Recommendations Regarding Regulatory Responses to the Market Events of May 6, 2010
Summary Report of the Joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues
The events of May 6, 2010 and the subsequent investigation, analysis, and reporting by the staffs of the Commodity Futures Trading Commission (“CFTC”) and the Securities and Exchange Commission (“SEC” and together with the CFTC, the “Commissions”) have highlighted many important policy and practice issues in today’s securities and futures market environment. In this Summary Report, the CFTC-SEC Joint Advisory Committee on Emerging Regulatory Issues focuses on recommendations targeted at the most important and pervasive issues affecting investors and the markets, rather than attempting to address all of the topics that have been raised in the course of our work.
One additional, specific point of background is appropriate to mention at the outset. The broad, visible, and often controversial, topic of High Frequency Trading (HFT)— including the definition of the practice, its impact on May 6, and potentially systemic benefits and problems that arise from the growing volume of HFT participants in all of our markets—has been pervasive in our discussions and in comments received from others. Rather than detail specific recommendations about HFT in this report, steps to address issues associated with this practice are evident throughout our report.
We cannot overstate the importance of addressing the most pressing issues highlighted here. While many factors led to the events of May 6, and different observers place different weights on the impact of each factor, the net effect of that day was a challenge to investors’ confidence in the markets. The quick actions of the Commissions and Self Regulatory Organizations that addressed several glaring issues were an excellent start to restoring confidence. We believe the recommendations that follow will accentuate that progress and we offer them to the Commissions in that spirit.
II. Restrictions on Co-location and Direct Access
One of the most notable developments which has greatly facilitated the growth and evolution of HFT has been the ability of individual firms, even if they are not registered broker-dealers or FCMs, to co-locate their routing technology with the market and limit book technology of the Exchanges. The Committee recognizes that there have always been participants who have had “time” advantages in the securities markets as a result of being a registered participant of an exchange floor or through the investment of technology. Nevertheless, the explosion of “naked access” participants who are sponsored by an executing and clearing broker but do not use the technology or real-time compliance screens of that broker raise novel control issues.
Specifically, the direct access to the market of large numbers of unregulated, and in many ways, unsupervised entities create risks of erroneous trades or manipulative or other violative strategies. We believe that it was absolutely correct for the SEC to have imposed and adopted rule requirements in this area. According to the SEC: “The new rule prohibits broker-dealers from providing customers with ‘unfiltered’ or ‘naked’ access to an Exchange or ATS. It also requires brokers with market access – including those who sponsor customers’ access to an Exchange or ATS – to put in place risk management controls and supervisory procedures to help prevent erroneous orders, ensure compliance with regulatory requirements, and enforce pre-set credit and capital thresholds.” ?
We believe that the SEC was correct in requiring that all direct access order routing occur through a registered broker-dealer. In this way, the SEC, FINRA and the Exchanges can more effectively assure that the sponsoring broker has put in place effective trading screens to reduce the occurrence of erroneous orders and manipulative activity and can implement effective continuing surveillance of both the firm’s customer order flow and firm proprietary trading activity.
The Committee supports the SEC’s “naked access” rulemaking and urges the SEC to work closely with FINRA and other Exchanges with examination responsibilities to develop effective testing of sponsoring broker-dealer risk management controls and supervisory procedures.
The CFTC also has been active in addressing the concerns of disruptive or ineffectively supervised trading. In Section 747 of the Dodd-Frank, Congress amended the CFA to expressly prohibit certain trading and quoting practices that it determined were disruptive of fair and equitable trading. Section 747 also amends Section 4c(a) of the Commodity Exchange Act to provide the CFTC with rulemaking authority to prohibit “any other trading practice that is disruptive of fair and equitable trading.” Subsequently, the CFTC has issued an Advanced Notice of Rulemaking in which it requests comment on a number of questions relating to, among other things, whether the CFTC should specify as a disruptive trading practice the disorderly execution of particularly large orders at any time during the trading day. Additionally, the CFTC questioned whether it should articulate specific duties of supervision relating to the trading practices prohibited in Section 747, as well as whether the CFTC should promulgate rules more generally regulating the supervision and monitoring of algorithmic or automated trading systems to prevent disruptive trading. The Committee strongly believes that the CFTC should impose supervisory provisions, similar to what the SEC has imposed, on any FCM sponsoring algorithmic orders to an Exchange. This would ensure that algorithmic firms would have to demonstrate that there had been a careful evaluation of how an algorithm would operate in a number of scenarios that engender high market volatility.
We also applaud the CFTC requesting comment regarding whether it is appropriate to restrict large order execution design that results in disruptive trading. In particular, we believe there are questions whether it is ever appropriate to permit large order algorithms that employ unlimited use of market orders or that permit executions at prices which are a dramatic percentage below the present market price without a pause for human review.
The Committee recommends that the CFTC use its rulemaking authority to impose strict supervisory requirements on DCMs or FCMs that employ or sponsor firms implementing algorithmic order routing strategies and that the CFTC and the SEC carefully review the benefits and costs of directly restricting “disruptive trading activities “with respect to extremely large orders or strategies.
III. Liquidity Enhancement Issues
While the steps taken by the SEC and CFTC and the recommendations made by this Committee would meaningfully improve the ability of the equity and related derivative markets to handle an event like May 6, there remain legitimate concerns over the absence of present incentives for market participants to provide liquidity in the present market structure. Accordingly, the Committee focused on four areas that might positively impact liquidity.
Liquidity Pricing and Liquidity Rebates
The rising proportion of equity transactions that trade without publicly displaying liquidity has been of concern to many market participants and economists. Price discovery depends upon the interaction of all types of market participants. The liquidity of these markets is valuable to society in general as well as to the financial markets. This concern was expressed in the SEC Concept Release on Equity Market Structure in January 2010.
HFT in decimals has dramatically changed the ways in which liquidity is provided to our markets. In the flash crash, the lack of liquidity on public Exchanges was the proximate cause of the trades that were subsequently broken. Market orders in some cases found no limit orders to execute against. We observe that incentives to display liquidity may be deficient in normal market, and are seriously deficient in turbulent markets.
The Committee suggests that the Commissions consider incentives to supply liquidity that vary with market conditions. Until recently, the fluctuations in the bid ask spread regulated the demand and supply of liquidity in financial markets. Now, it appears that in a world of HFT, bid ask spreads no longer provide sufficient incentives to offer liquidity in periods of high volatility. Such difficulties in equilibrating supply and demand have counterparts in some markets, where “peak load” pricing strategies of charging higher fees for traffic at peak hours have proven successful at stabilizing demand and supply.
In many Exchanges, the pricing structures for executing trades involve maker/taker pricing. Under this pricing system, resting limit orders that are available for execution by others receive rebates for providing liquidity (liquidity “maker” rebates). Orders sent to Exchanges that are executed immediately are charged “taker” access fees. The taker fees will typically be larger than the maker rebates, providing the Exchanges with profits. Adjustments to maker/taker pricing could alter these incentives. The Exchanges compete on access fees and rebates but the SEC in Regulation NMS limits access fees but not rebates. A peak load pricing solution to encouraging liquidity could have both access fees and rebates rise in turbulent markets. If one Exchange has a higher access fee than another, then it will get fewer aggressive liquidity demanding trades. If an Exchange has a higher rebate, it will get a disproportionate share of liquidity supplying limit orders to fill out its book. In order for “peak load” pricing to be effective it would be important to disseminate changes in rates on a real-time basis to permit high frequency market makers to redesign their algorithms to take advantage of this information. Accordingly, the Committee recognizes that the SEC and the Exchanges would have to carefully evaluate the most effective way to implement any “peak load” pricing changes to avoid unnecessary technology message traffic impacts.
The Committee emphasizes that this pricing model would not replace circuit breakers or rolling limits. We recognize that in many periods of sudden and extreme volatility trading uncertainties may result in active traders withdrawing no matter what the incentives. Nevertheless, such peak load liquidity incentives would be initiated before either of the other events occur and might encourage sufficient liquidity in some scenarios that thresholds are not hit and stops are not triggered.
Counter arguments can be made. High access fees will only encourage trades to go to internalizing firms. However, high rebates will reduce the value of internalizing trades. Moreover, in turbulent times such as the Flash Crash, it appears that most internalizing firms sent their trades to the Exchanges.
The Committee also notes that the trade through rule of Regulation NMS does not take access fees or rebates into consideration in determining the NBBO. This appears to be another area that might benefit from review and adjustment.
The Committee recommends that the SEC evaluate the potential benefits which might be gained by changes in maker/taker pricing practices, including building in incentives for the Exchanges to provide for “peak load” pricing models.
Market Maker Obligations
The traditional model of addressing excessive price volatility during the time prior to the enactment of Regulation NMS was specific market making obligations imposed by the then dominant primary Exchanges. The NYSE and the Amex dictated “affirmative” and “negative” obligations for specialists. The NASDAQ had imposed fewer obligations, but instead required each market maker’s quotes to be reasonably related to the market. The increased market competition and dramatic market fragmentation which has occurred subsequent to Regulation NMS, however, have effectively eliminated much of the profitability of the registered market maker function and therefore, eliminated the ability for the Exchanges to impose significant quoting or trading obligations.
The Committee is chary of overdependence on market maker obligations as a solution to market liquidity for a number of reasons. First, even historically, these obligations were of only limited effectiveness during times of extreme volatility because the risks were simply too great. Second, given the present market maker fragmentation, we are unclear how to provide sufficient incentives to encourage meaningful change in behavior of registered market makers.
Nevertheless, market making does take place today, albeit through the activities of High Frequency Traders. Such traders often engage in multi-market arbitrage activities that essentially result in liquidity provision to and across markets. As has been widely reported, such high frequency market making is a significantly profitable activity. As reported by the Staff Study, however, some of these traders chose to withdraw on May 6 as a reaction to the level of uncertainty. Under our current rules and regulation, the benefits from making markets in good times do not come with any corresponding obligations to support markets in bad times.
We therefore believe that the Commission should consider encouraging, through incentives or regulation, persons who regularly implement marker maker strategies to maintain best buy and sell quotations which are “reasonably related to the market.” While the Committee does not believe it is competent to identify all of the measures which could be applied to create incentives to accepting such an obligation, these measures could certainly include differential pricing and might include preferential co-location provisions. We recognize that many High Frequency Traders are not even broker-dealers and therefore their compliance with quoting requirements would have to be addressed primarily through pricing incentives. We note that these incentives might be effectively interconnected with the peak load pricing discussed above.
The Committee recommends that the SEC evaluate whether incentives or regulations can be developed to encourage persons who engage in market making strategies to regularly provide buy and sell quotations that are “reasonably related to the market.”
The SEC and CFTC should also consider addressing the disproportionate impact that HFT has on Exchange message traffic and market surveillance costs. The Committee notes that in some concentrated market structures, individual markets often impose costs on participants who have a large ratio of order cancellations to actual transactions. Because U.S. equity markets are so fragmented, it is impractical for any individual Exchange to impose such a fee. Yet the technology costs and possible capacity limitations imposed by such activity are undesirable. The Committee recognizes that there are valid reasons for algorithmic strategies to drive high cancellation rates, but we believe that this is an area that deserves further study. At a minimum, we believe that the participants of those strategies should properly absorb the externalized costs of their activity. While trading is concentrated in the stock index and single stock futures markets, we also believe that the CFTC should evaluate whether a similar fee initiative would be appropriate.
The Committee recommends that the SEC and CFTC explore ways to fairly allocate the costs imposed by high levels of order cancellations, including perhaps requiring a uniform fee across all Exchange markets that is assessed based on the average of order cancellations to actual transactions effected by a market participant.
Preferencing, Internalization, and Routing Protocols
A third area which has impacted the displaced liquidity of Exchange markets is the substantial expansion of order flow that is executed by individual broker-dealer firms through “internalizing” their customer’s order flow or as a result of agreements with order routing firms “preferencing” their order flow to a particular broker-dealer, usually as a result of a payment for order flow agreement. The percentages of order flow executed in this manner has sharply risen and is believed to account for over 20% of the share volume in listed equity securities.
In total, approximately one third of share volume is executed on dark trading venues. In focusing attention on this activity, the Committee emphasizes two points. First, we do not focus concerns on the relatively small part this activity which involves trading systems that attempt to provide a matching system for “block sized” executions (e.g. ITG, Liquidnet and Pipeline). These systems provide a variety of technology innovations aimed at reducing “information leakage” that has plagued classic block positions. This activity has always operated primarily in the “dark” with limited interaction with public markets, and has provided important opportunities for large trades to be executed efficiently. Second, we note that this internalizing and preferencing activity is subject to Regulation NMS and indeed often involves provisions for price improvement. Therefore, the activity does not appear to raise legal “best execution” issues.
We believe, however, that the impact of the substantial growth of internalizing and preferencing activity on the incentives to submit priced order flow to public exchange limit order books deserves further examination. While the SEC has properly concluded in the past that permitting internalization and preferencing, even accompanied by payment for order flow agreements, increases competition and potentially reduces transaction costs, we believe the dramatic growth argues for further analysis. Notable in the trading activity of May 6 was the redirection of order flow by internalizing and preferencing firms to Exchange markets during the most volatile periods of trading. While these firms provide significant liquidity during normal trading periods, they provided little to none at the peak of volatility.
The Committee recommends that the SEC conduct further analysis regarding the impact of a broker-dealer maintaining privileged execution access as a result of internalizing its customer’s orders or through preferencing arrangements. The SEC’s review should, at a minimum, consider whether to (i) adopt its rule proposal requiring that internalized or preferenced orders only be executed at a price materially superior (e.g., 50 mils for most securities) to the quoted best bid or offer, and/or (ii) require firms internalizing customer order flow or executing preferenced order flow to be subject to market maker obligations that requires them to execute some material portion of their order flow during volatile market periods.
A related concern has to do with the effects of the current routing protocols on the overall incentive to place orders providing liquidity in the public markets. Under the current Regulation NMS routing rules, venues cannot “trade through” a better price displayed on another market. Rather than route the order to the better price, however, a venue can retain and execute the order by matching the current best price even if it has not displayed a publicly accessible quote order at that price. While such a routing regime provides order execution at the current best displayed price, it does so at the expense of the limit order posting a best price which need not receive execution. An alternative framework is a “trade at” regime in which orders must be routed to one or more markets with the best displayed price. Note that in such a “trade at” regime venues would be able to retain and execute any order by improving the current price. Such a regime reinforces the incentive to post displayed limit orders and hence encourages the liquidity and price discovery roles of the market. We note, however, that such a change in routing may entail substantial costs with respect to technology and implementation and may adversely impact some forms of competition. Nevertheless, the Committee is concerned that present quote matching strategies when combined with the siphoning of much of the non-directional retail order flow from the publicly accessible Exchange markets can substantially reduce the attractiveness of either professional traders or the public placing priced orders on Exchange limit order books.
Moreover, the current Regulation NMS rules also only require top of book protection. During the crash, orders routed to the top of book were then free to move unfettered and execute at the bottom (or top) of the price range on the book if underlying orders were not present on the book. While the Committee is aware that many firms design their order routing algorithms to search for the best priced orders at each of the Exchanges, we are concerned that this may not be true for other programs. One possibility is to provide protection to greater levels of the book. This would require the receiving venue to “route back” any remaining order that would execute at a price below currently displayed prices at other markets. The Committee recognizes, however, that this approach may impose technological difficulties and significant expense. As an alternative, the Committee believes that greater information provision on the state of the book might provide valuable information to market participants as to the location, or lack thereof, of liquidity in a fragmented market. Specifically, while the most active traders access full book information from each market many firms and investors depend solely on top of the book consolidated information. We believe that it would be valuable for the Commission to evaluate as to whether summary information researching the depth of each exchange book would be a valuable addition to core quotation information.
The Committee recommends that the SEC study the costs and benefits of alternative routing requirements. In particular, we recommend that the SEC consider adopting a “trade at” routing regime. The Committee further recommends analysis of the current “top of book” protection protocol and the costs and benefits of its replacement with greater protection to limit orders placed off the current quote or increased disclosure of relative liquidity in each book.
The events of May 6 demonstrated that even in a single market setting such as a futures market liquidity problems can arise from unexpected imbalances in the book of orders. Given the speed of order placement and cancellation, these imbalances can arise quickly, and their impact can be far-reaching. Yet the speed that allows liquidity to dissolve also allows it to accumulate. Opportunities to provide liquidity provide opportunities to profit for market participants if they are aware of the underlying imbalance. The Committee believes that information provision on variables related to the state of the book and market may provide a basis for market-generated responses to liquidity imbalances. Such information, which may more naturally attach to exchange settings, could include statistics on the current buy/sell ratio of orders on the book, flow rates of orders to the respective sides of the book, or other metrics related to the current state of liquidity in the market. The Committee believes enhanced information provision is consistent with the long-standing view of the SEC and CFTC that market-based solutions play a preferential role in the efficient functioning of markets.
The Committee recommends that the Commissions consider reporting requirements for measures of liquidity and market imbalance for large market venues.
Regulators’ Access to Information
As stated in the SEC press release announcing its rule proposal for a Consolidated Audited Trail, “A consolidated audit trail system would help regulators keep pace with new technology and trading patterns in the markets. Currently, there is no single database of comprehensive and readily accessible data regarding orders and executions. Stock market regulators tracking suspicious market activity or reconstructing an unusual event must obtain and merge an immense volume of disparate data from a number of different markets and market participants. Regulators are seeking more efficient access to data through a far more robust and effective cross-market order and execution tracking system.” The Committee agrees.
The Committee recommends that the SEC proceed with a sense of urgency, and a focus on meaningful cost/benefit analysis, to implement a consolidated audit trail for the US equity markets and that the CFTC similarly enhance its existing data collection regarding orders and executions.
There are, of course, other important issues that we could have highlighted in this report and we encourage the Commissions to continue to use the events of May 6 and the subsequent analysis in their future market structure discussions and rulemaking. That said, we believe these 14 points are the most important ones upon which to focus to ensure the integrity of the markets and to maximize investor confidence in the aftermath of the many market disruptions over the past several years. We appreciate the opportunity to be of service in this effort.
the complete report is available at www.seyfarth.com