[Senate Hearing 113-413]
[From the U.S. Government Publishing Office]
S. Hrg. 113-413
CONFLICTS OF INTEREST, INVESTOR LOSS
OF CONFIDENCE, AND HIGH SPEED
TRADING IN U.S. STOCK MARKETS
=======================================================================
HEARING
before the
PERMANENT SUBCOMMITTEE ON INVESTIGATIONS
of the
COMMITTEE ON
HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS
UNITED STATES SENATE
ONE HUNDRED THIRTEENTH CONGRESS
SECOND SESSION
__________
JUNE 17, 2014
__________
Available via the World Wide Web: http://www.fdsys.gov
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Committee on Homeland Security and Governmental Affairs
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COMMITTEE ON HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS
THOMAS R. CARPER, Delaware Chairman
CARL LEVIN, Michigan TOM COBURN, Oklahoma
MARK L. PRYOR, Arkansas JOHN McCAIN, Arizona
MARY L. LANDRIEU, Louisiana RON JOHNSON, Wisconsin
CLAIRE McCASKILL, Missouri ROB PORTMAN, Ohio
JON TESTER, Montana RAND PAUL, Kentucky
MARK BEGICH, Alaska MICHAEL B. ENZI, Wyoming
TAMMY BALDWIN, Wisconsin KELLY AYOTTE, New Hampshire
HEIDI HEITKAMP, North Dakota
Richard J. Kessler, Staff Director
Keith B. Ashdown, Minority Staff Director
Laura W. Kilbride, Chief Clerk
Lauren M. Corcoran, Hearing Clerk
PERMANENT SUBCOMMITTEE ON INVESTIGATIONS
CARL LEVIN, Michigan Chairman
MARK L. PRYOR, Arkansas JOHN McCAIN, Arizona
MARY L. LANDRIEU, Louisiana RON JOHNSON, Wisconsin
CLAIRE McCASKILL, Missouri ROB PORTMAN, Ohio
JON TESTER, Montana RAND PAUL, Kentucky
TAMMY BALDWIN, Wisconsin KELLY AYOTTE, New Hampshire
HEIDI HEITKAMP, North Dakota
Elise J. Bean, Staff Director and Chief Counsel
Daniel J. Goshorn, Counsel
Henry J. Kerner, Minority Staff Director and Chief Counsel
Jack Thorlin, Counsel to the Minority
Brad M. Patout, Senior Advisor to the Minority
Scott Wittmann, Research Assistant to the Minority
Mary D. Robertson, Chief Clerk
C O N T E N T S
------
Opening statements:
Page
Senator Levin................................................ 1
Senator McCain............................................... 4
Senator Johnson.............................................. 6
Prepared statements:
Senator Levin................................................ 55
Senator McCain............................................... 59
WITNESSES
Tuesday, June 17, 2014
Robert H. Battalio, Professor of Finance, Mendoza College of
Business, University of Notre Dame, Notre Dame, Indiana........ 7
Bradley Katsuyama, President and Chief Executive Officer, IEX
Group, Inc., New York, New York................................ 9
Thomas W. Farley, President, New York Stock Exchange, New York,
New York....................................................... 31
Joseph P. Ratterman, Chief Executive Officer, BATS Global
Markets, Inc., Lenexa, Kansas.................................. 33
Joseph P. Brennan, Principal and Head of Global Equity Index
Group, The Vanguard Group, Inc., Malvern, Pennsylvania......... 35
Steven Quick, Senior Vice President, Trader Group, TD Ameritrade,
Omaha, Nebraska................................................ 36
Alphabetical List of Witnesses
Battalio, Robert H.:
Testimony.................................................... 7
Prepared statement........................................... 61
Brennan, Joseph P.:
Testimony.................................................... 35
Prepared statement........................................... 87
Farley, Thomas W.:
Testimony.................................................... 31
Prepared statement........................................... 77
Katsuyama, Bradley:
Testimony.................................................... 9
Prepared statement........................................... 69
Quick, Steven:
Testimony.................................................... 36
Prepared statement........................................... 93
Ratterman, Joseph P.:
Testimony.................................................... 33
Prepared statement........................................... 79
APPENDIX
EXHIBIT LIST
1.a. GMaker-Taker Conflict, chart prepared by the Permanent
Subcommittee on Investigations................................. 102
b. GPayment for Order Flow Conflict, chart prepared by the
Permanent Subcommittee on Investigations....................... 103
c. GConflict for Brokers Trading for Institutional Investors,
chart prepared by the Permanent Subcommittee on Investigations. 104
d. GConflicts for Retail Brokers Trading for Retail Investors,
chart prepared by the Permanent Subcommittee on Investigations. 105
2. GLetter from the Securities and Exchange Commission to the
Senate Permanent Subcommittee on Investigations, dated June 18,
2014, regarding the impact of high-frequency trading on the
efficiency, stability, and integrity of the U.S. capital
markets........................................................ 106
3. GLetter from the Securities and Exchange Commission to the
Senate Permanent Subcommittee on Investigations, dated August
5, 2014, regarding conflicts of interest in the U.S. equities
markets, including ``maker-taker'' fee schedules and payment
for order flow by wholesale brokers to retail.................. 123
4. GLetter from TD Ameritrade, dated June 19, 2014, clarifying
June 17, 2014 testimony of Steven Quick........................ 125
5. GResponse of Steven Quick, TD Ameritrade, Inc., to
supplemental questions for the record of Senator Carl Levin.... 126
6. GResponse of Joe Ratterman, BATS Global Markets, Inc., to
supplemental questions for the record of Senator Carl Levin.... 127
7. GResponse of Thomas Farley, NYSE Group, to supplemental
questions for the record of Senator Carl Levin................. 128
8. GResponse of Joseph Brennan, The Vanguard Group, Inc., to
supplemental questions for the record of Senator Carl Levin.... 129
CONFLICTS OF INTEREST, INVESTOR LOSS
OF CONFIDENCE, AND HIGH SPEED
TRADING IN U.S. STOCK MARKETS
----------
TUESDAY, JUNE 17, 2014
U.S. Senate,
Permanent Subcommittee on Investigations,
of the Committee on Homeland Security
and Governmental Affairs,
Washington, DC.
The subcommittee met, pursuant to notice, at 9:35 a.m., in
room SH-216, Hart Senate Office Building, Hon. Carl Levin,
Chairman of the Subcommittee, presiding.
Present: Senators Levin, McCain, and Johnson.
Staff present: Elise J. Bean, Staff Director and Chief
Counsel; Mary D. Robertson, Chief Clerk; Daniel J. Goshorn,
Senior Counsel; Joseph Bryan, Robert Heckert, and Timothy
Everett (Sen. Levin); Adam Henderson, Professional Staff
Member; Henry J. Kerner, Staff Director and Chief Counsel to
the Minority; Jack Thorlin, Counsel to the Minority; Brad M.
Patout, Senior Advisor to the Minority; Scott Wittmann,
Research Assistant to the Minority; John Lin, Law Clerk to the
Minority; Joel Churches, Detailee (IRS); Admad Sarsour,
Detailee (FDIC); Jacob Rogers, Law Clerk; Rebecca Pskowski, Law
Clerk; Michael Avi-Yonah, Intern; Amy Dreisiger, Law Clerk;
Owen Dunn, Law Clerk; Josh Katz and Richard Drucker (Sen.
Levin); Ritika Rodrigues and Meris Petek (Sen. Johnson); and
Myles Matteson (Sen. Ayotte).
OPENING STATEMENT OF SENATOR LEVIN
Senator Levin. Good morning, everybody. Most Americans'
image of the U.S. stock market is shaped by a single room: the
trading floor of the New York Stock Exchange, where traders
await a ceremonial bell to kick off the day's activity, then
trade shares worth millions on scraps of paper.
In reality, most shares are traded not on a floor in
Manhattan, but in racks of computer servers in New Jersey.
Trades happen not at the speed of a human scribbling on paper,
but in the milliseconds it takes for an order to travel through
fiberoptic cables. And, increasingly, the money made on stock
markets comes not from thoroughly assessing companies for their
investment potential, but from exploiting infinitesimal
advantages at unfathomable speeds, earning billions off price
differences measured in pennies.
We are in the era of high-speed trading. I am troubled, as
are many, by some of its hallmarks. It is an era of market
instability, as we saw in the 2010 ``flash crash,'' which this
Subcommittee and the Senate Banking Committee explored in a
joint hearing, and in several market disruptions since that
flash crash. It is an era in which stock market players buy the
right to locate their trading computers closer and closer to
the computers of stock exchanges--conferring a minuscule speed
advantage yielding massive profits. It is an era in which
millions of trade orders are placed, and then canceled, in a
single second, raising the question of whether much of what we
call the market is, in fact, an illusion.
Many, including this Senator, question whether the rise of
high-speed trading is, overall, a good thing for markets and
investors. But without question, this era has seen a rise of
conflicts of interest. These conflicts will be my focus today.
Other Senators may focus on this or other aspects of high-speed
trading.
New technologies should not erase enduring values.
Financial markets cannot survive on technology alone. They
require a much older concept: trust. And trust is eroding.
Conflicts of interest damage investors and markets--first, by
depriving investors of the certainty that brokers are placing
the interests of their clients first and foremost; and, second,
by feeding a growing belief that the markets are simply not
fair.
In fact, polling shows that roughly two-thirds of Americans
believe the stock market unfairly benefits some at the expense
of others. This distrust may be a factor in the fact that just
over half of Americans, according to a Gallup survey earlier
this year, own stock or mutual funds, which is down from more
than two-thirds of Americans who owned stock or mutual funds in
2002. That lack of faith--if allowed to fester and grow--will
undermine a very important public purpose of stock markets: to
efficiently raise capital so that businesses may grow, create
new jobs, and add to America's prosperity.
In previous hearings and investigations, this Subcommittee
has shown that our financial markets have become plagued by
conflicts of interest. We have uncovered investment banks
willing to create securities based on junk assets, tout them to
their clients, and then bet against those same securities,
making a fortune at the expense of their clients. We have seen
credit rating agencies assign artificially high ratings to
securities in order to keep or gain business. Now, with that
history in mind, those who argue that the conflicts we will
explore at this hearing are manageable or acceptable have a
mighty high burden of proof.
What seems to your average investor to be a simple stock
market trade is usually a complicated series of transactions
involving multiple parties, complex technology, and an ever-
increasing number of order types and payment arrangements.
There are retail brokers, like the ones found in Main Street
offices across the country and on TV advertisements. There are
wholesale brokers who buy orders from retail brokers. And there
are dozens of trading venues where shares are bought and sold.
Most Americans know the New York Stock Exchange, but there are
now 11 public exchanges, plus more than 40 alternative trading
venues including ``dark pools,'' which are essentially private
exchanges run by financial institutions.
As that complex structure has emerged, so have a number of
conflicts of interest. I will focus on two. The first conflict
occurs when a retail broker chooses a wholesale broker to
execute trades. The second occurs when a broker, acting on
behalf of either a retail client or an institutional investor
that manages pension funds and retirement accounts, chooses a
trading venue, often a public exchange, to execute a trade. At
both of these decision points, the party making the decision
should only be influenced by the best interest of the investor.
That is what ethics demands, and it is what the law requires.
But there is another factor in play. At both decision
points, the current structure gives brokers an incentive to
place their own interests ahead of the interests of their
clients. And here is how.
The first conflict, which is illustrated in that chart,\1\
occurs when retail brokers receive payments from wholesale
brokers for their orders. This money, known as ``payment for
order flow,'' can add up to untold millions, and almost every
retail broker keeps these payments rather than passing them on
to clients. The reasons wholesale brokers are willing to pay
for order flow are complex, but one big one is that wholesale
brokers can fill many of those orders out of their own
inventory and profit from the trade--a practice known as
``internalizing.''
---------------------------------------------------------------------------
\1\ The chart titled ``Payment for Order Flow Conflict,'' appears
in the Appendix on page 103.
---------------------------------------------------------------------------
The second conflict, shown on the second chart,\2\ arises
when a broker decides to use a public trading venue and then
chooses which venue it will send orders to for execution. Under
what is known as the ``maker-taker'' arrangement, there is an
incentive for the broker to choose the trading venue based on
the broker's financial interest, rather than the client's.
---------------------------------------------------------------------------
\2\ The chart titled ``Maker-Taker Conflict,'' appears in the
Appendix on page 102.
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Now, ``maker-taker'' can be complicated, but here is a
simplified explanation. When a broker makes an offer on an
exchange to buy or sell a stock at a certain price, the broker
is classified as a ``maker,'' and most exchanges will pay the
broker a rebate when that offer to buy or sell is accepted. A
broker who accepts a maker's offer to buy or sell is called a
``taker'' and will generally pay a fee to the trading venue.
The important thing to remember is that brokers, by maximizing
maker rebates and by avoiding taker fees, can add millions of
dollars to their bottom line, giving them a powerful incentive
to send the order to the trading venue that is in their best
interest even if it is not in their client's best interest.
It is significant that earlier this year, speculation that
regulators were considering restrictions on payment for order
flow sent shares of some brokerage firms significantly lower.
Obviously, there is a lot of money at stake in preserving
these conflicts of interest.
Even if firms disclose these payments, disclosure does not
excuse them from their legal and ethical obligations to
clients. Their legal obligation is to provide clients with what
is known as ``best execution.'' Whether they are meeting that
obligation is a subjective judgment. The outcome of this
subjective judgment affects the way tens of millions of trades
are executed.
Now, some who profit from these payments argue that seeking
this revenue does not interfere with their obligation to seek
best execution. However, one of our witnesses today, Professor
Robert Battalio of the University of Notre Dame, has done
research indicating that when, given a choice, four leading
retail brokers send their orders to the markets offering the
biggest rebates at every opportunity. The research further
suggests that exchanges offering the highest rebates do not, in
fact, offer the best execution for clients. These brokers argue
that they can pocket these rebates while still meeting their
obligation to provide clients with best execution. So while
they make a subjective judgment as to which trading venue
provides best execution, on tens of millions of trades a year,
that subjective judgment always just happens to also result in
the biggest payment to brokers. I find it hard to believe that
this is a coincidence.
Many market participants are worried about the conflicts of
interest embedded in the current market structure. In addition
to Professor Battalio, today's first panel will include Bradley
Katsuyama, the president and CEO of IEX and a prominent Wall
Street advocate for market reform. Our second panel will
include four witnesses. They are Thomas W. Farley of the New
York Stock Exchange, whose corporate owners have described
conflicts as having a ``corrosive impact'' on stock markets.
The next person on the second panel is Joseph Ratterman of BATS
Global Markets, which operates exchanges that compete with the
New York Stock Exchange and has a different view. The third
witness on the second panel is Joseph Brennan of Vanguard
Group, a major mutual fund company that has expressed concerns
about these conflicts. And the fourth witness on the second
panel is Steven Quirk of TD Ameritrade, a retail broker that
derives significant revenue from payment for order flow from
wholesale brokers and rebates that they receive from exchanges.
The duty of lawmakers and financial regulators is to look
out for the interests of investors and the wider public. There
is significant evidence that these conflicts can damage
retirement savings, pension holdings, and other investments on
which Americans rely. And even Americans without a single share
of stock or a mutual fund account have something at stake
because stock markets exist to foster investment, growth, and
job creation. Conflicts of interest jeopardize that vital
function.
Americans do not shy from innovation or technology; indeed,
we embrace them. But Americans are understandably suspicious
when technology can be turned against them and their families'
financial interests. They are rightly concerned when technology
and innovation are used to undermine basic, enduring principles
such as trust and duty to a client. Our goal is to advance the
protection of investors and our free markets by promoting those
enduring values.
I want to thank Senator McCain and his staff for their
close cooperation in this matter, as has always been the case
in all matters. Senator McCain.
OPENING STATEMENT OF SENATOR McCAIN
Senator McCain. Thank you very much, Mr. Chairman, and I
think this is a very important hearing, and I appreciate the
hard work that you and your excellent staff have done on it.
And I want to thank the witnesses for being here today.
When Michael Lewis' book ``Flash Boys'' came out, the
public knew very little about high-frequency trading. Important
questions were raised: Is the stock market ``rigged'' by
unethical high-speed traders with faster access to market
information, advanced technology, and sophisticated trading
algorithms? Is high-frequency trading adding costs for other
traders without contributing any real value to the market? Will
stock markets face another flash crash like in 2010 when the
Dow Jones temporarily lost $1 trillion in market value in 20
minutes?
These concerns about high-frequency trading have fueled
suspicions that Wall Street may well have become the ultimate
insiders' game, where the average investor can no longer
meaningfully participate. Consumers see firms that can make
trades in fractions of a second using cutting-edge technology
and wonder if the stock exchanges are still a place where their
interests matter. Hopefully, this hearing will shed light on
the high-frequency trading practices used on Wall Street and
help restore confidence in our financial system.
The Subcommittee interviewed many industry participants,
academic researchers, and key financial regulators. While the
problems facing the market are complex, we can address them
with a few commonsense solutions. For example, one of the most
predatory high-frequency trading practices depends on the
unintended consequences of the SEC's Regulation National Market
System, or Reg NMS. That regulation essentially mandated that
investment firms must buy or sell stocks at the best price
available. While that might sound like a reasonable
requirement, high-frequency trading firms can take advantage of
the rule by putting out offers to buy or sell small amounts of
stock at attractive prices. When a large investor, seeking to
make a big order, accepts the high-frequency trading firm's
offer because it is the best price available, the high-
frequency trader can predict that the large investor will have
to go to another exchange to purchase the rest of his order.
The high-frequency trader can then race ahead of that investor
to the other exchanges, buy up all available shares, and sell
them to the large investor at a higher price. Changing Reg NMS
so that investment firms are no longer legally required to take
the high-frequency traders' bait is an easy, clear first step
to cleaning up the worst high-frequency trading practices.
Another key tactic used by high-frequency trading firms is
co-location. This practice involves trading firms literally
renting space for their computers in the same room as the
computers that run the stock exchanges so that they can receive
market information directly from the exchanges' computers as
fast as possible. The investors that do not buy this direct
connection to the exchanges receive market data via a
government-established system using out-of-date technology
called the Securities Information Processor that compiles
market data much more slowly. But as experts told the
Subcommittee, there is no reason why public data feeds like the
Securities Information Processor cannot be improved so that
they are effectively as fast as private data feeds acquired
through co-location. Updating the technology in the Securities
Information Processor is another helpful measure that can be
quickly adopted to shore up consumer confidence in the market.
In addition to high-frequency trading, ``Flash Boys'' also
described how stock exchanges often pay rebates, as Senator
Levin pointed out, to stockbrokers to entice them to trade on
those exchanges. Those rebates, again, as Senator Levin pointed
out, called ``maker-taker payments,'' create an apparent
conflict of interest for the stockbrokers, who must choose
between sending their clients' orders to exchanges offering a
higher rebate or to exchanges that would fill the orders as
quickly as possible. While many trading firms argue that those
payments spur more market activity and reduce costs for
consumers, some experts have argued that these benefits are
minimal and that investors are harmed by their brokers'
conflict of interest.
The Subcommittee has found that there is a lack of publicly
available data regarding maker-taker payments, leading to
difficulties in determining whether the payments actually have
an adverse effect on the market. A logical first step would be
to have more transparency in the payments, allowing neutral
researchers to study the issue in greater detail.
I hope this hearing will educate the public about high-
frequency trading and broker conflicts of interest, and I hope
that as a result of this hearing and the information that we
will obtain from our expert witnesses that action will be taken
to restore investor confidence, which has clearly been eroded
in recent months, especially since the publication of Michael
Lewis' book.
I thank you, Mr. Chairman.
Senator Levin. Thank you very much.
Senator Johnson.
OPENING STATEMENT OF SENATOR JOHNSON
Senator Johnson. Thank you, Mr. Chairman. I also want to
thank you for holding this hearing. It was very interesting
getting prepared for it.
Both Chairman Levin and Senator McCain mentioned the word
``complex,'' and there is no doubt about it. What is happening
in terms of trading is highly complex.
From my standpoint, having been an individual investor, I
think the primary solution is increased competition and
transparency so that we really understand what is happening.
But because it is complex, it is difficult to fully understand.
I am hoping this hearing will really lay out the reality of the
situation, and, again, as an individual investor who has bought
stocks for literally decades, the competition has increased in
the marketplace. I used to pay hundreds of dollars to buy 100
shares of stock. Now I pay about $10.
So I really do hope that this hearing conveys exactly what
is happening in the marketplace, what benefits have come to
consumers over the years, what dangers may be out there, but
the bottom line is that this hearing should be about restoring
confidence. I do not think it restores confidence if we try and
create a state of fear and set up straw men in terms of the
bogeymen out there trying to game the system. The best way to
ensure confidence and to ensure best price, is through maximum
competition and transparency in the marketplace. I am hoping
that is certainly what this hearing reveals, and, again, I just
want to thank all the witnesses. I am looking forward to the
testimony.
Senator Levin. Thank you, Senator Johnson.
We will now call our first panel of witnesses for this
morning's hearing: Professor Robert Battalio, Professor of
Finance at the Mendoza College of Business at the University of
Notre Dame in Notre Dame, Indiana; and Bradley Katsuyama,
President and CEO of the IEX Group in New York.
I appreciate both of you being with us this morning, and we
look forward to your testimony. And pursuant to Rule 6, all
witnesses who testify before the Subcommittee are required to
be sworn. So at this time, I would ask both of you to please
stand and raise your right hand. Do you swear that the
testimony you are about to give before this Subcommittee will
be the truth, the whole truth, and nothing but the truth, so
help you, God?
Mr. Battalio. I do.
Mr. Katsuyama. I do.
Senator Levin. We will be using a timing system today.
Please be aware that 1 minute before the red light comes on,
you will see the light change from green to yellow, giving you
an opportunity to conclude your remarks. All of your written
testimony will be printed in the record in its entirety, and we
would ask that you try to limit your oral testimony to 5
minutes.
Professor Battalio, we will have you go first. Thank you
again for coming today and for your work.
TESTIMONY OF ROBERT H. BATTALIO,\1\ PROFESSOR OF FINANCE,
MENDOZA COLLEGE OF BUSINESS, UNIVERSITY OF NOTRE DAME, NOTRE
DAME, INDIANA
Mr. Battalio. Good morning. Chairman Levin and Ranking
Member McCain, thank you for inviting me to testify today. It
is an honor to have the opportunity to present my views on
conflicts of interest in U.S. equity markets to the Senate
Permanent Subcommittee on Investigations. My expertise is the
relationship between order flow inducements offered by dealers
and exchanges and the quality of trade execution.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Battalio appears in the Appendix
on page 61.
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Before discussing my current research with Shane Corwin and
Robert Jennings, I would like to provide a bit of context.
Orders used by retail investors can be broadly classified into
two categories.
Investors who want to trade quickly at the best available
price use marketable orders. These orders demand or take
liquidity from the market. Investors who are willing to buy or
sell stock but not at the prices that are currently prevailing
in the marketplace use nonmarketable or standing orders to
express their trading interests. Nonmarketable orders do not
immediately execute when they arrive in the market. Exchanges
use electronic order books to keep track of their nonmarketable
orders, and they typically use price-time priority to determine
which nonmarketable order trades when a marketable order
arrives. The nonmarketable orders resting on the electronic
books make or supply liquidity for other market participants.
Several exchanges use make or liquidity rebates to attract
nonmarketable orders. A make rebate is paid to an investor or
her broker when her nonmarketable order trades. To fund the
make rebates, the same exchanges charge marketable orders a
take fee when they trade with nonmarketable orders. As a result
of competition, exchanges offering high make rebates also tend
to charge high take fees, and those offering low make rebates
tend to charge low take fees.
The incentives created by the maker-taker fee structure
suggest marketable orders will tend to be first routed to
venues that have low take fees and, thus, low make rebates. As
a result, nonmarketable orders on high-fee, high-rebate venues
are likely to trade last at a given price and, thus, can miss
out on profitable trading opportunities. All else equal, this
suggests that the likelihood that nonmarketable orders trade is
lowest on the exchanges with the high make rebates.
NASD Notice to Members 01-22 states that brokers must take
into account differences in the likelihood of execution when
determining where to route nonmarketable orders and that
brokers must not allow inducements to interfere with the duty
of best execution. The conflict of interest associated with
make-take fee schedules arises from the fact that most brokers
do not pass fees and rebates directly through to their
customers, but instead charge fixed commission rates that
reflect fees, rebates, and other costs of doing business.
Thus, while investors prefer that their orders be routed to
the venue offering the highest possibility of trade, a broker
may have an incentive to route orders to the venue offering the
highest liquidity rebate. It may seem that economics and
competition should align the incentives of a broker and its
customers; however, this alignment of incentives is hampered by
an important agency problem. Brokers that maximize rebates may
be able to charge lower commissions. If investors choose
brokers based primarily on commissions--perhaps because they
lack the sophistication and/or the necessary information to
evaluate limit order execution quality--it may be profit
maximizing for brokers to focus on liquidity rebates rather
than the likelihood of execution when deciding where to route
their nonmarketable orders. Unfortunately, investors whose
orders do not execute do not receive the benefit of the low
commission.
In our paper, we examine two issues. We begin by exploring
whether make rebates appear to influence the routing decisions
of retail brokers. We present evidence from SEC-mandated Rule
606 filings that four popular retail brokers route
nonmarketable orders in a manner that is consistent with the
goal of maximizing make rebates. Our Rule 606 data are from the
fourth quarter of 2012, but subsequent Rule 606 filings suggest
these brokers have not significantly altered their routing of
nonmarketable orders.
After establishing that rebates appear to impact the order
routing decisions of some brokers, we next analyzed the
relationship between make rebates and several measures of
execution quality, including the likelihood that and the
conditions in which nonmarketable orders trade. Our analysis
makes use of a proprietary data set of nonmarketable orders
that represent about 1.5 percent of average daily volume and a
publicly available data base that contains all trades and
quotes.
As hypothesized, we find that nonmarketable orders routed
to venues with low make rebates are more likely to trade, trade
faster, and suffer less adverse selection than nonmarketable
orders routed to venues with high make rebates. Our results
suggest that when deciding where to route nonmarketable orders,
situations frequently arise in which brokers must decide
whether to maximize the likelihood of an execution or to
maximize make rebates.
Thanks for the opportunity to discuss my research with
Shane and Bob today.
Senator Levin. Thank you very much, Professor Battalio.
Mr. Katsuyama.
TESTIMONY OF BRADLEY KATSUYAMA,\1\ PRESIDENT AND CHIEF
EXECUTIVE OFFICER, IEX GROUP, INC., NEW YORK, NEW YORK
Mr. Katsuyama. Good morning, Chairman Levin, Ranking Member
McCain, Senators, staff, ladies and gentlemen. Thank you for
the opportunity to participate in this hearing and share our
thoughts on issues affecting the U.S. equity markets. My name
is Brad Katsuyama, and I am the President and CEO of IEX Group.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Katsuyama appears in the Appendix
on page 69.
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Since October 2013, IEX has been operating as an
alternative trading system for U.S. equities, and we intend to
pursue registration as a national securities exchange with the
Securities and Exchange Commission later this year.
IEX was founded on the premise of institutionalizing
fairness in the market through the use of technology and by
offering a balanced, simplified, and transparent market model.
IEX believes strongly in a market's responsibility to ensure
just and equitable principles of trade as required by Section 6
of the Securities and Exchange Act of 1934.
With that in mind, IEX deliberately sought to build a
platform that would eliminate conflicts of interest in the
operation of our market. Specifically, IEX is owned by a
consortium of mutual funds, hedge funds, family offices, and
individuals, but only has registered broker-dealers as trading
participants. IEX does not pay rebates or provide any other
payment for order flow, and as a result, we have a very limited
number of order types.
IEX has instituted a time buffer that applies to all of our
trading participants to neutralize certain structural
inefficiencies that we have discovered. IEX uses direct market
data feeds from all U.S. exchanges rather than the slower SIP
to price orders and trades in our market. And IEX was the first
ATS to publicly publish our confidential form ATS in an effort
to promote transparency.
It is important to recognize that IEX was created within
the current regulatory framework, serving as evidence that the
spirit of the rules governing our current market do allow for
innovative free market solutions to emerge. We believe that the
U.S. equity markets have improved dramatically over the past 20
years as participants can now trade less expensively and faster
than they did in the past. But we believe this was mainly due
to the inevitable improvements that technology has delivered
across many industries, with financial markets being no
exception.
Despite those benefits, it has become apparent to our team
and our supporters that the U.S. equity markets are also far
from perfect, and these imperfections that we have discovered
over the last several years are the reason we started IEX and
the reason I am sitting here today.
We believe that the number of independent equity trading
destinations across exchanges, dark pools, and other
internalizers, each having their own unique technology,
products, rule sets, and pricing schedules, creates a
tremendous amount of complexity. This complexity, combined with
the lack of clear language disclosure, has created structural
inefficiencies which allow unfair advantages and disadvantages
to various market participants.
This complexity has also put the health and stability of
the overall market at risk without contributing to the market's
ability to serve its core function--capital formation.
There are four main conflicts of interest that we would
like to highlight.
First, due to the complex fee and rebate structure of
trading venues, brokers have perverse incentives when deciding
where and how to route customer trades. Many high-quality
studies, including the one from Professor Battalio, have
demonstrated the direct relationship between a broker
attempting to harvest rebates and worse execution quality for
their customers. Based on our team's prior experience, we can
confirm these findings.
Second, to avoid high fees for taking liquidity on
exchanges, many of the largest brokers created their own
private dark pools to internalize order flow, in the process
isolating client orders away from the broader market. Although
many of these broker pools are interconnected, at times brokers
are unwilling to route orders to other broker pools to avoid
improving the performance of a competitor, even though it may
be in the best interests of their client to do so.
Third, trading venues, including exchanges and dark pools,
naturally seek to maximize profits by increasing their own
trading volumes, and as a result, there are many predatory,
high-volume trading strategies that are left unattended--
intermediating between venues--as certain market centers
prioritize market share over protecting the interests of client
orders.
And, fourth, markets that offer co-location and different
speeds of market data and connectivity have a direct conflict
in the profits garnered from selling these services versus the
structural inefficiency created when those same products enable
a participant to trade faster than the market itself to the
detriment of any participant who relies on the market to fairly
price trades.
Although many of these issues are deeply embedded in our
market structure, IEX believes that the best policies to
address these conflicts are those that promote transparency and
disclosure. The SEC's Midas website and FINRA's ATS reporting
rule are recent positive steps, and we would encourage further
pursuit of transparency, specifically these three points:
first, standardization of data collection and reporting;
second, disclosure of both routing and trading information in a
standardized form between brokers and clients; and, third, full
disclosure of rules, products, and services from all market
centers.
The most important implication of transparency is that it
brings accountability to all participants in our market.
Heightened forced transparency will give participants the
information they need to ask critical questions and to make
better decisions. This will allow the market to self-regulate.
We respectfully ask that if Congress or the Commission
looks to further modify the structure of the equity markets,
careful consideration is given to deciding which issues are
better solved through regulation and which issues are better
addressed through free market solutions.
In closing, IEX would like to echo SEC Chair White's recent
statement that, ``The secondary markets exist for investors and
public companies, and their interests must be paramount.'' As
the financial services work through this period of change, none
of us should forget why the market exists in the first place.
Thank you.
Senator Levin. Thank you very much, Mr. Katsuyama.
Let us try a first round of 8 minutes, if that is all
right, and we will have as many rounds as we need. And that is
true with both panels. We have four votes that are going to
begin at 11 o'clock. I will stay here at least through the
first two votes and miss those votes as currently planned, and
others can come and make the votes should they wish.
Professor Battalio, let us talk about the nonmarketable
orders. These are the ones that do not have an immediate match
and that add or make liquidity.
Now, under the maker-taker pricing, most exchanges are
willing to pay brokers for sending them nonmarketable orders.
Is that correct so far?
Mr. Battalio. Yes, sir. Very good.
Senator Levin. Some retail brokers send virtually all
nonmarketable orders to exchanges that pay a rebate. Is that
correct?
Mr. Battalio. That also appears to be true.
Senator Levin. OK. Now, your paper looked at where retail
brokers routed nonmarketable customer orders and stated that
Ameritrade, E*Trade, Fidelity, and Scottrade route orders in a
way that suggests that they may be focused on liquidity
rebates. How often did those retail brokers route nonmarketable
orders to the exchange offering the highest rebate?
Mr. Battalio. Those four brokers--well, three of the four
brokers either route things called--the SEC reports are not
good enough to distinguish between marketable and nonmarketable
limit orders, OK? But based on an assumption that is pretty
solid, three of the four either route limit orders to people
that pay for order flow--and those are probably marketable
orders--or to the high-fee venue, nowhere else.
Senator Levin. And the high-fee venue are the exchanges.
Mr. Battalio. It is one venue offering the high make
rebate.
Senator Levin. All right. So when it comes to order flow,
they go to the wholesale brokers generally. Is that correct?
Mr. Battalio. With the marketable stuff, they go to the
wholesalers.
Senator Levin. With the marketable stuff, and they are paid
for that.
Mr. Battalio. Yes, sir.
Senator Levin. And they always go to the high rebate
exchange----
Mr. Battalio. The one high----
Senator Levin [continuing]. For the nonmarketable ones?
Mr. Battalio. Yes, sir.
Senator Levin. OK. Now, your paper assessed whether the
decision by retail brokers to route nonmarketable customer
orders to exchanges that pay the highest rebate was consistent
with the broker's obligation to obtain best execution of their
customers' orders. And this is now quoting from your paper:
``The results of our analysis suggest that routing all
nonmarketable orders to a single exchange that offers the
highest liquidity rebates is inconsistent with maximizing
nonmarketable order execution quality.'' Is that quote correct?
Mr. Battalio. Yes, sir.
Senator Levin. All right. Now, the decision, your paper
says, ``to use a single venue that offered the high liquidity
rebates does not appear to be consistent with the objective of
obtaining best execution.'' Did I quote you correctly?
Mr. Battalio. Yes. It results in diminished fill rates.
Senator Levin. All right. That is the reason why, but,
nonetheless, I quoted you accurately.
Mr. Battalio. Exactly.
Senator Levin. All right. Now, is that then evidence of a
conflict that harms consumers?
Mr. Battalio. We certainly think that the routing could be
done better, yes.
Senator Levin. Well, to put it in terms that I understand,
is that then evidence of a conflict that would harm consumers?
Mr. Battalio. Yes, sir.
Senator Levin. And your data then shows and your conclusion
shows that the highest rebate and best execution do not go
together.
Mr. Battalio. Yes, sir. In certain circumstances, they do
not go together. Not always, but in certain circumstances.
Senator Levin. Would that be in most circumstances where
these orders are routed to an exchange?
Mr. Battalio. So in the most actively traded stocks where
the lines to trade are the biggest, that is where it matters
the most.
Senator Levin. And that would be true, what I just said?
Mr. Battalio. Yes.
Senator Levin. Now, Mr. Katsuyama, I expect that some of
the retail brokers that are named in Professor Battalio's paper
would claim that the fact that they directed all of their
nonmarketable orders to the exchange that pays them the most is
not inconsistent with providing best execution to their
customers. What is your view of that?
Mr. Katsuyama. So from a practitioner's standpoint, prior
to IEX, I worked and ran trading at a large broker-dealer. You
know, I think there are two ways to look at it. The first is
that the exchange that pays the highest rebate will have the
longest queue because people that are posting liquidity let us
just say on the bid, they want the rebate, so more people will
line up because of that inducement.
The first thing to consider--that getting in the longest
line will lower your probability of getting filled because
there are more people in front of you in line. The second thing
to consider is the inducement of, let us say in this instance,
the seller. Where is the seller most likely to go when selling
stock, looking to sell stock on the bid? The seller is most
likely to go to the place that either pays them a rebate or
definitely to attempt to avoid those who charge the highest
fees. So getting in the longest line, posting in the highest
rebate venue, exposes you to larger competition, reducing the
probability of fill, and it also makes you the least likely
venue to get filled on because the seller on the other side of
the order is not incentivized to go there first.
So it hurts you in two ways. We have run a series of tests
on this using our own capital back when I was at RBC, and the
tests confirmed the findings that Professor Battalio outlined
in his paper.
Senator Levin. And can you repeat that finding in your
words?
Mr. Katsuyama. Sure, that routing specifically with the
goal of maximizing your rebate lowers the probability of
getting filled and leads to adverse execution quality or worse
execution quality for the client's order who you are
representing or even your own order if a bank is routing on its
own behalf.
Senator Levin. Does that create a conflict of interest?
Mr. Katsuyama. Yes.
Senator Levin. Let me just go back to Professor Battalio
for one moment. Is best execution a subjective determination,
at least in part?
Mr. Battalio. At least in particular. We would argue more
so subjective for market orders because a lot of determinants
go into figuring out whether you have a good trade price or
not. With standing orders or these nonmarketable limits, it
seems like getting filled is paramount. And we came across the
Nasdaq Notice to Members 01-22 after we submitted this draft to
a journal, and we will incorporate--and we will certainly use
that to buttress what best execution means for nonmarketable
limits. Fill rate is paramount.
Senator Levin. But are there also subjective factors in
that determination for both?
Mr. Battalio. You are pushing the bounds of what I----
Senator Levin. All right. If you cannot answer it, you
cannot answer it.
Mr. Battalio. I cannot answer it.
Senator Levin. Mr. Katsuyama.
Mr. Katsuyama. Can you repeat the question?
Senator Levin. Are there subjective factors in determining
which market to go to for the ones for the orders which are
non--let me get the right word here--the nonmarketable?
Mr. Katsuyama. Sure. So at times there are. For example, if
there are--if you are establishing a new price, meaning that
you will be the only person on the bid at that price, bidding
on an exchange that pays a high rebate, since you are the only
person on the bid, it is justifiable; it makes sense. If you
are joining a queue that is very thick, that has multiple
exchanges represented, and you choose to get at the end of the
longest line to get a rebate, I would say that that would be a
conflict.
Senator Levin. Would that be a subjective factor? Are there
subjective factors in that determination?
Mr. Katsuyama. Yes. It is based on what is currently on the
bid, which would primarily be determined by the stock. So there
are factors where, a broker looking to get a rebate is not
necessarily in conflict with their duty to their client. So it
is subjective based on the conditions of the stock when you
come into--sorry if this is a complicated answer, but based on
what is happening in the stock, there are different decision
points, and there are times when you could be getting the
highest rebate, but also serving your client's interest.
Senator Levin. And there are times when that is not true.
Mr. Katsuyama. Yes.
Senator Levin. Senator Johnson.
Senator Johnson. Thank you, Mr. Chairman.
Professor Battalio, I am hearing terms--``adverse execution
quality,'' ``conflict of interest,'' ``dark pools.'' It all
sounds pretty sinister. What I want is an example of a trade,
so we can really put this all in perspective. So let us talk
about 100 shares at $20, just a retail customer placing that
with a broker. Now, if you are using one of the online brokers,
it is costing you $10.
Mr. Battalio. Yes.
Senator Johnson. So if you are basically buying $2,000
worth of stock, you are paying $10 to buy $2,000 worth of
stock. Twenty years ago, I know I would be paying $20, $30
commission, correct?
Mr. Battalio. Yes.
Senator Johnson. Now we are paying $10. So if this is going
into one of these dark pools or if this is to go into one of
these maker-taker arrangements, how much additional money could
it cost the consumer if there is a conflict of interest, if it
is routed to a situation where there is a higher maker-taker
fee?
Mr. Battalio. So imagine you have two orders to buy--one
here, one there. This one is the high-fee venue; this is the
low-fee venue. Only one trades. So they want to buy at $10. One
is going to trade, and then the price is going to rise to $20.
Which one trades? The one on the low-fee venue.
Senator Johnson. First of all, how many times in the stock
market do you try and buy a stock for $10 and it goes up to
$20?
Mr. Battalio. OK, make it go to $11, $10.50.
Senator Johnson. I mean, again, realistically, when I put
in a trade, I say I want to buy a stock. I have made a decision
that this company is worth $20 a share. And I put in an order
for 100 shares. I am going to get that executed at $20, aren't
I?
Mr. Battalio. So Goldman Sachs and others have done studies
kind of with better data than we have, so data is a big problem
to do these types of analyses. To really get at what you asked,
we need to have data that we do not have. All right? So Goldman
Sachs, the claim would be that you would lose three basis
points, five basis points over the course of a day by making an
inferior order routing----
Senator Johnson. No, no. I am talking about a retail
investor like myself, I buy 100 shares of stock at $20. I am
going to pay $2,000 to buy the stock. OK? I am going to get
that stock at $20, aren't I? If I put in an order that I say I
want to buy that stock at $20, I get it at $20.
Mr. Battalio. No. It will not trade. One person----
Senator Johnson. So what do I--well, if an order----
Mr. Battalio. You are going to cancel----
Senator Johnson [continuing]. Is on the books----
Mr. Battalio. You are going to cancel and chase the market
up. That is the point. Does this happen always? No.
Senator Johnson. Listen, I cannot remember a trade that I
have put in where I say I want to buy 100 shares at $20 where I
do not get it at $20, because I put in a stop loss. I am only
going to buy it at $20.
Mr. Battalio. So your trade----
Senator Johnson. And I get it at $20.
Mr. Battalio. You are trading volatile stocks that do not
have long queues. That is my answer to you. The data----
Senator Johnson. That is what most people do. So, anyway,
again, I am trying to get--forget the price movement, OK? Let
us talk about just the dollar value of this maker-taker fee. On
a $2,000 trade, how much is that maker-taker fee? On 100 shares
of stock at $20 a share, how much is that maker-taker fee?
Mr. Battalio. Thirty cents per hundred.
Senator Johnson. Thirty cents per hundred what, dollars or
shares?
Mr. Battalio. Shares.
Senator Johnson. So if there is a maker-taker fee that is
just outrageous at, what, 50 cents?
Mr. Battalio. The maximum is 30 cents per hundred that they
can charge, the taker fee.
Senator Johnson. For a hundred shares. So we are talking
about on a $2,000 trade that is a conflict of interest, a
broker is going to push a trade into a maker-taker arrangement
where he gets 30 cents----
Mr. Battalio. So an accurate----
Senator Johnson [continuing]. Versus what--I mean, what is
the high range of this: 30 to 50, 30 cents to--what is the
range of pricing on this maker-taker arrangement per hundred
shares?
Mr. Battalio. Negative 14 cents, maybe, to 32 cents per
hundred. These are all per hundred.
Senator Johnson. So you have a maximum range of 40 cents,
so if I am doing a $2,000 trade, you are concerned about a
conflict of interest where I might have to pay an additional 40
cents on a $2,000 trade. Is that what this is about really?
Mr. Battalio. No. It is about the fact that you did not get
to trade. So your assumption that you trade is wrong.
Senator Johnson. But I always have been able to trade.
Mr. Battalio. Maybe you have.
Senator Johnson. How many times do people not get to trade?
Mr. Battalio. The difference for certain types of stocks in
certain circumstances, the difference in fill rate is 25
percent. Sanford Bernstein puts out reports since 2010
highlighting the stocks in which this type of routing has a
huge impact on whether or not you trade at a price.
Senator Johnson. Now, how much of that is the institutional
investor and the high-frequency trader versus the standard
retail guy that--again, I am looking--I am a very long-term
investor, and I am looking at a stock, and I go, really, I
think this thing is worth $20 and I am willing to buy it at
$20, but if not, no harm, no foul. So there are definitely
different investors, right? So when you are talking about 25
percent of trades not being executed--is that in all the
institutional, the very high volume, or is that really
individuals like myself that say--I want to buy that hundred
shares of stock, I will pay any price, or I will put a stop
order and say I am only going to buy it at $20?
Mr. Battalio. So is Schwab a retail broker? Because they do
not make this decision. They do not do what these four brokers
do. Interactive brokers, a retail----
Senator Johnson. So let me ask you, how many--and I will
surely ask in the next panel, of those folks. How many trades
in to retail brokers like Schwab, like TD Ameritrade do not get
executed? Do you have any idea on that?
Mr. Battalio. We have asked for their data, and they have
never responded to give us the data. We cannot answer.
Senator Johnson. So where did you get your data from then?
Mr. Battalio. From a major iBank.
Senator Johnson. And, again, what is the data on?
Mr. Battalio. Orders. They get routed to two different
venues. They show up at the marketplace at exactly the same
time, and we watch what happens. And then we use data from the
entire marketplace, all trades and quotes.
Senator Johnson. So I did see TD Ameritrade revealed how
much they are making on these maker and taker, this order flow
fee, something like $200 million. It sounds like an awful lot
of money, but isn't it true that the market trades almost $27
trillion per year?
Mr. Battalio. Sure.
Senator Johnson. So what is $200 million in relation to $27
trillion----
Mr. Battalio. We are not----
Senator Johnson [continuing]. As a percentage?
Mr. Battalio. What we are here to speak to is the poor
investor, not like you, that wanted to buy at $10 and did not
get to because the market moved away and the broker chose to
route--make sure that--so the broker routed the order----
Senator Johnson. Again, I am trying to figure out how----
Senator Levin. Let him finish.
Senator Johnson [continuing]. Often that is. OK. I am
sorry.
Senator Levin. Do you want to finish the answer?
Mr. Battalio. With better data I could answer that. In our
data set, it can be as big as 25 percent difference in getting
the trade done.
Senator Johnson. OK. I will just finish by saying what I am
concerned about is, again, just creating this sinister
atmosphere with words like ``dark pool'' and ``conflict of
interest,'' and what we are talking about literally, I think,
is 30 or 40 cents on a $2,000 trade or maybe a $30,000--or a
$3,000 trade. I mean, we are really talking about minuscule
amounts. And, again, what I am looking at is over time of
investing, I have looked at my cost of a trade going from
hundreds of dollars down to $10. And now we are arguing over if
it should be $10.30 or $10.40. I do not know. I am just trying
to put it into perspective and trying to figure out where the
problem is here that I guess we are talking about potentially
government regulation intervention, which I think might have
very harmful unintended consequences versus letting the free
market competitive system drive transparency, drive
competition, and that is what has happened certainly over my
lifetime of investing over 20 years. It has gotten, from my
standpoint, more transparent and a whole lot cheaper.
Mr. Battalio. I am not arguing with that.
Senator Johnson. OK. Well, thank you. I will be back.
Senator Levin. Thank you.
Senator McCain.
Senator McCain. Do you want to give a more elaborate
response to that really this hearing does not matter, either
you, Mr. Battalio, or you, Mr. Katsuyama?
Mr. Katsuyama. So I guess just to respond to that--the fact
that it is 30 cents for a hundred shares and it is a $2,000
trade, I think that is exactly the point. I mean, we are
talking about conflicts where there is evidence that their
brokers are routing to get this 30 cents, and they are
representing a $2,000 order. It can be used on both sides of
the argument. You can view it as trivial, but you can view the
trivial nature of why is the broker doing that in the first
place if they are representing a $2,000 trade? So it is one
where the conflicts are real, and I think that even though the
harm is diffuse, there are more retail investors invested in
large pension funds and mutual funds who also are affected by
this practice.
So I think that, just trying to say that since it is a
small amount it could be used to deny that the conflict exists,
is wrong. I think that it needs to be a principle-based
argument.
The other part on costs, costs have come down. Of course
they have. Technology has delivered that cost reduction. There
is a Harvard Business Review study titled, ``How to Win a Price
War,'' and it talked about ``electronic brokers are changing
the competitive terrain of financial services with their
extraordinarily low [-priced] brokerage services. The
prevailing price for discount trades has fallen from $30 to $15
to $8 in the past few years.'' That report was written in 2000.
So when you look at the costs of technology since the year
2000, it has fallen even further.
So I think that it is one where competitive forces--I agree
with the fact that competitive forces should be setting prices.
The problem is that the inducement is so great, we do have a
prisoner's dilemma, where if every exchange pays an exchange
rebate, the one that moves away from the exchange rebate if
brokers are still incentivized to go after that rebate--they
will lose market share.
So I do think when you look at payments, it is something to
say there is a known conflict in the market and lets just
address it. The size of the conflict relative to the notional
amount traded is not a reason just to ignore the issue.
Senator McCain. And with that increasing technology, hasn't
that facilitated to a significant increase in volume of trades
as well?
Mr. Katsuyama. I think the fact that advances in technology
have been harnessed by certain participants, that is part of
free market competitive forces, and there is absolutely nothing
wrong with that. I think the challenge that the market was
faced with was one of the biggest confusions out there is that
the person that buys co-location and pays for this service has
an unfair advantage versus the person sitting at home trading
over a retail account. There will always be asymmetries----
Senator McCain. See, I think that is the key to this
problem, that there are certain players that have made this an
unlevel playing field, whether it is 30 cents or whatever.
Mr. Katsuyama. Sure. In order for the person at home to get
disadvantaged by the person that has spent all of the money on
high-speed technology, in order for them to be disadvantaged,
they have to trade, and that trade has to happen on a market.
The market's responsibility, at least in our view, is that
knowing that different parties will have different access to
technology and different levels of resources, different levels
of information; but when the trade happens, that the condition
with which this trade happens is done--is fair, meaning that we
have no bias one way or another what happens when this trade
occurs. And the problem is that as technology has evolved, the
exchange or the dark pool, the market itself should have
advanced their own technology to ensure that we are investing
in technology and building solutions with technology that
maintains this fairness. And the problem is that as the markets
have evolved, people got in the business of selling technology.
People got in the business of actually enabling participants
rather than creating and maintaining their neutrality. And I
think as that happened, the conditions for fair trading
changed. When your participants understand the market, what is
happening in the market, faster than the market itself, that
creates a pretty significant situation that we believe is
unfair.
Senator McCain. Well, sir, many commentators, including the
editors of the Wall Street Journal, have noted that Reg NMS has
enabled or exacerbated a number of predatory, high-frequency
trading practices. Do you think that Reg NMS should be
reformed? And if so, what would you recommend?
Mr. Katsuyama. Sure. So I think Reg NMS, the spirit of Reg
NMS, as was indicated, makes sense. You have multiple
competitive markets, and you want to try to attempt to tie them
all together. I think if you eliminate some of the conflicts in
how orders are routed, that brokers have invested heavily in
technology that can get around this issue of liquidity
disappearing. At RBC we had this problem from 2007 to 2009, and
then we solved the problem. So I think that free market
solutions can emerge to address the issues with Reg NMS. I
think undoing Reg NMS runs the risk of, again, further
unintended consequences, how exactly do you address those?
I think that it is something that definitely warrants
review. It just depends on what regulation comes out of
redefining what Reg NMS does, and that is something that
obviously I cannot comment on.
Senator McCain. Do you have any suggestions, Mr. Battalio?
Mr. Battalio. If you do anything to Reg NMS, do it with a
pilot study and study it very carefully.
Senator McCain. Have you got other solutions to this issue?
Mr. Battalio. With regard to high-frequency trading, that
is not something I have extensively studied, no.
Senator McCain. Mr. Katsuyama, Michael Lewis in his ``60
Minutes'' interview regarding his excellent book, ``Flash
Boys,'' said that the stock market is ``rigged.'' Is that an
accurate description?
Mr. Katsuyama. We have discovered that investors are
systematically disadvantaged in the way that the markets have
been set up. I think ``rigged'' is a word that can be used to
describe that. I think it is loaded. But I think at the same
time, the investment process is not broken. I am still an
investor in this market. You know, ``rigged,'' what it did is
it kind of gave our critics and people who are part of the
problem a reason to talk about something else other than what
we were actually talking about, which are these--a much more
precise way to put it or a much more precise question, which is
these systematic disadvantages and how they are created.
So, it was a distraction, which was unfortunate. I guess
the interesting part is that the people who took most offense
to that word were people on Wall Street. We have a tendency to
talk to ourselves on Wall Street, and I think that the response
we have seen from the general public is anything but. The claim
that we hurt investor confidence in the things that we brought
to light everything that we have seen I think would be exactly
the opposite of that in terms of the general public and their
reaction to what we have said and what we have done.
Senator McCain. On this issue of co-location, how do you
address something like that? Somebody rents a place or rents a
computer somewhere, they are free to do that. That is America.
How do you address that issue since co-location seems to be one
of the facilitating aspects of this whole system?
Mr. Katsuyama. Sure. I do not think you can regulate co-
location. If you say to an exchange you cannot sell space next
to your matching engine, cottage industries will pop up and buy
real eState across the street from the exchange and throw
cables over the fence. So I think it is every market's choice
to decide how they would like to set their market up.
At IEX, what we have done is we have introduced almost the
opposite of co-location where we have put 350 microseconds of
latency in between us and all of our customers, which
essentially means that we have coiled 38 miles of cable in a
data center, and we do that for all of our participants. The
opposite of getting close is pushing everyone an equal distance
away.
Senator McCain. I understand what you have done, but what
is the remedy to this?
Mr. Katsuyama. I think the remedy is, we keep harping on
transparency and disclosure, and I think that there are
distinctive----
Senator McCain. It should be disclosed if they are co-
locating.
Mr. Katsuyama. It should be disclosed, but also things like
anonymous listings of participants on venues, meaning does one
participant represent 35 percent of your trading volume or 50
percent of your trading volume on any dark pool or exchange?
And if they do, do they represent 50 percent of the volume on
every other market? Because if they are an outsize portion of
your own order flow, then that would indicate something.
Are the message rates across certain participants so much
higher than others? I think that we lack, as Professor Battalio
said, the data. What we learned--and we learned from
experience, we learned from talking in the industry, but we
lack the data. And I think, again, the SEC's Midas website, the
FINRA ATS report, we learned a lot in basically two attempts to
provide clearer understanding of what is happening in the
market. We could learn so much more.
The thing about co-location is that, just discussing and
understanding what the advantage is of being 5 or 10
microseconds away from a matching engine, you get information
quickly, and you can react quickly to getting information. As
we push that boundary farther out to 350 microseconds, what we
found is that we did have certain high-frequencing traders that
did show up to IEX. But the number of those high-frequency
traders was small, right now three. There are dozens and dozens
of firms who have decided not to connect. I cannot speculate as
to why that is, but clearly we have taken away something that
some high-frequency trading firms they found valuable.
So it is every market's choice to do something. It becomes
a very hard practice to regulate. But I think with the
increased transparency and disclosure, people can make better
decisions on whether they want to trade in venues that do offer
such services.
Senator McCain. Thank you.
Thank you, Mr. Chairman.
Senator Levin. Thank you very much, Senator McCain.
You made reference to disclosure on things like co-
location, but when it comes to the best execution obligation, I
gather that cannot be waived. Is that correct?
Mr. Katsuyama. Yes, absolutely. Best execution, I think it
might need some further refinement. It is a pretty subjective--
I guess it is a pretty subjective term. I think it is used
fairly liberally. One thing that we definitely think----
Senator Levin. That is a legal obligation. Is that correct?
Mr. Katsuyama. It is.
Senator Levin. So you cannot disclose--``we do not engage
in best execution in this firm.'' That does not fly. Is that
correct?
Mr. Katsuyama. That would not fly, no.
Senator Levin. Do you agree with that, Professor?
Mr. Battalio. Yes, sir.
Senator Levin. Going back to best execution as to who
determined--did I interrupt you?
Mr. Katsuyama. No.
Senator Levin. Who determines best execution for a broker?
Is it the broker himself?
Mr. Battalio. The broker, my understanding, is supposed
to--based on what I read--have monthly meetings and just
evaluate where they are routing, can it be done better where
should we alter things around the edges?
Senator Levin. But it is the broker who determines best
execution?
Mr. Battalio. Yes.
Mr. Katsuyama. Yes.
Senator Levin. OK. Now, I believe, Mr. Katsuyama, that you
indicated that the maker-taker system creates a conflict of
interest, and I think the testimony of both of you is that this
is a significant matter. Let me just ask you, Mr. Katsuyama,
should the maker-taker system be eliminated?
Mr. Katsuyama. I think that steps should be taken to
address what happens to the market if it is eliminated. I know
that a pilot study has been proposed----
Senator Levin. You mean--say that again?
Mr. Katsuyama. The pilot study that has been proposed, I
think that it should have----
Senator Levin. Which eliminates it?
Mr. Katsuyama. Which eliminates maker-taker in certain
stocks, I think that it should be given the chance to prove
that eliminating maker-taker will not harm the quality of the
markets.
Senator Levin. All right.
Mr. Katsuyama. So, yes, I definitely think that that step
should be taken. It should be analyzed, and then we should----
Senator Levin. At least that step ought to be taken.
Mr. Katsuyama. Definitely.
Senator Levin. Professor.
Mr. Battalio. I am not a risk taker. I am an academic.
Senator Levin. OK.
Mr. Battalio. So my view would be maybe not push to
eliminate maker-taker because you might push things underground
into the soft-dollar world where it would be even less able to
kind of see what people are doing.
Senator Levin. OK.
Mr. Battalio. So our view would be, with Shane Corwin and
Jennings, perhaps what you should do is push disclosure back
onto the broker so it is easier to tell, so you do not have to
do the studies we just did to map how is your broker doing
regarding routing your orders. Since the SEC took a first step
with this in 2000 and 2001, we think that you could do a better
job of that now.
Senator Levin. Would you support that test case that Mr.
Katsuyama talked about?
Mr. Battalio. If you insist of doing away with maker----
Senator Levin. Not me. I am not----
Mr. Battalio. A pilot is----
Senator Levin. A lot of other people are insisting on it,
and I happen to agree with that, but it is not----
Mr. Battalio. A pilot is better than going all-in.
Senator Levin. All right. Some have argued that the maker-
taker system is beneficial and that it has led to tighter
spreads, and I think you indicated, did you not, Mr. Katsuyama,
that that was technology that did that long before----
Mr. Katsuyama. Yes, I think decimalization and technology
both contributed to the lowering of spreads.
Senator Levin. All right. Now, does IEX make a similar
distinction that some high-frequency trading may be predatory?
Mr. Katsuyama. So I think not all high-frequency trading is
predatory, but some practices are, yes.
Senator Levin. Do you make a distinction that some high-
frequency trading may be predatory?
Mr. Katsuyama. Yes.
Senator Levin. And that that would hurt regular investors
while others may benefit the market?
Mr. Katsuyama. Yes.
Senator Levin. And has the maker-taker system led to the
creation of more exchanges in trading markets and more complex
order types, Mr. Katsuyama?
Mr. Katsuyama. Yes.
Senator Levin. Has the proliferation of trading venues and
order types created opportunities for predatory high-frequency
traders to take advantage of investors?
Mr. Katsuyama. At times, yes.
Senator Levin. And what are those opportunities? What kinds
of opportunities?
Mr. Katsuyama. Sure. I think given the structure, a quick
example is if there are 10,000 shares on offer to sell Intel at
$21 a share, a high-frequency trading firm could be offering
stock across multiple markets. One of those markets where they
are offering stock might be what is called a taker-maker venue
that actually charges someone to post liquidity and will pay a
rebate to the other side of the trade who comes to access that
liquidity. So this inducement, what it does is it--if a broker
is going to follow that inducement, it causes them to route
orders and remove liquidity from Intel, in a very predictable
and systematic way, starting at the highest rebate market for
taking liquidity and working its way down to the venue charging
the highest fee. This predictable pattern of routing leads to
lower fill rates and ultimately worse execution for the client
being represented.
So, it is a combination of fast technology, a combination
of inducements, and a combination of the broker falling for
those inducements. So that would be a series of events.
Senator Levin. You have been quoted as saying that people
have lost confidence that the markets are fair and that they
are working in their best interest. Would charging a standard
fee, regardless of whether the order adds or removes liquidity,
increase investors' confidence that they are getting a fair
deal?
Mr. Katsuyama. I think it is a step--at IEX we charge a
flat fee, regardless of whether you are making or taking. Price
competition is something that is hard to regulate, so if some
people want to charge a lesser or higher fee and justify it
through their service, I think that is acceptable. But I think
eliminating a conflict, most of the general public do not even
know this conflict exists. I think that as we talk through it,
as we try to regain the trust of the general public, talking
through these issues and admitting to the fact that they exist,
and then addressing these conflicts, that is the way to restore
that confidence. So I think that, yes, addressing this issue
will help restore confidence, or at least it is a step in the
right direction.
Senator Levin. And eliminating the conflict would help
restore confidence?
Mr. Katsuyama. Without question.
Senator Levin. Professor.
Mr. Battalio. Yes, sir.
Senator Levin. Would it?
Mr. Battalio. Yes, sir.
Senator Levin. Critics of your paper, Professor, said that
the data that you used to assess whether retail brokers were
getting best execution does not accurately reflect typical
retail order flow and that your results cannot be generalized
to judge the best execution performance of retail brokers. How
do you respond to that?
Mr. Battalio. In a couple ways. So those critics seem to
kind of ignore the back third of our paper where we use all
trades and all quotes in the U.S. equity market over the same
time horizon to demonstrate the results that we find with our
limited data generalized to the marketplace.
Second, as we have been pushing the paper around, we have
seen lots and lots--we wrote the major exchange that operates
two different fee structures, and they showed us that for the
retail orders resting on their exchange for a couple weeks,
they get the same results we get. You know, Sanford Bernstein,
we came across a report, same results we get.
So you can argue that our most detailed data analysis comes
from specialized data, but the results generalize with a lot of
different data sets. So we are quite comfortable.
Senator Levin. Now, would you be willing to run your
analysis using data from the retail brokerages identified in
your paper if they were willing to give you that?
Mr. Battalio. Of course. Anybody. The hard part for an
academic, we spent 2 years asking for data to test this,
because people--and it is just very, very hard. So, yes, that
is a standing offer that we make. It has become--we thought we
were going to be able to work with a guy who is starting to do
this with institutions, and, unfortunately, the sell side is
pushing back and threatening. So the executing venues have
threatened that if this guy shares data with us, they will stop
doing business with their buy side clients. So it is very hard
to get data to do the analysis that we did. We were very lucky
to find these data.
Senator Levin. Some argue that 30 cents on an order is a
tiny, minuscule amount, you have given a very strong answer or
response to that, by the way, in terms of the orders that are
not filled. And, also, Mr. Katsuyama, you have given a pretty
strong answer to that as well. These 30 cents also add up to
hundreds of millions of dollars for a broker, do they not?
Mr. Battalio. Yes, they do. Compare the payment revenue of
the brokers that do this practice to the ones that do not, and
you will see a marked difference at the aggregate.
Senator Levin. Mr. Katsuyama.
Mr. Katsuyama. Yes, I think it is----
Senator Levin. It is a big revenue source for the broker,
is it not?
Mr. Katsuyama. Yes. Well, some brokers. I think we cannot
paint them all in the same brush. Some brokers end up paying
the high take fee, and that high take fee is subsidizing
payments to other players. So some are hurt worse and some
benefit, depending on who the broker is.
Senator Levin. Thank you.
Senator Johnson.
Senator Johnson. Thank you. I have a little more time here,
so I do want to go back and really explore exactly what is
happening and exactly what type of harm could be happening.
When you are talking about 25 percent of trades that just
simply are not executed, can you describe that a little bit
more to me in terms of the volatility of that, what is being
missed? And aren't those trades basically because people put in
stop orders and say, ``I will buy a stock at this price''? I
mean, just tell me how that does not work?
Mr. Battalio. So you have people that maybe place an order
before they go to work, and they say, I want to buy a share of
stock at $20, a hundred shares of stock at $20, and it is just
a standing order--not a stop or anything like that, just a
standing order. What we identify in our paper is that some
brokers are routing that order so that they trade last at a
price. And so if throughout the day the market goes through
your limit price, you trade. It does not matter where you were
routed. That is true a large part of the time. Right? And that
would be, what I would argue, that is your trading experience.
OK.
But some stocks are much less volatile throughout the
trading day, and not all of the people looking to trade at a
price get to trade. Some do not, and they miss out. Why?
Because the price trades a little bit and moves up. The ones
that do not trade missed out.
Senator Johnson. So, I mean, part of the problem is some
investors have a lot of time to just be watching this in real
time 100 percent of the time.
Mr. Battalio. That is right.
Senator Johnson. Most investors, like myself, you look at
it about once a year, and you put a trade. So that is always
going to be the case, right? I mean, if you were watching this
100 percent of the time, if you were putting in the right type
of order, you could make sure that you were going to have an
executed trade, just about, I mean, couldn't you? Can't you, as
an investor, make sure that you get that stock purchased no
matter what?
Mr. Battalio. Not if all the interest at a given price does
not trade, no, because of the way they route. They are putting
you at the back of the line at a price all the time. And so if
the line does not fully exhaust, you go wanting.
And is this--this happens in certain--is this all stocks
all the time? No. But measurable time, 10, 20 percent of the
time, certain stocks, yes.
Senator Johnson. Again, I am trying to get my head around
the magnitude of this problem.
Mr. Battalio. OK. I guess----
Senator Johnson. Because it is true--I mean, we are using
all these sinister figures, and I agree with the Senators, this
is about restoring confidence in the market. And I am concerned
by throwing out those types of terms and making it seem like
everybody is in this business and they are just really trying
to stick it to the individual retail investor. That is not what
I have seen. I am not saying----
Mr. Battalio. And I would hope----
Senator Johnson [continuing]. That I have been pleased with
the transparency within the investment banking community during
my lifetime. But it just seems like we are moving in the right
direction, greater competition, lower prices, far easier
trading today than it was 20 years ago where you just kind of
call your broker and you did not know what was pulling off. Now
you have the computer. Now you can plug it in, and say how come
I did not get that--right now it is almost instantaneous, isn't
it, on online brokers? You put in an order----
Mr. Battalio. Or a market order, yes.
Senator Johnson [continuing]. And, boom, it comes right
back.
Mr. Battalio. For a market order, yes. And I am not going
to sit here and argue that we have not made great gains over
the past 20 years. That is not what our paper is about. Our
paper--and we are not crying ``Fire'' in a theater.
Senator Johnson. Well----
Mr. Battalio. No. Have you read our paper carefully? I
think we are very caveated, OK? We are pointing out certain
circumstances where routing only to the high-fee venue is going
to disadvantage investors. So statements that get made like,
``We employ sophisticated order routing technology and
processes to seek best execution for client orders,'' how can
that be if you are routing always to the high-fee venue? That
is what got us interested as academics in this problem.
Senator Johnson. And, again, you may not be shouting
``Fire,'' but I think the way that it is recorded in the press,
I think it really is. Do you disagree with that?
Mr. Battalio. I think there are some people out there
yelling ``Fire,'' but I would hope that we would not be
characterized----
Senator Johnson. Good. So, again, that is what I appreciate
about this hearing. It is about trying to lay out the reality
of the situation, put this all in perspective. And, again, I
want to get back to the overall dollar value of these maker and
taker arrangements, that type of thing, in relationship to
total trades----
Mr. Battalio. All right. So I can give you----
Senator Johnson [continuing]. In terms of--if at all
possible, if you had some sort of historical perspective in
terms of how much trading commissions there were 20 years ago
versus what we are talking about today.
Mr. Battalio. I will give you one stat, and then I will
give it to Brad. So if you eliminated all the rebates and
inducements, Bernstein Research predicts that one broker would
have a 16-percent earning-per-share decline.
Senator Johnson. But what----
Mr. Battalio. That is real time now, and then I have to say
I do not know the answer to your question and give it to Brad.
Mr. Katsuyama. I think there is no question that price per
trade has come down with technology. I think that--again, I
read this last time. I will read it again. Harvard Business
Review report, which is titled, ``How to Win a Price War,''
talks about ``electronic brokers are changing the competitive
terrain of financial services with their extraordinarily low-
priced brokerage services. The prevailing price for discount
trades has fallen from $30 to $15 to $8 in the past few
years.'' And that report was written in the year 2000. Here we
are in 2014, and my tech team sent me this, but the price of a
gigabyte worth of storage in 2000 was $10, today it is 10
cents. So when we talk about lower fees, lower commissions,
yes, they have come down. But they stopped going down, and I
think that they could probably come down further. The notion
that if a payment goes away then the price will go up, I think
that would be hard to justify. And, again, as you said,
competitive forces will force that out of the market. If you
double your price per share or price to trade, then new
entrants will come into the market.
So I think that it is one where they have come down, but
that is not an excuse, I think, for what is happening right
now.
Senator Johnson. Are there competitors in the marketplace
that actually conduct trades the way you want to see the trades
conducted? And compare those to some of the online models of
companies that we are familiar with what they provide with
their service. Because, one of the things I value in the online
is I have got research, There is just an awful lot within those
online platforms that are very helpful to a competitor--or to
an investor.
Mr. Katsuyama. Sure.
Senator Johnson. Do those competitive systems have similar
types of things? Is that part of the reason--again, I am a
business guy. It does not bother me that people make money.
They need to make money to provide different products and
services.
Mr. Katsuyama. So, I am not as familiar with each
individual retail platform, what they offer. I do know
Interactive Brokers routes in a way that would be consistent
with how I would route. You know, they are connected to IEX.
They trade with us. So I think that there are examples, and
they have been pretty vocal about that. I look at institutional
brokers. As Professor Battalio has noted, my experience at RBC
or Bernstein or even working with the people at Goldman Sachs,
people have spent a tremendous amount of time in understanding
this conflict, where you can route for a rebate and not harm
your client and where you route for a rebate and you do harm
your client. And it is one where, because it can toggle--for
example, there are 100,000 shares on offer in Intel at $21
[inaggregate, across the markets], and a market will pay me a
rebate to route there and is offering 10,000 shares, and I have
200 shares to buy, I can route it there, buy the 200, get the
rebate, and no one is harmed. If I have 100,000 shares to buy,
I cannot route the 100,000 to that one venue that is going to
pay me because they are only showing 10,000, because I will
ruin my experience with the rest of the venues, because of the
signals.
So there are times when you can get a rebate and fulfill
your obligation, and there are times where you cannot, and I
think it is up to every broker to understand where that
inflection point is and to be very transparent in terms of how
they route.
Senator Johnson. So I guess my point is if those companies
are already present in the marketplace that trade the way you
are suggesting without a conflict of interest, so that an
individual investor, if they are buying $2,000 worth of stock,
does not have to worry about being charged 40 cents versus 30
cents--OK?--those platforms exist, those competitors--the
marketplace, the free market competitive system have already
provided that investing model with that level of transparency.
And kind of getting back to part of your opening statement, you
said, well, this is a question of whether we need government
regulation to force the transparency, the competition, or the
free market competitive systems doing it.
I guess based on your answer, you are saying the free
market competitive system has already reacted to it, and that
possibility exists. If you are concerned--as an individual
investor, you are concerned about not being able to have your
trade executed or paying another 10 cents on a $2,000 trade,
there are people out there and they just need to do a little
more advertising so Americans understand it, right? Or maybe
this hearing will help out and more investors will take a look
at finding companies like yours.
Mr. Katsuyama. So, yes, I totally agree with you. I think
that, first off, you have to----
Senator Johnson. I like that answer.
Mr. Katsuyama. First off, you have to make people aware
that the conflict does exist, and you have to educate them on
what that conflict means to them, and now they can make a
better informed decision versus before, when they did not even
know that the conflict existed in the first place. I think
disclosure and transparency will let people make better
decisions, and then the market sorts it out. It is one where
with increased disclosure and increased transparency, everyone
knows exactly how the game works and things still happen. Then
you can kind of look back and say, OK, I guess the inducement
was enough or warranted the fact that they made this decision.
But right now a lot of it is opaque.
And as Professor Battalio noted, it is really, really hard
to get data, and the data you get is not standardized. So it is
very hard to synchronize data across multiple places because
the data comes back, I have seen client data where they have
got them from different brokers or even brokers from different
venues, and it is coming back in all sorts of forms. So I think
that standardization and transparency, forced disclosure,
people will just ultimately make better decisions. That is the
most proactive way to advance this discussion.
Senator Johnson. OK. Thank you.
Thanks, Mr. Chairman.
Senator Levin. Professor, do you have a comment?
Mr. Battalio. So the reason this is an agency problem was
first pushed for----
Senator Levin. When you say ``agency,'' what do you mean?
Mr. Battalio. Agency--and I will describe. So two former
chief economists, Chester Spatt and Larry Harris--OK, Larry was
around with Reg NMS, so was Chester--and then a guy who is on
the board of Direct Edge, Jim Angel, put forth--it is their
theory that we test in our paper, and they claim that the
retail investors, maybe not you, are able to shop on
commission. So the broker that offers the lowest commission
will get the retail trade. OK? The brokers that maximize
rebates are able to offer the lowest commissions. In fact,
anecdotal evidence suggests that Interactive Brokers, at least
during our sample period, had a higher commission than these
other four brokers. So these four brokers attract the retail
investor by offering low commission, and the retail investor
trusts the broker because of the best execution obligations,
and it does not have the tools--you could look at our paper and
decide how hard it is to figure out what we did. They do not
have the tools to understand, gee, in this instance did my
broker route to the right venue to maximize the likelihood of
execution like NASD 01-22 says? That is the agency problem.
You can shop on commission. You cannot evaluate the
execution quality. And so they are doing things that may
compromise execution quality. They have the lowest commission.
And they are going to attract a swath of customers that way.
And if you talk to people on the board of Interactive
Brokers, they will complain about this. So certainly
competition is forcing commissions lower, but people who do the
practice of routing all the nonmarketable to the high-fee venue
and selling the marketable to the wholesalers, they get more
revenue that could be used to push back through commissions,
right? And so it is hard--this would be a case where maybe the
market cannot fix things unless you can educate the investor to
evaluate this decision of routing nonmarketable orders, which
is tough.
Senator Levin. So you are saying maybe it cannot be solved
in this case----
Mr. Battalio. I am all about free markets, trust me.
Senator Levin. Of course. In this case, it may not and has
not so far worked, is what you are saying.
Mr. Battalio. That is what we think.
Senator Levin. Do you agree with that, Mr. Katsuyama?
Mr. Katsuyama. IEX is a new venue. Before the SEC published
the Midas data and before FINRA had their ATS reporting rule,
we had no idea how we compared to other markets. So other
markets would make claims that could or could not be
substantiated. So as you are competing, how do you compete in a
market that is completely opaque and, is primarily dictated by
word of mouth or self-generated reports? I do not think we
fully had a chance to solve this problem from an industry
standpoint because the data was just not available for people
to make good decisions, or better decisions.
Senator Levin. But do you think the average investor can
make a decision on where a broker is going to get best
execution?
Mr. Katsuyama. That is a good question. I would say
probably not. But the key part is that the people that do spend
the time to look at it, some people in the media are very
sophisticated. They understand the heart of this issue. And I
think that as they report on things that are happening as the
retail investors who do look at it start to make decisions, it
does create the right amount of momentum so that someone who
does not have time or inclination to understand market
structure understands that people are looking out for their
best interests and they can make decisions that way.
Senator Levin. How do they make a judgment on best
execution, is it a subjective judgment? How does your average
investor just looking at the fees, the commission, think that
is lower, that is pretty attractive? This is what the professor
is saying. Is that not right, Professor?
Mr. Battalio. That is correct.
Senator Levin. So now how does that average investor do
what you think needs to be done, make some kind of assessment
on best execution? How does he do that?
Mr. Katsuyama. Sure. You have to put in the requisite
amount of time to understand it, to make that judgment. Most
people will not. So, again, I think that the more that this is
discussed and reported on, hopefully the venues that are doing
the right things get the right amount of credit.
Senator Levin. If transparency is the answer, should the
government force transparency?
Mr. Katsuyama. I do believe there are cases where that
would definitely help.
Senator Levin. The government actually would have to force
transparency?
Mr. Katsuyama. I think outlining the types of metrics that
need to be reported and the way those metrics need to be
calculated and presented would definitely be helpful, yes.
Mr. Battalio. The government has done this one, and it is
not a big step, what they would have to do to kind of clean
things up.
Senator Levin. But the market has not done that yet. It
would take the government forcing that. Is that correct?
Mr. Katsuyama. There has been no attempt by the market to
try to solve this issue and just standardize across themselves
and to say let us make this easier for people to understand. We
have not seen evidence that that is happening.
Mr. Battalio. And indeed----
Senator Levin. And, therefore?
Mr. Katsuyama. And, therefore, I think the government would
be very helpful in helping to get the industry to coordinate to
a level to make these issues easier to identify.
Senator Levin. And it would be helpful if the government
required that?
Mr. Katsuyama. Yes.
Senator Levin. Thank you.
Mr. Battalio. The options market tried to do it on a
voluntary basis back in 2010, and the numbers they put out were
garbage, mostly, so yes.
Senator Johnson. Just a quick comment. Again, as an
individual investor, the way I evaluate best execution is I put
in an order for $20, I got it for $20. Again, this is so
incredibly complex, and there are so many esoteric terms of art
here. You have got to bring it back--I am trying to bring it
back to just the simplicity of what is happening in the
marketplace with individual retail investors, and if I put in
an order for 100 shares at $20 and if I get it and I am only
paying $10, I am reasonably satisfied.
Now, occassionally, there may be some very strange
circumstances where I do not get that share, but I kind of
shrug and go, OK, well, I did not get it. Maybe there is some
harm, but I am highly concerned about government interference
in the marketplace. If there is a very minimal amount of
transparency legislation in terms of this is the data that we
want everybody to report, again, minimal, not a huge overall
regulation that harms the market, that is something I would be
willing to support.
But, again, I really want to put this in perspective, what
is the real harm being caused, and let us make sure we do not
do more harm in trying to solve a problem that right now this
is really a solution looking for a problem in many respects.
Mr. Katsuyama. Yes, I definitely would say that focusing on
disclosure will create the least amount of harm and
implementation risk rather than diving into things such as co-
location and the actual mechanics of the market. So, if we are
going to move forward, I think that----
Senator Levin. Professor.
Mr. Battalio. I agree 100 percent.
Senator Levin. OK, with what he just said.
Mr. Battalio. Yes, and what Mr. Johnson said.
Senator Levin. OK. That you want to have disclosure, you
want to have transparency, but you would agree it may take
government action to get that transparency?
Mr. Battalio. Yes, and push it back on to the brokers.
Senator Levin. Push it on the--thank you.
Senator McCain. And this is just a minor issue that we
should not be concerned about in the overall scheme of things.
Is that correct?
Mr. Battalio. My view is the reason academics are around
and reporters are around is if the retail investors cannot
understand it, we study it, bring it to light, and then things
get cleaned up, somewhat.
Senator McCain. Is it a serious issue?
Mr. Battalio. We think it is. But we also think it is an
easy one to fix.
Senator McCain. Thank you.
Senator Levin. Mr. Katsuyama, is this a significant issue?
Mr. Katsuyama. I think it is significant it is a principle-
based issue. I think that you can try to minimize it by trying
to relate how much it is pennies, etc., and people are holding
stocks for years. But this is a principle-based issue, and it
comes down to the foundation of why the markets exist and
people's trust in those markets. Trust is really about saying:
``Without me paying attention, I believe that the right things
are happening in my best interests,'' and when you find out
that they are not, those are instances which undermines trust.
In your opening statement, discussing the fact that we have
had a tremendous rally from 2009, yet the amount of households
owning equities [participating in that rally] has not followed
that trend. So, I would argue that a series of events over the
last number of years have lead to a decrease in investor
confidence which led us to quit our jobs and start IEX. And I
think that, from an investor confidence standpoint, my hope is
that March 31 [publication date of Michael Lewis' ``Flash
Boys''] becomes a low point. We have received a tremendous
amount--thousands and thousands of calls and emails and letters
from people who are actually looking to get back into the
market.
If there are people that feel like we did the wrong thing
by speaking about it, we have not heard from them, we have not
heard from the general public. We have gotten a lot of anger
from Wall Street--not all--but, again, people embedded in the
status quo do not want to see change happening. And I think
that those who do want change have been very supportive of us.
Senator Levin. Thank you. Thank you both. I appreciate your
coming.
Mr. Katsuyama. Thanks a lot.
Mr. Battalio. Thank you.
Senator Levin. Let us see. What time is it now? Have the
votes started? I think the votes have started.
We are checking to see if the votes have begun. Again, I am
going to stay here through these first two roll call votes, so
my colleagues here, you can adjust how you wish.
We will now call our second panel of witnesses: Thomas
Farley, the President of the New York Stock Exchange Group in
New York; Joseph Ratterman, Chief Executive Officer of BATS
Global Markets in Lenexa, Kansas; Joseph Brennan, Principal and
Head of Global Equity Index Group at the Vanguard Group in
Malvern, Pennsylvania; and Steven Quirk, Senior Vice President
of the Trader Group at TD Ameritrade in Omaha, Nebraska.
We appreciate all of you being here today, and under our
Rule 6, as I think you heard, all of our witnesses are required
to be sworn, so we would ask you to please stand and raise your
right hands. Do you swear that the testimony you are about to
give to this Subcommittee will be the truth, the whole truth,
and nothing but the truth, so help you, God?
Mr. Farley. I do.
Mr. Ratterman. I do.
Mr. Brennan. I do.
Mr. Quirk. I do.
Senator Levin. Thank you, and we will use, again, the
timing system. A minute before the red light comes on, you will
see the light change from green to yellow, giving you an
opportunity to conclude your remarks. Your written testimony
will be printed in the record in its entirety. Please try to
limit your oral testimony to no more than 5 minutes.
Mr. Farley, we are going to have you go first, followed by
Mr. Ratterman, then Mr. Brennan, and then Mr. Quirk. Thank you
all for being with us.
TESTIMONY OF THOMAS W. FARLEY,\1\ PRESIDENT, NEW YORK STOCK
EXCHANGE, NEW YORK, NEW YORK
Mr. Farley. Thank you. Chairman Levin and Senator Johnson,
we appreciate your interest in the regulatory structure of the
U.S. capital markets. My name is Tom Farley, and I am the
President of the New York Stock Exchange. I have been in the
business of running exchanges for most of my career including
as President and COO of ICE Futures US--formerly the New York
Board of Trade.
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\1\ The prepared statement of Mr. Farley appears in the Appendix on
page 77.
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As market operators, we have come to the view that the U.S.
equities market is highly fragmented--making it overly complex
and opaque. The regulations and structures in place today
incentivize participants to make it more complex and more
opaque. Numerous surveys and recent history have shown that
this structure does not contribute to investor confidence or
high systems reliability.
As the dominant rule setting the boundaries of equity
market structure, Regulation NMS set out to accomplish several
objectives. The first was to increase competition among markets
and among orders. While the rule did an excellent job of
increasing competition among markets, we believe competition of
orders has been severely damaged, particularly in recent years,
due to the record level of off-exchange trading and increased
levels of order fragmentation. In fact, just last week, off-
exchange trading reached a record high of 40.5 percent across
all Regulation NMS securities. This means that despite someone
taking a risk to establish the National Best Bid or Offer on a
displayed market--fully regulated exchange--brokers decided to
execute the trade away from the displayed, or fully regulated,
market 40 percent of the time rather than rewarding the people
who established the NBBO--national best bid or offer--with an
execution. We find this troubling and damaging to price
discovery.
The second objective of Regulation NMS was to design a
structure to the benefit of long-term investors and public
companies. Long-term investors have benefited in many ways from
the implementation of Regulation NMS; however, data now shows
that some of these benefits, such as lower costs, might be
reversing. In addition, we consistently hear from large
institutional investors that there are too many conflicts in
the current market structure and that they would like to see
those conflicts eliminated or, at least, reduced.
Perhaps most importantly, we hear from listed companies and
entrepreneurs that they believe the market is not designed for
them but rather for the trading community, and as a result,
they have lost confidence in the market. Newly listed companies
via the IPO process are the lifeblood of our economy and our
markets.
The New York Stock Exchange will take a leadership role in
bringing about beneficial change. Our goal is simple: reduce
the level of complexity and fragmentation of the U.S. stock
market. To accomplish this goal, there are several unilateral
steps that we are committing to take and that we would welcome
our industry colleagues to also adopt. To start, we are self-
imposing a 6-month moratorium on any new, or novel, order types
that further segment the market. In addition, we have already
announced the elimination of more than a dozen existing order
types. We believe these are first steps toward reducing
complexity and toward a more efficient market structure, and we
will look for other steps that we can take along these lines.
At an industry level, we are seeking support for the
elimination of maker-taker pricing and the use of rebates.
Broad adoption of this policy would reduce the conflicts
inherent in such pricing schema and further reduce complexity
through fewer order types and fewer venues. In conjunction with
the elimination of maker-taker and rebates, we believe
regulation should require that deference be given to displayed
quotes on fully regulated exchanges. There is risk involved in
displaying a quote on such a venue, and we believe strongly
that the person taking that risk should be rewarded with an
execution at that price. Unfortunately, in today's environment,
those displayed quotes are used to inform trading on dark
markets which are not contributing to the price discovery
process. The original investors who posted these public quotes
are all too often left with no trade at all. Several countries,
including Canada and Australia fairly recently, have adopted
rules that establish this type of primacy of public quotes. In
the cases of Canada and Australia, the regulators have
established that this policy has simplified and even improved
their markets.
Last, as you heard on the first panel this morning, there
are questions as to whether or not some market participants are
able to build an advantage over others by using high-speed data
feeds and co-location services. While it should be noted that
both of these services are regulated and made available to all
investors equally, we believe that if something results in a
loss of investor confidence, we should find a way to change it.
NYSE is willing to put all options on the table as it pertains
to the delivery of market data; however, we highlight that this
cannot be done in a vacuum, and any changes must be applied
equally to all exchange and dark pool venues.
Thank you for your time, and I look forward to answering
any questions you may have.
Senator Levin. Thank you very much, Mr. Farley.
Mr. Ratterman.
TESTIMONY OF JOSEPH P. RATTERMAN,\1\ CHIEF EXECUTIVE OFFICER,
BATS GLOBAL MARKETS, INC., LENEXA, KANSAS
Mr. Ratterman. Good morning. My name is Joe Ratterman,
Chief Executive Officer of BATS Global Markets and one of the
founding employees. I want to thank Chairman Levin, Ranking
Member McCain, and Senator Johnson for inviting me to
participate in today's proceedings.
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\1\ The prepared statement of Mr. Ratterman appears in the Appendix
on page 79.
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I was encouraged with the sentiments recently expressed by
SEC Chairman Mary Lou White who said that our markets are ``not
broken, let alone rigged.'' I agree with her. The automation of
the U.S. equity markets has resulted in significant
enhancements in market quality for long-term investors.
Importantly, however, I also recognize that our markets are not
perfect and that efforts to improve them should never let up
and never cease. Our current market structure is a product of
Congress' 1975 amendments to the Exchange Act and subsequent
rulemaking by the SEC to implement a national market system.
The SEC, working in significant part through the exchanges
and other SROs, has created a system that allows market
competition while at the same time, and just as vital,
fostering price competition.
Today our equity markets are widely considered to be the
most liquid, transparent, efficient, and competitive in the
world. Costs for long-term investors in U.S. equities are among
the lowest globally and declining. These gains have been noted
by investors and experts alike.
In April 2010, Vanguard confirmed estimates of declining
trading costs over the previous 10 to 15 years, ranging from a
reduction of 35 percent to more than 60 percent, savings which
flowed directly to investors in the former of higher returns.
Three respected economists recently found that between 2001
and 2013, the spread paid by investors had decreased by more
than 70 percent for NYSE-listed stocks.
In April 2014, BlackRock noted that, since 1998,
institutional trading costs had declined and are among the
lowest in the world.
Earlier this month, ITG reported between 2009 and 2013,
implementation shortfall costs decreased from roughly 45 basis
points to 40 basis points, following a drop from 63 basis
points in 2003.
Further, our market is able to handle volume and message
traffic considered astronomical only a short time ago. The
efficient operation of our market structure throughout stress
of the 2007-09 financial crisis indicates the systemic risks
that have been reduced as a result.
Efforts to address infrastructure risks since the flash
crash of 2010 are producing further beneficial results. For
example, the number of erroneous executions occurring on our
markets is pace this year to be nearly 85 percent lower than
the previous 5-year average, results that stem from the success
of the recently enacted limit-up/limit-down plan.
In addition, exchange systems issues as measured by self-
help declarations have dropped by more than 80 percent since
the first years after Regulation NMS. We must, nonetheless,
remain squarely focused on improving market quality and
stability in a coherent and responsible way. We are also keenly
aware that investor confidence is important not only to help
Americans realize their investment and retirement goals, but it
plays directly into the overall health of our country's
economy.
Simply put, when investors are confident enough to put
their hard-earned capital to work in our stock market,
entrepreneurs and corporations can grow and thrive as well. As
such, we are fully supportive of the SEC's plan for a
comprehensive market structure review, and we look forward to
actively participated in that process.
Among other things, I see the following four areas as
offering potential benefits without disrupting existing market
quality gains.
First, institutional investors could benefit from
incremental transparency related to the ATSs that their brokers
route orders to, including the publication of Form ATS, which
some of the ATSs have already done. Consistent and thorough
reporting standards will create the greatest level of investor
confidence, so additional regulatory direction may be required
here.
Second, I support reviewing current SEC rules designed to
provide execution quality and routing transparency. For
example, Rule 606 could be amended to require disclosure about
the routing of institutional orders as well as separate
disclosures regarding the routing of marketable versus
nonmarketable orders.
Third, to strengthen the confidence of the investing public
in market data, I continue to support initiatives to make the
SIPs, also known as consolidated tapes, as fast as possible.
This is a position that BATS has advocated since becoming an
exchange in 2008.
And, finally, I support the eliminate of the ban on locked
markets, part of Reg NMS, which we believe is a primary driver
of excessive complexity in our national market system.
Thank you for the opportunity to appear before you today,
and I would be happy to answer your questions.
Senator Levin. Thank you very much, Mr. Ratterman.
Mr. Brennan.
TESTIMONY OF JOSEPH P. BRENNAN,\1\ PRINCIPAL AND HEAD OF GLOBAL
EQUITY INDEX GROUP, THE VANGUARD GROUP, INC., MALVERN,
PENNSYLVANIA
Mr. Brennan. Thank you, Chairman Levin, Ranking Member
McCain, and Members of the Subcommittee for inviting me to
participate today. My name is Joe Brennan. At Vanguard, I am
responsible for overseeing the management of our equity index
mutual funds.
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\1\ The prepared statement of Mr. Brennan appears in the Appendix
on page 87.
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Vanguard serves more than 20 million investors who entrust
us with $2.6 trillion of their retirement and education
savings. Vanguard's core mission is simple: to take a stand for
all investors, to treat them fairly, and to give them the best
chance for investment success.
Before getting into specific comments on potential
improvements to our current equity market structure, I would
like to make two fundamental points.
First, the markets are not rigged. We have a high degree of
confidence in the markets as a safe place for investors to
place their assets.
Second, all investors have benefited from improvements to
our equity market structure. Through regulatory initiatives
over the past two decades, most notably Regulation NMS, our
equity markets have evolved to a competitive marketplace that
is connected through highly advanced technology. Over time,
this structure has led to lower transaction costs for all
market participants. Individual investors who access the equity
markets through asset managers like Vanguard have benefited
from the market structure improvements that have been made over
the past 20 years. Additional improvements can be made, and we
are very pleased to discuss those issues with the Committee
today.
We also commend SEC Chairman White for initiating a
comprehensive review of ways to further strengthen the markets.
We look forward to working with the Commission in this regard.
I will now briefly discuss a topic that has garnered
considerable public attention recently: high-frequency trading.
While the term ``high-frequency trading'' has become shorthand
for disruptive trading, there is a significant amount of
legitimate activity, such as market making, which also falls
under this broad umbrella. Today's market structure contains
many venues in which trades can be executed. Professional
traders and technology are the yarn that knits these venues
together.
Our efforts should not be focused on banning high-frequency
trading; rather, we suggest examining our market structure
holistically to ensure it is providing the incentives for the
type of activity we would like to see.
To accomplish this goal, Vanguard supports efforts by
regulators to comprehensively reevaluate Reg NMS. As time has
passed and the markets have changed, most would agree that it
is time to reassess whether this regulation continues to
further the goals of our national market system. We would
suggest the most important goal of a national market system is
to create a structure that encourages market participants to
publicly display limit orders. Such a structure promotes price
discovery and lowers transactions costs for all investors.
In that light, Vanguard supports regulatory efforts to
revisit the current maker-taker pricing model of the exchanges.
Fundamentally, it is important to understand that these models
did not develop from any nefarious intent. They are the
exchanges' response to the proliferation of market centers
enabled by Reg NMS and a way for the exchanges to continue to
attract liquidity. However, the models have become unnecessary
complex, and the decision to submit orders to the public
markets should not be driven by the desire to capture a rebate
or avoid a fee.
Any reevaluation of the maker-taker models must be
connected to an analysis of other ways to encourage publicly
displayed orders. Specifically, we support a pilot of a
``Trade-At'' rule under Reg NMS. Today a market center can
execute an order at the best publicly displayed price without
actually contributing to the public price discovery process.
Generally speaking, those that publicly display their interest
first should be first in line for any execution at that price
across the markets.
A well-designed pilot of a ``Trade-At'' rule under Reg NMS
could help strike the appropriate balance between promoting
public competition of orders while still encouraging
competition among a variety of market centers. Regulators and
industry participants have been working diligently over the
past few years to take steps to continuously improve the manner
in which our markets operate. The equity markets are extremely
complex, and it is vitally important to examine all of the
potential consequences of any changes to our structure.
We believe the SEC and FINRA are well equipped to continue
to evaluate ways to improve our markets, and we commend them
for the work they have already performed.
I thank you for allowing me to participate in this
discussion, and I welcome your questions.
Senator Levin. Thank you very much, Mr. Brennan.
Mr. Quirk.
TESTIMONY OF STEVEN QUIRK,\1\ SENIOR VICE PRESIDENT, TRADER
GROUP, TD AMERITRADE, OMAHA, NEBRASKA
Mr. Quirk. Good morning, Chairman Levin, Ranking Member
McCain, and Members of the Subcommittee. My name is Steve
Quirk. I am Senior Vice President with TD Ameritrade. I
appreciate the opportunity to appear before you today. I
thought I would spend a brief moment on TD Ameritrade and the
clients that we serve so you have a better understanding of
what we do.
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\1\ The prepared statement of Mr. Quick appears in the Appendix on
page 93.
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We are a financial services company serving primarily
retail investors. We have over 6 million client accounts with
$600 billion in assets, including custodial services for 4,500
individual representative registered investment advisors and
their clients. We are based in Omaha, Nebraska, and we were one
of the first firms to offer discounted commissions to retail
investors. Since our founding in 1975, we have also pioneered
innovations such as touch-tone trading, Internet trading, and
most recently mobile trading.
We have been on a quest to level the playing field between
Wall Street and Main Street investors for almost 40 years. As a
result of that, our clients have entrusted us with
approximately a quarter trillion in net new assets since 2007.
We interact with these clients daily and do third-party surveys
to better understand their market sentiment. Based on this and
other data, we do believe that the current U.S. equity market
structure has never been better for those retail investors. In
fact, the number of our firm's accounts that are trading is up
31 percent on a year-over-year basis.
Our retail clients tell us they want their entire orders
filled quickly and inexpensively at the price quoted or better.
In each of those areas, we have seen significant improvement in
the last decade, as detailed in the written testimony.
When it comes to order routing, brokerage firms have two
options: they can internalize and trade against that, or they
can route that to the market centers and destinations. Based on
our open architecture and unbiased and unconflicted business
model, we believe it is in the best interest of our clients to
send their orders to a mix of market centers, including
exchanges, wholesale market makers, and ECNs. While these
market destinations serve a variety of purposes, we think they
are all vital in driving the competition, which ultimately
benefits investors.
The Subcommittee has asked for our views on conflict of
interests for brokers obligated to obtain best execution for
client orders but also receive payments or rebates based on
where that flow is directed. We strongly believe that with
compliance with best execution obligations and proper
disclosure, brokers can effectively manage any conflict that
may arise from payments. Furthermore, we strongly believe that
we effectively manage any such conflict.
Brokers are required to seek the most favorable terms
reasonably available under the circumstances for client orders.
At our firm we consider the opportunity to obtain a better
price than currently quoted, the speed of execution, and the
likelihood of execution, amongst other factors when making that
assessment.
We also give our clients a choice. Their orders can be
routed using our proprietary order routing logic, or they can
choose from a list of direct routing destinations.
Finally, we work with multiple market destinations. Rather
than internalize our client flow, we believe that routing all
orders to the market is more transparent and better aligned
with the needs of our clients. We select these market centers
based on rigorous due diligence where execution quality is the
top priority. After, and only after, a market satisfies our
standards for best execution do we consider transaction costs
or revenue opportunities. This process complies with SEC rules
enacted after thoroughly reviewing this issue on numerous
occasions.
The payments or rebates that brokers receive are
transparently disclosed as an average per share in our
quarterly 606 reports; they are also on our account Statements
and are on confirmations, which are all required by SEC rules.
Finally, we have provided the Subcommittee with a list of
recommendations that we believe could enhance our Nation's
current market structure without compromising many of the
benefits retail investors have realized in the past years. Just
as we constantly seek to improve our client experience, our
industry should do the same. But let us not lose sight or
compromise many of the improvements that have been made.
We appreciate the opportunity to be part of the
conversation. Thank you.
Senator Levin. Thank you very much, Mr. Quirk.
Let me start first with you, Mr. Farley. Jeff Sprecher, the
head of the Intercontinental Exchange, which owns the New York
Stock Exchange, which you represent here today, has said that
the maker-taker system misaligns the interests of brokers and
their customers and hurts everyone in the market. ``We should
get rid of it,'' he said. Do you agree with him?
Mr. Farley. Yes. Jeff also says--and let me start by
saying, Senator, that the U.S. capital markets are indeed the
best in the world, but for 225 years the New York Stock
Exchange has advocated on behalf of customers and stood for
improving markets and not just accepting a flawed status quo.
To answer your question directly, there are really two
areas where we are most concerned about the markets today: one
is the appearance of conflicts, primarily because we think that
undermines confidence in the markets; and the second is undue
cost and complexity in the markets that we have heard a lot
about today. Maker-taker gets to the heart of both of those
issues and concerns that we have, and it is for those reasons
that we have advocated eliminating maker-taker in its entirety
in the equity markets in this country.
Senator Levin. Well, very significant testimony when an
exchange which has been here as long as you have been here
makes that point. And you have said in your testimony that we
are seeking support for the elimination of maker-taker pricing
and the use of rebates. And then you said, ``Broad adoption of
this policy would reduce the conflicts inherent in such pricing
schema . . .'' Explain that now to the Subcommittee. I happen
to agree with you that those conflicts are inherent, but tell
us in your words why elimination of the maker-taker pricing
would reduce conflicts that are inherent in such pricing.
Mr. Farley. Sure. And if I may, if I could just provide a
little bit of context, I came from a company called
Intercontinental Exchange, and we agreed to acquire the New
York Stock Exchange on Thanksgiving of 2012. And so we came to
this with a perspective of other markets like the futures
markets, which are deep and liquid and people generally will
acknowledge that those markets function properly. And there is
no such thing in those markets as maker-taker pricing, for
example. So it was something we very quickly wanted to
understand more about.
The first thing that we noticed was that the maker-taker
schema results in many more order types in the equities markets
than you have in other markets, such as, for example, the
futures markets. And many of those order types are simply in
existence to help market participants capture the maker-taker
spread.
And so we realized while this pricing schema introduces a
good deal of complexity, with respect to the conflicts issue
that you described in particular, it has been frustrating to us
that in a period of rising stock prices we have not seen more
participation in the equities markets from investors. In fact,
data shows that the participation in terms of percentage
participation of U.S. citizens is at a 16-year low. And we
think a reason for that, an important reason for that, is just
confidence in the markets. Markets rely on confidence. We
cannot say that enough.
And irrespective of whether or not there is an actual
conflict or a conflict that is resulting in some sort of bad
behavior, the appearance of conflict matters. And it is for
that reason that we look at maker-taker pricing, and we say
there may be an appearance of conflict there if a broker-
dealer's interests are not aligned with their customers, and
that is something that can potentially arise with maker-taker
pricing.
Senator Levin. Well, the appearance of a conflict is
obviously important because of the confidence issue and also
because underneath the appearance there may be more than an
appearance. But your testimony actually is even clearer than
that. As you say, you support elimination of maker-taker
pricing and the use of rebates, and that broad adoption of that
policy would reduce the conflicts inherent--you use the word
``inherent.'' Explain that.
Mr. Farley. So any reasonable business person does not like
to be in a position of having their interests not aligned with
their customers'. When you have maker-taker pricing, there are
examples, as Professor Battalio described this morning, where a
broker-dealer has an incentive to post a price on a high-make
rebate venue even if the execution quality on that particular
venue is not as high as another venue. That arises specifically
because of--or it is certainly exacerbated because of maker-
taker pricing.
Senator Levin. And that is why there is a conflict inherent
in that pricing schema.
Mr. Farley. That is right.
Senator Levin. Now, Mr. Ratterman, I will give you a chance
now to--first of all, before we ask you to comment or react to
that, you said earlier this year, I believe, that businesses
offer incentives for customers to be in their ecosystem all the
time. Who are the customers you were referring to? Are they
brokers?
Mr. Ratterman. Yes, our customers are all brokers.
Senator Levin. All right. Now, let me give you an
opportunity to respond to Mr. Farley's testimony.
Mr. Ratterman. Sure. So from my perspective, in our firm we
do not believe that there should be a ban on maker-taker. We
are certainly open, if there is a pilot, to looking at the
data, but my answer stems from my concern for the potential
benefits and spread reduction that maker-taker may have
produced over the last 10 or 15 years, not for any commercial
purpose about the way we run our exchange. Our exchange is in
the business of matching buyers and sellers, fair and orderly
markets. When we have a trade, we are going to deserve revenue
for that trade as it happens. How we do that, there is today a
significant amount of flexibility, and I believe that
flexibility has allowed for innovation in pricing and markets,
and that incrementally the rebates that are offered in many
cases to market makers to take the risk to put bids and offers
in the market has yielded tighter spreads over time.
I also do not believe that eliminating maker-taker would
eliminate a conflict. I am thinking, as Senator Johnson walked
through an example earlier, a broker's evaluation of a trade,
examining where he would get a rebate for 30 cents or maybe pay
15 cents, he is looking at a spread of 45 cents in relation to
the likelihood or not likelihood of getting an execution where
he actually does get paid, and when he does not trade or his
order does not fill, there is no commission to the broker.
So by eliminating maker-taker, you would only compress the
range of the conflict, but the conflict would still exist as
long as there is differential pricing between exchanges. So I
think the only way to potentially eliminate the conflict then
is to mandate exchange pricing at a fixed level for all
exchanges all the time.
So the conflict will remain unless there is a significant
intervention, and I believe disclosure, as we have talked about
earlier today in the hearing, is the right answer to provide
the information so that not only brokers but their customers
can evaluate whether these conflicts have actually been managed
well in favor of the client or not. But I do not see any path
by which the elimination of the conflict can be achieved.
Senator Levin. Mr. Farley, do you want to comment on that?
Mr. Farley. Sure.
Senator Levin. Can we reduce the conflict that is inherent
that you talked about? And can we reduce the appearance by
removing the maker-taker pricing? Or have you changed your mind
after hearing Mr. Ratterman? [Laughter.]
Mr. Farley. I actually found more areas of agreement with
Mr. Ratterman than maybe I would have otherwise expected from
the way his answer started. I think he--if I am putting words
in your mouth, Joe, correct me. But he said, look, that may
reduce the conflict, but it would not eliminate it. And so we
are both agreeing directionally that it would have an impact on
conflict or the appearance of conflict in the market.
But I also want to highlight that, again, the reasons why
we have been focused on this are twofold: one is around this
conflict issue, and the second is around complexity in the
markets, additional order types and venues. And it is worth
noting that, at the New York Stock Exchange, I have three
equities trading venues, Mr. Ratterman has four. We have a
competitor that also has four. A lot of those venues exist
really principally because of maker-taker pricing, and those
venues are creating different pricing schemas using maker-taker
pricing for our customers.
And then, finally, and I will conclude briefly, I agree
with Mr. Ratterman about another point he made, which is that
we have to be careful about the elimination of maker-taker to
make sure that there are not wider spreads on fully regulated
exchanges, which is why it is very important to us that such a
move would be tightly coupled with giving what we call primacy
of the public quote on lit exchanges to the participants who
made those quotes. And that is something that does not exist
today, and people are able to trade in dark markets at the same
price as is posted on an exchange.
Senator Levin. And reducing the conflict would be valuable
even if you cannot eliminate it?
Mr. Farley. Yes.
Senator Levin. Mr. Sprecher, your boss, in January said the
following: ``The price that we see as a bid-offer price in the
market is really not the price because there are rebates and
other discounts that are applied. . . . So we do not have a
view of the actual price which I think is to a certain degree
false advertising when you have a public ticker.''
Do you agree that maker-taker fees are distorting market
prices?
Mr. Farley. I agree with what Jeff said. He is my boss,
after all.
Senator Levin. If he were not your boss--he is not
listening. [Laughter.]
Do you believe that maker-taker fees are distorting market
prices?
Mr. Farley. Well, if I can just address the comment that
Jeff made, I think it is a matter of fact that posted prices on
exchanges--and also there are posted prices that go out through
our own raw data feeds or public feeds--do not include the fees
associated with them. So that is accurate that they do not
include all-in prices.
So to the extent somebody is viewing that data and assuming
that it does include the various make rebates and take fees,
from their perspective it would be distorted. If somebody
understands that it is not included, they are just receiving a
different data set.
Senator Levin. Did anything that you hear Mr. Ratterman say
change your view that the maker-taker schema, as you put it,
creates an inherent conflict?
Mr. Farley. No.
Senator Levin. Now, Mr. Sprecher also said the following,
Mr. Farley, that maker-taker ``creates false liquidity.'' Do
you agree with that?
Mr. Farley. I suppose I have a slightly different
perspective on it.
Senator Levin. Give us your perspective.
Mr. Farley. So, again, I come from a career mostly spent in
the futures markets, and the type of liquidity and market
making we most value comes from participants who will show up
and buy from sellers and sell to buyers and actually engage in
risk transference where they will hold a position for a period
in time.
Fairly new to the equities markets now--a year and a half
in--what I see is there is a whole swath of market making that
is essentially stitching back the 50-plus venues you mentioned
earlier this morning, and there are many examples of
participants who are buying and selling at the exact same price
at the exact same time on different venues, in part to capture
maker-taker rebates. That is a different form of liquidity. I
would choose different words than Jeff did, ``false
liquidity,'' but it is not as valuable as the type of liquidity
that we have always valued at ICE in building markets.
Senator Levin. It is a different kind of liquidity which is
not as valuable as the kind of liquidity which is created where
there is a real shifting of risk.
Mr. Farley. No question. And it is a blanket of cost on the
industry, stitching back together those--50 is a conservative
number, but stitching back together those 50 venues.
Senator Levin. I think we have all heard about a recent
survey of equity market participants that suggested that the
majority of those surveyed thought that the equity markets were
not fair for all participants. Is there a lack of confidence?
Would you agree, Mr. Farley? And do the conflict of interests
fuel that lack of confidence?
Mr. Farley. I look at statistics such as the one that I
believe you cited, Senator, that two-thirds of Americans had
equities in their account not too long ago, maybe a decade ago,
and now it is half; that participation in the equities markets
is at a 16-year low; and I look at that empirical data. I also
look at the anecdotal data, and I am sure you, like I, have
conversation about the equity markets with your friends and
family. I grew up down the road here in P.G. County, and when I
go back home, inevitably people ask me, ``What is going on in
the equities markets? Tell me about these high-frequency
traders.'' And there is a sense, it is unfortunate, but there
is a sense that we do not have as much confidence in the
markets as we once had, which is why we as the New York Stock
Exchange, from the moment ICE agreed to acquire the New York
Stock Exchange, has been standing for what can we do to
increase confidence, what can we do to simplify the markets.
Because as simple as you can make--to inspire confidence, you
would to make the market as simple as you possibly can and as
transparent as you possibly can.
Senator Levin. And as free of conflict of interests as you
possibly can?
Mr. Farley. Yes.
Senator Levin. Mr. Brennan, your main business is
investment management, and you offer mutual funds and other
investment opportunities for your customers. Do you believe
that the maker-taker pricing creates a conflict of interest
between a broker's duty to seek best execution and the money a
broker can make by pursuing rebates?
Mr. Brennan. Yes, we think the maker-taker pricing model
creates an appearance of a conflict of interest and adds
additional complexity to the market. We are in favor, as we
have stated, of looking at maker-taker as part of a
comprehensive review of Reg NMS in our market structure.
Senator Levin. Do you think that that should be eliminated?
Mr. Brennan. I think we should test any changes with a
pilot. I am not sure elimination is the answer. I think pilots
and data-driven analysis are the best way to really make
decisions on changes in market structure.
Senator Levin. And the pilot would be to remove maker-taker
in a particular pilot area?
Mr. Brennan. Sure. I think----
Senator Levin. What area would you suggest that maker-taker
be eliminated on a pilot basis? How would you describe the
pilot or how would you define the pilot area?
Mr. Brennan. I think experts at the SEC should work with
industry participants to define the pilot. I think all market
participants should be involved in the definition of the pilot.
Senator Levin. And the reason that you want to move in that
direction is because you believe, and your company believes
that there is an appearance of a conflict?
Mr. Brennan. Yes, maker-taker does create an appearance of
a conflict. I think we are all in agreement.
Senator Levin. Now, Mr. Brennan, some of the conflicts that
we discussed today are the result of payments that are a penny
a share or a few cents a share. Why does it matter to you that
a conflict or an appearance of a conflict be removed if it is a
few pennies a transaction?
Mr. Brennan. Well, we generally stand for what is in the
best interests of our clients, and we are--for transparency and
a fair market, and conflicts--eliminating conflicts and
reducing conflict of interests in our market is something that
would benefit our clients.
Senator Levin. Does it also create a problem for you to
check on execution?
Mr. Brennan. It does not create a problem for us.
Senator Levin. Do you spend time looking at the execution
of brokers?
Mr. Brennan. Yes, so----
Senator Levin. If maker-taker were eliminated, would that
result in less time being spent by you and your company
reviewing the execution of brokers?
Mr. Brennan. Our approach to our counterparties is probably
four- or five-fold.
Senator Levin. When you say ``counterparties,'' who----
Mr. Brennan. Brokers, to the use of brokers, our choice of
brokers. We have a lot of choices in who we can transact with.
We really scour the marketplace looking for the best place to
execute our transactions. We have highly skilled traders who
manage our portfolios on behalf of our clients. And we have
choice to eliminate a broker if they are not living up to our
needs.
Along with that skill and expertise, we also have a trust
but verify mode of operation where post-trade analytics are
performed to see that our brokers are actually living up to our
requirements.
Senator Levin. And I think your company told our staff that
monitoring brokers to ensure or try to ensure best execution is
a significant effort and that they would rather not have to do
so in a conflicted environment. Is that true?
Mr. Brennan. We think it would be a significant effort,
whether maker-taker existed or not. To be honest, we do a lot
of trading, $1 billion, $2 billion of trading a day, 6 million
trades a year. I think we owe it to our clients to do
everything to ensure their execution is top-notch.
Senator Levin. And even though the amount of money per
transaction may be 30 cents, or whatever it is, is that still
true? Do you worry about that being added to a transaction?
Mr. Brennan. The 30 mil cap?
Senator Levin. Yes.
Mr. Brennan. Yes, so that is a pricing model, and that is a
cap on a pricing model. What actually happens with our
transactions is not necessarily 30 mils. We have a lot of
control over our trades. We do not just hand them over to a
broker.
Senator Levin. You spend time, as you said, reviewing this.
Mr. Brennan. We spend time in the actual trading and the
review of the trades.
Senator Levin. And the review of them.
Mr. Brennan. Yes.
Senator Levin. And if there were less of a conflicted
environment, would you have less need to review?
Mr. Brennan. I think we would still review, to be honest
with you.
Senator Levin. But would you rather be in a nonconflicted
environment?
Mr. Brennan. It might make the complexity and the review
process a little easier in the data that comes back.
Senator Levin. Would you rather review the trading in a
nonconflicted environment?
Mr. Brennan. Sure.
Senator Levin. Now, as a retail broker, does Vanguard
accept payments from wholesale brokers, so-called payments for
order flow?
Mr. Brennan. Vanguard has a retail brokerage. That is not
the area of the company that I am associated with.
Senator Levin. Do you know whether or not Vanguard accepts
payments from wholesale brokers?
Mr. Brennan. Vanguard in its retail brokerage does not
accept payments for equity flow.
Senator Levin. Do you know why?
Mr. Brennan. We would have to talk to that area of our
company. I am quite separate from our retail broker.
Senator Levin. All right. Here is what the person in that
area told our staff. Tell me whether or not you disagree with
this. They told us that they could make money by selling their
retail order flow, but they believe accepting payments would
create a conflict, so they do not do so.
Do you have any reason to not believe that or----
Mr. Brennan. I have not talked to the person that runs that
area of our company, so I cannot confirm or deny that.
Senator Levin. That would be fine. Would you take back to
your company that request?
Mr. Brennan. Sure.
Senator Levin. And give us an answer for the record----
Mr. Brennan. Absolutely.
Senator Levin [continuing]. As to whether or not what the
staff Vanguard folks told us that they believe accepting
payments would create a conflict, so they do not do so? Would
you let us know for the record if that, in fact, is the case?
Mr. Brennan. Yes, sir.
Senator Levin. Mr. Quirk, I understand that your company,
TD Ameritrade, sends marketable orders which would incur a fee
if sent to an exchange to a wholesale broker-dealer. Is that
correct?
Mr. Quirk. That is correct.
Senator Levin. And that the broker-dealer pays Ameritrade
for those orders. Is that correct?
Mr. Quirk. That is correct.
Senator Levin. And that you send nonmarketable orders,
which are the ones that are eligible for rebates to exchanges.
Is that correct?
Mr. Quirk. That is correct.
Senator Levin. And is it correct that TD Ameritrade
receives payment either from a wholesale broker as payment for
order flow or from an exchange as a rebate on nearly every
trade completed?
Mr. Quirk. I would not say on every trade completed----
Senator Levin. I said ``nearly every.''
Mr. Quirk. Nearly every trade, yes.
Senator Levin. All right. On nearly every trade, TD
Ameritrade receives two payments: one is the commission paid by
the customer, and another is from the venue where the trade is
executed. Who decides whether an exchange or a wholesaler has
provided best execution? Is it TD Ameritrade itself? Do you
make that decision?
Mr. Quirk. We would have committees that would make that
decision.
Senator Levin. So a best execution committee?
Mr. Quirk. We do. We have a best execution committee.
Senator Levin. All right. Can different brokers reach
different conclusions about which venue offers the best
execution?
Mr. Quirk. Yes, I think--yes. The answer to the question is
yes. But I think what is going to drive the decision as to what
is the best execution is the client, and what I mean by that is
if a retail client puts in a market order, they are telling us
they want a quick, timely execution at or better, at the
current price or better, in its entirety.
Senator Levin. If there is a market order?
Mr. Quirk. If it is a market order.
Senator Levin. Other than that?
Mr. Quirk. If it is a limit order, they are telling you
they want that order to be visible. They have picked a price,
they have determined where their interested in purchasing that
stock, and they want it to be visible.
Senator Levin. But basically the question is still the
same: Could different brokers reach different conclusions about
which venue offers the best execution?
Mr. Quirk. Yes, but I think the determinant factor would be
what is in the best interests of their client or what is their
client looking for. Our clients are not going to look like, for
example, your clients, so we are going to have different needs
with respect to execution.
Senator Levin. But the answer to the question is different
brokers, even with the same clients, can reach different
conclusions about the best venue. That is why you have a
committee.
Mr. Quirk. Yes.
Senator Levin. Would you all agree with that? Are you
shaking your heads yes, that different brokers----
Mr. Ratterman. Yes.
Senator Levin [continuing]. Can reach different conclusions
as to which venue offers the best execution?
Mr. Farley. Yes.
Mr. Brennan. Yes.
Senator Levin. All right. Now, for Mr. Quirk, back in 2009,
Chris Nagy, who is TD Ameritrade's managing director of order
routing strategy, said the following: ``With maker-taker, there
is a higher cost to retail investors.''
Now, that is not your position today. Is that correct?
Mr. Quirk. No, and I do not know what that is in reference
to.
Senator Levin. All right. But that is not your position
today.
Mr. Quirk. No.
Senator Levin. And he also--that was in Forbes Magazine,
September 10, 2009, and he was the managing director of order
routing strategy, and he said the following in the September
21, 2009, edition of Securities Technology Monitor: ``We felt
it would become deleterious to the retail investor if maker-
taker were allowed to proliferate.'' That was in 2009. Is that
your position?
Mr. Quirk. No, it is not.
Senator Levin. Do you know what changed?
Mr. Quirk. I do not know what his position was, so I
actually was not involved with the order routing.
Senator Levin. Were you there in 2009?
Mr. Quirk. I was there, but not in this capacity.
Senator Levin. OK. Do some trading venues, Mr. Quirk, offer
higher rebates than others?
Mr. Quirk. Yes.
Senator Levin. Is the size of the rebate offered by an
exchange a factor in determining where you route nonmarketable
customer orders?
Mr. Quirk. The way that our committees and the people
responsible for order routing approach this is they start with
the best execution, and they would go through a list of
variables that we should consider as hurdles. And in order to
get to a point where the revenue sharing is even considered,
those hurdles have to be cleared.
Senator Levin. And the revenue sharing that you are talking
about is the rebate?
Mr. Quirk. Correct, sir.
Senator Levin. When you get to that point----
Mr. Quirk. Yes.
Senator Levin [continuing]. After you say you have looked
at the other factors, and then you look at the rebate issue, my
question is: Is the size of the rebate offered by an exchange a
factor in determining where you route those nonmarketable
customer orders?
Mr. Quirk. Yes. It would be the last factor. All things
being equal, that would be a factor.
Senator Levin. And so the greater the rebate, that would be
where you would go if it is otherwise best market.
Mr. Quirk. Yes.
Senator Levin. How many trades does Ameritrade route to
exchanges in a typical quarter?
Mr. Quirk. We route--about 37 percent of our flow would go
to an exchange on a daily basis, so I am assuming that 40--I
will call it 40 percent of, let us call it, 400,000 trades a
day, so we are talking about----
Senator Levin. 150,000 trades a day?
Mr. Quirk. 150,000 trades a day times--you said a quarter,
right? So that is going to be about--let us see.
Senator Levin. Well, a week it would be about--let us round
it off, say half a million a week?
Mr. Quirk. Yes.
Senator Levin. And so maybe in a month that would be about
2 million. A quarter that would be about 8 million. How does
that sound?
Mr. Quirk. That sounds good.
Senator Levin. Round it off, OK.
Mr. Quirk. We did about 90 million trades last year.
Senator Levin. OK. Well, then, why would it be only 8
million?
Mr. Quirk. You asked----
Senator Levin. Well, that is through exchanges.
Mr. Quirk. Yes, and you asked per quarter.
Senator Levin. OK. So that is about 8 million, to exchanges
in a typical quarter.
Now, we looked at your Form 606 quarterly order routing
disclosures for the quarter that was covered in the Battalio
paper, and I am going to have to go vote. I apologize. We are
going to have to recess here for about 15 minutes. That will
give you all a chance to do something else that you might need
to do.
We will reconvene at 12:15. Thank you all.
[Recess.]
Senator Levin. We will come back into session. We thank our
witnesses for their patience and understanding with the Senate.
Let me pick up where we left off, Mr. Quirk. I guess we
were talking about how many trades Ameritrade routes to
exchanges in a typical quarter, and I think we rounded it off
to about 8 million, something like that. Is that correct?
Mr. Quirk. That is correct.
Senator Levin. Now, we looked at your Form 606 quarterly
order routing disclosures for the quarter covered in the
Battalio paper, and according to those disclosures, for the
quarter covered in that paper, which was the fourth quarter of
2012, TD Ameritrade directed all nonmarketable customer orders
to one venue in that quarter, Direct Edge. Is that correct?
Mr. Quirk. That is correct.
Senator Levin. Now, among all the exchanges, Direct Edge
paid the highest rebate during the fourth quarter of 2012,
which is, again, the period covered by the Battalio paper, and
you say that the orders, it was your policy, are directed first
and foremost on the basis of best execution. But as we have
learned today, best execution is a subjective judgment.
So your subjective judgment as to which market provided
best execution for tens of millions of customer orders a year,
about 8 million in a quarter, allowed you to route all of the
orders to the market that paid you the most. Now, I find that
to be, frankly, a pretty incredible coincidence.
Now, you directed all your orders for that quarter to
Direct Edge because what you have said is that that exchange
offered your company the best execution. The disclosure did not
show a single order being directed to the New York Stock
Exchange, for instance.
So, Mr. Farley, was the New York Stock Exchange just
consistently worse than Direct Edge in getting best execution
on retail orders?
Mr. Farley. No.
Senator Levin. And, Mr. Quirk, how much did TD Ameritrade
receive in rebates from exchanges last year for routing orders
to venues that pay maker rebates? Do you know how much you made
just from payment for order flow and rebates?
Mr. Quirk. I can estimate it was based on what we have
discussed. It would be about $80 million.\1\
---------------------------------------------------------------------------
\1\ See Exhibit No. 4, June 19, 2014 letter from TD Ameritrade to
the Permanent Subcommittee on Investigations, revising $80 million to
$36 million, which appears in the Appendix on page 125.
---------------------------------------------------------------------------
Senator Levin. About $80 million?
Mr. Quirk. Yes.
Senator Levin. And that would be just the part that goes to
the venues that pay maker rebates?
Mr. Quirk. Maker-taker.
Senator Levin. Maker-taker, right. Well, how much did TD
Ameritrade pay in fees to exchanges last year for routing
orders to venues that charge taker fees?
Mr. Quirk. I do not know the answer to that question, but I
can get it.
Senator Levin. Well, I think it is close to zero, isn't it?
Mr. Quirk. No, it is not close to zero, but I do not know
what the answer is. It would not be significant.
Senator Levin. All right. Will you get the answer for the
record?
Mr. Quirk. Yes.
Senator Levin. So, anyway, for virtually every trade, your
customers you say were better off by your routing their orders
to the exchange that paid you a rebate rather than a venue that
TD Ameritrade would have had to have paid a fee. Is that true?
Mr. Quirk. I would say in the subsequent 24 months, you
will note in our 606s that we have routed to a number of
exchanges in one quarter, and some of those exchanges would not
be the exchanges which were paying the highest rate.
Senator Levin. Well, let me go into that. In your 606
disclosures, for the first quarter of 2014, TD Ameritrade
routed all disclosed nonmarketable orders to either Direct Edge
or Lavaflow, the exchanges that appear from our review of your
disclosures to have offered the highest rebates available in
the market. Is that true?
Mr. Quirk. That would be true.
Senator Levin. And so, again, your subjective judgment as
to which market provided best execution for tens of millions of
customer orders virtually always led you to route orders to the
markets that paid you the most.
Mr. Quirk. No, it would not have always led us----
Senator Levin. I said ``virtually always.''
Mr. Quirk. Virtually, yes.
Senator Levin. Senator McCain.
Senator McCain. I want to thank the witnesses for coming.
Mr. Ratterman and Mr. Farley, what effect would banning
maker-taker payments have on your stock exchanges? Mr.
Ratterman?
Mr. Ratterman. Thank you, Senator McCain. The effect would
have us, as a commercial operation, change the way in which we
charge our broker-dealer customers to access our market. As I
mentioned earlier today, we take on the order of 2 cents for
every hundred shares traded as revenue for conducting the
services of an exchange. So if you take away the maker-taker
rebate, we will simply reconfigure the pricing mechanism that
we have so that we can continue to operate our business. So it
is not fundamental to the way we do business, and so related to
your question, we would simply adjust our pricing to whatever
framework that the law allowed.
Senator McCain. Mr. Farley.
Mr. Farley. We would have fewer order types, which would
reduce complexity in the market. We would likely have fewer
venues, Senator, as well. We have three separate equities
trading venues, and we would not need all three of those in a
world where we did not have maker-taker, and I suspect some of
our competitors would also reduce the number of venues they
have.
However, I do want to point out that if we ban maker-taker
in isolation, it is also probable that more business would move
away from fully regulated exchanges into dark markets.
Therefore, we would need to couple it with what is called a
trade-at provision, which would establish the primacy of public
quotes.
Senator McCain. I guess I have a question for all four of
you. In your business and ours, perception is reality and
reality is perception. And I think you would agree that we
would not be having this hearing if it was not for significant
questions out there about whether you do business fairly or
unfairly, if there is favoritism, if there is, even as was
charged in Michael Lewis' book, that there is real corruption.
I think you would agree that there is a problem out there.
Would you agree with that, all of you? Or you do not think
there is a problem of public perception?
Well, first of all, I guess beginning with you, Mr. Farley,
and going down the line here, do you believe there is a public
perception problem? And if there is, what do you think we ought
to do? What measures ought to be taken? If you think there is
no PR problem out there, then just say, ``I do not think there
is a problem.'' But if you think there is a problem, what do
you think we ought to do?
Mr. Farley. Markets are built on confidence and perception,
as you point out, and I think the perception could be a lot
better, the perception of the equities markets in this country.
We are talking a lot about trading businesses. At the New York
Stock Exchange, the most important part of our business is
actually our listings business--in other words, that part of
our business where entrepreneurs come to market to raise
capital to help create jobs, and that is built entirely on
perception. And so we want to do whatever we can to improve the
perception of the equities markets.
We have proffered several suggestions. We actually think
doing away with maker-taker, coupling it with a trade-at rule
would improve perception by itself because of some of the
aftereffects, reducing complexity, reducing order types,
reducing messaging, reducing venues. And when you bring that
sort of simplicity to the markets, that breeds confidence
because people can understand it. It is more tangible.
Senator McCain. Would co-location be part of that reform? I
think we all would agree transparency is. Would co-location,
elimination of that, also be a positive effect or no effect?
Mr. Farley. Eliminating co-location would go in the other
direction. I actually think that would be a perception problem.
But bringing more transparency to the practice of co-location I
think is a great idea, to whatever extent we can.
Senator McCain. Mr. Ratterman.
Mr. Ratterman. In my mind there is no question that these
questions about market structure have entered into the
mainstream and that people are wondering how the markets work.
I think that to address that, maybe a few things.
First, there are probably some areas of immediate
transparency that can be brought into the market, and I think
we are seeing market forces to some extent start to do that.
IEX and Credit Suisse and Goldman Sachs I believe are three
dark pool operators that have all released their Form ATS as an
example. Prior to recent months, those were forms that were not
made available to the public.
So I think you are seeing a trend in the direction of
transparency. In our testimony we have talked about areas of
Rule 606 and 605 and other areas of operation of dark pools
where transparency, I think, would yield a lot of insights and
potentially some additional confidence in the markets. So that
is the immediate response.
The medium-term response I believe is to let the SEC do the
holistic review that SEC Chairman White has articulated to the
industry. This holistic review will be fully comprehensive. It
will cover every tenet of market structure as we understand it
today, put everything on the table. And some things will
undoubtedly change through that process. They will find ways to
optimize and improve what are already some pretty good
attributes for today's market. But also, even things that we do
not change, there will be a recent mark where the regulator
will have said, ``We looked at this, we got the data, we have
concluded that this is a good tenet of market structure, and we
are going to leave it in place.''
And so I think every element of our market structure will
be addressed in this holistic review, and nothing will be left
out. And I think that process will be very healthy for our
markets.
Senator McCain. Mr. Brennan.
Mr. Brennan. Thanks, Senator McCain. As to whether the
markets--there is a perception problem or not and a confidence
issue, the only thing I can judge that on is generally our
business and our customers and our clients. At Vanguard we have
seen record interest over the last few years in our products.
The majority of the flows we have seen have been into our
equity market-based products. Vanguard had $138 billion of
client assets come in the door last year and $76 billion in the
first 5 months of this year. And, again, the vast majority of
those sums have been going to our equity products.
Senator McCain. Well, Mr. Brennan, I think it is like the
old story of a guy in a small town who said to the other guy,
``What are you going to do on Saturday night?'' And he says,
``I am going to the poker game.'' He said, ``Why are you doing
that? Because you know the game is crooked.'' And the guy said,
``It is the only game in town.''
So, Mr. Brennan, I do not accept your allegation that
everything is fine. But if that is your view, I respect it, but
I do not agree with it.
Mr. Quirk.
Mr. Quirk. I would probably have a closer view to Mr.
Brennan's. When I discuss the view, I am going to discuss the
view of our 6 million clients and just tell you in the
behaviors that they have exhibited in the last couple years,
again, it would be consistent with Mr. Brennan's. We have seen,
trading accounts increase 31 percent, and we have a proprietary
index which we created a couple years ago which indicates how
much exposure people are taking in the market. In other words,
are they participating in the rally that has happened over the
course of the last couple years? And a significant portion of
them have.
That being said, I would agree with you that there is a
perception problem in a segment of these clients. Those would
be the clients that are probably closest to this. Most of mom-
and-pop, really these terms do not mean anything to them. ``Co-
location'' and ``HFT,'' they are just terms to them.
The problem for us is in that segment trying to make sure,
as I think Senator Johnson pointed out, that we do not spook
them. We do not want them to think that they are being treated
unfairly.
Senator McCain. Thank you. I thank the witnesses.
Thank you, Mr. Chairman.
Senator Levin. Thank you, Senator McCain.
Mr. Brennan, earlier this year, you said that some high-
frequency traders play a role in knitting back together a
fragmented market structure, but that other high-frequency
traders ``may be unfairly taxing the system through their
behaviors.''
Now, when you mentioned that some high-frequency traders
unfairly taxed the system, were you talking about firms that
engage in practices like rebate arbitrage where they try to
capture rebates without actually providing liquidity?
Mr. Brennan. That would be one example, yes.
Senator Levin. And, therefore, the maker-taker system
contributes to that problem.
Mr. Brennan. I think the market structure as a whole has
improved dramatically over the past 20 years.
Senator Levin. I am talking about the part that has not
improved. I am talking about what you just said, that some
high-frequency traders unfairly tax the system and that you
agreed, you were referring to those firms that engage in rebate
arbitrage. And then I just asked you whether or not the maker-
taker system is obviously, by definition, contributing to that
problem.
Mr. Brennan. I think the maker-taker in combination with
the lack of a trade-at, in combination with differential data
speeds contribute to potential issues.
Senator Levin. And can you have rebate arbitrage without
rebates?
Mr. Brennan. No.
Senator Levin. So, therefore, rebates contribute to the
problem. I did not say it is the whole problem. I am just
saying, does it contribute to the problem?
Mr. Brennan. Yes.
Senator Levin. Mr. Quirk, I think you were critical of the
Battalio testimony, and I am wondering whether you would be
willing to provide Professor Battalio with TD Ameritrade's
order routing data so that he could analyze it.
Mr. Quirk. Yes, we were actually asked by Professor
Battalio after his paper was published or the draft of that
paper was published if we would be willing to share data, and I
think we would be willing to share data. Of course, with
security, we would have to ensure that that was not going
anywhere.
Senator Levin. And when you were asked, what was your
answer?
Mr. Quirk. To be honest with you, I am not entirely sure. I
believe that he was told that it was being considered, but I am
not certain.
Senator Levin. Let me conclude by very briefly saying the
following:
We have had a good hearing today, I think a very
constructive hearing, a very illuminating hearing. And we have
heard a consistent message, and that is that there is a lack of
confidence in the markets. The conflict of interests that we
have discussed contribute to that lack of confidence. Both the
actual conflicts as well as the appearance of conflicts
contribute to that lack of confidence. And they may lead also
to regular investors, average investors, being worse off. That
is what Professor Battalio told us today, and what his study
shows.
All these problems should be and can be addressed, and one
of the ways we have got to do it is to remove the conflict of
interests. This Subcommittee has looked at other conflicts,
some of which have been very dramatic, in earlier hearings, and
we have to rid our market of conflicts of interest to the
extent it is humanly possible if we are going to restore
confidence in our markets. And it is very important that we do
have confidence in our markets.
And so hopefully the regulatory agencies are going to take
action. SEC Chairman White, as a number of you have mentioned,
has said that they are going to look at structural issues, long
overdue, and hopefully they will not take as long as they take
on a whole lot of other things that sometimes just fester at
the agency, the regulatory agency, for years.
And I think there may be also a role for Congress. These
things sometimes happen, hopefully more often than not through
the operations of a free market, but some of them just do not
happen without government saying, ``You have got to change your
ways, folks. You have got to take Steps A and B if you are
going to restore confidence.''
Now, we may disagree perhaps as to what those steps are,
but there are steps which must be taken either by regulators or
by Congress to deal with conflicts and to deal with the other
kinds of problems which exist in the current market, because it
is clear there can be improvements.
We very much appreciate your testimony. We are sorry that
it was interrupted by two votes of the Senate, but that is the
way our life works around here. I wish we could pass a law to
end interruptions in hearings or have some regulatory agency
perhaps figure out a way that we could avoid these kind of
interruptions. But that is not yet in the cards.
Thank you all. We will stand adjourned.
[Whereupon, at 12:44 p.m., the Subcommittee was adjourned.]
A P P E N D I X
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