Aug. 2, 2016
Good morning and welcome to this August meeting of the Equity Market Structure Advisory Committee. I want to thank you all — members and panelists — for your continued hard work.
You are having a busy summer, which is great. Just last month, you made recommendations to the Commission concerning an access fee pilot and trading venue regulation reforms. I expect that the Commission will consider a recommendation regarding an access fee pilot later this year. I have also asked the staff to evaluate the trading venues recommendations, and they are exploring possible rulemakings to enhance the NMS Plan governance process.
Today's meeting features proposed recommendations from the Customer Issues and Market Quality subcommittees for the full Committee to consider. These recommendations build on the updates provided to the Committee by these subcommittees at the April meeting.
The Market Quality subcommittee's proposed recommendations focus on three topics: (1) the National Market System Plan to Address Extraordinary Volatility (commonly referred to as the Limit Up/Limit Down or LULD plan); (2) market-wide circuit breakers; and (3) the market opening. The subcommittee's work in this space complements the work the Commission and the SROs have been doing over the past several years on equity market volatility moderators. I have been asked to just quickly summarize those efforts to help put the subcommittee's recommendations in context.
The Commission and SRO regulatory efforts have focused on the unique issues that arise from electronic trading. While advancements in trading technology have obviously provided demonstrable benefits to investors and the markets, they also pose certain risks, including unchecked market volatility.
In our modern markets, electronic order books are used to aggregate trading interest and market participants use algorithms and other automated technologies to submit and cancel orders with great speed. This method of interaction in the market can lead to sudden liquidity imbalances and initial price moves which substantially reverse after liquidity balances are restored. We have seen this many times, both market-wide and at the individual stock level, and this type of volatility has occurred in non-equity markets as well. Events such as the Flash Crash of 2010, the Treasury market volatility of October 15, 2014, and August 24, 2015 have highlighted the volatility risks posed by our modern markets which require regulators to consider measures to mitigate those risks.
Our equity markets currently rely on two primary volatility moderators, market-wide circuit breakers and LULD. These mechanisms were created and modified in an attempt to address concerns that were highlighted by the equity Flash Crash of May 6, 2010.
The late-day market volatility on May 6 did not trigger the then-existing market-wide circuit breakers, which at the time were set at 10, 20 and 30%. In the wake of that event, close consideration to the adequacy of market-wide circuit breakers was given by the SROs, regulators and the Joint SEC-CFTC Advisory Committee on Emerging Regulatory Issues. That scrutiny led to several changes.
First, the reference index used for measuring market decline was changed from the Dow Jones Industrial Average to the S&P 500 Index. This change was made because the S&P 500 Index is comprised of a broader group of securities and was seen as providing a better measure for market-wide volatility. The S&P 500 Index was also considered to be a better measure of cross-market volatility, as it is closely correlated to financial derivatives products such as the E-Mini and SPY.
Second, the trading halt duration was shortened from 30, 60, or 120 minutes to 15 minutes. And finally, the market decline thresholds were reduced from 10, 20, and 30% to 7, 13, and 20% respectively, as the prior circuit breakers levels had shown during the Flash Crash that they were not adequate to safeguard against unusual volatility. The lower thresholds and reduced trading halts duration were designed to balance the need to halt trading for significant declines while also minimizing any disruption resulting from a trading halt.
Today, this Committee will consider potential recommendations to further refine our market-wide circuit breakers. These recommendations arise out of the Market Quality subcommittee's thoughtful assessment of the events that occurred a year ago on August 24, 2015 and reflect concerns that a market-wide halt in trading would have exacerbated that particular volatility event.
I am keenly interested in the views of Committee members and our expert panelists concerning the proposed refinements. A challenge with any market-wide mechanism like these circuit breakers is that it needs to be optimized for a variety of different market conditions and volatility events. May 6, a late-day volatility event, failed to trigger these circuit breakers, leading to a subsequent narrowing of the thresholds. Trading on August 24, a volatility event at the market open, would have triggered the circuit breakers had stocks in the S&P 500 Index opened in a timely fashion, potentially exacerbating volatility that day.
Some questions the Committee may wish to consider include: How can market-wide circuit breakers be optimized, given the range of volatility events that can occur in our modern markets? What considerations should be balanced and how might those considerations weigh in favor of one version of a circuit breaker over another in different market conditions? Would widening the trading bands or using futures market data cause foreseeable issues for other volatility events or market conditions?
The Committee will also consider potential recommendations on refinements to LULD. The Committee's consideration of these recommendations is particularly timely: LULD has been in effect on a pilot basis for several years to allow the Commission and the SROs to evaluate its operation and whether it has achieved its objectives of dampening extraordinary market volatility and reducing erroneous trades. Extensive analysis related to LULD has already been done and further analysis continues that will inform our collective assessment of LULD for the future.
As you know, Commission staff has published research papers on the events of August 24, evaluating the operation of LULD and the specific reasons behind the significant trading pauses that occurred on that day. Among other things, that analysis showed that many of the pauses occurred as a result of prices moving back to their original trading range, after the initial significant declines. One recommendation being considered today is intended to address those particular pause events. I am interested in the discussion around this recommendation, including how to determine the appropriate price a stock could revert to, without triggering LULD halts.
As the Committee knows, the SROs continue to evaluate LULD and potential improvements that may be warranted based on observations regarding how effectively LULD has operated thus far, including on August 24, 2015. That work, among other things, is considering harmonization of current clearly erroneous execution rules with LULD and the advisability of coordinated reopening procedures. I am glad to see that these two important topics are among the subjects of recommendations being considered by the Committee today.
I am very interested in Committee member and panelist views regarding the potential limit state and trading halt modifications that the subcommittee has recommended. The LULD analysis done to date suggests that reopening auctions may not be working as well as intended. Unlike the opening and closing auction mechanisms that are successful at aggregating liquidity, it appears that market participants have not been participating at the same rate in the LULD reopening auctions.
In addition to hearing more detail about how these potential alternative processes would work, I look forward to hearing opinions from participants today about whether the market may be solving these particular issues on its own. In other words, as market participants continue to gain experience with LULD and their own trading protocols during specific volatility events such as August 24, are they changing their behavior and becoming more willing to participate in these reopening auctions?
This afternoon, the Committee will consider recommendations from the Customer Issues subcommittee. These recommendations touch on two topics: the first relates to the creation by the SEC of what I will call an investor sentiment benchmark; the second relates to additional enhancements to Commission rules 605 and 606.
As you know, the Commission recently proposed amendments to Rules 605 and 606, focusing on customer-specific institutional order routing disclosures and targeted revisions to the retail disclosure provisions of Rule 605. I welcome this Committee's input on further improvements to these important disclosure rules.
The Customer Issues subcommittee's focus complements the Commission's proposal, as the subcommittee's proposed recommendations primarily address potential changes that go beyond the scope of the Commission's recent proposal. Today's recommendations, for example, focus on broader improvements to the existing retail disclosures, including expanding 605 public reporting to broker-dealers, expanding 606 public reporting to exchanges and ATSs, and including additional reporting metrics in the existing 605 reports.
The Customer Issues subcommittee has noted that it will provide specific comments on the Commission's recent proposal, and today's recommendations before the Committee also touch on several discrete issues the Commission requested comment on in its recently proposed 606 amendments. These include dividing 606 data by S&P 500 Index stocks and other stocks rather than listing market, including a new section for OTC equity data in the 606 reports, and improving the accessibility of 605 and 606 reports. Again, I look forward to the Committee member and panelist views on these proposed recommendations, as well as on the proposal for the SEC to monitor individual investor sentiment to help inform our ongoing regulatory efforts. Investor confidence in our markets is of utmost importance, and we should strive continuously to seek new and innovative ways to receive their full input.
As your work today again demonstrates, this Committee continues to march through and tackle some of the most complicated and important issues facing our equity market structure today. Thank you very much for your work and commitment.