With financial regulation being essentially overhauled in the wake of the 2008- 2009 financial crisis, the U.S. Securities and Exchange Commission is perhaps more relevant than ever for market participants.
On July 23, Markets Media sat down with senior staffers of the SEC’s Division of Trading and Markets at the agency’s Washington, D.C. headquarters for a roundtable interview. SEC participants were Jim Burns, deputy director of the division; Gregg Berman, senior adviser to the director of the division; and David Shillman, associate director of the Office of Market Supervision in the Division of Trading and Markets. What follows is an edited transcript of the discussion.
Jim, you were on Chairman Mary Schapiro’s staff for more than two years before joining the Division of Trading and Markets in May of this year. Can you talk about your work in that position as it pertains to the Division of Trading and Markets?
Jim Burns:I was initially the Chairman’s Trading and Markets counsel before becoming her Deputy Chief of Staff. About two months after I started working for her, May 6 (2010) hit. That was both a very exciting, challenging time for the Division and a time for self evaluation. Gregg Berman and David Shillman, along with Robert Cook and Dan Gray, are among the very knowledgeable individuals within the Division who were charged with tackling what that day meant and helping shape the response. But from the perspective of the Chairman’s Office, the charge to the Division was to get on top of this immediately -- what’s going on, what happened, why did it happen and what do we need to do about it.Both the analysis that followed and the portfolio of regulatory responses that the Division was very instrumental in rolling out with the SROs took a tremendous amount of thought and time. The fact that it took us a very long time to analyze what happened that day was instructive for us. We proposed the Consolidated Audit Trail a couple of weeks after that, and now two years later we’ve just adopted the rule laying out for the SROs what we expect to see in an audit trail.
Also during the time we were responding to May 6, Congress passed the Dodd-Frank Act, and market-structure initiatives had to compete for air time with the Dodd-Frank mandates. While the entire Commission had a lot to do, this Division in particular was taxed, with issues related to derivatives, issues related to credit-rating agencies, and an assortment of other new mandates. With Dodd-Frank, we were building essentially a new market from the ground up, and we are still very engaged in that project.
From the vantage point of the Deputy Chief of Staff, I can say that the Chairman wanted to see things get done, but she wanted to see things get done right. So notwithstanding a host of regulatory deadlines, you’ve seen the Commission approve a number of proposals and adopt what we hope are thoughtful rules to implement what Congress has asked us to do.
What are the biggest current initiatives of the Trading and Markets Division?
JB: We’re thrilled that the Commission adopted the Consolidated Audit Trail rule proposal. But to paraphrase Churchill, this is just the end of the beginning -- there’s a big task ahead as the SROs, working with various other market participants, bring an NMS plan to the Commission for its consideration. We’ve set nine months for them to do this. Once a plan is accomplished, it’s going to revolutionize our ability to monitor markets.
Gregg Berman: I think about the Consolidated Audit Trail as part of a three-phase approach to using data and analytics to further inform policy.
The first phase was to bring in people from the markets who can do market analysis, and who understand ‘big data’ and its analytical aspects. Each Division office is hiring quantitative people from a variety of different backgrounds.
The second phase is to have our people figure out what systems and data we need, and what analytics we need to be able to perform. The Office of Compliance, Inspections, and Examinations (OCIE), and the Enforcement, Trading and Markets, RiskFin, and Investment Management Divisions are all building out or buying new tools and systems and making very good use of that.
One of the earliest things the Commission put out was a completely revamped way of thinking about tips, complaints and referrals, or TCRs. There are new systems, as well as additional staff, who are doing a lot more monitoring using existing data, and recently we’ve had a very large initiative within the Division of Trading and Markets on a new real-time market-monitoring tool.
But even if you bring in the people and you bring in the tools and the analytics, that can only go so far because there are some things that we need to do as regulators that we cannot do. Even with 100 supercomputers, it’s still not going to help, because the information we need just does not exist in the industry. We can’t collect it because it’s not there, which is where the third phase, rulemaking, comes in.
Rulemaking is where the SEC instructs and mandates the industry that they must build something that collects new types of information or creates new types of information. That’s where things like large-trader reporting comes in, and of course the Consolidated Audit Trail. A lot of folks confuse CAT with a system that the SEC is building, when actually it’s an instruction that the SROs create a new audit trail and repository of information that otherwise just doesn’t exist in any usable form. Then the SEC and other regulators will be able to make use of that information.
Things like the Consolidated Audit Trail and Large Trader Reporting are the culmination of the broad mandate for doing detailed, data-intensive analysis to inform regulatory policy as well as support compliance, inspection, exams and enforcement.
David Shillman: Modern markets are very dispersed -- there are many exchanges, many more alternative trading systems, and many more internalizing broker-dealers. And, order-routing strategies are very complex. So in order for a regulator, whether it’s the SEC or an SRO, to see what a market participant is doing throughout the complex U.S. markets and track what’s occurring for surveillance and enforcement purposes and also for policy development, we need to create a new system that collects information about orders as they are routed through the markets. This information needs to be collected in a single place and in a consistent manner.
JB: When we had an open meeting several Wednesdays ago, it wasn’t just Trading and Markets, but also the markets focused staff within the Enforcement and RiskFin Divisions, and OCIE, who talked about how the new audit trail would help them do their jobs better. The entire Agency stands to benefit from having more information about the life of an order and what that can tell us about trading strategies, order flow, and other things.
Had CAT been on to-do list before the ‘flash crash’?
DS: It was already on the radar. It was an issue identified early on in Chairman Schapiro’s tenure, and we had the proposal largely prepared at the time of the flash crash. It was coincidental that the Consolidated Audit Trail was proposed a few weeks after the flash crash, but of course the flash crash made it all the more apparent as to why we need to have this.
In the wake of the ‘flash crash’ and more recently the Facebook IPO and Knight, what are you looking at with regard to exchanges and exchange technology?
JB: We aren’t able to speak about any particular examination or investigation. But I can tell you that we certainly have been focusing on incidents of “glitches,” including the Facebook IPO, the BATs IPO, Knight, and a number of other exchanges that have encountered technical problems. We are focusing on these issues and trying to fashion the right response. For example, since late 1980s, the SROs have been under a voluntary program and subject to the Automation Review Policy, which encourages industry best practices. There is certainly discussion about whether it makes sense to turn those voluntary policies into regulation and if so, what form that regulation should take. Also, our automation review program is about to launch a discussion among all the SROs to revamp the program, and better tailor it to the industry as it exists today.
DS: The markets have become very dependent upon technology over the last decade or so. And with some of the fairly high-profile incidents with technology problems, it has become apparent how quickly they can ripple through the markets and have a serious impact. This has led us to take another look at our existing oversight of exchange technology and consider whether there are ways to improve standards for the exchanges, given the central role technology has in our modern marketplace.
JB: Another critically important rulemaking initiative that we brought over the finish line last year was market access.
DS: The Market Access rule was fully implemented last fall. It deals with the fact that the markets have become very dependent on electronic connectivity and the risks associated with that. Given that technology makes it possible for anyone, anywhere in the world to place an order, or many orders, on U.S. exchanges very quickly, we need to place the responsibility on someone in the marketplace to check for risk. That risk includes the risks of errors, malfeasance, or that people exceed rational credit limits. We determined to place that responsibility on broker-dealers, which are really the gatekeepers to U.S. exchanges. This rule requires broker-dealers to assure that for any orders they allow to enter the market, electronically or otherwise, the broker-dealer places certain risk checks -- for erroneous trades, to assure certain financial limits are not exceeded, as well as to assure regulatory compliance.
The broker-dealers are responsible for making sure that risks are mitigated in the electronic environment. That’s a very important first step to addressing some of the complexities of an electronic marketplace.
GB: The flash crash, the Facebook IPO, and what happened at Knight, are each quite different. If you look at a lot of the other issues that have occurred, they form an entire spectrum that is all related to technology, but in different ways.
When people think about technology, often they think about a bug in a computer program, which is a true technology issue. If you program the system, how do you know it’s right, how do you know there’s not a bug that will send something off or route orders in the wrong way? But when technology works there still can be issues, and technology has increased the level of complexity, which can trip you up. So the Facebook IPO perhaps was more of a technology-related issue than the flash crash, which was enabled through advanced technologies. The complexity that caused the flash crash would not have been possible 25 years ago, or even 10 years ago. So sometimes the problem is not that there’s an issue with technology, meaning a bug; instead it’s that the technology creates complexities and linked markets, and then a market event happens and the technology takes over, and it runs to its logical conclusion. The result of that could be a flash crash, but it could be many other types of things.
The reason why it’s important to make a distinction between the two issues: that if you have a pure tech glitch you need to have developers and programmers go in to make sure you don’t have glitches, and you need to have rules and policies -- sometimes by the SEC, sometimes by the SROs -- discussing how do you roll out new software. But the complexity issues around technology require a completely different set of rules and regulations, and it also requires a different solution at the places that are producing those technologies.
We try to make a distinction between the two issues since the solutions are often different.
The Division of Trading and Markets oversees sectors including broker-dealers, alternative trading systems, and OTC markets. What can you say about the oversight and regulatory initiatives pertaining to specific sectors?
JB: In a broad sense, I think the trickiest part of our job is we’re trying to create a level playing field for everyone, in a complex and dispersed market. Whether it’s retail participants, institutional participants, a day trader, someone executing a single transaction, or someone executing thousands of transactions and cancelling orders in microseconds or nanoseconds, our job is to be a neutral arbiter and keep the markets fair and orderly.
Headlines chase the biggest stories, but that’s not necessarily where our focus is, or should be. We’re charged with a bigger and more difficult task, and a more boring one in some respects. That’s not to say when something hits the headlines we’re not trying to reach out and understand what happened, but in terms of a regulatory response such as rulemaking it takes a long time to amass and analyze data to calibrate our solutions. If you push down on one part of the market, another part might pop up -- people migrate from one venue to another. We have to try to be deliberate in how we tackle things.
GB: Market participants tend to follow the headlines, which generally are Commission undertakings. But in my opinion, what changes the market much more than anything the Commission can do is in the area of the new SRO rules and regulations that spawn new products and services that the exchanges themselves produce. That gets a lot less attention even though the net effect of those SRO rules is probably an order of magnitude larger than anything that the Commission can do.
There’s an interesting dynamic when the Commission puts out a proposal for a new rule or regulation. We get lots of feedback in the public-comment process: some people like it, some people don’t like it. But when an SRO proposes a new rule or regulation, it’s a completely different dynamic, because the people commenting are competitors. So we don’t get the same level of comment and input, and certain comments are based strictly on the perceived competitive advantage or disadvantage from the person who’s commenting. But SRO rulemakings change the market much quicker, sometimes in a much more subtle way that you only recognize years later. I haven’t observed the same level of scrutiny and comment from the industry on those types of initiatives that I have on the ones that come out of the SEC itself.
JB: In keeping with the Chairman’s focus on analysis, we’re also seeing some of these rule filings being approved and rolled out as pilot projects. With a number of these SRO rules, we’re asking for data so we can look a year or two out to see what the impact is.
DS: We receive more than 2,000 rule filings per year from the SROs. It’s a very competitive marketplace -- they’re always innovating, and some of the proposals are very complex. There are vociferous comments from competitors and allies alike – with a pilot program, the Commission will assess the impact of an SRO program proposal and analyze whether the allegations of harm or benefit have appeared.
What is the SEC doing in the way of regulatory harmonization with the CFTC and across borders?
JB: In the immediate aftermath of May 6th, Chairman Schapiro and Chairman Gensler at the CFTC pulled together a Joint Advisory Committee to help oversee and keep tabs on what the staffs of the two agencies were doing, both in terms of the analysis and the set of broad recommendations for further evaluation that were eventually generated. I had never seen anything quite like it in terms of the collaboration between the two agencies, both in terms of the analysis and the drafting under the auspices of the advisory committee. So on the market-structure side of the house, things have been going well in terms of inter-agency dialogue.What has gotten a lot more attention, both in terms of CFTC and international coordination, has been in the Dodd-Frank space. We recently adopted joint rules with the CFTC related to intermediaries and products definitions, two very critical steps in establishing Dodd-Frank. Our markets are different and the products we regulate and the timelines are going to be different, but there’s an acute awareness of how important it is to try to find common approaches. Our coordination continues with them. In terms of our international presence, we play an active staffing role in the Financial Stability Board and IOSCO, where we co-chair derivatives working groups. We seek to be leaders in terms of collaboration and cooperation, and key staffers from within this division play vital roles in this regard.
GB: A lot of people confuse the word “harmonization” with “it has to be identical.” So when we may have a proposal or a rule that slightly different than what the CFTC has, folks will say that’s not right.
But harmonization doesn’t always lead to the same end result if the products are different, and most important, if our statutes are different. So in derivatives, the CFTC has a particular statute, and legal obligations that were created by Congress. The SEC’s statutes are actually different, as they emphasize different things and they have different requirements. When Dodd-Frank was rolled out, it wasn’t rolled out to say all derivatives should go under one statute or the other. There was a dividing line, a choice made by Congress, that a certain percentage go to the SEC, and the majority goes to the CFTC.
So if regulators follow to the best of their ability being consistent with the statutes and the mandates they are given, by harmonizing you can actually wind up with slightly different rules.
Should high-frequency/algorithmic traders be subject to market-making requirements?
JB:This is a very hotly debated subject, and for us it’s an example of an area where the Division is trying to focus on what the data tells us. Before we are going to be able to take steps related to high-frequency and algo trading strategies, we have to look at the potential impact of these initiatives and try to understand what the cause-and-effect will be. Just like when an SRO files a rule the effects of which can be felt throughout the markets, when we tweak with incentives and obligations for market participants, we will hear from various stakeholders about the impact of the changes on them and on our markets.
DS: Our equity-market concept release focused on two key areas: high-frequency trading and dark liquidity. With high-frequency trading, one discussion point was that given the central role high-frequency traders appear to play in today’s marketplace and their sophisticated trading tools and technology, should they be subject to special obligations? One of the ideas presented was, should they be market makers and should they have meaningful affirmative or negative obligations?
This is one of the more complex issues in the concept release. It’s a tricky balance, and a lot of the feedback was to the effect that to the extent you place meaningful, affirmative obligations on market makers to be there when times are tough, they have to have corresponding benefits to make it worthwhile economically. This is still an open issue that will require further study before we reach any conclusion, but it is one of the possible policy responses to the high-frequency trading issue.
Should dark pool be required to provide price improvement vis a vis lit markets?
DS: Ideas like this have been raised as a possible regulatory response if it were determined that the increase in volume that has shifted to undisplayed markets has become problematic and is undermining price discovery. One possible policy response would be a trade-at rule, which would effectively preference executions in displayed markets. But similar to the market-making obligation policy response, before the staff would be in a position to recommend something as aggressive as a trade-at rule, we would need to have evidence that there in fact is a problem with the level of dark liquidity that exists. So it’s a possible policy response to deal with the dark liquidity issue, to the extent we have evidence that a real problem has developed.
JB:There does seem to be a shift of trading, a trend over time toward dark venues. The data we had in the concept release was pulled from September 2009, when about 73% of trading was on exchanges and about 8% in dark pools. In June 2012, by one measure on-exchange has declined to about 68%, and on the dark venues, it’s risen to just over 13%. So there seem to be forces at work, and the question takes us back to trying to do our job of trying to ensure a level playing field. We need to ask questions about the migration, and what it means for price discovery and for the different players who are interacting in our markets. It’s certainly something we’re trying to focus on.
There has been lots of talk about how overworked financial regulators are these days. What is a typical day like around here? Is there such a thing?
JB: It’s been a tough 4 years with a lot to do, but what I find really striking is that the enthusiasm never wanes. These guys [in TM] and their teams can be forgiven for being exhausted or even flip about things, but that’s not what you find in the Division or in the agency. There’s a real enthusiasm for staying on top of what’s going on and trying to get our regulatory answers right.
GB: I don’t think any two days are ever the same. There’s not a lot of coming in and moving papers around. You get in the habit of you can never accept a meeting -- you can only accept one “tentatively”. It’s almost become a standard that at any given meeting, it is okay to not show up with three seconds’ notice, because people realize that something can happen on any given day and the staff will have to react. We’re not regulating a static market; we’re regulating something that’s very dynamic, and so on any given day something is probably going to happen.
What market misperceptions about the SEC are there that you would like to address?
JB: There probably had been a perception that we were able to engage in real-time analytics of trading. Attentive observers noticed the time in between the flash crash and our initial report, and the time it took to generate our second report. Most of that intervening time was data and number crunching, so we’re excited to have new resources and new tools that are coming online before too long.
GB: After the flash crash, most people thought we had a big computer with knobs and buttons where we watched everything going on in the market. But we didn’t. In terms of monitoring, both for the purpose of enforcement and compliance as well as for monitoring for understanding market structure, recently we procured a very advanced analytical system. This will allow us to read, in real time, all trades and quotes that come out of the lit markets. It doesn’t give us access to the dark markets and it doesn’t give us any non-public information. We’re in the middle of implementation, and by the end of this year we’ll have fully implemented the system where we can basically see every quote, every trade, every cancellation, and every modification, as they are happening. And it will give us volumes of information that we’ll be able to then analyze as well as monitor in the way I think the public has thought we have been doing for a decade or two.
What else is important to note?
JB: While there is tremendous appetite for monitoring and regulating equity markets, we also have to think about spending more time on fixed-income markets, options, exchange-traded products, and other areas. I’d expect to see more attention and focus in those spaces too in the near future.
