Ted Kaufman - United States Senator for Delaware

Kaufman Testifies at Banking Subcommittee Hearing on Market Structure Issues

October 28, 2009

Watch Sen. Kaufman's testimony

WASHINGTON, D.C. – Today, Sen. Ted Kaufman (D-DE), who two months ago urged the Securities and Exchange Commission (SEC) to undertake a comprehensive, “ground-up” review of a broad range of opaque market structure issues, will testify on the first panel of a Senate Banking Committee, Subcommittee on Securities, Insurance and Investment hearing on dark pools, flash orders, high frequency trading and other market structure issues.

“Our stock markets have evolved rapidly in the past few years in ways that raise important questions for this hearing to explore,” says Sen. Kaufman in prepared testimony. “Technological developments have far outpaced regulatory oversight; and traders who buy and sell stocks in milliseconds – capitalizing everywhere on small price differentials in a highly fragmented marketplace – now predominate over value investors. Liquidity as an end seems to have trumped the need for transparency and fairness.  We risk creating a two-tiered market that is opaque, highly fragmented and unfair to long-term investors.”
 
Blaming opposition from high-speed traders for the SEC’s unwillingness to reimpose the uptick rule or impose pre-trade requirements that would end naked short selling, Sen. Kaufman warns: “Technology should not dictate our regulatory destiny; rather our regulatory policy should provide the framework and the guidelines under which technology operates.”
 
Sen. Kaufman goes on to say, “Our foremost policy goal should be to restore the markets to their highest and best purposes: serving the interests of long-term investors, establishing prices that allocate resources to their most productive uses, and enabling companies – large and small – to raise capital to innovate, create jobs and grow.”  
 
In an August 21 letter <http://kaufman.senate.gov/press/press_releases/release/?id=ac51e2a5-e413-4f52-ad37-8cf9d080e744> to SEC Chairman Mary Schapiro, Sen. Kaufman raised detailed concerns about a variety of market practices, connecting each of them to the decimalization and digitization of the market and resulting surge in electronic trading.  Concerned that high speed players are rapidly “moving us from an investor’s market to a trader’s market,” Sen. Kaufman has pushed the SEC to begin a holistic review to protect the interests of long-term investors, which the Commission subsequently has begun.
 
In his submitted longer testimony (attached), Sen. Kaufman proposes five “straightforward propositions” that should guide a regulatory framework that permits both “vigorous competition while substantially reducing the possibility of a two-tiered trading network.”
 
Opening statement, as prepared for delivery (longer statement submitted for the record):

Mr. Chairman, Senator Bunning, and Members of the Subcommittee, I want to thank you for holding this hearing and for inviting me to testify.
 
Mr. Chairman, I will keep my remarks brief, but I have a longer statement that I would like to submit for the record.
 
Mr. Chairman, our stock markets have evolved rapidly in the past few years in ways that raise important questions for this hearing to explore.   
 
Technological developments have far outpaced regulatory oversight; and traders who buy and sell stocks in milliseconds – capitalizing everywhere on minute price differentials in a highly fragmented marketplace – now predominate over value investors.  Liquidity as an end seems to have trumped the need for transparency and fairness.  We risk creating a two-tiered market that is opaque, highly fragmented and unfair to long-term investors.
 
I am very concerned that only timely and effective examination, which leads to clear and enforceable rules, can maintain the integrity of the U.S. capital markets, which are essential components of our nation’s success.
 
It was the repeal of the uptick rule by the SEC in 2007 which first caught my attention.  When I was at Wharton getting my MBA in the mid-1960s, the uptick rule was considered a cornerstone of market regulation.  As many on this subcommittee have noted, the uptick rule’s repeal made it easier for bear raiders – no longer constrained to wait for an uptick in price between each short sale – to help bring down Lehman Brothers and Bear Stearns in their final days.  
 
In April, Senators Isakson, Tester, Specter, Chambliss and I introduced a bill prodding the SEC to reinstate the rule.  As the months have gone by, I have asked myself – why is it so difficult for the SEC to mandate some version of the uptick rule and impose “hard locate” requirements to stop naked short selling?   
 
Then it became clear: None of the high-frequency traders – who dominate the market – want to reprogram their computer algorithms to wait for an uptick in price or to obtain a “hard locate” of available underlying shares.  
 
I began to hear from many on Wall Street and other experts concerned about a host of questionable practices – all connected to the decimalization and digitalization of the market and the resulting surge in electronic trading activity.  It became clear that the SEC staff was considering issues piecemeal – like the rise of flash orders – without taking a holistic view of the market’s overall structure, applying rules from a floor-based trading era to our current electronic trading venues in ways that were questionable.
 
The facts speak for themselves.  We’ve gone from an era dominated by a duopoly of the New York Stock Exchange and Nasdaq to a highly fragmented market of more than 60 trading centers.  Dark pools, which allow confidential trading away from the public eye, have flourished, growing from 1.5 percent to 12 percent of market trades in under five years.  
 
Competition for orders is intense and increasingly problematic.  Flash orders, liquidity rebates, direct access granted to hedge funds by the exchanges, dark pools, indications of interest, and payment for order flow are each a consequence of these 60 centers all competing for market share.
 
Moreover, in just a few short years, high frequency trading – which feeds everywhere on small price differences in the many fragmented trading venues – has skyrocketed from 30 percent to 70 percent of the daily volume.  Indeed, the chief executive of one of the country’s biggest block trading dark pools was quoted last week as saying that the amount of money devoted to high-frequency trading could “quintuple between this year and next."
 
So I’m pleased that the Securities and Exchange Commission has begun to address flash orders and dark pools.  
 
Let me quickly lay out three reasons why this hearing is so important:
 
First, we must avoid systemic risk to the markets.  Our recent history teaches us that when markets develop too rapidly, when they are not transparent, effectively regulated or fair – a breakdown can trigger a disaster.  
 
Second, while rapid advances in technology can produce impressive results, they are combining with market fragmentation in ways that are moving us from an investor’s market to a trader’s market.   
 
Third, we must ensure that retail investors are not relegated to second-tier status.  The markets should work best for those who want to buy and hold in hopes of a golden retirement, not just for high frequency traders who want to buy and sell in milliseconds.  
 
As SEC Chairman Schapiro acknowledged just yesterday, and I quote:  “I believe we need a deeper understanding of the strategies and activities of high frequency traders and the potential impact on our markets and investors of so many transactions occurring so quickly.”
 
Technology should not dictate our regulatory destiny; rather our regulatory policy should provide the framework and the guidelines under which technology operates.   As values, transparency and fairness must trump liquidity.
 
Our foremost policy goal should be to restore the markets to their highest and best purposes: serving the interests of long-term investors, establishing prices that allocate resources to their most productive uses, and enabling companies – large and small – to raise capital to innovate, create jobs and grow.  
 
Thank you, Mr. Chairman, and I look forward to your questions.

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