March 25, 2015
Today, the Commission considers a proposal to amend Rule 15b9-1, which exempts certain broker-dealers from the obligation to hold membership in a registered national securities association.[1] The proposed amendments are intended to realign the rule with current market practices and to curtail the use of this rule by certain high-frequency traders in order to avoid the membership requirement. The proposal being considered today represents an important step in improving market oversight.
Our securities markets looked quite different in 1965, when the Commission adopted Rule 15b9-1´s predecessor.[2] At that time, much of the trading in listed securities occurred on the floors of stock exchanges through specialists and floor brokers, who served as the nexus for buy and sell orders.[3] Rule 15b9-1 did not require these floor members to join an association because their business centered on a single exchange. These floor members were, however, permitted to engage in a de minimis amount of off-exchange activity, such as receiving commissions for client referrals[4] and conducting proprietary trading to hedge their positions.[5] These exceptions to association membership were appropriate at the time because they were tailored to the circumstances and ensured that the bulk of these entities´ trading could be monitored.
Of course, today´s markets look quite different. Electronic trading has achieved an unshakeable dominance, and has greatly reduced activity on the trading floors of equity exchanges.[6] Floor trading has retained a toehold in the options markets for the time being.[7] More importantly, the advent of electronic trading has given rise to a new breed of market participant that was wholly unforeseen—and wholly unforeseeable—at the time the Commission last revisited the substance of Rule 15b9-1 in 1983.[8] I am referring, of course, to active, cross-market proprietary traders, or what are more colloquially-known as high frequency traders.[9] High frequency traders, or HFTs, are now responsible for almost half of all the trading that takes place on alternative trading systems, or ATSs.[10] Despite this tremendous trading volume, certain HFTs have been relying on Rule 15b9-1´s exception for proprietary trading to avoid the requirement of membership in a registered national securities association. The proposed amendments will bring this to an end.
Being able to identify and respond to emerging trends is the hallmark of any effective regulator. Although long overdue, the proposed amendments are intended to bring Rule 15b9-1 in line with the realities of today´s securities markets. Specifically, the proposed amendments, if adopted, would achieve three things:
These changes are generally appropriate and should achieve their stated goals. But, there are some causes for concern. First, the Commission currently has no data regarding the nature or extent of floor members´ current hedging activities. Unless firms provide such data, it will be difficult for the Commission to make an informed decision as to whether the proposed hedging exemption is warranted and appropriately tailored. Second, the release includes questions suggesting that the Commission may consider expanding the hedging exemption to include other, as yet unspecified, activities. This is a discordant note in an otherwise measured approach, and it would not be prudent to pursue this course unless commenters demonstrate a legitimate need for such an expansion, and justify that need with reliable data.
Turning to the proposal to end certain HFTs´ reliance on Rule 15b9-1, it is important to understand that this will bring the largest HFTs within the supervision of an association or the exchanges that execute their trades. Why is this so important? There are several reasons.
Requiring HFTs to become members of a registered national securities association or of all the exchanges on which they trade will provide a more complete and detailed picture of their cross-market trading activity. This will help regulators develop a richer understanding of HFTs´ behavior, and every effort should be made to leverage this understanding into a more effective market oversight program. In particular, regulators should use the additional information they would receive under the proposed amendments to fine-tune their surveillance techniques to the unique issues posed by HFTs. This will improve efforts to ferret out potential trading abuses, and help regulators spot new types of abuses that may develop in the future.
In conclusion, I will vote to approve these proposed amendments because they mark a significant step forward in the Commission´s efforts to enhance the oversight of our options and equities markets. I recognize, however, that there is still much work to do to ensure that our regulatory regime keeps pace with developments in a rapidly evolving marketplace.
In closing, I commend the staff for their efforts in developing and refining these rules and amendments. In particular, I would like to call attention to the efforts of the Division of Trading and Markets, the Division of Economic and Risk Analysis, and the Office of General Counsel. I appreciate your hard work and diligence.
Thank you.
[1] Exemption from Registration for Certain Exchange Members, SEC Release No. XXXXX (Mar. 25, 2015) (S7-XX-XX).
[2] SEC Release No. 7697 (May 18, 1965), 30 FR 11673 (May 29, 1965).
[3] Report of the Special Study of the Securities Markets of the Securities and Exchange Commission, Chapter VI, 41-42, 46, 98 (July 17, 1963) (describing in detail how orders are routed to floor brokers on the New York Stock Exchange and elsewhere for execution, that floor brokers are "those Exchange members who actually execute orders on the floor of the Exchange as agents for others" and that "[t]rading by NYSE members on the Exchange but from off the floor accounts for approximately 5 percent of total Exchange purchases and sales . . . .")), available at http://3197d6d14b5f19f2f440-5e13d29c4c016cf96cbbfd197c579b45.r81.cf1.rackcdn.com/collection/papers/1960/1963_SSMkt_Chapter_05_1.pdf.
[4] SEC Release No. 7697 (May 18, 1965), 30 FR 11673 (May 29, 1965).
[5] SEC Release No. 12160 (March 3, 1965), 41 FR 10599 (March 12, 1976).
[6] Jeremy Olshan, This is the last photo we´ll ever run of the NYSE trading floor, MarketWatch (Oct. 1, 2014) (quoting Eric Scott Hunsader, founder of market-data provider Nanex, as saying that the amount of trading that occurs on the NYSE´s floor is "pretty darn close to zero," and that "[e]ven that is pushing it, because they don´t make markets, the guys in the jackets [on the NYSE trading floor]. They might say they do, but they don´t."), available at http://www.marketwatch.com/story/this-is-the-last-photo-well-ever-run-of-the-nyse-trading-floor-2014-10-01; see also Matthew Philips, How the Robots Lost: High-Frequency Trading's Rise and Fall, Bloomberg (June 6, 2013) (noting that "market makers on the floors of the exchanges" were "[a]mong the . . . first prey" of one of the earliest HFTs, an entity called Automated Trading Desk), available at http://www.bloomberg.com/bw/articles/2013-06-06/how-the-robots-lost-high-frequency-tradings-rise-and-fall.
[7] ‘Fungibility´ Leads to Multiple Options Exchanges, Markets Media (Sept. 5, 2014) (noting that, in the wake of the successful launch of the all-electronic International Securities Exchange, "the vast majority of options volume is now traded electronically," and that "there really isn´t a lot of activity on the floor these days anymore."), available at http://marketsmedia.com/fungibility-gives-rises-multiple-options-exchanges/.
[8] See SECO Programs; Direct Regulation of Certain Broker-Dealers; Elimination, Exchange Act Release No. 20409 (Nov. 22, 1983), 48 FR 53688 (Nov. 29, 1983).
[9] Matthew Philips, How the Robots Lost: High-Frequency Trading's Rise and Fall, Bloomberg (June 6, 2013) (noting that "market makers on the floors of the exchanges" were "[a]mong the . . . first prey" of one of the earliest HFTs, Automated Trading Desk), available at http://www.bloomberg.com/bw/articles/2013-06-06/how-the-robots-lost-high-frequency-tradings-rise-and-fall.
[10] Exemption from Registration for Certain Exchange Members, SEC Release No. XXXXX, [p.12] (Mar. 25, 2015) (S7-XX-XX).
[11] Non-Member Firms that engage in off-exchange transactions are not required to submit audit trail data to FINRA. See FINRA Rules 6610 and 6622(a)(i). When a Non-Member Firm routes an order to a FINRA member which then routes the order to an exchange or off-exchange for execution, OATS data would only indicate that the FINRA member received an order from a Non-Member Firm. The identity of the Non-Member Firm is often not captured because such Non-Member Firms are not required to use a unique Market Participant Identifier ("MPID") or other identifier when routing orders to a FINRA member. In some cases, FINRA is able to identify the Non-Member Firm that participated in a transaction if, for example, it has an MPID and provides it to the firm to which it routed an order and that firm reports it to FINRA. FINRA has solicited comment from its members on a proposed FINRA rule change that would require FINRA members to identify Non-Member Firms in off-exchange transactions reported to OATS. See Equity Trading Initiatives: OATS and ATS Reporting Requirements, FINRA Regulatory Notice 14-51 (Nov. 2014), available at http://www.finra.org/sites/default/files/14-51.pdf. This proposal has not yet been filed with the Commission pursuant to Section 19(b)(1) of the Act. 15 U.S.C. 78s(b)(1).
[12] Richard G. Ketchum, Restoring Investor Trust in the Markets, Remarks from the 2014 FINRA Annual Conference, 6 (May 19, 2014), available at https://www.finra.org/newsroom/speeches/051914-remarks-2014-finra-annual-conference. Chairman Ketchum also noted that, as of last May, FINRA had more than 170 investigations opened concerning abuses stemming from the algorithms on which HFTs rely. Id.
[13] Regulation of Exchanges and Alternative Trading Systems, SEC Release No. 40760 (Dec. 8, 1998), available at https://www.sec.gov/rules/final/34-40760.txt.
[14] The Department of Justice, the Commission, and the New York Attorney General have either opened investigations into the legality of HFT practices or filed claims against HFT firms. Dina ElBoghdady, Justice Dept. investigating high-frequency traders, Washington Post (Apr. 4 ,2014), available at http://www.washingtonpost.com/business/economy/justice-department-investigating-high-frequency-traders/2014/04/04/e77d1cb4-bc00-11e3-9c3c-311301e2167d_story.html; In the Matter of Athena Capital Research, LLC, AP File No. 3-16199, Securities Exchange Act Release No. 73369 (Oct. 16, 2014), available at http://www.sec.gov/litigation/admin/2014/34-73369.pdf; Scott Patterson, N.Y. Attorney General Sends Subpoenas to High-Speed Firms, The Wall Street Journal (Apr. 16, 2014), available at http://www.wsj.com/articles/SB10001424052702304626304579505931086501344. In addition, private lawsuits have been brought alleging that HFTs have engaged in illegal activity. See, e.g., City of Providence v. BATS Global Markets, Inc. et al., Civ. Action No. 1:14-cv-02811-KMW (S.D.N.Y. filed Apr. 18, 2014) (alleging that HFTs engaged in unlawful trading practices), available at http://wallstreetonparade.com/wp-content/uploads/2014/05/show_temp-HFT-complaint.pdf; Owen Davis, High-Frequency Trading Lawsuit: Algorithmic Traders Sue Other 'Flash Boys' Over 'Spoofing', International Business Times (Mar. 16, 2015), available at http://www.ibtimes.com/high-frequency-trading-lawsuit-algorithmic-traders-sue-other-flash-boys-over-spoofing-1846734.
[15] Daniel Frick and Austin Gerig, Liquidity Risk, Speculative Trade, and the Optimal Latency of Financial Markets, U.S. Securities and Exchange Commission, DERA Working Paper Series (noting that "[a]lthough there is evidence that some of these high-frequency traders . . . do not provide liquidity, the evidence suggests that a majority do" and that HFTs´ "low-latency trade can be beneficial."), available at https://www.sec.gov/dera/staff-papers/working-papers/dera-wp-liquidity-risk.pdf; Austin Gerig and David Michayluk, Automated Liquidity Provision, U.S. Securities and Exchange Commission, DERA Working Paper Series (noting that "automated liquidity providers" like HFTs "cause prices to be more efficient."), available at http://www.sec.gov/dera/staff-papers/working-papers/dera-wp-automated-liquidity-provision.pdf; Joseph E. Stiglitz, Tapping the Brakes: Are Less Active Markets Safer and Better for the Economy? Federal Reserve Bank of Atlanta 2014 Financial Markets Conference, Atlanta, Georgia, 4-11 (Apr. 15, 2014) (asserting that high frequency trading can lead to "less informative" and "less liquid" markets), available at https://www.frbatlanta.org/news/conferences/2014/140415-fmc/agenda.aspx; Lin Tong, A Blessing or a Curse? The Impact of High Frequency Trading on Institutional Investors, European Finance Association Annual Meetings 2014 Paper Series, 31 (Jan. 8, 2015), (finding "strong" evidence that high frequency trading increases the trading costs of traditional institutional investors), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2330053.