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- ICI Comment Letters
Securities, Insurance, and Investment Subcommittee
Committee on Banking, Housing & Urban Affairs
“Dark Pools, Flash Orders, High Frequency Trading, and Other Market Structure Issues”
Statement of the Investment Company Institute
October 28, 2009
The Investment Company Institute appreciates the opportunity to submit this statement for the record in connection with the Subcommittee’s hearing on October 28, 2009, on “Dark Pools, Flash Orders, High Frequency Trading, and Other Market Structure Issues.”
The structure of the securities markets has a significant impact on Institute members, who are investors of over $11 trillion of assets and who held 24 percent of the value of publicly traded U.S. equity outstanding in 2008. We are institutional investors but invest on behalf of over 93 million individual shareholders. Mutual funds and their shareholders, therefore, have a strong interest in ensuring that the securities markets are highly competitive, transparent and efficient, and that the regulatory structure that governs the securities markets encourages, rather than impedes, liquidity, transparency, and price discovery. Consistent with these goals, mutual funds have strongly supported past regulatory efforts to improve the quality of the U.S. markets. We therefore support the current examination of the market structure in the United States.
Issues Facing the Current U.S. Market Structure
The current debate is very similar to that which occurred during the last major review of the structure of our markets, specifically during the adoption of the Securities and Exchange Commission’s (“SEC”) Regulation NMS. In Regulation NMS, the SEC noted that its proposals were designed to address a variety of problems facing the U.S. securities markets that generally fell within three categories: (1) the need for uniform rules that promote the equal regulation of, and free competition among, all types of market centers; (2) the need to update antiquated rules that no longer reflect current market conditions; and (3) the need to promote greater order interaction and displayed depth, particularly for the very large orders of institutional investors.
Regulation NMS addressed these three categories but in the intervening years since its adoption, the securities markets have changed dramatically. The third category above, promoting greater order interaction and displayed depth, continues to be of great importance to mutual funds. As the SEC recognized in proposing Regulation NMS, “perhaps the most serious weakness of the [national market system] is the relative inability of all investor buying and selling interest in a particular security to interact directly in a highly efficient manner. Little incentive is offered for the public display of customer orders – particularly the large orders of institutional investors. If orders are not displayed, it is difficult for buying and selling interest to meet efficiently. In addition, the lack of displayed depth diminishes the quality of public price discovery.”
Problems surrounding the lack of order interaction, its causes, and its impact on the securities markets have long confronted mutual funds. The Institute and its members have, for many years, been recommending changes that would facilitate greater order interaction and, in turn, more efficient trading. A consistent theme throughout all of our recommendations was that in order to promote greater order interaction and displayed depth in the markets, a market structure should be created that contains several key components, the most significant of which are:
- Price and time priority should be provided for displayed limit orders across all markets;
- Strong linkages between markets should be created that make limit orders easily accessible to investors; and
- Standards relating to the execution of orders should be created that provide the opportunity for fast, automated executions at the best available prices.
Investors and the Current U.S. Market Structure
The changes we have experienced in the structure of our markets the last few years have not addressed all of the components we believe necessary for a fully efficient market structure but great strides that benefit all investors have been made. Trading costs have been reduced, more trading tools are available to investors with which to execute trades, and technology has increased the overall efficiency of trading. Make no doubt about it, investors, both retail and institutional, are better off than they were just a few years ago. Nevertheless, challenges remain - posted liquidity and average execution size is dramatically lower while volatility and the difficulty of trading large blocks of stock have increased.
Regulation NMS, which has been largely beneficial to investors, led to dramatic changes. The market structure in the U.S. today is an aggregation of exchanges, broker-sponsored execution venues and alternative trading systems. Trading is fragmented with no single destination executing a significant percentage of the total U.S. equity market. Some of the biggest and most active traders are high frequency traders, who by some accounts trade close to two-thirds of the daily volume of our securities markets. Tremendous competition exists among exchanges and other execution venues, primarily driven by differences in the fees they charge and the speed by which they execute trades, with floor-based exchanges quickly becoming irrelevant.
To combat the difficulties in executing large blocks of stock, mutual funds have demanded much greater control over their orders to protect themselves from the leakage of information about their orders. As such, funds have adopted new trading technologies to help them cloak their orders and deal more directly with other institutional investors. This provided the incentive that led to many of the technological innovations in the securities markets including, as discussed below, the development of certain alternative trading venues.
Trying to develop a market structure that promotes the fundamental principles of a national market system while balancing the competing interests of all market participants is no easy task. Nevertheless, one point should be made clear: mutual funds’ sole interest in this discussion is in ensuring that proposed market structure changes promote competition, efficiency and transparency for the benefit of all market participants and not for a particular market center, exchange or trading venue business model. Market centers should compete on the basis of innovation, differentiation of services and ultimately on the value their model of trading presents to investors. We are hopeful that regulators can achieve the goals of a national market system while focusing on the interests of the markets’ most important participant - the investor.
Much of the current debate over the structure of the U.S. securities markets have centered on the proliferation of so-called “dark pools.” We believe it is unfortunate that such a pejorative term has now become ingrained in the terminology used by the securities markets and policymakers to describe a type of trading venue that has brought certain benefits to market participants. We therefore are reluctant to use the term when discussing issues surrounding this part of our market structure and urge that an alternative term be established to describe such venues. However, since no alternative term has yet been formally recognized and for purposes of clarity, we will use “dark pools” in this statement to address these alternative trading venues.
Dark pools are generally defined as automated trading systems that do not display quotes in the public quote stream. Mutual funds are significant users of these trading venues, which provide a solution to problems facing funds when trading large blocks of securities, particularly those relating to the frontrunning of mutual fund orders. They provide a mechanism for transactions to interact without displaying the full scale of a fund’s trading interest and therefore lessen the cost of implementing trading ideas and mitigate the risk of information leakage and market impact. They also allow funds to shelter their large blocks from market participants who seek to profit from the impact of the public display of these large orders. The issue with these trading venues, however, is that the benefits of not displaying orders also lead to concerns for the structure of the securities markets. Sheltering orders from the marketplace can impede price discovery and transparency. As discussed above, these two elements are critical in creating an efficient market structure.
The SEC last week set forth several proposals to bring “light” to dark pools and to address concerns about the development of a two-tiered market that could deprive certain public investors from information regarding stock prices and liquidity. Specifically, the SEC’s proposals address concerns about pre-trade transparency, including pre-trade messages sent out by dark pools in an effort to attract order flow but that are only sent to selected market participants (so-called “indications of interest” or “IOIs”). IOIs raise questions about how “dark” some of these venues truly are on a pre-trade basis as well as whether these messages are similar to public quotes and therefore should be treated as such. The proposals also would lower the trading volume threshold required for the display of these venues’ best-priced orders.
The SEC’s proposals also would address certain concerns about the lack of post-trade transparency, particularly concerns that it often can be difficult for investors to assess dark pool trading and to identify pools that are most active in particular stocks. Currently, public trade reports do not identify whether an over-the-counter trade was reported by a dark pool and, if so, its identity. The proposals would create a similar level of post-trade transparency as currently exists for registered exchanges.
We appreciate the government’s desire to examine trading venues that do not display quotations to the public and understand concerns about the creation of a two-tiered market. As discussed above, the Institute has long advocated for regulatory changes that would result in more displayed quotes. At the same time, policymakers should take a measured approach to making trading through dark pools more transparent and we urge policymakers to ensure that there are no unintended consequences for mutual funds, which must execute large blocks of securities on a daily basis on behalf of their shareholders.
The SEC has taken an important step in this regard in its proposals. The proposals would preserve the ability for mutual funds to trade large blocks of securities by allowing certain large orders to be “dark” to address concerns about the leakage of valuable information about mutual fund trades or the frontrunning of fund orders. We must consider, however, whether additional steps must be taken by policymakers to address other ways that mutual funds trade, for example, when funds break up large orders into smaller pieces that are executed separately. We also urge policymakers to not view the issues surrounding dark pools in a vacuum without also examining other market structure issues. We therefore look forward to a broader debate on market structure that will raise important questions about numerous aspects of our markets in general.
High Frequency Trading and Related Issues
High frequency traders and a host of issues connected to high frequency trading have also garnered the attention of regulators. The proliferation of alternative trading venues, including dark pools, and the accompanying technological advancements in the securities markets, set the stage for the entrance of high frequency traders. There are many benefits to high frequency trading that have been cited, including providing liquidity to the securities markets, tightening spreads, and playing a role as the “new market makers.” High frequency trading, however, also raises a number of regulatory issues including those relating to flash orders, co-location, and the risks of certain sponsored access arrangements, as discussed below.
Mutual funds do not object to high frequency trading per se. We believe, however, that given the growing amount of the daily trading volume that high frequency trading now constitutes, many of the issues surrounding this trading practice are worthy of further examination.
The SEC already has proposed to prohibit “flash orders.” “Flash orders” are generally orders that trading venues disseminate, often for only milliseconds, to a select group of market participants, primarily high frequency traders, before they are displayed or traded against displayed bids or offers. While this advantage occurs in milliseconds, it gives a clear advantage to those who see it and have the capability to react to it, i.e., those with the requisite electronic connections. Most mutual funds do not allow their orders to be flashed, primarily because the process of displaying the orders to a select group of market participants could result in information leakage.
The free look that flash orders provide is not new. Proponents of flash orders argue that flash quotes are nothing more than the electronic version of practices that previously occurred throughout the equity markets. That is correct. For many years, the specialists at the NYSE had the same informational advantage relative to other market participants and for many years mutual funds asked that this information advantage be eliminated. We continue to believe that such information advantages, and therefore flash orders, should be immediately banned.
“Co-location” is another “fair access” issue that has been raised relating to high frequency trading. Co-location refers to providing space for the servers of market participants, often high frequency traders, in the same data center housing the matching engines of an exchange. Co-location can serve to greatly reduce the delay associated with locating servers far away from the exchanges which, for high frequency traders, can mean the difference in whether they can execute a trade. While we do not have an issue with the concept of co-location, we believe that all investors should have an equal and reasonable opportunity for access to a co-location facility.
Finally, sponsored access is the practice of market participants that are not themselves broker-dealers obtaining direct access to markets through a broker-dealer’s trading identifier. Certain types of sponsored access arrangements provide access to markets without any broker-dealer pre-trade risk management system reviewing orders being transmitted. For high frequency traders, this type of sponsored access saves valuable time in the execution of their trades.
Mutual funds do not often use sponsored access arrangements, as the speed that these arrangements provide is not critical to the type of trades funds typically execute. We recognize, however, that unfettered sponsored access arrangements raise a series of supervision, compliance and risk-management issues that could impact the efficiency of the securities markets, e.g., a broker-dealer sponsoring a trader may not have adequate controls over the trader that it has connected to an exchange and the trader is not an exchange member subject to exchange regulation. We therefore support proper controls over sponsored access arrangements.
We thank the Committee for the opportunity to submit this statement and look forward to continued dialogue with the Committee and its staff.