[House Hearing, 111 Congress]
[From the U.S. Government Publishing Office]
THE STOCK MARKET PLUNGE: WHAT
HAPPENED AND WHAT IS NEXT?
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON CAPITAL MARKETS,
INSURANCE, AND GOVERNMENT
SPONSORED ENTERPRISES
OF THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED ELEVENTH CONGRESS
SECOND SESSION
__________
MAY 11, 2010
__________
Printed for the use of the Committee on Financial Services
Serial No. 111-133
U.S. GOVERNMENT PRINTING OFFICE
58-043 PDF WASHINGTON : 2010
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HOUSE COMMITTEE ON FINANCIAL SERVICES
BARNEY FRANK, Massachusetts, Chairman
PAUL E. KANJORSKI, Pennsylvania SPENCER BACHUS, Alabama
MAXINE WATERS, California MICHAEL N. CASTLE, Delaware
CAROLYN B. MALONEY, New York PETER T. KING, New York
LUIS V. GUTIERREZ, Illinois EDWARD R. ROYCE, California
NYDIA M. VELAZQUEZ, New York FRANK D. LUCAS, Oklahoma
MELVIN L. WATT, North Carolina RON PAUL, Texas
GARY L. ACKERMAN, New York DONALD A. MANZULLO, Illinois
BRAD SHERMAN, California WALTER B. JONES, Jr., North
GREGORY W. MEEKS, New York Carolina
DENNIS MOORE, Kansas JUDY BIGGERT, Illinois
MICHAEL E. CAPUANO, Massachusetts GARY G. MILLER, California
RUBEN HINOJOSA, Texas SHELLEY MOORE CAPITO, West
WM. LACY CLAY, Missouri Virginia
CAROLYN McCARTHY, New York JEB HENSARLING, Texas
JOE BACA, California SCOTT GARRETT, New Jersey
STEPHEN F. LYNCH, Massachusetts J. GRESHAM BARRETT, South Carolina
BRAD MILLER, North Carolina JIM GERLACH, Pennsylvania
DAVID SCOTT, Georgia RANDY NEUGEBAUER, Texas
AL GREEN, Texas TOM PRICE, Georgia
EMANUEL CLEAVER, Missouri PATRICK T. McHENRY, North Carolina
MELISSA L. BEAN, Illinois JOHN CAMPBELL, California
GWEN MOORE, Wisconsin ADAM PUTNAM, Florida
PAUL W. HODES, New Hampshire MICHELE BACHMANN, Minnesota
KEITH ELLISON, Minnesota KENNY MARCHANT, Texas
RON KLEIN, Florida THADDEUS G. McCOTTER, Michigan
CHARLES A. WILSON, Ohio KEVIN McCARTHY, California
ED PERLMUTTER, Colorado BILL POSEY, Florida
JOE DONNELLY, Indiana LYNN JENKINS, Kansas
BILL FOSTER, Illinois CHRISTOPHER LEE, New York
ANDRE CARSON, Indiana ERIK PAULSEN, Minnesota
JACKIE SPEIER, California LEONARD LANCE, New Jersey
TRAVIS CHILDERS, Mississippi
WALT MINNICK, Idaho
JOHN ADLER, New Jersey
MARY JO KILROY, Ohio
STEVE DRIEHAUS, Ohio
SUZANNE KOSMAS, Florida
ALAN GRAYSON, Florida
JIM HIMES, Connecticut
GARY PETERS, Michigan
DAN MAFFEI, New York
Jeanne M. Roslanowick, Staff Director and Chief Counsel
Subcommittee on Capital Markets, Insurance, and Government Sponsored
Enterprises
PAUL E. KANJORSKI, Pennsylvania, Chairman
GARY L. ACKERMAN, New York SCOTT GARRETT, New Jersey
BRAD SHERMAN, California TOM PRICE, Georgia
MICHAEL E. CAPUANO, Massachusetts MICHAEL N. CASTLE, Delaware
RUBEN HINOJOSA, Texas PETER T. KING, New York
CAROLYN McCARTHY, New York FRANK D. LUCAS, Oklahoma
JOE BACA, California DONALD A. MANZULLO, Illinois
STEPHEN F. LYNCH, Massachusetts EDWARD R. ROYCE, California
BRAD MILLER, North Carolina JUDY BIGGERT, Illinois
DAVID SCOTT, Georgia SHELLEY MOORE CAPITO, West
NYDIA M. VELAZQUEZ, New York Virginia
CAROLYN B. MALONEY, New York JEB HENSARLING, Texas
MELISSA L. BEAN, Illinois ADAM PUTNAM, Florida
GWEN MOORE, Wisconsin J. GRESHAM BARRETT, South Carolina
PAUL W. HODES, New Hampshire JIM GERLACH, Pennsylvania
RON KLEIN, Florida JOHN CAMPBELL, California
ED PERLMUTTER, Colorado MICHELE BACHMANN, Minnesota
JOE DONNELLY, Indiana THADDEUS G. McCOTTER, Michigan
ANDRE CARSON, Indiana RANDY NEUGEBAUER, Texas
JACKIE SPEIER, California KEVIN McCARTHY, California
TRAVIS CHILDERS, Mississippi BILL POSEY, Florida
CHARLES A. WILSON, Ohio LYNN JENKINS, Kansas
BILL FOSTER, Illinois
WALT MINNICK, Idaho
JOHN ADLER, New Jersey
MARY JO KILROY, Ohio
SUZANNE KOSMAS, Florida
ALAN GRAYSON, Florida
JIM HIMES, Connecticut
GARY PETERS, Michigan
C O N T E N T S
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Page
Hearing held on:
May 11, 2010................................................. 1
Appendix:
May 11, 2010................................................. 67
WITNESSES
Tuesday, May 11, 2010
Duffy, Terrence A., Executive Chairman, CME Group Inc............ 47
Gensler, Hon. Gary, Chairman, U.S. Commodity Futures Trading
Commission..................................................... 14
Leibowitz, Larry, Chief Operating Officer, NYSE Euronext......... 42
Noll, Eric, Executive Vice President, NASDAQ OMX Group, Inc...... 45
Schapiro, Hon. Mary L., Chairman, U.S. Securities and Exchange
Commission, accompanied by Robert W. Cook, Director, Division
of Trading and Markets, U.S. Securities and Exchange Commission 12
APPENDIX
Prepared statements:
Kanjorski, Hon. Paul E....................................... 68
Duffy, Terrence A............................................ 70
Gensler, Hon. Gary........................................... 85
Leibowitz, Larry............................................. 95
Noll, Eric................................................... 106
Schapiro, Hon. Mary L........................................ 114
Additional Material Submitted for the Record
Kanjorski, Hon. Paul E.:
Written statement of Bart Chilton, Commissioner, Commodity
Futures Trading Commission................................. 135
Hinojosa, Hon. Ruben:
Insert regarding establishing a joint CFTC-SEC Advisory
Committee on Emerging Regulatory Issues.................... 138
Written responses to questions submitted to Chairman Schapiro 143
Schapiro, Hon. Mary L.:
``Preliminary Findings Regarding the Market Events of May 6,
2010--Report of the Staffs of the CFTC and the SEC to the
Joint Advisory Committee on Emerging Regulatory Issues,''
dated May 18, 2010......................................... 150
THE STOCK MARKET PLUNGE: WHAT
HAPPENED AND WHAT IS NEXT?
----------
Tuesday, May 11, 2010
U.S. House of Representatives,
Subcommittee on Capital Markets,
Insurance, and Government
Sponsored Enterprises,
Committee on Financial Services,
Washington, D.C.
The subcommittee met, pursuant to notice, at 3 p.m., in
room 2128, Rayburn House Office Building, Hon. Paul E.
Kanjorski [chairman of the subcommittee] presiding.
Members present: Representatives Kanjorski, Ackerman,
Sherman, Capuano, Hinojosa, Miller of North Carolina, Scott,
Bean, Klein, Perlmutter, Donnelly, Carson, Foster, Adler,
Kosmas; Garrett, Lucas, Manzullo, Royce, Biggert, Capito,
Hensarling, Campbell, and Neugebauer.
Ex officio present: Representatives Frank and Bachus.
Also present: Representative Moore of Kansas.
Chairman Kanjorski. This hearing of the Subcommittee on
Capital Markets, Insurance, and Government Sponsored
Enterprises will come to order. Pursuant to committee rules,
each side will have 15 minutes for opening statements.
Without objection, all members' openings statements will be
made a part of the record.
I ask unanimous consent that Congressman Moore be allowed
to participate in today's subcommittee hearing. Without
objection, it is so ordered.
Good afternoon. At today's hearing, we will examine the
frightening afternoon of May 6th, one of the most volatile
trading days in history. Within minutes, stock market indices
dropped precipitously, erasing more than $1 trillion in
capitalization before recovering. While we may not yet have all
of the facts about these events, we must quickly analyze what
happened and embrace reforms in order to restore market
integrity and promote investor confidence.
Going back to 2003, questions surrounding market structure
have received considerable attention in this subcommittee. Many
of the issues we have previously explored remain just as
relevant today, especially the longstanding debates of man
versus machine and price versus speed.
These prior hearings have also taught me that our
regulators must remain nimble by continuing to adapt market
structure rules to respond to an ever-evolving environment.
Technological advances have dramatically altered the way Wall
Street operates. Such progress is natural. For the United
States to continue to lead the world's capital markets, we must
continue to encourage innovation.
But change also can have its downside. Many have cited the
role of computers in contributing to and exacerbating last
week's gyrations. In recent years, high-frequency trading has
exploded. Barely a blip 2 decades ago when technology
constraints and growth last crushed the markets, automated
traders today move in miniseconds and make up as much as two-
thirds of daily trading volume. Their decisions to trade or not
to trade can produce real consequences.
We too have moved from a model of two major trading centers
to an electronic network with dozens of marketplaces for
trading equities, creating new headaches for regulators. The
ascendency of computerized trading and automated exchanges in
our capital markets appears to have created a plot as
intriguing as ``2001: A Space Odyssey.'' Today, however, it is
2010, and we must figure how to effectively balance artificial
intelligence with human judgment.
This hearing will help us to achieve that goal. It can also
help us to determine how to harness technology to create
effective audit trails for regulators.
Somewhere along the way, competition among exchanges,
alternative trading systems and others has additionally led to
increased fragmentation. As old trading methods have given way
to modern techniques, the rules governing our market
architecture have lagged behind. We now must better integrate
our markets.
In this regard, I encourage that regulators and exchanges
are already working together to adapt new rules for creating
uniform single-stock circuit breakers and updating archaic
marketwide trading halts. Most importantly, we must protect
investors' interests. They deserve fair and orderly markets,
which the Securities and Exchange Commission exists to ensure.
Despite this mandate, the markets were hardly fair or
orderly during last Thursday's roller coaster ride. In this
turmoil, some investors lost mightily. One recent news story
highlights a couple who lost $100,000 because their trade
cleared at the wrong moment during Thursday's chaos. This
turbulence additionally triggered costly stop-loss orders for
many investors and may have placed others in unintended short
positions as trades unwound.
The market mayhem also, unfortunately, revealed the
arbitrariness of the process for identifying and canceling
clearly erroneous trades. Moreover, the decision to rescind
some trades may have ultimately benefited those who aided and
abetted the plunge. This is wrong. They placed a bet and
deserve to lose.
Although stock values quickly sprang back this time, the
experience may prove quite different next time. A ghost-in-the-
machine scenario in which an enormous computer selloff sparks a
vicious cycle of selling and panic seems completely plausible.
To thwart this doomsday hypothetical, regulators must act with
great speed and great care to promulgate new rules. The SEC has
already begun this process with its January concept release on
market structure.
In sum, our witnesses can shed light on the 20 harrowing
minutes of last week's flash crash. They can also explain how
we should respond to technological advances, increased
competition, and other market evolutions in ways that best
protect investors.
I thank each of the witnesses for appearing, especially on
such short notice, and I am eager to hear their testimony.
I would now like to recognize the ranking member, the
gentleman from New Jersey, Mr. Garrett, for 5 minutes.
Mr. Garrett. I thank the chairman, and I thank the
witnesses.
Yes, today's hearing is certainly timely, given the events
of the last week. But in retrospect, considering the work that
the regulators have already been doing the last few days, it
might have been wise to wait just a few more days to hold this
hearing, to give our witnesses additional time to gather
information more fully and to analyze the events of the last
few weeks so ultimately we could come here and be fully
informed as to this subcommittee's inquiries.
Broadly speaking as well, in a more ideal situation, I
guess you could say that this subcommittee should be conducting
oversights of the SEC and our financial markets, I guess you
would say in a more proactive way, rather than a reactive way.
Until her recent testimony here with regard to the Lehman
bankruptcy, Chairman Shapiro had testified just twice since she
was sworn in. That is far less frequently than her peers who
head other major financial regulatory agencies. Never before
today has she been asked to testify on market structure reform,
despite the SEC's ambitious agenda in this area.
So it is precisely for this reason that Ranking Member
Bachus and I sent a letter to Chairman Frank requesting that
this committee hold one or more SEC oversight hearings and to
do it soon--4 weeks ago, we asked that.
We stated in the letter, ``It is our constitutional duty to
perform regular oversight to allow members and the general
public to determine the suitability and impact of the SEC
proposals as well as judge the quality of the Commission's work
in furtherance of its congressionally mandated mission to
protect investors, maintain a fair, orderly, and efficient
market, and facilitate capital formation.''
Clearly, some will say the degree to which the SEC is
currently fulfilling all of the aspects of this mission might
be said to be called into question during at least the events
of this last week, which is why it is important that this
subcommittee does examine what went on. That being said, the
events of last week will only serve to heighten the already
politicized atmosphere surrounding the SEC's examination
overall of market structure.
In another letter, in a comment letter on the Commission's
equity market structure concept release that I sent to Chairman
Schapiro on April 22nd, I wrote, ``While I appreciate the
Commission's recent efforts to undertake a comprehensive review
of our Nation's equity market structure, I want to ensure that
this analysis starts from the vantage point of preserving or
enhancing that which makes our equity trading markets strong
and that change is not pursued purely or largely in response to
any external pressures on entities.''
I went on to write, ``As an independent, nonpartisan
agency, the SEC has been entrusted with the responsibility to
make its decisions based on objective, prudent, and disciplined
analysis, and it is a great responsibility and requires an
adherence to a balanced and data-driven empirical approach to
ensure that regulatory efforts focus on those most productive
areas.''
Finally, I expressed concern in a letter that, in the
concept release, the Commission's request for comments
respecting the interests of long-term and short-term investors
seems to focus on a perceived conflict between such groups with
really no reference to the critical interdependency between
those groups and the overall equity market structure.
So I am hopeful that the tone of such requests are not
really reflective of the SEC's analytical framework, and would
rather urge the Commission to consider that it should be
determined that the additional rulemaking be required and the
most successful outcome would be the one that benefits the
synergy relationship as a whole.
So at today's hearing I will be as interested as everyone
else to hear from both the SEC and the CFTC, as well as
representatives from the other exchanges, to better understand
their perspective on the events of last week. Clearly, concerns
over the financial stability of Greece and other European
countries were weighing heavily on investors last week, but it
appears that something else may have factored into the sudden
drops in the markets as well.
I am hopeful that today's hearing will begin to provide
clarity as to what exactly happened, and I am also hopeful that
we will begin to have a measured and thoughtful discussion on
what, if anything, should be done in a regulatory manner to
address what happened then. We should not, however, rush to
judgment for the sake of any political cover in any of this. If
prudent steps can be taken to improve the performance of our
markets, we should always take those and be open to new ideas,
while keeping in mind throughout our discussion what potential
negative consequences might occur due to any proposed reforms.
Again, I look forward to all the witnesses' testimony.
Thank you.
Chairman Kanjorski. The Chair recognizes the chairman of
the full committee, Chairman Frank, for 2 minutes.
The Chairman. Mr. Chairman, I want to begin by
congratulating you for having this hearing. I think the
suggestion by the ranking member that we should have waited is
clearly wrong. The American people are rightly disturbed. The
world is questioning it. This is a very important issue. This
need not be the last word. But to have failed to have a public
hearing on these issues right away would have been to not have
done our duty, and you are to be congratulated for moving so
quickly to begin this process.
I also would say I was somewhat struck when the ranking
member made two points that seemed to me to be somewhat at odds
with each other: One, that we haven't had enough hearings in
which members of this committee can criticize the SEC for
overregulating, which is essentially what he was talking about;
and two, that we should respect their independence. He has a
right, obviously, to be concerned that the SEC is being more
activist in its regulatory agenda than the previous
Administration had been. I welcome that. I think that what they
are doing is very appropriate, and in fact I think hearings,
with the frequency which we have had them, have been a useful
way to do that.
I also want to note that one of the issues we need to be
addressing--and I will be talking about this later--is there
are some innocent victims here. There are individuals who had
invested in American stocks, as they have been urged to do, who
suffered losses through no fault of their own, and I think we
should continue to look at what could be done by way of
compensation.
Finally, it is clear that we have the interaction here of
some technical issues plus the crisis in Europe. I welcome--and
here, again, there was a difference amongst some of us; the
House Republican Conference had written to Vice President Biden
telling him to stay out of any efforts by the IMF to try to
deal with the crisis in Europe. I am glad that advice was
disregarded. I think the action in which the American officials
participated was very helpful in averting further damage, and
we will obviously be looking into that further.
Chairman Kanjorski. Thank you, Chairman Frank.
The gentleman from Alabama, Mr. Bachus, is recognized for 4
minutes.
Mr. Bachus. Thank you, Mr. Chairman.
The American financial markets are the most modern in the
world. They execute trades more efficiently and economically
than ever before. They are the envy of the world, the fastest
and most liquid in the world.
However, some of the innovations, high-frequency computer-
driven trading across multiple platforms and forums, does
create the possibility of the events that we witnessed last
week.
All innovations bring problems but also progress. Our
challenge is to find a solution that addresses the problems,
but does not destroy the benefits. In my opinion since, really,
January, the SEC has done this. They have acted in a measured
way, and I think the meeting yesterday was most appropriate. As
the full Financial Services Committee ranking member, I did say
that we probably should wait until at least the trades were
completed to meet and let you have an opportunity to respond,
and I think you have done so appropriately. But we are here,
and whether they we are here today or 2 days from now is, I
think, probably irrelevant.
Rational concern, rising risk, and a technically over-
bought market that had raced ahead 70 percent in the past year
resulted in a skittish market, increased volatility, and an
environment subject or vulnerable to panic.
Any number of events could have contributed to the market
plunge last Thursday. We have all read the laundry list of what
could have happened, what may have happened, or it could have
been a combination of things. But I think what is safe to
assume is without some preventive measures, they can happen
again, because any number of things, as were mentioned, could
precipitate such an event.
In fact, prior to last Thursday, on April 27th, you had a
smaller event occur, not of the velocity or steepness or
quickness, but you have had similar events happen in individual
stocks, but none as widespread as last Thursday. However, I
think because of the dramatic and suddenness of last week's
event, there is something constructive in that, and although it
undermined investor confidence, I think it clearly pointed out
the need for action.
In January of this year, the SEC, to its credit, voted
unanimously to move forward with a broad review of equity
market structure and issued a concept release seeking public
comment on such issues as high-frequency trading, collocating
trading terminals, dark liquidity, market quality metrics, and
the fairness of the market structure.
Last Thursday's events, I believe, give the SEC the
political clout it needs to take action to institute measures
to help insulate the markets from what has been described as
electronic meltdown, and I think it has brought a consensus
among the exchanges. It won't be a total cure, nor will there
ever be, but it is a good first move or good preventive
measure.
As we move forward, my only advice is to be cautious.
Solutions are likely to take careful thought and time, and I
commend the exchanges and the SEC for the good start on Monday.
It is more important to get it right than it is to get it done
quickly and with less precision.
I will close by saying when you see the type of temporary
anarchy that we witnessed last Thursday, it is appropriate to
take some preventive measures. With our children and
grandchildren, we take a timeout, and I think that we are
establishing a procedure similar to that with our markets when
they do lapse into what we witnessed last Thursday. It restores
our children's sanity, and I think these preventive measures
you proposed will restore investor confidence and a certain
amount of stability to the markets.
So I commend you for what I have witnessed in the last 72
hours. You have done a commendable job.
Chairman Kanjorski. The gentleman's time has expired.
The gentleman from New York, Mr. Ackerman, is recognized
for 2 minutes.
Mr. Ackerman. Thank you, Mr. Chairman.
I have been advocating for the reinstatement of the uptick
rule for the better part of 3 years, and for the better part of
3 years, critics of the uptick rule have argued that
reinstating the price test that had been in place for 70 years
would have had little or no practical impact on protecting our
exchanges and America's investors from nonsensical, irrational,
and arbitrary runs.
Then the Dow lost 1,000 points in a matter of minutes last
Thursday, despite the New York Stock Exchange's circuit breaker
protections, and apparently as a result of a well-intentioned
SEC regulation meant to encourage more faster trading that
mandates electronic trades bypassing exchanges that cannot
guarantee the investors the best price for a particular stock.
In other words, the SEC's regulation NMS overrode the New
York Stock Exchange's protection mechanisms, exacerbated a
nonsensical, irrational, and arbitrary run last Thursday, a run
that briefly wiped out $1 trillion, a run that the uptick rule
would have prevented.
I hate to say I told you so, so I won't. Instead, I will
say what I have been saying for years. I will say that the
uptick rule would have prevented the Dow's 1,000 point plunge
last Thursday. I will say that investor confidence is of
paramount importance to our markets and the ability of our
economy to recover from the deepest recession since the Great
Depression. And I will say, instead, that in the wake of last
Thursday's events, if our regulators don't reinstitute some
type of meaningful, permanent, across-the-board price test
similar to the uptick rule very soon, investors will have very
little confidence in our markets and in our regulators, and I
can't say that I blame them.
I yield back the balance of my time.
Chairman Kanjorski. Thank you very much, Mr. Ackerman.
We now have the gentleman from California, Mr. Royce, for 3
minutes.
Mr. Royce. Thank you, Mr. Chairman. I appreciate the time
here.
I am not sure the uptick rule would have done anything to
stave this off at all. In terms of the studies I have seen--and
I understand the SEC is still going to take the balance of the
week to give us the triggering event, and I know that they are
sorting through 40 different market participants, market
centers here, in order to try to glean that information.
But in the meantime, let me make some observations. One is
that I think if you ask the average American investor what is
important, he would say an orderly, well-functioning, trading
environment. I think she or he would say that there is a little
bit of apprehension in terms of what has happened in the past
in the market.
I am going to go back to October of 2002 when Bear Stearns
sent an order to sell $4 billion in stocks in the Standard &
Poor's 500 stock index. They meant to send an order for $4
million, not $4 billion. Fortunately, at the time, the New York
Stock Exchange specialists saw that and they sent that
information back to the Bear Stearns floor brokers. After all,
this was a time when we had specialists handling and slowing
down a lot of these problems. But they didn't get it handled
before $622 million in stock had been sold, instead of $4
million.
So that gives us a window back into what has happened in
the past, where I think investors first began to get spooked
about what could happen in the market. Back then, of course, we
only had two dominant centers: the New York Stock Exchange; and
NASDAQ. Now, the SEC is looking at 40 different market centers.
So I think as we go forward, we can look at some of the
upsides that we have seen. The bid-ask spreads have been
reduced by the fact that everything has sped up in the market.
In some ways, the market is more efficient. But we know that
Germany and other countries have looked at ways to look at
individual stocks and put real-time circuit breakers in effect,
where if those stocks drop more than 5 percent, you are going
to have a hold; in 5 minutes, you are going to have a hold
after that on transactions as regulators and market
participants focus on what is afoot, in case we have something
like the Bear Stearns errant order back in 2002.
As we move forward, I think we recognize that our markets
now react in milliseconds to events, but they are monitored by
humans who respond in minutes, and in those minutes, you can
have the loss of billions of dollars of damage.
Let me also say that I don't think the members here are
criticizing the SEC for overregulating. I think we want the SEC
to regulate. I think my concern has been that market knowledge
and experience is greatly lacking at the agency. As myself and
my colleagues have said in the past, it is overlawyered at the
SEC.
We had the observations during the Bernie Madoff and the
Alan Stanford Ponzi scheme cases, where we heard from Mr.
Markopolos about the problems at the SEC. And we are hoping
that culture can be changed as the SEC looks into this
particular problem as well, and reengineering the oversight,
and perhaps putting into effect better circuit breakers to
handle this problem.
Thank you, Mr. Chairman.
Chairman Kanjorski. Thank you, Mr. Royce.
Now, we will hear from the gentleman from California, Mr.
Sherman, for 2 minutes.
Mr. Sherman. Thank you, Mr. Chairman.
I think the issue before us is, what is the social utility
of high-frequency trading. Should it be limited? Should it be
taxed? Or do we benefit from enormous quantities of money
moving in and out of a stock for a few minutes?
We are told that the meltdown will cause no lasting harm. I
think this is shortsighted. Investors for many years will be
demanding a risk premium for what they perceive as a market
that can go crazy, at least for an hour or half an hour, and we
will be told that with a few patches, the system will work fine
in the future and this could never happen again.
Sure.
In our society, we have allocated some of the smartest
business and computer minds to Wall Street. We are told that
they should earn the highest rates of return on their
intellectual capital of any profession because they allocate
capital to our real businesses.
But what does that have to do with high-frequency trading?
Is high-frequency trading a necessary part of allocating
capital to real businesses, or is it a parasitic attachment in
which some smart people with some fast computers can take a
little piece of the profit that each real investor should get
and divert it to themselves? Are Accenture and Procter & Gamble
and 3M better off today as operating businesses because their
stocks are subject to high-frequency trading?
I would think that what is likely to happen is we will
patch up the present system and tell the American people not to
worry. But I hope, instead, that we will take a look at high-
frequency trading and see whether it should be limited or
subject to just a small tax to recognize that there is a social
cost to this activity and it is something that we might want to
discourage so that real investors reap the profits on Wall
Street.
I yield back.
Chairman Kanjorski. Thank you very much, Mr. Sherman.
The gentleman from Texas, Mr. Hensarling, for 3 minutes.
Mr. Hensarling. Thank you, Mr. Chairman.
I certainly agree this is an important hearing. Any time $1
trillion of market value disappears in a matter of minutes and
a lot of small investors are hurt, we need to have a
congressional hearing. To the extent that we are going to
receive answers today from our panel, then I applaud the timing
of the hearing. To the extent we are hindering the panelists
from finding those answers, then I question the timing of the
hearing.
Frequently, when we have extreme market volatility, the cry
goes out, somewhere quick, ``Let's shoot the computers.'' I
have never really agreed with that particular position,
although I do have an open mind that perhaps some reprogramming
may be in order. Specifically, I do believe that we at least
need to look and examine the desirability of having stock-
specific circuit breakers across all of our markets, and
certainly, there is an open question on the impact of canceling
trades. How many folks ended up with unintended short positions
while arguably adding needed liquidity in a sinking market?
But at the end of the day, I think we should tread very,
very carefully in this space. Improved technology, rule MNS,
have brought great benefits to trading: more competitive
markets; cheaper trades; and really a democratization of
investment opportunities. But more importantly, I believe that
we need to look beyond simply the mechanics of the panic and
look to its likely underlying cause, that being the
international debt crisis that is first manifesting itself in
Greece. A number of media outlets have spoken to this.
We had a CBS-AP report, ``Greek Debt, Trader Error Eyed in
Market Selloff,'' on May 6th: ``Traders were not comforted by
the fact that Greece seemed to be working towards a resolution
of its debt problems. Instead, they focused on the possibility
that other European countries would also run into trouble.''
Wall Street Journal: ``Many traders worried about the
economic situation in Europe. The Dow had already been moving
lower as television screens displayed scenes of rioting on
Greek streets.''
Fox Business quoted a managing director of Nye Capital
Partners: ``The tone and tenor of the global debt crisis has
taken over the market. Everything else has taken a back seat.''
So there is an open question among many in our investing
public whether or not we are on the road to becoming Greece
ourselves, given that the deficit has increased tenfold in just
2 years, and the President has put forth a budget that will
triple the national debt in 10 years. There is fear that Greece
is the preview of coming attractions to the United States, and
no matter how many well-designed exits you have, no matter how
many well-trained ushers you have, no matter how well-designed
your exit plan, if people in the theater sense that something
is smoldering, you cannot ultimately remove the conditions of
panic.
Thank you, Mr. Chairman. I yield back.
Chairman Kanjorski. Thank you, Mr. Hensarling.
We will now hear from the gentleman from Georgia, Mr.
Scott, for 1 minute.
Mr. Scott. Thank you, Mr. Chairman. I think what we have
here is a clear example of how we as a society have become more
the servants of the machine that was created to serve us. Our
technology has now far surpassed our human ability to keep up
with it.
I think we have to move with caution, to make sure we get
the right causes of this problem, to understand that our
foremost obligation at this point is to make sure we have
investor confidence, that the American people have confidence
in our system.
So it is important that we listen to you: The Securities
and Exchange Commission, you have to make it work; the
Commodities Trading Commission; NASDAQ; the Chicago Mercantile
Exchange; and, of course, the New York Stock Exchange.
But we have a very complex system. We have nearly 50
markets. We have hundreds of millions of computers that are
making these sales in megaseconds, far outpacing our human
capacity to deal with it. If we do get the circuit breaker
concept, we have to make sure how that is going to work. Will
it do the job? What is important here is to move carefully and
thoughtfully to get the right correction to this problem. The
American investors and the world investors are depending on us.
Chairman Kanjorski. Thank you, Mr. Scott.
We will now hear from Mr. Perlmutter for 2 minutes.
Mr. Perlmutter. Thank you, Mr. Chairman. I just would like
to remind the committee and the panelists that in the financial
reform bill that we passed to the Senate, we were sort of
directed to this nanotrading high-frequency trading issue by
some of our prior hearings; and there is a section of the bill,
section 7304, asking the SEC and other regulators to take a
look at high-frequency trading and its impact upon the markets.
The good news is, it is in the bill. The bad news is that
Thursday hit us before there was any action on the bill.
I know that the regulators have been looking at this under
their own authority, and I would encourage them to continue to
do this. I am surprised by my friends on the other side of the
aisle who question whether it is too early to look at this. We
should be looking at this high-frequency trading; 5,000 trades
per second, how do you manage something like that? That is the
real question. In the blink of an eye, by a mistake or by an
intentional act, whatever it might be, boom, this country lost
$1 trillion over 20 minutes.
My friends on the other side of the aisle complain about
the spending and all this stuff by the Obama Administration;
when, because of failures in the market, because of sales and
failure of the uptick rule, not having those kinds of things,
we lost $17.2 trillion in the last 18 months of the Bush
Administration. Since the Obama Administration has come in, we
have gained about $6.5 trillion back. We lost $1 trillion last
Thursday, and then have gained most of that back.
There has to be a real good understanding of the algorithm-
driven nanotrading that we have. It has benefits, Mr.
Hensarling is right, the liquidity that it brings. But
certainly if you were on the wrong side of that sale, you lost
a lot of money, and we can't have that in this system.
I yield back, Mr. Chairman.
Chairman Kanjorski. Now, the last presenter, Mr. Foster,
for 2 minutes.
Mr. Foster. Thank you. I want to thank the chairman for
holding this important and timely hearing.
As a high-energy particle physicist, I spent many years
programming and debugging large systems of high-speed digital
logic computers. So the fact that large interconnected
processing systems, individually programmed by very smart
individuals, exhibit complex and erratic behavior when they are
simply thrown together, does not surprise me at all. However,
the fact that these complex systems are put in control of a
large and important section of our economy, without
sufficiently robust testing of their interoperability and
immunity to coherent instabilities is an outrage.
The absence of systemwide circuit breakers to limit the
damage when a single element or set of elements malfunctions is
indefensible, as is the absence of uniform legal clarity when
it comes time to bust trades that have been made on a clearly
erroneous basis.
Part of the problem that we are facing is the mismatch
between the time scales of human thought and machine action.
While the logic of circuit breakers and market pauses to
restore liquidity has been understood for decades, we see now
that it must be implemented on a time scale of computer trading
and it must be implemented uniformly across a wide variety of
trading platforms.
The race towards lower latencies and higher-speed trading
shows no sign of abating. Startup companies are already
developing trading and matching engines based not on clusters
of computer servers, which will be too slow to compete, but on
dedicated pipeline logic based on field-programmable data
arrays that will typically perform a dedicated calculation 100
times faster than a dedicated computer processor.
In particle physics, these venues for years have been used
to perform specialized calculations at high speed. I have
personally spent years using them to stabilize large numbers of
particles traveling near light speed around the circumference
of a giant particle accelerator.
So while a market pause of 5 seconds may be appropriate to
restore liquidity for today's trading algorithms, using today's
technology, a market pause of only 50 milliseconds may be
appropriate when the next generation of technology comes on
line. We have to stay ahead of the technological curve and have
to institutionalize appropriate interoperability and stability
tests before new components and algorithms are brought on line.
The reason that secondary capital markets exist is to
provide a reliable and transparent means for investors to
appropriately profit from their wise investments in the real
economy. Events like those of last Thursday where $1 trillion
disappeared and then reappeared in the financial markets
destroys that transparency and destroys confidence and are
simply unacceptable.
I thank you, and I yield back the balance of my time.
Chairman Kanjorski. Thank you, Mr. Foster.
Now, we will move to the panel. But I want to make an
observation that the issue is not one of decline in stocks. The
issue is volatility. While some stocks like Accenture fell from
$40 a share to just pennies, others, like Sotheby's, soared. On
Thursday, the Auction House reported a $2.2 million quarterly
loss. Its shares went from $34 to over $100,000 within minutes.
Something was clearly wrong.
That is the reason that some 2 hours after that break,
Chairman Schapiro, I had the pleasure of calling you, and you
were so kind as to take that call, where we could structure
this public meeting.
I say that because, as you know, I stated to you I thought
that we would have a much more disturbed population as a result
of the happenings on Thursday. I am happy that it does not seem
to reflect that in the marketplace. But I am sure that has
something to do with the way you and Mr. Gensler as regulators
have handled this and publicly stated what you are doing.
So I commend you. I thank you for taking the time out to
take the call on Thursday and to be here today on such short
notice.
Now, we are going to charge you with the opportunity within
the next 5 minutes of reducing your statement to 5 minutes, as
best as possible, and tell us in its entirety what caused this
problem; what can be done about this problem; and how we can
get started.
We now would like to hear from Chairman Schapiro.
Accompanying Chairman Schapiro is Mr. Robert W. Cook,
Director of the Division of Trading and Markets, United States
Securities and Exchange Commission.
STATEMENT OF THE HONORABLE MARY L. SCHAPIRO, CHAIRMAN, U.S.
SECURITIES AND EXCHANGE COMMISSION, ACCOMPANIED BY ROBERT W.
COOK, DIRECTOR, DIVISION OF TRADING AND MARKETS, U.S.
SECURITIES AND EXCHANGE COMMISSION
Ms. Schapiro. Thank you, Mr. Chairman. I hope I won't
disappoint you.
Chairman Kanjorski, Ranking Member Garrett, and members of
the subcommittee, I appreciate the opportunity to testify
concerning the market disruption that occurred last Thursday.
As you mentioned, I am joined today by Robert Cook, the
Director of the Division of Trading and Markets at the SEC, who
has been deeply involved in the analysis of the market events.
The sudden evaporation of meaningful prices for many major
exchange-listed stocks in the middle of the trading day is
unacceptable and clearly contrary to the vital policy objective
of maintaining fair and orderly financial markets. The SEC is
working around the clock to identify the causes of this sudden
spike and to make changes which will help prevent disruptions
of this type in the future.
On May 6th, the Dow Jones Industrial Average dropped more
than 573 points in just 5 minutes. As quickly as the market
dropped, it suddenly and dramatically reversed itself,
recovering 543 points in approximately a minute and a half.
Many individual securities experienced much larger swings in
their trading activity and certain trades were executed at
absurdly low prices.
Pursuant to exchange rules, after closing, the equity
markets worked out a common standard to cancel trades effected
at prices sharply divergent from prevailing market prices. The
exchanges determined to cancel any trades from 2:40 p.m. to
3:00 p.m. at prices 60 percent away from the last trade at or
before 2:40 p.m.
Today, the SEC has more than 100 people working tirelessly
on this issue. We are sorting through literally millions of
trades and carefully comparing timing and activity across
markets to isolate the cause or causes of the spike. We will
take action to change any aspects of our market structure which
may have contributed to the extreme volatility.
We have made progress in our ongoing review and can provide
some preliminary findings.
First, while we cannot yet definitively rule out the
possibility of a ``fat-finger'' error, our own review and
reviews by the relevant exchanges and market participants have
not uncovered such an error.
Second, there have been reports that one or more
exceptionally large orders in certain stocks may have preceded
and helped to trigger the broader decline. However, there does
not yet appear to have been any unusual prior securities
trading that would have triggered the broader market decline.
Third, while some have focused on the role of the E-Mini
S&P 500 future in leading the market decline and recovery, it
must be recognized that the fact that stock prices follow
futures prices chronologically does not necessarily suggest
what may have triggered the price movements. Given that the E-
Mini futures price fell by more than 5 percent in a few minutes
and then quickly recovered all of the 5 percent decline, it
should be no surprise that the broader stock market indices
showed similarly fast and similarly large declines and
recoveries.
Finally, at this time we have not identified any
information consistent with computer hacker or terrorist
activity.
Ultimately, we may learn that the extraordinary disruption
in trading was the result of a confluence of events, which,
taken together, exacerbated what already had been a down day
and led to an extraordinarily steep price drop and recovery.
However, we continue our efforts to identify the triggers and
will share them with the public as they are identified.
Earlier today, the SEC and the CFTC announced the creation
of an advisory committee that will, among other things, work
with us in reviewing appropriate regulatory changes in response
to the events of May 6th, and the staff of our agencies intend
to provide that committee with our preliminary findings next
week.
Last Thursday's events could be likened to many dominos
falling, and while we are all understandably focused on why the
first domino fell, it is equally important to understand why so
many others fell as well. I believe we will eventually pinpoint
the triggering events, but it is fair to say that disparate
exchange rules and trading conventions caused many more dominos
to fall than should have.
For this reason, the SEC convened a meeting yesterday with
the leaders of six exchanges and FINRA, where we agreed to
strengthen cross-market circuit breakers, circuit breakers that
will not unnecessarily interfere with market activity, but that
will pause trading while the markets check for technical
problems and recover liquidity.
We also reached general consensus on the need for stock-by-
stock circuit breakers. I expect later today we will further
refine when those circuit breakers might be triggered and for
how long.
Further, we are also committed to creating a sound
framework for better handling the breaking of erroneous trades.
I believe all these actions can help to prevent a repeat of
Thursday's remarkable market volatility. But these are only
interim steps. We must quickly consider what additional steps
are necessary to strengthen our market structure and minimize
future disruptions.
We have already launched initiatives that will address many
of the issues illuminated last week. Earlier this year, we
issued a concept release on market structure that solicited
public comments on steps to minimize short-term volatility and
systemic risk. We also formally proposed creating a large trade
reporting system to enhance the Commission's surveillance and
enforcement capabilities. And we have proposed strong broker-
dealer risk management controls when a broker allows a customer
direct access to our markets.
In order to help regulators keep pace with technology and
trading patterns, we have also been working on a proposal to
create a consolidated order tracking system, or consolidated
audit trail. Within the next few weeks, I expect the Commission
to consider this proposal, which would capture all the data
needed for effective cross-market surveillance. This will
significantly improve our ability to conduct timely and
accurate trading analyses for market reconstructions and
complex investigations like that which is currently underway.
In conclusion, the SEC is making progress in its ongoing
review. We will ultimately find the cause or causes of the
disruption and will put in place safeguards that will help
prevent the type of unusual trading activity that occurred last
week.
I look forward to working with you on these issues in the
coming weeks, and, of course, we would be pleased to answer any
questions.
[The prepared statement of Chairman Schapiro can be found
on page 114 of the appendix.]
Chairman Kanjorski. Thank you very much, Madam Chairman.
Next, we have the Chairman of the Commodity Futures Trading
Commission, Chairman Gensler.
Incidentally, Mr. Gensler, thank you very much for
responding, too, as quickly as you did. Fortunately, I did not
have to call you, because I did not think it stretched to the
futures market. That becoming apparent, it is good that you can
be here as a corollary regulator so we can get to the bottom of
this.
Mr. Gensler, you are under the same restrictions, hopefully
to give us about a 5-minute presentation so we can get to
questions.
STATEMENT OF THE HONORABLE GARY GENSLER, CHAIRMAN, U.S.
COMMODITY FUTURES TRADING COMMISSION
Mr. Gensler. Thank you, Chairman Kanjorski, Ranking Member
Garrett, and members of the subcommittee. I am pleased to be
here alongside SEC Chair Mary Schapiro, with whom we have been
working very closely and diligently since last Thursday to
explore and see what we can find out about the events.
Before I turn to those events, let me just say something
about the stock index futures market. Stock index futures trade
on centralized exchanges and they are based upon the broad
market index. The total outstanding is about $360 billion. This
compares to the approximately $13 trillion of the overall
equity markets; however, stock index futures do play an
integral role to the pricing of the overall market. The largest
contract, the E-Mini S&P 500 contract, trades on the Chicago
Mercantile Exchange. It is about 80 percent of that market, and
we will focus on that a little bit in our testimony.
There are procedures on that contract, and I want to
mention four quick procedures that are risk-management
procedures to ensure the orderliness of the market.
First, electronic trading systems on all of the markets for
these contracts reject orders priced outside of a narrow band,
about a 1 percent band up or down.
Second, the exchanges actually have maximum order sizes.
Congressman Royce mentioned something from years ago, but
today, only about a $100 million transaction can be entered.
The average transaction, though, in the E-Mini is about
$330,000 in size.
Third, exchanges have something that limit stop-loss
orders, and I can get more into that in the testimony.
Fourth, they also have something which is a market pause, a
5-second pause if the order book gets out of balance. In fact,
last Thursday, that 5-second pause occurred exactly when the
market bottomed.
In terms of the preliminary review, we are looking at
millions of trades. The CFTC, fortunately, has all of the
trading data entered into our systems by the very next morning
because under our act, we are able to get that from the
exchanges. I think it would be good, and I know the SEC is
working on that, but the staffs of our agency, the SEC, and the
exchanges have looked at it and it is a very ongoing process.
Let me mention four things, though. May 6th started
turbulent. You can think of an airplane in turbulent skies. It
was very turbulent that day with the economic news emanating
out of Europe. Volatility pricing was pricing up. It had
actually gone up about 60 percent interday from Wednesday to
Thursday on some measures.
Further, the futures markets and other markets are so
intertwined that stock index futures looked to other price
signals from all of the other markets, and there were a lot of
markets coming in with signals that were showing risk premiums
were widening. Currency markets were volatile, and small
capitalization equity securities began declining sharply.
Between 2:00 p.m. and 2:20 p.m. East Coast time and by 2:24
p.m. East Coast time, there were 8 securities that were
exchange-traded securities that were already off 50 percent in
the preceding 24 minutes.
Other price signals started to come in after 2:30 p.m.--
some of the large markets started to delink under what is
called a self-help program that you will hear about a little
later, NASDAQ and some of the others. So some of these
signalings kept coming in.
Our own review of trading data shows that somewhere
starting around 2:40, some of the most actively traded
participants in the futures market, the high-frequency traders,
started to limit their participation around 2:42, 2:43, and so
forth; and that is exactly when that V was happening as some
people were limiting or even withdrawing from the market.
Another factor, in the midst of this, one large investor
executed a hedging transaction, a bona fide hedging transaction
in the E-Midi, in the size that on normal days would move
through the market. It was about 9 percent of the volume during
the period down and up. But that was also--and may have had
some participation within this.
So between 2:40 and 2:45, the market did go down 5
additional points. At 2:45 and 28 seconds, this 5-second pause
happened on the Chicago Mercantile Exchange. This was so the
order book could get sort of rebalanced in the computer, and in
fact, that was the bottom. The SPDR, which is the exchange-
traded fund that is a security but trades in the market,
bottomed 7 seconds later. The cash markets bottomed all in the
next minute, the 2:46 minute. And then you saw the market move
back up.
Exchanges and market participants have asked this question
about a ``fat-finger'' mistake. The exchanges have looked at it
closely. We have reviewed some of their work, of course, and
have not found the ``fat-finger'' issues, similar to what Mary
said earlier in that regard.
Despite the high volatility, the clearinghouses and the
settlement and the margin posting all worked, both Thursday and
Friday. So the plumbing or the backside of this worked. But we
continue to review May 6th with the SEC, particularly how the
S&P futures traded in relation to the cash market and, to the
extent of that trading, keyed in on some of the other indices.
And as Mary said earlier, we set up this morning a joint
advisory committee that will be issuing a preliminary staff
report early next week and hopefully convening that committee
to actively look at recommendations.
With that, I look forward to working with this committee
and taking your questions.
[The prepared statement of Chairman Gensler can be found on
page 85 of the appendix.]
Chairman Kanjorski. Thank you very much, Mr. Chairman.
I will take the first set of questions.
I think I heard you say, Madam Chairman, that there will be
an answer to this within a reasonably short period of time,
within a matter of weeks. Is that what you anticipate?
Ms. Schapiro. I didn't actually give a timeframe. I said we
will get to the bottom of this. I think we will be able to
determine what the initial triggers were. That is going to take
time. There were 66 million trades on May 6th, covering 19.5
billion shares of stock.
You think about what happened in 1987 when the market had
its largest move in history and the Brady Commission was
created. There were a tiny fraction of the number of trades
that we have experienced today, about 600 million shares of
stock compared to 19 billion shares. So that took several
months with a dedicated group of people working on it.
We will move as quickly as we can, but I can't give you a
date when we will have any final answers. But we will. We will
make them public. Next week, we plan to give preliminary
findings to our new advisory group, and we will make those
public at the same time.
Chairman Kanjorski. That is a very important question. In
order to have the stability in the market, I think that we
should not withhold anything from the public, because if we do,
we are apt to get all the conspiracy theorists very busy and
very active, and, as you know, you could imagine almost
anything. But you cannot rule out any particular cause at this
point; is that correct?
Ms. Schapiro. I think that is fair to say. We have not
found evidence of terrorist activity. We have not found
evidence of computer hacking or a ``fat finger'' or a
particular large trade that drove the markets initially. But we
are not ruling anything out at this point. And that is one
reason we want to make some preliminary findings available next
week, so the public can have confidence that we are moving
forward.
Chairman Kanjorski. What is the possibility that tomorrow
the same thing could happen?
Ms. Schapiro. I have to say it is not impossible. There is
no reason to expect that it would happen tomorrow. But that is
one reason, with quite a sense of urgency, we brought all of
the markets to Washington yesterday to start to work on some
solutions to the problem, focusing in particular on stock-by-
stock circuit breakers.
Chairman Kanjorski. So it is reasonable to assume, without
knowing the absolute cause of this event, you could put new
rules in place and organize the regulators and the markets to
prevent a similar occurrence of this in the future, even before
we get to the final cause?
Ms. Schapiro. Exactly. I think it is important to
understand the initial cause or triggering events. I think it
is critical. We know what the damage was that was done. We need
to put in place the mechanisms that can prevent that from
happening again, while we continue to diagnose the source of
the problem.
Chairman Kanjorski. I will ask this as a joint question
between the two of you, but do you have any suspicions that it
was done for profit or some other means by a group or
conspiracy group of any kind, or is this just a glitch in your
opinion, if you have one?
Ms. Schapiro. I don't think we have evidence--and, of
course, I will let Chairman Gensler speak to this as well--that
this was done in any kind of a malicious way. I think what my
inclination is is that we have a widely dispersed equities
market in the United States, several members have mentioned the
number of trading venues, and we had different rules and
conventions applying in those different markets that allowed
for activity to be transmitted rapidly from one place to
another without everybody following the same protocols.
Mr. Gensler. We may find that there is something that our
enforcement arm has to take up, and we have been very active as
of Thursday afternoon putting out a special call under our act
to large participants. There are about 250 participants in this
E-Mini contract during the course of the critical 20 to 30
minutes. We have been investigating most closely the 10 largest
shorts and the 10 largest longs in that market, but we are
looking at others as well.
I think it was sort of the turbulence in the skies added
with a lot of signals that were coming in, that markets do work
on, as they say, fear and greed, and in those critical moments,
I think in a sense, the fear took over. There was a second
factor, that individual stocks were breaking further down, and
that is an issue that we are talking about.
Ms. Schapiro. Mr. Chairman, if I may add, we have fully
integrated our enforcement group as well into the analysis, and
they have sent out a number of subpoenas so that we can look at
particular activity in very granular detail. Of course, if
there is anything there, we will be following up on it.
Chairman Kanjorski. As you know, we have passed in the
House the regulatory reform bill and it is now pending in the
Senate and being acted upon. There have been some individuals,
particularly some United States Senators, who have suggested
that there may be a remedy to be had that we could include
within the reform, regulatory reform provision.
Do you see that as a possibility? I guess the open question
I want to ask: Do either of you see a need for additional
authority as regulators to ultimately get to the solution to
this problem?
Ms. Schapiro. I think, Mr. Chairman, that we believe we
have the authority that we need with respect to the issue of
circuit breakers and potentially imposing stock-by-stock
circuit breakers. We certainly have the authority we need to
create and develop with the markets a consolidated order audit
trail which will facilitate our work greatly. And the other
issues that come out of the events of Thursday, looking at
whether market orders should be limited in certain
circumstances or how do we deal with canceled trades going
forward, I think we believe we have the full authority we need
there.
Coming out of our broader review of market structure, it is
possible that we will need to come to Congress for some kind of
authority, but I can't even predict at this point what that may
be.
Mr. Gensler. I would say, Mr. Chairman, I think that since
markets are so interrelated--securities, futures, but also the
over-the-counter derivatives marketplace--I think the reform
this committee has moved and hopefully Congress will move on
over-the-counter derivatives will give us a greater window,
because right now, our full review is on the listed securities
and, of course, the futures markets, but not the over-the-
counter derivatives that may have played some role on Thursday
as well.
Chairman Kanjorski. Thank you very much.
Now, the gentleman from New Jersey, Mr. Garrett.
Mr. Garrett. Thank you, Mr. Chairman, and I thank the
panelists again.
Just following up along that last line, I guess I was a
little confused by some of the comments from the Senate, which
often happens, as well. You had Senator Dodd saying we need to
get in place our bill, meaning the bill you just referenced,
and have the President sign it so we can have the tools to
protect our economy from these kind of events, sort of implying
that we do need to pass that legislation and give you that
authority.
Then, in the same breath, he also said, ``I don't think you
need the legislation in this area.'' My guess is you need the
regulators to step up and make sure that this high-frequency
trading, this flash trading that is going on, that is something
that clearly we ought to take a look at.
So on the one hand, he was saying we need more statutes and
more laws, but on the other hand, I think he recognized what
you just said, Madam Chairman, that you have the authority in
all these areas to address the situation.
Ms. Schapiro. We believe we have the authority to address
these events. Again, there may be issues that arise as we work
through the market structure concept release, all the many
issues we have raised there with respect to high-frequency
trading, volatility, and other matters that might require us to
come to you for legislation. But with respect to these issues,
and circuit breakers in particular, we have a high level of
confidence.
Mr. Garrett. Let's go to the circuit breaker situation for
just a second. I was just in Manhattan yesterday, meeting with
a number of my constituents who work in that area, and there
are, as you can anticipate, a number of rumors that are out
there right now. So maybe you dispelled one, and that is that
it was hackers. Maybe you can dispel another. But will you be
using your emergency authority in order to implement these
rules? That will be the first question.
Ms. Schapiro. First of all, we don't have final rules
constructed yet. And, one of the reasons we brought the markets
to Washington to discuss here in some detail and then to charge
them with going off and coming back with recommendations is
that we want the deep expertise and knowledge that they have
from running marketplaces every single day.
I think we are likely to do this through exchange rule
filings primarily that would come to the Commission for
approval. We understand the need for adequate time for
programming computer systems, and for educating other market
participants with respect to how the rules would operate.
Mr. Garrett. Okay. I will just throw out--here is an easy
one probably, as far as the rumors that are out there, is that
if you were going to suggest circuit breakers as far as
percentages of deviation of around as small as 2 percent, where
some of those traders would say that's just woefully too low.
Ms. Schapiro. We very much understand that issue. And that
is why again the exchanges are really assisting with how to
fine tune both the level of change in the stock price, over
what period of time, whether it's done off a rolling average or
off the prior day's close, and then what period of time for a
pause that gives the human being a sufficient amount of time to
make decisions that they need to make about whether algorithms
are not operating correctly, whether there is additional
liquidity that can be brought into the marketplace. So those
are all the issues we are discussing.
Mr. Garrett. I thought that was a simple question. So the
answer is, ``maybe?''
Ms. Schapiro. There is complexity to it. So I can't tell
you it would be 2 percent over 5 minutes in price changes. We
are just not at that point yet.
Mr. Garrett. Okay. Now, you also said, you all there at the
table, have set up a joint advisory committee? I am not sure--
Ms. Schapiro. That is right.
Mr. Garrett. That is right, a joint advisory committee? And
who all is on that joint advisory committee?
Ms. Schapiro. We selected people who have expertise in
markets and market microstructure in particular. So we have two
former CFTC Chairs: Susan Phillips, who was actually the first
woman appointed to Chair of a financial regulatory agency at
the Federal level by President Reagan; and Brooksley Born, also
a former CFTC Chair. We have David Ruder, a former SEC Chair
who went through the market break in 1987 and its aftermath;
Jack Brennan, the former CEO and chairman of Vanguard, a very
large institutional investor.
Mr. Garrett. I think my time is running out. Just quickly,
do you have any current market participants other than--
Ms. Schapiro. Actually, we have a current market regulator,
Rick Ketchum, who spent time at both NASDAQ and the New York
Stock Exchange. We did not want to have people who have a very
direct vested interest in advising the Commission, although
this group's deliberations will be fully in public and all of
our meetings will be public, but we tried to pick people,
particularly the academics, Maureen O'Hara from Cornell, Robert
Engel from NYU.
Mr. Garrett. It might just be good to have some of the
participants who are actually involved and up-to-date--
Ms. Schapiro. They are very involved. They will present to
this group. They will submit information to the group.
Mr. Garrett. One last--but you get my point on that area,
my concern there?
Ms. Schapiro. Yes.
Mr. Garrett. And in the last 10 seconds here, the chairman
indicated that he phoned you about 2 hours after this all
occurred. You are now asking the participants, the regulated
entities, to respond back in 24 hours from yesterday. One of
the questions I had over what happened yesterday is, if
Congress could call you within 2 hours to begin the process to
find out what's going on, did you have the authority actually
to e-mail out immediately to all 40 or 50 entities and say, we
want to have an answer back from you just like you did
yesterday from them?
Ms. Schapiro. I spoke with the heads of the major exchanges
on Thursday, through Thursday evening, all day Friday, and our
staffs were in minute-by-minute contact virtually the entire
day Saturday and Sunday. I did not want to bring them to
Washington on Friday. I thought they needed to be there when
their markets opened to handle any other fallout or issues that
might have come from Thursday. But Monday morning was a good
time. I wanted everybody in the room together. I didn't want ad
hoc e-mails with loose ideas. I wanted people together so that
we could think through what the issues were and how we might
best solve them as a group.
Mr. Gensler. And we, too, were talking directly to our
exchanges by 1 a.m., which, I guess, would have been Thursday
night. On Friday, we had our first memo from the Chicago
Mercantile Exchange analyzing this contract. We had the entire
data set loaded into our computers by 9:30 Friday morning.
Mr. Garrett. Okay. I appreciate that.
Chairman Kanjorski. The gentleman's time has expired.
Now, we will hear from the gentleman from California, Mr.
Sherman.
Mr. Sherman. Thank you, Mr. Chairman.
Volatility leads to perceived risk. Perceived risk leads to
higher cost of capital for real businesses in the real America.
If we had markets in which all the profits accrued to real
investors, I think that would be appealing to those making real
investments in real American companies. In contrast, a market
in which Procter & Gamble can drop to 1 cent is not appealing
to those who want to provide real capital to real companies.
Most of the testimony here simply assumes that we are going
to let people keep doing what they are doing unlimited and
untaxed and we are going to patch up the system in the hope
that it won't happen again. This is like the reaction if we had
an unplanned explosion of nitroglycerin. If that explosion took
place in a mining operation or something else socially useful,
we would say, let's have better regulations so that we can get
that social utility of the nitroglycerin without having it
explode in an unplanned way. But if this inherently risky
nitroglycerin had an unplanned explosion because kids or
gamblers were playing with it, we might instead say, how can we
somewhat reduce the risk of an inherently risky activity? We
would ask, why are we allowing this activity to take place? So
it raises the question of whether high-frequency trading serves
a social purpose.
Imagine--Chairman Schapiro, imagine if somehow by magic we
created a world in which those investing in U.S. stocks
actually held them for a couple of hours before they sold them
or went short for a couple of hours before they covered, and
let's say that applied to Procter & Gamble or 3M. How would the
employees of Procter & Gamble or 3M--what catastrophe would
they face if the stocks of their companies were not subject to
high-frequency trading? Would that help those employees in
those operating companies, or would there be some cataclysmic
problem if high-frequency trading did not apply to those
companies?
Ms. Schapiro. Congressman, let me first of all agree that
the purpose of our capital markets is to help companies raise
capital to create jobs, to help our economy grow, and that
investors who commit their capital to those markets get to
share economically in that growth and development. We have lots
of questions about high-frequency trading and its role in our
capital markets. It's one reason we have exposed many of the
issues related to high-frequency trading for public comment
and--
Mr. Sherman. Madam Chairman, I know you have many
questions. I have one question, and it is my time. What
catastrophe would occur to the employees of Procter & Gamble if
the stock of that company was not subject to high-frequency
trading?
Ms. Schapiro. I don't know that any catastrophe would.
There are those who will argue perhaps on the next panel that
high-frequency trading adds significant liquidity in the
marketplace so that when those Procter & Gamble employees want
to sell, it is easier for them to do that.
Mr. Sherman. Now, to what extent do you agree with the view
that those high-frequency traders are just parasites on the
market? You have a market in which real investors are buying
and selling and then people come into that market and grab a
little piece of the profit for themselves who are not engaged
in real investing.
Ms. Schapiro. I guess I can't really answer that question.
Mr. Sherman. So they may be parasites; they may not be. And
I will ask you to answer that for the record because I am going
to go on to the next question. Would a tax of 1/20 of 1 cent
per $1,000 be sufficient to disrupt the business model of those
who are engaged in high-frequency trading so that they would
substantially diminish the amount of high-frequency trading?
Ms. Schapiro. I honestly don't know the answer to that
question; so I will be happy to think through and--
Mr. Sherman. I will ask you to think it through, and then
we will have the argument that if we don't have the casinos on
our Main Street so they will play the casinos in Monte Carlo,
but I would say that if all the American markets trading
American stocks were insulated from most of this high-frequency
trading that is where real investors would want to go, and if
over in Dubai, somebody wants to bet for a millisecond on what
happens on the U.S. markets, at least it is not American minds,
American computers, or the American markets put at risk. And I
believe my time has expired.
Chairman Kanjorski. Thank you very much, Mr. Sherman.
Now, we will hear from the gentleman from Alabama, the
ranking member of the full committee, Mr. Bachus.
Mr. Bachus. Thank you, Mr. Chairman.
When the steam engine came along, it hit a lot of livestock
and a lot of the farmers thought that they should probably do
away with the steam engine. It also set fire to some of the
fields. But we figured out some preventative measures, and we
have done okay with it. Of course, it was replaced by the
diesel engine, and a lot of people thought that was a setback.
I kind of think high-frequency is not such a bad thing.
As I said in my opening statement, you identified some of
these problems back in January and started asking for public
comment, which is what we have always heard you to do. So I
think you have your hands around the problem. How do you--we
have gone from a highly structured duopoly, NASDAQ, not with
options, but with NASDAQ and the New York Stock Exchange. The
40 or now what I am now hearing 50 different trading platforms.
How do you ensure the integrity of the markets price discovery
without hurting competition and without degrading those
individual models which all have their strengths and
weaknesses. So I would ask both chairmen.
Ms. Schapiro. It is a great question because there are
clearly challenges associated with our highly automated and
highly disbursed and fragmented marketplace. And I think the
way we ensure integrity is to have those markets linked so
investors' orders get the best execution that they can, and
that is a requirement under Regulation NMS. But looking forward
what we have to do is make sure that the markets are operating
under basically the same rules so that an investor is not
disadvantaged by trading the same stock in different venues.
They should be able to get the best price wherever they are.
And I think the issues that are highlighted by Thursday, many
of them are addressed--not solved but addressed well by the
creation of single stock circuit breakers that would allow for
the times when the technology gets ahead of the people by too
much, to take a time out and refresh the marketplace. But we
have raised so many of these issues in our market structure
concept release because we really do want to explore them in a
thoughtful way.
While we do that, there are some short-term things I think
are very important for us to do. The circuit breakers are among
those. Dealing with direct access by customers into the
exchanges is something I think we need to deal with and some
issues around dark pools of liquidity and the use of flash
orders and others, all of which we have under consideration
right now.
Mr. Gensler. And I just think that--although it is outside
of my lane a bit, that it is really important that those 40 or
so venues, and it may be 70 in the future, have consistent
transparent rules that are available to the public. If there is
a timeout or a pause, whether it is 5 seconds, milliseconds, or
a minute, that it be consistently applied. If you go dark on a
stock somewhere, you go dark elsewhere. You even do it in
single stock futures where we co-regulate and so forth.
Mr. Bachus. And I commend you. I used the word ``address''
not ``solve'' in my opening statement too, because I think we
are trying to address them but you never quite solve all the
problems. I also believe--and both you and your statements, and
Chairman Gensler, you mentioned that there is already a lot of
skittishness in the market, a lot of increased volatility.
People are on the edge of their chairs anyway. So obviously, as
I said, it created an environment. Do you think we could find--
and I suspect that there is not one contributing cause of this,
that it was probably a combination. Now, you could have had a
large trade in the S&P 500 SPDRs and you could point to that as
possibly a part of it, but that doesn't mean that wasn't a
legitimate hedging to buy.
Mr. Gensler. Right. I think, Congressman, in our capital
markets there's not one king or one czar or something. It is
diverse. That is in a sense the beauty of markets. But I think
that this was a very turbulent time. I think there were a lot
of price signals by 2:00 to 2:30 that were going negative. If
it was an airplane analogy, you had the indicator lights now
sending charges back. You also had one of the engines start to
not run too well because liquidity was stepping out of the
market. We did see by 2:40, 2:42 a number of active market
makers, even these high-frequency traders were limiting their
capacity. The major exchanges have said their order books
seemed thinner. That means there were less bidders in it. In
addition to that, you had a little extra cargo, this bona fide
hedging program. It was only 9 percent of the E-mini, but it
may have had some factor in this.
Mr. Bachus. I know the SEC has addressed at least dark
liquidity as part of their concept. Do you have any comment,
Chairman Schapiro?
Ms. Schapiro. The only thing I might add to the scenario
that Chairman Gensler ran through is we also saw, because of
the skittishness in the market, I think, a lot of stop-loss
orders had been entered by investors hoping to limit their
losses. Those were run through, and as a result, the market
continued to drive down.
So one of the things we want to look at is the use of stop-
loss orders and the use of market orders, which get you a fast
execution, but maybe at a really terrible price, along the
lines of the chairman's comments at the very beginning. So
those are two other areas.
Mr. Bachus. It seems there should have been some obligation
by the brokers not to execute an order on a $30 stock at a
penny. That is just good--I think that is a fiduciary
relationship.
Thank you, Mr. Chairman.
Chairman Kanjorski. The gentleman's time has expired.
Now, we will hear from the gentleman from Texas, Mr.
Hinojosa.
Mr. Hinojosa. Thank you, Mr. Chairman. Thank you for having
this hearing.
Before I make a statement and ask some questions, I ask
unanimous consent to enter into the record the Joint CFTC and
SEC Advisory Committee on Emerging Regulatory Issues, dated May
10, 2010.
Chairman Kanjorski. Without objection, it is so ordered.
Mr. Hinojosa. Thank you.
I agree with my colleagues on both sides of the aisle that
the Dow Jones Industrial Average plummeting 990 points, losing
22 percent of its total value cost caused a great deal of
concern for those of us on the House Floor that Thursday
afternoon. The S&P 500 dropped 20 percent, falling from 282 to
225 points, and this was the greatest loss Wall Street had ever
received on a single day.
I want to ask a question first of Chairman Schapiro. Was
market fragmentation a key cause of last week's 990 point drop
in the Dow Jones index?
Ms. Schapiro. Congressman, I don't think there is any
question that the fact that we have a highly fragmented market
is a contributing factor here and creates challenges. It
doesn't have to be the result that we had last Thursday if the
markets, while dispersed and many of them, play by the same
rules and have the same trading convention, so that if all of
the markets are subject to halting trading in a stock when it
reaches a certain price, then I think we would not have had
some of the fallout that we had last week.
Mr. Hinojosa. Having a Brady Commission which has made lots
of recommendations, tell me, have any of those recommendations
been put into effect?
Ms. Schapiro. Oh, yes. The actual marketwide circuit
breakers that exist today were a direct result of the Brady
Commission's report in January of 1988. One of the things we
are also looking at jointly between the two agencies is whether
those marketwide circuit breakers that have the market shutting
for brief periods of time when the DOW goes down 10, 20, and at
30 percent shutting completely need to be updated and
modernized, and that is an effort we are undergoing right now.
Mr. Hinojosa. So if you could tell me the similarities then
of that October 19, 1987, market crash and give me the
similarities, and is that being investigated so, as you said,
that it not happen again?
Ms. Schapiro. Absolutely. If you look--I actually went back
and looked at the Brady Commission report over the weekend and
it is interesting that their findings are that there were
multiple events that caused the market to decline--I believe it
was 26 percent in October of 1987 on that day. And that is
similar, I think, to what we will ultimately find here, that
there were multiple contributing events. The difference is that
trading largely took place at that time on the NASDAQ stock
market and the New York Stock Exchange. There were not multiple
trading venues, although there was trading in the futures
markets that was delinked from the trading in the equity
market.
The delinkage issue exists today among the equity market.
So we see another similarity there. We are trying to do the
same careful and thoughtful review of the events that we expect
will lead us to some kind of recommendations that, while not
the same as the Brady Commission, are similar in that they lead
us to further elaboration on circuit breakers, for example, or
order types that we might want to limit going forward.
Mr. Gensler. I would say one thing, that 23--and I remember
because I was back then in a financial firm--I think one thing
is that 23 years ago, though there were computers back then,
there was nothing like what we have now, and this whole concept
of trading in nanoseconds and microseconds and automated
traders. That is why both of our agencies have active reviews
of high-frequency traders that includes looking at issues of
co-location, where they put the computers, where the exchanges
are, looking at issues with regard to account identification
and all of the issues in terms of access to the markets of
these high-frequency traders. That is something really new in
this market environment from 23 years ago.
Mr. Hinojosa. Chairman Gensler, let me ask you a question,
then, with that comparison you just gave. We need the SEC and
your group, the CFTC, to step up to the plate and ensure that
such market disruptions don't occur in the future. Do you have
enough funding and authority to prevent such an event from
reoccurring?
Mr. Gensler. I thank you for that. We are a sorely
underfunded agency and actually shrunk about 23 percent in the
8 years before this Administration. With Congress' help, we are
back to just about the size of we were 10 years ago, and we
have put in a request, particularly if over-the-counter
derivatives reform came into being to grow significantly from
where we are. We do need more enforcement lawyers, cops on the
beat, and we need more computer systems to try to stay up with
the automated surveillance that we need of these markets.
Mr. Hinojosa. Do you leave it to--I think my time has been
exhausted, and I thank you, Mr. Chairman.
Chairman Kanjorski. Thank you.
Next, we will hear from the gentleman from California, Mr.
Royce, for 5 minutes.
Mr. Royce. Thank you, Mr. Chairman. I think it was a London
economist who wrote--gave us a British perspective. They said
when Congress doesn't understand or like something like work or
investment, Congress has a tendency to further tax it or
legislate it out of existence, and I was reminded about that
when the legislation was referenced earlier. And I wanted to
ask Chairman Schapiro--there is legislation here in Congress
for a transaction tax on every financial transaction, and I was
going to ask you, is the solution to slow our markets through
this transaction tax on financial transactions, or is the
solution to speed up our protections through real-time circuit
breakers? I had mentioned earlier in my opening remarks the
concept that Germany has employed with respect to looking at
individual stocks.
If individual stocks fall more than 5 percent in 5 minutes,
then you have those circuit breakers go into effect until the
markets have sorted it out. And it just seems to me that if we
put this transaction tax on trading, what we are really going
to do is provide less liquidity, and I wanted to ask if that is
a valid concern there and your thoughts.
Ms. Schapiro. Let me, say I have studied the Deutsche Borse
individual stock mechanism, and it informed very much our
conversation that we had with the exchanges yesterday because
my personal view is that if we can do circuit breakers on
individual stocks, depending upon the velocity with which they
are declining in value, it will allow us to take a timeout for
some period of time, and that every market must honor that
timeout, we will have done a lot to make a difference here.
And I think it is important for us to do that in relatively
short order. I guess tax policy is way beyond my pay grade and
really my depth, but I don't--I just don't have a view, I
guess, about whether imposing a transaction tax would be an
effective mechanism to slow the market or not. I don't know
what the impact necessarily would be on high-frequency or
algorithmic traders.
Mr. Royce. My colleagues have brought it up on the other
side of the aisle, so I thought I would pursue that. But let me
ask you another question and that goes to the events on
Thursday. Does this situation justify looking at trying to put
all of the markets under one regulator? You have equities,
options, future markets--they are all interconnected. They are
all correlated against each other. And we passed a regulatory
reform bill out of the House last year which I think moves us
in the right direction, but you still have two separate
agencies with two separate sets of rules, and I just think
about some of the studies that I have seen where whether you
are liberal or conservative or in the center, these think tanks
and economists that have looked at this have all asked the
question, if you have the same entities trading the same
products but two different regulators with two different sets
of rules, aren't you compounding the difficulty here and isn't
this simply the result of not being able to move forward with
real world-class regulation? So I would like to ask you,
Chairman Schapiro, for your view on that.
Ms. Schapiro. Certainly. Let me just say that the SEC does
have jurisdiction over all of the equity and options markets;
we don't over the future markets. And I know Chairman Gensler
has heard me say this before, that I think if we were writing
on a clean slate, we would not create the regulatory structure
around these instruments or these market participants that we
have today and that there would be efficiencies gained by
merger of the two agencies. But I want to hasten to add that
I--and I was CFTC Chairman quite a few years ago and I have
been around both agencies for many years. Never in the history
of either of those agencies have I seen closer collaboration or
cooperation or willingness to support each other as we try to
get done these things that we think are important in each of
our marketplaces. So while we don't have a merged agency, I
think we have very--the next best--
Mr. Royce. Very good. Let me quickly ask you my last
question: Is there any evidence that the uptick rule would have
prevented this calamity on Thursday? I recall reading an SEC
study which said that there's no way that the uptick rule in
today's markets could be of assistance, but what is your view
on that?
Ms. Schapiro. As you know, we did pass a new version of the
uptick rule, a short sale circuit breaker rule that is not in
effect yet, and won't be until November. It is possible new
rules may have helped to the extent short sellers were active
during this time period, but what we actually understand is
that the level of short selling as a percentage of trading
volume during that critical 30 minutes from 2:30 to 3:00 was
lower than it was at other times during the day. So to the
extent the sales we saw were long sales, the uptick rule would
not have made a difference.
Mr. Royce. So it really seemed to be a lack of liquidity
problem?
Ms. Schapiro. To the extent they were short sales and
probably something we are looking at, it might have made--it
might have had some impact.
Mr. Royce. Thank you very much.
Chairman Kanjorski. Thank you very much, Mr. Royce.
And now, the gentleman from North Carolina, Mr. Miller, for
5 minutes.
Mr. Miller of North Carolina. Thank you, Mr. Chairman.
I assume that the value to our economy of securities
markets is that it matches people with money to invest with
people who can put the money to productive use, and the usual
justification for high-frequency trading is that it adds to
liquidity. And I could understand, for instance, that someone
who thought they might buy a house for an investment but might
need to sell it would be reluctant to buy a house because they
might have trouble selling. But I really don't think, before
high-frequency trading, that there was that much difficulty in
unloading a stock.
Is there any evidence that people are more willing to
invest in stocks now because of increased liquidity, that
people who really want to buy and hold a stock who actually
want to own the company?
Ms. Schapiro. I don't want to dodge your question, but I do
want to say this is exactly the kind of issues we are looking
at in our high-frequency trading release, the issues that we
published for public comment and public dialogue. And we want
to understand, what is the role of high-frequency trading? Is
there a benefit to our marketplace? Are the interests of high-
frequency trading aligned with long-term investors or are they
at odds with long-term investors? And if so, because our
markets serve the purpose of, just as you say, allocating
capital to useful endeavors and to creating jobs, we want to
make sure nothing is detracting from that. So we are doing a
very deep dive. The comment period just closed about 2 weeks
ago, and we are working through those issues now.
Mr. Miller of North Carolina. A stunning number of trades
are announced every day. Is there any reason to think--and I
know that you are still in the middle of this--that there are
more trades, more purchases every day by people who really want
to own a stock, who want to buy it and hold it and invest in a
company? We used to think of patient capital as being someone
who would hold a stock for years. Now, patient capital seems to
be a couple of hours or less.
Ms. Schapiro. I don't know the answer to that offhand, but
I would love to have some research done and see if we could
provide you with more detail. There are--just on this 1 day
last week on Thursday, there were 66 million trades and what
percentage of those were long-term buyers and holders versus
high-frequency traders who held instantaneously, I don't have
an answer, but I would like to see if we could get one for you.
Mr. Miller of North Carolina. The statistics or the
estimates that I have seen are that 40 to 70 percent of all
trades are high-frequency trading. Is that roughly correct?
Ms. Schapiro. Yes. We have heard those numbers as high as
70 percent.
Mr. Miller of North Carolina. Okay. Jon Stewart had a piece
the other night showing the number of times that events in the
financial markets have been called a ``perfect storm,'' and
they seem to happen every couple of weeks, which is maybe not
the idea of the definition of perfect storm, which is this
completely unpredictable combination of events that maybe
happens every 100 years. They seem to happen every couple of
weeks. In looking at what happened, can you also look at what
else--it seems unlikely that this very thing will happen again,
but something that we had no reason to think might happen seems
to be happening with disturbing frequency. Can you look at
destabilizing factors in the market generally so that maybe not
this perfect storm will happen again, but other ones also?
Ms. Schapiro. Absolutely, and that is part of our broader
market structure review that we are doing.
Mr. Miller of North Carolina. Okay. Thank you, Mr.
Chairman.
Chairman Kanjorski. Thank you very much, Mr. Miller.
The gentleman from Oklahoma, Mr. Lucas.
Mr. Lucas. Thank you, Mr. Chairman.
And Chairman Gensler, let me thank you for attempting to
track me down on Thursday evening. I was on a plane, but I
appreciate your attempt to call me in my role as ranking member
of the Agriculture Committee.
You mentioned earlier in one of your comments in reference
to last week that derivatives may have played a role. Chairman
Gensler, is that a hunch? Is that a gut feeling? Or is that
something you potentially see in all those reams of data you
are working through now?
Mr. Gensler. There are derivatives that are on exchange,
futures, and we can see that data. I think my earlier comment
was just saying that we can't look right now into over-the-
counter derivatives, and with your support and this committee's
support, I think the bill that you passed out of the House last
December would at least, in the future, in a similar
circumstance, allow us to at least see that data.
Mr. Lucas. Along that line, Mr. Chairman, you have always
been a very vocal supporter of the mandatory exchange trading
for derivatives that listed for clearing with little or no
regulatory flexibility. After last week's trading activity and
the listed equities market, which is, I think we would all
agree, about as liquid a market as you can have, do you still
believe that mandatory trading is the sensible route to go for
over-the-counter derivatives, which are very illiquid
instruments? And thinking about that reduced volume and reduced
liquidity, if there is a wild action or an aberrant trade,
isn't the potential far more damaging?
Mr. Gensler. I appreciate the question. I very much still
am. I think that the over-the-counter derivatives market, which
dwarfs the future exchange derivatives market by about 8 to 10
times the size, no small amount, I think we must bring the
transparency there. Not for all contracts, however. There will
be a whole group of contracts that are customized. There will
be a whole group that aren't listed, even if they are
clearable. But I think that for the portion of the market that
can be listed and has some characteristics that will add
transparency, we should have exceptions for block trading.
If somebody is doing a lower transaction, then it is just
reported afterwards, just as it is in the futures and
securities markets now, but I think that the events of last
Thursday are important to look at. They don't change my overall
view that we need to bring transparency to the off-exchange or
over-the-counter derivatives marketplace where we can, not in
the customized portion of the market but in the more
standardized portion of the market.
Mr. Lucas. So ultimately, when you do and your good folks
over there and your friends at the SEC grind through all of
this and come up with some sort of a determination, we will
have a much better feel. I just personally still have to
believe that having watched what the Agriculture Committee did
and working in conjunction with Financial Services, trying to
be a bit more flexible, a bit more rational in how we handle
these derivatives, I personally think was the route to go. I
know ultimately after last week, we will reassess the
situation. But I just wanted your perspective on that because
while both of you have indicated today there was no ``fat
finger,'' no magic mystery key stroke, no great confusion in
somebody's software, nonetheless, if whatever did occur could
have such an effect on the most massive, most liquid market in
the world, it does cause concern for me about these other
markets, these other instruments that don't even begin to
approach that.
Mr. Gensler. And that is why I think it is not only
important that we have strong risk management in the
clearinghouses that the Congress has been supportive of, but
also that these exchanges for derivatives have very strong
rules. I think the futures market has some very important
guidance, the four that I have mentioned earlier in terms of
not being able to put prices in in the outset of a ban; and
having the pause, the 5-second pause that happened in the
futures market last Thursday was, in fact, right at the bottom
where the order book got refilled. And the mention that
Chairman Schapiro was talking about of trying to do that across
the securities markets, I support her initiative on that.
Mr. Lucas. One last brief question. If indeed we do
determine what happened, what the odds that it will be
something of a proprietary nature where you won't be able to
share that with all of us and the public?
Mr. Gensler. We plan to make our findings public both to
Congress and this committee. Next week will just be initial
findings of staff. If there was a need to talk about individual
trading, information of individual accounts, than we would work
with this committee to do that in the appropriate setting.
Mr. Lucas. I look forward to letting the chips fall where
they may. Thank you.
I yield back, Mr. Chairman.
Chairman Kanjorski. Thank you very much, Mr. Lucas.
And now, we will here from the gentleman from Georgia, Mr.
Scott.
Mr. Scott. Thank you very much, Mr. Chairman.
First, let me commend you, Chairman Schapiro and Chairman
Gensler. Your presentation certainly gives us all confidence
that you have your hands around the problem. While you are
looking for the causes, you have certainly shown that you have
put certain measures in place to give confidence to investors
to keep on investing with confidence. It seems to me though
that what we really have here is a way we are trying to find to
stop a freefall in a free market in a free economy while it is
very important to keep the markets free. That is the strength
of our markets, the freedom. So as we move with controls, my
question has to evolve around this element that you are
presenting as the most basic means of controlling this free
market so at the same time making sure it is still free to
function in the beauty and the strength that it has. And your
instrument for doing this apparently is the circuit breaker.
And the circuit breaker basically is a function of time
increments. It is a function of pricing. And I wonder, how
would you determine that? Who will determine that? Will it be
an increment of 15 minutes if it goes down 5 percent, or would
it be 2 or 3 hours if it goes down 10 or 20 percent? And will
it apply across each exchange? We have seven of those
operative. Or would it apply just to individual stocks? How
simply would that circuit breaker work and allow still for the
freedom of trading?
Ms. Schapiro. Congressman, that is a great question. And I
think it is important to note that we very much believe in the
market and in the market mechanism, but I don't think anyone
would argue that when the market went down 900 points in a
very, very short period of time, and 500 points in a matter of
a couple of minutes, that the real forces of supply and demand
were operating. We clearly had a problem that was related to
the fact, in my view, that we had markets operating under
different sets of rules.
We also had some issues about liquidity leaving the
marketplace. Certain types of orders exacerbated that. The use
of something called stub quotes that allowed transactions to be
executed at a penny contributed to that. But clearly, something
didn't work unrelated to market forces that we normally applaud
and think make our markets better.
The circuit breakers that we are talking about with the
exchanges would be designed based on longtime experience in
other markets around the world which already have circuit
breakers on a stock-by-stock basis as well as the experience
of, for example the New York Stock Exchange which already has
the equivalent of a circuit breaker, which I am sure they will
talk about in their testimony in the next panel. Bringing in
collective experience of all those markets together with the
ultimate approval of the SEC for any rules that would institute
circuit breakers, I think gives us some confidence that we will
be able to get it right, and if we don't, we will have to
revisit it and make adjustments.
On a marketwide circuit breaker, as we have in our markets
today that applies across the equities options and futures
markets, both the SEC and the CFTC would ultimately decide
whether changes to those existing circuit breakers are
appropriate.
Mr. Scott. Part of the problem is the lack of uniformity
across the markets.
Ms. Schapiro. Absolutely.
Mr. Scott. So who in your estimation would be the entity
that would make that determination at the particular time that
circuit breaker goes into effect?
Ms. Schapiro. There are two ways to do it, and the way I
favor, quite honestly, is the one that has people knowing every
day when they walk in that the price of--if a stock moves--and
these are just examples--5 percent in 5 minutes that the market
for that stock will be shut at every place it trades for a
period of 3 minutes or 5 minutes or whatever is appropriate.
The certainty of knowing ahead of time, I think, is of enormous
benefit to markets because they thrive on that kind of
certainty about what the rules would do.
Another way to do it would be to allow a listing market, so
if it is a New York Stock Exchange stock for the New York Stock
Exchange, to be able to say that we are shutting down or we are
going into slow mode or we are turning off the electronic
systems for 1 minute in this stock and all other markets would
have to follow if that doesn't provide all of the upfront
certainty that we get from circuit breaker.
Mr. Scott. Let me just ask, since my time is up, would this
circuit breaker also work for a dramatic rise in price of stock
as well as a lowering?
Ms. Schapiro. There seems to be less appetite, I will say,
for circuit breakers on the upside.
Mr. Scott. And if you had your druthers, would we have one
centralized entity for determining when the circuit breaker
goes, or would you recommend that each of the major exchanges
have their own individual and that reaction sets in for the
others?
Ms. Schapiro. I think there has to be a minimum circuit
breaker that applies across every market that trades for
whatever the stock is or we will have exactly the problem that
we had on Thursday.
Mr. Scott. Okay. Thank you, Mr. Chairman.
Chairman Kanjorski. The gentleman's time has expired.
The gentleman from Texas, Mr. Hensarling.
Mr. Hensarling. Thank you, Mr. Chairman.
I have been here since the hearing was gaveled into order
and noticing the title of our hearing, ``What Happened and What
is Next?'', I don't think I have heard what has happened, but I
have heard a lot of debate about what is next, and I somewhat
question the wisdom of debating what is next when we don't know
what happened. Perhaps I missed something, but I think--
Chairman Schapiro, I believe I heard you say that you are
working around the clock to find the cause, but you don't have
an answer today; is that a fair paraphrase of what you said?
Ms. Schapiro. That is fair.
Mr. Hensarling. And that you will share the trigger as
identified with the public when you identify the trigger?
Ms. Schapiro. As we--trigger or triggers--
Mr. Hensarling. Trigger or triggers.
Ms. Schapiro. When we understand what the cause is, we will
absolutely share it with the public.
Mr. Hensarling. Okay. And Chairman Gensler, I think I heard
you say something similar, that your people are diligently
fact-finding at this point, but you are not prepared to
announce a cause of--
Mr. Gensler. I would say that I think that the four factors
I mentioned contributed to the turbulent market--we are
continuing to research to see if there is a fifth or a sixth
(and so forth) factor but the four factors I mentioned, the
turbulent environment that this--the market--if I can use the
airplane analogy, there were a lot of signaling advices. When
market participants start to see bad signaling, they start to
sell. They start to lay off risk, if I can use an old market
term.
Third, there were some active traders providing liquidity
stepping back from the market. I think there will probably be
others that we will find as we do more research. And we were
saying in a down market, we need to hedge. We need to put on
bona fide hedges.
Mr. Hensarling. So is it fair to say then that certainly
you have localized individual factors worthy of further
research, but you still have yet to draw the conclusion as to
the trigger for this incredible violent market volatility?
Mr. Gensler. I think we will have staff report preliminary
findings next week that will have more in them. However, there
is a factor that I think we have definitely identified, which
is across the securities markets that individual securities
trading down to a penny a share, if I can swim outside my lane,
as Chairman Schapiro said--really is not acceptable in the
capital markets when they were tracking moments before at $40.
That is something--that cross-market pauses or circuit breakers
is about.
Mr. Hensarling. I certainly agree, Mr. Chairman. It seems
like, to some extent, the hearing is concentrated less on
perhaps what is the underlying cause and is kind of turning
into a debate of high-frequency trading, its relative benefits
or relative cost. I have in my hand an editorial that was
written, Chairman Schapiro, by one of your predecessors, Arthur
Levitt, that appeared in The Wall Street Journal about 8 or 9
months ago. In the editorial, he posits, ``Due to the rise of
high-frequency trading, investors, both large and small, enjoy
a deeper pool of potential buyers and sellers and a wider
variety of ways to execute trades.'' He went on in this
editorial to write, ``Choice abounds and investors now enjoy
faster, more reliable execution technology and lower execution
fees than ever before. All of that contributes significantly to
market liquidity, a critical measure of market health and
something all investors value.''
Do you have a comment on your predecessor's thoughts?
Ms. Schapiro. I do think investors have a lot of choices
today. I think that is generally a good thing. I do think that
they benefit from narrower spreads and lower costs as a result
of competition in our marketplace. But I also don't think they
benefit from the kind of conduct that happened on Thursday
where, in part because of disparate rules across marketplaces,
investor orders were treated very differently and we had the
phenomenon of a stock at $40 trade at a penny.
And so while we don't know all the causes of the
volatility, we do know what some of the symptoms were, and we
can go ahead and tackle those, I think, understanding that we
want to be cautious, we want to be thoughtful. We don't want to
harm what is good about our markets. But I also think we run
the risk of losing investor confidence if we don't move forward
to fix some of the things that we believe and the exchanges
believe are problems.
Mr. Hensarling. If I could, Chairman Schapiro, have you
comment on another part of his editorial dealing with the
suggested 25 basis points per trade tax on all trades. Chairman
Levitt said, ``Such a tax has been tried before from 1914 to
1966. There is a transfer tax set at .2 percent of stock
trades. That expense was simply passed on to investors. A tax
on such transactions would probably drive high-frequency
traders and the liquidity they bring to foreign markets.'' I
know you didn't want to get dragged into tax policy, but do you
have an empirical observation on whether or not historically
such taxes have been passed on to investors?
Ms. Schapiro. I really don't know the answer to that. I
assume most costs are passed on to investors one way or
another.
Mr. Hensarling. I agree. Thank you for your time.
I yield back, Mr. Chairman.
Chairman Kanjorski. The gentleman's time has expired.
Now, we will hear from the gentlewoman from Illinois, Ms.
Bean.
Ms. Bean. Thank you, Mr. Chairman. And thank you, Chairmen
Schapiro and Gensler, and Director Cook, for your testimony
today.
In the Wall Street reforms that we have already passed in
the House and are pending in the Senate, an amendment that I
authored and was included will require evaluation by the
oversight camp council, the systemic risk council, to
evaluate--identify and evaluate potential threats to the
stability of the financial system. It would also require that
they establish plans and conduct exercises in the same way that
the Department of Homeland Security and other agencies do to
potentially avoid or respond to or contain emergencies that
would happen. And then they will provide a report back to
Congress on the results of what they have anticipated and what
they have discovered.
My question to both the chairmen is, the functional
regulators such as yourselves already have the authority to do
those types of exercises and plan ahead for eventualities,
however slight you think the probability. Can you share with me
in terms of those types of exercises reports and plans what had
been done prior to May 6th in each of your organizations? I
will start with Chairman Schapiro.
Ms. Schapiro. Sure. And I may ask Mr. Cook to jump in here,
because we do something called an ARP, an automation review
policy examination, of all of our regulated markets to test the
quality of their systems, the security of their systems, the
robustness and the resiliency of their systems and their
backups, and that is a routine program we engage in regularly.
We are also gathering data, as I have said, probably 300 times
here and everyone is tired of hearing, through our market
structure concept release on issues that will relate in some
part to systems and particularly the impact of strategies that
are utilized by algorithmic traders and high-frequency traders
on quality and the integrity of our markets.
Ms. Bean. Chairman Gensler?
Mr. Gensler. We are fortunate to be able to get the
position data every day, so what we got last week was not
unusual because under our statute, we are able to get the whole
set every day. Every Friday, the five commissioners sit in a
room and get a surveillance brief on the activities of that
marketplace for that week. Then, we also look at over the next
week as to how the futures market is coming together. So we do
it on a real-time basis week to week in terms of our
surveillance in the markets. In terms of last Thursday, if I
might say, Secretary Geithner had us and the whole President's
working group together--I think it was a 4:15 call.
I can't remember the evening call we had. The first thing
Friday morning again, and maybe there was a second one Friday.
I can't recall. So the President's working group may sort of
mutate into this council in a sense. But, there was a very
active cross-governmental collaboration Thursday evening,
Friday, and over the weekend.
Ms. Bean. Thank you. Director Cook, did you want to add
anything further? No?
I guess my question would then be, moving forward, do you
anticipate further rigorous planning, out-of-the-box thinking
about potential scenarios that you may not have otherwise
anticipated?
Ms. Schapiro. Absolutely. And one of the reasons we
proposed just a couple of weeks ago a large trader reporting
system, which exists on the CFTC side--I recall it from my days
there--on the equity side so that we can actually identify much
more quickly the activity of high-frequency traders in the
markets on a routine basis. And we are--the Commission will
vote in about 2 weeks on the proposal to create a consolidated
audit trail so that we can track from the inception of an order
through execution and settlement every modification, every
change, every hand that touches that order through our market
processes. And we can then do these kinds of market
reconstructions far more efficiently than we are able to do
this one now, having to combine multiple audit trails from
every one of our trading venues.
Ms. Bean. I guess my question is audit trails are after the
fact, but preemptively, will you be doing scenarios and
anticipating if someone seeks to do harm in the market or to
manipulate the market in some way for their own gain--are you
anticipating those potential attempts and running through
scenarios?
Ms. Schapiro. I think we are doing that now, and certainly
Thursday heightened our urgency about doing that. But I also
think that having an audit trail and understanding the trading
data better will enable us to think more creatively about what
kind of scenarios we ought to be thinking about and worrying
about.
Ms. Bean. I have another question--go ahead.
Mr. Gensler. I was just going to say that although we do
similar things internally, we don't think that is enough. One
of the reasons we came together to form this joint advisory
committee is really to have outside experts looking out over
the horizon and saying what is the next emerging risk that we
ought to be looking at.
Ms. Bean. I see my time has expired. I will yield back.
Chairman Kanjorski. Thank you. We will now hear from the
second gentlelady from Illinois, Mrs. Biggert.
Mrs. Biggert. Last but not least. Thank you, Mr. Chairman.
Following up on that, I think that some of us might recall
that we do have Chicago First, which is really a public-private
partnership that was created in 2003 legislation, and this was
following 9/11 that was a model for the rest of the country,
and I think there are quite a few of these groups. Have you
worked with them at all?
Ms. Schapiro. I have not.
Mrs. Biggert. Maybe we can discuss that at some time later.
But my next question was for Chairman Gensler and--
Mr. Gensler. Actually, to answer your question, we have
worked with them.
Mrs. Biggert. As you know, CME uses a number of risk
management controls. Can you explain how CME was able to
contain the contagion that originated in the equities markets?
Specifically, can you explain how the stop price logic works?
Mr. Gensler. There are a number of risk management controls
in the futures markets. The stop price logic, which is one of
four, works within their computerized trading platform called
glowbacks. As the market goes down or up, if the orders in the
book are going to be spreading so much that there will be a
cascading of what is called stop-loss limit orders--that is a
mouthful. But if there is a cascading that I believe goes more
than 6\1/2\ points, then it will actually pause, give 5 seconds
for more orders to come in.
That is what happened right at the bottom of the market at
2:45.28, there was a 5 second pause. As the market traded up
three-quarters of a point and then as it did it sort of moved
up.
Mrs. Biggert. So should a similar rule be applied to other
markets, equities?
Mr. Gensler. I think that Chairman Schapiro is talking--
because there are different characteristics, but across the
platforms to see whether there is something, I would say
broadly similar though not identical.
Ms. Schapiro. Broadly similar though not identical. We are
looking at individual stocks having circuit breakers that would
operate to stop trading for a period of time so that algorithms
can be refreshed and additional liquidity can be attracted to
the markets.
Mrs. Biggert. Next then, has the trading technology gotten
ahead of the regulators? If the regulators aren't ahead of the
technology, won't we have problems like last Thursday?
Mr. Gensler. I am very proud of the group at the CFTC. I
inherited most of them but it is a terrific group. But I do
think that we have been underfunded on technology. We have a
significant investment in front of us to do what we call
automated surveillance and compliance. We are trying to build
the flags and alerts to look at the hundreds of thousands of
transactions a day by basically what is called simply exception
reports and then flagging them for good people like Mr.
Sharrits, who is sitting behind me, and his team.
Mrs. Biggert. Okay. Chairman Schapiro?
Ms. Schapiro. We are significantly underfunded in
technology. Until just this year, our discretionary technology
budget for development projects was 50 percent below what it
was in 2005 and our markets are vast and complex--
Mrs. Biggert. I know, and I have asked you this question
before: How old is your technology? Is it 10 years, 20 years?
Ms. Schapiro. I think it probably depends system by system.
But Congress has been generous in the past year, we have been
able to build some new technology to consolidate our tips and
complaints and referrals more effectively, but we have some
very old systems, some of which I recall from when I was a
commissioner in the early 1990's.
Mrs. Biggert. And as you talked about your markets, I think
it has been said that you are still aggregating data from 50-
some electronic trading venues, and this really highlights the
fragmented nature, doesn't it, of our markets? And while this
fragmentation may be at least partially to blame for this
Thursday's market drop, is it also hampering the SEC's search
for explanations?
Ms. Schapiro. It is making the job more complex. I will say
I have been envious of Chairman Gensler's ability to download
files from a single marketplace largely and conduct their
analysis. We have to download voluminous files from multiple
market participants--19\1/2\ billion shares of stock traded on
May 6th in 66 million transactions. Once we are done analyzing
that, we then need to compare our analyses with the CFTC so
that we are sure we are linking the two markets together
appropriately. So more technology would absolutely enable us to
do this job a little bit faster.
Mrs. Biggert. Is there a plan and a timeline for
implementation of updated technology?
Ms. Schapiro. We still don't have the resources to do much
of what we would like to do. The Commission will consider in
the next couple of weeks a proposal to create a consolidated
order audit trail that will give us vast amounts of data and
make this kind of reconstruction far simpler than what we are
going through right now. That will largely be developed by the
markets and we will have full access to the data.
Chairman Kanjorski. The gentlewoman's time has expired.
The gentleman from Massachusetts, Mr. Capuano.
Mr. Capuano. Thank you, Mr. Chairman. I want to thank the
two chairmen and Mr. Cook for coming today.
I also didn't expect a whole lot of final answers today. I
have faith that you will rip this apart for the next several
weeks or more and come back with a more thorough response, and
I think that is an appropriate thing.
I do want to focus on one thing I do think is within your
purview, not so much for a conclusion as much as just
questions, particularly Chairman Schapiro, the decision to
cancel trades.
I have no problem with the concept. My concern is, where do
you draw the line? As I understand it, give or take 300
entities, or whatever it may be, if you are going to cancel
some, why not just cancel them all? Pick out the timeframe when
people started to fall off the table, and just from that point
forward, something went wrong. Because no matter where you draw
the line, somebody is going to get hurt and somebody is going
to sue somebody. They are probably going to sue you, not me, so
that is okay. But I just don't understand why you drew the line
that you drew.
Ms. Schapiro. We didn't draw the line, although let me
agree with you that this was a highly unsatisfying process from
my perspective. Under the rules of the exchanges, they draw the
line about when to cancel erroneous trades, and they met right
after the market closed on Thursday.
Mr. Capuano. ``They,'' meaning who?
Ms. Schapiro. The stock exchanges. And they came up with a
common standard to cancel trades at prices that they think are
sharply divergent from the previous day's close. They selected,
and it would be great to ask them, I think at the next panel,
60 percent off the prior day's close, or the 2:40 trades, the
last probably really solid trades in the market.
A lower threshold would have resulted in many, many, many
more trades being canceled, which would have had some ripple
effect in the markets in terms of traders who were hedged in
other markets would have had this trade canceled, but their
hedges are still standing.
But it is clear that it is not a process that I think works
to the advantage of investors. So when we brought the exchanges
to town on Monday, we asked them to think about how we can make
a more certain and clear process so that investors know up
front what trades might be broken and what trades might not be
broken if we have another kind of event like we had on
Thursday.
Mr. Capuano. Is this issue now settled? It is done? Going
forward is one thing, but for this particular day, is that
decision final in stone, not to be reviewed?
Ms. Schapiro. I believe the exchanges will tell you that
decision is final. I expect that there will be--
Mr. Capuano. I hope they have good lawyers.
Ms. Schapiro. You may be right about that.
Mr. Capuano. Oh, no, I am right about that. I am a lawyer.
I would sue you. Depending on what happened in my pension fund,
I might be suing you. I don't know. I think it is ridiculous. I
think it is inappropriate. I think it is arbitrary. Again, I am
hoping to hear answers, and if not from you, I will ask the
next panel. But 60 percent is some magic number and 59.9 isn't?
That is ridiculous.
Ms. Schapiro. Exactly. I share your concern, and we are
going to fix this going forward.
Mr. Capuano. Mr. Gensler, I am not exactly sure whether you
did the same thing.
Mr. Gensler. There were no busted trades in the futures
market. The rules in the futures markets are very tight, in
terms of what is called a ``busted trade,'' they have to occur
within a certain number of minutes after the trade and there is
a certain limit as to how many ticks away from any future that
trades that could actually generate that. So, there are very
prescribed rules.
Mr. Capuano. That is subject to a specific standing rule?
Mr. Gensler. That is correct.
Mr. Capuano. I may argue with what the rule might be, but
at least everybody who gets into it knows what the rules are.
Mr. Gensler. It is very transparent.
Mr. Capuano. I think the problem with the other exchanges
is the lack of transparency and arbitrariness. I think we have
enough problems with this. Generating hundreds of thousands of
lawsuits on the basis of probably billions or tens of billions
of dollars doesn't help the situation. But I will ask the next
panel.
Thank you, Mr. Chairman. I yield back the remainder of my
time.
Chairman Kanjorski. Thank you.
Now, we will hear from the gentleman from California, Mr.
Campbell.
Mr. Campbell. Thank you to all three chairmen and Director
Cook.
I am trying to understand what we know and what we don't
know at this point. So, Chairman Schapiro and Chairman Gensler,
jump in at any point if you want, but just sort of rapid-fire
questions.
If we focus on these well-publicized trades, the penny, the
Accentures and so forth, and P&G, which didn't go to a penny
but went down; those trades, those trades occurred and were
consummated, correct, at the time? So someone bought and sold
those stocks at a penny.
Ms. Schapiro. Yes.
Mr. Campbell. What sort of volume transacted at that level?
Do we know that?
Ms. Schapiro. I don't know that. I would be happy to
provide it for the record. I know that there were about 300
stocks where trades were broken because they were 60 percent or
more away from the market, and I believe the last number I was
told was about 19,000 trades.
Mr. Campbell. Nineteen thousand trades across all those
securities at significant volume. So in a given security, were
there 1,000 shares traded at a penny, or were there 300,000
shares traded at a penny, or do we know?
Ms. Schapiro. I would be happy to provide that for the
record. I don't know that we have all that data yet.
Mr. Campbell. Okay. Where were these trades transacted? The
New York Stock Exchange, NASDAQ, other exchanges?
Ms. Schapiro. At many places. And that is the nature of our
very fragmented and dispersed marketplace. NASDAQ. No stock
exchange trades basically more than 20 percent of the volume or
25 percent of the volume in its own listed securities because
we have so many trading venues. So they traded in markets like
NASDAQ, the New York Stock Exchange, the ECNs, like Direct Edge
and BATS, and in dark pools where they are not so transparent,
and through internalization by broker-dealers. So there are
multiple ways for a securities transaction to be executed.
Mr. Campbell. So again, if we take a given security that
traded at a penny, those transactions occurred on multiple
exchanges at a penny at that point; or do we know?
Ms. Schapiro. We don't know.
Mr. Campbell. That is part of what we don't know?
Ms. Schapiro. Of what we are working on.
Mr. Campbell. Okay. I suspect a lot of this is what we
don't know. And what I think we need to find out before we can,
you know--you can or we can jump to any conclusions about where
this should go.
I understand we have stop-loss orders and those turn into
market orders. But then how does it run through--if that
happens at $30, how does it run through everything to a penny?
How did that occur? I understand at that point it is a market
order and if the market is a penny, the market is a penny. But
somehow, it has to run from $30 to a penny.
Were there significant transactions all the way down the
line, or did we have a 20-point gap?
Ms. Schapiro. In some cases, there were, and in some cases,
there weren't. As the orders started to cascade down, there
were not buy orders on the books of these multiple venues that
could soak up that selling activity, and as there was continued
pressure from the sellers, nervous investors who put in stop-
loss orders that convert basically into a market sell order as
they go down, the sellers that were remaining in the market
ended up executing against what we call stub quotes, and that
is where you get the penny price.
A market maker does not want to stand there and provide
liquidity. They have to make a two-sided market. They will make
a one-cent to a $100 market, so that one-cent price is out
there in the marketplace, and some of these orders hit that.
Stub quotes--I think the view of the exchanges, as we
discussed yesterday, was universally that they serve no purpose
in our marketplace. So that is another issue that we have on
our immediate agenda, to consider whether we either have to
have real market-maker obligations to make genuine competitive
markets, tight spreads, or we get rid of the obligation to have
two-sided quotes, so we don't end up with these penny quotes.
Mr. Gensler. And if I could say, there is a difference in
rules in futures and securities, but I am not sure you could
translate one to another. There are no stop-loss market orders
in the futures market on both of the major exchanges. It is a
stop-loss limit order, meaning when the stop is hit. A stop is
when the price goes down and it hits a price and then the order
goes in; it has to have a limit to it.
Mr. Campbell. Let me just ask one more question, then,
before my time runs out, which is what has changed--this could
not have happened, I suspect, 15 years ago or 20 years ago or
25 years ago or 40 years ago, particularly if you go back to
traders on the floor with a piece of paper 40 or 50 years ago
and so forth. But I guess what has changed that enabled that
kind of significant--because stop-loss orders turning to market
orders are not a new thing. This has been around for a long
time. What is the new thing that occurred that caused this?
Mr. Gensler. I think that volatility is part of markets and
huge volatility was in 1987. I think the change is the floor
traders, the specialists, or the pit traders in futures, are
now more and more in some office with computers, and the
computers are located right next to the exchange engines--that
is called co-location--and everything is down to nanoseconds,
rather than those liquidity providers used to be either a floor
specialist or in the pit. That is one thing that has changed in
the 20-some years.
Ms. Schapiro. I would say that while we did have tremendous
volatility in October of 1987, we had many more market
participants who don't have the same sort of affirmative
obligations to the marketplace that we had at that time with
specialists, with market-makers on the NASDAQ stock market. So
speed, volume, velocity of trading, volatility, and lesser
obligations to the market as a whole.
Mr. Campbell. My time has expired. Thank you.
Chairman Kanjorski. Thank you very much.
Now, we will hear from the gentleman from Illinois, Mr.
Foster.
Mr. Foster. Thank you, Mr. Chairman.
Does anyone yet understand the origin of the tremendously
high share prices that were bid, at least reported, $100,000
for Sotheby's and so on? Were these algorithmic bids, or what
was the nature of them and what was the nature of the firms
that made them?
Ms. Schapiro. I believe we are still looking at that, and I
will ask Robert to jump in here. Interestingly, there were 20
stocks that traded at 90 percent above their 2 p.m. price
during that period when there were 250 or more stocks that
traded at 90 percent below their 2 p.m. price. But I don't know
if we know yet the reason.
Mr. Cook. No, we don't. There are many more that traded
below their 2 p.m. price than above, but we don't yet know the
nature of the orders that came in that fed into those prices
above.
Mr. Foster. So you don't even know who made them?
Mr. Cook. Not at this time. That is part of the information
we are gathering together, because we are pulling together the
information as to where the orders originated, at which trading
venue, and then we will go back further and find out who put
them in through the brokers.
Mr. Foster. So this many days later, you don't know who it
was that made these funny-sounding bids.
Chairman Gensler, would that be the case with you?
Mr. Gensler. No. In the futures market, we didn't have
either, because there are so many curbs and limits in this risk
management. One of the things that high-frequency or
algorithmic traders do is called ``sniping,'' if I may use the
term, in which the computers actually put in a bid, one
contract or one security at a time, and try to pull out the
liquidity and find it. If there was a resting order, a resting
bid at a penny or a resting bid at $100,000, the computers can
strip through and maybe find it. That may be a possible thing
to look at it--it may have been what happened.
Mr. Foster. Are there mandates that automated trading firms
appropriately version and archive their algorithmic code and
their databases so they can reproduce their trading decisions
after the fact in the course of these investigations?
Mr. Gensler. We have actually asked for some of these
largest traders to actually sit down and see their code. Our
folks in our Division of Market Surveillance are sitting down
this week with a number of the largest ones and are actually
looking at their codes.
Mr. Foster. Right. But it is a possible response that they
say, ``We just don't know. We had some version, but then we
overrode it.''
Are there enforced industry standards so that you can
actually go back and say what version of what code were you
running last Wednesday afternoon?
Ms. Schapiro. If they are regulated entities, yes, we can
see their code and they need to freeze their code if asked. And
we have told specific firms post-Thursday that we want the code
frozen so it is not changed. If they are not regulated
entities, we have to get that information by a subpoena.
Mr. Foster. Could you explain briefly how trade busting
works on synthetic positions? If the underlying stock is
determined to be broken, does that automatically imply the
breaking of various synthetic positions? How does that work? Is
there an agreed-upon way that should happen, and is that the
way it happens?
Ms. Schapiro. I can speak to how the securities trades are
busted. And as I think we have talked about, it is a pretty
unsatisfying process because it lacks real clarity and
consistency for the investors up front. But the exchanges in
this situation--and this is unusual, because your normal trade
bust situation is a single stock--something goes wrong in the
technology and you need to bust a lot of trades in one stock.
Here we had hundreds of stocks where trades needed to be busted
because prices were sharply divergent from where they had been
on the previous day's close. Exchanges meet. They come up with
a common standard so that they are all busting trades at the
same level.
Mr. Foster. My question was: How does that percolate back
into positions that are derivative positions on equities?
Ms. Schapiro. In terms of busting, I don't believe it does.
But it does have an impact on them. If they have hedged a
position that is then busted, they have a hedge, they are now
exposed.
Mr. Cook. To follow up on your question, in the securities
markets, the options markets would make the decision of whether
to break the trade if the underlying security trade had been
broken. In this case, I believe very few options trades were
broken, but some were.
Again, the process was not fully coordinated in the sense
that the options markets made that decision separately from the
securities markets, and that is one of the things we are
looking at going forward.
Mr. Gensler. Though I don't remember everything in CME Rule
5(8)(a), which is their busting rule, what we had last
Thursday, the indices themselves, S&P and Dow, didn't reprice
their indices. They didn't come back and say there was a
different thing, and I know that was relevant to those markets.
Mr. Foster. Okay. Would you say that overall what happened
last Thursday strengthens or weakens the case for merging the
CFTC and the SEC? First off, you all know my position that they
should be merged and moved to Chicago.
Ms. Schapiro. Okay, I am with you on half of that. I have
long held the view that the two agencies should be merged; that
the participants in these markets, the products are
increasingly similar and the markets are increasingly linked,
and there would be efficiency and economy of scale to a merger.
But if the political will for that to happen doesn't exist, I
think--as I said earlier, this is the best working relationship
in my many years of being around these two agencies I have ever
seen in terms of collaboration and cooperation--I am not sure
that the event of Thursday would have played out differently
had there been just one agency.
Mr. Foster. Do you share the development of software tools
that you are both frantically developing to analyze this, or do
you have independent groups? Do you have any comments?
Ms. Schapiro. I will tell you, it took an act of Congress
to allow us to create a joint advisory committee. So the
ability of Federal agencies to actually share things mystifies
me in its limitations.
Mr. Gensler. We actually want to thank you. You didn't know
you were voting on it at the time, but it was part of the
appropriations bill last year. Congressman Lucas probably did
know about it. I think that our two agencies, and I thank
Chairman Schapiro for her support the last 11 or 12 months I
have been in this job, have been very collaborative, and very
close. I think the will of Congress has been, since the 1930's
really, a strong agency in the SEC overseeing its orbit,
another agency overseeing the exchange derivatives markets, and
now we are trying to fill this gap in the over-the-counter
derivatives market as well.
Mr. Foster. I yield back.
Chairman Kanjorski. Thank you very much, Mr. Foster.
That completes our questioning for this panel. I will just
take a moment before we excuse you, I want to thank both of you
again and I want to reiterate something that Mr. Scott said in
his questioning. After hearing the testimony from our two
regulators, I feel a lot more secure. I am not certain I could
tell you why, but I feel a lot more secure. I look forward over
the next several weeks to open disclosure with the American
public and the Congress as to what you find, as soon as you
find it, so that we can get to a final conclusion, but in the
meantime, to participate in such rules or changes that can help
prevent what has happened last Thursday.
With that, I thank you both very much. We are going to
allow you to leave so you will be able to enjoy the rest of the
day.
Our second panel, first of all, I thank you for appearing
before the subcommittee today. Without objection, your written
statements will be made a part of the record. You will each be
recognized for a 5-minute summary of your testimony.
First of all, we have Mr. Larry Leibowitz, chief operating
officer, NYSE Euronext.
Mr. Leibowitz?
STATEMENT OF LARRY LEIBOWITZ, CHIEF OPERATING OFFICER, NYSE
EURONEXT
Mr. Leibowitz. Good afternoon. Chairman Kanjorski, Ranking
Member Garrett, and members of the subcommittee, my name is
Larry Leibowitz. I am the chief operating officer of NYSE
Euronext. Thank you for the opportunity to be here today.
We commend the subcommittee for your rapid response to the
events of last Thursday. As you know, we have begun a dialogue
with our regulators and our other trading venues, and it has
been very productive. We are committed to working with you and
other market participants to restore confidence and enhance
investor safeguards in the future.
Today, I would like to discuss three things: first, the
high-level causes of the events last Thursday; second,
clarifications about NYSE's market model and how it worked; and
third, our recommendations going forward.
It is understandable that everyone is looking for a smoking
gun behind last Thursday's dip. However, the circumstances are
more complicated than that. I will leave it to the regulators
we just heard from to link the interactions of various markets,
but from our standpoint, we see no evidence of the ``fat
finger'' error or market manipulation. But we also note that
more and more our markets within the United States, and indeed
within the world, are intertwined.
However, we do see the following: elevated market activity
coming from adverse European news, including a huge and a
broadly-based wave of orders and quotes at around 2:30 p.m.; a
significant reduction in market liquidity as measured by the
size of order books through the day which accelerated
dramatically through the downturn; and various microstructure
issues that resulted in certain marketplaces not interacting
with one another which exacerbated the liquidity effect.
The NYSE has embraced electronic trading, and we believe
our market model provides the best combination of cutting-edge
technology with human judgment. The NYSE hybrid market rules
expressly provide mechanisms to mitigate volatility and large
price swings, which we always have believed is a critical piece
of our offering to listed companies and their investors.
Specifically, the NYSE incorporates in our trading
structure a type of circuit breaker mechanism known as
liquidity replenishment points, or LRPs, which temporarily and
automatically pause trading in stocks when significant price
movement occurs. On a typical day, LRPs are triggered 100 to
200 times, lasting for seconds at most, and, during the recent
financial crisis, served the market well.
Let me be clear: The LRP mechanism does not halt trading.
Instead, for a short time, trading is automatically paused to
facilitate more accurate price discovery and prevent the market
from a sudden and significant move. During this pause, our
quote is visible to other market participants and new orders
are accepted. To jump on Chairman Gensler's analogy, our LRPs
are analogous to taking the controls of a plane off autopilot
during turbulence.
I want to highlight a few specifics and clarify some
anecdotal statements that have been made. This is not meant as
a comment on other markets or other market models, just to
clarify from the NYSE standpoint what we saw.
During the 2:30 to 3:00 period, market share on NYSE was 5
percentage points higher than usual during that time of day.
Participation rate of our designated market-makers, formally
known as specialists, was equally strong. This was evidence
that our liquidity providers did not walk away from the market
as we actively traded during the downturn. Furthermore, to
demonstrate that LRPs protected orders in our market, stocks
listed on other markets had price declines and erroneous
executions far greater than on NYSE-listed stocks.
Lastly, the overall marketplace needed to cancel
approximately 15,000 executions after Thursday's decline. On
NYSE, even though we handled the largest share of orders in the
marketplace, we had to cancel zero trades because of the
protective measures in our market.
One note: LRPs are not intended to prevent the market from
falling. Rather, our LRPs are designed to protect the integrity
of our market by preventing a panic-led downdraft and
mitigating systemic risk. Yet when we are in a slow mode, other
electronic markets may choose to ignore our quotes as permitted
under regulation NMS.
The bottom line is that while there is always room to
improve LRPs and other such mechanisms, these actually worked
reasonably well on Thursday. However, the mechanism is only
truly effective if observed by other trading venues, and that
is why Chairman Schapiro's plan for an industry-wide trading
circuit breaker is needed.
In terms of recommendations, I want to focus on three main
topics, echoing much of what Chairman Schapiro stated earlier.
First, our markets need a preestablished and coordinated
way to respond to extreme rapid volatility. The LRP system has
worked, but marketwide circuit breakers are necessary and will
be even more effective. The listing and trading venues have
agreed to develop these stock-level circuit breakers to pause
trading when the price of a security has changed dramatically
in a short period. Once circuit breakers have been triggered in
a security, they will apply to all trading in the security,
wherever it takes place.
Second, the current marketwide circuit breakers were
established long ago and are based on market moves of 10
percent, 20 percent, and 30 percent. There has not been a move
greater than 10 percent in a single day post-2000. These levels
will be tightened and the circuit breaker will be based on a
broader index, rather than a narrow Dow Jones index.
Third, the rules on cancellation of trades will be further
defined. On May 6th, it was announced, after markets closed,
that any trades executed at 60 percent above or below the last
price at 2:40 would be canceled. This action was not
predictable and caused confusion in the markets. We are working
with regulators and other exchanges to establish clear
cancellation rules for the future, though circuit breakers will
help mitigate this problem substantially.
To facilitate a review of extraordinary trading events,
there should be a consolidated audit trail that will allow
regulators to easily review marketwide trade data. We
understand the SEC is developing such a proposal and we are
committed to assisting in that effort.
Ultimately, these and other important actions may best be
achieved by consolidating market surveillance in one securities
regulator, probably FINRA, which will require an act of
Congress. We also at the same time need to ensure that both
FINRA and the SEC have the full funding required to perform
these duties.
Finally, the SEC should continue its broad-based market
review to help find ways to improve our current market
structure.
In closing, we applaud the SEC and the CFTC for working
together to review the events of May 6th and to develop a
coordinated response. We at NYSE Euronext are committed to
maintaining our ongoing productive dialogue with these agencies
and other trading venues.
Once again, thank you for the opportunity to appear, and
later on I will be happy to answer any questions you may have.
[The prepared statement of Mr. Leibowitz can be found on
page 95 of the appendix.]
Chairman Kanjorski. Thank you, Mr. Leibowitz.
Now, we will hear from Mr. Eric Noll, executive vice
president, NASDAQ Transaction Services.
STATEMENT OF ERIC NOLL, EXECUTIVE VICE PRESIDENT, NASDAQ OMX
GROUP, INC.
Mr. Noll. Good afternoon, Chairman Kanjorski, Ranking
Member Garrett, and members of the subcommittee. Thank you for
letting me speak to you today.
We met yesterday, along with our fellow exchanges, with
Chairman Schapiro to develop a strategy to combat market
instability and protect investors in the wake of last Thursday.
We will act jointly to assess and implement changes to enhance
the market's ability to handle unusual trading events in the
future.
Our markets are strong despite the 17 minutes of unusual
trading that occurred on May 6th. In fact, the market's rapid
recovery during the day confirms their resilience under
extraordinary strength.
To fully understand May 6th, you have to look at the state
of the markets heading into last week. Markets were nervous and
operating during an unusually long upward trend. From a market
low of below 1300 March 2009, the NASDAQ composite index had
risen steadily to 2535 on April 26, 2010.
Chairman Kanjorski. Mr. Noll, could you see if your
microphone is on or whether it is close enough to you?
Mr. Noll. Sorry.
Markets were also becoming increasingly volatile, according
to the CBOE Volatility Index, which measures volatility of the
S&P 500 expected over the next 30 days. Note that the VIX is
normally below 20, and by May 5th, the VIX reached the upper
20's, and on May 6th and 7th, it closed above 30, and it did in
fact trade above 40 on several occasions during that period of
time.
This increased volatility is tied to the escalating
financial crisis in Greece and Europe. While percolating for
several months, the potential harm seemed to sink into the U.S.
markets last week.
Against this backdrop, we arrive at the afternoon of May
6th. First, the Dow Jones Industrial Average was already
trading off 272 points for the day and 500 points in the last 3
days. Second, the Chicago Mercantile Exchange was beginning to
experience unusual trading activity in the E-Mini Junes at the
same time as equities handled heavy trading in the highly
correlated equities to that E-Mini future.
E-Mini volumes rose and prices began sinking rapidly at
2:42, just before equity prices sank rapidly as well. At
2:45:30, the E-Mini trading became so volatile that the CME
triggered an automatic 5-second trading pause in the E-Mini
futures. The price of the E-Mini future immediately leveled off
and began to climb rapidly. Equities followed shortly
thereafter.
Third, the NYSE Arc Exchange began experiencing data
communication issues that hindered the electronic linkages
between it and other exchanges. Simultaneously, the New York
Stock Exchange began reporting multiple liquidity replenishment
points, or LRPs, and gap quotes that impacted the trading of
individual stocks in the New York exchange market.
From 2:39 to 2:47, the Dow dropped 723 points to 9800.69,
its low for the day, and down 995 points total from the prior
close. From 2:47 to 2:56, the Dow recovered just as rapidly,
rising 612 points, from 9862 to 9974, down 387 points for the
day. From 2:56 to the close, the Dow rose another 45 points,
ending the day down 324 points.
NASDAQ's preliminary analysis indicates the unusual trading
activity on May 6th was triggered by a confluence of unusual
events, including events outside the cash equities markets.
NASDAQ continues to investigate Thursday's events, but at
present has located no smoking gun that single-handedly caused
or explained Thursday's events.
From a systems standpoint, NASDAQ's market operated
continuously during the day and the critical 17 minutes. Each
and every one of NASDAQ's electronic systems functioned as
designed and as intended: our execution engine, our market data
feeds, and our surveillance systems.
We have detected no system malfunction or errant trade by a
NASDAQ member interacting with the NASDAQ stock market. No
NASDAQ member has identified a system error or aberration
within their own systems.
As stated, NASDAQ supports the response of the SEC. We
support the recommendation to update market circuit breakers.
We think a circuit breaker should automatically halt trading in
all stocks and in all markets in measured stages. We would
expect that Chairman Schapiro, based on her testimony, will
have some announcements about what those finally will look like
in the very near future.
We also support the Commission's desire to explore cross-
market single-stock trading halts. The important
characteristics of such a halt should be consistency across all
the markets, initiation by the primary market, and an orderly
resumption of trading by the primary market. Any rule should
recognize that stocks trade in different ways rather than a
one-size-fits-all approach.
We do believe, however, that trading halts and other
regulator actions should never be a tool used by a primary
market or any other other marketplace for any competitive
reason or to disadvantage any other national market system
participant.
Finally, we are exploring other ideas that will improve and
encourage high-quality and continuous quoting on all markets.
Thank you again for the opportunity to share our views. I
am happy to respond to any questions you may have.
[The prepared statement of Mr. Noll can be found on page
106 of the appendix.]
Chairman Kanjorski. Thank you very much, Mr. Noll.
Now, I recognize the gentlelady from Illinois, Mrs.
Biggert, to introduce our next witness.
Mrs. Biggert. Thank you, Mr. Chairman. I would like to
welcome my constituent, Mr. Terrence Duffy, and thank him for
joining us today. Mr. Duffy is the executive chairman of the
CME Group, and I thank him for joining us and sharing his
expertise.
STATEMENT OF TERRENCE A. DUFFY, EXECUTIVE CHAIRMAN, CME GROUP
INC.
Mr. Duffy. Thank you, Congresswoman Biggert. Chairman
Kanjorski, Ranking Member Garrett, and members of the
subcommittee, I am Terry Duffy, executive chairman of the CME
Group, and I want to thank you for allowing me to testify
today.
It is widely known that futures markets are the leading
indicators for cash markets. Our reviews of the market's
activity revealed no suspicious or erroneous activity by our
customers. The exchange did not bust or reprice any
transactions. Further, our analysis indicates that the decline
in the SPDR ETFs and 3M stock preceded the drop in the S&P 500
contract. As I will show you in a moment, they were far more
severe, even after substantial price recovery in the S&P 500
futures contract. Liquidity in the S&P futures and its
effective spreads were considerably better than the SPDR ETFs
throughout the day on Thursday.
At this point, it is premature to draw any definitive
conclusions as to what caused the extreme market volatility on
May 6th. What we do know is that there were a number of
macroeconomic conditions, as well as lack of operational
harmonization across the multiple trading venues of the equity
markets. This resulted in the cancellation or busting of
securities transactions by the NASDAQ stock market and NYSE
Arca. In contrast, CME Group's E-Mini S&P 500 futures contract
performed smoothly despite significant market activity and
volatility.
The selloff and subsequent rebound in the E-Mini S&P 500
Index futures, while dramatic, was very orderly. Our markets
provided the liquidity investors needed to hedge against the
turmoil happening elsewhere.
As I mentioned earlier, CME Group's E-Mini S&P 500 is a
leading indicator, not a cause, of the decline in the
underlying primary market. Futures contracts, by design,
provide an indication of the market's view of the value of the
underlying stock index. This makes index futures a valuable
risk-management tool for market participants.
To illustrate this point, I would like to draw your
attention to these charts. When looking at this information, it
is important to note there is a difference between futures and
cash reporting. Cash index values are only updated every 15
seconds, while futures prices are updated on a real-time basis.
This means the futures market reflects conditions in real time,
while the cash market has a 15-second delay.
The first chart shows the comparative value of the E-Mini
traded on the futures market versus the equities markets. It
illustrates that the E-Mini S&P, which is the blue line, moved
virtually in tandem with the SPDR ETF market as well as the S&P
500 Index, which is the red line.
You can see at 13:46 p.m., the market had had time to
attract liquidity and rebalance, and the E-Mini led the
recovery, leading the Dow Jones to recover 400 points in 3
minutes.
Moving to chart 2, this graph shows price movement in the
E-Mini S&P futures as well as 3M stock. As you can see, the
price of 3M stock declined much more rapidly, starting at 13:45
while the E-Mini S&P 500 was hitting a low at 13:45 and 50
seconds, at which time you can see the market and the E-Mini
reverses, while the 3M stock continues to decline.
Market integrity is of the utmost importance to CME Group.
We have developed systems that maintain integrity in all our
markets, including a number of controls to protect market
users.
For example, CME is the only exchange in the world that
requires pre-execution credit controls. As Chairman Gensler
mentioned, CME Globex maintains functionality that causes the
match engine to pause when orders, if they were executed, would
exceed predetermined levels. Following the 5-second pause, new
orders would come into the market. This is a critical point.
We believe this functionality and these protocols do not
exist in the cash market. If they did, it would have been
highly effective in eliminating price dislocations in 3M and
Procter & Gamble. Furthermore, CME Globex electronic trading
infrastructure incorporates numerous risk protection tools.
They provide added safeguards to customers and clearing firms,
including stop price logic functionality, price banding and
circuit breakers.
As I mentioned earlier, stop price logic functionality
helps to mitigate market spikes that can occur because of the
continuous triggering or the election of trading of stop
orders. This is what happened last week with the E-Mini and S&P
futures, allowing liquidity to come into the market and
ultimately leading to the rally in the equities market.
We believe the focus of your review should be on the
national market system. We support Chairman Schapiro's
recommendation regarding harmonization across these platforms.
We have seen no evidence that high-frequency or other specific
trading practices in any way magnified the decline on May 6th.
In fact, we believe that high-frequency traders in our market
provided liquidity on both sides of the market on this
extraordinary day.
We do, however, recognize that changes should be considered
to avoid a repeat of the events of May 6th. We would make the
following recommendations.
As Chairman Schapiro pointed out, circuit breakers,
including circuit breakers for individual stocks, such as those
implemented by the NYSE, must be harmonized across markets.
We also believe that stop logic functionality should be
adopted across markets on a product-by-product basis to prevent
cascading downward market movements. The circuit breaker levels
of 10, 20, and 30 percent and the duration of the halt and time
of day at which triggers are applicable should be reevaluated
in light of current market conditions to determine whether any
changes are warranted. Any such changes must be implemented
across all market venues.
I thank the committee for the opportunity to share CME's
views, and I look forward to answering your questions.
[The prepared statement of Mr. Duffy can be found on page
70 of the appendix.]
Chairman Kanjorski. Thank you very much, Mr. Duffy.
Now, we will move on to questions. I will take my question
period first.
Mr. Noll and Mr. Leibowitz, listening to your testimony, I
am not sure anything happened on Thursday. Everything worked.
Is that correct?
Mr. Leibowitz. Oh, I don't think any of us would say that
everything worked. I think, in fact, what Mr. Noll was saying
was his systems worked. But I think we would all agree that the
market did not.
Chairman Kanjorski. What caused the market not to work?
Mr. Leibowitz. I think what both of us have found is
liquidity fled the market through the day as the market was
skittish, and then an overwhelming wave of orders came in on
the sell side that built on itself. I think having a marketwide
circuit breaker in effect would have helped mitigate that
problem. But in effect, the market was illiquid just at the
wrong time as sellers broke into the market.
Eric?
Mr. Noll. Thank you, Larry.
Mr. Chairman, I think there are two things to observe that
happened. I would agree with Mr. Leibowitz that in fact the
markets did not behave normally on that day. I think my point
was really our technology behaved as it was designed to behave
that day.
I think it is important to observe two things. One is that
the marketwide circuit breakers we do in fact have in place
today were not triggered, because the market did not fall to
the point where they were triggered and therefore cause a
marketwide halt. So I think Chairman Schapiro is correct when
she says that we should in fact revisit those and reinstitute
different types of marketwide circuit breakers that will arrest
those marketwide halts as they happen.
I think the other point that she made vividly today, which
we certainly agree with at NASDAQ, is that we do need a
coordinated stock-by-stock circuit breaker across all the
markets, which we don't currently have on our books and we
don't have the authority to implement. So I think we will see
that soon coming out of the SEC.
Chairman Kanjorski. There was no problem on your part on
either of the two exchanges with the fact that the New York
exchange did a slowdown operation, but NASDAQ continued going
right on and allowed the sales to pass through to the NASDAQ
exchange. That had no effect; is that correct?
Mr. Noll. I think we would say that was a contributing
cause to a confluence of events here. It points to what we
would argue, the need for a coordinated stock-by-stock circuit
breaker.
Mr. Leibowitz. From our standpoint, I think what we have
shown or what we see is we don't think the fact we were moving
slowly exacerbated the effect. In fact, the fact that we were
trading high-market share, keeping the stock prices in line,
might actually have helped, and the fact that other markets
that didn't have circuit breakers at all, like the NASDAQ
listed market, had even more damage than in the New York listed
market. But I think we can all agree that having uniform
marketwide circuit breakers would have helped in all events.
Chairman Kanjorski. I have a question there. Everybody
wants to protect the private market and have the market
function. But is this the first time you have made that
observation, either of the two major markets, that one set of
rules was in place in the New York Stock Exchange and another
set of rules in NASDAQ, and that you were not coordinated to
operate in tandem together, so that this could happen--or you
did not realize this could happen?
Mr. Noll. I think what is fair, Mr. Chairman, is our
markets are very coordinated in many ways. We have very similar
corporate governance standards for our listed companies. As an
example, not having to do specifically with trading, but for
marketwide declines, overall market circuit breakers, we are
coordinated. We have open ``meet me'' lines that we use
frequently during trading problems and technology problems.
Chairman Kanjorski. Mr. Noll, do not give me everything you
are coordinated on. We do not want to know that. We want to
know why this abnegation occurred.
Mr. Noll. I am suggesting that we speak often about many
issues. The one issue that had never appeared yet as a
significant problem between our two markets is the coordination
of a stock-by-stock circuit breaker.
Chairman Kanjorski. What you are saying is because it never
occurred, you did not simulate the possibility that it could
occur, and you did not cooperate together to put in place
common rules that would have prevented it from occurring; is
that correct?
What I am trying to drive at here is obviously two free-
market operations relying on either the United States Congress
or the regulators to take care of the problem rather than doing
it yourselves.
Mr. Leibowitz. So as permitted by SEC regulations, we do
have different trading models. We rely on designated market-
makers who have an obligation to the market. They have a
different type of trading markets. So there are various areas
where our rules are slightly different.
We have seen times during the crisis in the fourth quarter
of 2008 where there was significant breakage of trades in the
electronics markets, erroneous trades, that there were not in
the NYSE-traded market. At the time, no one felt that the
separate rules exacerbated the problem. It is just there were
more breaks in the electronic markets. There were tens of
thousands of trades taken off the tape in the fourth quarter of
2008.
Chairman Kanjorski. My time has expired. The gentleman from
New Jersey, Mr. Garrett.
Mr. Garrett. And as is often the case, I will follow up
where the chairman was perhaps going on that.
So is this something, from what you are saying, is this a
situation then, thinking back if you had this hearing awhile
ago, that we just could not have seen coming?
Mr. Noll. I think it is hard to say that we could have seen
this coming. So we have a set of rules in place called Regena
MES which governs the respect of different markets, and when
they are quoting and when they are not quoting, and a whole set
of procedures around that, that we believe have worked very
well up until to this point. I do believe they continue to work
very well. As a matter of fact, Mr. Leibowitz operates an
electronic market on NYSE Arca well that participates in Regena
MES as well as the New York floor. They were engaged in the
same electronic trading we were on Thursday and participating
with us. So generally I think that rule set works
extraordinarily well.
We did hit a confluence of events where clearly we need to
do something to address--and I think what Chairman Schapiro
suggests, which we agree with fully, is that we need that
coordinated stock-by-stock circuit breaker.
Mr. Garrett. And just to go down that road a little bit,
Mr. Leibowitz, maybe you were touching on it, if I was hearing
you as you were saying it, as far as those issues that are out
there, the confluence of issues, was one of those issues that
were in the confluence what was going on over in Europe and the
fact of the whole Greek situation?
And, Mr. Noll, I think you said the United States was
finally paying attention to that. Was part of that the fact
that the value of the Euro currency was going down, other
foreign currencies in relationship were going up, and the banks
were having a difficult time with their carry trade in that
respect, and so in order to deal with that, they had to do
something, which I guess is to unload equities? Was that an
element of what was coming out of Europe at that period of
time?
Mr. Leibowitz. I don't think we have any visibility into
that, and we haven't heard that. I think we are really focusing
on our market and leaving the SEC and CFTC to see the cross-
market effects.
Mr. Garrett. Does anybody else have a thought on that, as
far as what the influence of that, as being one of the
confluences of their impact to their trades as well?
Mr. Noll. We have seen no evidence of that, and as Larry
said, we are very focused on what happened in our individual
markets.
Mr. Garrett. To the extent you are focused on what is
happening in individual markets, the chairman was saying before
that here, 4 days later, we are still trying to get all the
data collected from all the 40 or 50, however many there are
right now, data sources. There is no central repository for all
those trades, and that is why she is going out to get them, as
she is, I guess. Is that a problem? Is that something that we
should have seen in the past and tried to address?
Mr. Noll. I think the chairman and I think other people in
the marketplace have recognized that was a potential problem
before. As a matter of fact, there have been ongoing
discussions with FINRA and the SEC and all the markets about a
consolidated audit trail that predates the May 6th event. It is
unfortunate that we have not gotten to that point so far in the
marketplace.
Mr. Garrett. Is there something that holds that up? Is
there somebody opposed to that?
Mr. Noll. As far as I know, no one is opposed to that. I
think it is a matter of applying the process and getting it
done.
Mr. Garrett. Who is responsible for that?
Mr. Noll. Again, it is a marketwide issue among multiple
regulators. I think there may even be, I am not absolutely
positive about this, but I think there may be some
congressional authority needed for the SEC in order to do so.
Mr. Garrett. To do something like that. To the point as far
as what authority the SEC has now and what they may need in the
future, one of the points has already been addressed, and you
raised this to some extent as far as the commonality of the
market callers that potentially bid on there.
Is there a difference as far as the folks who are at the
table right now, the major participants in it, and some of the
smaller alternative platforms, as far as whether this should be
uniform across them all? And if the answer is no, why shouldn't
it be? And if the answer is yes, would that impact upon the
slightly different models that some of the smaller market
participants would have?
Mr. Leibowitz. The answer is there should be one standard
across all platforms, whether it is an exchange, an ETS, an
ECN, any different venue. And there will be.
Mr. Garrett. And if we didn't have any of them here, but if
they were sitting here, what would their argument be why that
should be the case?
Mr. Noll. I don't believe anyone would argue against a
stock-by-stock circuit breaker at this point.
Mr. Leibowitz. I think you have already seen CESMA and
various other bodies come out in favor of it. I think that the
industry at this point would line up 100 percent behind it.
Mr. Garrett. Okay. And what about the time to implement
these changes? As you said, a lot this has been looked at for a
long period of time. Regulation NMS took a long time in order
to implement. We are talking here about implementing this like
this quickly. Is there a problem if we move too quickly at this
point in time, or is this just the right thing to do?
Mr. Noll. I think on the marketwide circuit breaker issue,
I think we can move very quickly on that. I think the chairman
will be discussing with us making rule filings, adopting new
marketwide circuit breakers, relatively shortly, and then we
will process those and put them in place very efficaciously.
I think as we deal with some of the stock-by-stock issues,
we may run across some technology issues with that--
Mr. Garrett. What issues? I am sorry.
Mr. Noll. There may be some technological issues putting
them in place, but I think those are short-dated, not long-
dated.
Mr. Garrett. Thank you. I thank the Chair. Thank you to the
witnesses.
Chairman Kanjorski. Thank you very much, Mr. Garrett.
The gentleman from California, Mr. Sherman.
Mr. Sherman. Thank you.
We are talking here about how to make high-frequency
trading safer. The question is, does it fulfill any social
utility at all? In the old days, somebody would want to sell a
stock for $10 and somebody else might want to buy it for
$10.05. I remember when there was an 18th of a point.
Somewhere, there was a settlement in between, and maybe--or the
other of those two real investors got a slightly better deal.
Now there is somebody with a fast computer who can come in and
scoop up that 5 cents to make sure that neither of the real
investors benefits from it.
I realize Wall Street makes a lot of money from all this
high-frequency trading, but the question is: Does it help
provide liquidity or in some other way allocate capital? Now,
the events of last week seem to indicate that high-frequency
trading doesn't provide liquidity, it uses up liquidity,
demands liquidity, and in fact, there was no liquidity for a
few minutes.
I will start with Mr. Leibowitz. If we didn't have high-
frequency trading, would this hurt the companies that are doing
business and their employees?
Mr. Leibowitz. Sure, though I am going to stay away from
whether there is any social value to this. What I will say is,
the market-makers have existed for hundreds of years, so it is
not correct to say that in the past if somebody sold at $10 and
they wanted to buy at $10.05, they matched up. The difference
is they were physical people, whether sitting on the floor of
the stock or market-makers at NASDAQ. But there has always been
a middleman in trading, and what they do is they match up
buyers and sellers. Sometimes they play a role, sometimes they
actually don't, they just match them together. And sometimes
when somebody wants to sell, the buyer doesn't happen to be
there. So they are matching different time horizons on the buy
and the sell.
I think as technology caused trading to speed up, people
were unable to keep up with that in a market-making capacity.
That is why the specialists have been replaced by what we call
``designated market-makers,'' who in effect are high-frequency
traders, but they have obligations into our market. They have
to have a quoting requirement. They have to provide a certain
amount of liquidity. They are not allowed to take more than a
certain amount of liquidity from the market. So they are high-
frequency traders that operate in a very structured
environment.
Mr. Sherman. What percentage of the high-frequency trading
is done by these--I will use the old term, ``market-makers?''
Mr. Leibowitz. I would say first, in the case of DMMs, they
provide 10 percent of the liquidity to the New York Stock
Exchange market. There is another form of market-maker that we
have also in that variety that is another 10 percent. I would
say on the broader market--
Mr. Sherman. If I can interrupt, because I only have 5
minutes, I am not asking what percentage of liquidity is
provided by these individuals, I am asking what percent of the
high-frequency trading.
It has been reported that two-thirds of the trades in the
United States are these high-frequency traders; you are
describing what would seem to be just a very small percentage
of the high-frequency traders.
Mr. Leibowitz. I would estimate that about 40 to 45 percent
of the market is high-frequency market-makers of some form,
either DMMs, SOPs or other things. The balance of what you make
into that two-thirds is really algorithmic trading. That could
be a big mutual fund deciding to sell 10 million shares in an
electronic form that is implemented in a series of small trades
that looks like a high-frequency trade.
So you have to be really careful, and that is why we
heartily endorse Chairman Schapiro's large trader reporting
scheme where we can get some transparency into what these high-
frequency trades are doing.
Mr. Sherman. Most of us, when we think in terms of high-
frequency trading, are looking at those buying and selling the
same stock within a short window, not somebody who is selling
it and selling it and selling it; which, as you say, could be
an investor deciding to unload a stock or a portion of it.
Mr. Noll, do you have a comment on this?
Mr. Noll. Yes. I think when you look at--notwithstanding
last Thursday's events, I think if you look at the quality of
our markets over the last number of years, I think you would
see an increasing tightening of the bid-offer spread and an
increasing provision of liquidity at those tighter spreads.
So I think our concern would be as we look at this issue--
and we agree with Mr. Leibowitz and Chairman Schapiro that we
do really have to study what high-frequency traders are doing
and how they are operating in the marketplace--I think the
prima facie evidence is, however, that they provide a real
value in the sense they provide deep markets, they provide
tighter bid-offer spreads, they have reduced costs for all
market participants to access the markets.
I do think, however, that we need to also look at how they
interact in the market on an ongoing basis. I think they have
to provide real liquidity.
Mr. Sherman. Obviously, last week they were the cause of
the absence of liquidity. But I believe my time has expired.
You can respond further for the record.
Mr. Noll. I would say that we are not sure that is in fact
the case. I think it is an overstatement to say that we know it
was high-frequency traders. I think that is an issue that we
are continuing to look at at this point. It appears to have
been a very broad market selloff with many market participants,
not just high-frequency traders involved in that.
Chairman Kanjorski. The gentleman from Alabama, Mr. Bachus.
Mr. Bachus. I know history teaches us there have been some
pretty dramatic falls in the market before we even had
electronic trading, so I don't think the culprit is high-
frequency trading. I guess that is part of the debate.
One thing I think we can never prevent is negative market
developments or economic developments from affecting the
market, so I am just trying to think of--you have shifts in
sentiment, so that is going to move the market and cause
changes in volatility. So what you really want is the market to
reflect all those things and to do it, I guess, as efficiently
as possible.
I am very encouraged by what I hear today and what happened
yesterday, in that I think that there has been, maybe as a
result of last Thursday, and the concern that I think everyone
had before, is that we are coming into an agreement that there
ought to be some sort of marketwide circuit breakers. Is that
right? Do you all agree on that?
Mr. Leibowitz. Absolutely.
Mr. Noll. Absolutely.
Mr. Bachus. And coordinated maybe stock-by-stock circuit
breakers?
Mr. Noll. We all agree with that.
Mr. Bachus. Mr. Duffy, do you agree with that?
Mr. Duffy. Yes. We agree with that and we see no issue with
that. But, again, this is not pertaining to the CME Group. We
don't trade individual stocks.
Mr. Bachus. Okay. I guess if you trade an option or you
trade an ETF or something, you trade options, do you trade
those?
Mr. Duffy. The CME Group, no. We trade futures. We trade
options on futures. We don't trade the SPDR.
Mr. Bachus. All right. Let me ask all of you, we have kind
of gone from a highly structured duopoly, at least with stock
trading, to a much more fragmented system. How would you advise
the regulators to meet the challenges of addressing marked
integrity and price discovery without hurting competition?
Mr. Duffy. I will be happy to start, even though I think
this is more your bailiwick, but I will jump in.
I do think that you need to have the same set of standards
and protocols across the multiple markets, and I think it is as
simple as that. You can't have one set of rules at the NYSE and
at NASDAQ, and then you have different sets of rules at BATS
and other ECNs. It is not going to work. It is a recipe for
disaster. No one has been able to explain how Accenture went
from $41 to a penny yet, and that to me is just amazing, how
you can't explain that. I think you have to have the same
protocol across these marketplaces.
Mr. Bachus. All right. Mr. Leibowitz or Mr. Noll?
Mr. Leibowitz. Sure. I think that it is clear that the
complexity of our market represents a challenge for regulators.
There is no doubt about it. And I think that the SEC is trying
to respond to that challenge.
I think the concept, the release that they just issued to
review various aspects, whether it is ATSs, whether it is Reg
NMS, whether it is sponsored access, are all exactly well-
timed, and they just need the resources and need to be nimble
enough to get through that.
I think the challenge is that it is just that we are in an
environment that is relatively complex, and small changes have
unintended consequences. So for example, just saying, ``Let's
ban high-frequency trading,'' I think we would be stunned with
the consequences. I think that even small changes have very big
effects that we may not see, and they just need to be careful,
while at the same time moving quickly when we see a problem
where we all agree, like marketwide circuit breakers on
individual stocks. That is easy one. That is a no-brainer.
Mr. Noll. I would agree with Mr. Leibowitz. And I think
some of the things that we have talked about already indicate
that we are moving in that direction, both on marketwide
circuit breakers on individual stocks changing marketwide
circuit breakers on the entire market as well as talking about
things like the consolidated audit trail and other
functionality that we give the SEC.
I think this is a very complex market. I think Chairman
Schapiro and Chairman Gensler are fully aware of how complex it
is and have the tools and intellectual capital to deal with
that. And we are here to assist them to do with that.
Mr. Bachus. All right.
Mr. Leibowitz, what you said I agree with, that the markets
and exchanges handled volatility quite well during the
financial crisis in 2008. They didn't react quite as well to
the volatility last Thursday. What do you see is the
difference?
Mr. Leibowitz. It is interesting because we actually
discussed this at considerable length. And I think it has to do
with things happening at a certain point in the day. A lot of
the news on the financial crisis came out overnight, where
markets had a chance to absorb that news.
This is something that happened during the day. And, as Mr.
Noll was saying, it was almost, like, set up. The market was in
a jittery situation. The VIX was rising. There was nervousness
about Europe. And then there was the speculation through the
day and the announcement of what was going on in Greece. And it
really just happened at a bad time.
Had that news come out overnight, my guess is we would not
have seen nearly the sort of swing that we saw during the day.
Mr. Bachus. All right. Thank you.
Mr. Scott. [presiding] Let me follow up on that. Let me ask
this question on the circuit breaker concept.
Right now, we are in a situation where we have computers
which are using very difficult mathematical formulas to trade
millions of shares of stock in milliseconds. And our solution
to this, as I hear you say, and Chairmen Schapiro and Gensler,
is to institute stock-by-stock circuit breakers marketwide in a
centralized way.
I saw a movie about a couple of weeks ago, and it is a fun
movie if you want to see it. It is called ``Eagle Eye.'' I
don't know if you saw that movie, but if you get a chance, it
is very interesting. It just simply points out what happens in
concentrating and putting so much control into a computer.
So what I want to ask each of you--because, apparently, as
I hear your testimony, particularly the New York Stock
Exchange, have said that you have circuit breakers. The
complaint was that maybe that moved too slow.
So, as we debate this issue of circuit breakers, I want
each of you to tell us, are there any downsides? Is there
anything we have to fear here? Is there an element of freedom
that takes out of the free enterprise system the freedom of the
market exchange?
Let us be very clear. Is there anything we have to fear if
this is the solution of putting this much control in a stock-
by-stock, marketwide, one central location of a circuit
breaker?
Mr. Noll. If I could address that in two parts, Mr.
Chairman. I think the issue for us is that technology, in and
of itself, is a tool. It is a tool used by market participants
and, I think, used very effectively by market participants. We
view the functioning of our market and its continuous operation
as one of the envies of the world. And, generally, with the
exception of that 17-minute period on May 6th, it functions
extraordinarily well.
And I would argue, even during that period of time, our
technology functioned well, but the market participants that
were on our market experienced an absence of liquidity. So what
we are really concerned about here is when our markets become
dysfunctional.
And I think what the chairman has proposed and what we have
discussed as exchanges is not putting centralized control over
the marketwide, stock-by-stock circuit breakers, but adopting
similar rules so that we all have the same standard rule for
when a stock gets halted.
We each have our own technology. We will continue to
operate our own technology separately from one another, with
the oversight of the SEC. So I don't think that we are talking
about a central computer that is going to control this. I think
what we are talking about is a coordination of our rule sets
with one another on when a marketwide, stock-by-stock halt
should be called.
Mr. Scott. Okay.
Mr. Leibowitz. I think we would agree with Mr. Noll, which
is that information is transmitted to the market faster and
faster. When events happen, it just ripples through the market.
It is on CNBC within seconds. And the fact that trading is
speeding up every day means that the market reacts faster.
I think all this is really designed to do is cause a quick
pause to make sure that everybody understands what is happening
and the symbols of liquidity so that we don't hit a down pocket
like we did before.
I think all of us are strong believers in free market. We
compete with each other, and we compete with each other
aggressively. And yet we can agree on certain principles like
these circuit breakers that I think make the market far better
for investors. Because, in the end, if we don't very a market
that investors believe in, if they feel it is a rigged game,
they are not going to invest their money. That is going to harm
capital formation, retirement savings, all of these things.
Mr. Scott. Mr. Duffy?
Mr. Duffy. Mr. Scott, I think you asked a very interesting
question, which is, what about technology? We continue to build
it; will it eventually consume us, is what I think I heard your
question to be, and what are we doing besides putting circuit
breakers in place to make sure that events like this don't
happen again?
There is more to it than just circuit breakers, sir. There
is pre-execution. There are multiple different technology
vendors you have to go to. But then you have to really get into
what is the most important, in my opinion; you have to have an
experienced risk management team. You have to have a deep
regulatory department within your institution to make certain
that all these transactions are done legitimately and your
technology team can work with your management team and your
risk management parameters to make certain that these computers
don't go out of control.
Mr. Scott. Exactly. That is my point. I know my time is up
here, but that is a very serious point. Because if we are going
to coordinate this, there has to be some mechanism that
triggers it.
And I think that was the failure in the New York Stock
Exchange. You have a circuit breaker there, and apparently it
did not work because of something with the trigger. Is that
correct?
Mr. Leibowitz. No, that is not correct, actually.
Mr. Scott. All right.
Mr. Leibowitz. Our circuit breakers actually triggered
perfectly well. The problem is that in the current U.S. market
regulations, the other venues don't have to obey us when we are
in a circuit breaker mode.
Mr. Scott. I see.
Mr. Leibowitz. So it worked perfectly well for our market
and for any other markets that observed our circuit breaker.
However, it clearly shows a failing in our market if another
market doesn't have to follow that circuit breaker. So that is
why we have agreed on marketwide circuit breakers.
But I would agree with Mr. Duffy that this doesn't end the
conversation. We have to continually look at ways that we can
safeguard the market, that we can make sure the technology is
doing what it is supposed to be doing, and that we don't, sort
of, go down this path.
Mr. Scott. My final point on this, and I will be finished,
is: If we go with this circuit breaker, marketwide, stock by
stock, from each of you very quickly, is there any downside? Is
there anything we have to worry about if we go this way?
Mr. Noll. I think, very quickly on that point, I think the
only downside is the true price discovery is not being found.
Mr. Scott. I am sorry?
Mr. Noll. The true price discovery could be interfered
with. So I think it is important for us, as we design these
marketwide, stock-by-stock circuit breakers, if we do so, that
we want to make sure that buyers and sellers are able to find
each other in an efficient and fair fashion but that we aren't
otherwise closing off price discovery inadvertently. Because
the impact of that closing it off will re-effect itself when
the stock starts to trade again, and you will have this
cascading effect as opposed to true price discovery.
Mr. Scott. All right. Thank you.
Mr. Duffy. I do believe that Mr. Noll is correct, but I
also believe that price discovery is done throughout a period
of the trading session, not on a microsecond. So you do need to
discover price over a period of time and let everybody
participate. So I hear what he is saying, but at the same time
I don't completely agree with that.
Mr. Scott. All right.
Mr. Leibowitz?
Mr. Leibowitz. I think it is incumbent upon us to build
these circuit breakers in a way that helps the market function
properly, go through the auction process, which is what is
supposed to happen, and give the market a chance to pause and
establish the right price.
I think Mr. Noll is right. If we don't do a good job of it,
then we will be in the same place we were. But it is incumbent
on us, as exchanges, to work together to make that process work
properly.
Mr. Scott. Thank you very much. My time is way past. I
thank the rest of the committee for my indulgence.
Ms. Biggert?
Mrs. Biggert. Thank you, Mr. Chairman.
Mr. Duffy, in your testimony, you talked about the stop
price logic. You also highlight a number of risk management
controls used at CME in addition to the circuit breaker rules.
Specifically, could you walk us through the difference
between the circuit breakers and the stop price logic employed
at CME?
Mr. Duffy. Sure. Circuit breakers, as we all know, were
coordinated amongst the securities exchanges with the futures
exchanges. There is a 10 percent, 20 percent, 30 percent
circuit breaker depending on what time of day it happens. So,
in the first half of the day, up until 1:30, it is 10 percent
of the market. Then it goes to 20 percent, and then it goes--if
it goes to 30 percent of the market, the market is closed all
day.
What the stop functionality that we have deployed at CME
Group is, if our market goes up or down in a--roughly, if you
used the equivalent price of the E-mini S&P contract today or
the S&P index, it is a half of 1 percent. If it cannot find
liquidity to fill that order in a half of 1 percent, it stops
for 5 seconds, it allows the market to take a breath to try to
seek liquidity. If it cannot seek liquidity in that 5-second
period, it will then halt another 5 seconds and then try to
seek the liquidity again. So that is the way the stop logic
functionality works.
And then, obviously, we have the circuit breakers in place
also, in coordination with the--
Mrs. Biggert. Then what happened on Thursday that
stabilized the market activity?
Mr. Duffy. There is no question, Congresswoman--we brought
these charts for a purpose because they absolutely make sense.
And you can see that the stop logic worked. The futures market
stop logic kicked in. People had an opportunity to assemble
liquidity. The market started to go the other direction, and we
led that direction. So I think our functionality worked
flawlessly.
Mrs. Biggert. You say that this functionality is not
available in the securities market. Is it just because they
don't use it or--
Mr. Duffy. To be perfectly honest with you, this is
patented technology by CME Group. And I am certain that we
would be happy, without a cost, to give it to the securities
exchanges if this made the whole system better.
Mrs. Biggert. So it can work for, really, any individual
stocks or--
Mr. Duffy. We do believe it could.
Mrs. Biggert. Okay.
I would also like to ask the other gentlemen, Mr. Noll and
Mr. Leibowitz, would you consider using this? Do you think that
this would be available?
Mr. Leibowitz. I think we would consider all options. But,
on the other hand, right now we actually have a circuit
breaker, the functionality of which works. The problem is it is
not marketwide.
So the LRPs are very similar, hopefully not patent-
infringing on what the CME is doing. In terms of what we do is
if the stock moves a certain amount in a certain amount of
time, and that amount is gauged by how much liquidity in the
stock and what the stock price is, it triggers a slow quote, in
which case we take some amount of time to attract liquidity and
unwind the slow quote. So it is very similar to what the CME
does, except theirs is fully automated, as I understand it,
just triggered by time. Ours involves DMM involvement to unwind
it.
Now, each exchange, we will figure out a way, Mr. Noll will
figure out a way for NASDAQ, we will discuss the rules for
implementing--but, essentially, in the end, the stock circuit
breakers will be very similar to the stop-loss pauses that Mr.
Duffy has explained.
Mrs. Biggert. Except that it is not now. It didn't work on
Thursday.
Mr. Leibowitz. No, I disagree. They actually worked in the
New York Stock Exchange market. The failure was that not all
the markets were obeying them. So what we need to do is just
implement them. Whether we implement his version, Mr. Duffy's
version, or a slightly different version, because securities do
trade slightly differently, we will figure that out.
But this is really--as Mr. Noll said, it is an
implementation from a technology standpoint, because we, as
exchanges, and the SEC have agreed essentially on a framework
for going forward with that.
Mrs. Biggert. In other words, for it to work, it has to be
implemented across all market venues?
Mr. Leibowitz. What will most likely happen is it is a
listing venue; so, in the case of--when I say ``listing
stocks,'' our exchange--in the case of NASDAQ listed stocks,
NASDAQ will implement the stop-loss trigger, and the other
markets will have to obey it with respect to their listed
stocks, as I understand it.
Mrs. Biggert. Okay.
Mr. Noll. I agree. I think that is where we will end up.
Mrs. Biggert. Mr. Noll, I am sorry. I didn't hear you.
Mr. Noll. I said that I think that is where we will end up,
where the listing venue will determine when a stock should be
halted across the markets, and all the other listing venues
will obey that stock.
Mrs. Biggert. How long do you think this will take to work
that out?
Mr. Noll. I think the rules set or at least an
understanding of the functionality will probably take place
over the next couple of days, where we will all agree on this
is the outside framework in which we should operate this--the
marketwide stock-by-stock framework in.
The actual implementation, I think, is still subject to all
of us revisiting our technology and revisiting how long it will
take us to implement that.
Mr. Leibowitz. Right. I think we are going to have answers.
We all have this as a high-priority item. Obviously, as the New
York Stock Exchange, we would throw out using our system and
having everybody obey the circuit breakers that are now in
place, but we recognize that is not amenable to most market
participants.
Mrs. Biggert. Okay.
Thank you. I yield back.
Mr. Scott. Thank you.
Now the gentleman from Indiana, Mr. Carson.
Mr. Carson. Thank you, Mr. Chairman.
A question for Mr. Duffy, even though no one had answers on
May 6th, CME took the unusual step of commenting on individual
participation in its markets when it denied that Citigroup may
have executed an irregular trade.
First, how was CME able, during that frenetic day, to
absolve Citigroup of any involvement? And, second, how do you
reconcile CME's Citigroup statement with its policy of not
commenting on individual market participation?
Mr. Duffy. Congressman, that is a great question. It was a
very difficult situation for us at the time because you have to
realize we are working on real time, with the situation
happening, with the rumors that somebody from Citigroup entered
in a $16 million notional transaction in the E-mini and instead
entered $16 billion of notional into the E-mini. We knew,
because of the systems we have in place, that was categorically
false.
We could ring-fence Citibank's inventory that they did on
CME Group on a real-time basis within moments. We traditionally
would not ever make statements like that because of the
situation the banks have been in. We thought it was the prudent
thing to do on Citibank's behalf and, actually, on behalf of
the taxpayers, since they own such a big portion of Citi. We
thought it was the right thing to do to make the statement to
make sure the rumor went away.
Mr. Carson. Mr. Leibowitz, although the cause of the May
6th volatility spike has yet to be determined, do preliminary
investigations indicate flaws in the current regulatory
framework? And, also, can regulatory improvements, whether at
the SEC or the CFTC or exchange levels, prevent what
essentially could be an extraordinary technological glitch?
Mr. Leibowitz. I think what we have recognized is the lack
of marketwide circuit breakers that everyone obeys on a stock-
by-stock basis is clearly a failure among our markets to work
together properly and create the right market environment.
I think the SEC concept review, which they are doing right
now, will help identify other areas where we may feel that
either regulation is lacking; maybe there is not enough
surveillance. I think many of us believe, at this point, that
centralized surveillance is critical in this market.
To be honest, I feel sorry for the SEC staff who has to
assemble from 40 different venues the amount of data they have
done. And they have done amazing work in doing it. But we need
to not be in this situation going forward, and I think we are
committed and I know Mr. Noll's group is committed to working
with the SEC to make that happen.
Mr. Carson. Okay. And lastly, Mr. Noll, can you please give
us a rundown of the decision-making process that resulted in
the cancellation of almost 300 trades of stocks and exchange-
traded funds?
Mr. Noll. Sure, I would be happy to do that.
First of all, I think it is important to note that this was
a multi-exchange decision. All the marketplaces participated in
the decision to break the trades that occurred in that period
of time between 2:40 and 3:00, so it was not one market making
the decision on behalf of all others; it was all markets in
consultation with one another.
And I think we were governed by two things that influenced
our decision-making process there. The first one was: When, in
fact, did the markets become disorderly as opposed to orderly?
So, if you look at some of the time in sales and some of the
trades that occurred in that period of time, their fall, even
though it was drastic and fast, was what we would call orderly.
In other words, they were walking down the order books step-by-
step in the way they were supposed to happen. It was only at
the very bottom where we started to see very anomalous prints.
So we were very concerned about drawing the line at a level
where we addressed the anomalous prints and not the, sort of,
order-by-order orderly trading that was going on.
And we were very cognizant of what I would call the moral
hazard problem, which is that people should bear the
consequences of their actions. We didn't know who was going to
win or lose by drawing the line where we did, but we were sure
that below that line, we were capturing the bulk of the
anomalous trades, but above that line, people's behavior--they
bear some consequence for that. And so, whether they won or
lost during that period of time, they should bear that
consequence for being a market participant there.
So we were very cognizant not to reward people for bad
behavior, but to save people from what we considered to be an
anomalous failure of the markets at that particular time.
Mr. Carson. Thank you, sir.
Mr. Chairman, I yield back.
Mr. Scott. Thank you very much.
The gentleman from Indiana, Mr. Manzullo--I am sorry,
Illinois. I apologize.
Mr. Manzullo. It is close.
Mr. Duffy, on page 1 of your testimony, you state that,
``The most significant equity index futures contract traded on
the CME Group exchanges is the E-mini S&P 500 futures
contract.''
Mr. Duffy. Yes, sir.
Mr. Manzullo. And then, also, ``In 2009, the average daily
volume for the E-mini S&P 500 futures contract was 2,207,596
contracts.''
And then you continue that theme on page 2. You discuss the
trading data for the time period between 1:00 and 2:00 Central
Standard Time. Your analysis of the trading activity during
that hour indicates that the E-mini S&P futures contract was
not the triggering event. I have heard reports that the E-mini
S&P futures contract led the sell-off that precipitated the
decline of the Dow.
Can you walk us through what happened with the E-mini and
your thoughts on what may have been the true triggering event?
Mr. Duffy. I think we have heard a lot about different
events in the marketplace leading up to the time coming into
question. The volume in the E-mini was heavy. This is not
unusual. E-mini trades about 4X or 4 times the amount of the
SPDR contract. At that particular time, we traded about 10
times the volume. So we saw a flight to quality, to CME Group,
to trade our most highly liquid product.
As I said earlier, futures contracts, by design, are
indicators of people's potential viewpoint on what they think
is going to happen. So they are traditionally leaders, up and
down, in the marketplace.
And, again, our markets operated within all the protocols
of CME's systems. So we didn't have any ``fat-finger'' issues;
we were confident of that. The market was moving quite rapidly.
At the same time, there were a lot of macroeconomic events that
were happening.
So, yes, it was unusual activity. Nobody is going to deny
that. It happened, and it happened quickly. But, again, we
didn't bust trades. We looked at some of the algorithmic
traders, as has been questioned here. They were basically more
liquidity providers at the time in question; they were not
aggressors or taking the market. So they were there on both
sides, bid and offer. So they were leading the market because
of the nature of the product, sir.
And then, as you could see, our stop logic worked, and the
listed stocks kept going down for whatever reason. That is
still yet to be explained, why they went to the prices they
did. We did not trigger, which would have been only--a stop
circuit breaker for CME would have been the 20 percent circuit
breaker that is instituted amongst all the exchanges, and we
were roughly about 9.5 percent at the lowest point in the S&P
contract, sir.
Mr. Manzullo. Let me ask you an unrelated question because
something obviously--maybe not obviously, but apparently
something spooked the market. Anything to do with the problem
in Greece or worldwide activity or inability to predict what is
going on with regard to the euro? Do you see any connection
there at all, or is it just a coincidence?
Mr. Duffy. I have seen a lot of high volatility, sir,
especially coming into that day. So all those events were on
the front page, so I am sure they had a contributing factor to
the market conditions that led up to the precipitous down-move.
And, at the same time, you have to remember we saw a couple
stocks trading at a penny that were $40 stocks. So one was
probably wondering what was going on in the marketplace.
Mr. Manzullo. Mr. Noll, would you like to comment on that
last question?
Mr. Noll. On the volatility in the marketplace at that
time?
Mr. Manzullo. Yes.
Mr. Noll. Yes, I--
Mr. Manzullo. It doesn't have to be a precise answer
because no one knows.
Mr. Noll. I don't think we have a precise answer yet, and I
am not sure that we will ever get a precise answer as to the
nature of what was the root cause of the uncertainty in the
marketplace.
But I do think what is very clear is that we saw an
increasing amount of volatility on the days leading up to May
6th. We have seen the spike in all the measurements of
volatility. The day of May 6th itself was already a volatile
day before the events we are talking about here happened. So it
was already a severe down day. It was also the third day in a
row of down equity markets.
So I think when we hit these air pockets or this confluence
of events, if I could call it that, we were in a position where
there was just a massive downdraft in the marketplace, which we
recovered from, but nonetheless I think it is important for us
to address the causes and to prevent that from happening going
forward.
Mr. Manzullo. Mr. Leibowitz?
Mr. Leibowitz. Yes, I think the two gentleman to my left
have hit it right, which is it was a spooked market--I think
you even used that term. The market became very illiquid and
choppy. And it is very likely that some news out of Europe
might have gotten people selling.
But I think the behavior that you then saw, selling some
stocks down to a penny, that is not permissible behavior. That
is a market structure failure that we have it incumbent upon us
to correct.
On the other hand, markets are allowed to sell off in a
reasonable way. And so, if investors were afraid of Greece and
the euro and anything else that was going on, they should be
selling the market off. What we are really addressing is, is it
happening in a reasonable and orderly way? Are investors being
disadvantaged by events transpiring on the exchange? It would
be hard to justify to a retail investor that he sold the stock
at a penny.
And so, that clearly has to be addressed. The fact that
something triggered a sell-off--if we can't find an actual
cause, meaning a trader or--and there are so many rumors, and
that is part of--what we live with that every day in our
market. The rumors get transmitted so quickly that we just have
to deal with that.
Mr. Manzullo. Mr. Chairman, could I ask one more question?
Mr. Scott. Yes, you may.
Mr. Manzullo. Thank you.
Your answers take into consideration or are obviously based
upon the fact that there really wasn't anybody out there who
``made a killing'' that day. Is that correct? There is no bad
person out there or somebody that you can say, look what he or
she or they did as a group that caused this?
Mr. Noll. I think the investigations and looking at the
evidence will take place over the next couple of days and weeks
until all the determinations are made of everyone's behavior,
whether it was good or bad or within the rules or not within
the rules.
As of today, on the NASDAQ systems and in the NASDAQ
market, we have not seen anything that would suggest to us that
anyone was behaving in an inappropriate fashion.
Mr. Leibowitz. And I would say quite the opposite of making
a killing, if algorithmic traders did, in fact, follow the
market down, chances are they got hurt pretty badly, because
the market just snapped right back and they sold way below
where the market ended up.
So, while retail investors and others followed it down with
them, my guess is whoever led it down, intentionally or not,
did not make a killing.
Mr. Manzullo. Okay.
Mr. Duffy. Congressman, yes, I agree with both of these
gentlemen. I have not heard anything extraordinary. But, then
again, it is a sensitive topic, and we will let our regulatory
departments investigate that with due process.
Mr. Manzullo. Thank you.
Mr. Scott. Thank you, sir.
Now, we will hear from the gentleman from New Jersey, Mr.
Garrett.
Mr. Garrett. Just with one last question. And I appreciate
all your time here.
You are all on board with the circuit breaker idea, and I
have spent a lot of time on it. And, Mr. Duffy, I think you
just mentioned with what your system, as far as the 20
percent--
Mr. Duffy. Our system on a circuit breaker?
Mr. Garrett. Yes.
Mr. Duffy. It is basically--the way that it works today, it
goes down roughly a half a percent of what the value of the S&P
contract is today. If it doesn't have the liquidity to fill the
number of contracts, buy or sell, it will halt for 5 seconds,
and then it will try to attract that liquidity. If it doesn't
do it, it will try to halt another 5 seconds to attract that
liquidity to fill the order in that period.
Mr. Garrett. Okay.
And from the other gentlemen, when you will be meeting with
Chairman Schapiro and the rest in the next few days and what
have you to try to come up with uniformity on these issues, is
there a lower level that you would say this was just not a
realistic figure?
If you here at my opening comment, I said there were rumors
out there saying that you are looking at bands of 2 percent or
so that would just be too restrictive for individual stocks and
what have you. So what is the appropriate level? That is my
final question.
Mr. Noll. Yes, I think we are still engaged in that effort
of determining the appropriate level. I happen to share your
concern that we not draw the bands too tightly.
Mr. Garrett. And what is that?
Mr. Noll. I think 2 percent, quite frankly, is too tight. I
think what we saw on Thursday was the LRP functionality going
off at 2 percent levels, which caused dislocations in the
marketplace, perhaps unintentionally, but nonetheless caused
dislocations in the marketplace, while other markets continued
to provide liquidity at that level.
So, I think as Larry has suggested earlier, we need to
agree on what the right, appropriate levels are. I don't think
2 percent is the right level. We tend to believe that it should
be 10 percent. But I think that is still a moving target for
all of us.
Mr. Leibowitz. Yes, I would agree with Mr. Noll 100
percent. We use for our LRPs relatively tight bands. In Procter
& Gamble, it actually is about 2 percent. But the intention is
to continue trading and get it going relatively quickly.
Mr. Garrett. Right.
Mr. Leibowitz. I think for this, we are going to use
broader bands, because we want them to be marketwide and we
need everyone to agree to them.
Mr. Duffy. Congressman, if I could just make one comment,
the 10 percent, 20 percent, and 30 percent, which the gentleman
is referring to here, can certainly be narrowed, but I think if
you narrow those percentages, what is more important then is to
narrow the timeframe that the markets close, because they will
be seeking liquidity at other venues, whether it is overseas or
somewhere else.
So if you narrowed a time to 5, 15, and 10--whatever you
want to come up with, pick your favorite number, you can't be
closed for an hour or you can't be closed all day. You narrow
those time windows and narrow the bands, and it will work out
for everybody.
Mr. Leibowitz. Yes, I think that is a great point. On a
stock-by-stock basis, we are talking about a couple of minutes
at most. And on a marketwide basis, as we narrow the marketwide
bands, we are really talking about moving the timeframe in for
the close, so it is not as long a close as it was in the past.
Mr. Garrett. Yes. That is a good point about overseas
trades. I was going to bring that up before, but--
Mr. Duffy. That is exactly where it will go, sir.
Mr. Garrett. --thank you, Mr. Chairman.
Mr. Scott. Thank you, Mr. Garrett.
I want to thank each of you--Mr. Leibowitz, Mr. Noll, Mr.
Duffy, and also Chairman Schapiro and Chairman Gensler--for
your excellent, superb, and well-presented testimony today on
this very critical issue as we move to make sure we maintain
the strongest investor confidence in our financial markets and
in our investor trading. Thank you again, very, very much, for
coming before our committee and helping us with this.
The Chair notes that some members may have additional
questions for this panel which they may wish to submit in
writing. Without objection, the hearing record will remain open
for 30 days for members to submit written questions to these
witnesses and to place their responses in the record.
Before we adjourn, the following will be made part of the
record of this hearing: the written statement of Commissioner
Bart Chilton, Commodities Future Trading Commission. Without
objection, it is so ordered.
The panel is dismissed, and this hearing is adjourned.
[Whereupon, at 6:32 p.m., the hearing was adjourned.]
A P P E N D I X
May 11, 2010