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S. HRG. 111–922 

EXAMINING THE EFFICIENCY, STABILITY, AND 

INTEGRITY OF THE U.S. CAPITAL MARKETS 

JOINT HEARING 

BEFORE THE

SUBCOMMITTEE ON 

SECURITIES, INSURANCE, AND INVESTMENT 

OF THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

AND THE

PERMANENT SUBCOMMITTEE ON INVESTIGATIONS 

OF THE

COMMITTEE ON 

HOMELAND SECURITY AND 

GOVERNMENTAL AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED ELEVENTH CONGRESS 

SECOND SESSION 

ON 

EXAMINING THE EFFICIENCY, STABILITY, AND INTEGRITY OF THE U.S. 

CAPITAL MARKETS 

DECEMBER 8, 2010 

Printed for the use of the Committee on Banking, Housing, and Urban Affairs 

( 

Available at: http://www.fdsys.gov/ 
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS 

CHRISTOPHER J. DODD, Connecticut, Chairman 

TIM JOHNSON, South Dakota 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

EVAN BAYH, Indiana 

ROBERT MENENDEZ, New Jersey 

DANIEL K. AKAKA, Hawaii 

SHERROD BROWN, Ohio 

JON TESTER, Montana 

HERB KOHL, Wisconsin 

MARK R. WARNER, Virginia 

JEFF MERKLEY, Oregon 

MICHAEL F. BENNET, Colorado 

RICHARD C. SHELBY, Alabama 

ROBERT F. BENNETT, Utah 

JIM BUNNING, Kentucky 

MIKE CRAPO, Idaho 

BOB CORKER, Tennessee 

JIM DEMINT, South Carolina 

DAVID VITTER, Louisiana 

MIKE JOHANNS, Nebraska 

KAY BAILEY HUTCHISON, Texas 

JUDD GREGG, New Hampshire 

EDWARD SILVERMAN, Staff Director 

WILLIAM D. DUHNKE, Republican Staff Director 

DAWN RATLIFF, Chief Clerk 

WILLIAM FIELDS, Hearing Clerk 

SHELVIN SIMMONS, IT Director 

JIM CROWELL, Editor 

SUBCOMMITTEE ON SECURITIES, INSURANCE, AND INVESTMENT 

JACK REED, Rhode Island, Chairman 

JIM BUNNING, Kentucky, Ranking Republican Member 

TIM JOHNSON, South Dakota 

CHARLES E. SCHUMER, New York 

EVAN BAYH, Indiana 

ROBERT MENENDEZ, New Jersey 

DANIEL K. AKAKA, Hawaii 

SHERROD BROWN, Ohio 

MARK R. WARNER, Virginia 

MICHAEL F. BENNET, Colorado 

CHRISTOPHER J. DODD, Connecticut 

JUDD GREGG, New Hampshire 

ROBERT F. BENNETT, Utah 

MIKE CRAPO, Idaho 

BOB CORKER, Tennessee 

DAVID VITTER, Louisiana 

MIKE JOHANNS, Nebraska 

KARA M. STEIN, Subcommittee Staff Director 

WILLIAM HENDERSON, Republican Subcommittee Staff Director 

PAUL SAULSKI, SEC Detailee 

DEAN SHAHINIAN, Senior Counsel 

LEVON BAGRAMIAN, Legislative Assistant 

(II)
COMMITTEE ON HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS 

JOSEPH I. LIEBERMAN, Connecticut, Chairman 

CARL LEVIN, Michigan 

DANIEL K. AKAKA, Hawaii 

THOMAS R. CARPER, Delaware 

MARK L. PRYOR, Arkansas 

MARY L. LANDRIEU, Louisiana 

CLAIRE MCCASKILL, Missouri 

JON TESTER, Montana 

CHRISTOPHER A. COONS, Delaware 

SUSAN M. COLLINS, Maine 

TOM COBURN, Oklahoma 

SCOTT P. BROWN, Massachusetts 

JOHN MCCAIN, Arizona 

GEORGE V. VOINOVICH, Ohio 

JOHN ENSIGN, Nevada 

LINDSEY GRAHAM, South Carolina 

MARK KIRK, Illinois 

MICHAEL L. ALEXANDER, Staff Director 

BRANDON L. MILHORN, Minority Staff Director and Chief Counsel 

TRINA DRIESSNACK TYRER, Chief Clerk 

PATRICIA R. HOGAN, Publications Clerk and GPO Detailee 

PERMANENT SUBCOMMITTEE ON INVESTIGATIONS 

CARL LEVIN, Michigan, Chairman 

THOMAS R. CARPER, Delaware 

MARK L. PRYOR, Arkansas 

CLAIRE MCCASKILL, Missouri 

JON TESTER, Montana 

CHRISTOPHER A. COONS, Delaware 

TOM COBURN, Oklahoma 

SUSAN M. COLLINS, Maine 

JOHN MCCAIN, Arizona 

JOHN ENSIGN, Nevada 

ELISE J. BEAN, Staff Director and Chief Counsel 

CHRISTOPHER J. BARKLEY, Minority Staff Director 

DAVID H. KATZ, Counsel 

TY GELLASCH, Office of Senator Carl Levin 

MARY D. ROBERTSON, Chief Clerk 

ANTHONY COTTO, Counsel to the Minority 

(III)
C O N T E N T S 

WEDNESDAY, DECEMBER 8, 2010 

Page 

Opening statement of Chairman Reed ................................................................... 1 

Opening statement of Chairman Levin ................................................................. 3 

Prepared statement .......................................................................................... 52 

WITNESSES 

Mary L. Schapiro, Chairman, Securities and Exchange Commission ................. 8 

Prepared statement .......................................................................................... 78 

Responses to written questions of: 

Chairman Reed .......................................................................................... 169 

Chairman Levin ......................................................................................... 171 

Senator Coburn ......................................................................................... 176 

Gary Gensler, Chairman, Commodity Futures Trading Commission ................. 10 

Prepared statement .......................................................................................... 84 

James J. Angel, Associate Professor of Finance, McDonough School of Business, Georgetown University ............................................................................... 24 

Prepared statement .......................................................................................... 87 

Responses to written questions of: 

Chairman Reed .......................................................................................... 179 

Thomas Peterffy, Chairman and Chief Executive Officer, Interactive Brokers 

Group .................................................................................................................... 26 

Prepared statement .......................................................................................... 156 

Responses to written questions of: 

Chairman Reed .......................................................................................... 187 

Manoj Narang, Chief Executive Officer, Tradeworx, Inc. .................................... 27 

Prepared statement .......................................................................................... 159 

Kevin Cronin, Global Head of Equity Trading, Invesco Limited ......................... 29 

Prepared statement .......................................................................................... 161 

Steve Luparello, Vice Chairman, Financial Industry Regulatory Authority ...... 31 

Prepared statement .......................................................................................... 164 

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Letter Submitted by Timothy B. Henseler, Deputy Director, Securities and 

Exchange Commission ......................................................................................... 189 

(IV)
(1) 

EXAMINING THE EFFICIENCY, STABILITY, 

AND INTEGRITY OF THE U.S. CAPITAL MARKETS 

WEDNESDAY, DECEMBER 8, 2010 

U.S. SENATE, SUBCOMMITTEE ON SECURITIES, INSURANCE, AND

INVESTMENT, 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, 

PERMANENT SUBCOMMITTEE ON INVESTIGATIONS, 

OF THE COMMITTEE ON HOMELAND SECURITY AND

GOVERNMENTAL AFFAIRS, 

Washington, DC. 

The Subcommittees met at 3:30 p.m., in room SD–538, Dirksen 

Senate Office Building, Hon. Jack Reed, Chairman of the Subcommittee, presiding. 

OPENING STATEMENT OF CHAIRMAN JACK REED 

Chairman REED. Let me call the hearing to order, and I want to 

thank the Members of the Permanent Subcommittee on Investigations, chaired by Senator Levin, for joining us in the joint hearing 

this afternoon. Both of our Subcommittees are extremely interested 

in understanding both the causes and implications of the May 6th 

Flash Crash, and in particular, we want to focus on how we can 

avoid and mitigate the effects of such events in the future. 

I am going to make an opening statement. I have been informed 

that Senator Bunning may be delayed and asked us to go ahead. 

Then I will turn it over to Chairman Levin who will recognize Senator Coburn when he arrives. 

Also, under the rules of the Committee on Investigations, witnesses are sworn, and I will ask Chairman Levin to do the—after 

my opening statement, when the witnesses are introduced, to do 

the official swearing-in according to the rules of his Subcommittee. 

I certainly want to thank Chairman Schapiro and Chairman 

Gensler for being here, and all our other witnesses, and I want to 

commend both Chairman Schapiro and Chairman Gensler for the 

effort, the collaboration, the hard work they have done already to 

implement the Dodd-Frank bill. It was a spirit that has been noticed of cooperation and collaboration, which is a model for all of 

us. Thank you so much. 

I want to also apologize ahead of time for the schedule of the 

Senate. First we had to delay the hearing, and I thank the witnesses for understanding that. We also understand that a series of 

four votes will begin some time after 4 p.m. this afternoon. It is our 
2 

hope that we can proceed, get the opening statements of at least 

our first panel, questions. Senator Levin and I have agreed to shuttle back and forth so that we do not necessarily have to recess the 

hearing. So we will do our best to maintain the continuity of the 

hearing throughout the afternoon, but I apologize again for these 

four votes that are pending. 

Let me now focus on the substance of our hearing. Although the 

recently released report on the events of May 6th was quite thorough and thoughtful, the length of time it took to complete is an 

issue. What tools do our regulators need so that they can understand what is happening in our capital markets when it is happening, or at least very shortly thereafter? That is, I think, one of 

the first issues. What resources do you need to effectively surveil 

and oversee capital markets, particularly markets that are evolving 

at such a tremendous rate given technology? 

In the report, the SEC and the CFTC reconstruct the events that 

took place across a myriad of securities and futures markets on 

May 6th, and I think that is a very important point. The interrelated aspect of securities markets and of CFTC product markets 

is such now that something happening in one market cannot be 

easily isolated. According to the report, a single trade by a mutual 

fund was the primary cause of the chain of events that led to the 

volatile swings in the capital markets on May 6th. In effect, a 

CFTC-regulated product produced significant impacts within SECregulated equity markets, and I am sure the opposite could occur, 

unfortunately, under the right circumstances. 

Even before the plunge, the markets were already stressed and 

showing high volatility due to the mounting concerns of the debt 

crisis in Europe on that particular day. According to the report, it 

was against this backdrop and a Dow Jones average that was already down about 2.5 percent that the mutual fund initiated an 

automated algorithmic trading program to sell $4.1 billion worth of 

E–Mini futures contracts which track the Standard & Poor’s 500 

stock index. In essence, the interaction of this one mutual fund’s 

trading algorithm with the trading algorithms of other market participants, particularly high-frequency traders, seemed to have created a vicious feedback loop that increasingly accelerated the rate 

at which the orders were executed. In the end, this one trade sold 

in a span of 20 minutes. It was the largest single trade in E–Mini 

futures since the start of the year. The net effect of this order was 

to send panic into the marketplace. 

How could one order by one trader do this? That is certainly an 

issue. How do we stop this from happening again? The events of 

May 6th bring into sharp focus concerns about the efficiency, stability, and integrity of our capital markets and the current structure of these markets. The existing structure of the U.S. equity 

markets is governed by a series of rules and regulations collectively 

known as Regulation National Market System, or RegNMS. One of 

the questions before us today is how does RegNMS need to be updated to modernize and strengthen the national market system for 

equity securities for the 21st century? 

In addition to the January 2010 Concept Release by the SEC— 

and, again, let me commend you, Chairman Schapiro and Chairman Gensler, for working on these issues proactively—on possible 
3 

revisions to the RegNMS, the SEC has responded with specific regulatory actions related to market structure and trading since May 

6th, such as the institution of a stock-by-stock circuit breaker pilot 

program. 

We hope that today’s hearing will help us understand some of 

the regulators’ recent proposals and answer some of the other important questions as well. These questions are long, but let me suggest a few. 

What does the May 6th Flash Crash tell us about the stability 

and vulnerability of the U.S. capital markets? And to what extent, 

if any, can the May 6th problems be attributed to the current fragmentation market structure and interconnectedness between the 

futures, options, bond, and equities markets? 

What effect do technology-driven trading practices have on the 

stability and integrity of U.S. capital markets? What type of information tools and authorities will regulators need for the effective 

supervision of the capital markets? How can they more actively police across both products and trading venues? 

What are effective strategies for minimizing future market dysfunctions like the May 6th event and for minimizing market abuses 

caused by technology-driven trading practices? What are the effects 

of the current market structure in trading practices on long-term 

capital formation in U.S. markets and, as a consequence, the 

health and vitality of the U.S. economy more generally? 

We look forward to hearing your testimony on all these topics, 

and I think I have just probably listed just a few of the questions 

that you have been dealing with quite diligently over the several 

months. Clearly, the cops on the beat—the SEC and the CFTC— 

need to have the same tools and resources as the traders so that 

they can police capital markets effectively. 

I will close with an old saying by the great New England poet 

Robert Frost: ‘‘Good walls make good neighbors.’’ You are the folks 

that build the walls and make sure the neighbors behave, and so 

we hope you can keep doing that. 

Now I would like to recognize Chairman Levin. 

OPENING STATEMENT OF CHAIRMAN CARL LEVIN 

Chairman LEVIN. Today, U.S. capital markets, which traditionally have been the envy of the world, are fractured. They are vulnerable to system failures and trading abuses, and they are operating with oversight blind spots. The very markets that we rely on 

to jump start our economy and invest in America’s future are susceptible to market dysfunctions that jeopardize investor confidence. 

I want to begin by thanking Chairman Jack Reed, his Ranking 

Member Senator Bunning, and all of our colleagues on the Securities, Insurance, and Investment Subcommittee, who have already 

held hearings on these issues. We thank him for welcoming our 

Subcommittee, including our newest Member, Senator Coons, to 

join with them today to shine a light on problems that threaten 

U.S. market stability and integrity. 

The first fact that we need to grapple with is that our markets 

have changed enormously in the last 5 years. In the past, most 

U.S.-listed stocks were traded on the New York Stock Exchange or 

the NASDAQ. Seven years ago, the New York Stock Exchange 
4 

alone accounted for about 80 percent of the trades in its listed 

stocks. But today, less than 25 percent of the New York Stock Exchange-listed stocks are traded there. 

What happened? 

There is a chart, which we will put up here. Exhibit 1 shows how 

the U.S. stock market has fractured. Stock trading now takes place, 

not on one or two, but on 13 stock exchanges, as well as multiple 

off-exchange trading venues, including three electronic communication networks, 36 so-called dark pools, and over 200 registered 

broker-dealer internalizers. 

Now, those off-exchange trading venues may need some more explanation. Electronic communication networks, or ECNs, are computerized networks that enable their participants to post public 

quotes to buy or sell stock without going through a formal exchange. Dark pools, by contrast, are electronic networks that are 

closed to the public and allow pool members to buy and sell stock 

without fully disclosing to each other either their identities or the 

details of their prospective trades. A broker-dealer internalizer is 

a system set up by a regulated broker-dealer to execute trades with 

or among its own clients without sending those trades outside of 

the firm. These off-exchange venues are increasing their trading 

volumes, most use high-speed electronic trading, and they escape 

much of the regulation that applies to formal exchanges. 

These new trading venues did not appear out of thin air. They 

are largely the result of Regulation NMS which the SEC issued in 

2005. Some call the resulting new world of both on-exchange and 

off-exchange trading a model of competition. Others call it a freefor-all that defies oversight and is ripe for system failures and trading abuses. In reality, both descriptions have some truth. Trading 

competition has led to lower trading costs and faster trading, but 

it has also opened the door to new problems. 

One of those problems involves system failures, of which the May 

6, 2010, Flash Crash is the most famous recent example. On that 

day, out of the blue, the futures market suddenly collapsed and 

dragged the Dow Jones Industrial Average down nearly 700 points, 

wiping out billions of dollars of value in a few minutes for no apparent reason. Both the futures and stock markets recovered in 

less than 20 minutes, but left investors and traders in shock. After 

5 months of study, a joint CFTC–SEC report has concluded that 

the crash was essentially triggered by one large sell order placed 

in a volatile futures market using an algorithm that set off a cascade of out-of-control computerized trading in futures, equities, and 

options. That one futures order, placed at the wrong time, in the 

wrong way, set off a chain reaction that damaged confidence in 

U.S. financial markets. 

In some ways, the May 6th crash was a high-speed version of the 

1987 market crash, where a sudden decline in the futures market 

led to a corresponding collapse in the broad stock market, which 

led, in turn, to crashes in individual stocks. And it is not the only 

type of system failure affecting our financial markets. So-called 

mini flash crashes in which one stock suddenly plummets in value 

for no apparent reason have become commonplace. 

On June 2, 2010, for example, shares in Diebold Inc., a large Ohio corporation, suddenly dropped from about $28 to $18 per 
5 

share. The stock recovered, but the company was left trying to understand and explain what happened. Even after the SEC initiated 

a pilot circuit breaker program after the May 6th crash, at least 

15 other companies have had similar experiences, including 

Newcor, Intel, and Cisco. A former senior NASDAQ executive told 

the Subcommittee that the NASDAQ exchange has experienced single-stock flash crashes five times per week. The New York Stock 

Exchange and FINRA told us these crashes are commonplace and 

attribute them to various glitches in computerized trading programs. 

Single-stock crashes might seem to be a minor problem, but what 

happens if the security that crashes is a basket of stocks or commodities? On November 29, 2010, three of the top five equities 

traded by volume were actually baskets of stocks. If a basket of 

stocks or commodities crashes in value, what happens to the underlying financial instruments? Uncontrolled electronic trading and 

cascading price declines in multiple trading venues, including in futures, options, and equities markets, could be the result—in other 

words, another May 6th. 

Many investors, by the way, are not waiting around to find out 

if our regulators have fixed the problem. According to the Investment Company Institute, each month since May, more investors 

have fled our markets, pulling billions of dollars of U.S. investments. 

System failures are not the only problem raised by our fractured 

markets. Another problem is their increased vulnerability to trading abuses. Traders today buy and sell stock on-exchange and offexchange, simultaneously trading in multiple venues. Traders have 

told my Subcommittee that orders in some stock venues are being 

used to affect prices in other stock venues; and that futures trades 

in the CFTC-regulated markets are being used to affect prices on 

SEC-regulated options and stock markets. Some traders are also 

using high-speed trading programs to execute their strategies, 

sometimes submitting and then canceling thousands of phony orders to affect prices. 

To get a sense of the trading activity that goes on today, take a 

look at this stack of paper. This stack, nearly 5 inches high, contains the actual message traffic generated in the futures, options, 

and equities markets with respect to one major U.S. stock over the 

course of 1 second. One stock, in 1 second, produced over 29,000 

orders, order modifications, order executions, and cancellations. 

This stack shows in black and white how traders are now analyzing orders in all three markets at once, evidencing how the futures, options, and equities markets are interconnected. Imagine 

the same stack multiplied countless times, filling this entire hearing room and the interconnectedness of the markets as well as the 

potential for system failures and trading abuses becoming alarmingly clear. 

One well-known trader, Karl Denninger, recently made this public comment about U.S. trading activity: ‘‘Folks, this crap is totally 

out of hand,’’ he said, ‘‘and it is now a daily game that is being 

played by the machines, which are the only things that can react 

with this sort of speed, and they are guaranteed to screw you, the 
6 

average investor or trader. Go ahead,’’ he said, ‘‘keep thinking you 

can invest.’’ 

While fractured markets and high-speed trading are causing new 

problems and forms of manipulation, they are also leaving our regulators far behind. Traders are equipped today with the latest, 

fastest technology. Our regulators are riding the equivalent of 

mopeds going 20 miles per hour chasing traders whose cars are 

going 100 miles per hour. 

Our regulators are confronting at least four challenges, and before I go through those challenges, I want to join Chairman Reed 

in congratulating and thanking our witnesses here today. You have 

led your agencies in important new directions and reforms, and you 

are doing it with, I think, great professionalism and talent;, and we 

commend the efforts that you are making. Here are some of the 

challenges that our regulators are facing. 

The first is the fact that each trading venue today has its own 

infrastructure rules and surveillance practices. Besides the expense 

and inefficiency involved, no regulatory agency has a complete collection of trade data from all the venues, much less a single integrated data flow allowing regulators to see how orders and trades 

in one venue may affect prices in another. 

Second, even if regulators had an integrated data flow, the current data systems fail to identify key information, including the 

names of the executing broker and customer making the trades. 

That means that regulators cannot use the electronic records to, for 

instance, trace trading by one person or set up alerts to flag trades. 

Instead, before any trading analysis can start, regulators have to 

figure out the broker and customer behind each trade. Patterns of 

manipulation are hidden. 

The third problem is that the SEC has no minimum standards 

for automated market surveillance by self-regulatory organizations, 

so-called SROs, and the quality of those efforts is apparently all 

over the map. Recent SEC examinations of certain exchanges have 

found, for example, that some ineffective surveillance systems were 

unable to detect basic manipulations or used such restrictive criteria that they failed to flag suspect activity, some exchanges failed 

to review some surveillance alerts, and some exchanges had only 

rudimentary or underbudgeted investigative examination and enforcement programs. 

The fourth problem is that the SEC and CFTC have not set up 

procedures to coordinate their screening of market data to see if 

trades in one agency’s markets are affecting prices in the other’s 

markets. Given the strong relationships between the futures, options, and equities markets, joint measures to detect intermarket 

trading abuses are essential. 

The impact of the regulatory and technology barriers is demonstrated by the fact that it took the CFTC and the SEC 5 months 

of intense work to figure out what happened over a few minutes 

on May 6th, and I believe that Chairman Reed made this same reference. In addition, over the past 5 years, there have been few 

meaningful single-day price manipulation cases. One recent case 

involves a small trading firm, Trillium Trading LLC, which apparently used phony trading orders to influence the price of several 

stocks. In that case, FINRA found that over a 3-month period in 
7 

2006 and 2007, Trillium submitted phony orders in over 46,000 

manipulations, netting gains of about $575,000. Apparently, the 

victims of the price manipulations got annoyed enough to research 

the manipulative trading and hand over the data to FINRA. Even 

then, it took FINRA 4 years to reconstruct the order books, prove 

who was behind the trades, and resolve the matter. Trillium and 

its executives recently settled the case by agreeing to pay over $2.2 

million in fines and disgorgements. 

Traders and regulators have told us that Trillium is not the only 

company that has engaged in or is engaging in price manipulation 

in U.S. financial markets. In fact, one of the more chilling examples involves suspect trading involving traders located in China. 

Are overseas traders trying to manipulate U.S. stock prices? Our 

regulators are currently ill-equipped to find out. 

The May 6th Flash Crash and the Trillium case provide powerful 

warnings that we need to strengthen U.S. oversight of our financial 

markets to restore investor confidence. Much needs to be done. Recent actions by the SEC to prohibit phony quotes, impose singleissue circuit breakers, and set up a consolidated audit trail are important advances. But there is a long, long way to go, particularly 

with respect to coordinating market protections and surveillance 

across market venues, and across the futures, options, and equities 

markets. 

There also needs to be a greater sense of urgency. The SEC’s proposed consolidated audit trail is expected to take years to put into 

place and will not cover all of the relevant products and markets. 

Requiring executing broker and customer information, an essential 

component to effective oversight, is in limbo, pending completion of 

the consolidated audit trail, as is integrating the trade data for 

multiple trading venues. Integrating trading data and market surveillance of futures, options, and equities markets by the CFTC 

and SEC is not even on the drawing board. 

I hope this hearing will help inject greater urgency into strengthening U.S. oversight of our fractured, high-speed markets to restore 

investor confidence. 

Again, I want to thank you, Chairman Reed, for holding these 

hearings and for the kind of leadership that you have shown in 

digging into these kind of issues over the years. Thank you. 

Chairman REED. Thank you very much, Mr. Chairman. 

Let me introduce our witnesses. Our first witness is the Honorable Mary Schapiro, Chairman of the Securities and Exchange 

Commission. Prior to becoming the SEC Chairman, she was the 

CEO of the Financial Industry Regulatory Authority, FINRA, the 

largest nongovernmental regulator for all securities firms doing 

business with the United States public. Chairman Schapiro previously served as a Commissioner of the SEC from December 1988 

to October 1994, and then as Chairman of the Commodity Futures 

Trading Commission from 1994 until 1996. 

Our second witness is the Honorable Gary Gensler, the Chairman of the Commodity Futures Trading Commission. He previously served at the U.S. Department of Treasury as the Under 

Secretary of Domestic Finance from 1999 to 2000 and as Assistant 

Secretary of Financial Markets from 1997 to 1999. Prior to joining 

the Department of Treasury, Chairman Gensler worked for 18 
8 

years at Goldman Sachs, most recently as a partner and cohead of 

finance. 

Before you begin your testimony, I will turn it over to Chairman 

Levin to administer the oath pursuant to Rule VI of the Rules of 

Procedure of the Senate Permanent Subcommittee on Investigations. Would you please stand? 

Chairman LEVIN. Thank you very much, Chairman Reed. 

As he said, pursuant to the rules of our Subcommittee, all witnesses need to be sworn. If you would raise your hands. 

Do you solemnly swear——that the testimony that you will give 

before these Subcommittees will be the truth, the whole truth, and 

nothing but the truth, so help you God? 

Ms. SCHAPIRO. I do. 

Mr. GENSLER. I do. 

Chairman REED. Chairman Schapiro, you may begin. 

STATEMENT OF MARY L. SCHAPIRO, CHAIRMAN, SECURITIES 

AND EXCHANGE COMMISSION 

Ms. SCHAPIRO. Thank you very much, Chairman Reed and Chairman Levin. Thank you for the opportunity to testify on behalf of 

the Securities and Exchange Commission concerning the U.S. equity market structure. 

When we discuss market structure, we are talking about everything from the organization of a market to the number and types 

of venues that trade a financial product, and we are talking about 

the rules by which those markets operate. Although these issues 

can be complex and the rules arcane, a stable, fair, and efficient 

structure is the backbone of the equity markets and an important 

engine of our economy. Keeping that backbone strong means responding to the ongoing dramatic changes that are reshaping our 

financial markets. 

A decade ago, most of the volume in stocks was executed manually. Now nearly all orders are executed by fully automated systems, often in less than a thousandth of a second. And as you have 

mentioned, just 5 years ago, the New York Stock Exchange executed about 80 percent of the volume in the U.S. equities it listed. 

Today it executes about a quarter of that volume. The remainder 

is split among 13 public exchanges, more than 30 dark pools, 3 

ECNs, and more than 200 internalizing broker-dealers; and about 

30 percent is executed in venues that do not display their liquidity 

or make it generally available to the public. 

At the SEC, we know that we must keep pace with the changing 

landscape of our securities markets. That is why more than a year 

ago we initiated a thorough review of equity market structure. As 

part of that review, we have received hundreds of public comments, 

some emphasizing the benefit of today’s structure and others raising concerns. 

We have heard how our current market structure fosters competition among trading venues and liquidity providers, lowering 

spreads and brokers’ commissions. We have heard about the benefits of highly interconnected markets and have been cautioned 

about regulatory changes that might have unintended consequences. But on the other hand, we have also heard deep concerns about the quality of price discovery and whether the current 
9 

market structure offers a level playing field on which all investors 

can participate meaningfully and fairly. 

As we consider regulatory responses, the Commission will evaluate these issues with a particular focus on obtaining the appropriate data and analysis to support our next steps. We will ask 

whether the changes we consider will aid capital formation and investor protection, enhance competition and price discovery, and improve inspection, surveillance, and enforcement. 

In this context, the prism through which I will view the role of 

market professionals, whether they are exchanges or ATSs, brokerdealers or high-frequency traders, is whether they compete in ways 

that ultimately benefit investors and are companies seeking to 

raise capital. 

As you know, our market structure review is not a theoretical exercise. Indeed, the events of May 6th, which profoundly impacted 

investors and listed companies, crystallized the importance of this 

effort. May 6th highlighted the need for regulators to be able to reconstruct the events of a given day across millions of trades, billions of shares, and multiple markets. 

Today each exchange has its own unique and often incomplete 

data collection system, complicating efforts to reconstruct trading 

activity that can involve millions of records across dozens of exchanges. 

In response, the Commission has proposed large-trade reporting 

requirements and a consolidated audit trail. This would for the 

first time allow regulators to track trade data across multiple markets, products, and participants simultaneously. We would also be 

able to rapidly reconstruct trading and quickly analyze unusual 

market events. 

Since May 6th, we have taken a series of measures to reduce the 

chances of such an event recurring. For instance, we approved a 

circuit breaker program that limits excessive price volatility in individual stocks. We approved rules designed to bring order and 

transparency to the process of breaking clearly erroneous trades. 

We adopted a new rule to require brokers and dealers to have risk 

controls in place before providing their customers with access to 

the market—a rule that effectively bans naked access. And we approved rules to enhance the quotation standards for market makers, including eliminating stub quotes, which represented a significant proportion of the trades that were broken after May 6th. 

In addition to regulatory responses, we are aligning our examination and enforcement efforts with the current realities of market 

fragmentation and high-frequency trading. We are making fundamental structural changes in the way we approach and conduct examinations of self-regulatory organizations, including focusing on 

how SROs surveil for potentially abusive high-frequency, highquote, or other algorithmic trading strategies. 

At the same time, our Enforcement Division is investigating 

whether various market participants have sought to unlawfully exploit the fragmentation of the markets, manipulate the price and 

volume of securities, or contribute to the market’s volatility at the 

expense of investors. Additionally, we created a specialized market 

abuse unit to conduct investigations and develop expertise in particular high-risk program areas. 
10 

We cannot turn the clock back to the days of trading crowds on 

exchange floors, but we must continue to carefully analyze market 

structure issues to ensure our rules keep pace with the new trading 

realities and to identify ways to improve our markets, provide additional transparency, and increase investor protection. As we move 

ahead, we look forward to working closely with the Congress, and 

I look forward to answering your questions. Thank you. 

Chairman REED. Thank you very much. 

Chairman Gensler. 

STATEMENT OF GARY GENSLER, CHAIRMAN, COMMODITY 

FUTURES TRADING COMMISSION 

Mr. GENSLER. Good afternoon, Chairman Reed, Chairman Levin, 

Members of the two Subcommittees. I thank you for inviting me 

here today. I am also pleased to be testifying along with Chairman 

Schapiro. I think this is our seventh time testifying together, and 

at least our third time since on May 6. 

The CFTC-regulated markets have rapidly transitioned from 

face-to-face. Electronic trading now represents 88 percent of our 

markets. As a father of three daughters, I have learned much 

about the new world of Twitter, social networking, and certainly 

texting. Well, just as we cannot turn back that clock—as a father, 

sometimes I might wish to—we cannot turn back the clock which 

now we have of automated execution, algorithmic market making, 

and high-frequency trading. 

The May 6 events highlighted the cross-market linkages that you 

spoke about between prices and volatility in the securities markets, 

the futures markets, and other derivatives markets, and it is all 

enabled by technology. Price discovery, which may first occur in 

any one of these markets, futures or securities, can then move rapidly over into correlated products in other markets. Where small 

disparities in prices arise, even just for milliseconds, market participants try to profit in what economists call arbitrage between 

these markets. 

The CFTC’s surveillance program works to promote market integrity and protect against fraud, manipulation, and other abuses. 

The CFTC is coordinating closely with the SEC on policy levels, 

specifically trying to coordinate with rulemaking implementation of 

Dodd-Frank, but importantly, we also work very closely on surveillance and data sharing. 

After May 6, as one example, our staffs promptly shared with the 

SEC position data and transaction data with regard to that day’s 

events, and the exchanges and the self-regulatory organizations, 

importantly, conduct front-line market surveillance and also coordinate very closely, not just on May 6, but on many other days, as 

well, and have regular interactions. 

In terms of data, the CFTC does currently receive futures data 

on a daily basis. This is most important for us. We get it the very 

next morning, the open interest and the transaction data. We do 

not regularly get the order book because we do not have the resources, really, to get that. May 6, we asked for it. It was 14 million orders. I have just calculated. It would 476 times more than 

that stack right there for that 1 day in one contract in 1 month, 
11 

and that was part of why it took a while to analyze that data, but 

we did get it and shared it with the SEC where they wanted it. 

We do in our marketplaces, in the futures marketplaces, have 

what we would call pretrade risk management functionality. Let us 

call them safeguards. These safeguards protect against extreme 

movements. They could be price bands, maximum order side, protection against market stop loss orders, and importantly, market 

pauses, sort of time-outs, back to the children’s theme, but a little 

time-out in the market. Exchanges are required to have these, and 

executing brokers also have to have some pretrade risk parameters 

for uses of the clearinghouses for the transactions. Last week, the 

Commission actually put out a proposal that mandates that markets have pretrade risk safeguards such as these but asked the 

public for their views. 

The events of May 6 and the Dodd-Frank Act present new challenges, however, and those new challenges, I just want to highlight 

a couple very quickly. Our new authorities also give us from Congress authorities to work with regard to disruptive trading practices. The Act prohibits three specific things, but we are also asking 

the public and working on other acts, and we put out an Advance 

Notice of Proposed Rulemaking. 

The second thing I would mention is resources, if I might. The 

CFTC’s current funding is less than what we would need to really 

do the surveillance, not only for the events of May 6, but, of course, 

the new Dodd-Frank Act. We currently have about 680 full-time 

staff. We estimate that we will probably need about 400 more staff. 

To put these in dollar terms, our current funding from last year 

was $169 million. The President’s request for 2011 is $261 million. 

We anticipate we will have 300 to 400 new applicants that will arrive on our doorstep next summer. These are swap dealers and 

swap execution facilities and so forth. We have no intention of 

robo-signing these applications. I mean, we are going to thoughtfully look at them as we are supposed to. We will need the resources to do that. 

Thank you. 

Chairman REED. Well, thank you both very much. 

Chairman Gensler, let me thank you, but also, I think you have 

raised a troubling concern, which Chairman Schapiro has also suggested in her testimony. Chairman Schapiro, in your testimony, 

you state, budget permitting—your words—the SEC hopes our enforcement staff with expertise in algorithmic trading strategy, market abuse, quantitative analysis, and many other skills you need. 

According to the numbers in the SEC’s fiscal year 2011 budget 

request, between fiscal years 2005 and 2007, the SEC experienced 

3 years of flat or declining budgets, which in effect with even small 

inflation means declines. The net result was that the SEC lost 10 

percent of its workforce and was severely hampered in key areas, 

such as enforcement and examination. By 2008, I think this became readily apparent to every American with the dysfunction in 

our marketplace. 

Even in the fiscal year 2010 budget levels, if you stay at that, 

your workforce is still below the 2005 level, as I understand it. And 

at the same time, as Chairman Gensler and you both point out, 
12 

with the Dodd-Frank legislation, there is significantly expanded responsibilities which we expect you to carry out. 

So, really, for both of you, to what extent are staff levels hampering your ability to improve and strengthen oversight of current 

high-tech trading, implement the new provisions of the Dodd-Frank 

Act, and then do what you both alluded to, try to keep up with the 

most dynamically and rapidly changing marketplace that we have 

ever had, from 80 percent of trades on the exchanges to a fraction 

of that today? So let me ask both of you to comment, and you can 

begin, Chairman Schapiro. 

Ms. SCHAPIRO. Thank you very much, Chairman Reed. Well, obviously, resources are a significant concern for the agency. As you 

rightly point out, we have had a very volatile history of funding at 

the Securities and Exchange Commission, and while Congress has 

been very generous in the last couple of years and we have been 

able to begin to staff up, we are really just now reaching our 2005 

levels of staffing and technology spending. 

We have been enormously fortunate in the last year to be able 

to attract tremendous help to the agency to supplement our already 

very talented staff, but we are trying to bring in new skill sets, 

people with expertise in algorithmic trading, people from credit rating agencies and trading desks and hedge funds, to try to help us 

have the capability to do the job we have always been charged with 

doing, but also to take on the new responsibilities, as you point out, 

that we have been given under Dodd-Frank. It is absolutely essential that we be able to continue to bring that kind of skill set into 

the agency. 

One of the most important initiatives for us going forward really 

is the consolidated audit trail, and I would love to respond at the 

appropriate time to Chairman Levin’s comments about how long it 

is going to take because we think there is good news on that front. 

But in order to make use of the data that we would receive from 

a consolidated audit trail, even understanding that the exchanges 

will be the primary users of that data, we need people with capacity in data management, quantitative analysis, and the servers and 

system capability to receive something on the order of 20 terabytes 

of data in a month. 

So our needs for both Dodd-Frank and for stepping up and doing 

what I think the American public has a right to believe we are 

doing with respect to the oversight of our highly fragmented marketplace, we need significant resources. 

Chairman REED. Chairman Gensler, go ahead, please. 

Mr. GENSLER. I thank you for that. I do think that our agency, 

on a little bit smaller base, we are going to be asked to take on 

the swaps market, which is approximately $280 trillion, notional 

amount, nearly 20 times the size of our economy, just 

arithmetically. We currently oversee a market that is about $40 

trillion in notional, the futures marketplace. So it is about seven 

times the size. We think we need about 70 percent more people, so 

we are trying to be efficient. 

Part of the efficiency comes from technology. We have asked for $18 million more in this coming year, and that is part of the President’s request for $261 million. That is to deal with data. A lot of 

data will be in data repositories, but we will need to be able to, in 
13 

essence, put a pipeline into that data and to search it, to analyze 

it, and to have automated surveillance. In later testimony, I noted 

that FINRA currently has surveillance tools and alerts on 300 different algorithms. I can assure you, we at the CFTC have a fraction of that right now. We only started the program of building our 

own algorithms in the last 2 years in a serious way. 

Chairman REED. Let me ask you both, and perhaps this might 

be a point if you wanted to comment on the consolidated audit 

trail, but essentially, we are asking two agencies who—and I again 

commend you for your collaboration, both informally and formally—to surveil these markets, to have sort of ongoing insights 

into what is going on. How are you doing that in informal and formal ways? How are you coordinating? I presume, Chairman 

Gensler, you have something comparable to the consolidated audit 

trail that you are trying to roll out. So let me begin with Chairman 

Schapiro, and talk about some of the collaboration as you go forward. You might even want to talk about the time tables that you 

have. 

Ms. SCHAPIRO. Sure. The collaboration really has been superb between the two agencies, and I think May 6 is a great demonstration of how the two staffs work together, understand each other’s 

data, and the interconnections between the marketplace. 

The consolidated audit trail would be designed in the first instance to give us a single consolidated set of data with really all 

the information one could want with respect to the equities markets and the options markets, but it would be our view that, over 

time, it should absolutely include all related financial products so 

that we should include municipal securities, Government securities, and futures that are on equities or equity products so that we 

have a truly comprehensive view of the trading of instruments in 

our economic substitutes for each other. Otherwise, it will not be 

a very effective system. 

The initial estimates of the SEC staff when we proposed the consolidated audit trail were quite extraordinary in terms of the dollar 

cost and the timeframe, about $4 billion all in and as long as three 

to 4 years to implement. We would ask that the SROs actually develop the plan for the consolidated audit trail. The SEC would set 

out the criteria, what has to be real-time reporting and what all 

the data elements are, and are many in order to have the information that we need. 

But as a result of the comment process and our meeting with a 

number of technology firms, we believe that we can dramatically 

reduce the cost and the timetables of implementation because a 

large portion of those costs, well over half, were thought to be necessary to allow broker-dealers to build the reporting systems to get 

the information into the repository. We do not think that that is 

likely to be necessary and that there are, in fact, technologies that 

already exist that can be utilized in this space. So we are hopeful 

that when we come to approving a final rule, the costs and the implementation period will be down significantly, which to my mind 

would mean we could more quickly bring in all the related products 

that we think are necessary for this to truly be a consolidated audit 

trail. 
14 

Chairman REED. And in that regard, Chairman Gensler, you 

both essentially regulate economic equivalence of each other in 

some cases, and you, I presume, have a complementary sort of vision about how you can build something like the consolidated audit 

trail. Could you comment on that? 

Mr. GENSLER. We are fortunate. We have a less fragmented market now. I think in the swaps world, it would become fragmented 

with these execution facilities. By the morning of May 7, but every 

morning, we have the full transaction file from the day before in 

the futures world already in our system and our analysts are able 

to analyze it. Actually, on the evening of May 6, we already knew 

of the single large trader, the 75,000 contract, and we told the SEC 

that evening and some of the other regulators that evening and 

interviewed the executing broker the morning of the 7th. So we ere 

fortunate in that way. 

Our challenges are we do not currently have what is called account ownership and control information. We put out a rule this 

summer and we very much need to do that. We have the data, but 

we do not always have the ownership. 

The second challenge is we do not have the resources to analyze 

the order book every day. We only did that for May 6. But it is 14 

million orders on one contract. Imagine on the whole market. It is 

probably measured in the billions of orders. 

And the third challenge is with the swaps market coming in, how 

we aggregate the data across the swaps and futures market, and, 

of course, aggregate. 

I do believe that we have work to do to institutionalize our cooperative nature. It has been a great working relationship, but we 

will not be there forever and our staffs will change and so I think 

we do have work to do to institutionalize some of this. 

Chairman REED. My last comment. You are collectively working 

on an institutionalization both in terms of technology systems and 

communication systems as well as people. That is going to go on. 

Mr. GENSLER. Yes, in the midst of a lot of rulemaking. 

Chairman REED. Right. Right. Let me recognize the Chairman. 

Chairman LEVIN. Chairman Schapiro, since we are talking about 

your consolidated audit trail and the good news you brought us, 

give us an estimate. Will it be less than half the cost and half the 

time? Is that fair, or is that too optimistic? 

Ms. SCHAPIRO. Almost certainly, any estimate I give you will be 

wrong, but I will tell you that we think that between 50 and 80 

percent of the current cost estimate is associated with the requirement for the broker-dealers to build the reporting systems, and to 

the extent there are existing technologies that would facilitate that, 

it should make a very significant change in the cost level and—— 

Chairman LEVIN. Would that be up to half, do you estimate? 

Could it be as much as half? 

Ms. SCHAPIRO. I would hope so. I honestly do not know. I also 

think it is important to point out that while it is a very large number, $4 billion, these are markets that trade $220 billion worth of 

securities every day. So it is a big number, but there is a lot at 

stake in getting this market structure right. 
15 

Chairman LEVIN. Absolutely. That is why we are pressing it. Do 

you think it could be done in perhaps less than half the previously 

estimated time? 

Ms. SCHAPIRO. Again, I do not know and I do not want to be misleading in any way because I truly do not know, but it would very 

much be my hope. I think this is perhaps for me one of the most 

important things I can try to get accomplished at the SEC. 

Chairman LEVIN. OK. Thank you. In your opening statements, 

you both acknowledged that the market prices in each venue are 

nearly simultaneously affecting each other and that the futures 

and stock prices in America—regulated by each of your Commissions—also affect each other. In my judgment, since these markets 

are so connected, it would seem to me that there is nothing preventing somebody from using one market to manipulate another 

market. 

So let us take a look at Exhibit 2, a chart. I do not know if you 

can see that or not. Turn that around, if you would, so they can 

see it, unless it is in front of them. Let us assume that Joe Trader 

was entering orders that he never intended to have executed in one 

market so that it would move prices to his benefit in another related market. After moving the market price and taking advantage 

of the price movement that he caused, he then cancels his original 

orders, allowing the markets to return to normal. Now, that seems 

to me to be a variation of what Trillium traders did, but this time 

using two markets. 

My question to you is, might that type of trading strategy be a 

manipulation? I am not asking you whether it is. You obviously 

cannot know. But might that kind of strategy I just outlined be manipulative? 

Ms. SCHAPIRO. I think it is entirely possible that it could be. 

Chairman LEVIN. OK. 

Mr. GENSLER. Because our statutory framework relates to intent, 

it would depend on the party’s intent. But it could be if the intent 

was there to manipulate a market. 

Chairman LEVIN. Now, I think you have testified already that 

since people trade in multiple markets, that our regulators need to 

be able to compare the trading data from more than one market 

to see if trading in multiple markets is being improperly used. Can 

your agencies coordinate your automated surveillance efforts to 

spot this type of cross-market price manipulation or anything else 

that might be appropriate? Is that a possibility? 

Ms. SCHAPIRO. I think it is a possibility. With the consolidated 

audit trail—and now again, we have two different agencies with 

different jurisdictions. We would have to ultimately agree to require that the exchanges and the market participants under two 

separate agencies’ jurisdictions agreed to contribute data to the 

same consolidator and to the same audit trail. But I do not know 

of any reason why, if there is a will to do it and there is the technical capacity to do it, why we would not do it, frankly. 

Chairman LEVIN. All right. Mr. Gensler. 

Mr. GENSLER. We already do it. I would say it is more on an ad 

hoc basis or an event-driven basis and an enforcement case-driven 

basis, and we have had some very good collaboration. I think to do 

it and institutionalize it might take some rule changes on both 
16 

sides to have exchanges and self-regulatory organizations on a regular basis from the two jurisdictions sharing information and that 

would be worthwhile to consider. 

Chairman LEVIN. OK. If you would consider that, it would be 

helpful. 

Chairman Schapiro, do you currently have an automated surveillance to detect cross-market manipulations? Do you have that in 

place now? 

Ms. SCHAPIRO. No. We have some tools in place that allow us to, 

upon request from the—we request the exchanges to provide us 

with information and so we can see activity in options markets and 

equity markets, but we do not have routine capability to see across 

to other derivative markets, over-the-counter markets, and we do 

not really have the tools to efficiently utilize the data that we do 

get. 

Chairman LEVIN. Now, is that what you hope the consolidated 

audit trail will help obtain? 

Ms. SCHAPIRO. That, as well as the large trader reporting system, which we believe could be in place even much sooner, that will 

at least give us the capacity to see what larger traders are doing 

in our market. 

Chairman LEVIN. OK. And when do you think that is possible, 

that large trader reporting system? 

Ms. SCHAPIRO. It was proposed earlier this year and it would be 

my hope that we would be able to finalize the rules for both that 

and the consolidated audit trail early in the new year, and then I 

do not know off the top of my head what the implementation timeframes are for large trader. They are measured in months, not in 

years. 

Chairman LEVIN. Now, FINRA has an Order Audit Trail System, 

as I understand it O–A–T–S. Are you familiar with it? 

Ms. SCHAPIRO. That is right, yes. Yes. 

Chairman LEVIN. Is that something which you could use as an 

interim step? 

Ms. SCHAPIRO. I think it is a great question and there are— 

FINRA has the OATS system. The New York Stock Exchange has 

the Order Tracking System. And the options exchanges have an 

audit trail that they use, as well. And I think it is kind of a philosophical question almost. The OATS system gathers data and it 

covers a significant portion of the marketplace. So we could look at 

whether to spend resources and time trying to make it a little bit 

better and a little more robust and broader or we could take those 

resources and time and create a genuinely consolidated audit trail 

system that is very scalable and very capable of capturing all the 

economic substitutes for equities. 

And so I think what we have said in the consolidated audit trail 

proposal is we expect exchanges and FINRA to come to us with a 

plan for how they are going to implement a consolidated audit trail 

that gives us all of the data that we need as regulators and that 

we expect them to use as market surveilors and leave the choice 

of the technology to them. 

Chairman LEVIN. And to kind of summarize your previous point: 

at the moment, at least, you are relying on someone to identify a 

problem for you first and then you can look across markets—— 
17 

Ms. SCHAPIRO. I think that—— 

Chairman LEVIN. At the moment. At the moment. 

Ms. SCHAPIRO. I think that is generally true, either someone 

identifying a problem or our own staff obviously sees market activity and may be concerned about a big spike in volume, for example, 

ahead of a corporate announcement, and then we would utilize a 

tool called the Electronic Blue Sheets to investigate whether the 

people who traded ahead of that corporate announcement might 

have had access to material nonpublic information and violated the 

Federal securities laws. So it is a combination. 

Chairman LEVIN. Let me just raise a question before I have to 

run off. We are talking about trading abuses here and I want to 

talk about a trading abuse that involves credit default swaps. Now, 

they were not subject, those swaps, to regulation before DoddFrank came along and that includes credit default swaps that bet 

against mortgage-backed securities, which are the bets that made 

a major contribution to the financial crisis. 

Now we have got Dodd-Frank, which requires your agency to 

monitor those types of swaps for a variety of uses, and I want to 

give you a description of something that my Subcommittee uncovered during our investigation of the financial crisis. I think you or 

your staff has seen some of these documents, which we were able 

to get to you yesterday, which we uncovered during our investigation of the financial crisis. I want to get your thoughts as to how 

either of your agencies could monitor swaps electronically to detect 

a type of market squeeze. 

From late 2006 to early spring of 2007, major financial investors 

had begun betting against subprime-related CDOs by purchasing 

credit default swaps, or CDSs. Soon, the price rose and no one in 

the market was willing to offer any more CDS protection against 

a fall in the value of subprime-related CDOs. Goldman Sachs wanted to continue to buy CDSs, but none were available at a reasonable price, so it changed the situation. Goldman’s asset-backed securities desk, their ABS desk, decided it would offer CDS protection 

at a lower and lower price in order to drive down the market price 

and induce current CDS holders to sell off their holdings. And 

when the sell-off was large enough and the price got low enough, 

Goldman planned to move in and purchase the CDSs for itself at 

artificially low prices. 

Now, that short-squeeze strategy was described in a number of 

exhibits, including Exhibit 3A, which I will start with. It is a selfevaluation which was done by one of the Goldman traders on the 

ABS desk who participated in that activity, and we will include 

that in the hearing record at this time, a self-evaluation report by 

a Mr. Salem, S-a-l-e-m. 

On page 15 of that Exhibit 3A, at the bottom of the first paragraph, this is what he wrote. ‘‘In May, while we remained as negative as ever on the fundamentals and subprime, the market was 

trading very short,’’ in caps, ‘‘and susceptible to a squeeze. We 

began to encourage this squeeze with plans of getting very short 

again and after the short squeeze caused capitulation of these 

shorts. This strategy seemed doable and brilliant, but once the negative fundamental news kept coming in at a tremendous rate, we 
18 

stopped waiting for the shorts to capitulate and instead just reinitiated shorts ourselves immediately.’’ 

Now, in an interview with us, the trader who wrote this self-evaluation denied that the ABS desk ever intended to squeeze the market. He claimed that he had wrongly worded his own evaluation report, and that his account is consistent with other Goldman documents. 

In May 2007, for example, Michael Swenson, the manager of the 

ABS desk who oversaw the traders’ efforts, wrote e-mails in which 

he encouraged the attempt to squeeze the market, and we will include these e-mails, Exhibits 3B and 3C, in the record at this time. 

In the first e-mail, dated May 25, Mr. Swenson wrote, ‘‘We 

should be offering a single-name protection down on the offer side 

to the street on tier one stuff to cause maximum pain.’’ And then 

on May 29, he followed up with another e-mail. ‘‘We should start 

killing the single-name shorts in the street. Let’s pick some highquality stuff that guys are hoping is wider today and offer protection tight. This will have people totally demoralized.’’ 

Now, when interviewed, Mr. Swenson also denied there was an 

effort by Goldman to squeeze the shorts. He said the purpose behind Goldman’s effort was to restore balance to a market that had 

gone too far to one side, leading to an artificially high cost for CDS 

protection, but he could not explain why he used the terms he did, 

‘‘cause maximum pain’’ and ‘‘this will have people totally demoralized’’ to describe an effort to restore balance to the market. 

Other e-mails suggest that the attempted short squeeze by Goldman negatively impacted its own clients. For several weeks, as 

Goldman tried to drive down the price of CDS protection, it required some of its clients to make collateral payments to Goldman 

on CDS protection that they had bought at a higher price. In some 

e-mails, clients asked Goldman how they could owe more collateral 

to Goldman when the clients had shorted the mortgage market, 

which was declining in value. 

In the end, short sellers did not offer to sell their shorts at the 

lower price. Instead, most went even shorter and Goldman abandoned its efforts to squeeze the market. Even after Goldman abandoned the effort, some investors were harmed by the lower prices. 

Now, this is my question. Chairman Gensler first. You are familiar with short squeezes in the commodities markets. Would this 

type of attempted short squeeze in the mortgage-backed securities 

market trouble you, number one, either as a conflict of interest or 

as manipulation on the part of Goldman. Mr. Gensler. 

Mr. GENSLER. Are you sure you did not want Chairman Schapiro 

to go first? 

[Laughter.] 

Mr. GENSLER. No, in more seriousness, I am not familiar enough 

with the facts, and the first time I have seen the document is, of 

course, now. But in our markets, in the futures markets, manipulation relates to intent and to distort a price. There is a four-factor 

test about price manipulation. The Dodd-Frank bill actually, fortunately, I think, broadens that, and we have a proposed rule out on 

fraud-based manipulation, and also Congress has given us additional authorities on disruptive trading practices, all that we will 
19 

be publishing rules on and get public comment on that are very 

helpful. 

In the current statutory framework on what is called price manipulation, you need to have an intent to, in essence, distort a 

price, and the price has to have been distorted, and those would be 

sort of the factors that would have to be applied to this situation 

or other situations. 

Chairman LEVIN. Alright, Chairman Schapiro, let me ask you a 

question. Does the SEC have the capacity to monitor MBS markets 

for this type of activity? Is the capacity there to monitor? 

Ms. SCHAPIRO. It is not there now. 

Chairman LEVIN. Would it be helpful for you to have it? 

Ms. SCHAPIRO. I think so, and I do think that we will have better 

capacity generally with respect to the asset-backed securities markets going forward based on rule proposals we did last spring, but 

also authorities under Dodd-Frank. But it would be, obviously, 

helpful. That is troubling language that you read to us. 

Chairman LEVIN. Thank you both very, very much, and I am 

going to run and vote. 

Chairman REED. Well, we again apologize for the tag-team actions caused by the votes, but one point I want to raise, and it goes 

to sort of the conceptual issue. The presumption, I think, from most 

people—not perhaps the most sophisticated traders in the world, 

but people who own a few stocks—is that the value of stocks, the 

liquidity associated with the stocks is directly a function of their 

economic value. The same thing with debt instruments, the same 

thing with derivatives, that there is a real economic value here. 

And one of the issues that we have to deal with is with the proliferation of these algorithmic high-frequency trades. Some of these 

algorithms do not take into account the fundamentals of the instrument, the economic value, the dividends, or the status of the municipality issuing them. They are simply saying if enough of these 

are sold, then we start selling. And then if we start selling, another 

algorithm kicks in. 

To the extent we get further away from the economic values 

here, does that not only cause concern but is that—you know, is 

that something that is good for the economy? It may be a naive 

question, but I will pose it. 

Ms. SCHAPIRO. I do not think it is a naive question at all. I actually think it is sort of the fundamental question that we are really 

grappling with: What is the role of traders versus investors? And 

what kind of trading really provides liquidity to the marketplace 

that enables investors to get in and out of positions successfully? 

When we meet with public companies—and I always ask this 

question of them, and I always ask this question of retail brokerdealers: How are the markets working for you, for what you need 

to do, as a public company, in raising capital; what your customers, 

as a retail broker-dealer, are looking for in the marketplace? And 

there is a lot of concern about whether the price discovery mechanism is efficient or whether we have the development of two-tiered 

markets that is hindering effective price discovery, whether the 

playing field is level so that long-term investors are going to be 

buyers and holders of securities, have an equal opportunity to get 

the best price in the marketplace, as traders do, whether issues 
20 

like speed and colocation and access to proprietary data feeds, 

skews the ability of others to effectively participate in the marketplace. And I do not know the answers to all those questions, but 

they are very much questions that are on the minds of the retail 

public and on the minds of public companies—for whom these capital markets are their lifeblood. Their capacity and their capability 

is in these markets to expand and grow and create jobs. 

So I think these are exactly the kinds of questions that we are 

trying to explore through our Concept Release. When we ask about 

what is the quality of the marketplace and what is the quality of 

our market structure and what are the best metrics to measure 

that in addition to looking at detailed questions about the role of 

algorithms and high-frequency traders and as well as dark pools of 

liquidity. 

Chairman REED. Before I turn to Chairman Gensler, one of our 

roles is to amplify these questions in the broader context and in the 

public debate and also to see if we can drive effective answers, and 

they might change over time. So I appreciate what you are doing, 

I know what you are doing, but your efforts—and please, ask us 

how we can be helpful—to find real answers to this that are questions that are to be posed, as you point out very adroitly, not only 

by the investor on the street but large institutional investors, large 

corporations, et cetera, go really to the nature of a functioning market versus a highly lucrative trading venue. And they can be two 

different things. 

Ms. SCHAPIRO. I think you made an excellent point. In the comment process that followed the Concept Release and a roundtable 

that we also held back in June to look at market structure issues, 

one commenter supplied a survey that they had done of a number 

of investors across a range, and not just investors but also trading 

firms and others, and even large institutional investors in that survey, only about half of them said they felt like the market structure 

was fundamentally working for institutional investors’ interests at 

this point. 

Chairman REED. Thank you. 

Chairman Gensler, your comments from your perspective? 

Mr. GENSLER. I think that markets have to have the confidence 

of the public, not just the investing public but as Chair Schapiro 

said, the capital formation and the markets, we oversee those that 

hedge, whether it is a farmer or a rancher in our core groups or 

a modern financial company hedging a risk. 

I think that markets for decades have included hedgers, investors, and speculators, and have even included the interdealer trader. In the old days, it was somebody in the pits of a Chicago futures 

exchange or on the floor of the New York Stock Exchange. Today 

in the modern Twitter and high-frequency world, it is somebody 

with a computer who is maybe collocated and so forth. 

I think the core that we have to make sure is that these markets—that everybody has sort of an equal access to these markets, 

that they are very transparent. That is at the core of the new 

Dodd-Frank bill for the swaps market, but that they are transparent and somebody does not have some information advantages, 

and that we do effectively police them against fraud manipulation. 

Whether what Chairman Levin laid out is manipulation I could not 
21 

speak to, but we have to police against those manipulations and 

have the tools to do that. 

Chairman REED. I think I have asked this question in different 

words, but succinctly, so much of this is cross-market activity, and 

you alluded to it, Chairman Gensler, and you, Chairman Schapiro, 

in your comments. The obvious thing is that arbitrage is something 

that is attractive because if you can catch two markets in a quick 

match, that is usually a profitable exchange. 

Again, anything that you want to add with respect to the steps 

you are taking to ensure that cross-market activities, someone who 

is trading a future to affect the price of an equity so that they can 

either short or go long on the equity, what are you doing? And 

then, Chairman Schapiro, what are you doing, or what do you both 

think you are doing? 

Mr. GENSLER. Well, candidly, most of what we are doing is within the jurisdiction that we are in, and so there is cross-market 

arbitrages within the futures market, the options on futures, and 

then most recently the swaps markets. So we are going to try to 

work to make sure that we really do have the data set within these 

markets and can aggregate and do surveillance across those markets, because they can even be in one futures contract between the 

months—that is called a basis trade or a spread trade. I do think 

we need to do more to institutionalize across the markets as well. 

But it is within our jurisdiction and then across our jurisdiction. 

Chairman REED. Chairman Schapiro. 

Ms. SCHAPIRO. Yes, I would really agree with that. I think our 

problem is we have so many markets and we have so many venues 

where trades are executed that just getting it to a point where we 

have consolidated data about the equity markets would be an enormous step forward. But it would be my hope that we would ultimately have a consolidated audit trail and the capability to surveil 

across related instruments. 

Chairman REED. In your Concept Release in January of 2010, 

Chairman Schapiro, you said, ‘‘Regulation has not kept pace with 

the rapid evolution of the securities markets.’’ I would assume you 

would both agree with that. I certainly agree with it. 

But there is another, I think, again, perhaps naive but I think 

a profound question. There is a window to catch up, and if you cannot catch up, are we always going to—is this something that will 

get beyond our capacity to regulate, frankly? And I think it goes 

back to the issues we have talked about in terms of resources, in 

terms of personnel, in terms of technology systems, et cetera. But, 

you know, this is not your father’s market or your grandfather’s 

market where it moves at something close to the pace—I hesitate 

to use the Congress as a model, but at a pace much slower than 

what is happening now. And I must say that one of my fears is 

that this is a critical moment to not only get up to speed and so 

that we are regulating on a near real-time basis or an effective 

basis, but if we miss this moment, the gap will widen so significantly that regulation will be simply—it will not be effective. It will 

be there, but it will not be effective. And the second part of this 

is just this proliferation of markets where you do not even have a 

perspective into it. Comment on those two major points, and then 

I will conclude. 
22 

Ms. SCHAPIRO. Sure. There are two things that I think are critical. One is the need for regulators to be, as you said, up to speed 

for the purposes of policing the market, to understand the activity 

that is happening, where there are abusive practices going on. Our 

enforcement program is looking into about 12 different kinds of 

trading strategies that we think have the potential to be problematic. So we have to have the capacity to do all that with the audit 

trail and with the human and technical resources at the SROs as 

well as at the SEC. 

But I think we also have to look at whether there are regulatory 

changes that are necessary in our marketplace in order to create 

a stronger infrastructure. We have talked about the things that we 

have done already with respect to—relatively simple things like 

single-stock circuit breakers, eliminating stub quotes, prohibiting 

naked access to the markets. But we also have a menu of ideas— 

and at this point they are really just ideas—for other steps that we 

might be able to take at the SEC that would strengthen that backbone of the market structure, including requiring broker-dealers to 

have procedures that prevent algorithms from behaving destructively in the marketplace, something we saw, obviously, on May 

6th. Whether there should be obligations on market makers to either support the markets or at least not to trade in ways that detracts from the quality of the marketplace, looking again at the 

quality of exchange data feeds and whether the public data feed is 

sufficiently robust in comparison to the one they sell for a lot more 

money in their proprietary context, we need to assess the fee structures within the exchanges, the maker-taker fee and so forth. And 

we are talking now very actively about migrating the single-stock 

circuit breaker to a limit up/limit down model which would much 

more closely actually mimic the futures model. 

So I think there are lots of things for us to do that will be incrementally important but important to try to solidify this market 

structure in addition to trying to do a better job with surveillance 

and viewing across all markets the activity that we see. 

Chairman REED. Chairman Gensler. 

Mr. GENSLER. I was going to say that maybe—the glass is halffull. I am an optimist, and we have certain tools. We leverage off 

of the exchanges. We leverage off of the self-regulatory organizations and also the big market participants, the dealers mostly, 

what we call futures commission merchants in our world. And we 

leverage by certain tools. We publish rules. We hopefully update 

them. They are never quite up-to-date, but, you know, we update 

them on a regular basis. We use enforcement actions as well. 

Sometimes there is signaling to the markets when there is a particularly bad actor or manipulation and so forth. I think these 

pretrade risk safeguards are absolutely critical. That is why we last 

week published a rule that included that the exchanges themselves—they have had them in a voluntary way, and the futures 

market has been very fortunate to have very robust pretrade risk 

management, but now we require some of this pretrade risk management. So I think we have to always leverage off the market participants and the self-regulatory organizations, use rules, enforcement mechanisms, and as I say, risk safeguards. 
23 

The last thing we use is transparency. I am a big believer that 

transparency helps economic activity, but it also helps in a sense 

the regulators, because, frankly, you get more people bringing information to you, too. 

Chairman REED. Well, thank you very much for your testimony 

and for your great effort at both the Securities and Exchange Commission and the CFTC. Thank you very much, and I am sure we 

will meet again. Thank you. 

Mr. GENSLER. Thank you. 

Chairman REED. The second panel can come forward. 

Let me introduce now the second panel, and then I am awaiting 

Senator Levin’s return. The second vote has been called. He will 

vote, return, then I will depart. But in the meantime, I can introduce the panel. He is not here. I will also swear the panel in, and 

then we can begin the testimony. 

Our first witness is Dr. James Angel, Associate Professor of Finance at Georgetown University’s McDonough School of Business. 

Professor Angel specializes in the structure and regulation of financial markets around the world. His current research focuses on 

short selling and regulation. Dr. Angel currently serves on the 

Board of Directors of the Direct Edge Stock Exchange. 

Our next witness is Thomas Peterffy. Mr. Peterffy is Chairman 

and CEO of the Interactive Brokers Group, a global market-making 

and brokerage firm with nearly $5 billion in equity capital. Its 

trading subsidiary is a registered broker-dealer and futures commission merchant that provides high-speed, technology-driven 

trade to individual clients, hedge funds, institutional investors, and 

others. Another subsidiary was one of the world’s first electronic 

market-making firms and is a registered market maker and liquidity provider in all major U.S. futures and securities markets. 

Our third witness is Manoj Narang, the CEO of Tradeworx. During the 1990s, he held a variety of technology research and trading 

positions at several major Wall Street firms, gaining experience in 

a multitude of markets, including equities, foreign exchange futures, and fixed income. In 1999, he left Wall Street to found 

Tradeworx Inc. with the mission of democratizing the role of advanced technology in the financial markets. 

Our fourth witness is Mr. Kevin Cronin, global head of equity 

trading at Invesco Ltd. He is responsible for Invesco’s trading desk 

in Atlanta, Hong Kong, Houston, London, Melbourne, Taipei, 

Tokyo, and Toronto. Mr. Cronin joined Invesco in 1997 as the head 

of listed equity trading for Invesco AIM and later became director 

of equity trading. Mr. Cronin is currently the chairman of the Investment Company Institute’s Equity Markets Advisory Committee, a recently appointed member of the NASDAQ Quality of 

Markets Committee, and a member of the National Association of 

Investment Professionals and the Securities Traders Association. 

Thank you, Mr. Cronin. 

Our final witness is Steve Luparello, vice chairman of the Financial Industry Regulatory Authority, or FINRA, the largest nongovernmental regulator for all securities firms doing business with 

the United States public. In this capacity, Mr. Luparello oversees 

FINRA’s regulatory operations, including enforcement, market regulation, member regulation, and business solutions. 
24 

And now pursuant to Rule VI of the Rules of Procedure of the 

Senate Permanent Subcommittee on Investigations, would you gentlemen please stand and raise your right hands? Do you swear that 

the testimony you will give before this Subcommittee will be the 

truth, the whole truth, and nothing but the truth, so help you God? 

Mr. ANGEL. I do. 

Mr. PETERFFY. I do. 

Mr. NARANG. I do. 

Mr. CRONIN. I do. 

Mr. LUPARELLO. I do. 

Chairman REED. Thank you very much, gentlemen. 

Dr. Angel, your testimony, please. 

STATEMENT OF JAMES J. ANGEL, ASSOCIATE PROFESSOR OF 

FINANCE, MCDONOUGH SCHOOL OF BUSINESS, GEORGETOWN UNIVERSITY 

Mr. ANGEL. Thank you. It is an honor to be here. I would like 

to thank you for the invitation. As you mentioned in the introduction, I study the nuts-and-bolts details of how financial markets operate around the world. And I am also the guy who warned the 

SEC in writing five times in the year before the Flash Crash that 

our markets are vulnerable to these kind of events, and I would 

like to say that the Flash Crash can happen again, and here is 

why. 

First, our market is a very complex network. It consists not only 

of equity exchanges and futures exchanges and options exchanges, 

but of all the broker-dealers, fixed commission merchants, IT vendors, analytics providers, media entities, and investors. It is a very 

rich and complex ecosystem, and a disruption anywhere in that 

network can feed throughout the network. 

Now, most of the time, this market network works pretty well— 

except when it does not—but, by most measurable dimensions in 

market quality, our market works far better, faster, and cheaper 

than it did 5, 10, 20 years ago. However, like any finite system, 

like any human system, our market has finite capacity. It can only 

handle so much trading activity before it chokes. And from time to 

time, our market is overwhelmed by massive quantities of trading 

activity that cause the market to choke. 

Now, this is not a new phenomenon. If you look in the history 

of financial markets, you will see that going back in time this has 

happened over and over again. In 1906, the New York Times had 

a headline that blared—let me get the words right here—‘‘Stocks 

Break and then Recover.’’ We saw it in 1929, we saw it in 1962, 

we saw it in 1987. We see these waves of activity that overwhelm 

the market mechanism. So what we need are safeguards for this 

market network that are integrated across the entire market network. And what we need is we need somebody to be able to call 

a timeout when the market network is going crazy, and we do not 

really have that right now. 

Now, some people grumble about market fragmentation. I think 

we need to worry less about the fragmentation of the market than 

we do about the fragmentation of regulation. We have literally 

hundreds of different financial regulators at the Federal and State 

levels, and, you know, they do not always play nicely with each 
25 

other. A lot of stuff has fallen through the cracks, as we saw in the 

meltdown of 2008, and there is also a lot of duplication. And most 

of these regulators have a pretty narrow mandate. And, here in 

Washington, we have the SEC in one granite fortress on F Street, 

the CFTC in another granite fortress a couple miles away in Lafayette Center. Both of them are hundreds of miles away from the financial markets they try to regulate. That lack of physical proximity makes it really hard to actually regulate the markets because 

it makes it much harder to figure out what is going on. 

How long it took the regulators to figure out what was going on 

in the Flash Crash is a direct result of the fragmentation of regulation and having regulators hundreds of miles away from the markets they are trying to regulate. So our regulators need better market intelligence, and they need better funding as well. 

We have spent approximately $18 billion on the SEC since its 

founding in 1934. That is less than half of what investors lost from 

Bernie Madoff alone. So I think we have been really penny-wise 

and pound-foolish in the way we have funded our regulators. 

Now, what can we do about this? First of all, I understand that 

there are political forces that make it really hard to consolidate 

agencies. But one thing we can do is we can deal with this fragmentation of regulation by putting all the financial regulatory 

agencies in one building. Instead of having them miles apart, which 

makes any kind of interaction difficult, stick them in the same 

building. 

Second of all, let us stick this building in the heart of our financial district in New York. That will make it much easier for our 

regulators to find out what is going on, and it will make it easier 

for them to attract the kind of people with market experience they 

need to understand what is going on in the markets. 

Finally, as we pay attention to market structure, we need to 

think about how the markets are working for all companies, large 

as well as small. And I think we need to pay attention to the fact 

that the number of public U.S. companies has fallen by almost 50 

percent in the last 15 years. The number of public companies is 

shrinking steadily, and if we run out of public companies, we run 

out of jobs. In 1997, before the dot-com bubble got out of hand, 

there were 8,200 U.S. public companies listed on our exchanges; at 

the end of 2009, approximately 4,400. 

Now, if you figure half of the missing 4,000 companies were dotcoms that should not be there or companies that were merged, 

well, that leaves 2,000 missing public companies. If each of them 

were responsible for 1,000 jobs, that is 2 million jobs lost to our 

public markets. That would make a big dent in our unemployment 

rate of 15 million. 

There are a lot of reasons for that, and I just want to say I think 

you should hold further hearings on the reasons why we are losing 

our public capital markets. 

Thank you. 

Chairman REED. Thank you very much, Dr. Angel. 

Just for everyone’s understanding, your statements will be made 

part of the record, so if you want to summarize, feel free to do that. 

Thank you, Professor. 

Now Mr. Peterffy, please. 
26 

STATEMENT OF THOMAS PETERFFY, CHAIRMAN AND CHIEF 

EXECUTIVE OFFICER, INTERACTIVE BROKERS GROUP 

Mr. PETERFFY. Thank you for inviting me. I am Chairman of 

Interactive Brokers Group, a brokerage and market-making firm 

that is headquartered in Connecticut. Our customers have about 

$21 billion of assets with us, so we are very focused on the health 

of the U.S. markets. 

Here is my worst nightmare. Imagine a high-frequency trading firm, or HFT, with a few computers, some programmers, and $30 

to $50 million in capital. These operations exist all over the world 

trading with sponsored access, where an often undercapitalized 

U.S. broker allows the HFT to send orders directly to the exchange 

using the broker’s membership ID. These orders are never seen by 

the broker before they are executed. 

One day, at 3:45 p.m., the HFT starts sending waves of orders 

to sell large cap stocks and ETFs. As the close nears, more sellers 

jump in and stop orders are triggered. The market closes down 30 

percent. The next morning, terrified investors and brokers holding 

undermargined accounts run for the exits and sell into cascading 

circuit breakers. Brokers fall like dominoes, but the HFT that 

started it all makes a huge profit, covering its short at fire-sale 

prices and moving its gains offshore before the regulators know 

who did it. 

In the alternate scenario, the market realizes that it was duped. 

No news is seen causing the prior day’s drop, and the market 

moves up 40 percent the next morning. The HFT’s short sales are 

big losers, and the sponsoring broker and clearing broker go bust, 

possibly starting a chain reaction. Under either scenario, innocent 

investors will be caught by the huge down move or up move, and 

confidence in our markets will suffer further. 

This is not far-fetched. We have nothing in place to prevent this 

from happening. It could happen on any day. It could be a manipulator seeking profits or a disgruntled employee at the hedge fund 

or HFT or a brokerage firm. It could be a terrorist act or a simple 

computer bug. 

What can be done? I have four recommendations to review briefly 

that are explained in detail in my written testimony. These recommendations apply to the securities and futures markets because 

these markets are inextricably linked, and it is critical for the rules 

and surveillance tools of the two markets to be coordinated with 

close coordination between regulators. 

First, sponsored access. Rather than in July of next year, the 

SEC’s new rules banning sponsored access should apply right away 

by emergency order of the Commission. Seven months is much too 

long to continue at risk. We screen or pat down over a million people every day to prevent a plane crash, yet we do not screen electronic orders to prevent the market crash. The ability to send orders to the exchanges should be restricted to brokers that are members of the clearinghouse. Brokers with no financial stake in the 

clearinghouse should not be sending unfiltered orders directly to 

exchanges any more than the HFT should. 

Second, surveillance tools. Regulators need real-time surveillance, especially the identity of the person behind each trade. The 

SEC should approve its proposed audit trail rules, but shorten the 
27 

2-year implementation deadline. And until then, the Commission 

should order that clearing brokers record the identity of the person 

associated with each trade, starting now. The CFTC should approve similar rules at the two agencies as they must work together. 

Third, improving liquidity of the exchanges. We must improve liquidity by banning or restricting off-exchange trading of exchangelisted securities. It is bizarre that under Dodd-Frank over-thecounter equity derivatives must trade on exchanges, yet exchangelisted securities can still trade over the counter. When exchangelisted products are traded on OTC, market makers leave and liquidity on the exchanges dries up, allowing crashes like May 6th 

to happen. We must address this by bringing trading in listed securities back to the exchanges. 

Fourth, and last, circuit breakers. The current circuit breakers 

are in effect only from 9:45 a.m. to 3:35 p.m., but they should be 

in effect at all times when the market is open. Also, the circuit 

breakers should kick in fixed price intervals instead of being moving targets so that everyone can precalculate what prices are allowed and not allowed. This would eliminate the single-stock mini 

crashes that seem to occur almost every week and that you were 

referring to some time ago. 

There should also be a marketwide circuit breaker that would 

not allow transactions to take place outside a certain limit for the 

day, but would allow continued trading inside those limits. 

Finally, the circuit breaker level must be coordinated among the 

stock and related derivative markets so as not to cause price misalignments that could result in temporary insolvencies. 

Thank you. 

Chairman LEVIN. Thank you very much. 

Mr. Narang, is that how you say your name? 

Mr. NARANG. That works. 

Chairman LEVIN. Thank you very much. 

Mr. Narang. 

STATEMENT OF MANOJ NARANG, CHIEF EXECUTIVE OFFICER, 

TRADEWORX, INC. 

Mr. NARANG. My name is Manoj Narang and I am the CEO of 

Tradeworx, Inc. We are a financial technology firm that provides 

high-performance trading infrastructure to investors and trading 

firms. In addition to supporting outside clients with our technology, 

we operate a proprietary trading practice which utilizes the same 

technology to engage in high-frequency trading strategies. Our proprietary trading business consists of highly complex and data-intensive algorithms based on correlations between securities that 

span multiple markets, including stocks, options, and futures. 

Before I begin, I would like to express my gratitude for the opportunity to share my perspectives and insights in today’s hearing 

and to recognize that smaller firms such as Tradeworx are not 

often afforded such a privilege. 

My prepared remarks are on the topic of restoring investor confidence to our markets. It is self-evidence that markets depend on 

confidence in order to function smoothly, and there is no denying 

that the confidence of investors was severely shaken on May 6. It 

is this loss of confidence that transformed the Flash Crash from 
28 

just the most recent chapter of the ongoing credit crisis into the 

referendum on market structure that it has become. 

Ever since May 6, investors have been plagued by the nagging 

suspicion that the regulatory agencies are powerless to understand 

the inner workings of the market or to meaningfully assess the 

practices of its most active participants. For the past 2 years, the 

public has been treated to endless debate about market structure 

issues. Are the prices posted by market makers fair or are they 

subject to widespread manipulation? What impact do rebates or 

elevated cancellation rates have on liquidity? Why is speed important to strategies which provide liquidity? How do the equities, options, and futures markets influence and interact with each other? 

The public should not be forced to accept anecdotal or speculative 

answers to such questions when definitive answers can be found by 

analyzing data. Firms like Tradeworx have the infrastructure to 

easily calculate objective answers to these kinds of questions, and 

while we happily share our insights with the SEC, what is needed 

to boost markets’ confidence is for the markets’ chief regulator to 

have these capabilities on its own. 

Another key issue related to investor confidence is that the market has become too complicated for ordinary investors to understand. That is one of the things that leads to speculation and unsubstantiated hypotheses. Our stock market sports the most complex and fragmented structure known to mankind. The cornerstone 

of this system, Regulation NMS, was 10 years in the making and 

it spans over 520 pages. For perspective, consider that in competitive games like chess, extraordinary complexity arises from just a 

handful of rules. It should surprise nobody that an undertaking of 

this magnitude might backfire, nor should it surprise anyone that 

such unnecessary complexity might fuel the perception among investors that the system is somehow rigged against them. 

Regulation NMS does many things, but at its core, its objective 

is to keep prices at the different exchanges synchronized. In most 

markets, this is accomplished via arbitrage, which tends to be incredibly efficient in this role. For example, consider the relationship between the stock SPY and the IVV S&P futures contract, 

both of which track the S&P 500 index. Because they are completely different securities that trade on different markets, their 

prices are not protected by Regulation NMS. But if you sample 

their prices at subsecond intervals, you will find that they have a 

99.9 percent correlation to each other. I have diagramed that correlation in the exhibit. You can see on the exhibit just how stable 

this relationship is, despite the existence of any regulation to cause 

that correlation to be that high. 

But apparently a 99 percent correlation was not good enough to 

dissuade policy makers from the incredibly daunting task of 

crafting rules to keep prices in sync. Unfortunately, the price for 

complex rules that solve imaginary problems is rather high. Rather 

than minimizing fragmentation, which was the stated goal, Regulation NMS has directly exacerbated it by guaranteeing that new exchanges will have orders routed to them. Rather than limiting the 

role of arbitrage, the regulation has diverted its focus from productive uses to the exploitation of the regulation itself. And to top it 

off, the rule has managed to ignite a massive technology arms race 
29 

by making the speed of information transmission a more critical 

issue than it ever was before. 

Now that a heightened appetite for more rulemaking clearly exists, I feel that we are doomed to repeat our past mistakes. Once 

again, proposals abound to solve nonexistent problems. It is easy 

to conjure up gimmicks such as speed limits on order cancellations, 

but it is also trivially easy to demonstrate how they would backfire 

and harm long-term investors. When lawyers with minimal trading 

expertise devise such rules, they should recognize that world-class 

engineers with profit motive will be there to exploit them. History 

makes abundantly clear who tends to win this battle of wits. 

Many market professionals have strong opinions on how to fix 

market structure, but to win back the confidence of investors, the 

SEC should engage in rulemaking that is supported by empirical 

evidence and analysis rather than by opinions and speculation. 

Furthermore, adding ambitious or superfluous regulations to a system which is already hopelessly complex is guaranteed to backfire 

by inviting unintended consequences. Such rulemaking will not restore investor confidence in our markets. Fixing the very real flaws 

in our existing regulations will. 

I hope to have the opportunity to elaborate on these topics at today’s hearing and I ask that the entirety of my written remarks 

be included in the record. 

Chairman LEVIN. They will be. Thank you very much, Mr. 

Narang. 

Mr. Cronin. 

STATEMENT OF KEVIN CRONIN, GLOBAL HEAD OF EQUITY 

TRADING, INVESCO LIMITED 

Mr. CRONIN. Thank you, Chairmen Reed and Levin, Ranking 

Members Bunning and Coburn, and Members of the Subcommittees for the opportunity to speak here today. I am pleased to participate on behalf of Invesco at this hearing examining efficiency, 

stability, and integrity of the U.S. capital markets. Invesco is a 

leading independent global asset management firm with operations 

in 20 countries and assets under management of approximately 

$620 billion. 

In the interest of time, I will keep my comments brief, but I have 

submitted for the record a more detailed statement. 

An efficient and effective capital formation process is essential to 

the growth and vitality of the U.S. economy. The most important 

aspect of the capital formation process is that it attracts long-term 

investors’ capital. To accomplish that, it is critically important that 

the primary and secondary capital markets which facilitate the 

capital formation process are transparent, effective, and fair. To 

that end, it is essential that sensible, consistent rules and regulations are in place to govern the markets and that regulators have 

the tools necessary to ensure the stability and integrity of those 

markets. Long-term investor confidence is the key to robust securities markets. 

To be clear, investors both retail and institutional are better off 

now than they were just a few years ago. Competition in today’s 

market, which was virtually absent 5 years ago, has spurred innovation and enhanced investor access. Trading costs, certainly in the 
30 

most liquid securities, has been reduced and investors have more 

choice and control in how they execute their orders. 

With that said, over the past several years, long-term investor 

confidence has been challenged by a series of scandals, financial 

crises, economic tumult, including most recently the Flash Crash of 

May 6. In order to recover long-term investor confidence, regulators 

must ensure that securities markets are highly competitive and efficient as well as transparent, and above all else, fair. 

While we laud the gains made in the last years, today’s market 

structure is far from perfect. The events of May 6 brought to the 

forefront several inefficiencies in the current market structure and 

highlighted the interdependencies of equity, options, and futures 

markets. Perhaps most significantly, the events of May 6 underscored the absence of an effective mechanism to dampen volatility 

at the single stock level. The lack of consistency and synchronization of rules which govern trading at the various exchanges, the 

outsize impact trading algorithms and small market orders can 

have on the prices of securities in times of duress, and perhaps not 

surprisingly, the fact that market-making mechanisms in place 

today provide virtually no liquidity to investors in times of market 

stress. 

Ruling all instability and volatility from the equity markets is 

neither possible nor appropriate. However, establishing mechanisms to address extreme price moves in the markets and volatility 

related to inefficient market structure will be critical in promoting 

investor confidence in markets going forward. Many of these issues 

have been addressed or are in the process of being addressed by 

the regulators. That said, the potential for another May 6 will not 

entirely be removed from these actions alone. The SEC, CFTC, and 

SROs must be coordinated, diligent, and measured in their efforts 

to create sensible regulation designed to minimize the inefficiencies 

in market structure and advance surveillance and enforcement capabilities to thwart nefarious behavior. 

There are today at least 13 for-profit exchanges. Competition between exchanges is fierce, resulting in new innovations and different ways for investors to seek and provide liquidity. This is a 

welcome development from our perspective, provided that the rules 

and regulations which govern the various exchanges are consistent 

and not incongruent with the goals of fairness and equal access for 

investors. 

One potential concern we have about exchange competition is 

that it has ignited an electronic arms race where speed appears to 

be the singular objective. While Invesco believes that speed is an 

important variable to consider in execution of trades, we believe 

price is the most important variable. Buying stocks at the right 

price, which is determined through a robust price discovery process, is what long-term investing is all about. There is a point where 

speed and robust price discovery diverge, a concept that must be 

understood by exchanges as they race to trade in increments of 

one-billionth of a second. 

There are today also 40 different trading venues, including dark 

pools, and over 200 broker-dealers who internalize customer orders. 

This vast network of exchanges and venues has resulted in a very 
31 

complicated web of conflicted order routing and execution practices 

by broker-dealer and execution venues. 

We believe that investors need improved information about order 

routing and execution processes to make better informed decisions. 

Today, as much as 50 to 60 percent of the trading activity in the 

U.S. equity markets is attributed to high-frequency traders, HFT. 

Given the recent ascendence of HFT, there is not a lot known about 

their practices and very little regulatory oversight. 

Invesco believes that there are many beneficial high-frequency 

trading strategies and participants which provide valuable liquidity 

and efficiencies to the market. On the other hand, we are concerned that some strategies could be considered as improper or manipulative activity. Some of these strategies, such as the so-called 

‘‘order anticipation’’ or ‘‘momentum ignition’’ strategies, provide no 

real liquidity to the markets or utility in any way. Rather, they 

prey on institutional retail orders, creating an unnecessary tax to 

investors. While there has been a recent case brought by regulators 

against this kind of improper activity, we are concerned that the 

ability of regulators to monitor and detect nefarious behavior by 

these participants is not where it needs to be. 

Additionally, regulators must address the increasing number of 

order cancellations in the securities markets. It has been theorized 

that as many as 95 percent of all orders entered by high-frequency 

traders are subsequently canceled. Order cancellations relating to 

making markets is one thing, but orders sent to the market with 

no intention of being traded is quite another—before they are canceled is quite another. These orders tax the markets’ technological 

infrastructure and under the right circumstances could overwhelm 

the systems’ capacities to process orders, causing massive system 

failures and trading disruption. 

Invesco believes that efficient trading markets require many different types of investors and participants to thrive. That said, it is 

noteworthy that where the interests of long-term investors and 

short-term trading professionals diverge, the SEC has repeatedly 

emphasized its duty to uphold the interest of long-term investors. 

We need to ensure that there are no abusive practices within highfrequency trading or, for that matter, any other participant in the 

marketplace which contravene the interest of long-term investors. 

I thank you for the opportunity to speak here today and I look 

forward to answering your questions. 

Chairman REED. Thank you very much, Mr. Cronin. 

Mr. Luparello, please. 

STATEMENT OF STEVE LUPARELLO, VICE CHAIRMAN, 

FINANCIAL INDUSTRY REGULATORY AUTHORITY 

Mr. LUPARELLO. Chairman Reed, Chairman Levin, thank you for 

the opportunity to testify today. My name is Steve Luparello and 

I serve as Vice Chairman of the Financial Industry Regulatory Authority. Also known as FINRA, we are the primary independent 

regulator for securities brokerage firms doing business in the 

United States. In addition to our work overseeing firms and brokers, FINRA performs market regulation under contract for a number of market centers in the United States. Through this work, 

FINRA is responsible for aggregating and regulating approximately 
32 

80 percent of U.S. equity trading. FINRA’s activities are overseen 

by the SEC, which approves all FINRA rules and has oversight authority over FINRA operations. 

Over the last several years, how and where trading occurs has 

evolved rapidly, as has execution speed, particularly with equity 

trading. High-frequency trading, dark pools, and direct access are 

now commonplace and have contributed to the fragmented markets 

that exist today. Fragmentation and increased competition have resulted in narrow quotation spreads and a high level of liquidity 

when markets are operating smoothly. However, it can also result 

in the fast electronic removal of liquidity when markets are 

stressed, as we all observed on May 6. 

The events of that day identified several areas where regulators 

could take steps to reduce the impact of extreme market volatility 

and provide increased transparency and predictability in restoring 

order to the markets following such events. FINRA has participated in these discussions with the U.S. exchanges, under the leadership and direction of the SEC, to establish and implement a 

number of important changes, as described in my written statement. 

While the disruption on May 6 focused attention on high-frequency and algorithmic trading, FINRA had already been scrutinizing trading activity to find attempts to use these technologies to 

implement manipulative strategies. In September, we fined a New 

York brokerage firm, Trillium Brokerage Services, and suspended 

and fined several individuals at the firm for the use of illicit highfrequency trading strategy. Trillium entered numerous layered, 

non-bona fide market moving orders to generate selling and buying 

interest in specific stocks. By creating a false appearance of buy or 

sell-side pressure, this strategy induced other market participants 

to enter orders to execute against Trillium limit orders. As a result 

of this improper strategy, Trillium’s traders obtained advantageous 

prices that otherwise would not have been available to them. 

FINRA is able to pursue instances of this and other illegal trading strategies in the markets we regulate. However, due to the limitation of current audit trails, the risk of missing instances of manipulation, wash sales, abusive short selling, and other improper 

gaming strategies is still unacceptably large. 

With the drop in exchange barriers to entry along with increased 

competition and connectivity among exchanges and other execution 

venues, it is clear that market quality can no longer be ensured by 

a single exchange acting in a siloed fashion. As the SEC correctly 

recognized in its recent proposal, this evolution of equity markets 

has created an environment where a consolidated audit trail is now 

essential to ensuring proper surveillance of and investor confidence 

in these markets. 

FINRA strongly supports the establishment of a consolidated 

audit trail as a critical step to enhance regulators’ ability to conduct surveillance of trading activity across multiple markets. In 

fact, it is very plausible that certain market participants, knowing 

the extent of current regulatory fragmentation, now consciously 

spread their trading activity across several markets in an effort to 

exploit this fragmentation and avoid detection. 
33 

Based on our experience developing and operating the Order 

Audit Trail System, or OATS, FINRA believes the key aspects necessary to ensuring an effective, comprehensive, and efficient consolidated audit trail are uniform data, reliable data, and timely access to that data by the SROs and the SEC. We also believe that 

the most effective, efficient, and timely way to achieve the goals of 

the consolidated audit trail is to expand existing systems, such as 

OATS, and to consolidate exchange data with discrete new data, 

such as large trader information, into a central repository. Building 

off existing systems would significantly reduce both the cost and 

time required for implementation of a fully consolidated audit trail 

and integration of that audit trail into surveillance systems. 

Significant changes in the financial markets in recent years have 

necessitated adaptation by regulators across a wide spectrum of 

issues. Both technological and policy developments have made the 

practice of regulating the markets a more complex task. 

The SEC has correctly identified one of the most pressing challenges for regulators conducting market surveillance. We are all 

hampered by the lack of a comprehensive, sufficiently granular, 

and robust consolidated audit trail across the equities markets. 

FINRA stands ready to work with Congress, the Commission, and 

our fellow SROs to help bring about a consolidated and enhanced 

audit trail that will facilitate more effective surveillance for the 

protection of investors and for market integrity. 

Again, thank you for the opportunity to share our views. I would 

be happy to answer any questions that you have. 

Chairman REED. Thank you very much, gentlemen, for your testimony. 

I just want to recognize Senator Coons has joined us. As soon as 

I conclude and Senator Levin concludes, we will recognize him for 

questions. 

I have questions for all the panelists, but let me first focus on 

the market participants, Mr. Peterffy, Narang, and Cronin. My presumption is that you would feel that the regulators do not have all 

the information they need at this time. From your perspective, 

what forms of information, market intelligence, et cetera, should 

they have? And you have listened to both Chairman Schapiro and 

Chairman Gensler about what they are doing in terms of a consolidated audit trail. Your comments on whether that is adequate, sufficient, or additions. Mr. Peterffy. 

Mr. PETERFFY. I agree that they do not have all the surveillance 

tools that they need. However, I do not think that we should wait 

for the two or three or 4 years to get this consolidated audit trail 

for $4 billion. I think that as of tomorrow, they could order U.S. 

registered brokers to keep an audit trail of their own orders, and 

most of all, to record the name of the beneficial interest associated 

with each order. Then if anything happens in the market, they 

would just go ask the broker, via the exchange, who did this trade? 

Please send order details tomorrow. It does not cost anything to do 

that. It can be done today. 

Chairman REED. Thank you. 

Mr. PETERFFY. Thank you. 

Chairman REED. Mr. Narang, your comments? 
34 

Mr. NARANG. So in terms of what data, I think, the regulatory 

bodies could benefit from, I think, absolutely, I support the acquisition of data that helps the regulators engaged in forensic analysis 

of various types, such as the audit trail, such as the large trader 

reporting requirement, and I say that as somebody who would certainly be affected by at least one of those. 

So that said, I think that there are some lesser known items that 

could be rather useful, as well. Many people have pointed to the 

analogy that I think one of you, in fact, said earlier, that the regulators are akin to a moped on a highway dominated by hundred 

mile-an-hour race cars. The way I would rephrase that in terms of 

data requirements is that the regulators very much need to be able 

to see the markets in the same way that its most active participants see it. 

So what that means is that they need not just direct data from 

the exchanges rather than the consolidated view that they see right 

now via the so-called SIP, or the Standard Information Processor. 

Those are consolidated feeds. The regulators need the direct data 

from the exchanges, but they need better than that. They need to 

be able to synchronize that data in the same way that a high-frequency trader, for instance, would. And that means that they cannot just rely on the time stamps that the exchanges put on their 

data in order to synchronize them. They need to collect that data 

over high-speed telecommunications networks themselves and selftime stamp it. 

Then, furthermore, both Ms. Schapiro and Mr. Gensler noted the 

fact that they do not have the ability to efficiently build order 

books from that quotation data. I think that that is something that 

is a prerequisite if you are going to have the capability to police 

modern traders. You know, technologies are out there—firms like 

ours possess them, for instance—that allow you to very, very efficiently construct order books from quotation data. 

Now, the data itself is just the starting point. One of the things 

that makes me nervous is that the SEC barley has the ability, as 

far as I can understand, to analyze the data that it already possesses. So adding a hundred to a thousand times more information 

to that mix is not going to really help matters if their analytical 

capabilities are not augmented at the same time. And the main 

thing that the analytical capabilities are missing, as was rightfully 

alluded to earlier, is the ability to analyze securities based on their 

correlation. 

A tremendous amount—I would say the majority—of the volume 

that occurs in today’s markets is premised upon the fact that securities, both within the same markets and across markets, have 

semi-stable correlations to each other, so that when price discovery 

happens in one instrument, it must propagate to other instruments 

that are correlated to it, and regulators currently have no clue how 

that works and have no tools to analyze those effects. Those effects 

are now structural issues and I think that the regulators need to 

have analytical tools that endow them with those capabilities. 

Chairman REED. Thank you. 

Mr. Cronin, your comments, please, and then I will recognize 

Chairman Levin. 
35 

Mr. CRONIN. Yes, sir. I would quickly add that I agree that having the information from a regulatory standpoint is helpful. I do 

tend to agree that being able to analyze the data is fundamental. 

The other point that is important is that the regulators have to be 

able to coordinate the information. It seems to me that having the 

data, even having the ability to analyze, in the absence of pulling 

all the pieces together is not going to get us where we need to be. 

This will be an effective deterrent to the extent that it is in place, 

but as Mr. Peterffy says, I do not agree that we have the kind of 

time that it sounds like it is going to take. I am not sure we have 

the financial appetite, either, but this is something that needs to 

happen. 

Chairman REED. Thank you. There will be a second round. Let 

me recognize Chairman Levin. 

Chairman LEVIN. Thank you, Senator Reed. 

Mr. Peterffy, you described your worst nightmare, and I think 

every member of the panel heard that description of your nightmare. I am wondering whether or not the other members believe, 

as you do, that the nightmare is plausible. 

Mr. ANGEL. It definitely could happen, that our market is very 

complex and there are all kinds of things which can go wrong and 

Murphy’s Law will strike. There will come a time when on a day 

of heavy trading volume, whether because of some malevolent action, some benign action, or some programming error, something is 

going to go haywire. This is the nature of complex electronic systems. And just like sometimes our computers crash, our computerized stock network will, as well, and we need to have good safeguards in place to protect us the next time it happens. 

Chairman LEVIN. This was not so much a crash based on some 

glitch; this was an intentional effort on the part of somebody who 

had as little as $30 to $50 million and a few computers and a couple programmers. In any event, you would agree that that nightmare scenario is plausible? 

Mr. ANGEL. Yes. 

Chairman LEVIN. Mr. Narang, would you say that you believe it 

is plausible? 

Mr. NARANG. No. I believe it is extraordinarily implausible, and 

I will explain why. I think there is no doubt that a larger trader 

could impact the market, but the attribution of that nightmare scenario to a high-frequency trader that controls only $30 to $50 million in capital is utterly preposterous on its face. You can do the 

math. 

You can statistically estimate, as we have done, and we have 

shared our findings with the SEC that, for instance, the trade by 

Waddell and Reed on May 6, the $4.1 billion trade, very likely had 

a price impact of around 2.7 to 2.9 percent, OK, with a reasonable 

degree of confidence. If you extrapolate from that what a $30 million to $50 million capitalized firm could have done on that same 

day at that same time, you come up with about three basis points, 

or three-hundredths of a percent of impact. So it is entirely implausible. A firm like that would exhaust its entire capital base before 

the market would even notice the movement. 

Chairman LEVIN. OK. Mr. Cronin, do you believe a scenario like 

that is plausible? 
36 

Mr. CRONIN. Plausible, yes. Three hundred shares took it from 

$52 to $100,000. 

Chairman LEVIN. OK. Mr. Luparello. 

Mr. LUPARELLO. I will fall somewhere between my fellow panelists. I would say it is implausible, but it is not impossible. I think 

there are structures in place around risk controls in terms of the 

firms that provide access to the marketplace. It is not a comforting 

thing just to rely on risk controls of broker-dealers. I think the 

steps that the SEC has taken in the adoption of its rule around 

controlling access will go a great way to making that scenario even 

more implausible and nearly impossible. 

Chairman LEVIN. OK. Now, Mr. Peterffy, do you want to comment on Mr. Narang’s comment? 

Mr. PETERFFY. Yes. You see, with naked access, you do not need 

to have any capital to send in orders. You send in the orders. The 

orders are not even seen by the broker. You only need the money 

the next day, when the clearing broker gets these trades and he 

says, where is the money? Well, in this scenario, there is a lot of 

money there because there are imbedded profits as the trader sells 

them down. But even if there is no money there, it is too late the 

next day to discover that all this should not have happened. That 

is why naked access is a problem and that is why these trades 

should be screened. Now—— 

Chairman LEVIN. Let me go through your remedies. 

Mr. PETERFFY. Yes. 

Chairman LEVIN. I am over my time—— 

Senator COONS. You are fine. 

Chairman LEVIN. Well, this may take a few minutes, so I am 

happy to come back to it. 

I would like to go through the remedies, because whether it is 

plausible, implausible but possible, or at least that much, there are 

a number of remedies for this that Mr. Peterffy has suggested. One 

of them is that the ability to submit orders to exchanges should be 

restricted to brokers that are clearing members. That is one of the 

suggestions that you make. I am wondering if anybody wants to 

comment on that, and also on the other suggestion that relates to 

this, that brokers who are not members of the clearinghouse are 

allowed to send orders directly to an exchange with the permission 

or the arrangement of a clearing member broker. They give their 

permission. All these 5,000 brokers that are not members of the 

clearinghouse can send orders directly, and you would prohibit 

that. 

Mr. PETERFFY. Yes. 

Chairman LEVIN. OK. So there are two suggestions there. Now, 

let me start with you, Professor Angel. What do you think of those 

ideas? 

Mr. ANGEL. There are a lot of subtleties involved with the proposal to ban anyone but clearing members from putting orders directly into the exchange. Given the economies of scale in clearing, 

there has been quite a consolidation in the business, so what that 

would do would be limit direct access only to the very largest Wall 

Street firms. Do we really want to encourage that kind of consolidation in the industry? So that is one thing to think about. 
37 

Also, I could see a clearing member actually providing naked access, and I support the SEC’s proposals to get rid of so-called naked 

access, where a broker is providing a direct pipe without screening 

the orders first. I think that is the most important thing here, that 

we have to have the right risk controls in place so that the people 

who are responsible for the trades know what they are sending into 

the markets. 

Chairman LEVIN. Even if they are doing it through a clearing 

broker, not being a clearing broker themselves? 

Mr. ANGEL. Right. There has to be—you need to have the risk 

controls in place. 

Chairman LEVIN. OK. So, Mr. Narang, your comment on that 

suggestion. 

Mr. NARANG. Yes. I would like to comment on that suggestion 

and I would also like to comment on Mr. Peterffy’s refutation of my 

refutation. So—— 

Chairman LEVIN. You know what that is going to produce, 

though. 

Mr. NARANG. What is that? 

Chairman LEVIN. You know what the next production will be of 

that: a refutation of your refutation. 

Mr. NARANG. Correct. 

Chairman LEVIN. Happily, my time will be up perhaps before 

that happens. 

[Laughter.] 

Mr. NARANG. So first of all, I fail to see the need for additional 

remedies. I think that Mr. Peterffy’s scenario, by his own admission, was based on a situation where naked access or sponsored access are in place. We are already at the stage where a ban on sponsored access has been posted to the Federal Register and is due to 

go into effect within 7 months. 

Chairman LEVIN. Would you make that effective immediately? 

Mr. NARANG. No, I cannot say that I fully—— 

Chairman LEVIN. Based on an emergency argument that Mr. 

Peterffy suggested? 

Mr. NARANG. I cannot say that I fully endorse the ban on sponsored access. I can see some of the rationale behind it, but I think 

that there are some little-known issues that are peripheral to that 

that are anticompetitive but I think are perhaps above the scope 

of this hearing. 

As for the refutation—— 

Chairman LEVIN. Nothing is above the scope of this hearing. 

[Laughter.] 

Mr. NARANG. If you want to keep us for a few hours longer, I am 

happy to comment on it. 

As far as the comment about the capital not needing to be there 

and risk checks not being applied, that is a little bit misleading because all that naked access means is that risk checks are not done 

on a pretrade basis. They are still absolutely done on a posttrade 

basis and there is not much latency between the time a trade occurs and the time—— 

Chairman LEVIN. That was the ‘‘next morning’’ comment. 
38 

Mr. NARANG. No, it is not—no. By posttrade, it does not mean 

next morning. Posttrade means as soon as the trade happens, your 

buying power is reduced, OK. 

Chairman LEVIN. Do you agree with that? 

Mr. NARANG. Brokerage firms monitor your day trade buying 

power. 

Mr. PETERFFY. No, I do not. The fact is that there are many little 

brokers who provide naked access. There is nobody policing whether they do any screening of orders or not. So some of them, I assume, do posttrade screening. Many of them probably do not. 

Chairman LEVIN. OK. I interrupted you, Mr. Narang. 

Mr. NARANG. I do not know of any who do not. I think that is 

a rather hypothetical statement. The point is that posttrade risk 

checks are nearly universal and adequately prevent people from exceeding their buying power. 

Chairman LEVIN. OK. Very quickly, Mr. Cronin, because I am 

way over my time. 

Mr. CRONIN. I am just amused, listening to the whole thing. Like 

all long-term investors, we get hung up in listening to some of this 

discussion and kind of scratch our heads and say, you know what, 

guys? When we are talking about naked access and that kind of 

thing, we are kind of losing sight of what the goal of the structure 

and the integrity of markets is. There have to be rules in place to 

prevent nefarious activity. If we think there is a chance that shutting the door today can contain that, I think we should shut the 

door today and move on. There are more important things for the 

world to worry about than the naked and unfiltered access. 

Chairman LEVIN. Thank you. Mr. Luparello. 

Mr. LUPARELLO. I would have to say Mr. Peterffy’s scenario is 

based on an assumption that a clearing firm is not managing 

intraday risk. So the idea that only clearing firms should be allowed to trade in that context would be, I think, an odd solution. 

I do not want to say that every clearing firm is perfect at managing 

intraday risk, but their economic livelihood is staked on it. Again, 

I would go back to the recent rulemaking by the Commission which 

puts some real teeth in what that monitoring means, but as a general matter, clearing firms monitor intraday risk because it is what 

keeps them open day after day. 

Chairman LEVIN. And would you make that rule immediately effective? 

Mr. LUPARELLO. I would not. I would assume that there is a fair 

amount of disruption that would go with that, and in the rare scenario that a clearing firm was mismanaging its intraday risk, to 

have that much dislocation in that short a period of time, I would 

worry that the costs would outweigh the benefits. 

Chairman LEVIN. Thank you. 

Chairman REED. Thank you, Chairman Levin. 

We have been joined by Senator Coons, who is the worthy successor to Senator Ted Kaufman, who was one of the, I think, 

great—I think the right word would be ‘‘and persistent’’ analysts 

of the whole issue of high-frequency trading’s impact on markets, 

and thank you, Senator Coons, for joining us. 

Chairman LEVIN. And made a major contribution—— 

Chairman REED. A major contribution. 
39 

Chairman LEVIN. ——to the bill. I know Senator Kaufman was 

right in the middle of that famous outbreak, also for the Permanent Subcommittee, an extraordinary contributor to our efforts. 

And we know that you are right in that capability, as well. 

Senator COONS. Well, thank you, Senator Reed, and, Chairman 

Levin, I hope to be Senator Kaufman’s successor in interest both 

in subject matter interest and interest in terms of representing 

both the people of Delaware and our country. Senator Kaufman did 

a great deal of work, I think, to ensure the stability, the transparency, the fairness, and liquidity of our markets following one of 

the greatest market dislocations we have known. I will report back 

to him that I had the opportunity to hear one of the first cases of 

refutation arbitrage that I think I have ever seen in testimony. 

And I just wanted to focus on a sort of simple question, I think. 

Markets’ fundamental role in our economy, in my view, is capital 

formation and serving and protecting long-term investors, and that 

is sort of part of the purpose of the transparency, fairness, and stability. So my question first to you, Mr. Cronin, if I might, to what 

degree are you concerned that the markets are no longer serving 

those functions and that high-frequency trading is detracting from 

price discovery in a way that undermines those core goals of our 

markets? 

Mr. CRONIN. As I said, Senator, the overall function of the market is much better for investors today than it was, say, 5 years ago. 

Competition has been enhanced. Our ability to have more control 

over our orders has clearly been enhanced. And we have seen a reduction in transaction costs. 

Now, I will say that that has not been a universal experience. 

Transaction cost reduction clearly in the top 200 names, I think, 

given the ubiquitous liquidity that is available now is clear. When 

we move down the market cap curve, it is not as clear that this 

market structure is serving the smaller companies in the formation 

process as well as it could otherwise. So I am confident that the 

market structure is better today. It can always be better. It will always probably be the case that it could be better. 

To the extent that high-frequency trading has entered the market, frankly, we are fairly agnostic. To the extent that the activity 

has liquidity and does not cause undue dislocation on a given day 

or week, we are OK. But the problem is that we do not believe that 

the regulators have the appropriate tools to really understand all 

the things that go on. We are pretty smart, and we understand a 

lot that goes on, and I am sure that there are areas that we cannot 

possibly understand today. So what does concern me is I think 

there are nefarious activities and participants who are out there 

who today are taking advantage of investors. That is wrong. If you 

bring nothing to the party in terms of liquidity or, you know, efficiencies, you shouldn’t tax investors. There is no purpose for that. 

So we have some concerns about high frequency, but we would 

have concerns about any participant who is trying to manipulate 

the market. So we would not single them out necessarily. 

Senator COONS. So then just two follow-up questions, and I 

might ask the members of the panel in my time left to comment 

on both of these. Some propose there is an IPO crisis that in part 

is a consequence or an outcome of these short-term strategies. 
40 

What linkage do you see between all the dynamics of market fragmentation and the difficulties identified here, particularly in the 

market sectors that maybe you do not participate in but others? 

And what is the impact of that on innovation and capital formation 

for IPOs? 

Then just the follow-on question, should high-frequency traders 

who act like market makers be subject to additional regulations 

that would help solve that specific problem? If you would, please, 

Professor. 

Mr. ANGEL. Thank you, Senator. I am very glad you are cognizant of the IPO crisis because I think it has serious implications 

for the long-term growth and stability of our economy. I do not 

think that high-frequency trading as such is at the root of it. There 

are many other things in our economy ranging from SarbanesOxley 404, the litigation environment, and other market structure 

changes that we can talk about if you have a few more hours. 

The thing about high-frequency trading is that there is both good 

and bad computerized trading. All investors these days are using 

computers basically to do what they used to do manually. And a 

lot of this is good for the market. For example, a lot of so-called 

high-frequency traders follow the old strategy of buy on the dip, 

sell on the rebound. That helps to stabilize prices. And one of the 

things that happened on May 6th was when the data feeds got 

scrambled and those people said we cannot trust our data feeds, 

those people who were stabilizing the market stepped aside and 

other traders kept on going, causing the market mechanism to fail. 

So some high-frequency traders are really good. Others help keep 

prices in line with each other. If Coke gets out of line with Pepsi, 

they step in to make sure that those prices stay in sort of the same 

correlated path. So a lot of what they do is good. I will not say everything they do is good. But we cannot just say, ‘‘Ew, high-frequency trading is bad.’’ You know, there are some strategies that 

may be harmful to the market, but the bulk of them are actually 

doing things that help the market. 

However, I do think we need to pay attention to the smaller cap 

side of the market because what we have done is we have collapsed 

transaction costs. We have a one-size-fits-all market mentality at 

the SEC, and I am convinced that smaller companies actually need 

a different market mechanism and that having a market mechanism with a very small bid-ask spread for those companies is not 

necessarily the best market mechanism. And I think we really need 

to pay a lot of attention to how small companies come to market 

and how hospitable the market is to them, because that is where 

our future growth lies and that is where we have a serious crisis 

on our hands. 

Senator COONS. Thank you. I am over time, so if any other members of the panel who want to comment could keep it just on that 

one question, I would appreciate it. 

Chairman REED. Yes, but take your time, Senator. 

Mr. PETERFFY. High-frequency traders are not by themselves 

good or bad. When they provide liquidity, they are good; when they 

take liquidity, they are not so good. I think this would be very simple to regulate; namely, when a high-frequency trader provides liquidity, it puts in a bid or an offer that does not take up any other 
41 

bid or offer. Then that is a useful activity and, therefore, they 

should be encouraged to do so. They could even be incentivized to 

become market makers because that is what market makers do. 

And when they are taking liquidity, which is basically a way of 

probably front-running statistical relationships that will come back 

in line, then they should—their order should be slowed by—I suggested a tenth of a second. 

Mr. NARANG. I would like to comment on your question earlier 

about the capital formation process and more generally about the 

social utility of high-frequency trading, because many people have 

raised that issue. 

I would like to point out that when an investor buys shares of 

a company in the open market, the proceeds of that purchase go 

to the seller. They do not go to the company that the stock is written on. No capital is raised for the firm in question when an investor purchases share of that security. In other words, no capital formation happens in the secondary market. The capital formation is 

the job of the primary market. 

The role of the secondary market is exclusively to encourage investors to participate in the primary market by providing them 

with liquidity. So when you are planning the desirable attributes 

for a secondary market to have, I firmly believe that there are few, 

if any, attributes that can trump liquidity. That is the overriding 

social purpose of a secondary market. It is to support the capitalraising function that occurs in the primary market. 

So to the extent that you believe that high-frequency trading is 

a fixture of our markets in terms of liquidity provision, then you 

would have to argue that it serves just as much, if not more of a 

social value than investing in company shares than the secondary 

market does. 

Second of all, on the notion of obligations, my major concern 

there is that obligations really put us on a slippery slope toward 

the two-tier market that we had in the 1990s. I think our goal or 

your goal as policy makers ought to be to keep the good features 

of the market that have occurred as the markets have evolved and, 

you know, address or ameliorate the bad ones. In terms of the bad 

features, we are talking about mostly unbridled fragmentation. 

In terms of the good features, I do not think that anyone disputes the fact that markets have gotten more liquid and that 

spreads have gotten tighter and transaction costs have gone down, 

and virtually no one disputes the notion that that has happened 

because the market-making function has been opened up to competition. The two-tiered system that we had was dismantled. Going 

back to that system would be counterproductive. 

Furthermore, I cannot think of any empirical evidence that market maker obligations actually matter in practice. Take the example of May 6th. On May 6th, there was a corner of our industry 

known as the wholesaling industry which executes the bulk of all 

retail order flow. Virtually every firm in that industry shut down 

for business during the Flash Crash and dumped its shares onto 

the market. That is the one corner of our industry that does have 

obligations. So it shows you how effective obligations are. 

And in 1987, during the great crash in October, Black Monday, 

market makers took a lot of heat for many, many months in the 
42 

press after that event for, quote-unquote, putting their hands down 

and refusing to take orders. 

So the point is that even if you are obligated 99.9 percent of the 

time to provide liquidity, the 0.1 percent of the time where you will 

choose not to is precisely at those moments where the market 

needs it most. So obligations, there is no empirical evidence that 

such a thing will work. There is empirical evidence that people who 

request obligations will also request certain privileges that go along 

with them. 

Senator COONS. Well put. Thank you. 

Mr. CRONIN. Well, that is a question with a lot of different dimensions. I think that I will try to condense my thoughts to this: 

There is always confusion of volume and liquidity in the market. 

There is without a doubt much more liquidity in the top 200 names 

than there has been certainly historically. But I am not sure that 

another 100 million shares trading in Citigroup qualifies as real liquidity in the marketplace. In fact, I do not think it qualifies at 

all. 

So I do think, again, if we were to look at the market in terms 

of all of the different components of the market, there is clearly the 

top part which has been functioning and served us very well by the 

current structure. It is very much less clear in terms of transaction 

costs—and believe me, we have done the analysis—that the market 

structure currently is serving the other parts of the market very 

well. 

So I think if there were value in market making—and I think 

historically market making has been an important part of the efficient market structure—then it is certainly worthy of consideration. I get that nobody wants to catch falling knives. No question 

about it. We have seen it time and again. However, we are putting 

in place circuit breakers; we are putting in place some other things 

that I think could be helpful in those calamitous events that make 

the provision of liquidity, albeit probably on the small end, at least 

at some level more orderly and fair than it has been historically, 

and maybe there is some value in that going forward. 

Senator COONS. Thank you. 

Mr. Luparello. 

Mr. LUPARELLO. It was multipart and there have been multipart 

responses, so I will just ally myself with the last bit that Mr. 

Cronin said. I do think there is a place for mandatory liquidity in 

the marketplace. I think Mr. Narang is right that that mandatory 

liquidity has not stepped in the way of moving trains, but Kevin 

is also correct that those trains with certain circuit breakers can 

only move so far. 

So as policy makers continue to analyze the place of high-frequency traders in the marketplace and analyze that tradeoff of in 

theory liquidity and volatility, I think one of the aspects that has 

to be looked at in there is: How productive is that liquidity? And 

how can you put some mandatory obligations back on certain participants in the marketplace? 

Senator COONS. Great. Thank you. Thank you very much to the 

panel. 

Thank you, Mr. Chairman. 

Chairman REED. Thank you, Senator. 
43 

Let me just start the second round briefly, and then I will turn 

it over to Chairman Levin to conclude the hearing. 

It strikes me that one of the, I think, consistent themes of all the 

panel has been that high-frequency trading has provided some efficiencies in the marketplace, has utility to the marketplace, et 

cetera. But there are high-frequency trading strategies that are 

dangerous and disruptive and harmful to investors. 

And the other point, I think, that emerges is that at this juncture the regulators do not have the ability to understand, even 

with all the data, these different strategies, and that their focus 

should be on, let us say, the unfortunate strategies or the perverse 

strategies, whatever the terminology. Mr. Narang and Mr. Cronin, 

quickly, is that a fair summary of where you think we are? 

Mr. NARANG. First of all, let me say that I certainly agree that 

there exist high-frequency strategies that perhaps have less social 

utility than others. I do not now of any high-frequency strategies 

that are in use or that could even be hypothetically conceived of 

that are destabilizing to the market system in some way. And the 

reason I say that is simply a recognition of the fact that virtually 

every high-frequency trading firm that is out there controls very, 

very little capital. The largest high-frequency trading firms in the 

world would not even be medium-sized hedge funds in terms of the 

capital they control. 

So the point is it takes capital to move markets. Markets move 

because of buying pressure or selling pressure. The buying pressure or selling pressure in any fixed unit of time that is sufficiently 

long is roughly equal for a high-frequency trading firm. That is 

what makes them have high frequency. The high frequency refers 

to their holding period. So if your holding period is only 1 minute, 

what that means is that in a minute on average you buy and sell 

the same number of shares. You cannot have a protracted or permanent effect on a stock’s price when you do that. 

So that virtually rules out the possibility of destabilization, barring some hitherto unknown accidental bug that occurs. But I 

think your question focused more on intentionality, so from an 

intentionality perspective, I would say that, yes, high-frequency 

strategies, like any other strategies, run the gamut in terms of 

what value they provide. But I do not know that markets should 

be policed based on some sort of subjective assessment about how 

much value a participant is adding to the market. I think that all 

that should happen is that rules should be obeyed, that, you know, 

make sure there is a level playing field, and that the markets are 

fair. 

What I will tell you is that even though I am a high-frequency 

trader, there are definitely unfair aspects of the market structure 

today that favor certain participants over others. 

Chairman REED. Well, thank you. First of all, I think you have 

illustrated there are at least two issues at play here: stability of 

the markets and fairness of the markets. 

Mr. NARANG. Yes. 

Chairman REED. The markets could be very stable but very unfair to participants, some participants, and grossly overcompensating on this, but I think it is an important point. 
44 

But, Mr. Cronin and Mr. Peterffy, just your quick comments, and 

then I want to—— 

Mr. CRONIN. So I would submit there is one other dimension 

other than buy and sell, and that is quote. 

Chairman REED. Right. 

Mr. CRONIN. Why are there participants allegedly quoting one 

stock 4,000 times in a second? What is the intention there? So I 

do believe that there is activity that goes on that is trying to get 

institutional or retail orders to react without, in fact, taking the 

risk of taking an offering or hitting a bid. I think that is out there, 

and it certainly needs to be looked at. 

Chairman REED. Mr. Peterffy, please. Quickly. 

Mr. PETERFFY. The risk of systemic disaster caused by disruptive 

trades is very real. There is no justification for continuing naked 

access. We should stop it now. It costs nothing to stop it. Only irresponsible, undercapitalized brokers support naked access, and 

there is no justification for continuing it. 

Chairman REED. Thank you. 

Mr. PETERFFY. If I may just say, I have never heard of Mr. 

Narang before, and as far as I know, his reputation is impeccable. 

[Laughter.] 

Chairman REED. Well, thank you very much. 

Mr. NARANG. I second that thought. 

Chairman REED. One of the interesting things about this hearing 

is it has raised more questions than it has answered, and that is 

a good hearing in my book, because this is a very extraordinarily 

complicated topic, and you have all shed so much light on it. 

There is one other issue here, and that is, Mr. Narang made the 

point that, you know, primary markets form capital. Professor 

Angel made the point that the primary market, the IPOs, seem to 

be diminishing, the public companies are diminishing, et cetera. So 

is there a contradiction between this very successful, if you will, 

secondary market, highly liquid, et cetera, but the fact that it is not 

generating the kind of capital formation that puts people to work, 

i.e., the classic, which always—I did not understand and I probably 

still do not, the real economy versus the financial economy? And we 

talk about high-frequency trading and naked access, you know, 

that is the financial. The real economy is: Do I have a job? Do I 

have capital to expand my business, et cetera? 

So if you can just comment briefly on that, Professor Angel. 

Mr. ANGEL. Sure. We have—I call it the best of times and the 

worst of times, just like in Charles Dickens. For the most liquid 

stocks, the big stocks, it really is the best of times. By almost any 

measurable dimension of market quality, the market for Microsoft, 

IBM, and Citigroup is very liquid, very cheap, very fast. It works 

really well. But when you get into the smaller stocks, you have liquidity drying up. I mean, it is better than it was 10 years ago, 

but still a lot of smaller companies just say, hey, it is not worth 

it to access the capital markets, whether because it is the high cost 

of being a public company with all the compliance requirements or 

the fact that the capital market is not recognizing the value of 

these enterprises. 

Now, we need good secondary markets to provide exits for the 

people who buy in the primary market. But we also need the IPO 
45 

market to provide exits for the entrepreneurs who build the companies, and we really need to pay a lot of attention to what is going 

wrong here. There is no one magic bullet here. But it is a serious 

crisis. 

Chairman REED. Well, Mr. Narang, very quickly. 

Mr. NARANG. I appreciate it. I think that the Committee would 

be well served to solicit the testimony of venture capitalists on this 

topic, and I am confident that what they would tell you is that the 

main reason why companies are not seeking to go the IPO route 

is because the stock market has been roughly flat for the past 10 

years, and a better exit for companies is to sell their firm to Google 

or some other big public company than to list themselves. So, in 

other words, economic conditions clearly have a lot more to do with 

the state of affairs when it comes to listing companies than, you 

know, the health of the secondary market. 

The second thing I would say is that it has also been shown, I 

believe, that other exchanges across the world are perhaps more 

competitive than the United States because of regulations such as 

Sarbanes-Oxley and other regulations that you have to comply with 

if you are listed in the United States. So that is another thing that 

I think ought to be studied. 

Chairman REED. Thank you all very much for excellent testimony and participation. 

Chairman Levin, thank you. 

Chairman LEVIN. OK. Thank you again, Senator Reed, for all you 

have done in this area and for today’s hearing, too. Doing this 

jointly with you and your staff has been very, very useful to us, 

and I hope also to the Senate, in its considerations. 

I have some additional questions which I am going to be asking 

of you, so let me start with Mr. Luparello and then go down the 

line. I think most of you, if not all of you, have said that the trading across multiple market venues has made it necessary for the 

regulators to have information from those same venues in order to 

effectively regulate or police potentially manipulative trading. They 

just cannot look at activity on their own trading platform. 

First of all, do you agree with that? 

Mr. LUPARELLO. A hundred percent. 

Chairman LEVIN. Does anyone disagree with that? 

[Witnesses shaking heads.] 

Chairman LEVIN. OK. So I will shorten that. 

Now, when it comes to the manipulative trading that exists in 

the view of some, I think many, between platforms, including 

phony bids and layering strategies or other strategies, let me start 

now with you, Mr. Cronin. Have you observed what appears to be 

manipulative, same-day trading between platforms? 

Mr. CRONIN. I have not directly. Anecdotally, certainly I have 

heard about different things, but not really so much across platforms. For example, if you are talking about the futures exchange 

relative to the underlying, I have not. 

Chairman LEVIN. OK. But you have heard anecdotally about 

such—— 

Mr. CRONIN. Yes. 

Chairman LEVIN. OK. Mr. Narang. 
46 

Mr. NARANG. Look, there is little doubt that that stuff happens. 

You know, I was a treasury market maker in the mid-1990s making markets on long bonds for a primary dealer, and it was very 

common in those days for traders to ‘‘paint the screens’’; in other 

words, to show buying interest on the screens when, in fact, they 

were sellers. That is not a new practice, and it really has nothing 

to do with computers or automation. In fact, I would hasten to add 

that those sorts of strategies really are the domain of human 

beings because they cannot be modeled, they cannot be simulated. 

You cannot model the effect of what would happen if you show a 

large quote. And that is why, you know, everyone—I was a little 

bit disturbed when the Trillium example which everyone points to 

occurred, and it was immediately blamed on high-frequency traders. Trillium was a firm, as far as I understand, that consisted of 

human day traders, and the fact that they held their positions on 

an intraday basis should not immediately paint everybody who 

does that with a bad brush. The point is that these sorts of strategies are psychological in nature, and humans have no—computers 

have no capacity to run those sorts of things. That is on a theoretical level. 

On a practical level, one of the benefits to the market of computerized trading that is not discussed very much is the fact that it 

leaves a very, very concrete paper trail. So the forensic analysis is 

readily doable when algorithmic traders are participating in the 

market. So because of that, you know, computerized algorithms 

have a very concrete recipe that is written down. It is discoverable; 

it can be subpoenaed. So it would be remarkably foolish for somebody who is intending to engage in manipulative activity to do that 

with an algorithm. That is something that is best done by human 

beings, and for all practical purposes, I know of no example that 

has been discovered thus far of manipulative activity being done by 

a computer. 

Chairman LEVIN. Putting aside how it was done—that was not 

part of my question. 

Mr. NARANG. Sure. 

Chairman LEVIN. My question was whether or not—— 

Mr. NARANG. I have no doubt that it is done, but I do not know 

of any concrete examples. 

Chairman LEVIN. OK. So you have not observed manipulative 

same-day trading between platforms? 

Mr. NARANG. No, but I would virtually guarantee that it occurs. 

Chairman LEVIN. OK. Mr. Peterffy. 

Mr. PETERFFY. We see that happening all the time, but I do not 

believe that that should be such a great concern. It is bad, but we 

have much, much worse situations to deal with at this time. But 

I am suggesting here that each broker keep on record the identity 

of a person associated with each order so if there are any orders 

that are questionable, they can be easily identified by the regulators across the different exchanges. 

Chairman LEVIN. Let me call on Professor Angel before I go back 

to that point. Do you have a comment on my last question about 

whether or not you believe that manipulative same-day trading between platforms exists? 
47 

Mr. ANGEL. Well, there are two types of manipulation. There is 

the old-fashioned manipulation like order ignition where you dump 

a big sell order in the market trying to push the price down to 

scare other people and trigger all the stop orders. That does not 

really depend on the platform. And, indeed, a lot of traders do not 

pay any attention to the platform. They just send an order to someone like Mr. Peterffy, and his very good smart router figures out 

where to get best execution for that order. 

There is a lot of trading, a lot of good trading, and a lot of manipulative trading that does not really pay attention to the platforms. 

Now, is somebody actually trying to say, OK, I am going to put 

this order into this exchange versus that exchange because nobody 

will notice? 

Chairman LEVIN. The regulators do not have such automatic access. 

Mr. ANGEL. Well, actually the Intermarket Surveillance Group 

feed actually does consolidate the data. So if somebody is trading, 

the folks over at FINRA can very quickly through an electronic 

blue sheet figure out who did what. They just cannot put together 

the order books to figure out the strategies, and that is why they 

need better data. 

Chairman LEVIN. And that is why it takes an awful lot of time 

to put together these studies and these analyses? 

Mr. LUPARELLO. That is certainly one of the reasons. But another 

reason is that the quality of data we get for the purposes of running surveillance is fragmented and incomplete, and that prevents 

us from looking at activity across markets. 

Chairman LEVIN. And that is what I want to ask you about next. 

That fragmented and incomplete information, what is not included 

in the information, is the beneficial owner or the person putting 

the order in. Is that correct? 

Mr. LUPARELLO. It is a variety of things. At this point, you still 

have the equities markets being regulated somewhat in siloed fashion. We are in the process of aggregating our current regulation of 

the over-the-counter market and NASDAQ and adding in the New 

York Stock Exchange regulated markets, which will give us a much 

closer to complete picture of the equities trading. But options markets are still done in a siloed fashion, and options and equities obviously are still done in that way. So a consolidated audit trail I 

think is the necessary step to getting to an ability to look at these 

things happening across markets on a real-time basis. 

Chairman LEVIN. And are broker-dealers required to report the 

executing broker or the customer information? 

Mr. LUPARELLO. At this point executing broker, but not customer 

information. 

Chairman LEVIN. At this point. 

Mr. LUPARELLO. At this point. 

Chairman LEVIN. Is that useful? 

Mr. LUPARELLO. Customer information is certainly useful, I think 

especially if you are looking at it not from maybe necessarily every 

customer but certainly at the large trader thresholds that the SEC 

has proposed. It is certainly a very useful bit of information for everybody. 
48 

Chairman LEVIN. And is that in the works? 

Mr. LUPARELLO. Well, I think Chairman Schapiro alluded to developments in the consolidated audit trail that I cannot speak to 

but one would hope that anything that came out of consolidated 

audit trail was not just the merger of the data at the executing 

level, but the inclusion of some level of more granular customer 

data. 

Chairman LEVIN. And what about the stock exchanges? You do 

not look at them, right? 

Mr. LUPARELLO. No, we do. 

Chairman LEVIN. Do you get that same information from them? 

Mr. LUPARELLO. Yes. The way it currently works and the way it 

would work in a consolidated audit trail is the merger of the data 

not just at the executing levels but also the exchange order books, 

and that is absolutely essential. 

Chairman LEVIN. And that is where the name of the customer 

would be useful as well? 

Mr. LUPARELLO. Yes, absolutely. 

Chairman LEVIN. OK. Does anyone want to comment on that? 

Mr. CRONIN. Can I just add on the customer information? 

Chairman LEVIN. Yes. 

Mr. CRONIN. While we completely support the idea of having the 

information in the regulators’ hands, obviously that is very sensitive and privileged information that if there was any leakage of 

could have very bad consequence to our clients and shareholders, 

so we would just make sure, while this data is being collected and 

for the right purposes, that it is secure and that we do not read 

about WikiLeaks or anything else with our positions because that 

would be catastrophic to our clients. 

Chairman LEVIN. OK. But subject to that, you would agree with 

Mr. Luparello that—— 

Mr. CRONIN. Yes. 

Chairman LEVIN. ——the regulators have got to have access to 

that information? 

Mr. CRONIN. Yes. 

Chairman LEVIN. OK. Mr. Luparello, is FINRA currently investigating activities involving foreign-owned accounts that are held at 

U.S. broker-dealers located in other countries? 

Mr. LUPARELLO. Our jurisdictional limitations make that difficult 

and it is an area that we are quite concerned about. Broker-dealers 

obviously have customers, some based in the U.S., some based 

abroad. In addition, sometimes those customers are just a holding 

entity that sits above a network of other customers. Since our jurisdiction only goes to the broker-dealer and our ability to compel that 

first level of information, investigations that we have get stopped 

at that level, and if there is an ongoing concern of illegal conduct, 

that will result in a referral to the SEC. 

Chairman LEVIN. All right. But you basically have difficulty investigating foreign accounts that you suspect of trading abuses— 

for the reasons you give, and also because you cannot get clients’ 

names. 

Mr. LUPARELLO. Yes. Well, we can get clients’ names in the 

course of an investigation. So if we are doing an investigation, we 

will ask the firm for client names. They will provide that to us. Our 
49 

ability to compel either financial information or testimony from 

customers is what limits us, and that is true whether they are domestic customers or international customers. Obviously, the ability 

of the SEC, then, to reach those international customers creates 

yet another layer of complexity. 

Chairman LEVIN. On the same point about foreign banks, Mr. 

Luparello, is it true that foreign banks that open accounts with 

U.S. broker-dealers are not required to disclose the names of their 

customers to U.S. broker-dealers? 

Mr. LUPARELLO. U.S. broker-dealers have an obligation to know 

their customer and that comes out in a variety of different other 

requirements including, importantly, antimoney laundering. What 

exact requirements those U.S. broker-dealers have to know not just 

the customer but the customer of a customer is an area that has 

been somewhat vague over the years. 

I think, again, I would point to what the Commission has put forward in terms of its rulemaking, it is mostly around sponsor and 

naked access, but could potentially be used to add some greater 

teeth to those ‘‘know your customer’’ requirements because there is 

that concern that actually the customer of the broker-dealer is just 

a holding entity for the real customer sitting behind that. That construct actually exists in the U.S., too, and in some master/subaccount scenarios that we try to look through to have the customer 

of the customer be treated as a customer of the broker-dealer. I 

think there is both further interpretive rulemaking and enforcement that needs to be done in that area. 

Chairman LEVIN. Mr. Narang, you made reference to certain unfair aspects that exist to some participants. Can you expand on 

what those unfair aspects are? 

Mr. NARANG. Yes. They are a little bit esoteric, but I will do my 

best. Basically, in the United States equity markets, the vast majority of exchanges observe what is known as price/time priority. 

That means that orders that arrive at the exchange at a particular 

price get first priority to execute against inbound orders based on 

their arrival time. If your order arrives before mine, then somebody 

who wants to trade at that price actively will give you a fill before 

they give me a fill. 

Now, because of some technicalities associated with Regulation 

NMS, particularly in Rule 611, the so-called Order Protection Rule, 

the long-term investors who are attempting to trade and form a 

new price in the process very often lose their priority to certain 

proprietary trading firms that have the ability to utilize a specialized kind of order known as intermarket sweep orders. And so 

what happens is that price/time priority gets violated. 

Now, you can empirically calculate what price/time priority is 

worth. It is worth a lot of money. So there is a massive transfer 

of wealth underway from long-term investors who are executing the 

VWAP algorithms or just old-fashioned techniques into the pockets 

of certain high-frequency traders who actively utilize that capability. 

I do not think that those high-frequency trading firms should be 

faulted for utilizing that capability because there is no 

intentionality behind that. What happens is that when a long-term 

investor goes to take an offer and post a bid at the new price, the 
50 

exchange will hold up that bid until the price is formed by somebody who is using an ISO order. So the user of the ISO order does 

not need to know why it is happening. They just need to know that 

there is a two-cent spread now and they want to tighten the 

spread. 

So the high-frequency trader who is doing that is acting in the 

interests of the market as well as his own interests, but that is not 

a fair proposition. That is one of the few unfair aspects of market 

structure that I know about. The other is the tiering of rebates. 

The exchanges tend to give much higher liquidity rebates—not all 

of them, the BATS Exchange is a notable exception—but many 

other exchanges give higher rebates, liquidity rebates, to their most 

active traders than they do to smaller traders, and I think that is 

an anticompetitive practice and ought to be seriously examined. 

By and large, I do not want to give the impression that the equities market is unfair. I think that this is one of the fairest markets 

in the world and one of the most well functioning. That does not 

mean it is perfect. 

The glitch in Rule 611 that I mentioned to you is the very same 

glitch that is responsible for all the market fragmentation that we 

have seen. This very same rule is what causes exchanges to route 

orders to other exchanges rather than posting them if they appear 

to walk the exchange’s notion of the national best bidder offer. 

That creates an economic incentive for new exchanges to spring up 

that never existed before Regulation NMS went into effect because 

they have the ability to virtually be guaranteed to get order flow 

from other exchanges. That is why the market centers have proliferated to the extent that they have since Regulation NMS went 

into effect in 2007. 

Chairman LEVIN. Thank you. Just one last question of Mr. 

Luparello. Our first panel was asked a question by me about—and 

I believe you were here during that question—about what appeared 

to be an attempted short squeeze by Goldman traders using credit 

default swaps that bet against mortgage-backed securities. You 

were here during that? 

Mr. LUPARELLO. I was. 

Chairman LEVIN. If a FINRA member were to attempt a short 

squeeze, was unsuccessful in it—this, to me, is an intended manipulation—would FINRA typically investigate this activity to determine whether it violated FINRA rules, such as the FINRA rule 

about, quote, ‘‘high standards of commercial honor and just and equitable principles of trade’’? 

Mr. LUPARELLO. Absolutely. That scenario, and I was not privy 

to the facts before this, and I think there is probably a question 

about whether those were securities at the time, but that fact pattern in the current environment—trading practices that had a specific manipulative intent behind them, irrespective of the success or 

failure of that, would be something that would be investigated and 

we would think could, with the right facts, run afoul of our rules. 

Chairman LEVIN. Does anybody want to add anything before we 

bring our hearing to a close? 

Mr. ANGEL. I would just like to thank the Chairman for investigating these very important issues. I was very impressed by the 
51 

eloquence and basically high quality of your opening speech and I 

just want to urge you to keep up the good work. 

Chairman LEVIN. Well, I am glad we gave you that opportunity 

to say that. 

[Laughter.] 

Chairman LEVIN. Does anybody else want to—no, I had better 

stop while I am ahead. 

[Laughter.] 

Chairman LEVIN. Thank you all. We have a good number of letters from two exchanges, which we will make part of the record. 

There may be some questions that we would like to ask each of 

you for the record that may come to you. You are not obligated to 

answer them, but we sure would appreciate your answers. 

We will stand adjourned, again, with our thanks to each of you, 

not just for your testimony and your direct answers, but also for 

very graciously being allowed to be moved about to satisfy a very 

crazy Senate schedule. I will not say it is unusual. Crazy is usual. 

But thank you. 

[Whereupon, at 6:20 p.m., the hearing was adjourned.] 

[Prepared statements, responses to written questions, and additional material supplied for the record follow:] 
52 

PREPARED STATEMENT OF CHAIRMAN CARL LEVIN 

Today, U.S. capital markets, which traditionally have been the envy of the world, 

are fractured, vulnerable to system failures and trading abuses, and are operating 

with oversight blindspots. The very markets we rely on to jump start our economy 

and invest in America’s future are susceptible to market dysfunctions that jeopardize investor confidence. 

I would like to thank Chairman Jack Reed, his ranking Member Senator Bunning, 

and all our colleagues from the Securities, Insurance, and Investment Subcommittee 

who have already held hearings on these issues and welcomed our Subcommittee 

to join with them today to shine a light on problems that threaten U.S. market stability and integrity. 

Fractured Markets. The first fact we need to grapple with is that our markets 

have changed enormously in the last 5 years. In the past, most U.S. listed stocks 

were traded on the New York Stock Exchange or the Nasdaq. Seven years ago, the 

New York Stock Exchange alone accounted for about 80 percent of the trades in its 

listed stocks. But today, less than 25 percent of the New York Stock Exchange listed 

stocks are traded there. What happened? Stock trading now takes place, not on one 

or two, but 13 stock exchanges. 

This chart, Exhibit 1, shows how the U.S. stock market has fractured. Stock trading now takes place on 13 exchanges as well as multiple off-exchange trading 

venues, including 3 Electronic Communication Networks, 36 so-called ‘‘dark pools,’’ 

and over 200 registered ‘‘broker-dealer internalizers.’’ 

Electronic Communication Networks or ECNs are computerized networks that enable their participants to post public quotes to buy or sell stock without going 

through a formal exchange. Dark pools, by contrast, are electronic networks that are 

closed to the public and allow pool members to buy and sell stock without fully disclosing to each other either their identities or the details of their prospective trades. 

A broker-dealer internalizer is a system set up by a regulated broker-dealer to execute trades with or among its own clients without sending those trades outside of 

the firm. These off-exchange venues are increasing their trading volumes, most use 

high speed electronic trading, and they escape much of the regulation that applies 

to formal stock exchanges. 

These new trading venues didn’t appear out of thin air. They are largely the result of Regulation NMS which the SEC issued in 2005. Some call the resulting new 

world of on and off exchange trading a model of competition. Others call it a freefor-all that defies oversight and is ripe for system failures and trading abuses. In 

reality, both descriptions have some truth. Trading competition has led to lower 

trading costs and faster trading, but it has also opened the door to new problems. 

System Failures. One of those problems involves system failures, of which the 

May 6 flash crash is the most famous recent example. On that day, out of the blue, 

the futures market suddenly collapsed and dragged the Dow Jones Industrial Average down nearly 700 points, wiping out billions of dollars of value in a few minutes 

for no apparent reason. Both the futures and stock markets recovered in about 20 

minutes, but left investors and traders in shock. After 5 months of study, a joint 

CFTC–SEC report has concluded that the crash was essentially triggered by one 

large sell order placed in a volatile futures market using an algorithm that set off 

a cascade of out-of-control computerized trading in futures, equities, and options. 

That one futures order, placed at the wrong time, in the wrong way set off a chain 

reaction that damaged confidence in U.S. financial markets. 

In some ways, the May 6 crash was a high-speed version of the 1987 market 

crash, where a sudden decline in the futures market led to a corresponding collapse 

in the broad stock market which led, in turn, to crashes in individual stocks. And 

it is not the only type of system failure affecting our financial markets. So-called 

‘‘mini flash crashes,’’ in which one stock suddenly plummets in value for no apparent reason have become commonplace. On June 2, 2010, for example, shares in 

Diebold Inc., a large Ohio corporation, suddenly dropped from about $28 to $18 per 

share. The stock recovered, but the company was left trying to understand and explain what happened. Even after the SEC initiated a pilot circuit breaker program 

after the May 6 crash, at least 15 other companies have had similar experiences, 

including Nucor, Intel, and Cisco. A former senior Nasdaq executive told the Subcommittee that the Nasdaq exchange has experienced single-stock flash crashes 5– 

6 times per week. The New York Stock Exchange and FINRA told us these crashes 

are commonplace and attribute them to various glitches in computerized trading 

programs. 

Single-stock crashes might seem to be a minor problem, but what happens if the 

security that crashes is a basket of stocks or commodities? On November 29, 2010, 

3 of the top 5 equities traded by volume were actually baskets of stocks. If a basket 
53 

of stocks or commodities crashes in value, what happens to the underlying financial 

instruments? Uncontrolled electronic trading and cascading price declines in multiple trading venues, including in futures, options, and equities markets, could be 

the result—another May 6th. 

Many investors, by the way, are not waiting around to find out if our regulators 

have fixed the problem. According to the Investment Company Institute, each 

month since May, more investors have fled our markets, pulling billions of dollars 

of U.S. investments. 

Trading Abuses. System failures are not the only problem raised by our fractured 

markets. Another problem is their increased vulnerability to trading abuses. Traders today buy and sell stock on and off exchange, simultaneously trading in multiple 

venues. Traders have told my Subcommittee that orders in some stock venues are 

being used to affect prices in other stock venues; and that futures trades on CFTCregulated markets are being used to affect prices on SEC-regulated options and 

stock markets. Some traders are also using high speed trading programs to execute 

their strategies, sometimes submitting and then cancelling thousands of phony orders to affect prices. 

To get a sense of the trading activity today, take a look at this stack of paper. 

This stack, nearly 5 inches high, contains the actual message traffic generated in 

the futures, options, and equity markets with respect to one major U.S. stock over 

the course of one second of time. One stock, in one second, produced over 29,000 

orders, order modifications, order executions, and cancellations in all three markets. 

This stack shows in black and white how traders are now analyzing trades in all 

three markets at once, evidencing how the futures, options, and equity markets are 

interconnected. Imagine the same stack multiplied countless times, filling this entire hearing room, and the interconnectedness of the markets as well as the potential for system failures and trading abuses becomes alarmingly clear. 

One well known trader, Karl Denninger, recently made this public comment about 

U.S. trading activity: 

Folks, this crap is totally out of hand. And it’s now a daily game that’s 

being played by the machines, which are the only things that can react with 

this sort of speed, and they’re guaranteed to screw you, the average investor or trader. Go ahead, keep thinking you can invest. (Emphasis omitted.) 

Regulatory Barriers. While fractured markets and high speed trading are causing 

new problems and forms of manipulation, they are also leaving our regulators far 

behind. Traders are equipped today with the latest, fastest technology. Our regulators are riding the equivalent of mopeds going 20 mph chasing traders whose cars 

are going 100 mph. 

Our regulators are confronting at least four challenges. The first is the fact that 

each trading venue today has its own infrastructure, rules, and surveillance practices. Besides the expense and inefficiency involved, no regulatory agency has a complete collection of trade data from all the venues, much less a single integrated data 

flow allowing regulators to see how orders and trades in one venue may affect prices 

in another. 

Second, even if regulators had an integrated data flow, the current data systems 

fail to identify key information, including the names of the executing broker and 

customer making the trades. That means regulators can’t use the electronic records 

to, for example, trace trading by one person or set up alerts to flag trades. Instead, 

before any trading analysis can start, regulators have to figure out the broker and 

customer behind each trade. Patterns of manipulation are hidden. 

The third problem is that the SEC has no minimum standards for automated 

market surveillance by Self-Regulatory Organizations (SROs), and the quality of 

those efforts is apparently all over the map. Recent SEC examinations of certain exchanges have found, for example, some ineffective surveillance systems that were 

unable to detect basic manipulations or used such restrictive criteria that they 

failed to flag suspect activity, exchanges that failed to review some surveillance 

alerts, and exchanges with only rudimentary or under-budgeted investigative, examination, and enforcement programs. 

The fourth problem is that the SEC and CFTC have not set up procedures to coordinate their screening of market data to see if trades in one agency’s markets are 

affecting prices in the other’s markets. Given the strong relationships between the 

futures, options, and equities markets, joint measures to detect intermarket trading 

abuses are essential. 

The impact of the regulatory and technology barriers is demonstrated by the fact 

that it took the CFTC and SEC 5 months of intense work to figure out what happened over a few minutes on May 6. In addition, over the past 5 years, there have 

been few meaningful single day price manipulation cases. One recent case involves 
54 

a small trading firm, Trillium Trading LLC, which apparently used phony trading 

orders to bid up the price of several stocks. In that case, FINRA found that, over 

a 3-month period in 2006 and early 2007, Trillium submitted phony orders in over 

46,000 manipulations, netting gains of about $575,000. Apparently, the victims of 

the price manipulation got annoyed enough to research the manipulative trading 

and hand over the data to FINRA. Even then it took FINRA 4 years to reconstruct 

the order books, prove who was behind the trades, and resolve the matter. Trillium 

and its executives recently settled the case by agreeing to pay over $2.2 million in 

fines and disgorgements. 

Traders and regulators have told my Subcommittee that Trillium is not the only 

company that has engaged or is engaging in price manipulation in U.S. financial 

markets. In fact, one of the more chilling examples involves suspect trading involving traders located in China. Are overseas traders trying to manipulate U.S. stocks? 

Our regulators are currently unequipped to find out. 

Solutions. The May 6 flash crash and the Trillium case provide powerful warnings 

that we need to strengthen U.S. oversight of our financial markets to restore investor confidence. Much needs to be done. Recent actions by the SEC to prohibit phony 

quotes, impose single issue circuit breakers, and set up a consolidated audit trail 

are important advances. But there is a long, long way to go, particularly with respect to coordinating market protections and surveillance across market venues, and 

across the futures, options, and equities markets. 

There also needs to be a greater sense of urgency. The SEC’s proposed consolidated audit trail is expected to take years to put into place and won’t cover all the 

relevant products and markets. Requiring executing broker and customer information—an essential component to effective oversight—is in limbo pending completion 

of the consolidated audit trail, as is integrating the trade data from multiple trading 

venues. Integrating trading data and market surveillance of the futures, options, 

and equities markets by the CFTC and SEC isn’t even on the drawing board. 

I hope this hearing will help inject greater urgency into strengthening U.S. oversight of our fractured, high speed markets to restore investor confidence. 
55 

Exhibits 1–5 Submitted by Chairman Carl Levin 
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PREPARED STATEMENT OF MARY L. SCHAPIRO 

CHAIRMAN, SECURITIES AND EXCHANGE COMMISSION

DECEMBER 8, 2010 

Chairmen Reed and Levin, Ranking Members Bunning and Coburn, and Members 

of the Subcommittees: Thank you for the opportunity to testify on behalf of the Securities and Exchange Commission concerning the U.S. equity market structure. 

Market structure encompasses all aspects of the organization of a market, including the number and types of venues that trade a financial product and the rules 

by which they operate. Although these issues can be complex and the rules technical, a stable, fair, and efficient market structure is the backbone of the equity 

markets and an important engine of our economy. 

My testimony today will note some important recent market structure developments and discuss the Commission’s ongoing review of our market structure. In particular, we have undertaken a broad-based appraisal of both the strengths and 

weaknesses of our current equity market structure. This review includes an evaluation of recent market structure performance and an assessment of whether market 

structure rules have kept pace with recent significant changes in trading technology 

and practices. The goal of this evaluation is to effectively address any market structure weaknesses while preserving its strengths. 

As will be described below, the Commission has recently moved to enhance regulators’ capacity to monitor trading across all trading venues and to enforce the securities laws and regulations and self-regulatory organization (SRO) rules. These initiatives include publishing for public comment one proposal that would mandate the 

development and implementation of a consolidated audit trail system and another 

that would require large trader reporting. 

In addition, the SEC published a concept release on equity market structure in 

January 2010 (the ‘‘Concept Release’’). The Concept Release described the current 

market structure and then broadly requested comment from the public on three categories of issues: (1) the quality of performance of the current market structure, (2) 

high frequency trading, and (3) undisplayed liquidity in all its forms. 

The Commission has received more than 200 comments on the Concept Release. 

A number of commenters identified benefits of the current market structure, in particular noting that it has fostered competition among trading venues and liquidity 

providers that has lowered spreads and brokerage commissions. These investors 

cautioned against regulatory changes that might lead to unintended consequences. 

Other commenters, however, raised concerns about the quality of price discovery 

and questioned whether the current market structure continues to offer a level playing field to investors in which all can participate meaningfully and fairly. These 

commenters suggested a variety of initiatives to address their concerns. 

Following up on the written comments, the Commission hosted a public roundtable on market structure in June. The roundtable participants, who included listed 

companies, investors, exchanges, market makers, high frequency traders, brokerdealers, agency-only brokers, and economists, offered a wide range of perspectives 

and recommendations. The debate at the roundtable was spirited and extremely 

helpful to the Commission in its efforts to obtain a deep understanding of complex 

policy issues. 

The Commission’s job in the coming months will be to evaluate these issues in 

a responsible, timely, and comprehensive fashion, with particular focus on obtaining 

the appropriate data and analysis to support our decisions to proceed with or to 

table any particular initiative. A few basic principles will guide our actions. 

I. Guiding Principles 

A. Capital Formation and Investor Protection 

At its most basic level, market structure must achieve two critical objectives: serving the interests of companies in efficient capital formation and the interests of investors in attaining their financial goals. Efficient capital formation and strong investor protection in our equity markets will promote economic growth and jobs, as 

well as the ability of individual Americans to realize economic security and invest 

for things such as retirement and college. 

Equity markets support these objectives by helping to turn the savings of investors into capital for business, enabling a flow of funds from investors to entrepreneurs and back again through dividends and capital gains. Those who purchase 

stock in an initial public offering, for example, can have confidence that they will 

be able to sell that stock at a fair and efficient price in the secondary market when 

they need or want to do so. The values assigned to stocks in the secondary market, 
79 

moreover, play an important role in the ability of companies to raise additional 

funding. 

Healthy equity markets allocate capital efficiently and help ensure that investors 

and companies are able to reap the rewards of their efforts. If, however, the equity 

market structure breaks down—if it fails to provide the necessary fairness, stability, 

and efficiency—investors and companies may pull back, raising costs and reducing 

growth. 

In sum, the interests of companies and investors lie at the heart of market structure. All of the securities industry professionals and entities that act as intermediaries between companies and investors play vitally important roles in our equity market structure, but their roles ultimately must serve the ends of capital formation and investor protection. 

B. Competition and Price Discovery 

To achieve efficient capital formation and strong investor protection, a market 

structure must secure the dual benefits of competition and effective price discovery. 

Competition among multiple markets and market making firms can benefit investors through specialized trading services, lower fees, and narrow spreads. When 

many markets and firms compete for order flow in the same stock, however, any 

structural inefficiencies can lead to order flow fragmentation and concerns about the 

quality of price discovery. If price discovery were to be impaired, it could cause the 

price of a company’s stock to deviate from true consensus values and lead to excessive volatility that is harmful to both investors and companies. 

Section 11A of the Exchange Act directs the Commission to facilitate a national 

market system that achieves multiple objectives, including: competition among markets and broker-dealers, efficient execution of securities transactions, price transparency, best execution of investor orders, and an opportunity, consistent with other 

objectives, for investor orders to meet directly. 

The Commission’s market structure task is further complicated by the continual 

change that characterizes modern financial markets. Even if an optimally balanced 

market structure were achieved at any particular time, the dynamic forces of technology and competition are sure to generate new market conditions that will effectively—and sometimes rapidly—alter the balance. As a result, the Commission must 

regularly review its rules to assess whether they have kept pace with changing market conditions. 

Our ongoing market structure review is focused on current, and potential future, 

market conditions, not those that existed in the past, and on whether the current 

rules continue to foster an appropriately balanced market structure that achieves 

all of the Exchange Act’s objectives. 

C. Surveillance, Inspection, and Enforcement 

A final guiding principle for the Commission’s market structure program is a recognition that the right rules are meaningless if they are not followed and enforced. 

All industry participants must know that the regulators are closely monitoring compliance and will take enforcement action against those who violate the rules. Consequently, the Commission is focused on obtaining the tools and resources necessary 

to better surveil trading, inspect regulated entities, and enforce the rules in today’s 

highly automated, high speed and high volume markets. 

II. Recent Market Structure Developments 

A. Technology 

The U.S. equity market structure has changed dramatically in recent years. A 

decade ago, most of the volume in stocks was executed manually, whether on the 

floor of an exchange or over the telephone between traders. Now nearly all orders 

are executed by fully automated systems at great speed. The fastest exchanges and 

trading venues are now able to accept, execute, and send a response to orders in 

less than one thousandth of a second. 

Speed is not the only thing that has changed. As little as 5 years ago, the great 

majority of U.S. equities capitalization was traded on a listing market—the New 

York Stock Exchange (NYSE)—that executed nearly 80 percent or more of volume 

in those stocks. Today, the NYSE executes approximately 26 percent of the volume 

in its listed stocks. The remaining volume is split among 13 public exchanges, more 

than 30 dark pools, 3 electronic communication networks (ECNs), and more than 

200 internalizing broker-dealers. Currently, approximately 30 percent of volume in 

U.S.-listed equities is executed in venues that do not display their liquidity or make 

it generally available to the public, reflecting an increase over the last year. 

The evolution of trading technologies has dramatically increased the speed, capacity, and sophistication of the trading functions that are available to market partici-
80 

pants. The new electronic market structure has opened the door for entirely new 

types of professional market participants. Today, proprietary trading firms play a 

dominant role by providing liquidity through the use of highly sophisticated trading 

systems capable of submitting many thousands of orders in a single second. These 

high frequency trading firms can generate more than a million trades in a single 

day and now account for more than 50 percent of equity market volume. 

B. May 6 Trading Disruption 

On May 6, 2010, two weeks after the end of the 90-day comment period for the 

Concept Release, the U.S. equity markets experienced one of the most significant 

price declines and reversals since 1929. While the decline in prices in broad market 

indexes on May 6 was not as steep and as persistent as the decline in October 

1987—when trading was slower and less reliant on technology—the broad market 

indexes, including the Dow Jones Industrial Average and S&P 500, dropped more 

than 5 percent in 5 minutes, only to almost entirely reverse the decline in a subsequent few minutes. Approximately 15 percent of stocks suffered even more severe 

declines and reversals of 10 percent or worse. These include two of the 10 largest 

capitalization stocks, which declined 36.7 percent and 19.5 percent, during the halfhour disruption, only to recover nearly their full value. 

At the worst end of the spectrum, 326 securities suffered declines of more than 

60 percent from their 2:40 p.m. prices, leading the exchanges to ‘‘break’’ or cancel 

more than 20,000 trades. Many of these broken trades were executed at absurd 

prices of one penny or less per share. Nearly 70 percent of these broken trades were 

in exchange-traded funds (ETFs), whose pricing integrity depends in significant part 

on the price integrity of individual stocks and the activities of professional liquidity 

providing firms. 

In September, the staffs of the SEC and the Commodity Futures Trading Commission (CFTC) published their second joint report on their inquiry into the day’s 

events. Producing the report required an extraordinary amount of staff resources. 

On the securities side in particular, much of the time and effort was devoted to collecting and then painstakingly sifting through the data necessary to reconstruct 

trading. These efforts highlighted the pressing need for enhanced data 

functionalities in the securities markets. 

The joint report lays out the multiple factors that in our view significantly contributed to the liquidity failure and disruptive trading on that day, outlining the 

complex interplay of multiple factors across the securities and futures markets. This 

interplay is significant because it demonstrates the need for a multifaceted regulatory response that addresses the full scope of the risks in a comprehensive and 

responsible way. 

C. Investor Views About Market Structure 

Since the events of May 6, some investors are questioning the integrity and fairness of the U.S. market structure. Many individual investors, for example, have submitted comments to the Commission that are highly critical of the current market 

structure. Retail broker-dealers have told us that their customers—individual investors—have pulled back from participating in the equity markets since May 6. Some 

institutional investors also have submitted comments outlining their market structure concerns after May 6. These concerns included the transitory nature of a large 

percentage of liquidity, an uneven playing field created by data latency and colocation, and trading tactics employed to detect the presence of large blocks and trade 

ahead of them. 

On the other hand, many institutional investors (such as mutual funds and pension funds who often represent the interests of many individuals investing indirectly 

in equities) who commented on the Concept Release believed that their trading costs 

had declined in recent years, that technology had fostered competition among trading venues and liquidity providers, improved the efficiency of trading, narrowed 

spreads, and that their brokerage commissions have never been lower. These investors highlighted important benefits in the current market structure that should be 

preserved. 

III. Responding to Developments in Market Structure Under Existing Authority 

A principal lesson of the financial crisis is that, because today’s financial markets 

and their participants are dynamic, fast-moving, and innovative, the regulators who 

oversee them must continuously improve their knowledge and skills to regulate effectively. In response to the ever-changing nature of our financial system, the SEC’s 

Office of Compliance, Investigations and Examinations (OCIE) and our Division of 

Enforcement have adopted new approaches to promote fair, orderly and efficient operation of the markets. 
81 

A vigorous examination program not only reduces the opportunities for wrongdoing and fraud, but also provides early warning about emerging trends and potential weaknesses in compliance programs. As described in more detail below, over the 

past year, we have begun reforming OCIE in response to developing Wall Street 

practices and lessons learned from recent fraud investigations. 

Enforcement is another critical element to fair and effective markets. Swift and 

vigorous prosecution of emerging schemes designed to circumvent the law is at the 

heart of the agency’s efforts to promote investor confidence in the integrity of the 

marketplace. 

A. Market Surveillance and Inspections 

In response to the dramatic changes that recently have developed in our markets, 

the Commission is employing an interdisciplinary approach designed to bring together subject matter experts from across the agency to identify, analyze and address issues that arise. 

Recognizing the sweeping industry and market changes that have occurred in the 

past few years, OCIE, under new leadership, recently completed a critical self-assessment of its national examination program, not only of SROs, but also of brokerdealers and other regulated entities. As a result of that self-assessment, OCIE determined that it needed to develop a more risk-focused strategic plan to address 

SRO oversight of individual market centers. 

OCIE is in the process of implementing its new SRO examination program this 

year. In addition to its ongoing examination responsibilities, OCIE staff currently 

is conducting risk assessment evaluations of each of the 13 registered exchanges 

and the options and equities markets that they operate. This assessment has been 

informed by recent market events, including the events of May 6, and will include 

an overview of key risk areas including conflicts of interest, corporate governance, 

regulatory structure, and market oversight and surveillance. 

OCIE expects to use the findings of these examinations to create a comprehensive 

risk matrix for each of the exchanges and use that risk-based approach to inform 

future examinations. In addition, the exam findings will provide the SEC with the 

ability to address cross-market issues more holistically, by, for example, articulating 

common risk factors and better practices that can be adopted by all markets. 

B. Enforcement Response 

While market structure is primarily a regulatory challenge, an enforcement response is available and appropriate where market participants violate the law. The 

SEC’s Division of Enforcement is devoting significant investigative resources to determine whether various market participants have engaged in conduct that unlawfully exploited the fragmentation of the markets, intentionally contributed to market 

volatility or manipulated the price and volume of securities at the expense of innocent investors. 

The Enforcement Division’s Market Abuse Unit is one of five specialized units established earlier this year to conduct specialized investigations and develop expertise in particularly high risk program areas. The Market Abuse Unit is helping to 

coordinate the Commission’s enforcement response to complex abusive trading practices and market participants seeking unlawfully to exploit current market structure. The Unit is planning an Analysis and Detection Center, to be staffed, budget 

permitting, with specialists having expertise in algorithmic trading strategies, trading abuse, quantitative analysis, market structure and data architecture. By concentrating expertise in these areas, the Division of Enforcement can more efficiently 

and effectively identify potentially abusive trading practices that pose the greatest 

risk of harm to investors. 

Investigating manipulation cases is often difficult, particularly given the speed 

and volume with which trading is occurring in today’s markets. The Enforcement 

Division is committed to discovering manipulation schemes at their incipient stages. 

The SEC has had recent success, for example, through close coordination with criminal authorities, who are able to use law enforcement techniques that are proactive, 

and may yield stronger evidence of scienter—or manipulative intent. 

That said, while traditional law enforcement approaches to investigating manipulation schemes are often effective, they alone are insufficient to police today’s markets for potentially manipulative practices involving high frequency, algorithmic and 

large volume trading. The Commission needs significant upgrades to our systems 

and analytical resources to be able to effectively identify manipulations as they 

occur in today’s markets. For example, we need the tools that will enable us to keep 

up with market participants who are placing thousands of orders per second. 

Similarly, the fragmentation of trading at different market centers means trading 

data often has format, compatibility and clock-synchronization differences, making 
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it difficult to quickly identify a complete picture of a single trader’s market activities 

on a timely basis. The prevalence of high-volume trading through direct market access providers requires that investigative staff trace the trading back through multiple layers of intermediaries to identify the original trader. Because the staff must 

manually evaluate each layer of data before it can request the next, the lack of advanced data analysis tools can both delay our investigations and make it more difficult to identify the trader whose conduct is of ultimate interest. Enforcement staff 

is currently focusing on whether certain trading practices occur that potentially give 

rise to Federal securities law violations. Such practices include layering or spoofing, 

improper order cancellation activities or ‘‘quote stuffing,’’ the use of order anticipation and momentum ignition strategies undertaken for a manipulative purpose, passive market making practices that incentivize possible manipulative quoting activity, abusive colocation and data latency arbitrage activity in potential violation of 

Regulation NMS, use of Direct Market Access arrangements to conceal manipulative 

trading activity and conduit entity market manipulation. 

We must stress that our investigative efforts in these areas at this stage are fact 

finding in nature and the pendency of an investigation does not mean that the Commission or its staff has determined that abuses have occurred. It is premature to 

predict whether enforcement actions will result from these matters, but the sustained specialized knowledge and insights we gain will inform the agency’s regulation and lead to greater efficiency and effectiveness in our investigations. 

IV. Steps to Strengthen the Equity Market Structure 

It is vital that the rules that govern market structure and market participant behavior support equity markets that warrant the full confidence of investors and listed companies. The Commission recently has adopted a number of important initiatives to further this goal: 

• Less than 2 weeks after May 6, the Commission posted for comment proposed 

exchange rules that would halt trading for certain individual stocks if their 

price moved 10 percent in a 5 minute period. Barely more than 6 weeks after 

the event, exchanges began putting in place a pilot uniform circuit breaker program for S&P 500 stocks. In September, the program was extended to stocks 

in the Russell 1000 Index and specified exchange-traded products. The aim of 

this program is to halt trading under disorderly market conditions, which in 

turn should help restore investor confidence by ensuring that markets operate 

only when they can effectively carry out their critical price-discovery functions. 

• In September, the Commission approved pilot exchange rules designed to bring 

order and transparency to the process of breaking ‘‘clearly erroneous’’ trades. 

On May 6, nearly 20,000 trades were invalidated for stocks that traded 60 percent or more away from their price at 2:40 PM. That 60 percent benchmark, 

however, was set after the fact. We now have consistent rules in place governing clearly erroneous trades that will apply to any future disruption. 

• In November, the Commission approved exchange rules to enhance the 

quotation standards for market makers. In particular, the new rules eliminate 

‘‘stub quotes’’—a bid to buy or an offer to sell a stock at a price so far away 

from the prevailing market that it is not intended to be executed, such as a bid 

to buy at a penny or an offer to sell at $100,000. Executions against stub quotes 

represented a significant proportion of the trades that were executed at extreme 

prices on May 6 and were subsequently broken. 

• Also in November, the Commission took an important step to promote market 

stability by adopting a new market access rule. Broker-dealers that access the 

markets themselves or offer market access to customers will be required to put 

in place appropriate pretrade risk management controls and supervisory procedures. The rule effectively prohibits broker-dealers from providing customers 

with ‘‘unfiltered’’ access to an exchange or alternative trading system. By helping ensure that broker-dealers appropriately control the risks of market access, 

the rule should prevent broker-dealers from engaging in practices that threaten 

the financial condition of other market participants and clearing organizations, 

as well as the integrity of trading on the securities markets. 

In addition to these adopted rules, the Commission has proposed large trader reporting requirements and a consolidated audit trail system to improve our ability 

to regulate the equity markets. These proposals would tremendously enhance regulators’ ability to identify significant market participants, collect information on their 

activity, and analyze their trading behavior. Both of these initiatives seek to address 

significant shortcomings in the agency’s present ability to collect and monitor data 
83 

in an efficient and scalable manner and to address discrete market structure problems. 

Today, there is not any standardized, automated system to collect data across the 

various trading venues, products and market participants. Each market has its own 

individual and often incomplete data collection system, and as a result, regulators 

tracking suspicious activity or reconstructing an unusual event must obtain and 

merge a sometimes immense volume of disparate data from a number of different 

markets. And even then, the data does not always reveal who traded which security, 

and when. To obtain individual trader information the SEC must make a series of 

manual requests that can take days or even weeks to fulfill. In brief, the Commission’s tools for collecting data and surveilling our markets do not incorporate the 

technology currently used by those we regulate. 

The proposed consolidated audit trail rule would require the exchanges and 

FINRA to jointly develop a national market system (NMS) plan to create, implement, and maintain a consolidated audit trail in the form of a newly created central 

repository. The information would capture each step in the life of the order, from 

receipt or origination of an order, through the modification, cancellation, routing 

and execution of an order. Notably, this information would include information identifying the ‘‘ultimate customer’’ who generated the order. And, it would require 

members to ‘‘tag’’ each order with a unique order identifier that would stay with 

that order throughout its life. 

If implemented, the consolidated audit trail would, for the first time, allow SROs 

and the Commission to track trade data across multiple markets, products and participants simultaneously. It would allow us to rapidly reconstruct trading activity 

and to more quickly analyze both suspicious trading behavior and unusual market 

events. It is important to recognize, however, that the consolidated audit trail is a 

major change in the technology infrastructure for our equity markets, and thus will 

require some time to fully implement. In addition, in order to fully use this new infrastructure, the Commission’s own technology and human resources will need to be 

expanded well beyond their current levels. 

We also are examining the circuit breaker mechanisms that directly limit price 

volatility. These include the recently adopted circuit breakers for individual stocks, 

as well as the longstanding broad market circuit breakers that apply across the securities and futures markets. While they have worked well, the individual stock circuit breakers adopted since May 6 may need to be further enhanced. They were important first steps that could be implemented quickly to address the worst aspects 

of excessive volatility, and as such were approved on a pilot basis. Now that we 

have some experience with them, however, we better understand some of their limitations and shortcomings. 

For example, we are working with the exchanges to consider a limit up/limit down 

procedure that would directly prohibit trades outside specified parameters, while allowing trading to continue within those parameters. Such a procedure could prevent 

many anomalous trades from ever occurring, as well as limiting the disruptive effect 

of those that do occur. 

In addition to these new circuit breakers for individual securities, the futures and 

securities markets long have had circuit breakers for the broad market that, when 

triggered, pause trading in futures, stocks, and options. None were triggered, however, during the severe market disruption on May 6. We are assessing whether various aspects of the broad market circuit breakers need to be modified or updated 

in light of today’s market structure. 

We also are examining a wide range of other market structure issues. These include the Commission’s proposals with respect to flash orders and undisplayed liquidity, issues arising out of May 6 (such as large order execution algorithms that 

can operate in unexpected ways and the role of registered market makers), and the 

broad policy issues raised in the Concept Release. 

One of these is the issue of competition and fragmentation. As previously noted, 

trading volume in U.S.-listed stocks is split among many different venues. These include exchanges that display quotations that are made widely available to the public 

and nonpublic markets that do not display quotations at all. These venues offer a 

wide range of choices that many investors value highly to meet their diverse needs. 

The emergence of multiple trading venues that offer investors the benefits of 

greater competition also has made our market structure more complex. Market participants use a multitude of information sources and routing strategies in their efforts to obtain best execution of orders across all the different venues. The venues, 

in turn, compete vigorously to attract this order flow by, among other things, distributing proprietary market data feeds that are separate from the consolidated 

data feeds that are made widely available to the public. We are assessing initiatives 
84 

to improve transparency of order handling and execution practices that were supported by many commenters on the Concept Release. 

In addition, orders executed in nonpublic trading venues such as dark pools and 

internalizing broker-dealers now account for nearly 30 percent of volume, up from 

approximately 25 percent 1 year ago. We are considering the effect of these venues 

on public price discovery and market stability. Many institutional investors value 

the opportunity to trade in dark venues because of a fear that trading in the public 

markets in large sizes will cause prices to run away from them. We will explore all 

aspects of this issue to reach a balanced conclusion. At the end of the day, investors 

of all types must have confidence that our market structure provides high-quality 

price discovery and the tools they need to meet their investment objectives in a fair 

and efficient manner. 

In sum, we must look comprehensively at the issues, identify if and where the 

current market structure is not fulfilling its guiding principles, and take appropriate 

steps in a balanced way that also preserves the strengths of the current market 

structure. As noted above, the Commission’s guiding principle must be to encourage 

a market structure that promotes capital formation and protects investors. We must 

also be mindful of the need for strong empirical analysis to support our actions, and 

of the potentially significant risk of harm to the markets that might arise from unintended consequences. In addition, we must continue to support and staff these and 

other market structure initiatives with appropriate levels of expertise. 

V. Conclusion 

The structure of today’s markets offers many advantages to investors. We should 

not attempt to turn the clock back to the days of trading crowds on exchange floors. 

But we must continue to carefully analyze the issues raised by our Concept Release 

and by the events of May 6 to determine whether our market structure rules have 

kept pace with the new trading realities and to identify whether there are ways to 

improve our markets, provide additional transparency and increase investor protections. 

As we move ahead, we look forward to working closely with Congress to continue 

addressing these critical market structure issues. 

Thank you for inviting me here to discuss the developments in market structure. 

I look forward to answering your questions. 

PREPARED STATEMENT OF GARY GENSLER 

CHAIRMAN, COMMODITY FUTURES TRADING COMMISSION

DECEMBER 8, 2010 

Good afternoon Chairman Reed, Chairman Levin, Ranking Member Bunning, 

Ranking Member Coburn, and Members of the Subcommittee on Securities, Insurance, and Investment and the Permanent Subcommittee on Investigations. I thank 

you for inviting me to today’s hearing. I am pleased to testify alongside Securities 

and Exchange Commission (SEC) Chairman Mary Schapiro. This is our seventh 

time testifying together, and our third on issues related to the May 6 market events. 

Since we last testified before the Subcommittee, staff from the Commodity Futures Trading Commission (CFTC) and SEC released a supplemental report on October 1 on the unusual market events of May 6, 2010. As outlined in the joint staff 

report, there were three chapters of the May 6 market events: 

• very fragile and uncertain markets due in part to the unsettling news concerning the European debt crisis; 

• a liquidity crisis in the E-Mini S&P 500 futures contracts (E-Mini) and related 

index securities; and 

• a liquidity crisis in individual securities. 

The events of that day highlighted many aspects of our markets, but two that I 

want to specifically focus on. One is how interconnected our markets are and the 

second is the role of technology in our markets. Before I talk about the overall nature of our markets today, though we have put this in previous reports, I want to 

mention some of the events during that critical half hour on May 6. 

At around 2:30 p.m. that day, in markets that were already frail and volatile, a 

large fundamental trader came into the E-Mini market to hedge about $4.1 billion 

of equity market exposure by selling 75,000 futures contracts, using an executing 

broker to execute the transaction. The trader chose to put the entire order into an 

automated execution algorithm. The trader chose to use an algorithm without establishing a price limit or a minimum time for execution of the order; instead, the order 
85 

was executed based upon an aggregate target of 9 percent of the trading volume calculated over the execution period. Once the order was entered into the algorithm, 

it stayed on auto-pilot to be executed in its entirety even if the market fell rapidly. 

This particular half hour highlighted cross-market linkages between securities, futures, and other derivatives marketplaces that are enabled by technology. Traders 

can employ automated trading systems to detect and take advantage of differences 

in prices of related markets. Cross-market trading strategies are about buying in 

one market and selling in another market products that are highly correlated. For 

instance, it may be something traded in the futures market that is indexed to the 

stock market and separately trading in the stock market itself. Where small disparities in the prices arise—even for just milliseconds—market participants try to profit 

from those differences in what economists and financial experts call arbitrage. 

During the critical 13-minute period on May 6, cross-market arbitrageurs transferred the price declines in the E-mini futures market produced in part by the large 

fundamental seller to the equities markets by opportunistically buying the E-Mini 

and simultaneously selling the S&P 500 SPDR exchange traded fund (SPY) and baskets of underlying stocks in the S&P 500 Index. Subsequently, prices in the SPY 

and individual securities rapidly fell. After a critical 5-second pause in trading of 

the E-mini in the futures market, the prices of the E-mini began to rise. During that 

period, as the price of the E-mini rose, the cross-market linkages resulted in a rise 

in the price of the SPY. 

Though the markets for the E-mini and the broad market SPY began to rise, 

there was a liquidity crisis in individual securities as well. 

Technology 

CFTC-regulated markets have rapidly transitioned from face-to-face to electronic 

trading, where 88 percent of trades are executed electronically. The move from trading on the floor of an exchange to electronic trading introduced significant changes 

in trading methods, spawning dramatic increases in automated execution, algorithmic market making and high frequency trading. 

Automated Execution 

Executing firms that have direct access to an exchange’s electronic trading platform provide investors with automated execution of large orders. These programs 

often are used to divide a large trade into many small trades with the goal of 

achieving the best average price. Automated execution is widely used by large investors, such as pension funds and asset managers, to acquire or hedge their exposures 

in different markets, including cash, futures, or options. 

Algorithmic Market Making 

Algorithmic market making broadly consists of placing limit orders, either as offers to sell above the current market price or bids to buy below the current market 

price. The goal of this strategy is to earn the bid-offer spread on lots of transactions. 

Algorithmic market makers generally do not access the markets in the same way 

that investors using algorithmic execution do. They tend to design their own algorithms to quickly, often in a manner of microseconds, get their orders into the trading platforms. 

High Frequency Trading 

High frequency trading typically refers to trading activity that employs extremely 

fast automated programs for generating, routing, canceling, and executing orders in 

electronic markets. They often act as algorithmic market makers, but they do other 

things as well, such as cross-market arbitrage, for example. Another high frequency 

trading strategy is referred to as ‘‘sniping.’’ This strategy submits and quickly cancels orders, looking for hidden pockets of liquidity. 

Surveillance and Safeguards 

The CFTC’s surveillance program works to promote market integrity and protect 

against fraud, manipulation, and other abuses. In the ever changing market environment, it is important that regulators have access to data, coordinate across agencies, trading platforms and self-regulatory organizations and have effective market 

mechanisms and pretrade safeguards. 

Data 

By the morning of May 7, the CFTC had all of the transaction and open position 

data for trading on May 6. We are fortunate to receive futures data every day. Because of the events of May 6, we also asked for full order book data, which we do 

not normally do. We do not have the resources to collect or examine order books 

on a daily basis, but, given the events of May 6, we reviewed that day’s order books. 
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This was a tremendous effort to collect and analyze an enormous data file that included more than 14 million messages just for 1 day in the lead month of the EMini. 

Though we do get daily futures data, it is currently missing an important bit of 

information: We receive traders’ account numbers, but we do not get the identity 

of the owner or controller of that account. Over time, CFTC staff has manually identified traders associated with a significant number of the more active trading accounts. The Commission published a proposed rule in July of this year that will, 

if finalized, require automated identification of account ownership and control. 

Though our interviews with traders did not suggest that on May 6 the swaps marketplace played a significant role, it may have on other days and may in the future. 

That is why I think it is very important that Congress has given regulators the authority to require swap dealers to provide swaps data to trade repositories that must 

make the data available to regulators. The CFTC has a rule out for public comment 

that would allow us to see all the data in the swaps markets that we see in the 

futures markets. Additionally, the CFTC will need to establish data linkages between swaps and futures data to conduct financial risk surveillance, market surveillance, economic analysis, and enforcement investigations across markets. 

Coordination With Regulators, Exchanges, and Self-Regulatory Organizations 

The CFTC is coordinating closely with the SEC on a policy level. We coordinated 

in providing recommendations to Congress on harmonizing our regulations. We also 

are closely coordinating on rulemakings to implement the Dodd-Frank Wall Street 

Reform and Consumer Protection Act. 

Importantly, we are working together on surveillance and data sharing. For instance, after the events of May 6, CFTC staff promptly shared position and transaction information directly with the SEC. 

Though coordination between the regulators is important, it is every bit as important that there be coordination between the exchanges and self-regulatory organizations, who conduct front-line market surveillance. The securities, options and futures exchanges have an intermarket working group to address surveillance concerns. 

Futures exchanges utilize computer surveillance systems that enable their investigators to conduct focused reviews of exception reports and create customized, ad 

hoc queries of trade data to identify instances of possible trade practice rule violations. The largest exchange also uses specific computerized pattern detection algorithms to identify trading patterns associated with several major types of violations. 

The exchanges monitor the basis relationship between cash and futures for both 

broad based index and single stock futures and look for anomalies. 

The CFTC also has been developing automated surveillance programs to detect 

prohibited trading activity and identify large price changes and large position 

changes. We have only just begun this process. We have significant more work to 

do to adequately automate surveillance in the futures market—not to mention the 

swaps market. The Commission will require additional resources to complete this 

project. 

Pretrade Safeguards 

Both CME Globex and the ICE trading systems have automatic safety features— 

termed ‘‘pretrade risk management functionality’’—to protect against errors in the 

entry of orders and extreme price swings. These features help ensure fair and orderly markets. These pretrade risk management safeguards include: (1) price bands; 

(2) maximum order size; (3) protections against market stop loss orders; and (4) stop 

logic functionality, or market pauses that prevent cascading stop orders. This is 

what was triggered on May 6 and coincided with the bottom of the E-mini. Exchanges also require executing brokers to have pretrade credit limitations to ensure 

that traders have the financial resources to complete transactions. 

One rulemaking that the Commission proposed on December 1 requires futures 

exchanges to have effective risk controls to reduce the potential for market disruptions and ensure orderly market conditions. To prevent market disruptions due to 

sudden volatile price movements, the proposed rule requires futures exchanges to 

have effective risk controls in place. This includes pauses or halts to trading in the 

event of extraordinary price movements that may result in distorted prices or trigger market disruptions. 

Implementing Enhancements to the CFTC’s Regulatory Program 

Though the Commission draws on more than 70 years of experience regulating 

futures, the events of May 6 and the Dodd-Frank Act present new challenges, responsibilities, and authorities. 
87 

1These remarks are my own and do not necessarily represent those of Georgetown University 

or the Direct Edge stock exchanges. 

Joint Advisory Committee 

The CFTC and SEC—with Congressional authorization—established the CFTC– 

SEC Joint Advisory Committee on Emerging Regulatory Issues. The first task of 

this Advisory Committee is to evaluate the events of May 6 and make recommendations to both agencies to improve market structures and regulations. The Advisory 

Committee has met four times thus far, and we are targeting to reconvene in late 

January. Amongst the areas we have asked them to address are the design of existing broad market circuit-breakers and pretrade risk management safeguards. 

CFTC staff is working with SEC staff to review and recommend potential revisions to the design of broad market circuit-breakers in light of today’s interconnected markets and changes in technology. 

Disruptive Trading Practice 

The Dodd-Frank Act gives the CFTC specific authority to restrict disruptive trading practices. The Act specifically prohibits three trading practices: (1) violating bids 

or offers; (2) intentional or reckless disregard for the orderly execution of transactions during the closing period; and (3) spoofing (bidding or offering with the intent to cancel the bid or offer before execution). In addition, Congress gave the Commission the authority to write rules and regulations that are reasonably necessary 

to prohibit trading practices that are disruptive of fair and orderly markets. 

On October 26, 2010, the CFTC published an advanced notice of proposed rulemaking seeking public comments on disruptive trading practices and the appropriate exercise of our rulemaking authority in this area. Specifically, the Commission solicited public input on the intersection of algorithmic and high frequency 

trading with possible market abuses and asked whether—outside of the closing period—there should be an obligation on executing brokers. 

Resources 

Before I close, I will address the resource needs of the CFTC. The futures marketplace that the CFTC oversees is currently a $33 trillion industry in notional 

amount. The swaps market that the Dodd-Frank Act tasks the CFTC with regulating has a far larger notional amount as well as more complexity. Based upon figures compiled by the Office of the Comptroller of the Currency, the largest 25 bank 

holding companies currently have $277 trillion notional amount of swaps. 

The CFTC’s current funding is far less than what is required to properly fulfill 

our significantly expanded role. The CFTC requires additional resources to enhance 

its surveillance program, prevent market disruptions similar to those experienced 

on May 6 and implement the Dodd-Frank Act. 

The President requested $261 million for the CFTC in his fiscal year 2011 budget. 

This included $216 million and 745 full-time employees for pre-Dodd-Frank authorities and $45 million to provide half of the staff estimated at that time needed to 

implement Dodd-Frank. The House Appropriations Subcommittee with jurisdiction 

over the CFTC matched the President’s request. The Senate Appropriations Subcommittee with jurisdiction over the CFTC boosted that amount to $286 million. We 

are currently operating under a continuing resolution that provides funding at an 

annualized level of $169 million. To fully implement the Dodd-Frank reforms, the 

Commission will require approximately 400 additional staff over the level needed to 

fulfill our pre-Dodd-Frank mission. 

I again thank you for inviting me to testify today. I look forward to your questions. 

PREPARED STATEMENT OF JAMES J. ANGEL 

ASSOCIATE PROFESSOR OF FINANCE, MCDONOUGH SCHOOL OF BUSINESS, 

GEORGETOWN UNIVERSITY

DECEMBER 8, 2010 

I wish to thank the Subcommittee for investigating these important questions in 

market structure. My name is James J. Angel and I study the nuts and bolts details 

of financial markets at Georgetown University. I have visited over 50 financial exchanges around the world. I am also the former Chair of the Nasdaq Economic Advisory Board and I am currently a public member of the board of directors of the Direct Edge Stock Exchanges. 1 I am a coinventor of two patents relating to trading 
88 

2See the Appendix for details. 

3See, http://www.upi.com/BusinesslNews/2008/09/08/United-Airlines-hit-by-5-year-oldnews/UPI-66501220903137/. 

technology. I am also the guy who warned the SEC in writing five times before the 

‘‘Flash Crash’’ that our markets are vulnerable to such big glitches. 2

Another Flash Crash can happen again, and we need to take steps to fix our fragmented regulatory system to prevent another one from further damaging our capital 

markets. Here’s why: 

The market is a complex network 

Our financial market is not a single exchange with a wooden trading floor, but 

a complex network linking numerous participants trading many different types of 

linked products including exchange-traded equities, options, and futures as well as 

over-the-counter instruments. This network includes not only numerous trading 

platforms but a vast infrastructure of supporting services. Participants include: 

• Equity exchanges 

• Option exchanges 

• Futures exchanges 

• Automated trading systems operated by broker-dealers 

• Proprietary trading systems operated by broker-dealers 

• Proprietary trading systems operated by other investors 

• Algorithm providers 

• Data vendors 

• Telecommunications providers 

• Data centers 

• Analytics providers 

• Settlement organizations such as DTCC 

• Stock transfer agencies 

• Banks 

• Proxy service firms 

• Professional traders 

• Money managers 

• Hedge funds 

• Retail investors 

• Media 

Problems anywhere in the network can disrupt the entire market 

A problem anywhere in the network can lead to a disruption. For example, on 

Monday, September 8, 2008, the South Florida Sun Sentinel erroneously published 

an old story that United Airlines had filed for bankruptcy—an event that had occurred in 2002. 3 Some investors thought that United Airlines was filing for bankruptcy again, and the stock of the new United Airlines temporarily plummeted more 

than 75 percent before recovering. Power outages and telecom problems can also disrupt the market. 

Most of the time our market network has enough redundancy to prevent a failure 

in one location from disrupting the whole network. Minor problems at one exchange 

or other part of the system are routine occurrences. Equity exchanges routinely declare ‘‘self help’’ when there are problems with other exchanges. Under normal conditions, market participants just trade around the problem and it never makes the 

news. On May 6, 2010, the market buckled under the flow of data and seemingly 

minor problems in data feeds cascaded into a chaotic partial failure of the entire 

network. 

Our market network performs really well—most of the time 

By most measurable standards, our market network is working better than ever 

before. Our automated markets provide fast, low cost executions. Total trading volume and displayed liquidity have jumped dramatically in recent years. This can be 

seen in the attached study I performed with Larry Harris of USC and Chester Spatt 

of Carnegie-Mellon, both former chief economists at the SEC. However, in that 
89 

4 Indeed, some stocks on May 6 did melt up. A trade in Sotheby’s was printed at $100,000 

per share. The study can be seen at http://www.sec.gov/comments/s7-02-10/s70210-54.pdf. 5Findings Regarding the Market Events of May 6, 2010: Report of the Staffs of the CFTC 

and SEC to the Joint Advisory Committee on Emerging Regulatory Issues, http://www.sec.gov/ 

news/studies/2010/marketevents-report.pdf, p. 35. 6Oral remarks at the Dow Jones Expert Series, Nasdaq Market Site, October 27, 2010. 

study, which was submitted to the SEC, we also warned of the danger of misfiring 

algorithms that could cause a meltdown—or a melt up of the market. 4

Our market network has finite capacity 

Just like any human system, our market network can only handle so much activity before it has problems with traffic jams. When the flow of data through a computer network overflows its capacity, strange things begin to happen. As the market 

is quite complex, bottlenecks can occur in unexpected places. Dealing with the capacity limitations of the network is not as simple as making sure that the equity 

exchanges have lots of spare computer capacity—the SEC does a pretty good job of 

that. As the network involves many unregulated entities, such as data vendors and 

IT providers as well as investors themselves, it is virtually impossible for the SEC 

or any regulator to force every network participant to maintain ludicrously high levels of excess capacity. This is especially true since network participants will rationally resist sizing their systems for once-a-decade data tsunamis. Instead, we need 

to have well thought out safeguards for dealing with these extreme events, which 

occur regularly in our financial markets. 

The Flash Crash was exacerbated by bad market data 

If traders don’t have good price data, they can’t trade. Many of the most important participants in our markets are known as ‘‘liquidity providers’’ who buy on the 

dips and sell on the rebound. They perform an important stabilizing role in markets. 

In the old days, they were known as specialists and hung out on those old wooden 

trading floors. Now they do their job with computers that hang out in stock exchange data centers in what is known as ‘‘colocation.’’ This kind of ‘‘high frequency’’ 

trading is a thin margin business with a lot of competition. These traders typically 

earn a small fraction of a penny per share, but they make money by trading in high 

volumes. These liquidity providers depend upon accurate data. If they detect that 

there is a malfunction in their data feeds, they do the rational thing and stop trading until they can figure out what is going wrong. As the SEC and CFTC noted in 

their report on the Flash Crash: 

As such, data integrity was cited by the firms we interviewed as their number one concern. To protect against trading on erroneous data, firms implement automated stops that are triggered when the data received appears 

questionable. 5

This is what happened on May 6: 

• Heavy trading activity led to traffic jams in market data. In the words of the 

Wall Street Journal’s Scott Patterson, ‘‘The market infrastructure was fried.’’ 6

• Important market participants detected problems in the accuracy of their market data, and stopped trading. This led to a decrease in liquidity. 

• Other market participants that did not detect the data problems kept trading. 

There were few buyers in the market when their sell orders arrived, causing 

prices to plummet temporarily. 

Flash Crashes are not new 

Financial market history contains many events in which the market was overwhelmed by the flow of data and the market mechanism broke down. Many of these 

events happened long before computers. On May 3, 1906, the New York Times headline blared ‘‘Stocks Break and Recover. On August 9, 1919, the New York Times reported a ‘‘sharp break’’ in prices. As in the Flash Crash, there were problems in getting prices out to the public: ‘‘In the break, prices quoted on the ticker tape were 

once again far behind the market . . . ’’ Soon there was an upturn and prices recovered. 

System problems in times of stress are not new 

Market history contains numerous examples of system problems that occurred 

during times of market stress. These problems were both a result of the level of 

market activity and a cause of additional confusion in the market. In the crash of 

1929, the ticker tape ran several hours late, adding to the confusion and panic. Investors did not know whether their orders had been executed or at what price. In 
90 

7http://www.sec.gov/news/studies/tradrep.htm 

8See, http://www.nyse.com/press/circuitlbreakers.html for the current circuit breaker levels. 

the crash of 1987, there were, in the SEC’s words, ‘‘large scale breakdowns in automated trading systems.’’ 7 Among other problems, the printers on the NYSE 

jammed, so that order tickets could not be printed. 

Market tsunamis are regular events, so we need to be prepared for the next one 

On May 6, the market network was so overwhelmed with the flood of data that 

it broke down and started spewing out bad prices. This is not the first time, nor 

will it be the last time. Market history teaches us that these extreme but infrequent 

events happen regularly. We need to be prepared for the next market tsunami. It 

is impractical to mandate an extreme amount of overcapacity throughout the extended market network. Instead, we should put safeguards in place so that when 

the next one hits, our market deals with the overflow of activity in a fail-safe manner. 

We need safeguards for individual stocks as well as for the whole market network 

Crude ‘‘circuit breakers’’ were put in place after the crash of 1987. 8 If the Flash 

Crash of 2010 had occurred just a few minutes earlier and been a little steeper, a 

1 hour trading halt would have occurred. Thank God that didn’t happen! Imagine 

the public panic that would have occurred when the news got out that the market 

crashed and then shut down. The public may well have thought that the fall in 

prices was a fundamental result of bad news stemming from the situation in Greece, 

and there may have been even more panic selling when the market reopened. Our 

close brush with doom on May 6, 2010, shows us how poorly the post-1987 circuitbreakers were designed. We need to seriously rethink the marketwide as well as 

stock specific safeguards. 

We also have mini-disruptions in individuals stocks with distressing regularity. 

The crude stock-by-stock circuit breakers that were imposed after the Flash Crash 

are an important first step, but there is much more refinement that needs to take 

place. The safeguards need to cover all stocks, and they need to be in effect during 

the open and the close. We need to fix the erroneous trade problem that has led 

to many false alarms after the circuit breakers were implemented. 

The current circuit breaker designs are based on price, which is good, but we 

should also have circuit breakers that are based on data integrity. When the data 

feeds can’t keep up with the market, we need to slow down the market so we can 

catch up. This will nip the problems in the bud before prices go crazy. 

The safeguards need to be integrated across the entire market network 

Currently, our fragmented regulatory system treats each exchange as an independent Self Regulatory Organization. There is no real time supervision of the entire market network. There is no entity that can call a timeout when there is some 

network problem that may not have been anticipated in the circuit breaker design. 

Somebody needs to be monitoring the system in real time and that somebody needs 

to have the authority to call a timeout when things go crazy. I think that FINRA 

is the obvious candidate to be that somebody. 

We need to worry less about a fragmented market than about fragmented regulation 

Some market participants grumble about the complexity and ‘‘fragmentation’’ of 

today’s markets. Yes, today’s market is far more complex than the days of old, but 

it works much better. Most of our technology today, from the automobile to the word 

processor, contains far more complicated technology than before, and most of the 

time works far better. 

One can think of the stock market of a few years ago as being similar to a manual 

typewriter. We upgraded it to an electric typewriter, and then to a word processor. 

On May 6, 2010, that word processor went into short spasm that highlighted many 

of the flaws I previously warned the SEC about. However, that does not mean that 

we should throw out the word processor and go back to a manual typewriter. It 

means we need to put safeguards in place to make sure that it doesn’t happen 

again. 

Even though the technology of our markets has improved dramatically in recent 

years, our regulatory system is still stuck in the manual typewriter days of the early 

twentieth century. There are literally hundreds of financial regulatory agencies at 

the State and Federal levels. None of them have the big picture in their in-baskets. 

Each of them has a fairly narrow mandate. 

In the 1975 ‘‘National Market System’’ amendments to the Securities Exchange 

Act, Congress mandated a competitive market structure. The SEC has dutifully im-
91 

9 In a discussion once with an SEC staffer a few years ago, I raised a concern about systemic 

risk. I was immediately and emphatically told that systemic risk was not in the SEC’s mandate 

and that it was the Fed’s job to worry about it. 

plemented this. However, Congress has not thought through how to regulate our 

interconnected financial markets. The Dodd-Frank bill did not meaningfully address 

the dysfunctional fragmentation in our regulatory system. 

We need regulators who understand the entire market 

Although the SEC has many dedicated and intelligent public servants, as an organization it does not really understand the entire market network. The Commission 

is a specialist agency with a narrow mandate that focuses on ‘‘securities.’’ Other related financial products (futures, insurance, and loan products) are left to other 

State and Federal agencies, which leads to gaps as well as overlaps in the regulation. If we think of our market network as a body, the SEC is perhaps, a cardiologist who might very well ignore the patient’s lung cancer as it assumes that other 

doctors treat it. 9 And since the cardiologist and the oncologist and in different granite towers, the cancer is ignored. 

The regulators need better market intelligence 

One of the frightening aspects of the Flash Crash was how long it took the regulators to piece together what happened, and how their reports still displayed a lack 

of a deep understanding of the significance of the facts they uncovered. We need 

regulators who really understand the market network and have access to the data 

and resources they need to properly nurture and supervise our markets. 

The regulators need good funding 

We have been penny wise and pound foolish with respect to funding the SEC. The 

SEC’s total cumulative budget since its founding has been, in today’s dollars, about 

$18 billion. That is less than half of investor losses in the Madoff scandal. We need 

good cops on the beat to keep the crooks out. We need to hire enough good people 

to do the job right, and make sure they have the right tools to do the job. We also 

need to be able to pay them enough to attract and keep good people. The pay level 

of SEC officials is very far below their private sector counterparts. SEC salaries 

should be benchmarked close enough to the private sector so that they can get the 

right people. 

One solution: De facto integration in our financial capitals 

The SEC is sequestered in a granite tower on F Street in Washington, hundreds 

of miles away from the heart of the markets that it attempts to regulate. The CFTC 

is in a different granite tower two miles away from the SEC in Lafayette Centre. 

The banking regulators are spread all over. Congress seemed unwilling to address 

the dysfunctional structure of our fragmented regulatory morass in the recent DoddFrank bill. 

However, there is an administrative solution to the fragmentation of our regulatory system that would not require massive legislation: If you want the regulators 

to work together, house them in close physical proximity. House all of the Federal 

financial regulators in one building with common shared facilities for security, food 

service, information technology, and so forth. In this way, it will become easy for 

regulators in the different agencies to literally work closely with each other. It will 

also make it easier for agencies to make use of the already existing Intergovernmental Personnel Act (IPA) mobility program to rotate employees through the different agencies. Increasing the rotation of employees through the different regulatory agencies will improve the thinking of regulatory agencies by making the 

agencies more cognizant of the entire market network rather than the narrow piece 

that their agency regulates. 

Second, locate this facility in the heart of our financial markets in New York City. 

Even though we live in an electronically linked world, physical proximity still matters. Being in the heart of the financial system makes it easier for the regulators 

to actually interact with the people in the markets. I know from my own experience 

that it is hard to understand markets from my ivory tower office. I learn about markets by taking every opportunity I can to make on-site visits to market practitioners. It is very important for the regulators to get out of their granite towers and 

interact with the financial markets, and it will be much easier if they are located 

closer to the markets they are regulating. It will also be easier for them to invite 

market practitioners in to visit them as well. 

Closeness to the markets is one of the reasons why trading firms still congregate 

in the New York City area. Notice that NASDAQ, which operates an all electronic 

market, moved its headquarters to New York when it realized that its key employ-
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10This data comes from the Center for Research in Securities Prices (CRSP) database for common stocks of U.S. companies listed on U.S. exchanges. 11http://www.wilshire.com/Indexes/Broad/Wilshire5000/Characteristics.html, accessed December 5, 2010. 

ees were spending so much time shuttling between Washington and New York. 

Pipeline Trading, which was founded by scientists from Los Alamos, New Mexico, 

set up shop in New York because that is the heart of the financial markets. 

Locating the bulk of our regulators in New York means that the regulatory agencies will draw from a labor pool that understands financial markets and has good 

market experience. I understand that it is hard right now for the regulators to attract good people to move to DC. The agencies thus draw from a labor pool of Government regulators who are well meaning but don’t have the background or experience needed for the job. 

The falling number of public companies is a major problem! 

Although not a focus of this hearing, there is another market-structure related 

problem that cries out for serious attention: The number of listed U.S. companies 

has fallen sharply over the last decade. At the end of 1997, before the dot-com bubble went crazy, there were 8,201 operating domestic companies listed on the NYSE, 

NASDAQ, and AMEX exchanges. At the end of 2009, only 4,439. 10

By the end of October, 2010, there were only 3,964 companies in the Wilshire 

5000 index, an index which include all domestic companies listed on our exchanges. 11

While private equity firms have picked up some of the slack, they are not a substitute for vibrant capital markets. Indeed, private equity investors need the public 

markets in order to be able to exit their investments. Without an exit strategy, investors won’t invest in the first place. 

Fewer public companies = fewer jobs 

In rough numbers, if we assume that half of the roughly 4,000 missing companies 

are now private or part of larger public companies, that still leaves about 2,000 

missing U.S. companies. If each of those missing companies employed 1,000 workers, that is two million fewer jobs. Two million more jobs would slash over 1 percent 

off of our unemployment rate. 

We have made it too expensive to be a public company 

There are several causes for the declining number of public companies: For one 

thing, it has become very expensive to be a public company compared with a private 

company. The compliance burdens on public companies, such as Sarbanes Oxley 
93 

12For the record, I strongly disagree with the allegations in the Litan and Bradley study that 

blame the proliferation of index products such as ETFs for the decline in public companies. 

‘‘Choking the Recovery: Why New Growth Companies Aren’t Going Public and Unrecognized 

Risks of Future Market Disruptions’’; http://www.kauffman.org/uploadedFiles/etflstudyl11- 

8-10.pdf. Although I do not agree with all of its recommendations, the Grant Thornton report 

is also worth noting: A Wake Up Call for America by David Weild and Edward Kim; http:// 

www.grantthornton.com/staticfiles/GTCom/ 

Public%20companies%20and%20capital%20markets/gtlwakeuplcalll.pdf 13Ortega, Edward, Nasdaq Will Let Stand Dendreon Trades Under Review http:// 

www.bloomberg.com/apps/news?pid=newsarchive&sid=a314cxKBoGHI 

§404 compliance is one problem. The Dodd-Frank law exempted tiny companies 

from this §404 burden, but the burden remains for the majority of exchange listed 

companies. The cost and risk of litigation exposure is another—the cost of directors 

and officers insurance for a public company is several times higher than the premium for a similar sized private company. 

Our market structure is not welcoming to small companies 

Market structure issues are also involved. Our markets provide great service to 

large companies, but it is not clear that the best market structure for big companies 

is also best for smaller companies. However, SEC policy over the last two decades 

has been to make the trading of smaller stocks the same as for larger stocks. There 

is no such thing as a ‘‘one size fits all’’ market, but the SEC does not seem to understand this. Small companies are lost and ignored by the market as an unintended 

consequence of many of the market structure changes of the last 20 years. We 

should encourage experimentation with different market models for smaller 

stocks. 12

Considerable attention needs to be applied to this problem. Smaller companies are 

the engine of innovation and economic growth. Without good capital markets nurture these companies of tomorrow, we will condemn our Nation to economic stagnation. 

APPENDIX: WRITTEN SUBMISSIONS TO THE SEC REGARDING MARKET GLITCHES PRIOR

TO MAY 6, 2010 

Warning Number 1 

In my May 5, 2009, comments presented at the SEC Roundtable on short selling 

(http://www.sec.gov/comments/4-581/4581-2.pdf), I warned on page 3 that we 

would have more high speed meltdowns like the one that affected Dendreon in April 

2009: 

We need a shock absorber to prevent another Dendreon. 

Those calling for a return of some type of uptick rule are expressing a legitimate concern. They intuitively grasp that there is something wrong with 

short-term price formation in our markets today. The recent incident with 

Dendreon (DNDN) on April 28, 2009, demonstrates the need for a shock absorber. The company was about to make an announcement regarding the 

effectiveness of its prostate drug Provenge. The stock plunged 69 percent 

in less than 2 minutes. 13 After the news was revealed, the stock quickly 

returned to its previous levels. Investors who had placed stop loss orders 

to protect themselves found that their orders were executed at very unfavorable prices. Why did the stock plunge? It is too early to tell. Was it a 

‘‘fat fingers’’ mistake in which an investor hit the wrong button? Did an algorithm misfire? Was it a chaotic interaction between dueling algorithms? 

Did a long seller panic and dump too many shares too fast? Was there a 

deliberate ‘‘bear raid’’ manipulation going on from informed traders hoping 

to push the price down so they could trigger stop loss orders and scoop up 

shares cheaply? Or was it just the case that the market was very thin just 

before the news announcement and a few large sell orders exhausted the 

available liquidity, triggering the selloff? Regardless of the reason, the incident demonstrates the need for a shock absorber to deal with extreme situations. 
94 

The era in which humans traded with humans is long gone. Now computers 

trade with other computers in the blink of an electron. Most other developed equity markets around the world have some kind of procedure for 

dealing with extreme situations. Whether it is a price limit, a trading halt, 

or a special quote mechanism, the United States needs to install a shock 

absorber to deal with excessive volatility. One of the main purposes of the 

stock market is to provide good price discovery. If the price discovery mechanism appears to be broken, it will reduce investor confidence in the market. 

Unfortunately, merely reimposing the old useless uptick rule or forcing a 

preborrow for shorted shares will not solve the problem of excessive 

intraday volatility. What is needed is to think outside the box of ‘‘lets get 

the short sellers’’ to the more useful question of ‘‘what kind of shock absorber works best in our modern markets?’’ 

It is certainly not obvious what form such a shock absorber should take. 

One thing that is clear is that the 1939 uptick rule will not achieve the objective of reducing excess volatility. Installing a broken shock absorber from 

a 1939 Chevrolet Coupe into our 2009 Corvette market will not do the job. 

What would make sense is a dampener similar to the exchanges’ proposal. 

The beauty of the exchange’s circuit-breaker with restriction idea is that it 

does not interfere with normal market operations under normal conditions. 

It only kicks in when needed, at times when the market is under stress. 

Perhaps a more gradual shock absorber would make more sense. For example, one approach would be: 

• At prices at or above 5 percent below the previous close: No restrictions 

• At prices below 5 percent below the previous close: Hard preborrow for short 

sales 

• At prices 10 percent below the previous close: price test for short sales 

• If the price hits 20 percent below the previous close: Automatic 10 minute trading halt. The stock would reopen with the usual opening auction after market 

surveillance has determined that there are no pending news announcements. 

I urge the Commission to begin consultation with the industry to develop 

one that fits the unique and competitive nature of our markets. If nothing 

is done, there will be more Dendreons. 

Warning Number 2 

In my comment letter of June 19, 2009 (http://www.sec.gov/comments/s7-08-09/ 

s70809-3758.pdf), I stated on page 2: 
95 

14http://deutsche-boerse.com/dbag/dispatch/en/binary/gdblcontentlpool/importedlfiles/ 

publiclfiles/10ldownloads/31ltradinglmember/10lProductslandlFunctionalities/ 

20lStocks/50lXetralMarketlModel/marktmodelllaktien.pdf 

Our electronic markets lack a shock absorber. 

Most electronic exchanges around the world have automated systems in 

place to deal with extreme events. We don’t. High speed algorithmic trading 

has brought amazing liquidity and low transactions costs to the markets, 

but it also brings the risk of market disruption at warp speed. 

Our markets are vulnerable to short-term fluctuations that can result in 

prices that do not reflect the market’s consensus of the value of the stock. 

The disruption in the trading of Dendreon (DND) on April 28, 2009, that 

I referred to in my remarks at the Roundtable is a smoking gun. (My remarks are repeated at the end of this comment letter for you convenience 

as well.) 

The stock plunged for no apparent reason, and by the time the humans 

halted trading the damage was done. Many investors who had placed stoploss orders discovered that their orders had been filled at very low prices. 

Furthermore, incidents like these bring up suspicions of foul play, and 

these suspicions hurt our capital markets. When investors think that market manipulation is unpunished, they will withdraw from our capital markets, reducing their usefulness to our society. 

Short selling is not the only cause of short term market disruptions. 

A burst of short selling can cause a ‘‘Dendreon moment’’, but so can long 

selling. Markets can also be disrupted on the up side as well. In considering 

what to do about situations like this, the Commission should consider the 

broader needs of the market for a shock absorber to deal with excessive 

short-term volatility. 

The Commission should actively consider shock absorbers that deal with 

ALL price disruptions, not just ones triggered by short sales. One time-tested model to consider is the ‘‘volatility interruption’’ used by Deutsche 

Bo ̈rse. 14 When the stock moves outside of a reference range, trading is halted for a period of time and trading then restarts with a call auction. 

We need not follow the Deutsche Bo ̈rse model exactly. Short orders at 

prices below the previous opening or closing price could be excluded from 

the restarting auction (with appropriate exemptions for market makers and 

arbitrageurs). After trading restarts, restrictions should be placed on short 

sales at prices 5 percent or more below the previous opening or closing price 
96 

to maintain fair and orderly trading. These could include (1) preborrowing 

requirements or a bid test. 

Any changes should be carefully studied with a transparent pilot experiment. 

Before the Commission institutes any such changes, it should experiment 

carefully as it did with the original Regulation SHO pilot. In this way, the 

Commission could adopt the best of the different proposals after carefully 

examining their impact. 

Warning Number 3 

In my September 21, 2009 comment letter to the SEC on short selling (http:// 

www.sec.gov/comments/s7-08-09/s70809-4658.pdf), I stated on page 1: 

The big picture is that today’s warp speed computerized markets contain 

the potential for another financial catastrophe at warp speed. If an algorithm at a large financial institution misfires, whether because of an honest 

malfunction or sabotage, it could create an enormous critical chain reaction 

that would cause a tsunami of economic destruction within milliseconds. 

Yet we currently rely on slow humans at our exchanges to make decisions. 

We need automated circuit breakers that function on a stock by stock basis 

that will kick in instantly when something goes haywire. To date, the SEC 

has taken the same approach to such warnings as FEMA took to warnings 

that New Orleans was vulnerable to a Category 5 hurricane. Do we need 

a Category 5 meltdown in the equity market before the SEC moves to take 

action to prevent such a preventable calamity? The individual exchanges 

cannot act on their own because of the competitive fragmented nature of 

our modern markets. If a single exchange halts trading, it stands at a competitive disadvantage to its competitors. Dealing with this threat requires 

intelligent coordinated action by the SEC. 

Warning Number 4 

In my joint study with former SEC chief economists Lawrence Harris and Chester 

Spatt (http://www.sec.gov/comments/s7-02-10/s70210-54.pdf), we stated on page 

47: 

8.3 Misfiring algorithms 

In a related area, we are also concerned that, even without naked access, 

the risk control procedures at a brokerage firm may fail to react in a timely 

manner when a trading system malfunctions. In the worst case scenario, 

a computerized trading system at a large brokerage firm sends a large 

number of erroneous sell orders in a large number of stocks, creating a 

positive feedback loop through the triggering of stop orders, option replication strategies, and margin liquidations. In the minutes it takes humans at 

the exchanges to react to the situation, billions of dollars of damage may 

be done. 

Currently our exchanges have no automatic systems that would halt trading in a particular stock or for the entire market during extraordinary 

events. It is our understanding that the circuit breakers instituted after the 

Crash of 1987 would be manually implemented, which could take several 

minutes. These circuit breakers are triggered only by changes in the Dow 

Jones Industrial average, so severe damage could be done to other groups 

of stocks, and the circuit breakers would not kick in. Also, a misfiring algorithm could also create a ‘‘melt-up’’ as well. We recommend that the exchanges and clearinghouses examine the risk and take appropriate actions. 

Perhaps the issue most simply could be addressed by requiring that all 

computer systems that submit orders pass their orders through an independent box that quickly counts them and their sizes to ensure that they 

do not collectively violate preset activity parameters. 

Warning Number 5 

In my comment letter of April 30, 2010 (http://www.sec.gov/comments/s7-02-10/ 

s70210-172.pdf), I stated on page 5 (Italic text is in the original): 

High frequency technology requires high frequency circuit breakers. 

There is one risk that HFT imposes on the market that must be addressed 

by the Commission. With so much activity driven by automated computer 

systems, there is a risk that something will go extremely wrong at high 

speed. For example, a runaway algo at a large firm could trigger a large 
97 

15See, Bernard S. Donefer, ‘‘Algos Gone Wild: Risk in the World of Automated Trading Strategies’’, Journal of Trading 5(2), Spring 2010 pp. 31–34 http://www.iijournals.com/doi/abs/ 

10.3905/JOT.2010.5.2.031 

series of sell orders across multiple assets, triggering other sell orders and 

causing major disruptions with losses in the billions. With the global linkage of cash and derivative markets around the world, it would be extremely 

difficult to go back after the fact and bust the appropriate trades, leading 

to years of litigation. The uncertainty and confusion would cause serious 

damage. Even more troubling is the prospect that such a glitch could be 

caused intentionally, either by a disgruntled employee or a terrorist. 

All market participants have the right incentives to prevent this from happening. The brokerage firms and exchanges have filters in place designed 

to catch ‘‘fat fingers’’ and other mistakes. However, the never ending quest 

for higher speed also creates incentives for them to cut corners and eliminate time consuming safeguards that might slow their response time. In today’s competitive market place, no one market center can take all the needed actions alone. There needs to be coordinated guidance from the Commission on this issue. 

No human system is perfect. Despite all of the correct incentives and precautions, airplanes sometimes crash. Eventually there will be some big 

glitch. We need a marketwide circuit breaker that is activated automatically in real time. It is my understanding that the crude marketwide circuit 

breakers imposed after the crash of 1987 are currently operated manually. 

In the minute or so it takes for humans to respond to a machine meltdown, 

billions of dollars of damages could occur. 15 The April 28, 2009, incident involving Dendreon is an example of what can go wrong. The stock lost over 

half its value for no apparent reason in less than 2 minutes before the humans could stop trading. When trading resumed, the stock returned to its 

previous value. Many investors who had placed stop orders experienced severe losses from trades that were not busted. Almost exactly 1 year later, 

on April 27, 2010, a botched basket trade resulted in the need to bust clearly erroneous trades in over 80 different stocks. It is extremely messy to attempt to bust erroneous trades after the fact, especially if multiple instruments in multiple asset classes traded on multiple exchanges in multiple 

countries are involved. For example, an investor may sell stock that was 

purchased during the malfunction only to find that the purchase was busted but not the later sale, leading to an inadvertent naked short position. 

We need a real time circuit breaker that can stop the market before extreme damage occurs. 

The Commission should consider imposing an automated marketwide trading halt in any instrument that falls 10 percent in a short period of time. 

The stock would then reopen using the opening auction after humans have 

examined the situation to make sure that the stock can be reopened in a 

fair and orderly manner. 

If this Commission fails to act on this risk after asking so many questions 

about HFT in this Release, this Commission and its staff will be blamed for 

ignoring this risk when the inevitable big glitch occurs. 
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1There is a new short sale restriction scheduled to become effective in March 2011, which 

restricts short sales from hitting the bid if a certain downward threshold has been reached. In 

the case of a sponsored account, one wonders how this rule would be enforced. If the high frequency trading firm does not label short sales as such, the market damage will be done and 

the violation only detected, if at all, some time after the event. 

PREPARED STATEMENT OF THOMAS PETERFFY 

CHAIRMAN AND CHIEF EXECUTIVE OFFICER, INTERACTIVE BROKERS GROUP

DECEMBER 8, 2010 

A. Introduction 

Chairman Reed, Chairman Levin, Ranking Member Bunning, Ranking Member 

Coburn, and Senators, thank you for inviting me here to discuss some of the issues 

facing the Nation’s securities and futures markets and what we might do to address 

these issues. 

I am the Chairman and CEO of the Interactive Brokers Group. Interactive Brokers is a technology-focused brokerage firm that provides sophisticated investors 

and institutions with access to securities and futures trading in the U.S. and across 

the world. Interactive Brokers also has a large market making business, in which 

we provide liquidity on stock, options and futures exchanges. We are an $8 billion 

company by market capitalization and our customers hold about $21 billion dollars 

with us, and so you might say we have a lot of ‘‘skin in the game’’ in terms of our 

interest in the health of the U.S. markets. We have some serious concerns that I 

would like to share with you. 

B. The Interconnected Securities and Futures Markets of the U.S. Continue 

To Be Vulnerable to Major Disruption 

To begin, I would like to tell you about my worst nightmare: 

Consider a high frequency trading—or ‘‘HFT’’—operation with as little as $30 to 

$50 million dollars. This HFT firm consists of a few computers, a couple of programmers, and maybe a 3-month track record of high volume, computerized trading with 

modest gains or losses. 

Many such high frequency trading operations exist today scattered around the 

world. They gain direct, unfiltered access to U.S. exchanges via what is called Sponsored Access, wherein the sponsoring, often undercapitalized, U.S. broker will essentially lend out its exchange membership for a fee and under that broker’s membership, the high-frequency trading operation is able to do an unlimited number of 

transactions without any prescreening by the sponsoring broker (i.e., the sponsoring 

broker does not see the orders before the HFT firm executes them). 

One day, at 3:45 p.m., the HFT firm’s computers start sending orders to sell large 

capitalization stocks and Exchange-Traded Funds (ETFs). The circuit breakers are 

not in effect after 3:35 p.m., but even if they were, perhaps our HFT firm would 

try to mediate its orders to avoid triggering the circuit breakers. As the HFT firm’s 

selling continues, the market decline accelerates and spreads to the futures and options markets. As the close of trading approaches, many other sellers jump in, including day traders trying to go home flat, traders with stop orders in the system, 

and securities and futures brokers liquidating undermargined customer accounts. 1

With the right pressure applied, the market might easily close down 30 percent for 

the day. 

The next morning, scared investors and brokers holding undermargined accounts 

all have to run for the exits and sell into the cascading circuit breakers. Undercapitalized brokers fail. Other HFTs and hedge funds that were long going into the 

decline, fail, and their clearing brokers fail. Clearinghouses may be threatened, as 

more and more positions must be liquidated for margin reasons. There will be a 

great many losers, but the HFT firm that started it all will garner huge profits 

when it covers its short positions during the fire sale. Its gains will be moved quickly to offshore accounts before the regulators figure out who did it. 

In the other, almost-as-bad scenario, when the market opens the next day it realizes it was duped. No external event or news is seen justifying the prior day’s break, 

and the source of the orders has been isolated. In this scenario, the market rallies 

sharply, climbing 40 percent the next morning. The HFT firm’s sell orders that 

caused the original decline become massive losers, losses that the broker sponsoring 

the access (and its clearing broker) cannot cover. Bankruptcies follow. 

Under either scenario, many innocent, ordinary investors will be caught by the 

huge downdraft or updraft and confidence in the stability and integrity of our markets will suffer further. 
157 

Unfortunately, what I have just described is very plausible. It could be an attempted manipulation by an HFT firm with a goal of simple profit. It could be an 

intentional act by a terrorist or anarchist, or by a dissatisfied employee of a hedge 

fund or broker or HFT firm. Or it could be caused by a simple computer bug. 

So the question becomes, what can we do to prevent these and other, less dramatic abuses? 

C. Recommendations 

I. The SEC’s New Rules Banning Certain Forms of Sponsored Access and Requiring 

Risk Management Procedures Should Be Strengthened and Should Be Made Effective Immediately, by Emergency Order if Necessary. The CFTC Should Also 

Adopt Similar Rules. 

The SEC recently approved new rules banning certain forms of sponsored access 

and requiring brokers to implement new risk management procedures, but the rules 

do not go into practical effect until mid-July 2011, seven months from now. A great 

deal could happen between now and then. 

In addition, the regulations are somewhat vague and seem to leave enough discretion to brokers that some might allow orders to be sent to market that are beyond 

the financial wherewithal of the customer. 

Finally, although the new rules prevent customers from sending orders directly 

to an exchange using sponsored access, about 5,000 brokers that are not members 

of the clearing house are still allowed to send orders directly to an exchange, with 

no prefiltering or credit review by the clearing member broker that is ultimately financially responsible. 

These gaps need to be closed. First, the SEC should make the new rules (or at 

least the important, operational portions of them) effective very shortly, by emergency order if necessary and hopefully by the end of the year. 

Second, the regulations should be clarified to require that the clearing broker that 

is financially responsible for a particular customer’s orders must set a specific credit 

limit for that customer. This credit limit must not exceed the smaller of: (1) the customer’s stated capital (as reasonably relied upon by the broker); or (2) the assets 

on deposit with the broker plus 10 percent of the broker’s capital. 

The broker should calculate the margin requirements on the customer’s existing 

positions in real time and reject any order that, if executed, would cause the customer’s margin requirements to exceed the prescribed credit limit. This is an elementary risk management tool that most reputable brokers already use, and all reputable brokers should use. 

Finally, the ability to submit orders to exchanges should be restricted to brokers 

that are clearing members. Thinly capitalized firms or firms with poor risk management systems may register as broker-dealers, become exchange members, and send 

orders directly to the exchange, for which another broker—the clearing broker—ultimately will be responsible. And yet that clearing broker whose capital is at risk is 

not required to see or to credit check these orders before execution. This is a huge 

risk management gap that must be closed. 

II. The SEC Should Approve and Accelerate Its Proposed Audit Trail Rules. The 

CFTC Should Adopt Coordinated Rules and Use the Same Unique Beneficial 

Owner Codes so That the Agencies Can Effectively Share Surveillance Information. As a Stopgap Until These Systems Are Fully Developed, the Commissions 

Should Require Clearing Brokers To Create Basic Audit Trails, Including Beneficial Owner Information. 

Manipulation and insider trading are frequent and appear to be on the upswing, 

and the SEC and the CFTC need real-time consolidated audit trail information, including most importantly the identity of the underlying beneficial owner behind 

each trade. 

The SEC has proposed comprehensive rules providing for the creation of a single, 

consolidated audit trail, but these rules have not yet been approved and will not 

become fully effective for at least 2 years, and probably more like three or four including the extensions of time that the industry undoubtedly will request. 

The SEC should approve its proposed audit trail rules and shorten the timeframe 

for implementation substantially. But as a stopgap, the SEC should issue a very 

basic order, effective in no greater than 90 days, requiring that clearing brokers 

maintain a basic audit trail, including the identity of the underlying beneficial 

owner behind each order for which the clearing broker is responsible. The information would have to be provided to the Commission and relevant SROs on demand, 

perhaps using existing systems. 

Having immediate access to the identity of the underlying traders behind each 

order by a simple request to the clearing broker will be a marked improvement over 
158 

2The ultimate goal of the proposed consolidated audit trail is to allow regulators to view order 

and trade information in time-sequence in order to be able to replay actual market events. Due 

to calibration difficulties and inherent latencies in communications, it will be impossible to precisely recreate market events. In any event, we usually know what happened but do not know 

who did it. The presence of quickly accessible data identifying rule violators would serve as a 

deterrent. 3The internalizers are supposedly matching the best prices prevailing at the exchanges, so 

that they can argue that their customers get best execution. This is subject to serious doubt, 

however. Transaction Auditing Group, Inc., a third-party provider of transaction analysis, has 

consistently determined that Interactive Brokers’ U.S. stock and options executions are significantly better than the industry (on average 28 cents better per 100 shares in the most recent 

6-month period studied). Rather than internalize its customers’ orders, Interactive Brokers simply routes each order, or parts of an order, to the exchange or market with the best price for 

that order, and quickly reroutes if another market becomes more favorable. 

the current system until the full-blown, cross-market consolidated audit trail comes 

on line in 2 or 3 or 4 years. 2

When the consolidated audit trail system does come on line, the SEC and CFTC 

should have similar or identical systems. Most importantly, the unique large trader 

and beneficial owner codes that would be issued by the central audit trail processor 

should be the same across the securities and futures markets so that cross market 

activity can be monitored effectively. 

III. To Improve Liquidity and Transparency and Help Prevent Future Crashes, OffExchange Trading of Exchange-Listed Products Should Be Limited or Prohibited. 

An observer from another planet, here to study our financial regulation, would 

have some difficulty understanding the following proposition: In the wake of DoddFrank, equity-based ‘‘Over-the-Counter’’ derivatives must trade on exchanges, so 

long as similar products are listed there. Yet ‘‘Exchange-Listed Securities’’ remain 

free to trade over-the-counter. This is bureaucracy at its best, or perhaps at its 

worst. 

In the current U.S. equity markets, brokers ‘‘internalize’’ stock trades by trading 

against their customers’ orders directly or selling them to another firm to do so 

(thus avoiding the exchanges). The trades are then printed to the tape and put up 

at the clearinghouse. Brokers are supposed to provide best execution even when 

they internalize or sell their order flow, but best execution is vaguely defined and 

essentially unenforced. 3 Brokers in the U.S. must post reports showing where they 

route their customers’ orders, but it is clear that most brokers do not care what is 

reflected in those reports. 

It should be shocking that according to the Rule 606 reports mandated by the 

SEC, no major online broker, with the exception of our company Interactive Brokers, sends more than 5 percent of its orders to organized exchanges. More than 

95 percent of their orders go to internalizers! 

The fact is that when exchange-listed products are traded off of the exchanges, 

liquidity on the exchanges dries up. As fewer orders are sent to exchanges, fewer 

market makers compete for those orders or quote in size because they get nothing 

out of it. Exchanges become illiquid and are unable to withstand supply and demand imbalances. This causes confidence-draining mini-crashes in single stocks 

from time to time, but becomes disastrous on days where a major market event occurs. On such days, the internalizers suddenly dump their orders on the exchanges 

because the internalizers are afraid to take on large positions, but there is no liquidity on the exchanges to deal with the orders sent there. 

Congress or the SEC should prohibit off-exchange trading of exchange-listed securities or limit it to large institutions trading very large size. This is essential to restore liquidity and confidence in our markets. 

IV. The Existing Circuit Breakers Must Be Modified and Must Be Effective at All 

Times While Markets Are Open. 

First, the current circuit breakers in the equity markets are only in effect from 

9:45 a.m. until 3:45 p.m., leaving the volatile opening and closing periods of trading 

uncovered. The circuit breakers should be in effect at all times that the market is 

open. 

Second, the circuit breakers do not kick in until a price moves 10 percent in a 

5-minute period. This allows prices to move 2 percent per minute indefinitely without ever triggering the circuit breakers (allowing the market to move, for example, 

nearly 80 percent in 40 minutes). This needs to be changed. 

Circuit breakers should first take effect at a price 10 percent up or down from 

the prior day’s close. When a circuit breaker is triggered, trading would not be halted, but no trades would be allowed for 5 minutes at any price further than 10 per-
159 

4 ‘‘Mini-crashes’’ continue to occur even with the recently enacted circuit breakers in the equity markets. This is because the primary listing market for each equity security has to calculate throughout the day whether the circuit breaker has been tripped for that security and 

then notify the secondary markets if the circuit breaker has been tripped. But between the time 

that such electronic notification is made by the primary market and the time that the secondary 

markets can react to it, the security can continue to trade on the secondary markets at prices 

well outside the circuit breaker. If the circuit breakers instead were set at 10 percent, 20 percent, 30 percent, etc., away from the prior day’s close, the secondary markets would not need 

to wait for notice from the primary market that a circuit breaker was triggered (because they 

could calculate the circuit breaker triggers themselves by comparing trade prices throughout the 

day with the prior day’s close). 

cent from the prior close. In a falling market, for example, trades at prices above 

10 percent down would still be allowed during the 5-minute circuit breaker period, 

thus allowing the stock to bounce but preventing it from falling any further for 5 

minutes. 4

After 5 minutes, the stock would be able to trade freely again, except that another 

circuit breaker would take effect at 20 percent down from the prior day’s close, for 

another 5 minutes. The process would be repeated at 30 percent down from the 

prior close, 40 percent, and so on. 

In addition to these individual circuit breakers, there would be a marketwide circuit breaker that would take effect if at any time more than 10 percent of National 

Market System stocks had tripped the 20 percent price band. If this overall circuit 

breaker were triggered in a down market, then the 10 percent of NMS stocks already trading outside the 20 percent price band would not be allowed to trade at 

any price lower than their day’s low to that point. Stocks that had not yet traded 

below 20 percent down from the prior close would be allowed to trade at any price 

down to 20 percent but no further. The price limits would last for the rest of the 

trading day. 

The current circuit breakers in the futures markets should be augmented with the 

same marketwide circuit breaker. Thus, when 10 percent of NMS stocks traded outside the 20 percent band, futures markets would limit the move in related index 

contracts by calculating the maximum allowed price move of each index component 

(including some index components that would be allowed to trade down 20 percent 

and some that might already have broken that band and thus would be allowed to 

trade down to their day’s low) and than applying these individual component limits 

to the fair value of the lead futures contract. 

Likewise, functionally equivalent restrictions would have to be applied to other 

equity-based derivatives markets (such as exchange-traded options). 

PREPARED STATEMENT OF MANOJ NARANG 

CHIEF EXECUTIVE OFFICER, TRADEWORX INC. 

DECEMBER 8, 2010 

My name is Manoj Narang, and I’m the CEO of Tradeworx Inc., a financial technology firm that provides hardware and software solutions to investors interested 

in ultra-high-performance trading. In addition to supporting outside clients with our 

technology, we operate a proprietary trading practice which utilizes the same technology to engage in high-frequency trading strategies. We also manage money in 

lower-turnover quantitative strategies for outside investors. All of our strategies involve technology-driven trading based on statistical arbitrage. 

I’d like to begin by expressing my gratitude for the opportunity to share my insights and perspectives in today’s hearing, and by recognizing that small firms like 

Tradeworx are not often accorded such an opportunity. 

Restoring Investor Confidence in the Markets 

My prepared remarks focus on the topic of restoring investor confidence in our 

markets. It is self-evident that markets depend on confidence in order to function 

smoothly, and there is no denying that the confidence of investors was severely 

shaken on May 6. It is this loss of confidence that transformed the Flash Crash from 

just another chapter of the ongoing credit crisis into the far-reaching referendum 

on market structure that it has become. Ever since May 6, investors have been 

plagued by the nagging suspicion that the regulatory authorities are unable to understand the inner workings of the market, or to meaningfully assess the practices 

of its most active participants. 

For the past 2 years, the public has been treated to endless debate about market 

structure issues. Are prices posted by market-makers fair, or are they subject to 

widespread manipulation? What impact do rebates or elevated cancellation rates 
160 

have on liquidity? Why is speed important to the business of market-making? How 

do the equities, options, and futures markets influence and interact with each other? 

The public should not be forced to accept anecdotal or speculative answers to such 

questions when definitive answers can be had by analyzing data. Firms such as 

Tradeworx have the ability to produce objective and factual answers to questions 

of this sort with only minutes of effort. While we have shared our insights with the 

SEC, there is no substitute for the regulators having these sorts of capabilities on 

their own. 

Regulation NMS 

Another key obstacle to restoring the confidence of investors is that the markets 

have become too complicated for ordinary investors to understand. The U.S. Equity 

Market sports the most complex and fragmented market structure known to mankind. The regulators deserve their share of the blame: their magnum opus—Regulation NMS—was 10 years in the making and spans over 520 pages. For perspective, 

consider that in competitive games like chess, extraordinary complexity arises from 

just a handful of rules. It should surprise nobody that an undertaking of this magnitude would overreach and backfire. Nor should it surprise anyone that the Byzantine structure it foisted upon the market would generate paranoia among investors, 

fueling the perception that the system is somehow ‘‘rigged’’ against them. 

Remarkably, the most complex and problematic part of the regulation adds almost 

no value to the market in practice. I’m referring to Rule 611, which is designed to 

keep prices at the different exchanges synchronized with each other. Consider that 

the stocks SPY and IVV, both of which track the S&P 500 index, have a 99.9 percent correlation with each other when their prices are sampled at subsecond intervals, despite the fact that there is no regulation to keep their prices in sync. This 

is compelling evidence that arbitrage alone is more than sufficient to keep prices 

in line with each other. 

Unfortunately, 99.9 percent was not good enough for policy makers. With Reg 

NMS, the SEC decided to keep prices in line by decree, rather than by the traditional mechanism, arbitrage. Never mind that the underlying idea violates the laws 

of physics—exchanges can never perfectly incorporate each other’s information, because information takes time to transmit. 

The market continues to pay a steep price for this overreach. Rather than minimizing fragmentation, which was its stated objective, the regulation has directly encouraged it, giving upstart exchanges an economic incentive they never before enjoyed by virtually guaranteeing that they will get orders routed to them by other 

exchanges. Rather than limiting the role of arbitrage, the regulation has diverted 

its focus from keeping prices in check to exploiting the shortcomings of the regulation itself, often to the detriment of long-term investors. To top it off, the rule has 

managed to ignite a massive technology arms race, by making the speed of information transmission a more critical issue than it ever was previously. 

Now that the regulators clearly have the mandate to create even more rules, I 

fear we are doomed to repeat our past mistakes. Once again, superfluous proposals 

which solve nonexistent problems abound. It is easy to conjure up gimmicks such 

as ‘‘speed limits’’ on order cancellations, but it is also trivially easy to demonstrate 

how they will backfire and harm long-term investors. When lawyers with minimal 

trading expertise devise such rules, they should recognize that world-class engineers 

with a profit motive will be there to exploit them. Who do you think will wind up 

with the upper hand? 

Adding ever-more expansive regulations to a system which is already hopelessly 

complex is guaranteed to backfire by inviting unintended consequences. This will 

not restore investor confidence in our markets. Fixing flaws in the existing regulations will. 

There is plenty of low-hanging fruit to be picked here, starting with the provision 

of Rule 611 which prohibits exchanges from posting orders which lock the quotes 

of other exchanges. Of all the provisions of Reg NMS, this is the most utterly useless, the most exploitable, and the most flagrantly damaging. 

Were this one superfluous provision to be relaxed, trading venues would cease 

their unabated proliferation, and fragmentation would likely begin a steady reversal. Volumes would start migrating back from dark pools to the lit exchanges. Message traffic and excessive order cancellations would decline. Proprietary traders 

would cease to have the ability to jump in front of investor orders. The wind would 

be taken out of the sails of the high-tech arms race. All of this could be accomplished while leaving the vast majority of Reg NMS intact and without altering the 

framework of the national market system in a meaningful way. I hope to have the 

opportunity to elaborate on these topics at today’s hearing, and I ask that the entirety of my written remarks be included in the record. 
161 

PREPARED STATEMENT OF KEVIN CRONIN 

GLOBAL HEAD OF EQUITY TRADING, INVESCO LTD. 

DECEMBER 8, 2010 

Thank you, Chairman Reed, Ranking Member Bunning, Chairman Levin, Ranking Member Coburn, and Members of the Senate Subcommittee on Securities, Insurance, and Investment and the Senate Permanent Subcommittee on Investigations 

for the opportunity to speak here today, I am pleased to participate on behalf of 

Invesco at this hearing examining the efficiency, stability and integrity of the U.S. 

capital markets, Invesco is a leading independent global asset management firm 

with operations in 20 countries and assets under management of approximately 

$620 billion. 

An efficient and effective capital formation process is essential to the growth and 

vitality of the U.S. economy. The most important aspect of the capital formation 

process is that it attracts long-term investors’ capital. To accomplish this, it is critically important that the primary and secondary capital markets which facilitate the 

capital formation process are transparent and working in the best interests of investors. To that end, it is essential that sensible, consistent rules and regulations are 

in place governing the markets and that regulators have the tools to ensure fairness 

and integrity in the markets. Such a foundation fosters the confidence of long-term 

investors to provide the capital necessary for companies to create new and innovative services, products and technologies which in turn create additional jobs and advance our standards of living. We therefore commend the Subcommittees for holding 

this hearing to examine these critical issues. 

Unfortunately, over the past several years long-term investor confidence has been 

undermined by a series of scandals, financial crises and economic tumult, including 

most recently the ‘‘flash crash’’ of May 6th. In order to recover long-term investor 

confidence, it is incumbent upon regulators to ensure that the securities markets 

are highly competitive and efficient as well as transparent and fair. The regulatory 

structure that governs the securities markets must encourage, rather than impede, 

liquidity, transparency, and price discovery. Consistent with these goals, Invesco 

strongly supports regulatory efforts to address issues that may impact the fair and 

orderly operation of the securities markets and investor confidence in those markets. 

To be clear, investors, both retail and institutional, are better off now than they 

were just a few years ago. Competition in today’s markets, which was virtually absent 5 years ago, has spurred trading innovation and enhanced investor access. 

Trading costs, certainly in the most liquid of securities, have been reduced and investors have more choice and control in how they execute their trades. Advances in 

technology have increased the overall efficiency of trading. These gains, however, 

haven’t come without accompanying challenges. Some of these challenges were highlighted by the market events of May 6 and others are broader market structure 

issues that were raised in the SEC’s concept release on market structure. 

The Market Events of May 6th 

The events of May 6 brought to the forefront several inefficiencies in the current 

market structure and highlighted the interdependency of the equity, options and futures markets, particularly the connection between price discovery for the broader 

stock market and activity in the futures markets. Perhaps most significantly, the 

events of May 6 underscored the absence of an effective mechanism to dampen volatility at the single-stock level; the lack of consistency and synchronization of rules 

which govern trading at the various exchanges; the lack of clearly defined rules on 

the handling of clearly erroneous trades; the outsized impact trading algorithms and 

small market orders can have in the prices of securities in times of duress; and the 

fact that the market making mechanisms in place today provide virtually no liquidity to investors in times of market stress. 

Several of these issues have already been addressed by regulators, including the 

need to establish mechanisms in single stocks to address extreme price moves and 

better procedures for resolving clearly erroneous trades. In addition, discussions are 

ongoing among regulators and market participants regarding the inconsistent practices of exchanges when dealing with major price movements. Invesco is a diversified investment manager and as such we participate in trading in many types of 

securities on many different exchanges and market venues. We believe it would 

serve our investors’ interests as well as other long-term investors’ interests to have 

better coordination, both at the regulator and exchange levels, between the options, 

futures, equities, and credit markets. 
162 

Establishing Mechanisms To Address Extreme Price Moves 

Removing all instability and volatility from the equity markets is neither possible 

nor appropriate. However, establishing mechanisms to address extreme price moves 

in the markets and volatility related to inefficient market structure will be critical 

in preventing a repeat of the May 6 market event. 

Circuit Breaker Rules and Clearly Erroneous Rules 

Invesco supported the single stock circuit breaker proposals as a means to immediately mitigate the impact of sudden market volatility by implementing a trading 

pause for individual securities in times of market stress. As the circuit breakers are 

set to expire soon we would strongly encourage replacing them with a so-called 

‘‘limit up/limit down’’ regime. Circuit breakers require a trading halt when the 

threshold price is reached which can be confusing and inefficient for investors. As 

we have seen over the past few months, the single stock circuit breakers have been 

triggered a number of times due to system errors or gaps in liquidity that cause 

an unnecessary disruption of trading. We believe a limit up/limit down regime 

would be a more effective means of accomplishing the same goal of having a more 

orderly process in place in times of duress. 

One thing is clear, whether the answer is circuit breakers or limit up/down, there 

absolutely must be coordination among futures, options and equity exchanges to ensure a consistent approach to extreme market movements. 

The integrity of trading data is critical given the speed and volume of trading in 

the markets. Invesco therefore has strongly supported amendments to the rules relating to clearly erroneous executions to clarify the process for breaking erroneous 

trades and to provide uniform treatment across the exchanges for clearly erroneous 

execution reviews. We believe, however, the whole notion of taking trades off the 

tape is generally detrimental to investor confidence. We would propose that the exchanges instead clearly define and articulate the parameters that constitute erroneous trades and then program their systems to detect and reject trades outside of 

those parameters. We believe uncertainty surrounding the clearly erroneous rules 

and the risks associated with entering orders during the drop in stock prices likely 

contributed to the rapid and dramatic price declines on May 6. Ensuring that only 

good trades are reported to the tape will provide investors and liquidity providers 

an increased level of confidence regarding the trading data they need to participate 

in good and bad markets. 

Use of Market Orders 

As was clearly illustrated by the events of May 6, when there is a vacuum of liquidity, smaller market orders can have an outsized impact on the prices of securities. As an institution, we have long understood the significant risk of using market 

orders particularly as the market has become more fragmented. We abandoned their 

use many years ago in favor of marketable limit and limit orders. In light of the 

events of May 6 and the continuing issues small market orders have had in the 

market (i.e., electing newly imposed single-stock circuit breakers on WPO, CSCO, 

C, APC, and others), Invesco strongly supports the examination of the current practices surrounding the use of market orders, particularly the use of ‘‘stop loss’’ orders. 

There can be nothing more erosive to the confidence of investors in the efficient 

workings of the market than to watch a small market order take a stock from $50 

to $100,000. 

Trading Algorithms 

The Joint CFTC–SEC Advisoty Committee report on the market events on May 

6th clearly shed negative light on the use of trading algorithms, particularly in 

times of market duress. While we agree that using a price agnostic algorithm in any 

environment incurs significant risk, we believe trading algorithms, when appropriately employed, can be highly effective tools in our best execution process. Algorithms allow us to approach our trades from a number of different pursuits giving 

us the speed, anonymity and access to liquidity that we need to be effective for our 

clients. That said if regulators feel compelled to act with respect to algorithms, we 

would encourage them to focus their efforts on broker dealer and venue order routing practices and any potential manipulative practices being employed by market 

participants through the use of algorithms. 

Responsibilities of Market Makers 

The role of traditional liquidity providers such as market makers has taken on 

more significance since the events of May 6, as the sudden absence of liquidity in 

the markets played a critical role in the severe decline in stock prices. We recognize 

that the obligations market makers have in times of market duress likely succumb 

to innate self-preservation instincts—after all catching falling knives is generally 
163 

not a good idea. Several ideas have been put forth to improve the operation of market makers that are worthy of further examination, including increasing obligations 

surrounding best price, depth of markets, and the maximum quoted spread obligation. Similarly, there should be an examination of the incentives that market makers currently have to make reasonable two-sided markets. Given the introduction 

of single stock circuit breakers and more clarity around the handling of clearly erroneous trades, it would appear that some of the risk of making markets in volatile 

times has been reduced. In any event, the goal of our capital markets has to be the 

provision of fair and orderly markets in good times and bad. We believe that market 

makers who have appropriate incentive and obligations are an important aspect of 

that. 

Ensuring May 6th Doesn’t Happen Again 

While many of the steps being taken by the various regulators and exchanges will 

greatly reduce the potential for another May 6th—the risk will not be entirely removed from these actions alone. The SEC, CFTC, and SROs must be coordinated, 

diligent and measured in their efforts to create sensible regulation designed to minimize inefficiencies in market structure and advance surveillance and enforcement 

capabilities to thwart nefarious behavior. 

One idea which deserves further consideration in that regard is the consolidated 

audit trail ( CAT) or a similar solution to provide regulators the data they need to 

surveil markets on a timely basis. The proposed CAT would provide regulators with 

timely access to order and execution information for all securities within the National Market System (NMS). This would give regulators the ability to perform 

timely, detailed analysis of single stock or general market activity which would 

greatly enhance existing oversight and enforcement capability. Our expectation is 

that all information collected within the CAT or equivalent system will be absolutely 

secure with no possibility for leakage or manipulation and that the costs to create 

and maintain the CAT (or equivalent) will be much more reasonable than some of 

the published estimates. 

Beyond May 6th 

While the events of May 6th highlighted some of the challenges of the current 

market structure they did not reveal all of them. Regulators should not lose sight 

of the broader market structure issues raised by the SEC’s concept release examining the structure of the U.S. equity markets, including the adequacy of information provided to investors about their orders, the impact of high frequency trading, 

and nondisplayed liquidity. These issues are equally critical to investors’ ability to 

trade efficiently under the current market structure. 

Fragmentation 

There are today at least 13 for-profit exchanges. Competition between exchanges 

is fierce resulting in new innovations and different ways for investors to seek and 

provide liquidity. This is a welcome development from our perspective provided that 

the rules and regulations which govern the various exchanges are consistent and 

not incongruent with the goals of fairness and equal access for investors. We believe 

that the notion of exchanges having their own SROs is outdated and potentially disruptive to the efficient operation of securities markets. Therefore Invesco would support a move to a single SRO for all exchanges. It is interesting to note that exchange 

competition has also spurred an electronic arms race where the race to microseconds 

will soon cede to nanoseconds. It has also dramatically changed the revenue models 

of exchanges to a point where so called ‘‘maker-taker’’ models thrive and fees for 

cancelled trades are routinely waived for the most active participants. 

While Invesco believes that speed is an important variable to consider in the execution of trades, it is clearly not the only one which long-term investors should consider as they seek best execution. Some of our fundamental fund managers may 

take months to research a particular company before they are ready to buy its stock; 

buying those shares in one-millionth of a second isn’t exactly the manager’s top priority. Buying the shares at the ‘‘right’’ price which is understood through a robust 

price discovery process wherein there is real understanding about the underlying 

supply and demand in the shares is much more appealing. If this happens in seconds or days is at best a secondary consideration. Invesco believes that there is a 

point where speed and robust price discovery diverge—a concept that must be understood by exchanges as they race to trading in one-billionth of a second. 

There are also 40 different trading venues/dark pools and over 200 broker dealers 

who internalize customer order flow in the market today. The nondisplayed liquidity 

traded in dark pools and with internalizing broker-dealers is estimated to be as 

much as 30 percent of the shares traded in the U.S. This fragmentation has the potential to seriously undermine the price discovery process essential to efficient mar-
164 

ket structure. As an institutional investor with larger-sized orders, Invesco utilizes 

dark pools and institutional crossing networks as essential elements of our best execution process. While our use of these venues may contribute to the fragmentation 

of the markets, until we create a more efficient market structure for the execution 

of institutional sized orders, these venues allow institutional investors to avoid 

transacting with market participants who seek to profit from the impact of the public display of large orders to the detriment of funds and their shareholders. 

This vast network of exchanges and venues has resulted in a very complicated 

web of conflicted order routing and execution practices by broker dealers and execution venues. Institutions like Invesco are in a position to get the routing data from 

broker-dealers and trading venues to perform an analysis of the effectiveness of 

trading in the various venues. However we are concerned that many investors do 

not have this level of transparency. We believe that improved information about 

order routing and execution practices would allow investors to make better informed 

investment decisions. 

High Frequency Trading 

Today as much as 50–60 percent of trading activity in U.S. equity markets is attributed to High Frequency Traders (HFT). Given the recent ascendance of HFT 

there is not a lot known about their practices and very little regulatory oversight. 

It can certainly be argued that some high frequency trading activity provides real 

liquidity to the markets. In fact, Invesco believes there are many beneficial high frequency trading strategies and participants which provide valuable liquidity and efficiencies to the markets. For example strategies such as statistical arbitrage help 

maintain pricing efficiencies in the markets. On the other hand, we are concerned 

that some strategies could be considered as improper or manipulative activity. Some 

of these strategies, such as the so-called order anticipation or momentum ignition 

strategies provide no real liquidity or utility to the markets, rather they prey on institutional and retail orders creating an unnecessary tax on investors. 

While there has been a recent case brought by regulators against this kind of improper activity, we are concerned that the ability of regulators to monitor and detect 

nefarious behavior by these market participants is lacking. We therefore believe 

there is an immediate need for more information about high frequency traders and 

the practices of high frequency trading firms. 

Additionally, regulators must address the increasing number of order cancellations in the securities markets. It has been theorized that as many as 95 percent 

of all orders entered by high frequency traders are subsequently cancelled. Order 

cancellations related to making markets is one thing, but orders sent to the market 

with no intention of being executed before they are cancelled is quite another. These 

orders tax the market’s technological infrastructure and under the right circumstances could overwhelm the systems capability to process orders causing massive system failures and trading disruptions. 

Efficient trading markets require many different types of investors and participants to thrive. It is important to note that where the interests of long-term investors and short-term professional traders diverge, the SEC has repeatedly emphasized that its duty is to uphold the interests of long-term investors. We need to ensure that there are no abusive practices within high frequency trading which contravene the interests of long-term investing. 

Conclusion 

We believe investors, both retail and institutional, are better off now than they 

were just a few years ago. That said long-term investor confidence is critical to the 

efficient operation of the capital formation process in the U.S. To restore potentially 

damaged investor confidence, regulators must ensure that the securities markets 

are highly competitive, transparent and efficient and that the regulatory structure 

that governs the securities markets is consistent, congruent and encourages, rather 

than impedes, liquidity, transparency, and price discovery. 

PREPARED STATEMENT OF STEVE LUPARELLO 

VICE CHAIRMAN, FINANCIAL INDUSTRY REGULATORY AUTHORITY

DECEMBER 8, 2010 

Chairman Reed, Chairman Levin, Ranking Member Bunning, Ranking Member 

Coburn, and Members of the Subcommittees: I am Steve Luparello, Vice Chairman 

of the Financial Industry Regulatory Authority, or FINRA. On behalf of FINRA, I 

would like to thank you for the opportunity to testify today on the important issues 
165 

of how markets and trading have evolved, and how we can enhance the information 

regulators receive to ensure market integrity and the protection of investors. 

I’d like to commend Chairmen Schapiro and Gensler for their leadership in spearheading the coordinated review of market activity after the events of May 6. We appreciated the opportunity to collaborate with the SEC and other SROs to identify 

measures that could be taken quickly to significantly reduce the chances of a recurrence of the market disruption that occurred that day. FINRA’s Chairman, Rick 

Ketchum, serves on the CFTC–SEC Joint Advisory Committee on Emerging Regulatory Issues that is continuing its work to identify additional steps regulators may 

take to respond to the lessons of May 6. 

FINRA 

The Financial Industry Regulatory Authority (FINRA) is the largest independent 

regulator for all securities firms doing business in the United States. FINRA provides the first line of oversight for broker-dealers, and, through its comprehensive 

regulatory oversight programs, regulates both the firms and professionals that sell 

securities in the United States and the U.S. securities markets. FINRA oversees approximately 4,600 brokerage firms, 166,000 branch offices and 636,000 registered securities representatives. FINRA touches virtually every aspect of the securities business—from registering and educating industry participants to examining securities 

firms; writing rules and enforcing those rules and the Federal securities laws; informing and educating the investing public; providing trade reporting and other industry utilities and administering the largest dispute resolution forum for investors 

and registered firms. 

In addition, FINRA conducts surveillance of over-the-counter (OTC) trading in equities and debt, and provides market surveillance, investigatory and related regulatory services for equities and options traded on U.S. exchanges, including the New 

York Stock Exchange, NYSE Arca, NYSE Amex, NASDAQ, NASDAQ Options Market, NASDAQ OMX Philadelphia, NASDAQ OMX BX, BATS Equities and Options, 

and The International Securities Exchange. Through this work, FINRA is responsible for aggregating and providing market surveillance for approximately 80 percent of U.S. equity trading. 

FINRA’s activities are overseen by the Securities and Exchange Commission 

(SEC), which approves all FINRA rules and has oversight authority over FINRA operations. 

Response to May 6 

During the last several years, how and where trading occurs has evolved rapidly, 

as has execution speed, particularly with respect to equity trading. High-frequency 

trading, dark pools and direct access are now commonplace—and have contributed 

to the more fragmented markets that exist today. While the market fragmentation 

that has occurred has lowered barriers to entry and created fierce competition resulting in narrow quotation spreads and a high level of liquidity in good times, it 

can also result in the fast electronic removal of liquidity when markets are stressed, 

as we observed on May 6. 

The events of May 6 identified several areas in which regulators could be more 

proactive in preventing or reducing the impact of extreme market volatility, as well 

as provide additional transparency and predictability in restoring order to the markets following such events. FINRA has been pleased to participate in these discussions with the U.S. equities and options exchanges, under the leadership and direction of the SEC, to establish and implement a number of important changes. 

First, in June 2010, as a result of this coordinated effort, a framework for 

marketwide, stock-by-stock circuit-breaker rules and protocols was established and 

implemented on a pilot basis. Under these pilot rules, a single-stock circuit breaker 

is triggered if the price of a security changes by 10 percent within a rolling 5-minute 

period. If triggered, all markets pause trading in the security for at least 5 minutes, 

and then the primary listing market employs its standard auction process to determine the opening print after the 5-minute pause period. 

The pilot commenced with securities included in the S&P 500 Index and then was 

expanded in September 2010 to the Russell 1000 Index and certain exchange traded 

products. Where there is extreme volatility in a stock, this solution provides for a 

pause in trading that will allow market participants to better evaluate the trading 

that has occurred, correct any erroneous ‘‘fat finger’’ orders and provide for a more 

transparent, organized opportunity to offset the order imbalances that may have 

caused the volatility. FINRA and the exchanges, with the SEC, have been monitoring continuously the application and effectiveness of the pilot to determine 

whether expansion to additional securities is appropriate and whether adopting or 

incorporating other mechanisms, such as a limit up/limit down procedure that would 
166 

directly prevent trades outside of specified parameters, would be a more efficient 

and effective permanent approach. 

Similarly, new rules were established to improve the consistency and transparency surrounding the process for breaking erroneous trades, particularly with respect to events like those that occurred May 6, which impacted multiple stocks within a very short time frame. In September, FINRA and the exchanges, in coordination with SEC staff, adopted on a pilot basis new rules to establish standards for 

breaking trades following multistock events. For events involving between 5 and 20 

stocks, FINRA and the exchanges will break trades at least 10 percent away from 

the reference price (typically the consolidated last sale), and for events involving 20 

or more stocks, at least 30 percent away from the reference price. These rules provide more certainty to market participants as to when and at what prices trades 

will be broken by FINRA and the exchanges, facilitating a more transparent and 

orderly resolution of multistock events. 

Most recently, in November 2010, the SEC approved FINRA and exchange rules 

to strengthen the minimum quotation standards for market makers and effectively 

prohibit what have been called ‘‘stub quotes’’ in the U.S. equity markets—quotes to 

buy or sell stocks at prices so far away from the prevailing market that they are 

not intended to be executed. Executions against stub quotes represented a significant proportion of the trades that were executed at extreme prices on May 6, and 

subsequently broken. The new rules require market makers to maintain continuous 

two-sided quotations throughout the trading day within a certain percentage of the 

NBBO, thereby prohibiting the use of extreme stub quotes. 

Through the CFTC–SEC Joint Advisory Committee, deliberations continue about 

potential additional measures regulators may institute in the wake of May 6. 

FINRA is committed to working with our fellow regulators, through the Committee 

and in other ways, to continue this analysis. 

Lastly, it is worth noting that the SEC also recently adopted rules preventing 

unfiltered market access, as well as requiring brokers with market access to have 

risk management controls and supervisory procedures to help prevent erroneous orders, ensure compliance with regulatory requirements and enforce credit or capital 

thresholds. FINRA has consistently taken the approach that brokers sponsoring 

market access have a responsibility to ensure that proper screens are in place before 

providing access to firms, including those who may use high-frequency or algorithmic trading strategies. FINRA has questioned brokers providing access to determine whether they have fulfilled their obligations to understand the ownership of 

firms to whom they are providing access and what is being done with algorithms 

used through those agreements. FINRA will continue to examine the firms it regulates for compliance in this area, analyze whether enhancements to our supervision 

rules are warranted and enforce the new SEC requirements vigorously. 

High-Frequency Trading and the Trillium Case 

While the disruption on May 6 focused significant attention on high-frequency 

traders and algorithmic trading in today’s highly automated marketplace, FINRA 

had already been scrutinizing trading activity closely in order to detect attempts to 

use these technologies to implement manipulative trading strategies. In today’s 

fragmented trading environment, it is very plausible that market participants will 

spread their activity across multiple markets and accounts in an attempt to avoid 

detection of trading abuses such as wash sales, frontrunning, insider trading, marking the close and open, and manipulative trading strategies like layering. FINRA 

is aggressively pursuing these types of illegal trading practices that inappropriately 

undermine legitimate market trading. 

In September, FINRA fined a New York brokerage firm—Trillium Brokerage 

Services—over $1 million and suspended several traders at the firm for using an 

illicit high-frequency trading strategy. Trillium, through nine proprietary traders, 

entered numerous layered, non-bona fide market moving orders to generate selling 

or buying interest in specific stocks. By entering the non-bona fide orders, often in 

substantial size relative to a stock’s overall legitimate pending order volume, Trillium traders created a false appearance of buy- or sell-side pressure. 

This trading strategy induced other market participants to enter orders to execute 

against limit orders previously entered by the Trillium traders. Once their orders 

were filled, the Trillium traders would then immediately cancel orders that had only 

been designed to create the false appearance of market activity. As a result of this 

improper high-frequency trading strategy, Trillium’s traders obtained advantageous 

prices that otherwise would not have been available to them. Trillium’s traders 

bought and sold NASDAQ securities in over 46,000 instances, reaping nearly 

$575,000 in improper profits. Other market participants were unaware that they 

were acting on the illegitimate, layered orders entered by Trillium traders. 
167 

In addition to the nine traders, FINRA also took action against Trillium’s Director 

of Trading and its Chief Compliance Officer. The 11 individuals were suspended 

from the securities industry or as principals for periods ranging from 6 months to 

2 years. FINRA levied a total of $802,500 in fines against the individuals, ranging 

from $12,500 to $220,000, and required the traders to pay out disgorgements totaling roughly $292,000. 

While FINRA is able to pursue instances of these illegal trading strategies on 

markets we regulate as well as through the cooperative information-sharing efforts 

of market surveillance staffs, the risk of missing instances of manipulation, wash 

sales, abusive short selling and other improper ‘‘gaming strategies’’ is still unacceptably large. While FINRA’s ability to aggregate an increasing share of regulatory 

data for surveillance purposes is a strong step in the right direction, establishing 

a consolidated audit trail is the key to enhancing regulators’ abilities to detect these 

activities. This would allow FINRA and the exchanges to more efficiently detect violations and adapt surveillance programs to new scenarios. 

FINRA Market Regulation 

In addition to performing its own regulatory obligations to conduct surveillance 

of over-the-counter (OTC) trading in equities and debt, FINRA increasingly is providing surveillance and related regulatory services for equities and options traded 

on U.S. exchanges. FINRA is responsible for insider-trading surveillance for all exchange-listed equity securities across all U.S. exchanges, regardless of the market 

on which a trade is executed. FINRA is responsible for surveillance of NASDAQ 

OMX, originally as a sister subsidiary when NASDAQ was part of NASD and now 

under contract, and subsequently NASDAQ OMX BX (formerly the Boston Stock Exchange) and NASDAQ OMX PHLX (formerly the Philadelphia Stock Exchange) (collectively NASDAQ). In June 2010, FINRA became responsible for surveillance of the 

NYSE Euronext’s three U.S. exchanges, the New York Stock Exchange (NYSE), 

NYSE ARCA and NYSE AMEX (collectively the NYSE). FINRA also provides regulatory services to the International Securities Exchange, the Boston Options Exchange, the BATS Y and Z Exchanges and the EDGA and EDGX Exchanges. 

As a result, FINRA presently is responsible for conducting posttrade market surveillance of approximately 80 percent of the equity share volume and 30-35 percent 

of the option contract volume traded on U.S. exchanges. With the recent addition 

of the NYSE, FINRA has started an integration process that will combine for the 

first time detailed trading data from FINRA, NASDAQ and the NYSE in one data 

center. With this aggregated data, FINRA will be able to conduct comprehensive, 

cross-market surveillance of 80 percent of the equity market. 

FINRA uses a variety of sophisticated online and offline surveillance techniques 

and programs to detect potential violations and reconstruct market activity using 

trade, quote and order information that is captured daily. Specifically, FINRA’s 

Market Regulation Department is comprised of approximately 440 employees that 

are organized into roughly 70 specialized teams of subject matter experts for certain 

rules and trading activity. These teams conduct investigations based on alerts generated by over 300 surveillance patterns that are designed to detect particular 

threat scenarios by canvassing some or all of the one billion or more market events 

that are captured by FINRA each day. FINRA also provides interpretive guidance 

on a variety of trading issues and rules, investigates market-related complaints 

from investors, broker-dealers and other parties, and conducts market and tradingrelated preventive compliance activities. 

Consolidated Audit Trail 

With the growth in the number of registered exchanges and alternative trading 

systems, increased competition among trading venues and market structure policy 

compelling connectivity among exchanges and between exchanges and other execution venues, it is clear that market quality can no longer be ensured by a single 

exchange acting in a siloed fashion. In fact, as noted earlier, it is plausible that certain market participants, knowing the extent of current regulatory fragmentation, 

now consciously spread their trading activity across several markets in an effort to 

exploit this fragmentation and avoid detection. As the SEC recognized with its recent rule proposal, that evolution of the U.S. equity markets and the technological 

advances in trading systems have created an environment where a consolidated 

audit trail is now essential to ensuring the proper surveillance of the securities markets and the confidence of investors in those markets. 

In its proposal to adopt a consolidated audit trail, the SEC correctly identified the 

challenges that exist in conducting market surveillance with today’s regulatory 

audit trails. FINRA agrees with the SEC on those issues and strongly supports the 
168 

establishment of a consolidated audit trail as a critical step to enhance regulators’ 

ability to conduct surveillance of trading activity across multiple markets. 

The events of May 6 also have demonstrated the need for SROs and the SEC to 

have direct and more timely access to consolidated audit trail data. As the Commission noted in its proposal, the SEC’s and SROs’ inability to timely and efficiently 

access the patchwork of audit trail data that currently exists creates delays in identifying potential market abuses and creating market reconstructions. Thus, FINRA 

believes the key aspects necessary for ensuring an effective, comprehensive and efficient consolidated audit trail are: uniform data (both data format and data content 

across markets); reliable data; and timely access to the data by SROs and the SEC. 

In terms of implementation, FINRA believes the most effective, efficient and timely way to achieve the goals of a consolidated audit trail is to expand existing systems, such as FINRA’s Order Audit Trail System (OATS), and consolidate this information with exchange data and discrete new data, such as large trader information, 

into a central repository. Building off existing systems would significantly reduce 

both the cost (to the industry, and ultimately, investors) and the time for implementation of a fully consolidated audit trail and integration of that audit trail into surveillance systems. 

Because market participants already have systems in place to comply with OATS 

requirements, programming changes needed for an entirely new system are substantially greater than expanding existing protocols. In addition, FINRA recently received SEC approval to expand OATS beyond NASDAQ-listed issues to include all 

exchange-listed issues, further enhancing the benefits of leveraging OATS for a consolidated audit trail. 

FINRA also believes that the practicality, costs and benefits associated with incorporating a broad array of real-time data into the consolidated audit trail should be 

considered carefully. In many cases, information may be extremely difficult to provide accurately on a real-time basis. In addition, there are many types of information that have limited real-time regulatory benefit, due to the time needed to validate and analyze data to detect complex, violative trading activity. It has also been 

FINRA’s experience that the quality of real-time data can degrade during significant 

market events due to capacity and other issues. 

In terms of the content of any consolidated audit trail, FINRA’s experience has 

shown that there are certain critical elements necessary to conduct effective surveillance across multiple markets. As an initial matter, it is essential that each market 

participant be required to report the same data elements in a uniform way. Moreover, consolidated data is only useful if each reporting entity uses the same 

timekeeping system. FINRA also believes that each broker-dealer must have a 

unique identifier that remains the same regardless of the market on which the participant is trading, and that those identifiers should be more granular than at the 

firm level. Similarly, FINRA agrees with the SEC that each customer of a firm 

should have a unique identifier that is constant across all firms through which the 

customer trades. 

Based on our experience developing and operating OATS, FINRA has a unique 

perspective on many of the specific issues and questions raised in the SEC’s proposal. We have provided detailed comments to the Commission and are committed 

to working with them as consideration of the proposal moves forward. 

Conclusion 

Changes in financial markets in recent years have necessitated adaptation by regulators across a wide spectrum of issues. Both technological and policy developments have driven changes in the markets that make the practice of regulating 

them a more complex task. 

FINRA continually reviews its programs and technology to ensure that our approach reflects the realities of today’s markets. May 6 clearly demonstrated areas 

where regulators should alter rules going forward to avoid a repeat of the events 

of that day. As noted above, several coordinated rulemakings have been implemented and consideration of additional steps continues. 

The SEC has correctly identified one of the most pressing issues that faces regulators conducting market surveillance—that we are all hampered by the lack of a 

comprehensive, sufficiently granular and robust consolidated audit trail across the 

equity markets. It is vital that we consolidate audit trail data in one place so that 

abusive trading practices can be more readily identified. FINRA stands ready to 

work with Congress, the Commission and other SROs to help bring about a consolidated and enhanced audit trail that will facilitate more effective surveillance for the 

protection of investors and market integrity. 

Again, I appreciate the opportunity to share our views. I would be happy to answer any questions you may have. 
169 

RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED 

FROM MARY L. SCHAPIRO 

Q.1. Will the consolidated audit trail and large trader reporting requirements proposed by the SEC be coordinated with the CFTC so 

that ‘‘unique tags’’ and customer identification information you described in your testimony would be the same across the securities 

and futures markets? Why or why not? 

A.1. The scope of the consolidated audit trail (CAT) and large trader reporting proposals currently under consideration by the Commission is limited to certain securities products, specifically NMS 

securities. I believe these proposals are a critical first step towards 

enabling the Commission to better carry out its oversight of the securities markets and to perform market analysis in a more timely 

fashion, whether on one market or across markets. I anticipate 

that over time the scope of the CAT will be expanded to include 

other types of securities, including debt and OTC equities. I also 

hope the CAT ultimately will include information on related futures products, and we will work with the CFTC toward this end. 

Due to the enormity of this project even when just focusing on equities, however, we felt it was more feasible—and made more 

sense—to utilize a phased approach that started with equities and 

built out from there. 

Further, I note that the newly created Office of Financial Research (OFR) is considering implementing a rule pursuant to which 

all legal entities in the financial industry would be assigned unique 

identifiers. Such a system could be of significant benefit to regulators worldwide, as each market participant could readily be identified using a single reference code regardless of the jurisdiction or 

product market in which the market participant was engaging. 

Such a system also could be of significant benefit to the private sector, as market participants would have a common identification 

system for all counterparties and reference entities, and would no 

longer have to use multiple identification systems. 

The CAT rule as proposed is written to ensure that market participants have sufficient flexibility to use the unique identifier assigned under such a rule to comply with the proposed CAT requirements. Thus, the Commission and the CFTC could use the common 

set of identifiers if such identifiers are mandated by the OFR. 

Q.2. In regard to the proposed consolidated audit trail, what is the 

benefit of establishing a new audit trail system as opposed to building on an existing system such at FINRA’s Order Audit Trail System? 

A.2. Although FINRA’s Order Audit Trail System is one of several 

existing technologies that could be used to expedite the CAT implementation process, other technologies are currently available that 

can leverage the resources, speed, and accuracy of existing business 

practices and normalize and consolidate different data sets in real 

time. Each available technology has benefits and drawbacks that 

require careful analysis and balancing before selection. 

We are also considering some interim steps to improve the current audit trail systems, and our large trader reporting rule will be 

a useful first step. That said, we feel it is critical to remain focused 

on creating an audit trail that directly addresses today’s problems, 
170 

can be expanded to include all types of financial products, and will 

remain useful as we tackle tomorrow’s problems. 

Q.3. Should there be serious consideration of removing the SRO 

function out of the individual exchanges and placing it into a single 

SRO? Should this consideration be extended to include a single 

SRO responsible for the equities as well as the futures markets? 

Could that possibly be a way to reduce the regulatory fragmentation that Professor Angel discussed in his testimony? 

A.3. Because the structure of our securities markets and their regulation is complex, there invariably can be room for improvement. 

The establishment of a single SRO to supervise all securities markets, however, would not necessarily be a simple solution to regulatory fragmentation. Congressional action likely would be required 

to change our system of self-regulation to create a new ‘‘super 

SRO.’’ Moreover, there could be collateral consequences to removing the SRO function from each exchange and placing it into a single SRO. For example, exchanges have varying market structures 

and do not necessarily trade the same types of securities, and personnel at each exchange have experience with that exchange’s particular structure, rules, systems, and listed products. As an SRO, 

each exchange is required to submit its proposed rule changes with 

the Commission, among other obligations under the Exchange Act. 

If there were a single SRO, the personnel at that SRO would have 

to acquire the expertise to oversee all exchanges and the single 

SRO also would have to submit proposed rule changes to the Commission for each exchange. 

In a number of ways, the exchanges and FINRA already have 

been working together to create a more efficient regulatory system 

that is consistent with the Exchange Act. For example, NYSE 

Euronext and its three subsidiary exchanges, NYSE, NYSE Amex 

and NYSE Arca, recently entered into a regulatory services agreement in which FINRA now conducts a substantial portion of regulation on behalf of these three exchanges, with each exchange retaining full regulatory responsibility in the event that FINRA fails 

to perform appropriately. Other exchanges also have entered into 

regulatory services agreements with FINRA with respect to aspects 

of their regulatory programs. Further, the exchanges and FINRA 

have entered into Commission-approved delegation plans in which 

a number of SROs delegate to a single SRO full regulatory responsibility for particular matters, i.e., oversight of one or more common 

rules. SROs are members of the Intermarket Surveillance Group 

and, as such, their respective staff and Commission staff meet regularly on matters that reach across SROs. Also, the Commission recently proposed a consolidated audit trail that would provide the 

SROs and the Commission with data allowing them to conduct 

cross-market surveillance when regulatory issues arise. 

The current system of self-regulation is based on the notion that 

each securities market is in the best position to monitor and understand the activity in its market and to respond to rapidly changing 

conditions and business practices. We will continue, however, to 

work with the SROs to reduce regulatory fragmentation wherever 

possible, while maintaining the benefits of regulatory expertise and 

focus in each market. 
171 

RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN LEVIN 

FROM MARY L. SCHAPIRO 

Q.1. My Subcommittee staff has reviewed a number of the examination reports produced by the Securities and Exchange Commission staff to evaluate the market surveillance programs at some exchanges. The reports show wide variations and some serious deficiencies in the ability of some exchanges to conduct basic surveillance. 

For example, one report, which took 3 years to complete, from 

January 2007 to April 2010, found the exchange’s trading surveillance program was generally ineffective for monitoring trading on 

its system and had problems reviewing trades to detect even the 

most basic manipulations such as wash sales. It found that the exchange was also operating without a dedicated regulatory budget. 

A second examination report found that another exchange had 

failed to develop effective automated surveillance programs to monitor trading activity on its market, and was only in the early stages 

of developing investigative, examination, and enforcement programs. Other reports were equally troubling. 

These report findings were issued during the same years trading 

volume was exploding on the new exchanges, and market participants were developing software to trade across markets in fractions 

of a second. 

(a) Do you find these examination findings troubling, and does 

the SEC have any plans to develop minimum standards for market 

surveillance efforts at the exchanges? 

(b) You testified that you envision the consolidated audit trail 

being used by exchanges and other SROs to help monitor the markets. Given the deficiencies your examination staff has identified, 

do you have confidence in the capability of the SROs and exchanges 

to make use of the new data or will new capabilities need to be developed? 

(c) Please describe any efforts undertaken by the SEC to improve 

and coordinate trading surveillance and enforcement efforts by its 

exchanges and SROs, in particular with respect to trades that may 

influence prices on more than one market. 

A.1. Both the examination staff responsible for these reports and 

I do find these results troubling. 

As a general matter, Commission staff devotes significant examination resources both to identifying deficiencies at SROs, as well 

as to ensure that the SROs take adequate remedial actions to address those deficiencies. Without speaking to any specific matter, 

I can tell you that referrals to our Enforcement Division have in 

fact been made in connection with certain past SRO examinations. 

In addition, and again without speaking to any specific matters, 

what is contained in an examination report may not reflect the full 

universe of steps that the Commission or its staff have taken in 

connection with its oversight function. For example, the staff supplements its examination efforts with regular meetings with the 

SROs, surprise on-site reviews, staff compliance letters to all SROs 

on specific risk topics, and reviews of SRO surveillance plans for 

certain rule proposals. 

The staff uses these efforts to help establish and communicate 

general standards for SRO market surveillance, as well as tailored 
172 

guidance to specific SROs when appropriate. As noted below, we 

have revised our SRO examination program to better address 

evolving market risks, and will continue to evaluate the standards 

for market surveillance—and the methods of communicating those 

standards—in light of the evolving risks. 

We recognized that our SRO and exchange exam program needed 

to change to adapt to new market realities, and it in fact is changing. Recently, we consolidated the SRO inspection function into one 

group singularly responsible for SRO inspections, the Office of Market Oversight (Market Oversight). Market Oversight is headed by 

a new Associate Director with significant SRO, policy, and enforcement experience. 

We also recognized that market developments, such as high frequency trading and increased market fragmentation, required us to 

adjust our examination program to address newly emerging areas 

of risk. As a result, we have made fundamental structural changes 

in the way we approach and conduct SRO examinations, including 

looking at how SROs surveil for potentially abusive high frequency, 

high quote or other algorithmic trading strategies. In November 

2010, the heads of our Division of Trading and Markets and Office 

of Compliance, Inspections and Examinations (OCIE) sent a letter 

to all the SROs specifically requesting that they conduct a thorough review of its data feeds as well as its regulation and surveillance of its members’ order and trading practices to ensure compliance with the securities laws. 

In addition, Market Oversight has developed an examination 

plan for Fiscal Year 2011 that includes assessments of each of the 

15 registered exchanges and 22 options and equities markets that 

they operate. The assessments have been informed by recent market events, including the events of May 6, and will include an overview of key risk areas, including market oversight and surveillance. 

OCIE expects to take the findings of these assessments to create 

a comprehensive risk matrix for each of the exchanges and use that 

risk-based approach to inform future inspections of each of the 

SRO ‘‘complexes.’’ 

At the same time, though I am recused from FINRA issues, I was 

informed in preparation for this hearing that OCIE will be conducting an in-depth examination of FINRA, including all of the 

items articulated in Dodd-Frank Section 964. As part of the FINRA 

review, I was informed that staff will be building on an examination of FINRA’s surveillance programs that it started last year. 

Specifically, staff will be using the information garnered in its initial examination to focus on FINRA surveillances related to high 

frequency trading strategies, high quote traffic strategies, and 

other algorithmic trading such as spoofing and layering. 

In terms of the timing of our SRO examinations, SRO examinations have historically been resource intensive reviews that, while 

appropriate in some cases, occasionally resulted in unnecessary 

delays. OCIE intends to focus future inspections on high risk areas 

that can be completed within 180 days after conducting the onsite 

portion of our examinations. In addition, OCIE and our Trading 

and Markets Division are leveraging their resources and using 

other methods of overseeing the SROs, such as sending compliance 

letters to all SROs on cross-market issues. 
173 

We previously worked with the SROs to better regulate certain 

cross-market issues, and we expect to continue that process as appropriate in the future. For example, pursuant to a staff recommendation in an examination sweep, the SROs have worked together to better manage market fragmentation and allocate regulatory responsibility for insider trading surveillance. The SROs also 

continue to work together through the Intermarket Surveillance 

Group, which was formed in 1983 to improve the detection of intermarket securities fraud and share regulatory concerns. 

Finally, if approved, I believe that a consolidated audit trail will 

dramatically improve market regulation. The new data will allow 

for the development of new regulatory capabilities, including improved risk assessment and more precise, effective, and comprehensive surveillance, examination, and enforcement efforts. The SROs 

and the Commission will need to work collaboratively to take full 

advantage of the proposed audit trail, and I am committed to making sure that happens. 

Q.2. FINRA recently announced a settlement regarding same-day 

manipulations by Trillium Trading LLC. According to the settlement, during a 3 month period about 4 years ago, Trillium traders 

manipulated the market by combining legitimate and phony orders 

to bid up the prices of some stocks. Trillium’s traders used this manipulation strategy more than 46,000 times, netting profits of more 

than $575,000. After several years and thousands of hours of investigation, FINRA settled the case, and both Trillium and its executives paid $2.2 million in fines and disgorgement. 

(a) How many trading manipulation actions have been brought 

or settled by the SEC in the last 5 years? 

(b) How many of these involved same-day manipulations? 

(c) What factors inhibit the SEC’s ability to investigate and pursue these cases, including any legal standards? 

(d) Please provide the same information for actions brought or 

settled by your exchanges or SROs. 

A.2. The Commission’s Enforcement Division is devoting significant 

resources to investigating whether various market participants 

have engaged in conduct that unlawfully exploits the fragmentation of the markets, intentionally contributes to market volatility 

or uses high-frequency trading strategies to manipulate the price 

and volume of securities at the expense of innocent investors. The 

Division’s new Market Abuse Unit is helping to coordinate the 

Commission’s enforcement response to complex abusive trading 

practices. Practices that are the focus of our Enforcement staff include layering or spoofing, improper order cancellation activities or 

‘‘quote stuffing,’’ the use of order anticipation and momentum ignition strategies undertaken for a manipulative purpose, passive 

market making practices that incentivize possible manipulative 

quoting activity, abusive colocation and data latency arbitrage activity in potential violation of Regulation NMS, use of Direct Market Access arrangements to conceal manipulative trading activity 

and conduit entity market manipulation. 

In the last 5 years, the Commission has filed approximately 200 

enforcement actions where the staff classified the primary type of 

misconduct as market manipulation. The Commission does not 
174 

track manipulation cases according to whether the conduct occurred intraday or over a period of time. The enforcement actions 

the Commission filed that involved manipulative conduct included 

misconduct such as account intrusions, wash trades, matched orders, kickback manipulations, and ‘‘pump-and-dump’’ schemes. For 

the most part, the filed actions allege misconduct over a period of 

time, though certain of the misconduct occurred both intraday and 

over a lengthier period, particularly in cases involving matched orders and wash trades. In addition, in certain cases that were coordinated with the criminal authorities, the Commission has filed 

enforcement actions that halted intraday manipulation schemes in 

their incipient stages as the result of undercover operations undertaken by criminal authorities. 

During the last 5 years, registered exchanges and self-regulatory 

organizations brought 47 proceedings involving trading manipulations, 32 of which they characterized as same-day manipulations. 

This includes information from NYSE AMEX, NYSE ARCA, BATS, 

Boston Options Exchange, C2 Options Exchange, CBOE, CBSX, 

Chicago Stock Exchange (CHX), Direct Edge, FINRA, the International Securities Exchange, NASDAQ OMX, NASDAQ BX OMX, 

NASDAQ PHLX OMX, the National Stock Exchange (NSX), and 

NYSE. 

There are a number of factors that make these cases challenging 

to investigate, particularly given current technology-driven trading 

practices. 

First, the volume of data creates extraordinary resource challenges. The Commission needs similar technological and human analytical resources as those possessed by the firms that are placing 

thousands of orders per second. For example, the Enforcement Division’s Market Abuse Unit currently has vacancies for specialists 

with current industry knowledge that the unit has not been able 

to fill due to current budget constraints. The unit’s planned Analysis and Detection Center, if able to be staffed by these specialists, 

would coordinate trading abuse investigations with the Division’s 

investigative staff and would generate specialized insight into other 

abusive high frequency and algorithmic trading practices. To perform these functions, the specialists will need advanced data analysis applications, better hardware and access to greater third party 

databases and information warehouses. 

Second, the fragmentation of trading at different market centers, 

including exchanges, dark pools, broker-dealer internalizers, and 

direct market access providers requires data collection—often with 

format and compatibility differences—from a variety of market centers. 

Third, because of the prevalence of high-volume trading through 

direct market access providers, our investigators often must trace 

the conduct back through multiple layers of broker-dealers to identify the original trader. This can both delay our investigation and 

also serve to obscure the true identity of the trader at interest. 

Fourth, the use of algorithmic code to direct trading decisions 

presents multiple challenges. We must ensure that historical 

versions of algorithmic code are maintained so that we preserve the 

ability to study high-frequency trading instructions, which could 

contain important and unique evidence of scienter. In addition, it 
175 

requires resources to analyze computer code in the course of our investigations. 

The consolidated audit trail and large-trader reporting initiatives, if adopted, will help address some of these challenges. Ultimately, only when we have: (1) comprehensive and accessible data 

sources; (2) adequate technology resources; and (3) additional personnel with the appropriate backgrounds and skills will it become 

easier to detect and stop technology-driven market abuse. 

Q.3. On May 6, much like the crash of 1987, a fall in the price for 

a broad futures product triggered severe price drops in the equities 

markets, including in individual stocks. 

(a) Given the connection between the futures and stock markets, 

would it make sense for the SEC and CFTC to coordinate and ensure that circuit breakers or other stabilization measures, such as 

a limit up/limit down function, apply consistently across all markets in similar financial instruments (futures, options, and equities)? 

(b) If so, are there any efforts underway to do that now? 

A.3. It does make sense to seek to coordinate such efforts between 

the Commission and the CFTC, and we have been doing so. SEC 

and CFTC staffs worked closely together on both the preliminary 

and final joint staff reports that set forth their findings regarding 

the events of May 6, and presented those reports to the agencies’ 

Joint Advisory Committee comprised of prominent experts that was 

created to advise both agencies on emerging regulatory issues. 

Some of the initial regulatory actions taken by the Commission 

after May 6—for example, the pilot programs with respect to single 

stock circuit breakers and the enhanced procedures for breaking 

clearly erroneous trades, as well as the approval of SRO rules banning of stub quotes—were designed to quickly address regulatory 

concerns unique to the securities markets. As noted in the staff reports, on May 6 the futures markets already had mechanisms in 

place such as limits and trading pauses applicable to futures contracts, and some restrictions on how far from the midmarket a participant can quote. 

As the Commission moves forward with a more comprehensive 

and permanent set of regulatory responses to the events of May 6, 

such as a possible limit up/limit down mechanism applicable to individual securities, we will consult regularly with CFTC staff. And 

in some areas, such as the modernization of the cross-market circuit breakers put in place after the 1987 market crash, SEC and 

CFTC staffs have been working closely together—and will continue 

to do so—to help assure a consistent mechanism is applied across 

the futures and securities markets. 

Q.4. Exchanges, traders, and SROs have told us that the equities 

markets have been experiencing mini-crashes in single stocks regularly for years. Since the pilot circuit breaker took effect in June, 

there have been at least 18 instances of the triggers going off. In 

some instances, trades were still reported at prices outside of the 

circuit breaker’s range. 

(a) Why hasn’t the pilot program prevented these mini-crashes? 
176 

(b) How does the SEC plan to improve the functioning of the stabilization measures to prevent trades from occurring outside of 

their bands? 

A.4. While the individual stock circuit breakers have helped limit 

the extent of price moves in the securities to which they apply, I 

believe our experience with the pilot program shows that improvements to that mechanism are warranted. 

For the actively traded stocks included in the circuit breaker 

pilot, to date we have observed 20 instances of stocks experiencing 

a sudden price move that triggered an individual circuit-breaker 

halt. In a few cases, these price moves were attributable to significant news concerning the company. In many others, they were attributable to mistakes in order submission or trade reporting. To 

trigger the circuit breaker, the price of the security, as reflected in 

an executed trade, must move 10 percent or more over a 5-minute 

period. As such, there must be an executed trade outside of the circuit breaker parameters in order to trigger the circuit breaker for 

that stock, which explains, at least in part, why trades are still 

being reported outside of the circuit breaker parameters. 

One way to improve the individual stock circuit breakers may be 

to replace or enhance them with a ‘‘limit up/limit down’’ mechanism. One of the advantages of this approach is that it could prevent trades from occurring outside of a designated price band that 

is tied to the current market price, and thus prevent ‘‘mini-crashes’’ 

outside of that range. At the same time, it could be less restrictive 

than a circuit breaker because it would not halt trading within the 

applicable price band. Recourse to a trading pause could be maintained to accommodate more fundamental price moves. At present, 

Commission staff is actively working with the exchanges on a proposal for a limit up/limit down mechanism, and I would expect a 

proposal to be published for comment in the near future. 

RESPONSES TO WRITTEN QUESTIONS OF SENATOR COBURN 

FROM MARY L. SCHAPIRO 

Q.1. How much money will the SEC spend in the next year to comply with Dodd-Frank? 

How many employees at the SEC are working on the new DoddFrank requirements? 

A.1. So far, the SEC has proceeded with the first stages of implementation of the Dodd-Frank Act without additional funding. This 

has largely involved performing studies, analysis, and the writing 

of rules. These tasks have taken staff time from other responsibilities, and have been done almost entirely with existing staff. To accomplish minimal Dodd-Frank Act implementation (hiring six people and initial IT expenditures) in FY2011 would require an estimated $14.6 million. 

To fully carry out its new responsibilities for oversight of overthe-counter derivatives, private fund advisers, credit rating agencies, and other areas of the financial industry, the SEC will indeed 

require additional resources. In FY2012, we estimate a requirement for 468 new staff, of which many would need to be expert in 

derivatives, hedge funds, data analytics, credit ratings, or other 

new or expanded responsibility areas. We also will need to invest 
177 

in IT systems to facilitate the registration of additional entities and 

capture and analyze data on these new markets. The agency’s overall cost estimate for Dodd-Frank in FY2012 is approximately $123 

million. 

Q.2. Your proposal for a Consolidated Audit Trail reflects an enormous cost—$4 billion, with an ongoing cost of nearly $2.1 billion 

per year. That is $15 billion over the next 5 years. However, during 

our hearing, you stated your belief that the SEC could ‘‘dramatically reduce the cost and the timetables of implementation.’’ 

(a) When do you expect to issue a revised proposal with the new 

cost and timetables for implementation? 

(b) How and when would you plan to use the data available in 

this new database? 

(c) What, if any of this information, do you currently have access 

to? 

(d) How would you balance the need for transparency with the 

need for businesses to maintain some privacy? 

(e) Your proposal emphasizes real-time data, instead of data that 

arrives at the end of the day. Can you give an example for when 

the SEC would use real-time data differently than end-of-day data? 

A.2. On May 26, 2010, the Commission proposed Rule 613 to establish a Consolidated Audit Trail (CAT). The Commission received 

many thoughtful comments on the proposal that addressed a wide 

range of issues, including the way in which audit trail data would 

be provided to the central repository, the scope of the required data 

elements, and suggestions on how to reduce implementation costs. 

Commission staff has been actively considering the comments it received in response to the proposal, following up with a range of 

market participants and technology providers, and preparing a recommendation for the Commission for the adoption of the rule. I 

currently expect the Commission will consider the staff’s recommendation for adoption of the rule, including the implementation timetable and revised cost estimates, in the first half of this 

year. 

Though the full realization of the benefits of a CAT would not 

come until a proposal is fully implemented, upon implementation 

I expect we would begin to realize the benefits of the data almost 

immediately. For example: 

• surveillances of the markets should be significantly enhanced 

by being more focused, less manually intensive, and better able 

to detect cross-market issues; 

• examinations should be informed by better risk assessments, 

and more exam work could be done without burdening registrants with time-consuming document requests; and 

• enforcement investigations should be more efficient and less 

reliant on the production of information by respondents. 

In short, the CAT data would be tremendously useful both to the 

SEC as well as the national securities exchanges and national securities associations (‘‘self-regulatory organizations’’ or ‘‘SROs’’). 

Currently, there is no single database of comprehensive and 

readily accessible securities order and execution data available to 

the Commission. Instead, the Commission must obtain and merge 
178 

together a very large volume of disparate data from numerous different market participants, a process which takes a significant 

amount of time and effort. 

The Commission staff itself does not have immediate access to 

the individual SRO’s audit trail information, and instead must specifically request that an SRO produce the audit trail information 

that it has. Though the SRO audit trails vary, generally they collect information covering order receipt and origination, order terms, 

order transmissions, and order modifications, cancellations and 

execution. The audit trail information is collected through submissions from SRO members by the end of each business day or, in 

certain cases, upon request by the regulating entity. Significantly, 

the SRO audit trails do not collect beneficial owner information (as 

the CAT proposes to do), a critical limitation that makes the process of identifying the ultimate customer responsible for the transaction at issue both extremely labor intensive and time consuming. 

Moreover, information provided to the Commission from the individual audit trails of the various SROs does not provide a view of 

trading activity occurring across multiple markets. An SRO’s audit 

trail information effectively ends when an order is routed to another exchange. As a result, key pieces of information about the life 

of an order may not be captured—or easily tracked—if an order is 

routed from one exchange to another, or from one broker-dealer to 

an exchange. As a result, regulators cannot readily piece together 

activity related to the same order or customer occurring across several markets to determine whether violative conduct has occurred. 

Commission staff currently obtains information about orders or 

trades directly from broker-dealers through the Electronic 

Bluesheet System (EBS) under Rule 17a-25, and from equity 

cleared reports. However, the information provided through these 

systems is limited in detail and scope. For example, EBS data does 

not include the time of execution, and often does not include the 

identity of the beneficial owner. Commission staff often must make 

multiple requests to broker-dealers to obtain sufficient order information—such as information identifying the customer submitting 

an order, the person with investment discretion for the order, or 

the beneficial owner—to be able to adequately analyze trading. 

Again, collecting, interpreting and analyzing diverse data sources 

such as these are labor intensive and time consuming. 

I believe that implementation of a consolidated audit trail would 

significantly improve the comprehensiveness and timeliness of the 

data the Commission needs in order to efficiently and effectively 

regulate today’s markets. 

Transparency and privacy are both important considerations as 

we consider the CAT proposal. To meet the need for transparency, 

the proposal would require that specified order information for all 

equities and options be collected from the SROs and their members 

and reported to a central repository. At the same time, the proposal 

would include provisions designed to address the legitimate privacy 

concerns of market participants. Access to audit trail information 

would be strictly limited to regulators, and the proposed rule provides that the SROs may access and use the consolidated audit 

trail data only for regulatory—and not commercial—purposes. The 

proposed rule also requires that the SROs maintain policies and 
179 

procedures to assure the confidentiality of all information submitted to, and maintained by, the central repository. 

Regarding your question about real time data, end-of-day reporting, coupled with the current laborious process of identifying the 

ultimate customer responsible for a particular securities transaction that may take weeks or even months, can impact effective 

oversight by hindering the ability of SRO regulatory staff to identify manipulative activity close in time to when it is occurring, and 

respond quickly to instances of potential manipulation. As a fundamental matter, our markets work in real time, and I therefore 

think regulators overseeing the markets should seek, when feasible, to work in real time as well. That is already happening today 

as the exchanges use real time data to monitor and control order 

flow and to run certain surveillances. I believe that these current 

efforts would benefit from the detailed and cross-market data in a 

real time CAT. I also believe new monitoring and surveillance efforts will be developed to take advantage of the consolidated data, 

as the CAT proposal requires the SROs to develop and implement 

enhanced surveillances to make use of the CAT data. For example, 

cross-market order flow could be monitored in real-time for potential problems, which could then be expeditiously addressed, potentially preventing further damage and future problems. 

RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED 

FROM JAMES J. ANGEL 

Q.1. Does the increased reliance in the market on dark pools and 

other types of ‘‘undisplayed liquidity’’ have the potential for negatively affecting public price discovery? If so, does this have the potential of making our markets less efficient? Does it make the markets more prone to bouts of episodic volatility as we saw on May 

6? 

A.1. Price discovery is one of the most important features of our 

public markets. It is important that investors be able to find 

counterparties to their trades and reach agreement on an appropriate price. There is a concern that if too much trading occurs ‘‘in 

the dark,’’ then market quality may deteriorate. 

How much trading can occur in the dark before price discovery 

deteriorates? Statisticians point out that one does not need to 

measure every member of a population in order to measure it. We 

only need a statistically valid sample, which can be a rather small 

fraction of the total population. For example, public opinion polls 

typically only use a few thousand people to get a sense of the opinion of the whole U.S. population. 

There can also be too little trading in dark pools as well as too 

much. Dark pools allow market participants to provide some conditional liquidity that they may not want to provide unconditionally. 

For example, a firm may want to act as a market maker by providing liquidity to retail investors, but wants to avoid trading 

against sophisticated high-speed traders. If the firm were to post 

quotes in the public markets, it may get picked off by the highspeed sharpshooters. The firm may gladly add liquidity to a dark 

pool that caters to retail investors, giving them better executions 

than they would get in the public markets. 
180 

1For details on how U.S. market quality has improved over the last decade, see my study 

(joint with Larry Harris and Chester Spatt) Equity Trading in the 21st Century, available at 

http://papers.ssrn.com/sol3/papers.cfm?abstractlid=1584026. 

I don’t know precisely how much is too much or too little dark 

pool participation rates. This is a question that calls for careful empirical research done. I suspect that we are far from the point of 

having too much activity in dark pools. In general, by most measurable standards, the quality of the U.S equity market has increased in recent years at the same time as activity in dark pools 

has increased. 1

By the way, there is really no such thing in the U.S. as a completely ‘‘dark pool’’ because the moment a trade takes place, a 

flashbulb goes off and the price and volume of the trade are instantly public information. Investors thus know almost immediately the prices at which trades are taking place in the market, 

which certainly helps in price discovery. Dark pools are only dark 

before trades, not afterward. 

With respect to increasing the risk of disruptions such as May 

6, I do not believe that they present any more risk than other market participants. There is always the risk that a computer glitch 

may occur that destabilizes the market network. This can occur 

anywhere in the market network. However, additional trading platforms such as dark pools may provide additional liquidity and additional trading capacity that may ameliorate market disruptions. 

Q.2. In your testimony you argued that both marketwide and 

stock-by-stock circuit breakers should be redesigned and that these 

circuit breakers should be based on ‘‘data integrity’’ as well as 

those based on price. Can you elaborate on this? What would such 

circuit breakers look like, what data would they monitor, and how 

would the system effectively determine the integrity of that data? 

Why wouldn’t these circuit breakers be just as prone to errors as 

those based on price? 

A.2. One of the key lessons of May 6 is the importance of data integrity. The SEC/CFTC report clearly stated that the reason given 

by many firms for pulling out on May 6 was that they were experiencing data integrity problems. The report also indicated that computerized trading firms perform a variety of tests on market data 

and pause trading when they detect the possibility of problems 

with the price feeds, either because of extreme movements in price 

or when different data feeds disagree. It makes sense to design 

data integrity pauses based on what the industry is already doing. 

It would make sense to pause the market under the same conditions that cause the important liquidity providers to pause. Not 

doing so runs the risk that the market will experience another May 

6th event in which technical issues push the liquidity providers to 

the side, but other orders are still allowed to execute at bad prices. 

A quick look at trade data shows the kind of problems that were 

experienced on May 6. The following table shows 25 seconds of normal trading in Accenture on May 6 just before the crash: 
181 

Time Venue Size Price 

2:30:01 PM ............................................................................................................ NASDAQ ........... 100 41.52 

2:30:03 PM ............................................................................................................ NYSE ................ 200 41.51 

2:30:06 PM ............................................................................................................ ADF .................. 200 41.5115 

2:30:12 PM ............................................................................................................ NYSE ................ 100 41.52 

2:30:12 PM ............................................................................................................ NYSE ................ 100 41.52 

2:30:12 PM ............................................................................................................ NYSE ................ 100 41.52 

2:30:15 PM ............................................................................................................ NYSE ................ 100 41.52 

2:30:19 PM ............................................................................................................ NASDAQ BX ..... 200 41.52 

2:30:19 PM ............................................................................................................ NASDAQ BX ..... 100 41.52 

2:30:19 PM ............................................................................................................ ADF .................. 100 41.52 

2:30:19 PM ............................................................................................................ ADF .................. 100 41.52 

2:30:20 PM ............................................................................................................ NYSEARCA ....... 100 41.52 

2:30:20 PM ............................................................................................................ NYSE ................ 100 41.52 

2:30:20 PM ............................................................................................................ ISE ................... 100 41.52 

2:30:20 PM ............................................................................................................ NATIONAL ......... 100 41.52 

2:30:20 PM ............................................................................................................ ADF .................. 100 41.52 

2:30:22 PM ............................................................................................................ ADF .................. 500 41.5201 

2:30:25 PM ............................................................................................................ ADF .................. 4700 41.53 

2:30:25 PM ............................................................................................................ ADF .................. 300 41.53 

Note that the prices are usually the same on each market, and 

when they change the amount of the change is usually less than 

one cent. 

Market quality began to deteriorate. Here are 5 seconds in 

Accenture showing that reported trades on different exchanges are 

getting farther and farther apart in price. Note that there are large 

jumps in price between trades during the same second: 

Time Venue Size Price 

2:46:51 PM ............................................................................................................ NASDAQ ........... 400 38.13 

2:46:51 PM ............................................................................................................ NASDAQ ........... 100 39.01 

2:46:51 PM ............................................................................................................ NYSE ................ 200 39.12 

2:46:51 PM ............................................................................................................ NYSE ................ 100 39.12 

2:46:51 PM ............................................................................................................ NYSEARCA ....... 100 39.02 

2:46:51 PM ............................................................................................................ NYSE ................ 200 39.55 

2:46:51 PM ............................................................................................................ ISE ................... 100 39.02 

2:46:51 PM ............................................................................................................ NYSE ................ 100 39.56 

2:46:51 PM ............................................................................................................ NYSE ................ 100 39.62 

2:46:51 PM ............................................................................................................ ISE ................... 100 39.02 

2:46:51 PM ............................................................................................................ NYSE ................ 200 39.61 

2:46:51 PM ............................................................................................................ NYSE ................ 300 39.61 

2:46:51 PM ............................................................................................................ NYSE ................ 100 39.53 

2:46:52 PM ............................................................................................................ NYSE ................ 100 39.36 

2:46:52 PM ............................................................................................................ NYSE ................ 100 39.36 

2:46:52 PM ............................................................................................................ NYSE ................ 200 39.16 

2:46:53 PM ............................................................................................................ NASDAQ ........... 300 39.11 

2:46:53 PM ............................................................................................................ ISE ................... 100 39.04 

2:46:54 PM ............................................................................................................ NASDAQ ........... 500 38.00 

2:46:55 PM ............................................................................................................ NYSEARCA ....... 100 38.13 

2:46:55 PM ............................................................................................................ NYSEARCA ....... 100 38.13 

2:46:55 PM ............................................................................................................ NYSEARCA ....... 100 38.13 

2:46:55 PM ............................................................................................................ NYSEARCA ....... 609 38.00 

The markets continued to disintegrate. Here are 2 seconds showing the disconnection of the market centers: 
182 

Time Venue Size Price 

2:47:47 PM ............................................................................................................ NASDAQ ........... 100 34.61 

2:47:47 PM ............................................................................................................ NYSEARCA ....... 151 32.62 

2:47:47 PM ............................................................................................................ NYSEARCA ....... 3780 32.62 

2:47:47 PM ............................................................................................................ NASDAQ ........... 100 32.40 

2:47:47 PM ............................................................................................................ NASDAQ ........... 100 33.69 

2:47:47 PM ............................................................................................................ NASDAQ ........... 100 33.69 

2:47:47 PM ............................................................................................................ NASDAQ ........... 100 33.69 

2:47:47 PM ............................................................................................................ NASDAQ ........... 100 32.40 

2:47:47 PM ............................................................................................................ NASDAQ ........... 200 31.91 

2:47:47 PM ............................................................................................................ CBOE ............... 100 31.80 

2:47:47 PM ............................................................................................................ NASDAQ ........... 150 31.79 

2:47:47 PM ............................................................................................................ NYSEARCA ....... 100 39.10 

2:47:48 PM ............................................................................................................ NASDAQ ........... 155 31.26 

2:47:48 PM ............................................................................................................ NASDAQ ........... 145 31.26 

2:47:48 PM ............................................................................................................ NASDAQ ........... 100 30.79 

2:47:48 PM ............................................................................................................ CBOE ............... 100 31.60 

2:47:48 PM ............................................................................................................ NASDAQ BX ..... 300 33.34 

2:47:48 PM ............................................................................................................ NASDAQ BX ..... 170 31.72 

2:47:48 PM ............................................................................................................ ADF .................. 100 32.125 

2:47:48 PM ............................................................................................................ NASDAQ ........... 100 29.34 

2:47:48 PM ............................................................................................................ CBOE ............... 100 30.92 

2:47:48 PM ............................................................................................................ NASDAQ ........... 186 28.12 

A few seconds later we hit the well-known Armageddon: 

Time Venue Size Price 

2:47:54 PM ............................................................................................................ NASDAQ ........... 100 1.84 

2:47:54 PM ............................................................................................................ NASDAQ ........... 100 0.01 

2:47:54 PM ............................................................................................................ CBOE ............... 100 0.01 

2:47:54 PM ............................................................................................................ NASDAQ ........... 100 1.74 

2:47:54 PM ............................................................................................................ CBOE ............... 100 0.01 

2:47:54 PM ............................................................................................................ NASDAQ ........... 100 1.54 

2:47:54 PM ............................................................................................................ NASDAQ ........... 100 1.44 

2:47:54 PM ............................................................................................................ NASDAQ ........... 100 1.34 

2:47:54 PM ............................................................................................................ NASDAQ ........... 100 1.24 

2:47:54 PM ............................................................................................................ CBOE ............... 100 0.01 

2:47:54 PM ............................................................................................................ NASDAQ ........... 100 1.14 

Later more normal conditions returned: 

Time Venue Size Price 

2:59:35 PM ............................................................................................................ BATS ................ 100 40.68 

2:59:35 PM ............................................................................................................ NYSE ................ 200 40.68 

2:59:37 PM ............................................................................................................ NYSE ................ 100 40.69 

2:59:37 PM ............................................................................................................ ISE ................... 100 40.68 

2:59:37 PM ............................................................................................................ NYSE ................ 100 40.69 

2:59:40 PM ............................................................................................................ ADF .................. 100 40.69 

2:59:44 PM ............................................................................................................ ADF .................. 100 40.70 

2:59:45 PM ............................................................................................................ BATS ................ 100 40.69 

2:59:45 PM ............................................................................................................ BATS ................ 200 40.69 

2:59:45 PM ............................................................................................................ BATS ................ 100 40.69 

2:59:45 PM ............................................................................................................ NYSE ................ 100 40.69 

2:59:45 PM ............................................................................................................ BATS ................ 100 40.69 

2:59:46 PM ............................................................................................................ NYSEARCA ....... 100 40.68 

2:59:46 PM ............................................................................................................ BATS ................ 100 40.68 

2:59:46 PM ............................................................................................................ NYSE ................ 100 40.68 

2:59:49 PM ............................................................................................................ BATS ................ 100 40.68 
183 

Time Venue Size Price 

2:59:49 PM ............................................................................................................ NYSE ................ 100 40.68 

A data integrity pause could be one in which the market supervisor monitors the quality of the data feed and calls a 5 minute 

halt when any one of a number of anomalous situations occur. 

These situations could include: 

• Price gap between exchanges greater than 5 cents. 

• Price jump of +/- 10 percent in 5 minutes or less (current circuit breaker) 

• Price discrepancy between data feeds, such as the direct feed 

from an exchange and the consolidated quote. 

• Crossed or locked market quotes 

• Bid-ask spread larger than some amount 

These pauses should be done on a stock by stock basis, as the 

exchanges often run different stocks on different computers. For example, symbols AAAA through CZZZ may be on one server, DAAA 

through FZZZ on another, and so forth. By pausing only those 

stocks that are experiencing problems, overall disruptions to the 

market are minimized. 

There are two types of errors in circuit breakers: One type of 

error is to not halt trading when it is clear that the market mechanism is misfiring. The other type of error is to halt trading when 

the market should not be halted. We have seen both types of errors 

in the last year. 

Clearly, data integrity pauses would be subject to both Type I 

and Type II errors. However, it is my belief that including such 

pauses would prevent more serious breaches of the type we saw on 

May 6. 

Careful consideration needs to be paid to the design of these systems, especially since they will be called upon at times when the 

market is under great stress and when the need for good price discovery is most important. The basic goal of circuit breakers is to 

maintain fair and orderly markets by stopping the market when 

the market mechanism is likely to be producing incorrect prices. 

This maintains the integrity of the market and prevents trades 

that have to be busted later. 

The marketwide circuit breakers instituted after the Crash of 

1987 were based on the notion that stopping the entire market 

after a large drop in prices would provide time for investors to assess what was happening in the market, to assimilate any new information that had arrived, and to bring additional liquidity to the 

market. In the Crash of 1987, the market mechanism could not 

keep up with the flood of trading, much as the market mechanism 

could not keep up with the flow of activity in the Flash Crash of 

2010. 

We learned on May 6 that a disruption can occur for technical 

reasons. Imagine what would have happened on May 6 if the drop 

had been just a little more severe and a few minutes earlier. It 

would have triggered the 1 hour trading halt, causing headlines 

around the world: ‘‘Stock market crashes. Trading Halted!’’ Many 
184 

investors may have interpreted the event as signaling fundamental 

news, and additional panic selling may have occurred in other markets still open, such as the bond and currency markets. Furthermore, the closed market may have led to more panic selling when 

the market reopened. 

The stock-by-stock circuit breakers imposed in some stocks after 

May 6 were a step forward, but they need to be refined. Such protection needs to be applied to all stocks, not just the ones in the 

current pilot. Also, methods need to be found to prevent erroneous 

trades from occurring and triggering the circuit breakers when 

they should not be triggered. 

Q.3. What is your view on limit up/limit down price banding idea 

referred to in Chairman Schapiro’s testimony? 

A.3. I think that the limit up/limit down idea is conceptually appealing because it looks like a method for preventing erroneous 

trades: Just don’t let any trades take place outside of a given band. 

However, it has a fatal flaw that will result in many complaints to 

the regulators. In a limit up/limit down system, there is a price 

band within which trades are allowed to occur. For example, if the 

reference price is $10 and the band is 10 percent, then trades could 

occur anywhere between $9 and $11. The system automatically rejects any trades outside the band. 

Clearly, there are times when the price should move outside the 

band because new information has arrived. All limit up/limit down 

mechanisms allow for an eventual reset in the trading band. At 

some exchanges, the trading band is set for the entire day and 

resets the next day. Some of the proposals currently circulating call 

for a faster reset of the band, perhaps after several minutes. 

Alas, a limit up/limit down system does not stop trading and 

thus allows unsophisticated retail investors to trade at what is demonstrably not the fair price of the asset. This will cause an enormous number of complaints from retail investors to the regulators 

and to legislators. Here is an example: 

The current band is from $9 to $11. News comes out that a takeover offer has been made at $20 per share. Buyers immediately 

start buying and quickly push the price up to the limit. The stock 

is stuck at the limit with orders to buy at $11 but no sellers at that 

price. At some point, the band will be reset so the stock can trade 

at its new fair and higher price. However, an unsophisticated retail 

investor who submits a market sell order during this time will be 

executed at $11. Shortly thereafter, the band resets and the price 

jumps. The investor feels that he or she has been taken advantage 

of and complains to the regulators as well as to their congressional 

representatives. 

If any such system is put in place, it should be tested in a carefully controlled pilot experiment that investigates different sized 

bands and different reset periods. 

Q.4. Many claim that one of the benefits of high-frequency traders 

is that they supply needed liquidity to the market. Yet the events 

of May 6 seem to show that this liquidity is fleeting and disappears 

when it is needed most. As such, do the events of May 6 demonstrate that this liquidity is only illusionary? If so, what, if any-
185 

2http://www.sec.gov/news/studies/2010/marketevents-report.pdf 

thing, should be done to ensure that the liquidity high-frequency 

traders claim to offer is there in bad times as well as the good? 

A.4. The SEC/CFTC report investigated why these firms stopped 

trading. 2 The report stated on page 35 ‘‘As such, data integrity was 

cited by the firms we interviewed as their number one concern. To 

protect against trading on erroneous data, firms implement automated stops that are triggered when the data received appears 

questionable.’’ And on page 36: ‘‘Whenever data integrity was questioned for any reason, firms temporarily paused trading in either 

the offending security, or in a group of securities.’’ 

Indeed, it is quite reasonable for these firms to stop trading 

when they detect the possibility of machine malfunctions. They 

cannot know where the malfunctions are occurring, and if they 

trade based on bad data they could lose enormous amounts of 

money in a short time and cause havoc in the rest of the market. 

The implication is simple: If we want these firms to keep providing liquidity when the market is under stress, we need to make 

sure that the market has data integrity when the market is under 

stress. This is another reason to have data integrity pauses as discussed above. 

I am not a fan of rules that try to force market makers to trade 

when they don’t want to trade. Imposing such costs will result in 

fewer firms willing to make markets. Even if there are such rules, 

firms will try to get around them when the market is under stress. 

This was especially apparent in the Crash of 1987 when there were 

widespread accusations that NASDAQ market makers and NYSE 

specialists were not living up to their market maker obligations at 

that time. 

Markets that have affirmative obligations for market makers 

generally also give market makers special privileges in their systems, such as special access to the market unavailable to others. 

This gave them an edge that offset the cost of their affirmative obligations. For example, the old NASDAQ system did not allow customer limit orders to compete directly with dealer quotes. Market 

structure changes over the last decade have eliminated these advantages, which has led to a decline in the number of traditional 

market makers. Any proposal to impose obligations should also be 

very clear as to what special privileges will be given to market 

makers in compensation. 

One way to improve the liquidity provided by market makers is 

to permit the issuers to contract directly with and pay market 

makers for providing liquidity. This would allow the firm to compensate market makers for the expected losses they would experience by providing liquidity at times when they would otherwise 

choose not to do so. This system, which is used in Europe, is not 

currently permitted under current FINRA rules. Our rules should 

be changed to permit experimentation with this approach. 

Q.5. What are the economic tradeoffs that need to be considered in 

placing curbs on the use of high-frequency trading in the markets? 

What might such curbs look like? 
186 

3For more details on the beneficial as well as harmful uses of high-frequency trading, see 

my joint work with Douglas McCabe available at http://papers.ssrn.com/sol3/papers.cfm?abstractlid=1737887. 

A.5. Traders use fast computers for a number of applications, many 

of which are beneficial to the market such as market making and 

arbitrage. 3 Any curbs on high-frequency trading run the risk of 

curbing such beneficial trading more than any harmful trading. I 

personally do not see a need for curbs on all high-frequency trading 

as such, and would want to see good empirical data demonstrating 

harm before imposing any curbs. 

There are numerous potential curbs on high-frequency trading. 

Abusive strategies such as spoofing should be curbed by an enforcement regime good enough that any spoofers are quickly caught and 

sanctioned. 

Excessive cancellations impose bandwidth costs on other market 

participants who must process all the data generated. One simple 

curb would be a speed limit on the number of quote updates in a 

given security in a given time. If a market participant cancels more 

than 200 orders per second in a given stock in a given exchange, 

then that exchange would reject all orders in that stock from that 

participant for the next 5 seconds. 

Another approach is economic rather than regulatory. Surveillance costs increase with the amount of message traffic. As we consider the design and funding of the new consolidated audit trail 

system, part of the cost allocation could be based on the amount 

of message traffic generated by a given participant. 

I am not in favor of requiring orders to have a minimum time 

in force for the following reason. There are times when it is appropriate for a long-term investor to cancel a legitimate order, even if 

it was just placed a nanosecond ago. For example, a patient mutual 

fund may be trying to accumulate shares by placing buy orders at 

the current bid. It uses a computer algorithm that places orders at 

the bid. When the algorithm senses that the price is going down 

(perhaps by seeing the bid fall on another exchange), it cancels the 

order at the bid and replaces it with a new order at the new lower 

bid. If this mutual fund was unable to cancel the order when the 

market moves, it will be picked off by sharp-shooting high-frequency traders. The result is that the mutual fund will experience 

higher transactions costs when filling its orders. 

Q.6. Should there be serious consideration of removing the SRO 

function out of the individual exchanges and placing it into a single 

SRO? Should this consideration be extended to include a single 

SRO responsible for the equities as well as the futures markets? 

Could that possible be a way to reduce the regulatory fragmentation that many of the witnesses, including you, mentioned in their 

testimony? 

A.6. Yes, we should consider separating the operation of a trading 

platform from that of enforcing our securities laws. The business 

of running a trading platform is very different from the business 

of enforcing Federal securities laws. Our financial markets have 

changed dramatically since the SRO model was adopted in the Securities Exchange Act of 1934. In 1934, the deputizing of the NYSE 

made sense as the NYSE was by far the dominant force in the U.S. 
187 

equity market. This no longer makes sense in our more modern 

and competitive markets. 

Exchanges currently have two types of regulatory responsibilities 

under section 6(b)1 of the Securities Exchange Act of 1934: They 

must be able to enforce compliance with their own rules as well as 

national securities laws. Clearly exchanges have a clear commercial 

interest to enforce their own rules. Calling on them to enforce national securities laws is more problematic. How should the duties 

be divided among the exchanges? Traditionally, the listing exchange bore the bulk of the responsibility. However, this does not 

work well in a competitive environment. It is not fair to have one 

exchange do all the regulation and then charge the other exchanges. It is almost impossible to allocate the costs in such a way 

as to avoid either over or under charging the other exchanges. 

Different regulatory functions naturally reside in different 

places. The exchanges naturally have an incentive to enforce their 

own rules. However, a manipulative trading strategy may involve 

numerous different instruments traded in numerous venues. It 

makes sense for a marketwide regulator such as FINRA to surveil 

for trading abuses, paid for fairly with a charge on transactions 

similar to the SEC fee. 

The idea of a single SRO for all financial products (including securities, commodities, and insurance) is very appealing and should 

be seriously explored. 

RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED 

FROM THOMAS PETERFFY 

Q.1. Many claim that one of the benefits of high-frequency traders 

is that they supply needed liquidity to the market. Yet the events 

of May 6 seem to show that this liquidity is fleeting and disappears 

when it is needed most. As such, do the events of May 6 demonstrate that this liquidity is only illusionary? If so, what, if anything, should be done to ensure that the liquidity high-frequency 

traders claim to offer is there in bad times as well as the good? 

A.1. There are hundreds of high frequency trading (HFT) operations that exist today and more will come into being in the future. 

They employ different strategies and practices that change often. 

Some provide liquidity most of the time while others take liquidity. 

Some trade continuously throughout the day, while some wait for 

opportunities to arise in the markets. 

I would suggest two alternatives that would increase liquidity 

and reduce abusive trading on the part of HFTs. 

A. A simpler but less beneficial solution would be to delay all orders, regardless of their origin, to the exchanges’ matching 

engines by a tenth of a second when those orders take liquidity (i.e., buy orders priced at the best offer or above and sell 

orders priced at the best bid or below). This would decrease 

the ability of HFTs to take liquidity and in turn increase liquidity providers’ willingness to provide liquidity. 

B. A more encompassing alternative would be to delay the transmission of ALL orders to the exchanges’ matching engines, 

with the sole exception of quotes transmitted by market mak-
188 

ers for products in which they are registered and have undertaken the obligation of providing quotes of minimum size and 

width, depending on market conditions, on a continuous basis. 

This measure would incentivize HFTs to become regulated 

market makers, and reaffirm the obligations and incentives of 

currently registered market makers to continue in their function. 

Either alternative that is chosen should apply to all stock, option 

and futures markets. 

Q.2. What are the economic tradeoffs that need to be considered in 

placing curbs on the use of high-frequency trading in the markets? 

What might such curbs look like? 

A.2. With the growing participation of HFTs, the interaction in the 

market place between: (a) market makers and customers, and (b) 

customers with each other, have diminished (i.e., HFTs are stepping in the middle of these trades). Anecdotal evidence points to 

HFT annual revenues of $2 to $5 billion. Some of this comes from 

traditional market makers who have lost some of their business to 

HFTs but the bulk comes from institutional and retail customers. 

Accordingly, reduced HFT participation would benefit customers. 

HFTs are large customers of certain brokers and of the exchanges 

and pay substantial exchange fees. Any reduction of HFT activity 

would have a negative impact on exchange revenues. It would also 

reduce the income of their brokers that tend to be small, undercapitalized firms. 

Proposed curbs on HFT activity that are often mentioned in the 

press include the prohibition of canceling orders for a certain period of time, limiting the number of submitted orders to some multiple of orders actually executed, or financial penalties for frequent 

order submission. However, all these measures would act to reduce 

liquidity. Either of the proposals outlined in (A) and (B) above 

would be a much more constructive approach to channeling HFT 

activity into a more productive use while still allowing HFTs to 

participate actively in markets. 

Q.3. Should there be serious consideration of removing the SRO 

function out of the individual exchanges and placing it into a single 

SRO? Should this consideration be extended to include a single 

SRO responsible for the equities as well as the futures markets? 

Could that possibly be a way to reduce the regulatory fragmentation that several of the witnesses mentioned in their testimony? 

A.3. YES, DEFINITELY! 
189 

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Letter Submitted by Timothy B. Henseler, Deputy Director, Securities and 

Exchange Commission 
190 
191