Senate Subcommittee Questions Industry Insiders on Market Structure Issues

Market structure issues including flash orders, dark pools, high frequency trading and sponsored access were the focus of a Senate subcommittee hearing this morning. Lawmakers gathered to question industry participants and the SEC’s Co-Acting Director of the Division of Trading and Markets, James Brigagliano, and gather information on these topics.

Senator Ted Kaufman (D-DE) set the tone with his opening remarks that, “Technological developments have far outpaced regulatory oversight.” He added, “We risk creating a two-tiered market that is opaque, highly fragmented and unfair to long term investors.”

Kaufman said that flash orders, liquidity rebates, direct access, dark pools, indications of interest (IOIs) and payment for order flow are all the direct result of fragmentation and the 60 centers that all compete for market share.

But not all agreed with the senate and the SEC’s call for broad market reform. William O'Brien, Chief Executive Officer, Direct Edge, said in his testimony that the current market structure is fundamentally fair and sound and that it is performing as well as it ever has. He added that trends and change obviously dictate continual review of market structure but that should not be confused with a broader need to re-architect the market.

“All brokers in some form have adapted high frequency technology so retail orders can be executed in less than a second,” he added.

“Exchanges play a critical role in price discovery and there are benefits to trading off exchange as well,” said O’Brien, adding that its important to keep exchanges relevant and not drive exchanges and non-exchanges apart.

“Brokers are those best suited to decide how to execute customer orders and how to use the tools provided by the exchanges,” said O’Brien.

On the dark pool front, Brigagliano, said in his testimony that “collectively darkness is harming the markets but individually dark pools are helpful.”

Daniel Mathisson, Managing Director and Head of Advanced Execution Services at Credit Suisse, noted, “Much of the debate over dark pools has not been properly focused.”

“Dark pools only make up about 7 percent of U.S. stock volume,” said Mathisson. “They will always remain a niche trading product and will not lead to the end of publicly displayed bids and offers.”

Peter Driscoll, Chairman of the Security Traders Association and VP and Senior Equity Trader at The Northern Trust Company, concurred, “While we understand the price discovery concerns and believe that at some point degradation may occur, we do not feel that with dark volumes trending around 10-15 percent of overall volume we are anywhere near that degradation point.”

Driscoll added that moderation is key and an efficient market structure can include the coexistence of alternative liquidity pools and public quoting venues. “As long as we keep the appropriate level of order flow pumping through the price discovery process we should not see negative effects from this coexistence,” he said.

But Mathisson advocated strongly for equal access to dark pools. “We propose that the Fair Access provision of Regulation ATS be changed to force all dark pools to be open to all broker-dealers, and through those broker-dealers, to the investing public,” he stated.

He explained that objective standards could be put in place to maintain a level of membership but ensure equal access to all venues. Mathisson noted that traders could be shut out based on order size or the time they want to leave orders in or disciplinary action history.

“I think it can be done in an objective way so that anyone who meets the criteria is in but anyone that doesn’t is out,” he said. “I don’t think they should be able to shut out brokers they perceive to be competitors.”

Robert Gasser, President and Chief Executive Officer at Investment Technology Group (ITG) whose Posit venue sees the vast majority of its volume solely from the buy side, respectfully disagreed with Mathisson. “There are a lot of broker dealers that have competing business models and some have principal trading objectives and our focus is on the client and the quality of execution,” he said.

Driscoll agreed, “I don’t want my orders going in to fuel somebody’s proprietary trading engine, I want to know who is in the pools and who I am trading with.”

“Market fragmentation does not harm market quality,” said Gasser. He added that he does support efforts to increase post-trade transparency and believes the data will help market participants better measure execution quality and make better routing decisions.

Driscoll stated that limited dark pools is not the answer and that instead increasing access and transparency are key.

There was also muted concern over high frequency trading form the industry witnesses. When asked about high frequency trading, Driscoll explained, “When I have an order I’m working and I see a high frequency trader has sniffed it out I’ll take the order out and wait. That is part of the job of an institutional trader is to trade against these people.”

In response, Senator Bob Corker (R-Tenn.) said he gathered that high frequency trading has made the cost of transactions far less for the investing public. He added that while it may sound like a bad thing, “looks to me that generally there are lots of attributes these market makers are bringing.”

Senator Chuck Schumer (D-NY) was also on hand and advocated for his proposed consolidated market surveillance for all trading venues. The witnesses agreed that consolidated surveillance was necessary and Brigagliano even said the SEC has an inter-division task force working on it.

Driscoll cautioned though that a harmonized surveillance model might be a better choice. He wanted to ensure that the marketplaces keep the nuances that make them unique. “The regulators from Nasdaq understand their marketplace to a much higher degree than someone from say the NYSE regulation department so those people have to have the ability to continue working,” he noted.