Remarks From the Exchequer Club

As prepared for delivery.

Essential Elements of Sound Capital Market Structure

Good afternoon. First, let me thank Alison [Watson] for the invitation to speak with you today. The Exchequer Club plays a unique role in Washington by providing an important venue to discuss the major issues facing the financial services industry, and business generally. So it's a pleasure to be here with you today to talk about topics of mutual interest. I suspect that one of those shared interests is capital markets, where businesses and investors intersect.

In recent years, there has been increased debate about the structure of capital markets. Market structure, once the domain of regulators, market operators and large, sophisticated investors, is now a topic for much broader public discourse, in part because of the flamboyance of recent market moves, and in part because popular authors have claimed that the markets are "rigged."

It's not just regulatory geeks like me anymore who are interested in how capital markets are structured, or the role of rapidly advancing technology, increased speed and efficiency, and the highly technical details of governance and operations. Now, those topics are discussed widely in some of the most-read newspapers and magazines.

I've been analyzing and regulating stock, bond and derivative markets for nearly 40 years, and it is only in recent years that I've heard in elevators and at social gatherings terms of art previously limited to the market nerds—like nanosecond execution, colocation, dark pools and spoofing. More often than I would like, these talks included questions about whether or not the markets are fair—whether they provide a level playing field for all investors.

Along with questions about market structure and fairness, markets are now tossed about by volatility and possibly gripped by secular shifts, derived from a number of sources, most notably fears about China's economy and the decline in commodities prices, such as crude oil.

China's current boom-and-bust equity market—which lacks the hundreds of years of experience enjoyed by U.S. and other major world markets—appears to have its share of structural issues, as well as fundamental market concerns. On the first trading day of the year, slowing Chinese manufacturing triggered a global sell-off; and since that day, China's chief securities regulator has blamed the "abnormal volatility" on "an immature market, inexperienced investors, imperfect trading system, flawed market mechanisms and inappropriate supervision systems."

And recall last August when the Dow Jones industrial average plummeted more than one thousand points within the first ten minutes of trading due to, among other things, concerns over China's economy. That day was one of the busiest for our market surveillance staff. FINRA processed more than 75 billion pieces of market data, significantly more than the 42 billion we process on average each day. And the CBOE Volatility Index—the U.S. market's so-called fear gauge—surged 45 percent to its highest level in nearly four years. While the gauge has cooled since then, it remains elevated, recently hovering around 22, which is nearly double last year's low mark of just under 12.

While I can't fully diagnose what is ailing the equity markets—those of China or the rest of the world—this tumult exemplifies the importance of the structure of markets for financial instruments. In today's globally connected world, the issues in a national market can affect the economic life of not only that country, but economies and asset valuations around the world.

It is important here to make the distinction between structure and valuation. My principal concern today is not the price at which investments trade on various markets here and abroad—that is the domain of investors and traders. My concern is the framework and stability of that trading process.

All of us here today know that peripheral issues can take on an exaggerated importance in public discourse. That can make it difficult to home in on what we really need to be addressing. For example, while we are right to be concerned about market structure, not every market structure issue that makes the headlines is important. So what really matters? I see three key aspects of the markets that the securities market participants and the regulators should always be working to strengthen:

• market transparency;
• market liquidity; and
• market fairness.

Transparency

I'll start with market transparency, which is a central part of any market regulator's job and represents a significant portion of what we do at FINRA every day, in both the stock and bond markets. Part of transparency is price reporting—for example, the tickertape of old—that makes markets understandable, and helps allow for a realistic assessment of value, liquidity and fairness.

We ought to be concerned about whether information is available from all trading venues, to foster investors' ability to assess prices and valuations in a timely and accurate manner, and enable regulators to investigate and analyze market events.

We know from our experience with TRACE—FINRA's Trade Reporting and Compliance Engine—that reporting of corporate bond transactions has enabled careful surveillance of trading in these bonds. And when information on these transactions was made public, this transparency in corporate bonds contributed to better pricing, more precise valuations, reduced investor costs and substantial reductions in the bid-ask spreads, resulting in lower investment costs for both individual and large institutional investors.

Before FINRA introduced TRACE in 2002, information about most trading of corporate bonds wasn't immediately available to brokers or investors. To find out where a given bond was trading, a broker would place a series of telephone calls to dealers and hope he or she was getting valid and recent information as to what price a bond had recently traded. Today, TRACE provides wide access to trade data for corporate bond transactions, including the price and size. Since we introduced TRACE, we have steadily expanded it to make trading in bonds less opaque. Investors now have access to information about transactions not just in corporate bonds but also in asset-backed securities, mortgage-backed securities and Small Business Administration-backed securities. Similarly, the Municipal Securities Rulemaking Board, through its EMMA database, has greatly enhanced transparency in the municipal bond market.

On the equities side, we've had more than 40 years of experience with consolidated data feeds for quotes or trades. Investors now benefit from lower trading costs, tighter spreads, timely executions at firm quotes, a wider variety of order types to achieve their investment objectives, and the availability of multiple, innovative trading platforms.

Today, an investor can pay $4.99 or less for a stock trade and get instantaneous electronic confirmation. Compare that to 1975, when the SEC, after much wrangling, abolished fixed commissions. Then, it would have cost an investor hundreds of dollars to buy 500 shares of a blue-chip company. An investor buying 100,000 shares of the same blue chip stock would have paid the same amount per share for the trade. The excessively high trading costs of the 1970s also meant retail investor participation in the market was a fraction of what we see today.

Consolidated information on equity trading has been crucial for investors as the growth of electronic markets has resulted in greater dispersion of trading. Today's equity markets are fragmented, with trading volume spread not just among some dozen exchanges, but also among some 40 alternative trading systems. Where the NYSE and NASDAQ once had an overwhelmingly dominant share of the market for their listed issues, a substantial portion of that volume is now handled by new electronic venues, including exchanges and so-called "dark pools." These are tied together by quotation and trade systems that make information readily available to the public. While regulators of equity and futures markets can readily access transaction and quote data, it's not the same for other markets, like the $13 trillion Treasury market. When yields on the 10-year note plummeted on October 15, 2014, then rebounded without a clear impetus for the highly unusual volatility, regulators didn't have real-time access to trading data to determine the cause.

Having been involved in financial markets regulation for the better part of 37 years, I can tell you it is very frustrating to not have the necessary data to pinpoint the cause of a market event. That data is a necessary step in working toward a solution to prevent it from happening again, and investors often rightly assume that regulators already have all the data they need.

Last July, staff from the responsible agencies—the Treasury Department, Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, the SEC, and the Commodity Futures Trading Commission—published a joint report on the unusual trading activity that October day. The report highlighted four areas for additional work, including work to assess what U.S. Treasury cash securities markets data is currently available to the public and to regulators, and continuing efforts to strengthen surveillance and to promote inter-agency coordination related to U.S. Treasury market trading.

The U.S. Treasury Department is now signaling its intention to expand the transparency regime to Treasury securities and foster more informative collection of trading data for Treasuries. As part of the process, Treasury staff is gathering industry feedback on how best to achieve that goal through a request for information issued last month.

While various agencies and trading venues publish data related to order and trade activity for treasuries, there are differences in pre- and post-trade public reporting—especially between futures and Treasury cash securities. And the level of publicly available information is often not consistent across Treasury market venues or products. The U.S. Treasury is now looking to standardize that data and data dissemination requirements.

Even with equities, where we have a mature transparency framework, is there more we can do? Absolutely. A substantial percentage of trading today takes place in dark venues, which lack transparency in many respects. For example, the orders placed in a dark pool are not displayed; and while a trade, once executed within a dark pool, is reported to the tape, the trading by an individual dark pool is not separately identified. So while dark pools have their place in the financial market ecosystem, subject to appropriate regulation, we are right to be concerned about their lack of transparency.

Some changes are already underway. At FINRA, we have taken steps to increase market transparency of alternative trading systems, including all market facilities commonly called "dark pools." We currently make the volume and trade count information for equity securities executed in an ATS available on the FINRA website, and plan later this year to start providing additional data about the levels of block activity within ATSs. And starting in April, we will publish the remaining equity volume executed over-the-counter by FINRA member firms, including the trading activity of non-ATS electronic trading systems and internalized trades. This information will be available free of charge to all users on FINRA's website, and will help investors better understand a firm's trading volume and market shares in the equity market.

On the fixed income side, there's room for improvement as well. We are seeing increased trading of TRACE-eligible securities in dark pools, greater use of request-for-quote processes, and more executions of customer orders by firms that participate as both broker and as dealer. Among the issues we should consider is how we can apply the transparency principles of the national market system that governs stock trading to bonds.

Among the concerns is whether there is a role for pre-trade transparency that will afford investors better information to assess prices and valuations. Of course, FINRA understands broad concerns about pre-trade transparency telegraphing what a market participant with a large order is doing, and that issue has to be addressed. But, as the fixed income market continues to expand, it's time we look more closely at whether we can bring the benefits of a national market system to the fixed income area.

Volatility and Liquidity

The second point I'll raise is market volatility and liquidity. Since the May 2010 flash crash, the SEC, FINRA and U.S. stock exchanges have implemented a variety of initiatives to minimize the impact of extreme volatility, the causes of which can vary from market forces to technological malfunctions. These initiatives have created a multi-faceted safety net for the markets and are designed to promote investor confidence. Among the changes, regulators adjusted the market-wide trading pause, which gives market participants an opportunity to assess their positions, valuation models and operational capabilities when extreme periods of volatility occur.

On top of that, we implemented a limit up/limit down initiative, which addresses the type of sudden price movements that the market experienced during the flash crash. Under the plan, a limit up and limit down mechanism prevents trades in national market system stocks from occurring at prices outside of certain ranges. And if the changes in price are more significant and prolonged, the limit up/limit down plan would trigger a trading pause in that security.

We had an excellent opportunity to evaluate the effectiveness of these changes last August 24th, when the Dow plummeted more than 1,000 points within the first 10 minutes of trading. The events of last August illustrated not a market out of control, but the value of having appropriate controls in place. Were it not for the limit up/limit down procedures, the market fluctuations last August would have been more dramatic. There were more than 1,200 trading pauses that day, with more than 1,000 occurring in exchange-traded products, many of which were repeats in the same ETP. Clearly, the August events showed that refinements to these processes are serving a crucial function, but also showed that additional enhancements are necessary.

For example, while the index recovered a portion of the early losses, the extreme volatility raised questions about the operation of exchange-traded funds, and equities, more generally. One of the issues that day was the big gaps between the value of underlying indexes and the exchange-traded funds that track them. ETFs combine aspects of mutual funds and conventional stocks. They operate like a mutual fund by offering an investor an interest in a professionally managed, diversified portfolio of investments. Unlike mutual funds, however, ETF shares trade like stocks on exchanges and can be bought or sold throughout the trading day at fluctuating prices, whereas mutual funds are priced just once at the end of the trading day. On August 24th, unusual trading affected many of the major ETFs. While trading volume surged, public display of trading interest—or liquidity—dropped. And we saw pricing volatility in ETFs because of the conflicts between halts on the underlying stocks within the indices and the pricing of the index.

The volatility and the issues we saw with ETFs offers up a great opportunity for the SEC, with input from its recently formed Equity Market Structure Advisory Committee of which I'm a member, to take another look at the effectiveness of the initiatives put in place after the 2010 Flash Crash, as well as our market structure generally. Among the issues ripe for review are:

• the opening processes on primary listing exchanges;
• the operation of the limit up/limit down at the opening of trading, at re-openings after a trading pause and where the price is rebounding;
• the use of single market prices rather than consolidated prices for index calculations at times when the primary market opens outside its normal process;
• the use of stop orders, which become market orders when triggered and can execute at a price substantially worse than anticipated by the investor, particularly in volatile markets; and
• whether market maker quoting obligations are stringent enough to promote market stability.

Liquidity in the U.S. markets has thrived because of confidence in the markets, and investors need to be sure that markets will operate predictably. And it's important for us as regulators to implement programs that minimize the impact of market volatility and to limit market disruption.

Fairness

The third point I want to raise is market fairness. Investors must have confidence that they can access current, accurate, bona fide market prices that reflect true investor supply and demand.

Market structure must provide retail investors with accurate prices and low trading costs. Having been in this business for a long time, I've been part of many significant regulatory changes that have benefitted investors.

However, competition and regulatory changes have also led to a more complex, fragmented market. In today's increasingly fragmented market, bad actors can consciously disperse their trading activity across markets, asset classes, and broker-dealers in an attempt to hide their footprints and avoid detection. It is part of our job at FINRA to monitor what's happening in the market and ensure that the markets operate fairly.

It is absolutely critical that regulators have a bird's eye view across markets. Through our agreements with exchange clients, FINRA monitors trading in 99 percent of the listed equity market and 65 percent of the listed options market. We have the ability to pull together data across exchanges and alternative trading systems to see one big, virtual market instead of a disjointed patchwork of individual markets.

We developed an innovative cross-market surveillance program that allows us to run dozens of surveillance patterns and threat scenarios across the data we gather to look for manipulation and frontrunning, as well as layering, spoofing, algorithmic gaming and other abusive conduct. This sophisticated surveillance allows us to detect activities that we were not able to see before. For example, 47 percent of our cross-market alerts identify potential manipulative activity by two or more market participants acting in concert. And 60 percent of our cross-market alerts identify potential manipulation by a market participant on multiple markets.

As strong as our cross-market surveillance program is, the implementation of the SEC's proposed Consolidated Audit Trail, or CAT, which will collect, identify and link orders, trades and quotes in equities and options from all market participants, would also go a long way toward improving the ability of regulators to surveil the market. Currently, regulators don't have a single database with comprehensive and readily accessible order and execution data. Each regulator uses its own separate audit trail system to track information relating to orders in its respective markets. For its surveillance, FINRA must gather and merge large volumes of data from different entities to analyze market activity. A consolidated audit trail that functions on a near real-time basis would significantly enhance regulators' ability to monitor and analyze trading activity. By having unique identifiers for accounts, better order audit trail information for options, more detailed information about each trade, and linkages between related equities and options trades, among other things, regulators' surveillance systems should be able to zero in on problematic trading, with the result being quicker and more exacting investigations that will better serve investors.

Close

You can see how interconnected these three areas are. If there is a widespread market operations failure, market transparency and liquidity are impaired and market fairness can be severely questioned. So it is imperative that regulators and the industry continue to work together to strengthen these interconnected areas to uphold the integrity of our financial markets, and rebuild investors' trust in the securities markets.