Thank you for that kind introduction. Before I begin, I should remind you that the views I express here today are my own and do not necessarily reflect those of the Securities and Exchange Commission or my fellow Commissioners.
The Securities and Exchange Commission is better equipped to make sound decisions in discharging its regulatory responsibilities when we receive the thoughtful input of organizations such as the Security Traders Association and its members. Accordingly, I would like to start by thanking STA for its longstanding active participation in the regulatory process and for the invitation to speak to you this afternoon at STA's 77th Annual Conference and Business Meeting. I welcome the continuing dialogue with you â€â€� as I do with others who engage the Commission — as we work to promote the public interest by protecting investors; maintaining fair, orderly, and efficient markets; and facilitating capital formation.
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I last spoke to an STA gathering on May 6, 2009, at the Association's 13th Annual Washington Conference. A lot has happened since then. Among other things, we experienced the so-called "flash crash" of May 6, 2010, which prompted swift regulatory action, including the implementation of single-stock circuit breakers on a pilot basis;1 the President signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act, which overhauls our economy's financial regulatory infrastructure; the Commission advanced rulemaking initiatives concerning short selling,2 flash orders, 3 dark pools,4 options exchange access fees,5 large trader reporting,6 a consolidated audit trail,7 and sponsored access;8 and the Commission put forth a concept release on equity market structure to receive input on a range of topics, including high frequency trading, co-location, data feeds, market fragmentation, order execution quality, and the interests of "long-term investors" as compared to those of "short-term professional traders."9 In addition to these and other regulatory developments, the Commission has pursued an active enforcement agenda.
It is no wonder, then, that STA decided that the theme of its conference this year would be "Wall Street & Washington: Finding the Balance."
There is much to say about the relationship between the government and the private sector. Indeed, volumes have been written over centuries that speak to the question. For now, let me just say this: I am concerned that the appropriate balance is not being struck when it comes to the regulation of our financial system. The extent to which the recent wave of federal government regulation already has displaced and distorted private sector decision making in our financial markets is disquieting, and I remain troubled that future regulatory initiatives — notably, the regulations implementing Dodd-Frank — will go too far, unduly burdening the financial system at the expense of economic growth.
Dodd-Frank charges the SEC with extensive rulemaking that allows the Commission a great deal of choice and discretion to shape the legislation's practical contours and thus to determine Dodd-Frank's ultimate impact. Without question, there is a fundamental role for government, including the SEC, in overseeing our financial markets and our economy more generally; and financial regulatory reform affords us the chance to fashion a regulatory framework that is resilient and that fits our increasingly interconnected and complex financial system.
Yet even as we share the common goal of mitigating the prospect of a future financial crisis and look to fend off the hardship that such a crisis would spawn, we have to recognize the real-life costs to society if the implementing regulations excessively constrain and hamper the financial system. As we strive to further secure the financial system and protect investors and others from misfortune, we need to mind the risk that, as the regulatory regime becomes increasingly restrictive, financing may be more costly for companies and individuals to come by; the ability of businesses and investors to manage their risks appropriately may be compromised; fewer valuable investment opportunities that would create wealth and income for investors may become available; and innovation and competition in the financial sector may be dampened. The more confining and rigid the regulatory regime becomes, the more likely it is that financial firms will lose the business flexibility they need to provide the full range of products, transactions, capital-raising techniques, and services that benefit companies, entrepreneurs, consumers, and investors. New regulatory strictures that end up burdening the financial system in this way come at the expense of our country's economic growth and our long-term standard of living.
This builds to a straightforward but important point — that is, we need to use the regulatory authority Dodd-Frank has conferred upon us cautiously, carefully evaluating the intended benefits of our actions while giving due regard to the potential undesirable consequences of our regulatory steps.10 This should include assessing the cumulative impact of the entire package of new regulatory demands to anticipate the overall effect of the regulatory regime when viewed as a combined whole. We must approach our regulatory responsibilities with humility, appreciating the complexity of the challenges before us, to ensure that we succeed in striking appropriate balances when we exercise the choice and discretion Dodd-Frank entrusts to us as regulators.
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I now want to turn to the topic that will occupy the balance of my remarks this afternoon — equity market structure — and highlight two collections of thoughts that guide my analysis of our equity markets and the various regulatory initiatives that the Commission has advanced to date or may put forth in the future.
First, data, to the extent available, and rigorous economic analysis should drive the evaluation of our equity markets and how they are regulated. Data not only allow the Commission to leverage its expertise, but empirical analysis can serve as a firm foundation upon which the Commission can resist external pressures — be they pressures to regulate or deregulate — if those pressures encourage us to follow a course that is not in the best interests of investors. Indeed, the pendulum does swing between periods when regulators are urged to act more aggressively and climates that are more deregulatory, and excess is possible in both directions.
To start with, it is worth emphasizing that the data we have today — as reflected, for example, in the extensive comment the Commission has received in response to our market structure concept release — substantiate that the U.S. presently enjoys high quality markets that have performed extremely well, including during the financial crisis. The data consistently show, among other things, that bid-ask spreads are narrow; that execution speeds have fallen; that liquidity has increased; and that commissions for retail investors have decreased. Concerning the turmoil of 2008, although price declines and volatility led to investor losses and unease, U.S. equity markets opened and closed in an orderly fashion and transactions cleared. Unfortunately, this overall positive story of our equity markets does not seem to get its appropriate due, as more discrete aspects of market structure get singled out for criticism.
This is not to say that there is no room for improvement. Instead, it is to underscore what can be viewed as the risk-reward tradeoff of additional regulatory steps that further engineer our equity markets. More specifically, given that, on the whole, U.S. markets already perform very effectively according to a host of measures, one has to weigh whether the incremental benefits of suggested regulatory initiatives are worth pursuing given the initiatives' corresponding costs. In other words, one has to assess whether the intended benefits of the additional regulation are substantial enough to justify the risk that the new regulatory demands might blunt innovation, inhibit productive trading activities, and constrict investor choice.
Empirical analysis remains key throughout the entire process of evaluating opportunities for improving the performance of our markets, not just in informing the overarching perspective of U.S. equity markets as being high quality. For example, some have identified various equity market features and dynamics that concern them, such as the level of undisplayed liquidity and the impact of high frequency trading. I welcome the active discussion of these and other important topics. But in rendering policy judgments, it is important to allow the data to channel the regulatory agenda in the directions that are most productive.
More to the point, it is one thing to posit that a problem exists; it is another to demonstrate it empirically. It is not difficult to fashion an example to illustrate that an activity that presently benefits society could be appreciably harmful under circumstances that, although they do not exist today, could exist in the future, at least in theory. To what extent, though, should such speculation about a potential but still unrealized harm spur regulatory action? Should we first have to approximate the probability that the harm will come to pass and the magnitude of the harm if we were visited by it? It seems to me that some concerns simply are too speculative to justify regulation that puts at risk private sector behavior that in fact has benefitted society. For that matter, some potential costs of regulation may themselves be too speculative to recommend against further reforms.
To be clear, in considering the role that data should play in regulatory decision making, the touchstone should not be whether or not grounding decisions in the rigorous analysis of data will result in more or less regulation. Rather, the purpose of relying on data is that data have a way of disciplining decision making so that we make better, more informed choices in discharging our regulatory duties.
If you will allow me one final point on data it is this: I want to say "thank you" to the staff in the Commission's Division of Trading and Markets for their extraordinary efforts in the aftermath of the May 6 "flash crash." I greatly appreciate the staff's dedication, as they have worked tirelessly to reconstruct what occurred that day, poring over an incredible amount of data. I expect that the staff's painstaking work will provide an instructive empirical basis to build upon in determining what, if any, additional regulatory steps are warranted in May 6th's wake.
My second collection of thoughts centers on competition. The high quality of our equity markets depends on robust competition that spurs innovation and expands the options investors enjoy to receive the best executions. Investors benefit when liquidity is forthcoming, prices are more efficient, and trading costs are minimized. For these results to obtain — and thus for investors to benefit to the fullest extent — the regulatory regime must permit exchanges, ATSs, and other market participants due flexibility to innovate new products, services, and trading opportunities that advance the varied interests of investors by affording them a wide range of choices. Relatedly, it is important to guard against imposing undue regulatory demands that erect barriers to entry that keep entrepreneurs and other new entrants from starting up, thus reinforcing the position of established interests.
This perspective offers a partial lens through which to view market fragmentation. Simply put, while market fragmentation has long been a regulatory concern and is again the subject of serious consideration, it is important to consider that the advancement of different trading venues is a key source of competition. Technological developments and other innovations that link trading venues by facilitating the search for liquidity can contribute to high quality markets by allowing investors to take advantage of the diverse choices competition affords them, even though the sheer number of trading venues might suggest a fragmented market structure at odds with the goals of a national market system.
I want to conclude this thought by bringing one point into sharper relief: To flourish, innovation needs to be rewarded. Market participants — be they exchanges, broker-dealers, investors, or others — expect that they will be rewarded when they invest in the latest technology and develop their skills to gain a market edge. When the regulatory regime erodes a market participant's opportunity to profit from its legitimate competitive advantage, the incentive to innovate is dampened and investors forego the gains they would have enjoyed had the innovation come to fruition.
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Having spoken more generally up to this point, let me briefly address two specific topics that have received attention lately. The first is the Commission's proposal to establish a consolidated audit trail; and the second concerns high frequency trading.
A fundamental charge of the Commission in administering the federal securities laws is to detect and root out fraud and manipulation. In May of this year, the Commission proposed a rule that would provide for a consolidated audit trail that the SROs would establish and maintain.11 The expectation is that the consolidated audit trail would, if implemented, better position regulators in fulfilling their surveillance and other law enforcement obligations. Regarding the Commission, not only would the audit trail afford the agency more efficient and timely access to important market information, but the consolidated nature of the information would offer the Commission a more comprehensive look at trading activity across markets, thus better equipping the agency in identifying and pursuing potential violations. Furthermore, the Commission would enjoy added insight into our markets that could inform the agency's rulemaking agenda by highlighting areas of concern or, alternatively, assuaging suspicions that otherwise might have prompted regulation.
That said, the cost to implement the consolidated audit trail, as proposed, would be considerable. I continue to believe what I expressed at the open meeting when the Commission approved the proposal — namely, it is important to explore refinements to the proposal and alternative approaches that could reduce costs but without appreciably frustrating the consolidated audit trail's functionality. For example, should a more limited consolidated audit trail be pursued if it could be up-and-running more quickly than the more comprehensive audit trail the proposal contemplates? To what extent is real-time reporting necessary to ensure that the audit trail serves its intended purposes? As compared to reporting that occurs on a modestly delayed basis, do the incremental benefits of real-time reporting warrant the additional costs?
The comments the Commission has received provide a number of insights and suggestions for how to scope the audit trail so that it is both efficient and effective. I look forward to continuing to review the comments and giving the proposal careful consideration.
Attention has also focused lately on high frequency trading. The Commission's market structure concept release, for example, notes that high frequency trading is "[o]ne of the most significant market structure developments in recent years" and solicits comment on a range of related topics, including the role of high frequency traders as "passive market makers," to use the release's term. The events of May 6 have galvanized further interest in the role of high frequency trading, particularly insofar as high frequency trading is a key source of market liquidity.
So I will conclude my remarks today by addressing the following question: To what extent, if any, should high frequency traders, by virtue of their active and rapid buying and selling, be subject to the kinds of obligations that registered market makers traditionally have been or are currently subject to?
Questions of this type were posed in the Commission's concept release, but the concept of imposing market-maker-type obligations on high frequency traders was accentuated when liquidity dried up during the May 6 "flash crash." Some have suggested that if a high frequency trader, in practice, serves to make markets, then perhaps the trader should be obligated to buttress the market by providing liquidity during periods of stress, such as we experienced on May 6, even if the trader would not have voluntarily registered as a market maker.
I do not have time to offer detailed thoughts, but do want to express one take grounded in what seems to be a reasonable view of a trader's incentives. During periods of stability, the value of subjecting high frequency traders to market maker obligations is not self-evident. In short, when liquidity already is forthcoming and equity markets are not stressed, one has to question what the benefit is of imposing obligations that are intended to bring forth liquidity. Yet these obligations are a burden that traders nonetheless would have to account for. One, therefore, has to consider that expanding the reach of market maker obligations may establish the equivalent of entry barriers that discourage market participation and may incentivize traders to cut back on the liquidity they provide to avoid triggering whatever obligations are imposed.
Moreover, it may be difficult to impose market maker obligations on high frequency traders without affording them some form of compensation, such as by granting them privileges, as specialists themselves used to enjoy. Another mechanism by which high frequency traders might be compensated for bearing regulatory responsibilities is by widening their spreads. It would be unfortunate for investors if, as a result of burdening a wide swath of liquidity providers with new obligations, the quality of our markets actually deteriorated during the overwhelming majority of trading days when liquidity would be plentiful in the absence of expanded market maker obligations.
On the other hand, if our equity markets were under exceptional stress, and the rational economic interest of a trader providing liquidity was to exit, there is reason to query whether any set of obligations could keep that liquidity in the market to shore it up. Assume the market is experiencing an abnormally unstable time, with prices dropping precipitously and volatility spiking for reasons that are inexplicable based on the information that is then available. The typical high frequency trader — who generally may be prepared to provide liquidity — may face a relatively straightforward set of choices in this environment. One option for the trader would be to fulfill its market maker obligations and risk suffering significant financial losses that, in the extreme, could cause the trader to fail. The trader's second option would be to escape its obligations and curtail its trading considerably, including the prospect of completely withdrawing from the market. At least in that case, the trader would have assured that it withstood the market decline. This vignette obviously is stylized and oversimplified, but it nonetheless serves my purpose, which is to illustrate the difficulty of using regulation to force a trader to transact against its best interests.
All of this can be recast as yet another question: To the extent imposing market maker obligations on high frequency traders would not, in practice, meaningfully induce liquidity when it is needed most, is burdening liquidity providers with such regulatory responsibilities warranted?
There still is much to consider — including the relevant data — when it comes to high frequency trading, and I look forward to the continuing dialogue and to continuing to benefit from commenters' input.
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As you can imagine, it is an extraordinarily busy time at the Commission. Therefore, I would like to end my remarks by thanking the entire staff of the Commission — both those who are here in Washington and the staff who work in our regional offices — for their professionalism and commitment shouldering so many significant responsibilities. Speaking more personally, I continue to be honored and humbled by the opportunity to serve at the Commission, especially during such a historic period.
Thank you.