SEC Chair Mary Jo White has been reshaping the agency in the months since she joined the Commission. A new “get tough” policy has been adopted. Settlement procedures for enforcement cases have been modified to require admissions in select cases. A new financial statement fraud task force has been created. And, a new enforcement doctrine detailed in remarks delivered to the Council of Institutional Investors on September 26, 2013 (here).
Now the new SEC Chair is addressing market structure and the related issues. In remarks delivered on October 2, 2013, Ms. White addressed the Security Traders Association 80th Annual Market Structure Conference, Washington, D.C. Her address, titled Focusing on Fundamentals: The Path to Address Equity Market Structure (here), centered on the notion that “Gathering, disseminating, and analyzing data, testing assumptions about our complex, dispersed marketplace, and ensuring the integrity of market technology are the fundamental steps that are needed to address today’s market structure concerns in a responsible manner.” In developing this theme Ms. White detailed several critical points. What may be more interesting about her remarks is what she did not address.
Ms. White began with the straight forward notion that the key point for the U.S. capital markets is their integrity and the perception of fairness by investors and issuers. Capital formation depends on the participation of investors and public companies, the new SEC Chair declared. Critical to the process is not just the direct access of business to raise capital, but a secondary market since it “assures investors will have an efficient means of liquidating their positions if and when they choose. And a strong secondary market generates price discovery that helps efficiently allocate capital to the companies most able to put it to productive use.” This process depends on a market structure which generates confidence thereby attracting investors and companies.
While the U.S. markets are the envy of the world, in recent years the number of U.S. listed companies has significantly declined. Likewise, the number of U.S. households participating in our markets has declined since 2007. In analyzing these trends it is important to consider three fundamental points: 1) technology; 2) basic assumptions; and 3) market data.
There is no doubt that technology is fundamental to the markets today. In this regard it is important that there be operational integrity. Stated differently, the systems must work properly. While there is always a risk of failures, the proper steps must be taken.
There has been progress in this area, and the SEC staff has addressed the questions with new Regulation SCI. Yet more must be done in view of recent failures Ms. White stated. Accordingly, in a recent meeting with executives of exchanges, Ms. White requested that they develop a kind of action plan moving forward to address critical issues. Likewise, the exchanges and FINRA were requested to “prioritize” their efforts on a number of initiatives to make sure that when issues do arise they are resolved quickly.
In addressing questions of market structure it is also important that key underlying assumptions be rethought and changes made where necessary. One key assumption is the “one-size-fits-all” premise – that all markets must be the same. Following-up on one suggestion, Ms. White has instructed the staff to work with exchanges to consider a “plan to implement a pilot program that would allow smaller companies to use wider tick sizes.” Another assumption which must be critically evaluated is if “the current regulatory structure continues to meet the needs of investors and public companies. Does it provide sufficient flexibility for exchanges to implement transparent trading models that can effectively compete for investor orders? Does the current approach to self-regulation limit or support exchange trading models?”
Finally, market structure has to be grounded in empirical evidence. To this end the staff has been developing critical sources of information about the markets. One is MIDAS, the new system which became operational in January. This system collects one billion records each day from the consolidated tapes and the proprietary feeds of each exchange. Information from this new system, along with that from the new Large Trader Reporting Rule and the Consolidated Audit Trail Rule when implemented should enhance the ability of regulators to monitor the equity markets.
At the same time current sources of information are providing the SEC with significant insights. For example, “the staff has developed a data series tacking the total volume of visible orders at all the price levels sent to our public exchanges and comparing this volume to the total volume of shares actually traded. As expected, only a small percentage of orders sent to exchanges are not canceled and actually result in trades.” The staff has also “used this data to compare the speed at which exchange orders are cancelled to the speed at which orders are executed. Recent data on corporate stocks shows that almost two-thirds of all orders ‘rest’ for half a second or longer. . . These findings not only provide an empirical basis for measuring and tracking the speed of today’s markets, but also suggest that even short-lived quotes are generally accessible by at least some traders.”
To facilitate decision making based on data the Commission will, in the immediate future, make available a website where information from MIDAS, along with other research by the staff, will be available for the public. This will provide all investors with access to information which has typically been available only to select market participants.
Ms. White concluded noting that: “Ultimately, we must be able to show investors and companies that concerns about the current U.S. equity market structure can be properly diagnosed and, when needed, properly addressed.”
The premise of Ms. White’s remarks is fundamental: To attract investors and companies to the U.S. markets, and maintain them as the best in the world, there must be confidence in their integrity. That begins with operational integrity. In recent months there has been a series of incidents which raise significant questions regarding this point. The market outage several weeks ago is only the most recent. While there is little doubt that the SEC has put forth initiatives to try and address these issues, the difficulties persist. As Ms. White correctly noted, there is always the potential for difficulties given the highly complex technology which drives the markets.
At the same time, whether holding a meeting with executives and giving them what amounts to a “homework” assignment to come up with ideas represents an adequate solution is at best questionable. To be sure, those executives and exchange officials should have insight into the problems and their ideas should be solicited. Indeed, they have a vested interest in solving the difficulties. In the end, however, the SEC remains the regulator charged with supervising and maintaining the integrity of the U.S. markets.
Equally fundamental are the points that underlying assumptions should be re-examined and data and evidence should inform decisions. Again, there is no doubt that as the markets continue to evolve old ways of doing things should be evaluated, re-evaluated and modified as necessary. In making those decisions data such as that provided by MIDAS and other sources should prove critical. Making much of this data available on a new website should also help inform public debate and is commendable.
In all the discussion about data and markets what was not mentioned may, however, be most significant. One point we have learned from the data Ms. White noted is that most orders entered and displayed are not executed. Yet even short lived quotes “are generally accessible by at least some traders” she stated. While there may be reasons for orders not to be executed, it also suggest that in many instances investors and traders may be drawn to the markets by quotes offering an appearance of liquidity which is less than accurate. It may mean that at least in some instances investors may be lured to the markets by an appearance of liquidity created in part by orders which were put there only for that purpose and not for execution.
If some traders rapidly place orders which are displayed, attract investors and are then canceled moments later – a point which should be able to be confirmed at least in part by the data – it may suggest that certain participants are using the speed of the markets to create an illusion of liquidity, that is a false appearance. If this is the case, it presents a fundamental question about the integrity and fairness of the U.S. markets. That would undercut any claim of integrity by the U.S. markets while fueling a continued decline in investor participation. It would also undercut any “get tough” enforcement posture by the Commission.