competition because they have 19 already bought that order flow. So they had the first 20 chance to interact with it. So they don't have to put 21 out competitive bids and offers to interact with that 22 flow. It is coming to them. It is being sent to them. 23 This affords the OTC market maker the ability to free 24 ride off the public quotation. 25 Increased toxicity of order flow on public 0139 1 exchanges as an increasing amount of retail order flow, 2 which is typically more uninformed than professional 3 flow, is routed away from the public exchanges. The 4 toxicity of the order flow on the public exchange tends 5 to rise. This could potentially increase adverse 6 selection risk for quoting market makers. Sviatoslav 7 Rosov, Ph.D. and CFA of the CFA Institute, authored a 8 paper last year entitled "Liquidity in Equity Markets," 9 which examines adverse selection issues on LIT markets. 10 Specifically, the issue considered is whether OTC market 11 makers predict when the quote is about to roll, so 12 talking about a stock like Bank of America with a long 13 quote, and route their orders to LIT venues, where they 14 can trade in the direction of the expected price 15 movement. The study did find evidence of OTC market 16 makers offering price improvement and capturing the 17 spread during stable quote periods before executing 18 against LIT orders when they could predict the quote was 19 about to roll. 20 Discouragement of displayed liquidity 21 providers. If toxicity levels continue to rise, market 22 makers could potentially feel like they were setting the 23 price, taking the adverse selection risk, but not getting 24 the rewards of receiving the execution. This could 25 reduce their incentive to quote aggressively. And I 0140 1 believe this is a big problem in the small cap space. 2 In 2012, CFA Institute examined the 3 relationship between undisplayed trading and equity 4 market quality and found that increases in 5 internalization dark to an off-exchange trading activity 6 are initially found to be associated with lower bid offer 7 spreads and higher market depths, so kind of going 8 against what I am saying. One possible explanation is 9 that initially competition for order flow among on and 10 off exchange venues causes more aggressive quoting in the 11 limit order, but it makes intuitive sense. If, you know, 12 at a certain level and I am a displayed market marker and 13 I am seeing, you know, trades happen, I might 14 aggressively quote a little bit more. But at a certain 15 level -- and this is the point -- the report continues. 16 The gains from dark trading are not indefinite. 17 The results from the study suggest that if a majority of 18 trading in a given stock takes place in undisplayed 19 venues, spreads will likely increase and market quality 20 will deteriorate. If the majority of order flow is 21 filled away from pre-trade transparent markets, investors 22 could withdraw quotes because of the reduced likelihood 23 of those orders being filled. As investors become 24 disincentivized from displaying orders, bid offer spreads 25 are likely to widen. Therefore, competition should be 0141 1 maintained to encourage aggressive quoting and displayed 2 order books. And a predominance of dark trading should 3 be avoided. 4 I looked at this issue for Bright Trading in 5 2013, and I found 1,927 stocks that had off-exchange 6 trading as more than 50 percent of the volume. So 7 basically 1,927 stocks trading under a million shares 8 average daily volume had more than half of their trading 9 occurring off exchange. It is in those securities that 10 market makers are hesitant to quote, so policy 11 considerations. 12 Meaningful price improvement. To better 13 protect displayed liquidity providers and encourage more 14 aggressive quote competition, OTC market makers should 15 provide meaningful price improvement over the displayed 16 NBBO when internalizing and transacting against 17 marketable retail flow, meaningful price improvement 18 being defined as at least half of the minimum price 19 variation of the individual security. 20 Improvements to 605-606 reporting. Due to the 21 complexity and enormous amount of data contained in the 22 605 monthly reports, many retail traders rely on summary 23 statistics from their brokers when analyzing execution 24 quality. These statistics often focus on retail price 25 improvement metrics, which obviously do not tell the 0142 1 entire story. Opportunity costs for missed trading 2 opportunities would be difficult to assess but more 3 nonmarketable limit order metrics, such as length of time 4 and nonmarketable limit order rests on the top of the 5 book before execution, could help with this assessment. 6 Combining 605-606 reports to better assess the 7 execution quality a broker's order flow receives on a 8 venue-by-venue basis would be helpful for individual 9 investors as well. You could also help the retail 10 investor to answer the question about whether their 11 broker is routing orders to where they can maximize price 12 improvement execution speed or to where they get paid the 13 most. 14 Reduced access fees. If regulatory action is 15 taken to direct more marketable retail order flow to the 16 displayed public market, cost to retail brokers could 17 increase substantially as they would be paying access 18 fees more often. Retail brokers would have to absorb 19 these extra fees, pass the access fees on to their 20 customers, or potentially raise brokerage commissions to 21 offset the increase in fees. Therefore, any regulatory 22 actions to increase the amount of marketable order flow 23 routed to the public exchanges should coincide with the 24 reduction in the access fee cap. 25 I thank you for the opportunity to speak with 0143 1 you today and look forward to any questions you may have 2 in the upcoming discussion. 3 MR. LUPARELLO: Thank you, Dennis. 4 Christine? 5 MS. PARLOUR: Thank you. My comments will be 6 somewhat similar to Dennis Dick's but somewhat more 7 brief. 8 (Laughter.) 9 MR. DICK: Sorry. My apologies. 10 MS. PARLOUR: It was great. It was great. It 11 was great. 12 First, as a caveat, let me just say that both 13 Maureen and Chester worked extensively on payment for 14 order flow, which is going to be what I am talking about. 15 So they are people who I am sure will have a lot of 16 interesting points to make. 17 So there are two issues that I want to raise. 18 So, one, what we are interested in is the all-in cost to 19 retail investors. So the question becomes, in the 20 presence of payment for order flow, do commissions fall 21 in such a way that retail investors are better off? 22 The other question, which is much more 23 difficult to answer and, unfortunately, we can't do it 24 with data, is to say, well, what would the world look 25 like if there wasn't payment for order flow? 0144 1 On the first point, I have to say that if there 2 is payment for order flow and it flows through to the 3 retail brokers, they are in a position to compete more 4 aggressively, either on fees or providing better service, 5 in a way that will flow through to the retail investors. 6 I think this is how competition works. 7 On the second question, if there wasn't payment 8 for order flow, what would the world look like, I would 9 have to say that liquidity provision would probably be 10 more efficient. So when you think about payment for 11 order flow, what does it do? It basically takes very 12 valuable order flow and removes it from the public 13 markets. This is very much as your example. And so the 14 other people who provide liquidity have less of an 15 incentive to compete aggressive. 16 It doesn't mean that spreads aren't narrow. It 17 doesn't mean that they haven't been falling over time. 18 It does mean that if payment for order flow was not in 19 the markets, they would be even tighter. And liquidity 20 provision would even be more robust. 21 So on the basis of work that I have done with a 22 co-author of mine, we sort of came to the conclusion 23 that, yes, commissions would fall, but all-in costs to 24 the retail investors probably wouldn't fall. And this is 25 because liquidity provision in the presence of payment 0145 1 for order flow is less robust. And, essentially, there 2 is a liquidity provider out there who doesn't compete as 3 aggressively just because this institutional feature is 4 there. 5 So, that said, what can one do? Unfortunately, 6 I have absolutely no answer for that. I mean, if payment 7 for order flow is explicitly prohibited, there are other 8 ways in which value can flow just because these 9 relationships are very long and enduring and repeated. 10 So one could imagine different ways of value to flow 11 through given that retail orders come in and they have to 12 go to markets. So it is not clear. 13 And the regulators presumably will have some 14 idea on this. But it is not clear the best way forward. 15 But I think it is clear that in the presence of payment 16 for order flow, the all-in costs for the small guys are 17 probably higher than they should be. 18 Those are my comments. 19 MR. LUPARELLO: Thank you very much. 20 Jamil? 21 MR. NAZARALI: All right. I have so much to 22 say I don't even know where to start. 23 (Laughter.) 24 MR. NAZARALI: So, first of all, I disagreed 25 with pretty much everything Dennis said except we should 0146 1 not ban stop orders and market orders. 2 (Laughter.) 3 MR. NAZARALI: Okay? Let's just start with the 4 de minimis price improvement. There is a very active and 5 competitive market for wholesaling. And we compete on 6 price improvement. Every year, Citadel provides between 7 $100 and $150 million in price improvement. We estimate 8 for the industry that it is several hundreds of millions 9 of dollars in price improvement. 10 Now, that price improvement is over the 11 national best bid or offer. As Jeff and Frank pointed 12 out, if those orders were going to be sent to an 13 exchange, they would actually on average receive a worse 14 price than the national best bid or offer, even taking 15 into account the hidden liquidity that you talk about 16 because on average, those orders tend to be larger than 17 the displayed size. They tend to be very correlated in 18 nature. Retail all tends to buy at the same time, sell 19 at the same time. And so when their orders go to an 20 exchange, they don't get the national best bid or offer. 21 They on average tend to do worse. So that is a point on 22 de minimis price improvement. 23 In addition, I think you actually made a point 24 about how retail orders tend to be much less toxic than 25 orders in general. And you talk about when there is more 0147 1 internalization, the toxicity of an exchange actually 2 goes up. That is true. And, for that very reason, 3 retail orders deserve a better price than the national 4 best bid or offer. They tend to be smaller in size. 5 Their order tends to be the entirety of what that 6 customer wants to do. So when they are buying 500 7 shares, it is not 500 shares. It is part of a larger 8 100,000-share order. And because of that, they deserve 9 to get a better price than a larger trader who is doing a 10 100,000-share order. The only mechanism in which you can 11 do that is to have an OTC market where you can actually 12 price-improve and give that customer the better price 13 that they deserve. 14 Now, Christine, I think you make some good 15 points, but I think that you are conflating. Getting rid 16 of payment for order flow is getting rid of 17 internalization because internalization happens, even in 18 the absence of payment for order flow. You know, Frank 19 from Wells Fargo points out virtually all of his flow is 20 sent to wholesale market makers. The reason it is sent 21 there is because they get much better prices than they 22 would on exchange. And I think you would find that 23 practice across all retail broker-dealers. Virtually all 24 retail broker-dealers send their orders to wholesale 25 market makers, irrespective of whether or not they 0148 1 receive payment or nonpayment. 2 And, you know, Winston Churchill has a great 3 quote, "Democracy is the worst form of government except 4 for all others." I think the same somewhat applies to 5 payment for order flow. It is not perfect, and it is not 6 a great system, but it is better than any of the 7 alternatives. If you ban payment, you are going to have 8 a market in which firms that have an integrated model, 9 that internalize are going to have an advantage. You are 10 going to go back to a system where you have reset deals. 11 And it is going to become much less transparent. 12 And the truth is right now retail investors 13 have a choice. There are many firms that don't take 14 payment. And there are many firms that take payment. 15 And as an investor opening up an account, you have a 16 choice on where you want to open up your account. This 17 is not always true, but in general the firms that accept 18 payment tend to be online retail broker-dealers with 19 lower commission. And I can as a retail investor choose 20 to open my account with one of those knowing -- and, you 21 know, we talked about the disclosures -- that they 22 receive payment or I could go to a full-service that 23 doesn't. And so I have choice and think that that is an 24 important thing to point out. 25 Anyway, I have lots more to talk, but I will 0149 1 yield to someone else for now. 2 MR. LUPARELLO: Dennis? 3 MR. DICK: Jamil, I am just going to throw it 4 back to you. I have just got a couple of questions. 5 First of all, you talk about in Citadel. If they are 6 doing, you know, better price improvement, you know, that 7 is great. 8 What about this example because I still see the 9 trades on the table? The .001 is better than the 10 national best bid. What about those trades? What does 11 Citadel say about that? Because there may be other off- 12 exchange market makers that are providing very little 13 price improvement. And, you know, should we maybe step 14 it up? Like I said, you know, I am suggesting meaningful 15 price improvement. Should we look at, you know, saying 16 this should be a minimum amount? So to improve that 17 price improvement, it would help the retail trader 18 obviously more and then maybe tries to discourage a 19 little bit of, you know, the stepping in front for that 20 small, small fraction. 21 MR. LUPARELLO: Since that was a directed 22 order, I think it should go to Jamil first and then 23 Maureen. 24 (Laughter.) 25 MR. NAZARALI: Well, I will point out it is a 0150 1 hypothetical. They do happen on tape. And we should 2 look at the data. Certainly there are certainly trades 3 with smaller price improvement, a 100th of a cent. I 4 would say the average price improvement -- and we can 5 look at the 605 data. It is right there. But the 6 average price improvement for a market order 605 below 7 10,000 shares is roughly .03 to .04 cents a share. 8 MR. BROWN: And I would just say if we sent 9 that order to Citadel, we would probably call them and 10 say, "What the hell is going on?" 11 MR. DICK: So where are these .001s coming from 12 that I see on the tape? Like where are they coming from? 13 I am sorry. I am sorry. 14 MS. O'HARA: I just wanted to -- not at all. 15 Let me just jump in with a few things because I think 16 some of the comments you raise seem eminently sensible. 17 And, as you point out, you know, we should think about 18 the real world. But I actually think the real world 19 tells us some of the answers to the questions you have. 20 For example, Canada very nicely made a rule saying you 21 had to have significant price improvement. 22 And so the question before you -- you could go 23 dark. So the question is great. You know, what 24 happened? And the answer is not so great. Right? I 25 mean, we have already seen from international evidence 0151 1 that what may seem sensible doesn't actually play out 2 that way. So I think we have already kind of run that 3 experiment that says that if you go for the significant 4 price improvement, you don't get the significant quality 5 improvement. 6 The second issue that I think is sort of an 7 interesting question is when you go back to when payment 8 order flow sort of began, we were back in the lovely 9 world of 12 and a half-cent spreads. Right? And the 10 reason why payment order flow came along is they were too 11 big. And it was a natural way to make the retail 12 customers who aren't toxic pay prices that were closer to 13 what the toxicity of the orders reflected. 14 So, unfortunately, as is the case with 15 everything we talk about, a lot of these issues are 16 interconnected. Right? It may be that our minimum tick 17 size is too big for some of the more actively traded 18 stocks and payment order flow is a natural evolution to 19 go in that direction. But that then leads to sort of the 20 same problems that you are concerned about, which is were 21 we to -- you know, as we think about trying to 22 incentivize more people to put orders on the limit order 23 book perhaps by raising tick sizes, you then create 24 incentives to put more stuff off exchange, where they can 25 get payment that brings them back to, you know, the 0152 1 prices that the retail trader wants. 2 So I think I am kind of like Jamil on this one 3 that, on balance, all of these factors together suggest 4 that you may not like payment order flow and you may not 5 like the fact that individual limit orders don't execute, 6 but unless we move to a world with Trade-At and we move 7 to a world with a different tick policy, we are going to 8 end up with a lot of these sorts of things. And, on 9 balance, retail traders are doing better and the markets 10 are doing better I think. 11 MR. LUPARELLO: Joe? 12 MR. MECANE: So just to maybe frame it, I think 13 there are two very interrelated concepts that we are kind 14 of discussing simultaneously. And I have been on every 15 side of this debate. But, you know, there is sort of the 16 collective internalization impact on the market 17 component. And then there is the conflict of payment for 18 order flow. And they are obviously interrelated, but I 19 think the remedies for both are very different. So it is 20 maybe worth separating them. 21 You know, I think in a way, even though 22 everyone is disagreeing, I do think that there is 23 actually violent agreement underneath at least the first 24 piece because the debate that I think has raged on 25 forever and has never really been resolved is clearly 0153 1 through internalization retail is advantaged. And from 2 Dennis' standpoint, there are participants in the public 3 market who maybe feel disadvantaged because they are not 4 able to participate in those kinds of flows. And the 5 million-dollar question is, does the positive benefit to 6 retail outweigh the collective impact on the broad 7 market? 8 And I think if you ask 10 people that question, 9 you will get 5 people that say yes and 5 people that say 10 no depending on what their perspective is on the market. 11 And I don't know how to solve that question, but I think 12 every time Trade-At and internalization come up as a 13 topic, that is basically where it goes. 14 And then I think the second piece, which is 15 obviously just a different flavor but has a different 16 question, is payment for order flow itself and the 17 conflict that that raises and what is the right way to 18 address that conflict? And some people will say it is 19 such a broad conflict, you can't address it. So you need 20 to ban it. And some people will say, well, it is a 21 conflict, and we need to recognize it and disclosure is 22 the best way to solve that problem. 23 I mean, one thought that I had, at least 24 reading through the materials and rethinking that 25 particular piece of the equation, which I think was at 0154 1 least where the memo tried to focus the question, is what 2 it seems like we are trying to question there is, is the 3 disclosure today adequate such that we can determine that 4 firms are not routing purely for economic benefit and not 5 for execution-quality benefit or does the disclosure need 6 to be improved in such a way that we can answer that 7 question or do we need to ban payment because we can't 8 answer that question or improve the disclosure in a way 9 where it fixes it? 10 And so that is a longwinded lead up to maybe a 11 broad question around the disclosure angle. And a 12 suggestion to put out there is, you know, should we think 13 about improving 606 in a way where it makes it easier to 14 answer that question? I mean, you know, I have seen the 15 606 evolution along the way. And I think firms have, the 16 retail firms have, gone a long way in improving that 17 disclosure. But it still strikes me when I look at it 18 now as being somewhat general and hard to, frankly, draw 19 many conclusions from. 20 And so, you know, one thought is maybe at least 21 a next step could be to look at 606 in a way where you 22 can actually see, all right, these are the different 23 venues that a firm could route their orders to. These 24 are the types of metrics I get from them. This is the 25 payment I get from them. And this is the percentage of 0155 1 flow I route to them or, you know, I am making it up to 2 just make the point. 3 But it seems like if that is ultimately what we 4 are trying to answer, that might be the best way to try 5 and address that question. 6 MR. LUPARELLO: Jamil, then Eric. 7 MR. NAZARALI: No. I think Joe makes, 8 actually, an excellent point. And the paper touches on 9 it. If we are really trying to get at that conflict 10 between accepting payment and how I route my orders, it 11 seems to me the best way to address that is to enhance 12 the 606 disclosures so that not only do you have to show 13 where you are routing your orders and how much you are 14 receiving from each venue but what kind of execution 15 quality that you are getting from that venue. And then 16 investors could see for themselves if you are managing 17 that conflict well. Right now they really can't see 18 that. And so I think enhancing that would really put 19 that in the hands of investors. 20 MR. NOLL: Two observations and then a question 21 for Christine. My first observation is I think we are in 22 a little bit of a danger of conflating uninformed order 23 flow from retail with sort of their mental state. So we 24 almost sound like, you know, they need to be protected 25 from themselves as they walk down the street. 0156 1 I think retail investors are fairly 2 sophisticated. They have enormous amount of choice out 3 there. Their order flow may be uninformed, but that 4 doesn't mean that they aren't sophisticated enough with 5 disclosure and understanding the way the market works to 6 make choices that are best for them, whether they should 7 go to an online retail shop or a higher-touch retail 8 business. 9 I think we should be careful not to assume that 10 there is an investor class out there that needs a seeing- 11 eye dog to get through the rest of the day. You know, 12 they tend to be more sophisticated. 13 One of the things Jamil said I do disagree 14 with. I don't think there is a class of investors that 15 deserves more price improvement than others. I think 16 Kevin would probably disagree with that. I think Met 17 would probably disagree with that. I think anybody who 18 has money in a mutual fund would probably disagree with 19 that, that, you know, like everybody, investor, should 20 get the best price out there and there isn't a class, at 21 least in my opinion, of investors that should do better 22 than others because of who they are. 23 The question I had for you, Christine, is, did 24 you look at when you thought about payment for order flow 25 and whether it affected liquidity provision by market 0157 1 makers and other market participants the impact of 2 exchange rates on that because, to a certain extent, you 3 could argue that an exchange rebate program is payment 4 for a flow for liquidity providers. And so, therefore, 5 to counteract sort of the negative effects of not seeing 6 every order by receiving a rebate, they are, in fact, 7 being incented to make markets. And that may be an 8 offset to the negative missing certain trades. 9 MS. PARLOUR: I completely agree. Those sorts 10 of payments work in the same way. We didn't consider 11 them at all. We were specifically looking at or trying 12 to isolate the effective payment for order flow. But you 13 could definitely think about other sort of mitigating 14 payments or systems. 15 MR. LUPARELLO: Chester? 16 MR. SPATT: I had a question for Jeffrey. I 17 wanted to clarify if I am interpreting one of your 18 comments correctly. Were you saying that the routing 19 decisions that are made at Schwab are not dependent upon 20 fees? 21 MR. BROWN: Between the competing wholesalers 22 who provide execution services for us, yes, because we 23 mandate that they are all within a tiny, narrow band, 24 almost all of them are the same price. And so we have no 25 incentive to go out to one or the other. It is based on 0158 1 how well they perform in executing the order. What is 2 the site for price improvement? You know, and we measure 3 how well they are doing. 4 MR. SPATT: Because they are all offering you 5 the same fee. 6 MR. BROWN: That is correct. 7 MR. SPATT: And the ones that don't offer you 8 these fees, are they off the table? I guess I am 9 thinking about this relative to some of the academic 10 evidence, for example. And I don't remember if it was 11 specifically about Schwab, but some of the academic 12 evidence in the study by Battalio, Corwin, and Jennings 13 suggests that there are active routing decisions that are 14 based upon fees. And I was wondering how your statement 15 related to that. I guess I didn't really get my -- 16 MR. BROWN: I don't believe -- 17 MR. SPATT: I don't know. I don't remember if 18 Schwab was specifically in those tables or not. 19 MR. BROWN: I don't either. 20 MR. SPATT: Therefore, more broadly, I wasn't 21 sure how to interpret what you were asserting about the 22 irrelevance -- 23 MR. BROWN: My answer is -- 24 MR. SPATT: -- because it would seem like if 25 you weren't taking into account fees, that would seem 0159 1 certainly very odd and maybe not even very businesslike. 2 MR. BROWN: Well, but if a firm came to us and 3 said, "We will execute your orders but not pay a fee," we 4 would consider that. We would want to see, what can they 5 do? What services do they provide? But among the firms 6 that we do have established relationships and new 7 entrants into this business of providing wholesale 8 executions for retail investors, we line them up so that 9 there is no discrepancy about price. It is all about 10 execution quality. 11 MR. SPATT: So the ones that don't provide 12 rebates, they are not even in the game? Is that what the 13 issue is or -- 14 MR. BROWN: Not necessarily. They have to come 15 and prove that they would provide superior services. 16 MR. LUPARELLO: Mark? 17 MR. FLANNERY: So I wanted to pursue this 18 disclosure question a little bit further. Does anybody 19 report back to the customer what the fees were associated 20 with a particular order so I can find out that you 21 charged me $9.95 for 200 shares but you got back $2 in 22 fees? 23 MR. BROWN: The amount of payment for order 24 flow is not disclosed to the client, say, on the 10b-10 25 confirm. That is prepared on trade date. And we notify 0160 1 them that payment for order flow would have been a part 2 of the transaction, but payment for order flow is an 3 aggregate number. We get it at the end of the month. We 4 don't know exactly. And we aren't able to on tee tell 5 them exactly what that specific amount would be on that 6 specific trade. Now, if they inquire, we will give them 7 that information. 8 MR. FLANNERY: Yes. I am just thinking from 9 the perspective of someone who is not expert in the field 10 and is looking for disclosure. An ex-ante statement 11 that, well, we might get some payment for order flow, 12 that doesn't help me very much I don't think. 13 An ex post accountability; whereas, you know, 14 as I suggested, we got $2 back or we expect to get $2 15 back, you could imagine somebody saying, well, we will do 16 your trades for $9.95, regardless of what we get back on 17 the order flow. We will charge you $9.95 after the order 18 flow charge. So the question is, what is difficult about 19 that? And I guess part of it is the ex post requirement 20 that you don't find out what the flow payment is. 21 MR. BROWN: That is correct. 22 MR. FLANNERY: You could change that. 23 MR. LUPARELLO: Met? I am sorry. 24 MR. KINAK: Yes. So I think I am going to 25 touch on Chester's point that he is trying to make. When 0161 1 you guys get nonmarketable limit orders, what do you do 2 with those? I think that is what he is referring to when 3 he is saying, what do you decide with the fees? Because 4 you are taking those to the exchange level at that point, 5 are you not? 6 MR. BROWN: That is correct. They are routed 7 to wholesale brokers. Let's say we manage that security. 8 They then post them. They are primarily on the listed 9 market. For us, they flow to the primary listed market, 10 where the securities trade or BATs. And so that is where 11 they are posted. 12 MR. KINAK: How do you deem best execution on 13 those, though? Right? So someone might argue that they 14 are going to obviously go to the place where they are 15 going to get the best rebate, especially with all of the 16 fees they are paying for all of the other marketable 17 order flow. How do you determine that you are getting 18 best execution on those orders, especially when we are 19 encouraging people to put in limit orders on the retail 20 side? 21 MR. BROWN: Well, there are metrics about fill 22 orders, fill rates. There are metrics about -- we have 23 something called do-a-fill. And we track where we 24 believe a limit order was do-a-fill and may or may not 25 have received it and we go back and inquire about that. 0162 1 So we do track my metrics to measure that limit order 2 execution quality. 3 MR. KINAK: I think we can enhance disclosures 4 on that as well probably because I think we do a lot with 5 the marketable stuff that goes for the wholesalers, but 6 we don't do enough with the orders that actually get done 7 on the exchanges. That is an important thing for people 8 to realize. 9 MR. SPATT: And if I could just say, that is a 10 very helpful follow-up to my question, but the context of 11 my question was really about limit orders. And I think 12 the empirical evidence is pretty clear that there is a 13 relationship between the fee/rebates and what the routing 14 decisions of limit orders seem to be across firms. 15 MR. BROWN: I mistook your question because I 16 thought you were referring to market orders. But on 17 limit orders, again, we are primarily posted on primary 18 listed exchange of the security or BATs. 19 MR. LUPARELLO: Kevin, then Met, then Joe, and 20 then Manisha. 21 MR. CRONIN: Jamil, I agree with Eric in that 22 there isn't a particular investor group or class to do 23 anything in this marketplace. What I would suggest, 24 though, is remember that all of this activity is 25 predicated on there being a national best bid and offer. 0163 1 Right? All of this dark trading breaks down without it. 2 So, Dennis, I am obviously very sympathetic to 3 your point because we end up in a very principled 4 discussion in these kind of conversations always. The 5 retail investor has a high focus with the SEC and others. 6 And their outcome is always something that is, for 7 better or for worse, Eric looked after at a level that 8 very few other interests in the marketplace are. 9 So we have a system that today would appear, 10 certainly on the surface to be benefiting retail 11 investors. And that is great. On the other hand, we 12 also have an environment that does not facilitate the 13 price discovery mechanism in that you need posted bids 14 and offers for the price discovery mechanism and then 15 there to be interaction amongst those bids and offers to 16 truly have a robust and substantial, you know, price 17 improvement/price discovery mechanism. 18 So the concern I have is that sometimes it 19 appears that the retail investors' interest trumps the 20 greater and perhaps more substantial thing, which is in 21 order to solve a number of these problems, you have to 22 have robust price discovery, whether that is on the open, 23 whether it is during the middle of the day, et cetera. 24 And it is clear to me. And I don't have the answer 25 either, Christine. So I feel your pain. But it does 0164 1 seem to me that there are obvious costs that the retail 2 investor assumes in this model, namely opportunity costs, 3 which are much harder to quantify and understand but 4 there nevertheless because every time I get an order that 5 I have on the book, you know, subpennied, it is 6 frustrating. And it discourages my promoting further 7 bids and offers on that same book. So I think there is 8 something to be had here. 9 I am not saying that Trade-At is the way 10 forward. I am not saying everything should happen on 11 exchange, far from, but I do think that we have to be 12 honest in this discussion, which is there is a balance 13 that is very, very hard to strike here. And at some 14 point, they become incongruent with one another. And, 15 you know, I think that for the record, the obligation, 16 first and foremost, has to be for the price discovery 17 mechanism. It isn't about a particular investor class. 18 MR. LUPARELLO: So, to refresh the bidding, 19 Met, Joe, Manisha, then Jamil. 20 MR. KINAK: Yes. So, obviously, I am going to 21 agree with Kevin on that one -- 22 MR. CRONIN: Who wouldn't? 23 MR. KINAK: -- on price discovery and, you 24 know, not necessarily benefiting retail over anyone 25 else. And, you know, I will emphasize again we are 0165 1 pooled retail and how we trade. If you are in a mutual 2 fund or if you are in a pension plan or anything like 3 that, we are investing your dollars or in a pooled level. 4 So we don't want to forget that we do represent the 5 retail investor in a way. 6 Just going back, I will address conflict real 7 quick. And I have a question for Frank. But on the 8 conflict side, Jamil makes the point that they paid 9 hundreds of millions of dollars for, you know, price 10 improvement that they have given out. 11 What is interesting is -- and, you know, 12 Charles Schwab sells their flow and gets money for it for 13 a service that they say is actually a best execution 14 service. So think about it that way, how perverse 15 something is. You are getting something. And, instead 16 of paying for getting the ultimate reward, you are 17 actually getting paid for that reward. Right? That is 18 kind of silly in the way it sounds. 19 So the point is, yes, you are paying hundreds, 20 but you are obviously receiving a benefit for that. 21 Jamil gets that. Other firms do get that, that 22 wholesale. Let's not forget that part of this; right, 23 that they are not just doing this in their help to help 24 the world. You know, they are not going to get a Nobel 25 Prize for wholesaling at this point. 0166 1 (Laughter.) 2 MR. KINAK: But my question is for Frank. So 3 you said that you guys do not receive payment. Do you 4 find that you get better execution quality from those 5 wholesalers because they are not actually paying you? 6 And if you are not relative to your peers -- and this 7 goes to the 605-606 reporting. I think it is useful for 8 you guys to be able to compare each other to the likes of 9 Charles Schwab and to the other brokers. But do you find 10 if you are not getting that, shouldn't you get payment 11 for order flow and then actually pass that on to the 12 investor or to the retail? 13 MR. CHILDRESS: So we have the ability to 14 measure our execution quality versus the public averages. 15 We significantly do better than the public averages. 16 How much of that is measurable with respect to payment 17 for order flow versus just our internal processes of how 18 we go about putting dealers in competition with 19 themselves is we don't have the ability to break that 20 out. But I think net-net if you matched a firm that 21 doesn't take payment versus one that does for equity 22 marketable flow, the one that doesn't is going to have 23 marginally better execution-quality statistics than the 24 one that does. 25 I would say that if you look at the public 0167 1 numbers versus ourselves or anywhere else, there has been 2 more improvement in the public side than those of us who 3 have not taken, historically taken, payment. In other 4 words, we were at a low number to start with. And we 5 have continued to improve. The public numbers were quite 6 a bit higher, but they have improved more dramatically. 7 So it feels to me that some understanding of concern 8 around payment and what is appropriate and what is not 9 appropriate has been somewhat self-correcting and that 10 the firms that do accept payment have moderated that to 11 something that they can justify a little bit better. 12 But if you are looking at, you know, .0001, as 13 I mentioned, that is basically a dollar on a $95,000 14 Apple transaction. That is not overly offensive to me. 15 MR. LUPARELLO: Joe? 16 MR. RATTERMAN: I just have two clarification 17 type of statements to make. One is -- and I will do this 18 in reverse order. I think the comment was made or the 19 question was posed, you know, retail limit orders, you 20 know, are they being measured appropriately? Are they 21 getting good execution or not because we are all tugging 22 at marketable flow? And I have said this before. And I 23 just want to say again we have done a limited study that 24 shows that based on the nature of retail orders that are 25 limit orders, the characteristics of those orders, they 0168 1 tend to come into the market prior to the market. They 2 don't chase the market throughout the day. They tend to 3 set the price when they show up because they are first in 4 the order book before the day even starts. 5 And so, irregardless of where a retail limit 6 order is placed in our national market system, it has a 7 high probability -- and I mean on the order of 99 percent 8 -- likelihood of being executed if their price was 9 touched at all during the life of their order anywhere. 10 So I certainly am not concerned myself about retail limit 11 orders, where they are placed, because they tend to be 12 executed based on the nature of the way they enter the 13 market. They tend to be executed, regardless of where 14 they are posted in our national market system. So a 15 broader study could be done. I think it would show the 16 same results. But that is our analysis, that it just 17 doesn't matter where they come in. They get executed 18 because they tend to be the top of the Q in the national 19 market. 20 And, then, secondly, just a little bit for 21 clarification, it felt a little bit like exchanges were 22 thrown under the bus. I know this wasn't your point, 23 Jeff. And Jamil kind of added on to that that, you know, 24 exchanges couldn't offer the same kinds of price 25 improvement that market makers would to the retail folks. 0169 1 I just want to point out that there is a very 2 different mechanism. Exchanges have limit orders that we 3 can only do what is on our book to match the orders that 4 you send us. We are not taking the other side of the 5 trade, so to speak. And so we are limited in that 6 regard. 7 And, then, secondly, exchanges are also limited 8 in how granular of a price they can display. I am not 9 asking or suggesting that a policy discussion should come 10 up on the size of ticks, but the fact is the best we can 11 do is display a penny wide. And sometimes we can show 12 hidden orders at the midpoint, but the price improvements 13 below half a penny, price improvement can't be shown or 14 executed on an exchange. And so it is a completely 15 different game. And so I agree with the way it works 16 today. Market makers can provide that service. And they 17 provide a lot of follow-through benefits as well. But I 18 just want to make sure we are not looking at exchange 19 like the group that failed to deliver. We are just not 20 in the same game on the same playing field. 21 MR. LUPARELLO: So you don't have to suggest a 22 subpenny pilot because Maureen did it about 15 minutes 23 ago. 24 (Laughter.) 25 MR. LUPARELLO: Manisha? 0170 1 MS. KIMMEL: I have a question on disclosure. 2 You know, one of the things that was in the client issues 3 briefing paper was essentially bringing 605 to the retail 4 brokers. And it is a question, really, for Frank and 5 Jeff in terms of what do you see as the kind of 6 implementation and sort of ongoing compliance burden if 7 that obligation were to come to the retail brokers? 8 MR. BROWN: We have been actually disclosing 9 what would be our 605 numbers for several years now. So 10 we don't think that is a burden at all. And, indeed, we 11 are working along with a couple of other firms with the 12 FIF in enhancing these disclosures. So we think more 13 disclosure is appropriate. 14 MR. CHILDRESS: Just to follow up, I think 15 there would be certainly a level of burden to requiring 16 firms to establish metrics similar to 605 for retail. It 17 would certainly take a lot of operational work as well as 18 working with vendors that prepare our best execution 19 statistics. 20 So I don't want to take it lightly. We haven't 21 created it at this point. I think we would fare very 22 well in that type of comparison. So I welcome it from 23 that perspective. But it does feel like it would be a 24 bit of a burden. And I think it would also create some 25 other regulatory issues, you know, that we would have to 0171 1 monitor and make sure that we are correct with our 2 numbers and everything else. But I think it is 3 something. It feels like the industry may be headed that 4 way. And I think it is something we can manage. 5 MR. LUPARELLO: So Dennis and Brad and then 6 Reggie. 7 MR. NAZARALI: I am sorry, Steve. I was on 8 deck. 9 MR. LUPARELLO: Oh, I am sorry. 10 MR. NAZARALI: Okay. 11 (Laughter.) 12 MR. LUPARELLO: And you were so patient. So I 13 do apologize. 14 MR. NAZARALI: Yes. I just wanted to react. I 15 think, Kevin and Mehmet, you actually raise a really, 16 really important policy issue. And I didn't mean to 17 suggest, you know, to your point, Eric, that retail 18 investors deserve a better deal than institutional 19 investors. What I was really trying to say is if you are 20 doing a trade and someone wants to buy 100,000 shares, 21 someone else wants to buy 100 shares, which one are you 22 going to give a better price to? You know, obviously if 23 you are selling, you are going to sell 100 shares at a 24 better price to your counterparty than 100,000 because 25 you know that if you take the first 100 shares, you are 0172 1 going to get run over. Right? 2 So as a retail investor, if you are forcing 3 everything to be traded at the same price on exchange, 4 you are essentially forcing retail investors to not get 5 the benefit of the fact that they trade at smaller 6 prices. And they will all get worse prices. And 7 everyone else will get better prices. 8 So as a policy perspective, you have to think, 9 is this a good thing? If I force everyone to trade at 10 the same price, then those who would naturally get a 11 better price are going to get a worse price. Those who 12 would get a worse price are going to get a better price. 13 Now, you might like that because you are an 14 institutional investor. And you will probably on average 15 do a little bit better off, but it is kind of akin to 16 saying, you know, whether or not you buy, you know, in 17 bulk or not in bulk, you have got to get, everyone has to 18 get, the same price. You are disadvantaging one group at 19 the expense of another. 20 MR. CRONIN: The only thing I would say is 21 don't assume that every order we have has to be done 22 immediately. Right? We are liquidity providers to the 23 market. We are often quantified as liquidity takers in 24 the marketplace. And that is not true. Right? So why 25 shouldn't we have an ability to walk a book down if we 0173 1 are buying it. Right? What you are proposing is that 2 those people would perpetually be able to trade in front 3 of us. And we as price setters and people willing to 4 take the risk of showing a bid or offer would be 5 disadvantaged the entire time. 6 So I think we shouldn't be solving for a 7 particular investor or class. If we are to err on the 8 side of market structure, I think it should be in favor 9 of long-term investors for sure. You might guess I would 10 say that. But the answer is I think the way to solve 11 this problem is to really think about how do we promote 12 integrity and quality in the price, you know, discovery 13 mechanism itself? And that is not a retail thing, and it 14 is not an institutional thing. It is an all-in thing. 15 MR. DICK: Just a general question I guess for 16 the panel. And I want to get your thoughts on this as 17 well. So we have talked about a lot of things here. One 18 thing that I have always considered and just looking at 19 the market events, like August 24th, when liquidity, you 20 know, suddenly vanishes, or the May 6, 2010 flash crash, 21 when liquidity is, all of a sudden, gone. 22 I wonder if the market isn't too dependent on 23 high-frequency liquidity because it is obviously 24 fleeting, you know, in times of stress. And I wonder 25 because there isn't this discouragement that I have 0174 1 talked about. 2 Like I know our traders, for instance, if I 3 talk about it, Bright Trading, we have got about 100 4 guys. The first thing I teach all of our new traders is 5 it is better to take liquidity than it is to provide 6 liquidity. And I give them these same presentations. So 7 firms like ours are takers of liquidity. You could say 8 Bright Trading is primarily takers of liquidity. I don't 9 know how many other prop firms are the same way, but we 10 are hesitant to provide liquidity because our quotes get 11 stepped ahead of. 12 So, you know, if there is institutional flow 13 that is getting stepped ahead as well and they are 14 deterred from providing liquidity, maybe at the end 15 result, we are left with a lot of just high-frequency 16 liquidity that is being obviously incentivized by 17 providing rebates or getting rebates. So it helps to 18 keep them on the book. So is the liquidity book too 19 homogenous? Have we lost the diversity and our markets' 20 liquidity? 21 MR. LUPARELLO: I think that may be too large a 22 question for today. 23 (Laughter.) 24 MR. LUPARELLO: That is right, exactly. I will 25 see you in April. 0175 1 Brad? 2 MR. KATSUYAMA: So I had a question for Dennis, 3 but I will try to answer his question first. Actually, I 4 think he said a good point. There aren't a lot of 5 incentives for long-term investors to provide liquidity 6 in the public exchanges right now. 7 You know, so from a rebate perspective, that 8 rebate typically doesn't make it back to them. You know, 9 there are mechanisms for people to jump ahead, as Kevin 10 says. He is getting stepped in front of as a trader. At 11 RBC, it happened to me all the time, posting displayed. 12 I would be setting the price for someone else to jump 13 ahead. I used to bury discretionary orders deep in the 14 book with 17 cents discretion so it could pop out of 15 nowhere and buy stock. Okay. Dennis nods his head. 16 So, you know, part of the philosophy, at least 17 from our seat, is to try to give long-term investors the 18 level of confidence to display orders or to bring orders 19 back. Even non-displayed orders at public exchanges 20 helps to absorb liquidity in shocks because those 21 midpoints have to trade before our displayed trades. And 22 what we are seeing in the feedback we get from more and 23 more buy-side firms is that they actually feel more 24 comfortable resting larger orders in our market. 25 So I think that, absolutely, most of the 0176 1 mechanisms, you look at the payment for order flow 2 rebates, the generation of a lot of these at-liquidity- 3 only order types, these are all short-term incentives for 4 short-term traders to provide liquidity, none of them 5 really providing incentives for long-term investors. And 6 I do think there is probably an imbalance right now, 7 which is leading to some of these issues. 8 The question I had for Dennis because I have 9 seen these trades as well dating way back in terms of 10 .0001 or .9999. Do you know what percentage of off- 11 exchange trades are trading at those increments? I have 12 seen some reports. I just am not -- 13 MR. DICK: I don't have those stats, but I see 14 them. I think from my observations -- and I used to 15 trade small cap stocks almost exclusively probably for 16 the first 10 years of my prop career. And I don't trade 17 small caps at all anymore because I really see it. It 18 seems to be more prevalent almost in small caps. And 19 maybe you have got the competition in the large caps with 20 those payments because there are more orders coming in. 21 So I wonder, you know, in a Bank of America that it isn't 22 more competitive in stocks like that. But it seems like 23 if you're even trading like the preferred market or 24 something, which is primarily what a lot of retail 25 traders trade in, preferred markets, you try to make 0177 1 markets in that. You can forget about that. That is the 2 .001 all over the place still. 3 MR. KATSUYAMA: Right. 4 MR. DICK: So I think it depends on the type of 5 security, but I don't have the statistics. 6 MR. KATSUYAMA: I remember I saw I think it was 7 a Nanex report that talked about 30 percent of off- 8 exchange trades were happening at these one mil 9 increments. I think it is probably worth getting a data 10 set, putting those numbers out, and actually seeing that 11 because, in reality, there is a benefit and a mechanism 12 to price improvement. One mil price improvement I think 13 is really questionable. And I think, you know, Dennis 14 brings up a reasonable solution to say, "Well, should 15 there be a minimum increment to step ahead? Because if 16 one mil isn't it, what is that number? And is that 17 something that we should be discussing?" 18 If it is true that 30 percent of off-exchange 19 trades are happening at one mil inside the inside, then 20 that is probably pretty frustrating to Kevin. And when 21 you talk about price improvement, I would say that is a 22 pretty nominal amount. So maybe there is an amount that 23 Kevin can say, "Okay. I am bidding 5" and someone trades 24 at 5 plus something, maybe it is not as bad that someone 25 is willing to step up. But one mil is extremely 0178 1 frustrating. Having been on the receiving end of that a 2 lot, it is frustrating. So it is probably worth seeing 3 number one. What percentage of off-exchange trading is 4 happening at that increment? If anyone has that number, 5 that would be great and to verify that number and then to 6 look to go back and say, "Is this really what we had 7 intended with this mechanism?" 8 MR. LUPARELLO: First Reggie I think and then 9 Matt. And, echoing Stacey from this morning about how 10 everything interrelates, all conversations seem to come 11 back to Trade-At. Reggie? 12 MR. BROWNE: Listening to this debate, it is 13 pretty healthy. And there are a lot of germane, 14 connecting themes here. You know, I had two thoughts 15 just sitting here. You know, as an ETF person, one of 16 the reason why bond ETFs are growing so rapidly is that 17 you have equity market structure rules inside of the bond 18 market. And we are sitting debating about de minimis 19 quote spreads in equities. Meanwhile, the bond market is 20 quoted in much higher increments. I would like to point 21 that out to you. 22 In polling our clients, Cantor Fitzgerald 23 clients, our broker-dealer clients, repeatedly we are 24 hearing that the retail client has it better than ever. 25 And we keep hearing that over and over again. 0179 1 And then you have different firms that take 2 payment, don't take payment, better, effective spreads 3 over quoted, you know, based on payment. But the result 4 is market access for retail clients. I hope we don't 5 lose sight of that. If there isn't payment for order 6 flow and then those firms who do take payment for order 7 flow, majority based on my conversations with retail 8 clients is that that money gets plowed back into their 9 platforms for the benefit of their clients. And the 10 firms who don't take payment for order flow, the cost of 11 access on their platforms is higher. 12 We don't want to artificially reduce 13 competition by creating higher costs for retail clients 14 to access the marketplace to invest their retirement 15 dollars because we are going to have unintended 16 consequences. So I urge this august body to think about 17 reduced competition among brokers. So if a new broker 18 who has innovation and a new idea is coming to the 19 marketplace and in order for that innovation to occur, 20 payment for order flow is part of that model, still 21 provide best ex but to bring innovation to the 22 marketplace, if you reduce that innovation and that 23 competition, the end result is a bad environment for the 24 retail client. 25 MR. ANDRESEN: Well, I just want to hearken 0180 1 back to Joe Mecane's thoughtful summary from a while back 2 that we proceeded to go completely afield of almost 3 immediately, -- 4 (Laughter.) 5 MR. ANDRESEN: -- which is that there are 6 two -- it was a good effort -- distinct issues here. One 7 is the concept of whether payment for order flow 8 represents a conflict and what, if anything, should or 9 could be done about it. Separately there is an issue of 10 internalization whether or not it should exist, but these 11 have gotten increasingly conflated as our afternoon has 12 gone on. I think, Dennis, to make you feel a bit more at 13 ease, I can assure you that if payment for order flow 14 went away in some way, ban or something else, your 15 traders at Bright are still probably not going to see any 16 of Frank's orders. Frank has made a choice with 17 literally no concern or acceptance of payment for order 18 flow. And he has chosen to say, "My customers are better 19 served. Send these order flows where they can be 20 disproportionately better served and in the public 21 market." So that is a distinction that has to be 22 underscored and a debate that has to be had separately. 23 In terms of why someone would behind this concept of the 24 not sufficient price improvement, it is worth noting that 25 when one sees some price improvement of this .001, the 0181 1 access fee on that dwarfs that amount. So the true 2 spread associated and the true cost associated execution 3 is actually much higher. 4 So there are all sorts of rational reasons that 5 a retail broker-dealer or someone else could realize that 6 they are better served by that execution. One, they 7 avoid the access fee, which can be 30 mils. 8 Two, they avoid taking the risk of execution, 9 as was pointed out by Jeff Brown and I think also by 10 Frank. When you go to the public exchange, you are not 11 going to get that price. You most of the time get that 12 price, but a decent percentage of time, you end up with a 13 worse price. So guaranteeing yourself a little tick 14 better than the NBBO, avoiding the fee, and avoiding the 15 chance you miss that is a pretty powerful basket. 16 And then there is one additional benefit, which 17 is exchange calamity, so the earmuffs for anyone from the 18 wholesaling business, but Facebook had an exchange 19 problem with its IPO. And all of the retail customers, 20 which is probably the most widely participated-in retail 21 IPO of all time, were protected from that problem at the 22 exchange. The result was the intermediaries had to eat 23 tens and sometimes hundreds of millions of dollars of 24 loss. The exchanges, as Joe points out, are not at a 25 position to be in the business of protecting them from 0182 1 that. But the end retail customer was protected. 2 So between those things, I feel like it is 3 getting a big lost in the shuffle and that we are 4 agreeing that there is a minimum amount of price 5 improvement that sort of decides the debate. You have to 6 lay that amount of price improvement, the certainty of 7 execution, the avoided access fee penalty, and the 8 operational calamity, as a whole basket of benefits and 9 then say that versus the very fair points about Invesco 10 and T. Rowe and Bright not getting the advantage of this. 11 This is a complex issue. And I was worried 12 that we were drifting into a quick fix of saying a 13 certain amount of price improvement would cure all. 14 MR. LUPARELLO: Maureen? 15 MS. O'HARA: I would actually like to take us 16 back to an issue we talked about this morning and which 17 Jeff started us off on today. And that is the stop 18 orders. I thought you raised a lot of interesting points 19 about stop orders and the challenges that individuals 20 have because they don't really stop. But, of course, you 21 could create real stop orders, right, by basically, you 22 know, tying the order to an out of the money put. Right? 23 I mean, that would certainly work. And that had the 24 advantage that you actually don't even have to sell the 25 stock to protect the underlying. But the downside, of 0183 1 course, is that would be a relatively expensive solution. 2 And your individuals probably wouldn't want to pay to 3 avoid that outcome. 4 So you can think about the individuals as being 5 kind of one over of the market. They could avoid that, 6 but they don't want to pay that. 7 There is also kind of the flipside of, do the 8 stop orders, in turn, create an externality on the 9 market? That is, by having all of these stops in there, 10 that when the market moves, all of a sudden, now you get 11 this avalanche of orders coming in. That is kind of 12 imposing a cost on the market as well. 13 And the question is, how could we avoid that 14 cost? I don't know the answer, but it strikes me that in 15 some sense, you know, the notion that education solves 16 all the problems with stops misses the other side of the 17 coin, which is the stops actually impose a problem for 18 the market. And education seems a little far afield to 19 fix that. 20 So could you, instead of having stops that, you 21 know, in principle, turn into these market orders, 22 instead structure stops that if the person doesn't want 23 the perfect insurance or the out of the money put, these 24 things are going to turn into limits. They get put on 25 the book when a certain trigger point in that order hits. 0184 1 I mean, I don't know that that solves it entirely, but it 2 begins to move on this idea that there is an externality 3 of those orders as well. 4 And I like your point that you have stops that 5 people didn't even remember. So it almost seems like a 6 natural thing to do is to say stop orders have to have a 7 maturity date. Right? Think of them almost like an 8 option. Right? This stop is enforced until this date. 9 And then it goes away. 10 Do these ideas have any currency or are they 11 all wrong? 12 MR. BROWN: They do. You are absolutely right 13 buying an out of the money put gives you the protection 14 that you are looking for in the deep dive of the 15 security, but, of course, that is, like you say, 16 expensive. And it adds complexity to our clients that 17 they may not quite understand. 18 You know, not all of Schwab clients -- we have 19 about 10 million. Certainly we would welcome them all to 20 be option traders, but they don't. And, you know, they 21 are really not equipped to be into the option market. So 22 that is a solution that many I am sure do. You know, a 23 sophisticated investor will cover himself with that way. 24 I mean, having the stops be limit only is a 25 solution in the sense of you are not dumping a market 0185 1 order into a falling security. However, then the problem 2 is if they miss the next trade and they are now posted, 3 particularly in a flash environment, they are subject to 4 greater losses. And, even in a flash environment, they 5 may now have a posted limit order that by the time the 6 market snaps back, it takes it and runs ahead. And now 7 at the end of the day, they come home. They turn on 8 their computer. They see they have sold at a price that 9 is way below where the stock may have ended. I mean, all 10 of these things are dangerous. You know, you can imagine 11 the scenario where they create bad execution 12 environments. 13 So what we do with our clients is to tell them 14 these risks and try to get them to understand what they 15 are doing and why these types of orders, but darks 16 particularly, have greater risk and they need to 17 understand. 18 MR. CHILDRESS: Yes. I would just echo that I 19 agree with everything Jeff said, that there is no single 20 answer for stop orders because even putting a limit on it 21 has its own consequences. But to your other question, 22 which is a great idea, the idea of an expiration on the 23 stop orders, we all essentially have that. It is part 24 just of the ability to manage the limit order book but 25 also as an enjoinment for people to rethink their trading 0186 1 strategies. 2 But limit orders roll off. And each firm has 3 different guidelines for whether that is 60 days, 90 4 days, 180 days. And I think most firms today don't have 5 limit orders that are out there for many years. And most 6 of us, given today's volatility, have lost most of our 7 limit orders over the last couple of weeks. 8 MR. LUPARELLO: Chester? 9 MR. SPATT: You know, so I had a final question 10 to Maureen's question to Jeff. I, too, was intrigued by 11 your comments about the importance of education and the 12 role of stock and how do the stop orders work. So I am 13 kind of curious. Maybe you could elaborate a little bit 14 upon what does Schwab do in this space with respect to 15 its customers, either when the customer is putting on a 16 stop order or ex-ante? Because it seems like Schwab 17 would be much better positioned as that educational 18 intermediary than, for example, the SEC would be because 19 of its relationship to the customer. 20 MR. BROWN: In fact, the idea of having warning 21 screens is a good one. We are working to develop those 22 based on August 24th. When you put in a stop, it will 23 flash up and give you a warning about what the risks may 24 be. 25 Now, we also have detailed explanations of 0187 1 these orders on our website that our clients can go to to 2 read all the risks that are entailed with stop orders. 3 So, you know, our clients are self-directed investors. 4 And they need to understand, you know, we try to help 5 them understand, what the risks are that they take on 6 when they engage in these activities. 7 MR. LUPARELLO: Yes, Nancy? 8 MS. SMITH: Thanks to the panelists. This has 9 been terrific to listen to all of you. 10 On follow-up, Jeff, on that, how do you judge 11 the effectiveness of your education? How do you look at 12 the behavior or any of the panelists, Frank, if you are 13 doing any of this as well? How do you judge 14 effectiveness of investor education and to the degree you 15 have to do broker education or investment adviser 16 education? 17 MR. BROWN: I think what you do is after an 18 event as of August 24th, you do go back and look to see 19 what happened in your client base. And you will find, in 20 fact, we will get calls from clients who are irate about 21 what they have done with where their stop order would 22 have been executed. And so that kind of brings you to, 23 well, obviously we weren't as effective as we would like 24 to be if we have had even one client who loses, you know, 25 or has a bad outcome in what they want to do. But it is 0188 1 really a review of what happens and then trying to make 2 adjustments to what we are telling our clients. 3 MS. SMITH: So what is your perception of what 4 did happen after August 24th? What did you see and for 5 anybody else who would like to address that, too? 6 MR. BROWN: We had clients who have had ETF 7 positions that moved violently, as compared to the 8 underlying. And those clients were who made execution 9 decisions based on the fear of where the end result of 10 that day was going to be, lost significantly. So they 11 are happy to then call us and tell us how unhappy they 12 are. 13 (Laughter.) 14 MS. SMITH: So they learned through the school 15 of hard knocks. 16 MR. BROWN: Yes. 17 MR. CHILDRESS: So I would say that we learned 18 a lot of things, obviously, on August 24th. And we did a 19 handful of things proactively. And in Jeffrey's case, he 20 is more likely going to the individual investor. We are 21 more likely going to an FA for education. 22 But there was a handful of things that we did 23 from an educational standpoint that were not limited to 24 but included enhancing communications and things that we 25 already had out there. We also created a couple of 0189 1 videos for those who don't want to read or would rather 2 track media. We also have a very brief video that pops 3 up as an available to them any day that we see extreme 4 market volatility that just basically says, "Reminder: 5 Consider using limits with your stop orders" or "limits 6 with other orders" as well as the order entries that pop 7 up. 8 But we have seen a reflex response that is 9 encouraging. I will mention this. It is about a 35 10 percent increase over what we had before in using limits 11 on stop orders versus not having. It is directionally 12 where we want to go, but we are not there yet. 13 So we will continue to look at other ways to 14 enhance education. And when brokers are coming in for 15 respective training for their annual compliance reviews, 16 I think these order types are certainly going to get more 17 attention. And that will serve us all well. 18 MR. LUPARELLO: I see no hands up or lights on. 19 So I think I will thank the panel for an outstanding 20 discussion and conversation. 21 Why don't we take a 15-minute break and 22 reconvene at 3:00 o'clock with subcommittee reports. 23 Thank you. 24 (A brief recess was taken.) 25 MR. LUPARELLO: So the last order of business 0190 1 for today is a report out from the four subcommittees 2 from each of the four subcommittee chairs. As you all 3 know, we created these subcommittees upon the 4 recommendation of the full Committee at the last meeting. 5 And I know a lot of work has been done, I think mostly 6 in an organizational sense. And so this will become I 7 believe a bigger part of the work of the Committee as we 8 go forward. But just a brief status update from each of 9 the four committee chairs would be great. 10 I think we will start on the Reg NMS 11 Subcommittee with Kevin. 12 MR. CRONIN: So thank you. 13 Again, maybe just a word on process to give 14 some sense of how we are trying to come to a reasonable 15 recommendation. So, first of all, we are all committed, 16 certainly within our subgroup, to coming up with 17 practical and hopefully sensible recommendations around a 18 number of the topics within Regulation NMS Subcommittee. 19 And as part of those proceedings, we thought it would be 20 a good idea to obviously include others who are really 21 important in the conversation. 22 So, for example, I don't think I am jumping in 23 front by telling you access fees would certainly appear 24 to us to be an area where there is something to be done. 25 I am not here to say exactly what that something is, but 0191 1 it certainly seems like there is enough agreement among 2 the broad Committee and certainly the subcommittee that 3 this is a topic that if we could come with some 4 reasonable and sensible recommendations that, actually, 5 we might be able to effectuate some positive change in 6 the industry. 7 So, as we thought about our group and the 8 constituents within our group, it did strike us that 9 there are some important members of this conversation who 10 aren't either part of the larger Committee or are on the 11 Committee but aren't part of our subcommittee. So we 12 want to make sure, for example, retail investors are 13 included in our conversations, certainly market makers. 14 And we wanted to think about this from both the equity 15 and the option side of the business. So we are going to 16 try to include people who would be sensible in that 17 respect. 18 The issuer community. Obviously, there are 19 Met, myself, and others on this Committee who are parts 20 of issuing companies, either ETFs or are corporate 21 companies, corporate entities, or are listed companies. 22 So there is some perspective, but I think there is some 23 substantial perspective to be brought incrementally to 24 that conversation. So we want to include the issuer 25 community. 0192 1 The others that we wanted to include -- and I 2 know that there was a recent article written last week 3 from our friends at the Wall Street Journal on the topic. 4 We do want to include New York and NASDAQ in these 5 conversations. I think it would be difficult to not have 6 them as part of the conversation. And so we are looking 7 to extend investigations to both New York and NASDAQ. We 8 would envision that this isn't just a one-time 9 discussion, fire and forget, thank you very much, and see 10 you later. We would want to do a discussion, for 11 example, again, around access fees where they would be 12 part of the conversation until the recommendation were 13 made. 14 So I don't know if that helps in some of the 15 concerns that have been had around their participation, 16 but I would hope we can all get together and work on this 17 important issue because I know certainly from, again, our 18 subcommittee's perspective, we are very committed to 19 trying to come to again sensible solutions and practical 20 recommendations here from the subcommittee. 21 So, with all of that said, I think the process 22 is important, making sure it is transparent and people 23 understand that we are trying to consider all of the 24 reasonable constituents within to come up with highly 25 credible and again hopefully reasonable recommendation 0193 1 set. 2 So we start with access fees. Again, what we 3 would look to do is come up with a recommendation of what 4 to do. It probably won't surprise you to hear that we 5 are already really interested in getting more educated 6 again on what NASDAQ did, for example, in its pilot 7 program on access fees. We certainly want to start a 8 discussion on whether or not we should be having a more 9 specific dialogue on a pilot program. And so we will 10 endeavor to bring perhaps other academics and others in 11 to help us structure a program that would be sensible and 12 not as complicated, for example, as some others have 13 recently become. So access fees are probably priority 14 number one. 15 Priority number two is market data. Now, this 16 is a very big issue, and we could probably say that each 17 one of the subgroups has some element of connection to 18 this. So I think there is probably part of this that is 19 in the Governance Committee, and there is probably some 20 of this that fits very nicely into the NMS Committee. So 21 perhaps what we might recommend as we think about the 22 agenda for the next meeting, maybe a deeper dive on 23 market data itself would be helpful as we really kind of 24 try to figure out, you know, the divide-and-conquer 25 methodology to try to get some reasonable solutions 0194 1 around that. 2 Six eleven, of course, will factor prominently 3 in our discussions at some point. We have had discourse 4 already several meetings ago on 611. The trade-through 5 rule is something that is seen as virtuous and 6 villainous. I think what we would like to do is really 7 dig into the issue and see if there are reasonable things 8 that can be brought to that to bring relief if it is 9 appropriate and necessary. And, again, for each of these 10 issues, we would look to invite very specific 11 participants we think would be valuable parts of the 12 conversation. 13 So those are sort of the assessments. We have 14 had two meetings so far. We are looking to do an in- 15 person meeting next week in New York. And that will be a 16 half-day meeting, where we really start the deeper dive 17 into the access fee discussion. 18 MR. LUPARELLO: Great. 19 MR. CRONIN: I will throw it open to any of our 20 committee members who would like to comment. 21 MR. LUPARELLO: And I would remind that the 22 meetings and the minutes of the meetings are reflected or 23 will be reflected in the website. So there is also that 24 public aspect of the subcommittee meetings. 25 So questions for Kevin? 0195 1 (No response.) 2 MR. LUPARELLO: Great. Thank you. Yes. I 3 thought that is what I was interpreting. Yes. So we 4 will go slightly out of order and ask Eric to give an 5 update on the Market Quality Subcommittee. 6 MR. NOLL: Sorry. I have a phone call, and I 7 want to make sure I get my time in the sun. 8 So we obviously have the Market Quality 9 Subcommittee. We have had two meetings so far. Like 10 Kevin, much of what we are trying to do is about process, 11 which is getting the right people in front of us. We 12 have not had external speakers so far. We have extended 13 invitations to the exchanges, the large exchange groups 14 in general. We are trying to work through how we can get 15 their participation and have them part of this process, 16 which we think is important for us to get everyone's 17 thoughts around that. 18 Our focus has really been using the August 24th 19 events, really, as a launching pad for a larger 20 discussion, both around how the opening process works and 21 how to coordinate the open across all exchanges and make 22 sure that the impacts of that are effective for the 23 market and that we are not seeing externalities in that 24 opening process that are negative for the market, also 25 spending a lot of time on limit up-limit down and 0196 1 concurrently with that clearly erroneous and how those 2 two should work together, what changes we would like to 3 recommend to limit up-limit down as we go forward. 4 Paired into that I think is an important point as well 5 that we are spending an increasing amount of time on is, 6 what does it mean to be a market maker? And what does it 7 mean to be a market maker, and what other things should 8 we do if you are a market maker? So what sort of 9 obligations should a market maker have but also what sort 10 of benefits should a market maker in the marketplace 11 have? And we will spend some time on that. 12 Obviously we are also spending time around ETFs 13 and how they impact the market, again particularly around 14 the 24th; and then, lastly, market data, which I think is 15 everyone's favorite topic. And I think every 16 subcommittee at some level is looking at market data and 17 its impact and how it interacts. 18 We have the benefit I think of having Maureen 19 on the committee. She has been enormously helpful at 20 sourcing academic research for us, some of which is 21 unpublished yet. And that has been very helpful for us. 22 We are going to continue to want to do that, both with 23 the academic literature as well as external speakers, as 24 we go through. We fully expect to have some solid 25 recommendations for the April meeting. 0197 1 MR. LUPARELLO: Great. Thank you. 2 Questions for Eric before we do so? 3 (No response.) 4 MR. LUPARELLO: Good. Rick, hopefully you are 5 there. If you could give us an update on the Trading 6 Venues Regulation Subcommittee and see if we can keep the 7 streak going in terms of mentioning market data? 8 (No response.) 9 MR. LUPARELLO: Maybe not. Rick? 10 MR. KETCHUM: Sorry. I always forget to take 11 the MUTE button off. Thank you. 12 With apologies to everyone for not being there 13 today, I will just pass on that the Trading Venues 14 Regulation Subcommittee has held two meetings as well. I 15 think the committee members know that the subcommittees' 16 broad objective is reviewing and analyzing whether the 17 current regulatory model for trading venues is optimally 18 serving the market as a whole and providing a level and 19 fair playing field for all market participants. And for 20 our initial session, we focused on two discrete topics 21 within that broad directive, the first looking generally 22 at the exchange versus ATS issues from the standpoint of 23 the regulatory environment for both and the comparative 24 impact of both regulatory environments; and then, second, 25 the much more discrete issue of NMS plan governance. 0198 1 Within the first topic of the comparison and 2 exchange in ATS regulatory environment, obviously a 3 significant event occurred between these last two 4 meetings of the committee. And that was the SEC's 5 proposed revisions to regulation ATS, which required 6 greater public disclosure concerning the operation and 7 business dealings of NMS stock ATSes and with that also 8 provide enhanced SEC oversight of NMS stock ATS filings. 9 While not reaching any final conclusions from 10 the standpoint of the proposal, I think it is fair to say 11 that the consensus of the committee was that the proposal 12 directionally hit the mark, focusing on adding additional 13 transparency, process, and oversight to ATSes and other 14 causes and effects discussed, including providing more 15 consistency to the level of disclosure across ATSes than 16 certainty around the operations of each ATS. I think 17 each of those steps, without presuming where the SEC ends 18 with respect to final rule, I think generally was viewed 19 as positive. 20 The subcommittee also discussed the broader 21 issues from the standpoint of the regulatory framework 22 across both SRO exchanges and ATSes as well as broker- 23 dealers that engaged in analogous activities. And that 24 fits, both from the standpoint of the impact of those 25 with the regulatory requirements that exist, the 0199 1 potential conflicts or challenges that are related. And 2 given the nature and significance of that, we will look 3 to have an in-person meeting shortly in the month of 4 February with respect to that. And we also will be 5 looking to reach out to the relevant constituencies in an 6 attempt to engage in a dialogue and get input. 7 With respect to the second, narrow, issue from 8 the standpoint of NMS plan governance, the SEC was 9 helpful in providing an overview of the current role of 10 NMS plans and equity market structure functions, giving a 11 range of them from shift plans, limit up-limit down, CAT 12 tick size pilot as well as the traditional ones. 13 And I think our focus is really particularly on 14 the question of industry participation. When I speak of 15 industry, I think the committee consistently believed 16 that the question would be how to effectively provide the 17 most useful interaction from the standpoint of both buy 18 side and sell side with respect to that industry 19 participation. We recognize that there isn't uniformity, 20 that while there is provision for industry participation 21 in virtually every NMS plan in some way, there isn't 22 uniformity on selection process approach and role of the 23 advisory committees across the NMS plans. And we look 24 towards the issues involved in trading more formal 25 framework for the participation in input flow of advisory 0200 1 committee. 2 Now, we didn't not reach any final conclusions 3 as to whether that more effective participation involved 4 actual membership with respect to the committees or, if 5 not, how that participation could be enhanced, that that 6 will be the focus of ongoing discussion in a future 7 meeting. 8 Steve, with that, I will pass it back to you. 9 MR. LUPARELLO: Thank you, Rick. 10 Any questions for Rick? 11 (No response.) 12 MR. LUPARELLO: Great. And our last 13 subcommittee report is the Customer Issue Subcommittee. 14 And I will turn it over to Manisha. 15 MS. KIMMEL: Great. Thank you. 16 So the Customer Issue Subcommittee has met 17 three times. And our initial discussions were really 18 about setting the context for retail investor concerns. 19 So as part of that, we reviewed data as it relates to 20 investor attitudes. We have looked at publicly available 21 studies regarding investor participation, investor 22 confidence, and financial literacy. 23 There may be opportunities for additional study 24 around investor attitudes as it relates to equity market 25 structure. So we have formed a subgroup to further 0201 1 explore that topic. 2 With the release of the client issues briefing 3 paper, we have started our review of the topics 4 discussed. With respect to rule 605-606, we are 5 reviewing areas for additional disclosure, more 6 granularity and standardization for both executing and 7 routing broker-dealers. As an example, with respect to 8 605, we have talked about the inclusion of odd lots and 9 segregating out IOC orders. With respect to rule 606, we 10 have talked about categorization away from the listing 11 market structure to potentially S&P500-type 12 categorization. We have also talked about the inclusion 13 of OTC equity securities on rule 606 as well as limiting 14 the use of the other category. 15 With respect to market and stop orders, we have 16 discussed the importance of investor choice with the role 17 of education and the value of data-driven response to any 18 changes with these order types. We expect to review the 19 payment for order flow section of the briefing paper in 20 future meetings. And in order to better inform our 21 discussions, we will be seeking input from retail broker- 22 dealers in our next meeting. 23 Any questions? 24 (No response.) 25 MR. LUPARELLO: If no questions for Manisha, I 0202 1 will say we are scheduled to have our next meeting on 2 April the 26th. I think we will work with the Committee 3 as a whole as well as subcommittee chairs in terms of 4 what issues we want to tee up and schedule along the 5 lines of what we have done today and how much of that 6 will come from the subcommittee. So we look forward to 7 continuing the dialogue, and we look forward to you 8 making progress on the discrete issues. 9 Anybody have any other questions or concerns or 10 issues before we close? 11 (No response.) 12 MR. LUPARELLO: Hearing none, I will entertain 13 a motion to adjourn. I hear multiple motions and 14 multiple seconds. So I think with that, we are 15 adjourned. Thank you very much. I look forward to 16 seeing you again. 17 (Whereupon, at 3:20 p.m., the meeting was 18 concluded.) 19 * * * * * 20 21 22 23 24 25 0203 1 PROOFREADER'S CERTIFICATE 2 3 In The Matter of: EQUITY MARKET STRUCTURE 4 ADVISORY COMMITTEE 5 File Number: OS-0202 6 Date: February 2, 2016 7 Location: Washington, D.C. 8 9 This is to certify that I, Nicholas Wagner, 10 (the undersigned), do hereby swear and affirm that the 11 attached proceedings before the U.S. Securities and 12 Exchange Commission were held according to the record and 13 that this is the original, complete, true and accurate 14 transcript that has been compared to the reporting or 15 recording accomplished at the hearing. 16 17 _______________________ _______________________ 18 (Proofreader's Name) (Date) 19 20 21 22 23 24 25