Current Equity Market Structure Issues - PowerPoint Presentation

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Current Equity Market Structure Issues

Presented by:Jerry CiteraManaging DirectorAssociate General CounselJP Morgan Chase & Co.

September 2016

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Outline of Presentation

1IntroductionBasic Concepts in Equity Market StructureThe Development of

Equity Market StructureStructure of the Equity Markets Current Issues in

Equity Market Structure

Recent Regulatory Responses

Conclusion*

*

This presentation is based in part on a previous practice outline published by Jerry Citera while Counsel at Davis Polk & Wardwell:

Current Market Structure Issues in the U.S. Equities and Options Markets (2012).

The appendix of terms at the end of this presentation is taken directly from the previous practice outline. Two additional sources for the presentation are

Flash Boys

by Michael Lewis and

Dark Pools

by Scott Patterson.Slide3

Introduction

Slide4

Introduction

3The United States equity trading market is one of the most liquid and efficient trading markets in the world.Billions of shares change hands seamlessly on a daily basis in a market that is generally regarded as having high liquidity, low volatility and few market disruptions

.Nonetheless, the rate of change in the market over the past twenty years has been unprecedented

.

These

changes have fundamentally altered the way the market functions and how market participants interact.

The changes to market structure have been driven primarily by technological developments, competitive forces, and related regulatory developments.

Today, I will focus on these issues in the equity trading markets.

While there are similar issues in the FX and fixed income markets, discussion of those issues will have to wait until later date.Slide5

Basic Concepts in Market Structure

Slide6

Basic Market Structure Concepts

5Markets – Investors come together to find liquidity and execute transactions

ExchangesOver the Counter Market

Electronic Trading

Venues

Bid Offer Spread

Tick Size

Market Structure – How the markets are organized and regulated

Primary Regulators

SEC

FINRA

Self Regulatory Organization

High Frequency Trading

ATS

AlgorithmSlide7

The Development of Equity Market Structure Slide8

Equity Markets – The Buttonwood TreeSlide9

UBS Trading Floor: Now and Then

8Slide10

The Development of the Current Equity Market Structure

9Historically, trading in U.S.- equities was dominated by exchanges with manual trading

floors and OTC trading with upstairs market makers.The equity trading market has evolved from a collection of a few, mostly manual markets, to a broad variety of trading centers that are almost completely automated and dependent upon sophisticated technology and extremely fast interconnected systems.

Trading equities today is no longer as straightforward as sending an order to the floor of a single exchange on which a stock is listed.

Three

main drivers of these

changes: technology, competitive forces

and

related regulatory developments.Slide11

The Role of Technology

10Continuous evolution of technologies for generating, routing and executing orders. Dramatic improvement in the speed, capacity and sophistication of the tools and trading functions available to market participants

. Microwave transmission is the latest tech.Increased availability of widespread, inexpensive automation and electronic communication systems gave rise to electronic trading systems that challenged the dominance of the floor-based exchange trading model.

Electronic trading has generally been beneficial to the trading markets by reducing costs and increasing the speed of execution and, in some cases, fostering greater transparency. At the same time, however, it has also significantly increased the complexity of the markets.

As a result, the risks of market or technological failures has increased significantly

.Slide12

11

Key Regulatory Developments in the Equity Trading Markets

Enactment of the Securities Act Amendments of 1975 Mandating National Market System

Evolution of the Third Market and Repeal of NYSE Rule 390

Limit Order Protection Rules Adopted (NASD Manning Rule and NYSE Rule 92)

Introduction of SuperSoes Automated Trading Capacity

Enforcement

Actions Against OTC Market Makers in 1996 (Antitrust, SEC, NASD

)

Adoption of the Order Handling Rules (Display Rules) in

1996

Evolution of Best Execution Concepts

Adoption of Regulation ATS in December 1998

Decimalization 2000

Adoption of Rules Requiring Disclosure of Order Execution and Routing Practices 2001

Adoption of Regulation NMS in June 2005

Demutualization of the Stock Exchanges

SEC Concept Release and Related Rule Proposals 2010

Market Access Rule

Liquidity and Integrity Events

Consolidated Audit Trail

Tick Test and Maker Taker Pilots

SEC Concept Release

SEC Advisory CommitteeSlide13

Core Principals

12In 1975, Congress set forth the core principals of a national market system.

Section 11A(a)(1)(C) of the Exchange Act states: “It is in the public interest and appropriate for the protection of investors and maintenance of a fair and orderly market to assure

–

economically efficient execution of securities transactions;

fair

competition among brokers and dealers, among exchange markets, between exchange markets and markets other than exchange markets;

the availability to brokers, dealers, and investors of information with respect to quotations for and transactions in securities;

the practicability of brokers executing investors' orders in the best market;

an opportunity, consistent with the provisions of causes (i) and (iv) of this subparagraph, for investors' order to be executed without the participation of a dealer

.”Slide14

Decimalization

13Pre-decimalization, the U.S. equity market used fractions – eighths and sixteenths of a dollar – as pricing increments. (Ironically this can be traced back to the infamous “Pieces of Eight” from old Spanish pirate lore.)

In 2001, the SEC ordered the stock exchanges to implement decimal pricing.

In 2005, the SEC adopted Rule 612 of Reg. NMS, which set a minimum price variation of one penny applicable to essentially all NMS securities.

(Tick test pilot will impose five cent minimum spreads in certain illiquid securities.)

These changes have reduced spreads, which has led to decreasing profits for the middlemen, i.e., market makers and

specialists but has cut costs to investors.

Decimalization has played a major role in the proliferation of electronic trading venues and computerized trading

strategies and has undoubtedly led to more efficient pricing and lower costs for investors.Slide15

Regulation ATS

14Adopted in 1998 in response to the proliferation of non-exchange trading venues providing exchange-like functionalities.

Establishes a regulatory framework for alternative trading systems to more fully integrate them into the national market system. Exempts certain alternative trading systems from registration as an exchange, subject to conditions that applied certain core elements of exchange regulation to such exempted alternative trading systems.

Conditions that need to be satisfied to be exempt from the requirement to register as an exchange:

Broker-dealer status

No self-regulatory activities

Name

limitationsSlide16

Regulation ATS (cont.)

15Core “exchange” regulatory elements applicable to ATSs: Limited SEC registration and reporting

Order display and execution access (if certain volume thresholds met)*Fair access (if certain volume thresholds met)*Capacity, integrity and security requirements (if certain volume thresholds met

)*

*In

practice, thresholds are high enough that few, if any, ATSs are required to comply with these requirements

.Slide17

Regulation NMS

16Passed by the SEC in 2005 and implemented in 2008Major restructuring of the equity trading marketsKey Components

Order protection rule – prohibited trade-throughsRestriction on locked and crossed markets

Fair access requirements on exchanges

Fee caps

Prohibition on sub-penny bidding or

quotingSlide18

Demutualization of Stock Exchanges

17A major change in regulatory structure that led to many of the conflict issues in the market today.Previously, stock exchanges were membership organizations owned and managed by the members of the Exchange.

This was the primary basis for the concept of Self Regulation, i.e. members would govern their own markets for the benefit of and protection of their member participants.Beginning in early 2000’s, the exchanges began to convert to for profit organizations, issuing stock, establishing separate boards, and limiting ownership by particular broker-dealers.

NASD followed suite in creating the NASDAQ Market.

Today, there are no mutually owned stock exchanges.

Key issue is that this places the exchanges in direct competition in the market place with their members to profit from the trading, market data, listing and other fees generated in the market place.

This is one of the key drivers of the debate between ATS’s and exchanges discussed belowSlide19

Development of Dark Markets

18As a result of Reg. ATS and the implementation of Reg. NMS, two separate markets have evolved – the fully disclosed public, highly regulated and openly accessible market on one hand; and the dark, selective and private non-transparent market on the other hand

.Even though Reg. NMS was intended to protect visible orders and encourage displaying quotes, today over 50% of the trading volume for more than 3,000 securities occur off-exchange in dark markets

.

In

the NYSE MKT listed market for example, which represents 709 securities, off-exchange trading accounted for 42% of the volume in November 2012

.

This

level of off-exchange activity can have a negative effect on the fully disclosed markets by eroding the incentive for market makers to display liquidity, which has a negative impact on price discovery. Slide20

SEC Concept Release

19In January 2010, the SEC issued a concept release seeking comment on a broad range of market structure issues, including market quality metrics, high frequency trading, co-location, undisplayed liquidity and the regulation of ATSs, among other things.

The SEC raised a number of very important questions regarding the structure of the markets and engendered a substantial amount of public comment on these issues. So far, the SEC has addressed certain of these issues in a piecemeal fashion through targeted releases and has held public roundtables and other forums to discuss other

issues.

But, the SEC has

not addressed these issues in a comprehensive market structure

proposal.

SEC Chair White, and former SEC Commissioners Gallagher and Piwower have called for a holistic review of the equity trading markets.Slide21

SEC Market Structure Advisory Committee

20In 2015, the SEC

established an Advisory Committee of a cross section of industry experts to consider various market structure issues and advise the SEC on future actions.The Advisory Committee has

held

several meetings to date on various issues and is expected to make recommendations on potential enhancements to market structure.

The

Advisory Committee has now broken into four subcommittees to address specific issues.

Each Committee has made specific recommendations:

Regulation NMS Subcommittee:

W

ill

consider the causal effects of Regulation NMS and its four main

components)

on equity market structure in the U.S.

Trading Venues Regulation Subcommittee:

W

ill

consider the fundamental changes in trading venues, including the growth of trading conducted through alternative trading

systems and

the impact of

demutualization.

Customer Issues Subcommittee:

W

ill

consider initiatives to protect investor interests and promote investor confidence.

Market Quality Subcommittee:

Will

consider

the impact of technology on the efficiency of the markets and systemic risks. Slide22

Structure of the Equity Markets

Slide23

Current Trading Venues

22Displayed VenuesExchanges Electronic Communication Networks (“ECN”)Non-Displayed Venues

Dark ATSsBroker-dealer internalizersTraditional market makersSlide24

National Securities Exchanges

23

Registered exchanges have self-regulatory responsibilities for their members and must file their proposed rule changes for approval with the SEC.

Currently, registered exchanges collectively execute approximately

[50]%

of share volume.

Major exchanges operators include

, among others, the New York Stock

Exchange,

the NASDAQ Stock Market, BATS Exchange, and Direct Edge

.

Newest registered stock exchange is

IEX.Slide25

Electronic Communication Networks (ECNs)

24ECNs are operated by broker-dealers and regulated as ATSs.

ECNs offer trading services that are generally analogous to those of registered exchanges.

Key

characteristic: ECNs provides their best-priced orders for inclusion in the consolidated quotation data.

Currently, ECNs execute approximately 2% of share volume. Slide26

Dark ATSs

25Historically, dark ATSs (often called “dark pools”) were developed to offer trading services to institutional investors and others that seek to execute large trading interest in a manner that minimizes the movement of prices against the trading interest and thereby reduce trading costs.

However, the

size of orders

in dark ATSs has

decreased significantly in recent years and is generally comparable to the size of typical exchange orders.

In contrast to ECNs, dark ATSs do not publish quotes. ATSs do publish last sale data.

The majority of dark ATS volume is

executed by

ATSs that are sponsored by multi-service broker-dealers. These broker-dealers also offer order routing services, trade as principal in the sponsored ATS, or both.

Currently there are over 50 different ATS

.

Currently

, dark ATSs execute approximately 15% of share volume

.Slide27

Broker-Dealer Internalizers

26Broker-dealer internalizers are broker-dealers

that execute internally against their own, or other customers’ trading interest, whether as agent or principal. The internalized

trading interest of

broker-dealers

may be considered “dark” because it primarily

reflects liquidity that is not included in the consolidated quotation data.

Nearly 100% of retail market orders are routed to broker-dealer internalizers via “payment for order flow” arrangements between broker-dealer internalizer firms and retail broker-dealers.

“Payment for order flow” refers to the practice whereby some market-makers and exchanges pay brokers to route orders to them.

Currently, broker-dealer internalizers execute approximately 20% of share volume

.

This category includes market makers and block positioners as well as othersSlide28

Result: Complex Order Routing

27A customer sending a marketable order to their broker typically gets their order filled in less than a second—however, much has happened in the interim.

The broker may use “smart order routers” (i.e.

algos

)

to analyze all available market data and determine the best venue or venues to execute the order. This may depend on, among other things:

Whether the order can be filled

internally;

Where external contra-side liquidity exists;

Where the best price is available; and

Which venue charges the lowest fee or offers the greatest rebate.

Once each venue receives the order (or part of the order), it may execute it in full or part, and may route unexecuted portions on to other venues.

If an exchange receives an order and does not have the best price, it may often route it to a dark pool, rather than another exchange, in order to save fees.Slide29

Current Issues in Equity Market Structure

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Current Issues in Equity Market Structure

29Regulatory Structure

: Exchanges vs. ATSsHigh Frequency

T

rading/Co-Location

Market I

ntegrity and

M

arket

D

isruptions

Structural Issues

Fragmentation of the MarketSlide31

Debate Over Regulatory Structure: Exchanges vs. ATSs

30On October 4, 2012, former SEC

Commissioner Gallagher called for the SEC and its staff to engage in a “comprehensive market and regulatory structure review, including a review of the self-regulatory paradigm as a whole,” with “no sacred cows.” Chair White and former Commissioner Piwower have also called for comprehensive reviews of market structure.

Exchanges and

broker-dealers operating ATSs compete

for order

flow and

have been engaged in a debate regarding whether the regulatory requirements governing each favor one set of competitors over the other.

Each side has undertaken very public advocacy:

Exchange and ATS representatives have testified in front of

Congress.

Letters

to the SEC.

In April 2013 exchange officials met with SEC leaders to discuss competition issues, including a potential “trade at” rule.

Trade at proposal is part of Tick Pilot.Slide32

Debate Over Regulatory Structure:

EXCHANGE ARGUMENTS31Market share keeps moving off exchange, to less “lit” or regulated venues:

Source: Exchange Presentation to SEC, May 1, 2013Slide33

Debate Over Regulatory Structure:

EXCHANGE ARGUMENTS (cont.)32

Shift to off-exchange venues is bad for investors, as there is less transparency and less orders contributing to price discovery.

Exchanges claim that they are at a competitive disadvantage compared to ATSs:

Exchanges have to file

public rule

changes with the

SEC.

ATSs merely have to file notice with the SEC.

Exchanges have costly self-regulatory responsibilities and market surveillance

obligations.

ATSs do not regulate their subscribers.

Exchanges

generally must allow “fair access” to all eligible broker-dealers.

ATSs

may discriminate – may lead to “negative selection” on exchanges.Slide34

Debate Over Regulatory Structure:

ATS ARGUMENTS33

Market share had not significantly shifted off-exchange:

Source: Credit Suisse Presentation to SECSlide35

Debate Over Regulatory Structure:

ATS ARGUMENTS (cont.)34

ATSs claim that they are at a competitive disadvantage compared to

exchanges:

Exchanges are now for-profit

enterprises, not member-owned cooperatives.

Most regulation is outsourced to FINRA.

Exchanges have common law and rules-based immunity from civil liability

ATSs are liable for their errors.

Exchanges receive significant revenue from the sale of market data.

ATSs are required by regulation to provide their market data to SROs, who may then sell it at a profit.

Exchanges are SROs and able to regulate their competing broker-dealers

Exchanges can examine their members and bring enforcement actions and impose fines and regulatory fees.

Exchanges are called upon by the SEC to help design market structure changes.Slide36

High Frequency TradingGENERALLY

35“

High frequency trading” does not have a single, standard definition. Generally refers to algorithmic trading by professional traders that engage in strategies that generate a large number of orders and trades on a daily basis.

Large number of cancelled orders.

Electronic markets now trade in fractions of a second with greater and greater speed highly relevant to the trading participants

Cuts out almost entirely human interaction.

High frequency trading has received and continues to receive a tremendous amount of attention from market participants, regulators, politicians, academics, the media and the general public

. See e.g. Flash Boys.

Key question is whether it helps markets by increasing liquidity or imposes unreasonable costs on so-called long term investors.Slide37

High Frequency Trading (cont.)

WEIGHING THE COSTS AND BENEFITS36

It is generally understood and agreed that high frequency trading provides some benefit to the market by providing a constant source of liquidity and immediacy of execution. Electronic trading in all of its forms has largely replaced the market makers and specialists who previously provided liquidity to the market.

At the same time, concerns have been raised about potential negative impact, both real and perceived, of high frequency trading. Some contend that high frequency trading:

significantly contributes to market

volatility;

puts individual investors and non-professional traders at an unfair competitive disadvantage because they do not have the technology or resources to monitor and take advantage of price movements in the same way as high frequency

traders;

may

be leading to an erosion of investor confidence in the markets, particularly in light of the Flash Crash and other recent high-profile market

disruptions; and

while HFT may provide

liquidity,

it is fleeting and they

are free to cease doing so at any time.

Chair White in a recent speech recognized the difficulty in addressing the issue by regulation.Slide38

High Frequency Trading (cont.)

CO-LOCATION37

The term “co-location” refers to the service offered by exchanges and ATSs that operate their own data centers and by third parties that host the matching engines of trading centers.

Exchange and ATSs rent rack space to various market participants to enable the market participants to place their servers in close physical proximity to a trading center’s matching engine.

Demand for co-location services stems from the fact that speed is critical to many trading strategies, in terms of both achieving very small latencies and in terms of being faster than competitors, even if only by a microsecond.

Some commenters have suggested

that co-location

arrangements

are fundamentally

unfair to individual

investors and

those firms that do not have the

access to

co-location services

.

IEX coiling solution to slow down order flow from HFT firms.Slide39

Market Integrity and Market Disruptions

38Market technology issues have become a prime focus of regulators in the wake of several large-scale, high-profile technological mishaps.

“Flash Crash” (May 6, 2010): Major equity indices in both the futures and securities markets lost more than 5% of their value in a matter of minutes when an automated order led to extreme downward price movement and a liquidity crisis in the Chicago Mercantile Exchange’s E-mini futures contract.

NASDAQ/Facebook IPO Problems (May 18, 2012): NASDAQ experienced technology problems in its handling of Facebook’s IPO, causing large-scale confusion as to the status of customer orders.

Knight Trading Loss (August 1, 2012). Due to a software problem, Knight submitted a series of unintended orders on August 1, 2012, resulting in an estimated trading loss of $440

million, and ultimately the sale of the firm.

NYSE Market

Disruption Event

(August 24, 2015).

Extreme volatility at the opening of the equities markets on August 24 caused a significant price dislocation in a variety of

securities traded on the NYSE

particularly ETFs.Slide40

Market Integrity and Market Disruptions (cont.)

39

Other recent major technology disruptions: NASDAQ SIP Outage (August 22, 2013)

Goldman

Sachs Options Losses from Computer Glitch (August 20, 2013)

Options

Price Reporting Authority Outage (September 16, 2013

)

CBOE

Outage (April 25, 2013)

BATS

IPO Cancellation (March 23, 2012

)

Calls for increased reliability and integrity.

Cyber security – a

major concern.Slide41

Structural Issues

40Market DataBig question about how to distribute revenue – can distort markets

Raise concerns about NMS plan management and whether broker-dealers should have greater voting representation in NMS plan management

Proprietary Data Feeds

SIP Processor is slower than direct market feeds sold by exchanges

Could cause harm to investors who do not have access to these markets feeds

Tick Size

Question about liquidity in the lower liquidity markets

Tick Test Pilot intended to determine whether higher tick with theoretically higher profit to market participants will increase liquidity in these markets

Maker-Taker Models

Distortive Effect of rebates

Proliferation of Order Types

Unique order types that make the market more complex and may create an advantage for one class of investors over another.Slide42

Market Fragmentation

41Proliferation of Market Centers

Arises out of the competitive requirements in the 1975 amendments.14 exchanges and over 60 dark pools.

Challenges the concept of a National Market System.

Proliferation of Dark Pools

As an alternative to exchanges.

Serve a purpose but also raise questions about the continuing validity and integrity of the displayed markets.

Too much trading in the dark markets will undercut pricing in the lit markets.Slide43

Recent Regulatory Responses

Slide44

Recent Regulatory Responses

43Single stock circuit breakers and limit up / limit down plan

Market-wide circuit breakersLarge trader reporting

Market access rule

Consolidated Audit Trail (“CAT”)

Proposed Regulation Systems Compliance and Integrity (“SCI

”)

FINRA ATS Reporting Disclosure Rule

FINRA and other Market Rules

NYSE Rule Changes in Response to the August 24 Market Disruption

HFT Enforcement Actions

Approval of

IEX

Stock Exchange

Continued

SEC

focus

Report of the Committee on Capital Markets RegulationSlide45

Recent Regulatory Responses (cont.)

SINGLE STOCK CIRCUIT BREAKERS AND LIMIT UP / LIMIT DOWN PLAN44

The single-stock circuit breaker plan imposed a trading pause for an individual security if the price of the security moved by 10% as compared to the price of that security in the preceding five-minute period during the trading day.

The limit up / limit down plan replaced the single stock circuit breaker plan.

The

plan requires exchanges, ATSs, broker-dealers and other trading centers to establish policies and procedures that prevent the execution of trades and the display of offers outside of a specified price band.

Price bands for each security generally set (and reset throughout the trading day) at a percentage above and below the security’s average price over the prior five minutes of trading.

If bid or offer quotations are at the far limit of the price band for more than 15 seconds, trading in that security will be subject to a five-minute trading pause

.

Tested in the August 24 Market Disruption. Worked OK but caused some fueling of the market disruption

. Double wide bands at opening.Slide46

Recent Regulatory Responses

(cont.)MARKET-WIDE CIRCUIT BREAKERS45

Provides for specified market-wide trading halts following certain “Level 1,” “Level 2” and “Level 3” market declines.

Level 1, 2, and 3 are calculated daily, using 7%, 13%, and 20%, respectively, of the S&P 500 Index, compared to the prior day’s closing value.

The length of halts for each Level depend on the time of day the halt is triggered

The currently effective updated market-wide circuit breakers fine tune the market-wide circuit breaker program put into place in October 1988 in several ways

.

SEC conference on market structure focused on “kill switches” and other enhancements to protect the market from runaway orders.Slide47

Recent Regulatory Responses

(cont.)LARGE TRADER REPORTING46

In July 2011, the SEC adopted a rule that establishes a large trader reporting system.

Requires “large traders” (any persons who trade two million shares or shares with a fair market value of $20 million in a single day, or twenty million shares or shares with a fair market value of $200 million in a single month) to register with the SEC and obtain a unique large trader identification number, which they must provide to their registered broker-dealers with every order.

Also requires broker-dealers to keep records of large traders’ transactions, be able to report this information to the SEC by the morning after the transactions were

effected

and monitor for compliance by

“unidentified”

large traders with the registration requirements

.

Intended to provide information about big traders in the market.Slide48

Recent Regulatory Responses

(cont.)MARKET ACCESS RULE47

Adopted on November 3, 2010.

Requires broker-dealers providing access to trading directly on an exchange or ATS, including those providing sponsored or direct market access to customers or other persons and ATSs providing access to the ATS to non-broker-dealers, to implement risk management controls and supervisory procedures reasonably designed to manage the financial, regulatory, and other risks of this business activity.

The required controls and procedures effectively prohibit the practice of unfiltered or naked access to an exchange or ATS

.

But rule has much greater reach affecting all access to the trading markets.

Compliance with the market access rule has been a big focus of the SEC exam program.Slide49

Recent Regulatory Responses

(cont.)CONSOLIDATED AUDIT TRAIL (“CAT”)48

Currently, stock trading tracked through several uncoordinated systems, including FINRA’s Order Audit Trail System, the NYSE’s Order Tracking System and the multi-SRO Consolidated Options Audit Trail System. No single system tracks orders routed through multiple SROs or all activity in a particular NMS

securities across

all SROs.

On July 11, 2012, the SEC adopted Rule 613 of Regulation NMS, which requires the SROs to jointly file a national market system plan that will govern the creation, implementation and maintenance of a consolidated audit trail (the “CAT”) that would track all events in the lifecycle of every quote or order

in the listed

equities and options markets.

Rule 613 sets in motion a vast, multi-year, billion-dollar project that will culminate in the creation of a comprehensive, real time data repository for all information concerning

quotes, orders

and executions.

Final NMS Plan is expected to be approved and issued by the SEC in November of 2016. A vendor will then be selected to provide run the CAT.Slide50

Recent Regulatory Responses (cont.)

REGULATION SYSTEMS COMPLIANCE AND INTEGRITY (“SCI”)49

The SEC adopted

Regulation Systems Compliance and Integrity (“Reg SCI”),

which formalized

and

made

mandatory many of the provisions of the SEC’s Automation Review Policy (“ARP”).

The

rule

would

applies

to all SROs, clearing agencies that are exempt from SEC registration, ATSs that exceed certain volume thresholds, and plan processors.

Covered entities

are required

to, among other things:

establish

policies and procedures relating to the capacity, integrity, resiliency and security of their technology systems

;

take timely corrective action in response to disruptions, systems compliance issues and intrusions

;

and notify and provide the SEC with detailed information when systems issues occur.

Currently not applicable to other broker-dealers but may be expanded to include others in the future.Slide51

Recent Regulatory Responses (cont.)

FINRA AND OTHER MARKET RULES50

FINRA has embarked on a transparency initiative to bring greater transparency to the trading markets

.

FINRA

has adopted proposal to registration requirements for certain persons who program ALGOs.

FINRA has proposed anti market disruption rules. [SEC and CFTC Rules]

SEC has proposed a revision of FORM ATS to include substantially more disclosure about the operations of ATS and dark pools to further inform the investing public

.

SEC has proposed revisions to Rule 606 requiring greater disclosure of routing determinations.Slide52

Recent Regulatory Responses (cont.)

NYSE RESPONSE TO AUGUST 24 MARKET DISRUPTION51

The NYSE proposed a number of actions that are intended to "improve the stability" of the exchange markets in adverse environments while at the same time "maintaining the efficiency of trading

.“

Areas proposed by the NYSE for action and study included the following:

disseminating order imbalance information until a security opens;

discontinuing the acceptance of stop-loss

orders (

pr

oposal adopted);

widening market collars for opening and reopening auctions;

expanding maker exemptions from Reg. SHO; and

revising the rules that pertain to "clearly erroneous trades

.“

On September 12, 2016, the NYSE implemented changes to its opening procedures to speed up trading and make it more efficient on volatile days eliminating “Rule 48” which had previously allowed Market Makers to delay openings in the face of volatility.Slide53

Recent Regulatory Responses (cont.)

HFT ENFORCMENT ACTIONS52

The SEC, FINRA and State Regulators have brought a number of actions against HFT firms and ATSs relating to High Frequency Trading

.

The

actions have focused on failure to disclose how the ATS worked and on unfair practices that disadvantage certain clients in the ATSs in favor of HFT traders

.

The SEC is continuing investigations of other firms and may bring further actions in the future.Slide54

Recent Regulatory Responses (cont.)

APPROVAL OF IEX STOCK EXCHANGE53

IEX (of Flash Boys

fame)

filed an application to become an exchange which raised some concerns about how the IEX Exchange would operate.

In

particular, commentators

were concerned

that the built in delay in executions of 350 micro

seconds by coiling wire

(ostensibly to even the playing field) would not be in conformance with the requirements of Regulation NMS requiring the immediate posting of quotations and executions

.

The

application was approved by the SEC on the basis that a deminimis delay of less than 1 millisecond would not change the immediacy of the executions in the market

.

Other exchanges and markets have announced that they are considering similar delays.Slide55

Recent Regulatory Responses

(cont.)CONTINUED SEC FOCUS54

In January 2013, the SEC staff began operating the Market Information Data Analytics System (“MIDAS”) to capture order and execution information and help the SEC staff monitor the markets.

On September 12, 2013, SEC Chair Mary Joe White met with leaders of the equities and options exchanges, FINRA, DTCC and the Options Clearing Corporation.

Following the meeting, Chair White stated, in part, “In short order, I also want those at the meeting – with the input of other market participants – to identify a series of concrete measures designed to address specific areas where the robustness and resilience of market systems can be improved, including the systems that were at the core of last month’s trading interruption.”

In a subsequent interview in September 2013, when asked about the recent technical glitches and other operational problems, Chair White stated that, in part, “The key is a zero tolerance objective.”

In an October 2, 2013 speech, Chair White expressed a continued focus on equity market structure issues. The SEC staff will soon develop a webpage to share data and analysis regarding market structure issues.

As noted above, the SEC has established the Market Structure Advisory Committee and approved the tick test pilot.

One of Chair White’s goals before stepping down is to complete a number of market structure initiatives

-- ATS Transparency Proposal is one of the top priorities.

September

2016 Speech by Chair White on Market Structure Goals for

2016. Focused on operational integrity; market transparency; and algo trading.Slide56

Recent Regulatory Responses

(cont.)REPORT OF THE COMMITTEE ON CAPITAL MARKETS REGULATION55

In July 2016, The Committee on Capital Markets Regulation

, an independent and

nonpartisan

research organization dedicated to improving the regulation of

U.S. capital markets, issued a report on the U.S. Equity Market.

The Report is entitled “

The US Equity Markets

: A Plan for Regulatory Reform.”

After studying and reporting on the development of the market over the past twenty years, the Committee made twenty six recommendation to enhance the performance of the equity markets.

These were categorized into three broad themes:

Increased Transparency;

Strengthened Resiliency; and

Lower transaction Costs by Enhancing Competition.

The Report concludes that now is the time for policymakers to act in the best interests of long term investors and public companies by making these reforms.Slide57

Conclusion

56

A number of critical equity market structure issues exist today.

Few

of these issues have obvious or straight forward resolutions.

Consideration of these issues is further complicated by the interdependency among these various issues

.

Broadly speaking, any change to equity market structure should look to simplify the current market structure and reduce the complexity and cost of operating the markets, while at the same time seek to maintain the competition in, and the liquidity, efficiency and stability of, those markets

.

The efficient functioning and the continued integrity of the market is critical to the capital raising process in the U.S. as well as the economy of as a whole and should be protected and strengthened as appropriate.Slide58

Questions?

57 Slide59

ANNEX A – Glossary of Selected Market Structure Terms

58

ATS refers to an “alternative trading system” that acts as a venue for trading securities and is subject to regulation under Regulations ATS and NMS. ATSs are typically electronic trading systems involving multiple parties (although manual interdealer broker systems are also ATSs). An ATS must be registered with the SEC as a broker-dealer and as an ATS. ATSs are subject to requirements for quoting, fair access, systems reliability and information confidentiality at differing thresholds of market share. ATSs cannot call themselves exchanges.

Circuit Breakers

refers

to

rules that limit trading activity upon the occurrence of specified events. Market-wide circuit breakers, when triggered, halt trading in all exchange-listed securities throughout the U.S. markets. Single-stock circuit breakers, when triggered, halt trading in an individual security.

Co-location

refers to the practice whereby exchanges, ATSs or third-parties provide space for the servers of market participants in the same data center housing the matching engines of the trading center. Co-location is favored by high frequency traders because it affords lower latency in the transmission of the order from the trader to the market center

.

Dark Pools

refers narrowly to ATSs that do not display bids and offers in the public quotation stream. More broadly, Dark Pools refers to sources of liquidity not reflected in public quotes, such as dark orders on exchanges and internalization of orders by broker-dealers. Slide60

ANNEX A – Glossary of Selected Market Structure Terms

59Decimalization

refers to the transition from quoting stock prices in 1/16ths or 1/8ths of a dollar to quoting in pennies, or decimals. The transition to decimal pricing occurred in 2000.Direct Market Access

refers to the practice of a broker-dealer providing its client with the ability to route orders directly to a market using the broker-dealer’s market participant identifier, or MPID. Direct Market Access sometimes refers only to orders that are routed through a broker-dealer’s systems for credit and regulatory checks before routing on the market; in this context, orders that are not routed through the broker-dealer’s systems are referred to as “sponsored access” or “naked access

.”

High Frequency

Trading

refers to automated trading by complex algorithms that enter and often cancel orders frequently, often thousands of times a minute. Many firms that engage in high frequency trading seek to end the day with little or no exposure to the market. Various strategies are used, including statistical arbitrage, market making and event-based strategies. In general, the term is vague and commonly has different meanings to different people

.

Limit

Order

refers to an order to execute a transaction at a specified price. Marketable limit orders are buy limit orders at or above the national best offer to sell, and sell limit orders at or below the national best bid to buy. Non-marketable limit orders are buy limit orders below the national best offer, and sell limit orders above the national best bid. Slide61

ANNEX A – Glossary of Selected Market Structure Terms

60

ECN refers to an “electronic communications network.” An ECN is an ATS that is distinguishable from a dark ATS or a dark pool because it provides its best-priced orders for inclusion in the consolidated quotation data. In general, ECNs offer trading services (such as displayed and undisplayed order types, maker-taker pricing, and data feeds) that are analogous to those of registered exchanges.

Exchange

refers to a national securities exchange registered with the SEC. Examples include the New York Stock Exchange and Nasdaq. Exchanges are subject to greater regulatory oversight than ATSs

.

Flash Orders

refers to a practice whereby a trading center will for a few milliseconds show to subscribers customer buy orders priced at the national best offer, or customer sell orders priced at the national best bid. Subscribers with fast electronic connections can then execute the orders at the flash price. If the order is not immediately executed, it is withdrawn without exposure to the entire marketplace, or is routed to other exchanges. Flash orders are only tangentially related to high frequency trading

.

Locked and Crossed Market

refers to a national best bid to buy that is at the same price as the national best offer to sell (Locked Market) or at a higher price than the national best offer to sell (Crossed Market). Exchanges are required by Regulation NMS to have rules to deter and correct locked and crossed markets. Locked and crossed markets occur when a quote is temporarily inaccessible, or when the quotes have access fees that discourage hitting the quote

.Slide62

ANNEX A – Glossary of Selected Market Structure Terms

61

Maker-Taker Fees refers to an exchange or trading platform pricing system where rebates are given to participants that provide liquidity to the market, and fees are charged to participants that take liquidity out of the market.

Naked Access

refers to direct market access where the non-broker-dealer connects directly to the market without first having its orders pass through the broker-dealer’s system, including its risk management controls.

Spread

refers to the difference in price between the national best bid to buy and the national best offer to sell

.

Over the Counter

Market

refers to the market for trades executed internally by a broker-dealer or over-the-counter with another broker-dealer rather than on an exchange. Dark Pools have been analogized to the “upstairs market” for block trading that was prominent in the era of stock exchange dominance

.

Trade-through

refers to transacting an order on one market center when a more advantageous price is available at another market center,

i.e.

, “trading-through” the order. The order protection rule of Regulation NMS, Rule 611(a)(1), requires a trading center to establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent trade-

throughs

, subject to numerous exceptions.