Ted Kaufman - United States Senator for Delaware

Kaufman Delivers Speech on Restoring Market Credibility

August 5, 2010

Mr. President, I rise to discuss the need of the Securities and Exchange Commission to take meaningful action to protect the credibility of our markets.

As my colleagues know, I believe deeply in the importance of our capital markets to America's future economic success and the ability of Americans to invest for their retirement years. I have said many times on this floor that democracy and our capital markets are the fundamental pillars that make America great. I have always maintained that if we do not have credible markets, our country will be in serious trouble. Credible capital markets are one of America's crown jewels and we should protect them as such.

I am deeply concerned about the state of our equity markets. Many rapid and dramatic developments have inextricably changed the way stocks are traded in today's marketplace. The markets have become fragmented and dominated by high-frequency trading.

These changes came to a head on May 6 when stock prices spiraled out of control, ultimately dropping and recovering over 500 points during a dizzying 20-minute time period.

It is clear we must rely more than ever on our regulators to protect the integrity and credibility of our capital markets. Without a doubt, the SEC--the Securities and Exchange Commission--along with the Commodity Futures Trading Commission--CFTC--has worked heroically to study the flash crash and put circuit breakers in place to prevent another event of the magnitude we witnessed on May 6 from occurring, or even more. But that is not anywhere--nowhere even close--to enough.

As Chairman Mary Schapiro has repeatedly stated, our markets exist to perform two principal functions: capital formation so that companies can raise capital and invest, create jobs and grow; and attracting and serving long-term investors to help facilitate that process. The May 6 flash crash revealed structural flaws in our market structure that must be addressed--must be addressed--in order to ensure our markets are performing their best and highest purposes.

There are many questions that remain unanswered and many solutions that I hope the SEC already has been exploring. More and more market participants and regulators are sharing their own concerns about the overall performance of our equity markets.

Michael Cembalest, the chief investment officer of J.P. Morgan's private banking division, wrote a commentary on July 13. This is J.P. Morgan. Mr. Cembalest outlined several areas of current market structure, including the market's increasing reliance on volume driven by high-frequency traders, which merit careful review.

In addition to supporting circuit breakers, Mr. Cembalest suggested that high-frequency traders should: ``be required to register as broker-dealers ..... [and] act more like the floor specialists they're replacing.''

Cembalest also noted that while high-frequency volume has ostensibly made trading cheaper by narrowing the spreads investors often pay to get their orders filled, there are other costs associated with trading that might be less obvious. One such cost, according to Cembalest, occurs when high-frequency traders ``spray the tape'' with thousands of quotes to ``ferret out'' the intentions of large investors, and then trade ahead of their order flow.

A draft report submitted by a British member of the European Parliament to the Committee on Economic and Monetary Affairs expresses similar concerns.

The report, which could influence the European Union's ongoing review of market structure, states ``limiting systemic risk must be prioritized.'' Accordingly, it proposes that all trading platforms should ``stress-test their technology and surveillance systems.'' It also called for ``an examination of the costs and benefits of high frequency trading on markets and its impact upon other market users. .....'' Finally, the report calls for ``the regulation of firms that pursue high frequency trading strategies to ensure that they have robust systems and controls with ongoing regulatory reviews of the algorithms they use.''

While I stated many of these concerns last August 21 in a letter to Chair Schapiro, it has taken almost a year later--and in large part due to the May 6 flash crash--that these ideas have finally gone mainstream and people are talking about it in all the different areas of the news media. Although the task before us is daunting, as even tweaking the market's structure is rife with potential unintended consequences, the SEC must act to protect investors and restore market credibility in the coming months. Navigating these issues will be difficult, particularly with so many business models based, or even dependent, on the existing regulatory framework.

Another challenge comes in the form of the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act which places a raft of new responsibilities, including 95 rulemakings and 22 studies, on the Securities and Exchange Commission. Nevertheless, the SEC must triage its responsibilities and work expeditiously to adopt much needed reforms in the market structure area. There can be no back burner when it comes to resolving a broken market structure. There can be no delay when long-term investors are losing confidence. The time for action is now.

The direction the Commission takes in its bid to fulfill its mission will say much about the type of country in which we live. As difficult as it might be, regulators must stand apart from the industries they regulate, listening and understanding industry's point of view, but doing so at arm's length and with a clear conviction that on balance, our capital markets exist for the greater good of all Americans.

This is a test of whether the Commission is just a ``regulator by consensus,'' which only moves forward when it finds solutions favored by large constituencies on Wall Street, or if it indeed exists to serve a broader mission and therefore will act decisively to ensure the markets perform their two primary functions of facilitating capital formation and serving the interests of long-term investors.

A consensus regulator may tinker here and there on the margins, adopt patches when the markets spring a leak, and reach for low-hanging fruit when Wall Street itself reaches a consensus about permissible changes. In these times, however, the Commission must be bold and move forward. The American people deserve no less.

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